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Discuss monetary policy and fiscal policy’s importance for the USA, in the light of stagflation.

Introduction to Monetary and Fiscal Policy, and Stagflation

Monetary policy means to control the money supply and interest rates to affect aggregate demand (AD) in an economy, according to what is known as demand-management. Fiscal policy is another demand-management policy that deals with manipulating government spending and direct taxes so as to affect AD. Stagflation is defined as a situation of low economic growth with high inflation - both stagnation and inflation. Inflation is defined as a persistent and sustained increase in the general price level (GPL), that poses a problem to society because this increase in GPL is sustained and inordinate. 

This Economics paper discusses the strengths and limitations of monetary and fiscal policy, each in turn, in relation to stagflation in the USA. This paper concludes that both policies are equally important for the US, but they should be used in conjunction with supply side policy. 

Monetary Policy

Monetary policy works, in theory, by two ways. First, according to the classical direct transmissions mechanism, increases in money supply help consumers spend more and firms invest more directly because they have more money and they feel richer. Second, according to the indirect transmissions mechanism, increases in the money supply lower the interest rate, which lowers the cost of borrowing. Since it is cheaper for households to borrow money to consume, and cheaper for firms to borrow money to invest, C and I both increase, and since AD = C + I + G + (X-M), then AD increases, which helps to solve unemployment and which also causes actual economic growth. 

Unemployment is defined simply as the situation where people who are able and willing to work cannot find jobs, or they are unwilling to take up the jobs at the wage rate given to them. Actual economic growth merely refers to increases in real output at the macroeconomic level caused by increases in AD. Hence, it would seem that prima facie, monetary policy can help solve unemployment and lack of growth in the USA, and hence fight stagflation by countering the “stagnation” part.  

Limitations of Monetary Policy

However, monetary policy might suffer from the liquidity trap, which means that beyond a certain point interest rates cannot be lowered further, thus hampering the workings of monetary policy. If interest rates cannot be lowered, the costs of borrowing cannot be reduced. This can be seen in an analysis of the liquidity preference theory put forth by Keynes. 

Fiscal Policy

On the other hand, Keynesian fiscal policy works when governments spend more, for instance on national defence and education, or when they tax less, through lowering income and corporate taxes. Increasing G raises AD directly given that G is one of the components of AD. Lowering direct taxes cause C and I both to increase, and since AD = C + I + G + (X-M), then AD also increases, which helps to solve unemployment and which also causes actual economic growth. Because of the multiplier effect, where the multiplier means that national income increases by a factor more than the initial increase in the injections into the economy, the USA’s AD will increase, promoting and boosting growth. 

In the USA, both C and I are large components of the AD. It can also be argued that G is also a big component given that the USA has a large military. Hence, it would seem that prima facie, fiscal policy can also help solve unemployment and lack of growth in the USA, and thus fight stagflation by countering the “stagnation” part.  

Limitations of Fiscal Policy

However, there are also limitations to fiscal policy, one of which is the famous “crowding out effect”. If governments run a budget deficit, and the USA is arguably famous for running both a budget as well as a trade deficit for many years, then they will have to borrow money. According to the loanable funds theory, this increase in demand for funds by governments will crowd out private consumption and investment, and hence C and I will fall despite G increasing, thus negating the effects of fiscal policy. The US government would be “crowding out” private consumption and investment. 

Supply Side Policies?

Hence, supply side policies that target the aggregate supply (AS) curve, which is affected by the factors of production which are land, labour, capital, and enterprise, could be better for the USA in handling stagflation. Subsidies for energy and other natural resources, increases in the US labour force in both numbers and quality, for instance by increasing American high school education and human capital, and increases in both the quantity and quality of American capital, plus encouraging immigration especially of entrepreneurial foreigners, would help massively. 

These methods and means would shift the AS curve both down and to the right and help solve cost push inflation in the USA. These would be better because they would solve both the “lack of growth” and “high inflation” aspects. 


In conclusion, perhaps both demand side and supply side policies should be used hand in hand, and together they can help solve stagflation because they encourage both potential and actual growth, which is great for the American economy. 

JC Economics Essays: Tutor's Comments - This Macroeconomics essay on monetary policy and fiscal policy, set in the context of the USA, is interesting and provides a suitable level of analysis. There are consistent references to the USA as well as relevant macroeconomic policies, and the underlying economic reasoning behind those policies. There are also well-defined terms that are explained clearly. Note: this particular Economics essay on the USA is related to the earlier Economics question on stagflation: Explain possible causes of stagflation in the USA. However, my usual question applies here: if you were the Economics tutor grading this Economics paper, what areas of improvement would you suggest? Let's look, for example, at the conclusion. While this essay's conclusion makes a good argument and tries to justify the argument made, there is a lack of detailed evaluation which could possibly make it an even better essay. What other areas of improvement for this Economics essay do you observe or notice? Thanks for reading and cheers!

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