Question

How can the government use monetary policy and fiscal policy to reduce the effects of an economic crisis?...


How can the government use monetary policy and fiscal policy to reduce the effects of an economic crisis?

Answer

Monetary policy refers to the policy of central bank of change in the money supply to affect the economic growth. The two types of monetary policy are: expansionary monetary policy and contractionary monetary policy. Expansionary monetary policy increases the money supply in the economy to simulate the economy.  Contractionary monetary policy decreases the money supply to decrease the inflation. 

On the other hand, fiscal policy refers to the government policy of tax, subsidy, and government expenditure. The two types of fiscal policy are: expansionary fiscal policy and contractionary fiscal policy. Expansionary fiscal policy tries to increase the aggregate demand to stimulate the economy and contractionary fiscal policy tries to decrease the aggregate demand to keep the economy under potential level.    

 

In the case of economic crisis, economy experience a fall in the national income level, aggregate demand, employment, and living standard. The effect of economic crisis can be overcome with the help of expansionary monetary policy or expansionary fiscal policy, or both. 

The expansionary monetary policy increases the money supply in the economy. It increases the money holding in the hands of people, which enables the people to demand more goods and services. It reflects an increase in the aggregate demand, which will encourage businesses to increase their production level. Thus, the economy will stipulate and recover from economic crisis.

The expansionary fiscal policy (increase in subsidy or decrease in tax) directly increases the disposable income of households. Increased income level increases the aggregate demand in the economy, which encourages the production level. Thus, it increases the economic growth and helps in recovering the economy from crisis.

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