Monetary Policy Vs. Fiscal Policy

According to monetarists, money is very important in determining the level of aggregate demand and that monetary policy is very potent. In contrast, they claim that fiscal policy, unless accompanied by a change in the money supply, is impotent, at least in the long run.

In maintaining that fiscal policy is ineffective, monetarists stress that an increase in government spending must be financed by a tax increase, by issuing government debt, or by issuing high-powered money. If the increase is financed by a tax increase or by issuing government debt, they claim that the increase in government spending is offset by the decrease in private spending (known as "crowding-out effect"), which occurs as a result of the tax increase or increase in government debt. Since the increase in government spending results in a corresponding decrease in private spending, private spending is said to be crowded-out by the government spending. As a consequence, little or no increase in output occurs in the long run. In contrast, if the increase in government spending is financed by an increase in high-powered money, private spending is not crowded-out and this results in higher growth rates of output and employment.

To summarize, monetarists argue that monetary policy is very effective and powerful. They regard changes in money stock as the most important cause of changes in output, employment and prices. At the same time they consider fiscal policy, unless supported by changes in the money supply, as ineffective. On the contrary, Keynesians, although conceding the effectiveness of the monetary policy, contend that fiscal policy, even in the absence of a change in the money stock, is reliable. They maintain that the government should maintain an activist stance with a combination of tax and expenditure policies to maintain the desired levels of output and employment through manipulation of aggregate demand or effective demand.