Republic of the Philippines

Surigao del Sur State University

Rosario, Tandag City, Surigao del Sur 8300
Telefax No. 086-214-4221
Website: www.sdssu.edu.ph

Lesson 7
MONETARY AND FISCAL POLICY

This lesson guide concludes the uses and limitations of monetary

and fiscal policy and discusses the basic economic concepts behind
INTRODUCTION: both monetary and fiscal policies and how they are used to impact a
country's economy and population, and how supply and demand
affects monetary circulation and interest rates.
At the end of this lesson, the students should be able to:
INTENDED LEARNING
OUTCOMES: Understand the rationale behind the governments monetary
and fiscal policies
Print Materials:
Readings
Syllabus
INSTRUCTIONAL MATERIALS: Lesson/Assignment Files
Handouts
Online discussion via Zoom and LMS

LESSON DEVELOPMENT

Pre-Test:
BRAINSTORMING I. True or False. Read carefully each sentence and determine if the sentence is
True or False.
Direction: Just simply
answer the following 1. Cutting taxes is an expansionary fiscal policy
questions.
2. Decreasing taxes and increasing government spending will lead to deficit
spending.
3. Monetary Policy is managed by Central Bank
4. Raising taxes is a contractionary fiscal policy.
5. Fiscal policy is managed by the Government.

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 Republic of the Philippines
Surigao del Sur State University
Rosario, Tandag City, Surigao del Sur 8300
Telefax No. 086-214-4221
Website: www.sdssu.edu.ph

6. Central Bank will act as a “lender of last resort” if a bank runs into liquidity
problems.
7. In general, fiscal policy requires less time to plan and carry out than
monetary policy does.
8. Central Bank helps with fiscal policy.
9. Fiscal policy involves changing the interest rate and influencing the money
supply.
10. Monetary policy involves the government changing tax rates

 Monetary vs. Fiscal Policy

 Monetary policy involves changing the interest rate and influencing the money supply.
 Fiscal policy involves the government changing tax rates and levels of government spending to
influence aggregate demand in the economy.
 They are both used to pursue policies of higher economic growth or controlling inflation.

Fiscal Policy Monetary Policy

Change in government spending and tax rates
Set by the government
No specific target
Side effect on government budget/borrowing
Strong political dimension to changing tax rates
Change in interest rates/money supply
Set by a central bank
Target inflation
Side effect on exchange rate and housing market
Mostly independent from the political process

Monetary policy

 Monetary policy is usually carried out by the Central Bank/Monetary authorities and involves:
 Setting base interest rates (e.g. Bank of England in UK and Federal Reserve in the US)
 Influencing the supply of money. E.g. Policy of quantitative easing to increase the supply of money.

How monetary policy works

 The Central Bank may have an inflation target of 2%. If they feel inflation is going to go above the
inflation target, due to economic growth being too quick, then they will increase interest rates.

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 Republic of the Philippines
Surigao del Sur State University
Rosario, Tandag City, Surigao del Sur 8300
Telefax No. 086-214-4221
Website: www.sdssu.edu.ph

 Higher interest rates increase borrowing costs and reduce consumer spending and investment,
leading to lower aggregate demand and lower inflation.
 If the economy went into recession, the Central Bank would cut interest rates.

Types of Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They reduce the money supply by
restricting the volume of money banks can lend. The banks charge a higher interest rate, making loans
more expensive. Fewer businesses and individuals borrow, slowing growth.

Central banks use expansionary monetary policy to lower unemployment and avoid recession. They
increase liquidity by giving banks more money to lend. Banks lower interest rates, making loans cheaper.
Businesses borrow more to buy equipment, hire employees, and expand their operations. Individuals
borrow more to buy more homes, cars, and appliances. That increases demand and spurs economic
growth.

INDIVIDUAL WORK

Answer the question briefly but thoroughly.

 Discuss, which monetary policy is better for our economy?
Expansionary or contractionary monetary policy?

Fiscal policy

Fiscal policy is carried out by the government and involves changing:

 Level of government spending
 Levels of taxation
o To increase demand and economic growth, the government will cut tax and increase spending
(leading to a higher budget deficit)
o To reduce demand and reduce inflation, the government can increase tax rates and cut
spending (leading to a smaller budget deficit)

Types of fiscal policy

There are two main types of fiscal policy: expansionary and contractionary. Expansionary fiscal policy,
designed to stimulate the economy, is most often used during a recession, times of high unemployment or
other low periods of the business cycle. It entails the government spending more money, lowering taxes or

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 Republic of the Philippines
Surigao del Sur State University
Rosario, Tandag City, Surigao del Sur 8300
Telefax No. 086-214-4221
Website: www.sdssu.edu.ph

both. The goal is to put more money in the hands of consumers so they spend more and stimulate the
economy. Contractionary fiscal policy is used to slow economic growth, such as when inflation is growing
too rapidly. The opposite of expansionary fiscal policy, contractionary fiscal policy raises taxes and cuts
spending.

INDIVIDUAL WORK

Answer the question briefly but thoroughly.

 Describe how expansionary fiscal policy works?

Which is more effective monetary or fiscal policy?

In recent decades, monetary policy has become more popular because:

o Monetary policy is set by the Central Bank, and therefore reduces political influence (e.g. politicians
may cut interest rates in the desire to have a booming economy before a general election)
o Fiscal policy can have more supply side effects on the wider economy. E.g. to reduce inflation –
higher tax and lower spending would not be popular, and the government may be reluctant to
pursue this. Also, lower spending could lead to reduced public services, and the higher income tax
could create disincentives to work.
o Monetarists argue expansionary fiscal policy (larger budget deficit) is likely to cause crowding out –
higher government spending reduces private sector expenditure, and higher government borrowing
pushes up interest rates. (However, this analysis is disputed)
o Expansionary fiscal policy (e.g. more government spending) may lead to special interest groups
pushing for spending which isn’t really helpful and then proves difficult to reduce when the
recession is over.
o Monetary policy is quicker to implement. Interest rates can be set every month. A decision to
increase government spending may take time to decide where to spend the money.
However, the recent recession shows that monetary policy too can have many limitations.
o Targeting inflation is too narrow. During the period 2000-2007, inflation was low but central banks
ignored an unsustainable boom in the housing market and bank lending.

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 Republic of the Philippines
Surigao del Sur State University
Rosario, Tandag City, Surigao del Sur 8300
Telefax No. 086-214-4221
Website: www.sdssu.edu.ph

o Liquidity trap. In a recession, cutting interest rates may prove insufficient to boost demand because
banks don’t want to lend and consumers are too nervous to spend. Interest rates were cut from 5%
to 0.5% in March 2009, but this didn’t solve recession in the UK.
o Even quantitative easing – creating money may be ineffective if banks just want to keep the extra
money on their balance sheets.
o Government spending directly creates demand in the economy and can provide a kick-start to get
the economy out of recession. Thus, in a deep recession, relying on monetary policy alone, may be
insufficient to restore equilibrium in the economy.
o In a liquidity trap, expansionary fiscal policy will not cause crowding out because the government is
making use of surplus saving to inject demand into the economy.
o In a deep recession, expansionary fiscal policy may be important for confidence – if monetary
policy has proved to be a failure.

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