The Growing Importance of Monetary Policy

The growing importance of monetary policy and the diminishing role played by fiscal policy in economic stabilization efforts may reflect both political and economic realities. The experience of the 1960s, 1970s, and 1980s suggests that democratically elected governments may have more trouble using fiscal policy to fight inflation than unemployment. Fighting inflation requires government to take unpopular actions like reducing spending or raising taxes, while traditional fiscal policy solutions to fighting unemployment tend to be more popular since they require increasing spending or cutting taxes. Political realities, in short, may favor a bigger role for monetary policy during times of inflation.

One other reason suggests why fiscal policy may be more suited to fighting unemployment, while monetary policy may be more effective in fighting inflation. There is a limit to how much monetary policy can do to help the economy during a period of severe economic decline, such as the United States encountered during the 1930s. The monetary policy remedy to economic decline is to increase the amount of money in circulation, thereby cutting interest rates. But once interest rates reach zero, the Fed can do no more. The United States has not encountered this situation, which economists call the "liquidity trap," in recent years, but Japan did during the late 1990s. With its economy stagnant and interest rates near zero, many economists argued that the Japanese government had to resort to more aggressive fiscal policy, if necessary running up a sizable government deficit to spur renewed spending and economic growth.

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This article is adapted from the book "Outline of the U.S. Economy" by Conte and Carr and has been adapted with permission from the U.S. Department of State.