Fiscal, Monetary and Supply-Side Policy: Question 4

Worked solution

Part (a): How a higher interest rate reduces AD

A rise in Nordevik’s central bank interest rate from $4\%$ to $7\%$ raises the cost of borrowing throughout the economy. For households, loans, mortgages and credit-card borrowing all become more expensive, which discourages borrowing to fund consumption, especially on big-ticket or credit-financed items (reducing consumption (C). At the same time, a higher interest rate makes saving more attractive, since savers now earn a higher return, giving households a further reason to spend less and save more. For firms, a higher interest rate raises the cost of financing new capital projects, so fewer investment projects remain profitable once the higher cost of borrowing is taken into account) reducing investment (I).

Since $AD = C + I + G + (X-M)$, the falls in C and I both directly reduce Aggregate Demand.

Part (b): AD/AS effect of contractionary monetary policy

Because C and I both fall, Nordevik’s AD curve shifts to the left. Holding the aggregate supply curve constant, a leftward shift in AD moves the equilibrium to a point further down and to the left along the AS curve. This lowers the equilibrium price level, reducing the inflationary pressure the central bank is trying to address, and lowers the equilibrium level of real output, which represents a possible cost of using this contractionary policy (for example, slower growth or a rise in unemployment).

Part (c): Discussing monetary versus fiscal policy for controlling inflation

There is a case for the statement. An independent central bank can typically change the policy interest rate quickly, often at a regularly scheduled meeting, without needing new legislation. Fiscal policy, by contrast, usually requires a government to design and pass new tax rates or spending plans, a process that can take much longer and is often subject to political negotiation and delay. Because central banks are usually insulated from short-term electoral pressure, an interest rate rise can also be easier to implement than an unpopular tax rise or spending cut, which elected politicians may be reluctant to carry out, especially close to an election.

However, the word “always” makes the statement too strong. The effectiveness of an interest rate rise depends heavily on how sensitive households’ and firms’ borrowing and spending decisions actually are to the cost of credit: if consumers hold relatively little variable-rate debt, or if firms’ investment decisions are driven mainly by expectations of future demand rather than borrowing costs, a rise in interest rates may have only a weak and unpredictable effect on AD. Even where the interest rate channel does work, it can take many months for changes in borrowing costs to feed through into actual changes in spending, so the full effect on inflation can be just as slow to appear as a fiscal policy change. Fiscal policy, by contrast, can act more directly and mechanically on AD, a specific cut in a government spending programme, once implemented, removes that spending from AD immediately and fairly predictably.

Overall, whether monetary policy is faster and more reliable than fiscal policy for controlling inflation depends on factors such as how sensitive Nordevik’s households and firms are to interest rate changes, the credibility and independence of its central bank, and the political conditions surrounding any fiscal tightening at the time. It is therefore not correct to say contractionary monetary policy is always superior to contractionary fiscal policy. Each policy has circumstances in which it is likely to work faster or more reliably than the other.

Final answers

• (a) A higher interest rate reduces both consumption (higher cost of borrowing, greater incentive to save) and investment (higher cost of financing capital projects), so AD falls
• (b) AD shifts left; holding AS constant, both the equilibrium price level and equilibrium real output fall
• (c) Monetary policy can be faster and more politically straightforward, but its effect depends on the responsiveness of borrowing to interest rates and can still be slow to transmit, so it is not always faster or more reliable than fiscal policy. The answer depends on the specific economy and circumstances