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Economic Stimulus: What is the role of monetary policy?

Economists view monetary policy as the first line of defense against economic slowdowns. Compared with fiscal policy, monetary policy has the advantages of the Federal Reserve’s ability to act faster than the administration or Congress and to better judge the appropriate timing and magnitude of a stimulus. Further, unless well crafted, fiscal stimulus may impose long-run costs on the economy without providing much short-run gain.

  • The Federal Reserve can adjust monetary policy more quickly than the administration and Congress can adjust fiscal policy. Because most contractions in economic activity last for only a few quarters, the timeliness of the policy response is crucial. Fiscal policy in practice responds to changes in economic conditions with a considerable lag: it takes time first to enact a stimulus bill and then to implement it, and time for the spending increases or tax reductions to reach the pockets of consumers. As a result, the effect of fiscal stimulus on household and business spending may come too late.
  • Whether and how much stimulus is needed depends on economic conditions today, on projections of likely future conditions, and on assessments of the risks to both economic activity and inflation going forward. Forecasting economic conditions-or even determining the current state of the economy-is inherently very difficult, given limitations in the available data and in economists’ understanding of the world. But the Federal Reserve’s large and sophisticated team of analysts is better positioned to accomplish this task than any other agency of the federal government. In addition, the Federal Reserve staff carries out this work independent of political considerations.
  • Economists worry that poorly crafted fiscal stimulus would have little short-run economic benefit and could do long-run harm. For example, permanent tax cuts unaccompanied by permanent spending reductions would increase the long-run budget deficit. And a permanent increase in the deficit-especially now, when the budget is already so far out of long-run balance-would reduce economic growth over time. Moreover, because higher expected government borrowing is likely to push up current long-term interest rates, the short-run stimulative effect would be muted as well. In fact, under plausible assumptions about economic behavior, the response of forward-looking financial markets to a sustained reduction in personal income taxes would offset about half of the incipient stimulative effect of the tax cut.
 
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  Entry 4 of 10