Principles of Microeconomics

FISCAL & MONETARY

POLICY
[Document subtitle]

[DATE]
[COMPANY NAME]
[Company address]
Submitted to:
Dr. Bilal Aziz
Submitted by:
Wajiha Sameen

Date: 8-June-2022

Institute of Business & Management

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Table of Contents

Fiscal Policy...................................................................................................1
How Fiscal Policy Works............................................................................................................2
Balancing Act.............................................................................................................................3
When the Economy Needs to Be Curbed?................................................................................3
Who Does Fiscal Policy Affect?..................................................................................................4
Origins of Fiscal Policy...............................................................................................................4
Types of Fiscal Policy.................................................................................................................5
Expansionary Fiscal Policy..................................................................................................5
1. Neutral fiscal policy.......................................................................................................5
Expansionary fiscal policy.....................................................................................................6
2. Contractionary fiscal policy...........................................................................................7
Methods of fiscal policy funding...............................................................................................8
Borrowing..............................................................................................................................8
Dipping into prior surpluses...................................................................................................9
Fiscal straitjacket.....................................................................................................................9
Economics Effect.......................................................................................................................9
Similarities and differences between Fiscal and Monetary Policy.................................10
What is Monetary Policy?..........................................................................11
Objectives of Monetary Policy................................................................................................11
Tools of Monetary Policy........................................................................................................11
3. Open market operations.....................................................................................................12
Expansionary vs. Contractionary Monetary Policy.................................................................12
Expansionary Monetary Policy...............................................................................................12
Contractionary Monetary Policy.............................................................................................14
Monetary Policy.................................................................................................................15
Nominal Anchors in monetary policy.....................................................................................16
Types of Nominal Anchors......................................................................................................16
Inflation targeting...................................................................................................................16
Price level targeting................................................................................................................16
Monetary aggregates/money supply targeting........................................................................16
Fiscal Policy Theory...................................................................................18

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 Major points of fiscal theory...................................................................................................19
Keynesian Economics and Fiscal Policy...................................................................................20

Fiscal Policy
Fiscal policy describes changes to government spending and revenue behavior in an
effort to influence the economy. We can say that Fiscal policy is the means by which a
government adjusts its spending levels and tax rates to monitor and influence a nation's
economy. It is the sister strategy to monetary policy through which a central bank
influences a nation's money supply.By adjusting its level of spending and tax revenue,
the government can affect economic outcomes by either increasing or decreasing
economic activity. For example, when the government runs a budget deficit,it is said to
be engaging in fiscal stimulus—spurring economic activity—andwhen the government
runs a budget surplus,it is said to be engaging in a fiscal contraction—slowing economic
activity.

The government can use fiscal stimulus to spur economic activity by increasing
government spending, decreasing tax revenue, or a combination of the two. Increasing
government spending tends to encourage economic activity either directly through the
purchaseof additional goods and services from the private sector or indirectly by the
transfer offunds to individuals who may then spend that money. Decreasing tax revenue
tends to encourage economic activity indirectly by increasing individuals’ disposable
income, which can lead to those individuals consuming more goods and services. This
sort of expansionary fiscal policy can be beneficial when the economy is in recession, as
it lessens the negative impacts of a recession, such as elevated unemployment
andstagnant wages. However, expansionary fiscal policy can result in rising interest
rates, growing trade deficits, and accelerating inflation, particularly if applied during
healthy economic expansions. These side effects from expansionary fiscal policy tend to
partly offset its stimulative effects.

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How Fiscal Policy Works
Here's a look at how fiscal policy works, how it must be monitored, and how its
implementation may affect different people in an economy.

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also
known as Keynesian economics, this theory basically states that governments can
influence macroeconomic productivity levels by increasing or decreasing tax levels and
public spending. This influence, in turn, curbs inflation (generally considered to be
healthy when between 2% and 3%), increases employment, and maintains a healthy
value of money. Fiscal policy plays a very important role in managing a
country's economy. For example, in 2012 many worried that the fiscal cliff, a
simultaneous increase in tax rates and cuts in government spending set to occur in
January 2013, would send the U.S. economy back into recession. The U.S. Congress
avoided this problem by passing the American Taxpayer Relief Act of 2012 on Jan. 1,
2013.

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Balancing Act
The idea is to find a balance between tax rates and public spending. For example,
stimulating a stagnant economy by increasing spending or lowering taxes, also known as
expansionary fiscal policy, runs the risk of causing inflation to rise. This is because an
increase in the amount of money in the economy, followed by an increase in consumer
demand, can result in a decrease in the value of money—meaning that it would take
more money to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are up, consumer
spending is down, and businesses are not making substantial profits. A government
may decide to fuel the economy's engine by decreasing taxation, which gives consumers
more spending money while increasing government spending in the form of buying
services from the market (such as building roads or schools). By paying for such
services, the government creates jobs and wages that are in turn pumped into the
economy. Pumping money into the economy by decreasing taxation and increasing
government spending is also known as "pump priming." In the meantime, overall
unemployment levels will fall.

With more money in the economy and less taxes to pay, consumer demand for goods and
services increases. This, in turn, rekindles businesses and turns the cycle around from
stagnant to active.

If, however, there are no reins on this process, the increase in economic productivity can
cross over a very fine line and lead to too much money in the market. This excess in
supply decreases the value of money while pushing up prices (because of the increase in
demand for consumer products). Hence, inflation exceeds the reasonable level.

For this reason, fine-tuning the economy through fiscal policy alone can be a difficult, if
not improbable, means to reach economic goals.

When the Economy Needs to Be Curbed?

When inflation is too strong, the economy may need a slowdown. In such a situation, a
government can use fiscal policy to increase taxes to suck money out of the economy.
Fiscal policy could also dictate a decrease in government spending and thereby decrease
the money in circulation. Of course, the possible negative effects of such a policy, in the
long run, could be a sluggish economy and high unemployment levels. Nonetheless, the

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process continues as the government uses its fiscal policy to fine-tune spending and
taxation levels, with the goal of evening out the business cycles.

Who Does Fiscal Policy Affect?

Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending
on the political orientations and goals of the policymakers, a tax cut could affect only the
middle class, which is typically the largest economic group. In times of economic decline
and rising taxation, it is this same group that may have to pay more taxes than the
wealthier upper class.

Similarly, when a government decides to adjust its spending, its policy may affect only a
specific group of people. A decision to build a new bridge, for example, will give work
and more income to hundreds of construction workers. A decision to spend money on
building a new space shuttle, on the other hand, benefits only a small, specialized pool of
experts, which would not do much to increase aggregate employment levels.

Origins of Fiscal Policy

Before the Great Depression, governments across the world followed the policy of
Laissez-faire (or Let it be). This approach to the economy was based on the teachings of
classical economists such as Adam Smith and Alfred Marshall. Classical economists
believed in the power of the invisible hand of the market. They were of the opinion that
the government should not interfere in the economy, as any interference in the market
was uncalled for.

However, the 1929 stock market crash that ushered in the Great Depression
fundamentally changed the course of economic thought. The Depression resulted in low
economic demand along with high unemployment. Classical economics could not
provide any solution to the crisis.

In 1936, British economist John Maynard Keynes published “The General Theory of
Employment, Interest, and Money” (known simply as “The General Theory”). In it,
Keynes called for an increase in government spending to combat the recessionary forces
in the economy. He believed that an increase in government spending would bring about
an increase in demand for commodities in the market.

The Second World War provided empirical evidence of Keynes’ theory. Nations across
the world increased government expenditure in order to build their armed forces. The

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rise in government expenditure saw massive growth in employment and an increase
in demand for commodities in the market. In fact, the Second World War is often
credited with bringing Europe out of the Great Depression.

Types of Fiscal Policy

Expansionary Fiscal Policy

During a recession, aggregate demand (overall spending) in the economy falls, which
generally results in slower wage growth, decreased employment, lower business revenue,
and lower business investment. As seen during the current recession caused by the
Coronavirus Disease 2019 (COVID-19) pandemic, recessions often lead to serious
negative consequences for both individuals and businesses.2 The government can replace
some of the lost aggregate demand and limit the negative impacts of a recession on
individuals and businesses with the use of fiscal stimulus by increasing government
spending, decreasing tax revenue, or a combination of the two. Government spending
takes the form of both purchases of goods and services, which directly increase
economic activity, and transfers to individuals, which indirectly increase economic
activity as individuals spend those funds. Decreased tax revenue via tax cuts indirectly
increases aggregate demand in the economy. For example, an individual income tax cut
increases the amount of disposable income available to individuals, enabling them to
purchase more goods and services. Standard economic theory suggests that in the short
term, fiscal stimulus can lessen the negative impacts of a recession or hasten a recovery.3
However, the ability of fiscal stimulus to boost aggregate demand may be limited due to
its interaction with other economic processes, including interest rates and investment,
exchange rates and the trade balance, and the rate of inflation.

Depending on the state of the economy, fiscal policy may reach for different objectives:
its focus can be to restrict economic growth by mediating inflation or, in turn, increase
economic growth by decreasing taxes, encouraging spending on different projects that
act as stimuli to economic growth and enabling borrowing and spending. The three
stances of fiscal policy are the following:

1. Neutral fiscal policy is usually undertaken when an economy is in neither

a recession nor an expansion. The amount of government deficit spending (the
excess not financed by tax revenue) is roughly the same as it has been on average

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 over time, so no changes to it are occurring that would have an effect on the level
of economic activity.

Expansionary fiscal policy is used by the government when trying to balance the
contraction phase in the business cycle. It involves government spending exceeding tax
revenue by more than it has tended to, and is usually undertaken during recessions.
Examples of expansionary fiscal policy measures include increased government
spending on public works (e.g., building schools) and providing the residents of the
economy with tax cuts to increase their purchasing power (in order to fix a decrease in
the demand).

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2. Contractionary fiscal policy, on the other hand, is a measure to increase tax
rates and decrease government spending. It occurs when government deficit
spending is lower than usual. This has the potential to slow economic growth if
inflation, which was caused by a significant increase in aggregate demand and the
supply of money, is excessive. By reducing the economy's amount of aggregate
income, the available amount for consumers to spend is also reduced. So,
contractionary fiscal policy measures are employed when unsustainable growth
takes place, leading to inflation, high prices of investment, recession and
unemployment above the "healthy" level of 3%–4%.

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Methods of fiscal policy funding
Governments spend money on a wide variety of things, from the military and police to
services such as education and health care, as well as transfer payments such
as welfare benefits. This expenditure can be funded in a number of different ways:

 Taxation
 Seigniorage, the benefit from printing money
 Borrowing money from the population or from abroad
 Dipping into fiscal reserves
 Sale of fixed assets (e.g., land)
 Selling equity to the population

Borrowing
A fiscal deficit is often funded by issuing bonds such as Treasury bills or and gilt-edged
securities but can also be funded by issuing equity. Bonds pay interest, either for a fixed
period or indefinitely that is funded by taxpayers as a whole. Equity offers returns on
investment (interest) that can only be realized in discharging a future tax liability by an
individual taxpayer. If available government revenue is insufficient to support the
interest payments on bonds, a nation may default on its debts, usually to foreign

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creditors. Public debt or borrowing refers to the government borrowing from the public.
It is impossible for a government to "default" on its equity since the total returns
available to all investors (taxpayers) are limited at any point by the total current year tax
liability of all investors.

Dipping into prior surpluses

A fiscal surplus is often saved for future use, and may be invested in either local
currency or any financial instrument that may be traded later once resources are needed
and the additional debt is not needed.

Fiscal straitjacket
The concept of a fiscal straitjacket is a general economic principle that suggests strict
constraints on government spending and public sector borrowing, to limit or regulate the
budget deficit over a time period. Most US states have balanced budget rules that prevent
them from running a deficit. The United States federal government technically has
a legal cap on the total amount of money it can borrow, but it is not a meaningful
constraint because the cap can be raised as easily as spending can be authorized, and the
cap is almost always raised before the debt gets that high.

Economics Effect
Governments use fiscal policy to influence the level of aggregate demand in the
economy, so that certain economic goals can be achieved:

 Price stability;
 Full employment;

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  Economic growth.

The Keynesian view of economics suggests that increasing government spending and

decreasing the rate of taxes are the best ways to have an influence on aggregate demand,
stimulate it, while decreasing spending and increasing taxes after the economic
expansion has already taken place. Additionally, Keynesians argue that expansionary
fiscal policy should be used in times of recession or low economic activity as an essential
tool for building the framework for strong economic growth and working towards full
employment. In theory, the resulting deficits would be paid for by an expanded economy
during the expansion that would follow; this was the reasoning behind the New Deal.

Similarities and differences between Fiscal and Monetary Policy

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What is Monetary Policy?
Monetary policy is an economic policy that manages the size and growth rate of the
money supply in an economy. It is a powerful tool to regulate macroeconomic variables
such as inflation and unemployment.

These policies are implemented through different tools, including the adjustment of
the interest rates, purchase or sale of government securities, and changing the amount of
cash circulating in the economy. The central bank or a similar regulatory organization is
responsible for formulating these policies.

Objectives of Monetary Policy

The primary objectives of monetary policies are the management of inflation or
unemployment, and maintenance of currency exchange rates.

1. Inflation

Monetary policies can target inflation levels. A low level of inflation is considered to be
healthy for the economy. If inflation is high, a contractionary policy can address this
issue.

2. Unemployment

Monetary policies can influence the level of unemployment in the economy. For
example, an expansionary monetary policy generally decreases unemployment because
the higher money supply stimulates business activities that lead to the expansion of the
job market.

3. Currency exchange rates

Using its fiscal authority, a central bank can regulate the exchange rates between
domestic and foreign currencies. For example, the central bank may increase the money
supply by issuing more currency. In such a case, the domestic currency becomes cheaper
relative to its foreign counterparts.

Tools of Monetary Policy

Central banks use various tools to implement monetary policies. The widely utilized
policy tools include:

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1. Interest rate adjustment

A central bank can influence interest rates by changing the discount rate. The discount
rate (base rate) is an interest rate charged by a central bank to banks for short-term loans.
For example, if a central bank increases the discount rate, the cost of borrowing for the
banks increases. Subsequently, the banks will increase the interest rate they charge their
customers. Thus, the cost of borrowing in the economy will increase, and the money
supply will decrease.

2. Change reserve requirements

Central banks usually set up the minimum amount of reserves that must be held by a
commercial bank. By changing the required amount, the central bank can influence the
money supply in the economy. If monetary authorities increase the required reserve
amount, commercial banks find less money available to lend to their clients and thus,
money supply decreases.

Commercial banks can’t use the reserves to make loans or fund investments into new
businesses. Since it constitutes a lost opportunity for the commercial banks, central
banks pay them interest on the reserves. The interest is known as IOR or IORR (interest
on reserves or interest on required reserves).

3. Open market operations

The central bank can either purchase or sell securities issued by the government to affect
the money supply. For example, central banks can purchase government bonds. As a
result, banks will obtain more money to increase the lending and money supply in the
economy. 

Expansionary vs. Contractionary Monetary Policy

Depending on its objectives, monetary policies can be expansionary or contractionary.

Expansionary Monetary Policy

This is a monetary policy that aims to increase the money supply in the economy by
decreasing interest rates, purchasing government securities by central banks, and
lowering the reserve requirements for banks.

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An expansionary policy lowers unemployment and stimulates business activities and
consumer spending. The overall goal of the expansionary monetary policy is to fuel
economic growth. However, it can also possibly lead to higher inflation.

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Contractionary Monetary Policy
The goal of a contractionary monetary policy is to decrease the money supply in the
economy. It can be achieved by raising interest rates, selling government bonds, and
increasing the reserve requirements for banks. The contractionary policy is utilized when
the government wants to control inflation levels.

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Monetary Policy

 Monetary policy involves influencing the supply and demand for money
through interest rates and other monetary tools.
 Monetary policy is usually conducted by the Central Bank, e.g. UK –
Bank of England, US – Federal Reserve.
 The target of Monetary policy is to achieve low inflation (and usually
promote economic growth)
 The main tool of monetary policy is changing interest rates. For example,
if the Central Bank feel the economy is growing too quickly and inflation
is increasing, then they will increase interest rates to reduce demand in the
economy.
 In some circumstances, Central Banks may use other tools than just
interest rates. For example, in the great recession 2008-12, Central Banks
in UK and US pursued quantitative easing. This involved increasing the
money supply to increase demand.

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Nominal Anchors in monetary policy
A nominal anchor for monetary policy is a single variable or device which the central
bank uses to pin down expectations of private agents about the nominal price level or its
path or about what the central bank might do with respect to achieving that path.
Monetary regimes combine long-run nominal anchoring with flexibility in the short run.
Nominal variables used as anchors primarily include exchange rate targets, money
supply targets, and inflation targets with interest rate policy

Types of Nominal Anchors

In practice, to implement any type of monetary policy the main tool used is modifying
the amount of base money in circulation. The monetary authority does this by buying or
selling financial assets (usually government obligations). These open market
operations change either the amount of money or its liquidity (if less liquid forms of
money are bought or sold). The multiplier effect of fractional reserve banking amplifies
the effects of these actions on the money supply, which includes bank deposits as well as
base money.

Inflation targeting
Under this policy approach, the target is to keep inflation, under a particular definition
such as the Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the central bank interest
rate target. The interest rate used is generally the overnight rate at which banks lend to
each other overnight for cash flow purposes. Depending on the country this particular
interest rate might be called the cash rate or something similar.

Price level targeting

Price level targeting is a monetary policy that is similar to inflation targeting except
that CPI growth in one year over or under the long term price level target is offset in
subsequent years such that a targeted price-level trend is reached over time, e.g. five
years, giving more certainty about future price increases to consumers. Under inflation
targeting what happened in the immediate past years is not taken into account or adjusted
for in the current and future years.

Monetary aggregates/money supply targeting

In the 1980s, several countries used an approach based on a constant growth in the
money supply. This approach was refined to include different classes of money and

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credit (M0, M1 etc.). In the US this approach to monetary policy was discontinued with
the selection of Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

Central banks might choose to set a money supply growth target as a nominal anchor to
keep prices stable in the long term. The quantity theory is a long run model, which links
price levels to money supply and demand. Using this equation, we can rearrange to see
the following:

π = μ − g,

where π is the inflation rate, μ is the money supply growth rate and g is the real
output growth rate. This equation suggests that controlling the money supply's
growth rate can ultimately lead to price stability in the long run. To use this nominal
anchor, a central bank would need to set μ equal to a constant and commit to
maintaining this target

Unconventional monetary policy at the zero bound

Other forms of monetary policy, particularly used when interest rates are at or near 0%
and there are concerns about deflation or deflation is occurring, are referred to
as unconventional monetary policy. These include credit easing, quantitative
easing, forward guidance, and signalling. In credit easing, a central bank purchases
private sector assets to improve liquidity and improve access to credit. Signaling can be
used to lower market expectations for lower interest rates in the future. For example,
during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for
an "extended period", and the Bank of Canada made a "conditional commitment" to keep
rates at the lower bound of 25 basis points (0.25%) until the end of the second quarter of
2010.

Helicopter money

Further heterodox monetary policy proposals include the idea of helicopter

money whereby central banks would create money without assets as counterpart in their
balance sheet. The money created could be distributed directly to the population as a
citizen's dividend. Virtues of such money shock include the decrease of household risk

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aversion and the increase in demand, boosting both inflation and the output gap. This
option has been increasingly discussed since March 2016 after the ECB's
president Mario Draghi said he found the concept "very interesting”  and was revived
once again by prominent former central bankers Stanley Fischer and Philipp
Hildebrand in a paper published by BlackRock.

Some have envisaged the use of what Milton Friedman once called "helicopter money"
whereby the central bank would make direct transfers to citizens[32] in order to lift
inflation up to the central bank's intended target. Such policy option could be particularly
effective at the zero lower bound

Fiscal Policy Theory

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also
known as Keynesian economics, this theory basically states that governments can
influence macroeconomic productivity levels by increasing or decreasing tax levels and
public spending. This influence, in turn, curbs inflation (generally considered to be
healthy when between 2% and 3%), increases employment, and maintains a healthy
value of money. Fiscal policy plays a very important role in managing a
country's economy.

Keynesian economics is a macroeconomic economic theory of total spending in the

economy and its effects on output, employment, and inflation. Keynesian economics was
developed by the British economist John Maynard Keynes during the 1930s in an
attempt to understand the Great Depression. Keynesian economics is considered a
"demand-side" theory that focuses on changes in the economy over the short run.
Keynes’s theory was the first to sharply separate the study of economic behavior and
markets based on individual incentives from the study of broad national economic
aggregate variables and constructs.  

Based on his theory, Keynes advocated for increased government expenditures and lower
taxes to stimulate demand and pull the global economy out of the depression.
Subsequently, Keynesian economics was used to refer to the concept that optimal
economic performance could be achieved—and economic slumps prevented—by
influencing aggregate demand through activist stabilization and economic intervention
policies by the government

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Major points of fiscal theory
 Keynesian economics focuses on using active government policy to manage

aggregate demand in order to address or prevent economic recessions.

 Keynes developed his theories in response to the Great Depression, and was
highly critical of previous economic theories, which he referred to as “classical
economics”. 

 Activist fiscal and monetary policy are the primary tools recommended by
Keynesian economists to manage the economy and fight unemployment.

Volume 75%

 Keynesian economics represented a new way of looking at spending, output, and

inflation. Previously, what Keynes dubbed classical economic thinking held that cyclical
swings in employment and economic output create profit opportunities that individuals
and entrepreneurs would have an incentive to pursue, and in so doing correct the
imbalances in the economy. According to Keynes’s construction of this so-called
classical theory, if aggregate demand in the economy fell, the resulting weakness in
production and jobs would precipitate a decline in prices and wages. A lower level of
inflation and wages would induce employers to make capital investments and employ
more people, stimulating employment and restoring economic growth. Keynes believed
that the depth and persistence of the Great Depression, however, severely tested this
hypothesis.

In his book, The General Theory of Employment, Interest, and Money and other

works, Keynes argued against his construction of classical theory, that during recessions
business pessimism and certain characteristics of market economies would exacerbate
economic weakness and cause aggregate demand to plunge further.

For example, Keynesian economics disputes the notion held by some economists that
lower wages can restore full employment because labor demand curves slope downward
like any other normal demand curve. Instead he argued that employers will not add
employees to produce goods that cannot be sold because demand for their products is
weak. Similarly, poor business conditions may cause companies to reduce capital
investment, rather than take advantage of lower prices to invest in new plants and

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equipment. This would also have the effect of reducing overall expenditures and
employment.

Keynesian Economics and Fiscal Policy

The multiplier effect, developed by Keynes’s student Richar Kahn, is one of the chief
components of Keynesian countercyclical fiscal policy. According to Keynes's theory of
fiscal stimulus, an injection of government spending eventually leads to added business
activity and even more spending. This theory proposes that spending boosts aggregate
output and generates more income. If workers are willing to spend their extra income,
the resulting growth in the gross domestic product( GDP) could be even greater than the
initial stimulus amount.

The magnitude of the Keynesian multiplier is directly related to the marginal propensity
to consume. Its concept is simple. Spending from one consumer becomes income for a
business that then spends on equipment, worker wages, energy, materials, purchased
services, taxes and investor returns. That worker's income can then be spent and the
cycle continues. Keynes and his followers believed individuals should save less and
spend more, raising their marginal propensity to consume to effect full employment and
economic growth.

In this theory, one dollar spent in fiscal stimulus eventually creates more than one dollar
in growth. This appeared to be a coup for government economists, who could provide
justification for politically popular spending projects on a national scale.

This theory was the dominant paradigm in academic economics for decades. Eventually,
other economists, such as Milton Friedman and Murray Rothbard, showed that the
Keynesian model misrepresented the relationship between savings, investment, and
economic growth. Many economists still rely on multiplier-generated models, although
most acknowledge that fiscal stimulus is far less effective than the original multiplier
model suggests.

The fiscal multiplier commonly associated with the Keynesian theory is one of two broad
multipliers in economics. The other multiplier is known as the money multiplier. This
multiplier refers to the money-creation process that results from a system of fractional
reserve banking. The money multiplier is less controversial than its Keynesian fiscal
counterpart.
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Keynesian Economics and Monetary Policy
Keynesian economics focuses on demand-side solutions to recessionary periods. The
intervention of government in economic processes is an important part of the Keynesian
arsenal for battling unemployment, underemployment, and low economic demand. The
emphasis on direct government intervention in the economy often places Keynesian
theorists at odds with those who argue for limited government involvement in the
markets. 

Keynesian theorists argue that economies do not stabilize themselves very quickly and
require active intervention that boosts short-term demand in the economy. Wages and
employment, they argue, are slower to respond to the needs of the market and require
governmental intervention to stay on track. Furthermore they argue, prices also do not
react quickly, and only gradually change when monetary policy interventions are made,
giving rise to a branch of Keynesian economics known as Monetarism. 

If prices are slow to change, this makes it possible to use money supply as a tool and
change interest rates to encourage borrowing and lending. Lowering interest rates is one
way governments can meaningfully intervene in economic systems, thereby encouraging
consumption and investment spending. Short-term demand increases initiated by interest
rate cuts reinvigorate the economic system and restore employment and demand for
services. The new economic activity then feeds continued growth and employment. 

Without intervention, Keynesian theorists believe, this cycle is disrupted and market
growth becomes more unstable and prone to excessive fluctuation. Keeping interest rates
low is an attempt to stimulate the economic cycle by encouraging businesses and
individuals to borrow more money. They then spend the money they borrow. This new
spending stimulates the economy. Lowering interest rates, however, does not always lead
directly to economic improvement.

Monetarist economists focus on managing the money supply and lower interest rates as a
solution to economic woes, but they generally try to avoid the zero-bound problem. As
interest rates approach zero, stimulating the economy by lowering interest rates becomes
less effective because it reduces the incentive to invest rather than simply hold money in
cash or close substitutes like short term Treasuries. Interest rate manipulation may no
longer be enough to generate new economic activity if it cannot spur investment, and the

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attempt at generating economic recovery may stall completely. This is a type of liquidity
trap.

When lowering interest rates fails to deliver results, Keynesian economists argue that
other strategies must be employed, primarily fiscal policy. Other interventionist policies
include direct control of the labor supply, changing tax rates to increase or decrease the
money supply indirectly, changing monetary policy, or placing controls on the supply of
goods and services until employment and demand are restored.

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