Monetary versus Fiscal Policy

In the words of Milton Friedman

“The key source of misunderstanding about the issue of monetary policy, in my opinion, has been the failure to distinguish clearly what it is that money matters for. What I and those who share my views have emphasized is that the quantity of money is extremely important for nominal magnitudes, for nominal income, for the level of income in dollars—important for what happens to prices. It is not very important at all, or, if that’s perhaps an exaggeration, not very important, for what happens to real output over the long period.”

“A steady rate of growth in the money supply will not mean perfect stability even though it would prevent the kind of wide fluctuations that we have experienced from time to time in the past. It is tempting to try to go farther and to use monetary changes to offset other factors making for expansion and contraction…The available evidence…casts grave doubts on the possibility of producing any fine adjustments in monetary policy—at least in the present state of knowledge….There are thus serious limitations to the possibility of a discretionary monetary policy and much danger that such a policy may make matters worse rather than better.”

“To avoid misunderstanding, it should be emphasized that the problems just discussed are in no way peculiar to monetary policy….The basic difficulties and limitations of monetary policy apply with equal force to fiscal policy.”

“Now let’s turn to fiscal policy. I believe that the state of the government budget matters; matters a great deal—for what fraction of the nation’s income is spent through the government and what fraction is spent by individuals privately. The state of the government budget determines what the level of our taxes is, how much of our income we turn over to government. The state of the government budget has a considerable effect on interest rates. If the federal government runs a large deficit, that means that the government has to borrow in the market, which raises the demand for loanable funds and so tends to raise interest rates.”

Monetary policy versus fiscal policy---the issue must be posed in terms of the questions, “What happens if you hold monetary policy constant and you change fiscal policy?” and “What happens if you hold fiscal policy constant and you change monetary policy?”