Macroeconomics: long run effects of fiscal and monetary policies

As a reminder, in the long run, wages and prices are considered variables in the economy. Thus in periods of economic expansions, workers will demand higher wages due to the pressure on the labor market (higher demand), increasing costs to firms, shifting the SRAS to the left. They opposite effect happens during periods of economic contraction.

Expansionary policies have no direct effect on the long run level of full employment. It can be the case that a positive demand side policy also has a positive supply side effect.

Expansionary monetary policy, and its effect on the LRAS: lower interest rates implies more investment which implies more capital (i.e machines), making the workers more productive, leading to economic growth (i.e increasing the level of output in the long run).

More investment does shift the AD to the right but so do the LRAS and SRAS curves.

Contractionary demand side policies can have an impact on the long run level of full employment if and only if the policy has an effect on the productive capacity of the economy.

Say a new fiscal policy aims at reducing spending in education and health, this will reduce the productivity of the workers in the economy, the long run level of output will decline.

Note that less government spending will reduce the variable G, shifting the AD curve to the left, but so will the SRAS and LRAS curves.

Fiscal vs monetary policies:

Depending on how large a recession is, fiscal policy might be more effective than monetary policy. If the demand for investment is very steep, then expansionary monetary policy has little effect on the economy. Also the zero lower bound or liquidity trap is another problem (see also QE policies).

Fiscal policies in such cases might be more effective, since they directly injects funds into the circular flow and move the AD curve to the right. Furthermore, when saving is high and investment level low, the government can borrow at a relatively cheap rate.

high unemployment rate implies that fiscal policy can greatly reduce it, while having little effect on the inflation rate.

One can usually think of monetary policies as a tool to regulate the economy when it deviates from its trend by some small epsilon, whereas fiscal policies are used during major economic contractions.

Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 192-202.

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