Monetary and Fiscal Policies

General monetary and fiscal policies work by influencing aggregate demand. They remove shortfalls in aggregate demand by stimulating demand, and they check inflation caused by expenditure gaps by reducing demand. The interest rate obtained depends on the mix of monetary and fiscal policies used.

Fiscal policies are accompanied by money supply disturbances which reinforce them if the Federal Reserve accommodates the Treasury debt operations they require with open-market purchases or sales Otherwise, associated money supply disturbances do not occur. 

The unemployment and inflation rate combinations experienced in the United States since 1970 have been much poorer than those experienced during the 1950s and 1960s in terms of price and employment goals

Some of the early interpretations of these poorer combinations saw hem as arising from stronger wage-push pressures and concluded that monetary and fiscal policies would have to be supplemented with price and wage controls if acceptable price and employment results were to be achieved.

Today, most economists see an increase in the natural rate of unemployment caused by expansions in income-maintenance programs and increased proportions of women and teenagers in the labor force as the principal factor in the higher unemployment rates. They see overly expansive monetary and fiscal policies as the principal factor in the higher inflation rates. In this view, general price and wage controls are not appropriate. Since the inflation is chiefly the demand-pull type, monetary and fiscal policies can contain it. If the higher natural rate of unemployment is unacceptable, specific fiscal policies targeted to frictional and structural unemployment are the appropriate policy response.

Milton Friedman's natural rate hypothesis explains the trade-off between unemployment rate and inflation rate of the empirical Phillips curve as a short-term response to demand-pull inflation, a response arising from worker underestimation of the inflation. In the long term, when both price and money-wage inflation are perceived correctly, the unemployment rate is independent of the inflation rate. The long-term Phillips curve is vertical at the natural rate of unemployment in Friedman's formulation.