Was Monetary Policy The Most Effective Tool To Tackle The Great Recession? A Look At Fiscal Policy As An Alternative Solution

Abstract

Mainstream economists have always considered monetary policy, which focuses on setting the interest rates, a powerful tool to tackle the problems of inflation and unemployment. In the wake of the U.S. 2007-09 Financial Crisis, which led to the Great Recession globally, conventional monetary policy proved to be ineffective, and central banks adopted quantitative easing, the well-known unconventional monetary policy tool. Even though quantitative easing works directly in lowering the long-term interest rates, it is ineffective in reviving an economy where the private sector is in excessive debt and is trying to deleverage. Using a Post-Keynesian framework, this paper argues that fiscal policy becomes essential in stimulating spending and investment in an over-indebted economy. Using Modern Money Theory, this paper also shows that mainstream critiques of fiscal policy, such as the “crowding out”, “Ricardian Equivalence” and “sound finance” arguments are not accurate. A government with fiat money faces no financial constraints because it spends by issuing its own liabilities; however, it still faces real resources constraints.