How can a change in monetary policy reduce the inflationary consequences of fiscal stimulus?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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When a government uses fiscal policy to try to stimulate the economy (by taxing less and/or spending more) aggregate demand tends to rise.  All other things being equal, this increase in AD can lead to inflation.  A major goal of monetary policy is to ensure that inflation does not become excessive.

To prevent inflation, a central bank would need to increase interest rates.  As the link below tells us,

Monetary policy works through the effects of the cost and availability of loans on real activity, and through this on inflation...

A central bank that was concerned about inflation, then, would raise interest rates so that loans would be less attractive and economic activity would slow.

There is, however, a danger in doing this.  If the economy is in need of fiscal stimulus, increasing interest rates could be harmful because an increase in interest rates typically slows economic activity.

So, a central bank can reduce the inflationary consequences of fiscal stimulus by increasing interest rates.  However, this may not be compatible with the goal of stimulating the economy.

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