How do financial frictions influence the effectiveness of fiscal or monetary policy?

• A. Credit constraints damp multiplier effects; high debt or tight lending standards reduce transmission.
• B. They only affect monetary policy, not fiscal policy.
• C. They have no impact on policy effectiveness.
• D. They enhance policy effectiveness by boosting liquidity.

Answer: (B)

Financial frictions shape how policy signals translate into real spending and investment by affecting who can borrow and at what cost. When credit markets are tight or borrowers’ balance sheets are strained, a fiscal expansion or a monetary tightening doesn’t flow as freely into higher demand. The fiscal multiplier can shrink because households and firms may choose to save extra income or delay spending if credit is hard to obtain or if debt levels are high, limiting how much government spending actually boosts spending. At the same time, monetary policy can be less potent if banks face balance-sheet problems or stricter lending standards; even with lower interest rates, banks may hesitate to lend, and borrowers may face higher effective costs or tighter credit constraints. These frictions reduce the transmission of policy in both channels, and higher debt or tighter lending standards tend to further weaken transmission. So the idea is that financial frictions dampen the effectiveness of both fiscal and monetary policy, not just one.