Analysis of Fiscal and Monetary Policies
We are all faced by different levels and types of decisions in our life, which, by default, affects other aspects of life, in this case, the economy. Decisions made by households can greatly impact economic growth and development. For instance, if several households decide to consume more and less, they can create opportunities for employment, investment, and, eventually, profits. Spending more means, they are utilizing available resources, which brings up needs for more production. The same happens when corporate same investment decisions, which directly affects the real economy and the firm’s profits. However, and individual corporations or persons cannot make a very large difference to the economy alone; it will not be noticed when a single household decides their consumption. This means there is a need for collective entities to work together in an attempt to boost the economy.
When it comes to the governments, however, things are different. Decisions made by policymakers can have a significant impact on any economy, including the largest and more developed ones. Consider that public sectors in more developed countries normally make the largest part of the population, which makes them responsible for major spending in an economy. Also, governments are the largest borrowers in the world debt markets. Developing countries, for instance, borrow from developed ones to establish themselves. Besides, government policy is expressed through how they borrow and how they spend.
Fiscal and monetary Policies
Two government policies make the biggest impact on the economy. When there is an issue, these are the laws of reference, for rectifying the failing markets and economies. They are fiscal policies and monetary policies. Monetary policies carry the activities of central banks that impact the quantity of money and credit within an economy. By contrast, governments use fiscal policies in decisions about taxation and spending. Both of these policies are vital in the regulation of economic activities over a specified period. They can be applied to the increase in the speed of economic growth, where things are going slow and moderate when it starts to overheat. Fiscal policies also appear in the redistribution of income and wealth.
Both fiscal and monetary have the same overreaching goal of creating an economic environment that brings out a stable and positive growth, and stable and low inflation. They are extremely crucial in steering underlying economies so that there are no booms/ bubbles that are normally followed by long periods of slow or negative growth. Such an effect can be seen through elevated levels of unemployment. When the economy stabilizes, households become more confident in the spending and saving decisions. In contrast, firms can focus their energy on investment decisions, making normal coupon payments to bondholders as well as dividend payouts to the shareholders.
This is the description of an ideal economy, where balance is achieved in all areas. Consumers are happy, and the producers are even happier. But there are so many challenges to achieving this goal, among others. Constant economic shocks like price jump and inflation make it a bit hard to get ideal markets. Apart from this, some economists do believe in natural economic cycles. As if that is not enough, there are situations where government interventions cause more harm good. There have been situations where these government policies, monetary, fiscal, or both, has initiated economic booms that eventually led to devastating consequences to the real economy. There are pieces of history that account for financial markets and investors facing trouble due to government policies.
The Keynesian school on Fiscal Policy
In his major work, “The General Theory of Employment, Interest, and Money,” John Maynard Keynes, a British economist, revealed new theories about economics and how they work. Commonly known as the Keynesian school of thought, or Keynesianism, this is where the most process in the fiscal policy is linked. Most of his theories came during the Great Depression, which, until today, have become a vital point of reference for economies, with some using them right, while others have misused them over time. Nevertheless, they are have become popular and used widely to mitigate economic failures.
According to the Keynesian theory of economics, the basis of economic growth, development, and sustainability is that governments' proactive action is the main way of steering the economies. In other words, a government should use its powers to elevate aggregate demand by fueling spending and ensuring there is an environment for easy money. This should boost the economy through the creation of employment, ending up with increased prosperity. Keynesian followers' movement argues that monetary policy alone does not have the capability to resolve financial crises, which ultimately creates the Keynesian versus the Monetarists argument.
It is critical to appreciate the monetary theory has been successfully employed after the Great Depression. However, Keynesian thoughts were called into question in the 1980s, after enjoying long periods of popularity. At this time, monetary theorists like Milton Friedman and supply-siders rose up, arguing that there was not evident that the current government actions had helped shield economies against continuous cycles of under-average GDP ( Gross Domestic Product) expansion, recession, and surging interest rates.
Effects of Fiscal Policies
Similar to monetary policy, fiscal policy can also be applied as a measure to steer both GDP expansion and recession, since its feature as a measure of economic growth. For instance, a government may exercise its power by creating laws that reduce taxes while increasing its expansion. In this case, they are applying an expansionary fiscal policy. In most cases, this expansionary input may seem to lead only to a positive impact, but a deeper look reveals some domino effects that may be more serious. Where a government spends more than what tax collected can recover, the same can lead to the accumulation of excess debt. This is because of the issues of interest-bearing bonds to finances such expenditure, which results in increased national debt.
Another effect may see when the government increases the quantity the debt gives out during an expansionary fiscal policy. When it offers bonds in the open market, it may end up in competition with proving entities who may see the need to issues such bonds at the same time. This leads to an effect called crowding out, which can indirectly increase rates due to competition for borrowed money. It may be true that this stimulus from increased government spending is short-lived in terms of positive effects; there could be a part of this expansion that can be controlled through high-interest expenses for borrowers.
Then there are also indirect effects that result in foreign investors bidding up the country’s currency, for example, the U.S. dollar, when they try to invest its higher-yielding bonds in the open market. It sounds great to have a stronger domestic currency, right? Well, it is. But then, depending on the extent of exchange rates, it can make the country's goods costly to export and import foreign goods cheaper. The consumer idea reveals that consumers tend to use price as a major determinant for buying certain goods. This means they will buy more foreign goods, impacting a slow demand for home-made good, which may result in short-time
trade imbalance. Note, however, there are all possible scenarios of the outcome, and there is no telling with certainty which outcome is sure. There are so many moving targets, including market influences, natural disasters, wars, and many other economic influencers.
A natural lag or delay in time from when they are established to when needed to when they go through parliamentary discussion also affects fiscal policy efforts. When considering a forecasting perspective, where economists can offer 100% accuracy for future occurrences, it would be beneficial to summon fiscal policies whenever required. But that is not the situation since there so much uncertainty and dynamics in economics, which creates a lot of challenges for economists while trying to predict short-run economic outcomes.
Money and Monetary Policy
Apart from fiscal policy, monetary policy has also been a major player in igniting or slowing down economies. The policy features under the Federal Reserve in the U.S., or under Central Banks in other economies, and they bear the ultimate goal of creating an easy money environment. In earlier economies, Keynesians did not believe in monetary policies would offer long-run solutions. They based the arguments on the facts that:
1. Because banks have the power to choose whether to lend or not to lend out the excess reserve they have with lowered interests, they can refuse to do so.
2. According to Keynesians, consumer demand for products may not have a relation to the cost of capital to acquire the said goods.
There is no telling for sure whether this is true or false, since it may be, or may not be at certain stages of business cycles. Nevertheless, there are unlimited resources for evidence that monetary policy indeed does influence and impact and economy. It extended into equity and fixed income markets, which are among the biggest contributors to economic growth and development.
The Fed is equipped with three most significant tools in its arsenal, one of them being open market operations. This is the most utilized tool, which has a great impact on money supply, where it can buy or sell U.S. government securities – by buying, Fed increases the money supply, and by selling, it reduces. The second tool is its ability to change the reserve requirements at the bank, which may directly reduce the money supply. The Fed leads by a reserve ratio, which directly impacts money supply, where there is a regulation on the quantity of money a bank can hold. It can increase money by decreasing the number of reserves required. On the other hand, the Fed is able to reduce the money supply, which they do by increasing the number of reserves banks can hold.
The Fed also has the power to alter the discount rate, a tool that has been attracting a lot of media attention, forecasts, and speculations over the past few years. The whole world waits for the Fed to announce any changes that would have an effect on the global economy. Note that many people often misunderstand and misinterpret the discount rate. It is not the official rate paid by the consumer on their loans or what they receive on their savings accounts. But it is the rate that banks charge when seeking to increase their reserves if they borrow directly from the Federal Reserve. The Fed can decide to change this rate, which does not flow through the banking system. In other words, it does not affect what borrowers have to pay to geta a loan, or what they get when they make deposits. Theoretically, when the Fed holds the discount rate low, it can induce banks to hold far fewer reserves. This will mean then that the banks can create demand for more money.
Looking at the fiscal and monetary policy like we have above, one may not help but wonder; which the most effective policy. For decades, this has been one of the major topics of discussion, which has always led to various answers. The Keynesians support the fiscal policy of an extended period of time, say up to 30 years, in which the economy will have gone through various cycles. And when these cycles come to an end, the hard assets, like infrastructure, and life-long assets will be standing still, which means they may not require any fiscal intervention. During the cause of this time, the Fed may have intervened multiple times using their monetary policy tools, in which case they may not have succeeded 100%.
In summary, using only one approach will not do much good. Consider that, when filters start getting into the market, the case a lag in the fiscal policy. On the other hand, monetary policy has been very sound when economies start heating up at an undesired rate. But then the monetary policy does not have much effect in a rapidly-changing economic environment in terms of expanding money eased. The U.S. has always sported a middle ground by combining the approach of both policies when the need arises to resolve economic crises. It is always in the interest of economic restoring when things don’t go as planned to use these policies.
Author: James Hamilton