The Conduct of Monetary and Fiscal Policy
Households always make decisions. It could be from individuals or influenced by several family members, and these decisions have a huge impact on the economy. Governments use consumer activities as part of expressing the national GDP. Hence, anything that households do is monitored by economic experts who encourage more spending than saving. If households consume more and save less, they create a perfect economic environment with increased employment, investment, and later profits. In the same manner, investment decisions that firms make also have a critical role in the real economy or the profits of the said firm. This happens when the decisions are collective because an individual corporation cannot make impactful decisions on the broader economy. Also, the decision of a single household about what they should or should not consume will not have any recognizable effect on the general economy. It is only where these decisions are collective and taken by many households within a community that they become known.
Contrastingly, a single decision made by the government can have an impactful effect on the largest and most developed economies. It is government decisions that boost or bring down economies. And there are two reasons why these decisions matter:
The public sectors in every developed economy employ the largest proportion of the population. The government is dedicated to creating jobs for its people than just relying on the private sector. Besides, they are normally the biggest spenders within the economy. Consider, for instance, that the government is usually the biggest borrower and customer for financial institutions.
Governments are the largest borrowers in the world debt market. This means the significantly contribute to the growth of a particular economy. The world debt market indicates general growth within the global economy. It helps economic analysis make assumptions and decisions based on real data.
And it is because if these two reasons that we have government policy. This policy is expressed in terms of borrowing and spending activities. There two major government policies in this regard: the fiscal policy and the monetary policy.
Both fiscal and monetary policies have many overreaching goals. Economic cycles are inevitable; they are caused by constant shocks within these economies, creating a state of natural cycles. As if that is not enough, there are a lot of instances where these policies have exacerbated t and economic expansion that could lead to over-reaching damages to the real economy, touching both financial markets and investors.
In this the next section of this reading, we are going to look at the conduct of these two policies. It is vital to understand where they all come together and operate as separate entities since they are widely applied in the general economies. There are all many challenges to applying these policies, something that we are also going to look at within the article. In the section, we shall be looking at the meanings of monetary and fiscal policies. And we will finish with how they relate in terms of application and functionality within a real economic situation.
As the name suggests, this is a policy that involves money decisions. This policy is typically used by central banks to either stimulate and stabilize the economy or check its growth. For instance, if there is a low rate of borrowing and spending, the central bank can use these laws to incentivize both individual consumers and firms so that they can spend more and save even more. In this case, the policy is used to spur economic activity. Conversely, a government can use these policies to restrict spending and incentivize saving. In this case, monetary policies act as a brake to inflation and other issues that comes from overheated economies.
One of the major causes of the 2008/2009 Great Recession has been attributed to high-interest rates. Through the 2000s, there as an economic boom, especially in the housing industry. Expenditure was very high, with many consumers getting the impression of great wealth across markets. Banks become very aggressive in lending; they ran out of funds and needed a load to continue operating. And because of increased consumption, central banks increased the lending rates to control the borrowing spree and shield the economy from overheating. The result becomes catastrophic, with one of the worst market failures in history. Again, policymakers had to go back to the drawing board to apply policies that could make better output into the economy. One such decision involved lowering the interest rate as a way to incentivize consumers to spend more and save less.
In the US, the Federal Reserve, or simply 'Fed,' has time and again used three policy approaches to influence sustainable economic growth. These include using open market activities, changing reserve requirements and financial institutions, and setting the discount rate. The open market operation happened daily where the Fed sells and sells bonds on behalf of the US government to inject money from the economy or pull money out of circulation. The Fed has a direct impact on the amount of money/profit made with banks give out loans. It does this by setting the reserve ratio, or the percentage of the deposits the banks can keep at the reserve. The Fed also targets changes in discount rate – the interest rate charged on loans – which goes into impacting short-term interest rates in the economy.
In simple terms, monetary policy is like a blunt tool used in expanding and contraction the money supply, which influences inflation and growth. It is said to have less impact on the real economy. For instance, the Fed was extremely aggressive during the Great Depression. It acted fast with polices that prevented deflation and total economic failure. But it did not generate any significant economic growth to reverse the condition that would have easily gone out of hand. Expansionary monetary policy can only increase asset prices and lower the costs of borrowing, incentivizing companies with more profit – but that is just as far as they go in terms of real economic growth impact.
Note that monetary policy seeks to spur economic activity. Fiscal policy, on the other hand, addresses either total spending, the total spending composition, or both aspects.
In general, governments use fiscal policies to target the total level of expenditure, spending composition, or sometimes both. The most widespread means of applying this policy is through government spending and tax policies. Where a government believes business activity of low, it can increase the amount of public spending, which is called stimulus spending. And if there are not enough tax receipts to pay for increased spending, governments issue securities like government bonds, which makes it accumulate debt and, in the process, get enough money for its activities – which is called deficit spending.
When there is too much money in an economy, the government settles it by pulling out money, a process that slows down all business activities. In this case, fiscal policy is applied when the government wants to stimulate an economy. For instance, it will lower taxes or offer tax rebates as a way to incentivize economic growth. In other words, there are always fluctuations within the economy. This means every step the government takes comes with a great impact on the economy. Fiscal policy is one of the aspects of Keynesian economics.
The government also needs to spend money on fiscal policy. And for this, it has to know how much it spends to change the policy, or in changing tax policy, it has to choose where to spend it, or what to tax. By doing so, a fiscal policy initiated by the government can be used to target specific communities, industries, investment in any other area. Or it can be used to discourage commodities as a way to favor or discourage production based on what is happening within the general economy, though some of the considerations may not be related to the economy entirely. This is why fiscal policy is one of the hottest topics of discussion among economists and political observers.
Essentially, fiscal policy targets aggregate demand. It is not only consumers or the government that benefits from these economic changes, but companies also reap from increase revenues. If the economy is in full capacity, however, or near full, it will not be wise for the government to use expansionary fiscal policy because they risk sparking inflation. When the inflation rate is high, along with other factors like the high rate of unemployment, it wastes the margins of selected corporations in a competitive industry, which may not be able to pass on the costs to consumers. This also means it will eat away the funds of people in terms of a fixed income.
Fiscal effects come with certain side effects. A high-income tax or corporation can reduce work incentives. In such situations, a business may not like the uncertainty of various economic facto, which may affect the investment rate. And this is why fiscal policy is not used much in controlling inflation.
Cutting government expenditure is not always a good step since it also harms capital investment. It can also lead to lower benefits with increased inequality.
Fiscal and Monetary policy together
Whenever there is a recession, the monetary policy comes in through cutting of interest rates to attempt stimulation of spending and investment. Such policies could only weaken the exchange rate, helping exports in the process. When the 1992 recession cut through the UK, there was a cut in the interest rates (which brought up the need for the devaluation of the over-valued pound) was very effective in initiating economic growth. This recession was caused by interest rates. Hence, when they were cut, it reduced the burden on homeowners and firms, allowing the economy to pick up again and recover.
We cannot stop asking how fiscal policy affects monetary policy because they touch central banks through their mode of operation. There are direct and indirect ways through which the effects can be felted. For a start, there are several methods through which fiscal policy may impinge on monetary policy. The expansionary fiscal policy is perhaps one of the major ways of influence as it may bring up excessive fiscal deficits, that could create a strong temptation for the government to inject money into the economy. This means an expansionary fiscal policy could lead to an expansionary monetary policy. Doing this can also be fueling inflationary pressures, which possibly creates a real appreciation of the currency. It can resolve issues such as the balance of payment difficulties, with a potential result in a currency crisis. It is in the hands of governments to come up with these policies at the right time and just enough to resolve a specific problem.
Sometimes governments may think of financing their deficits through a non-monetary way, for instance, through markets. In this case, there will always be a cause for concern, especially in terms of crowding out. If it happens that a government injects too much funding into the markets, it could create too little or too expensive credit for the private sector. Such things are harmful to economic development and growth, calling for central bankers' attention. On the outside, too much dependence on foreign funding for domestic debt creates a risk in which the exchange rate and/or balance-of-payment risks would arise. This, too, will not go unnoticed by the central banks.
The effect of indirect taxes on price level affects inflation, and thus a more direct impact of fiscal policy on monetary policy. Governments can also be forced to resort to a substantial increase in indirect taxes (sales taxes) and in value-added taxes as opposed to other forms of income, which directly affects commodity prices. The key issues are that a one-off in-increase may lead to a wage-price spiral, causing permanent inflation or inflationary expectations.
Fiscal and monetary policies are two critical players in economic growth and development. Apart from the direct relations mentioned above, there are many other indirect channels of conduct. Consider, for instance, the perception and expectations of large and on-going budget deficits as well as the resulting large borrowing requirements. Such issues may initiate a lack of confidence in business prospects, which becomes a huge concern for financial market stability. In summary, both fiscal and monetary policies can be applied together for economic health.
Author: James Hamilton