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Effects of Fiscal and Monetary Policy on the Economy
Fiscal policy and monetary policy are two tools that are used to influence the economic activity of a country. The economic policy of any government comprises of fiscal and monetary policies. These tools are used by the government to stabilise the economy to achieve economic growth. Fiscal policy involves altering government spending, government borrowing and direct and indirect taxation to influence the level of aggregate demand in the economy. Fiscal policies are applied whenever a government wants to influence expenditure on goods and services. Fiscal policy also serves as a means of redistributing income and wealth. This can be achieved by changing the tax rate levied on different levels of income. Fiscal policy is divided in two parts:
a). Government Spending- divided into three areas; current spending of the government on goods and services, capital spending on projects like infrastructure and transfer payments which focuses on state pensions and other kinds of benefits.
b). Taxation- used by the government to raise revenue, change the distribution of wealth and income in the country, control aggregate demand in the economy and to adjust market failure in the economy.
Monetary policy is the use of interest rate and changing monetary supply to control the economy and achieve the desired results. The central bank is responsible for making decisions on changing interest rates and money supply. Implementing any tool of monetary policy controls inflation by keeping it low or stable. This contributes to economic stability. Monetary policy always aims at achieving low inflation rate which spills over to increased economic growth. The main tool used in monetary policy is changing the interest rate. Depending on the situation in the economy, the Central Government may adjust its strategy and use other tools of stabilising the economy (Pettinger).
Fiscal policy is further divided into two parts. We have expansionary fiscal policy and contractionary fiscal policy. Expansionary fiscal policy aims at increasing economic growth. The government may decide to either increase government spending or to reduce tax rates. Increasing government spending in the economy increases economic growth. Reducing the tax rates also leads to increased economic growth. Contractionary fiscal policy is the reverse of the former. It serves to reduce the level of economic growth. This is done by reducing government expenditure of increasing the tax rate. Increasing tax rate reduces money circulation in the economy which stabilises the economy.
Expansionary fiscal policy increases the level of aggregate demand in the economy. This is achieved by reducing the tax rates or increasing the amount of government expenditure. Expansionary fiscal policy can be achieved by implementing three strategies;
Increasing consumption- to increase consumption, the government needs to raise the amount of disposable income held by the citizens. This can be achieved by reducing the amount of personal tax levied on individuals.
Increasing investments- investments can be raised by channelling more money in the economy through funding of projects such as infrastructure projects or health projects. Reducing business taxes also increases economic growth.
Increasing government purchases- this is where the federal government increases the amount that they spend on final goods and services. The government raises the grants used by the state and local government which will in turn increase the amount of expenditure on final goods and services.
Contractionary fiscal policy will do the reverse. It will decrease the level of aggregate demand in the economy. This is achieved by increasing tax rates or decreasing the amount of government expenditure. Contractionary fiscal policy is achieved by decreasing consumption, decreasing investments and decreasing the amount of government purchases (Kuepper).
Monetary policy can be implemented by adopting either expansionary monetary policy or contractionary monetary policy. Expansionary monetary policy aims at increasing money supply in the economy. Contractionary monetary policy aims at decreasing money supply in the economy. Monetary policy can either increase or decrease the amount of money in the economy. To determine whether to use an expansionary or contractionary monetary policy there needs to be an understanding on the real trend in the economy and the neutral interest rate.
There are three tools of monetary policy:
a). Reserve requirements- this is the minimum amount of money that banks are required to maintain or to deposit in their vaults with the Federal Reserve Bank.
b). Open market operations – also known as OMO. It involves the buying and selling of government securities. The fact that it is open market suggest that the Federal Reserve Bank does not decide by itself which security business dealers should use to trade in. The idea behind it is that the dealers who trade with the Federal Reserve Bank compete in terms of price on the various securities that they are going to deal with.
c). Discount rate- this is the amount that the Federal Reserve Bank charges when it gives short term loans to the government or to depository institutions.
Expansionary monetary policy applies when the Federal Reserve Bank uses the above three tools to stabilise the economy. This is done by reducing the minimum reserve requirement that banks are required to maintain or to deposit with them. Reducing the discount rate that the Fed charges when it is giving short term loans to the government or to depository institutions. To increase liquidity in the economy the Federal Reserve Bank will liquidate treasury bills and bonds.
Contractionary monetary policy achieves the opposite of the expansionary monetary policy.
In conclusion we need to answer the big question which is which of the two methods effective to use to stabilise the economy. The economic situation at hand will dictate the method that will be used. When the economy is experiencing a serious recession a combination of both fiscal and monetary policies will salvage the economy from the recession.
Monetary policy is mostly used to make minor adjustments in the economy. Adjusting the interest rates is the easiest strategy to use to change the economic cycle that the economy is experiencing. Contractionary fiscal policy is quite unpopular with many state governments. Fiscal and monetary policies have their own pros and cons.
There is no generic strategy that clearly outlines which method needs to be used. Ideally both policies should work together but this is rarely the case. Leaders in the government are the ones who get to decide which method to adopt. More often than not they tend to adopt expansionary fiscal policies. Reducing taxes increases the chance of leaders getting re-elected to government office. To avoid inflation in this situation the Federal Reserve Bank enforce contractionary monetary policy.
Work Cited
Pettinger, Tejvan. “Monetary Policy Vs Fiscal Policy.” Economics Help, 23 Apr. 2018, https://www.economicshelp.org/blog/2253/economics/monetary-policy-vs-fiscal-policy/.
Kuepper, Justin. “How Fiscal and Monetary Policy Influences an Economy.” The Balance, The Balance, 25 June 2019, https://www.thebalance.com/fiscal-vs-monetary-policy-whats-the-difference-4042632.
“Expansionary Monetary Policy and Its Effects (With Diagram).” Economics Discussion, 11 Aug. 2015, http://www.economicsdiscussion.net/microeconomics/expansionary-monetary.