An Overview of Monetary and Fiscal Policy
Monetary and Fiscal Policy The Monetary and Fiscal Policies, although controlled by two different organizations, are the ways that our economy is kept under control. Both policies have their strengths and weaknesses, some situations favoring use of both policies, but most of the time, only one is necessary. The monetary policy is the act of regulating the money supply by the Federal Reserve Board of Governors, currently headed by Alan Greenspan. One of the main responsibilities of the Federal Reserve System is to regulate the money supply so as to keep production, prices, and employment stable. The "Fed" has three tools to manipulate the money supply. They are the reserve requirement, open market operations, and the discount rate. The most powerful tool available is the reserve requirement. The reserve requirement is the percentage of money that the bank is not allowed to loan out. If it is lowered, banks are required to keep less money, and so more money is put out into circulation (theoretically). If it is raised, then banks may have to collect on some loans to meet the new reserve requirement. The tool known as open market operations influences money and credit operations by buying and selling of government securities on the open market. This is used to control overall money supply. If the Fed believes there is not enough money in circulation, then they will buy the securities from member banks. If the Fed believes there is too much money in the economy, they will sell the securities back to the banks. Because it is easier to make gradual changes in the supply of money, open market operations are use more regularly than monetary policy. When member banks want to raise money, they can borrow from Federal Reserve Banks. Just like other loans, there is an interest rate, or a discount rate, the third tool of the monetary policy. If the discount rate is high, then fewer banks will be inclined to borrow, and if it is low, more banks will (theoretically) borrow from the reserve banks. The discount rate is not used as frequently as it was in the past, but it does serve as an indicator to private bankers of the intentions of the Fed to constrict or enlarge the money supply. The monetary policy is a good way to influence the money supply, but it does have its weaknesses. One weakness is that tight money policy works better that loose money policy. Tight money works on bringing money in to stop circulation, but for loose policy to really work, people have to want loans and want to spend money. Another problem is monetary velocity. The number of times per year a dollar changes hands for goods and services is completely independent of the money supply, and can sometimes contradict the efforts of the Fed. The benefits of the monetary system are that it can be enacted immediately with quick results. There are no delays from congress. Second, the Fed uses partisan politics, and so has no ties to any political party, but acts in the best interests of the U.S. Economy.
A change in government spending has a stronger effect on the economy than a change in tax rates. It is possible to manipulate the money in private hands without directly affecting them. thus reducing demand and inflation. A change in tax rates is usually implemented when inflation is unusually high. Because a tax cut can take a year to really take effect. then the president is more likely to be re-elected. The main point of fiscal policy is to keep the surplus/deficit swings in the economy to a minimum by reducing inflation and recession. and changing government spending. The policies are simply a myriad of tools used to prevent a long period where there is high unemployment. The fiscal policy consists of two main tools. Monetary and fiscal policies help keep the nation's economy stable. The changing of tax rates. all of which is released into the economy. and the economy begins to revive. anyway. If tax cuts are initiated and government spending is increased.
Although a fiscal policy does achieve in helping the economy for a short period of time by affecting the elements of aggregate demand namely investment and consumption it does have several problems that hinder its effectiveness. With them it is possible to control demand for services and goods and the ability to pay for them. During a recession with high unemployment. and it can be a long period of time before the situation is even recognized. along with low wages and investment. It is hard to predict inflation and recession. The fiscal policy can also be used as a campaign tactic. but has first to deal with the inflation his tactic caused. The major problems are timing and politics. Politics are another problem. taxes are lowered to give more people money to spend and thus increasing demand for goods and services. the fiscal policy is initiated by the government. On the one hand as previously stated an expansionary fiscal policy by decreasing
. taxes are increased so people have less to spend. inflation. When the government decides to fight a recession it can spend a large amount of money on goods and services. and so politics play a key role in the policy. Despite the effectiveness of the Fiscal policy. it does have drawbacks. When the concerns of the government are viewed.The second way to influence the money supply lies in the hands of the government with the Fiscal Policy. Unlike the monetary policy run by the partisan Fed. the economy could revive from the recession and the new unnecessary tax cut could cause inflation. it becomes obvious that a balanced budget is not the primary objective. and prices. With high inflation. and there is a recession with high unemployment.
This is an effective way to combat economic problems such as unemployment and recession. This will happen since the decrease in taxation will increase people’s disposable income and consequently depending on the marginal propensity to consume the domestic consumption of an economy which in turn will increase aggregate demand. On the other hand if there is low marginal propensity to consume no matter how low the government drops the tax domestic consumption wont increase and thus domestic consumption wont increase. This policy will increase taxation thus decreasing the citizen’s disposable income thus in turn reducing consumption which will reduce aggregate demand which will in turn reduce inflation. rent and interest rates. In the case of financial crowding out increased government spending will lead in an increase in demand to borrow money so as to finance this spending. Moreover a fiscal policy could lead to the crowding out effect. This may occur due to information problems seeing that information is sometimes difficult to collect on the exact position of the economy at any moment and thus may make false estimations on the extent to which the policy should be dragged. This happens in the case of an expansionary fiscal policy government spending on public and merit goods as a result the government increases demand for specific factors of production. Another problem that may occur is that the government may over or under estimate the problem and thus impose a non effective fiscal policy since it will either increase demand too much or too little. Firstly fiscal policy can’t be effective if consumption isn’t effective to tax changes in other words if there is a high marginal propensity to consume. This increased demand will lead to increases in wages. This is divided in two categories. There is also the issue of time seeing that in order for the fiscal policy to be constructed this may take some time and by then the situation will be altered thus the policy wont be as effective. Similarly the government by increasing spending in all sectors of its economy it will increase investment which in turn may lead to an increase in aggregate demand. As a result there will be an increase in interest rates which in turn may discourage investment from private firms. Finally there is the issue of the fiscal drag that may make fiscal policies ineffective.taxation and increasing government spending the fiscal policy will probably achieve in increasing aggregate demand. This can be explained by the fact that people earning higher income due to an increase in government spending will move to a higher income bracket and pay higher taxation something that will reduce consumption on their part and leas the economy to slowdown instead of growth.
. This happens because if the government keeps increasing government spending with taxation levels remaining stable the government may move into recession and a deflationary gap might emerge. What this will mean is that no matter how high the government raises taxes the people will still insist on spending as much as they previously did thus not decreasing domestic consumption. However these policies aren’t always very effective for several reasons. On the other hand it will decrease government spending thus decreasing investment which will again reduce aggregate demand and thus in turn reduce inflation. resources and financial crowding out. On the other hand if a government wants to eliminate recession it will have to pursue a contractionary demand side policy. In the case of resources crowding out this indicates an increase in reward for the factors of production.