Governmental Discretion over Fiscal and Monetary Policy - Essay Example

?Running head: GOVERNMENTAL DISCRETION OVER FISCAL AND/OR MONETARY POLICY Governmental Discretion over Fiscal and/or Monetary Policy Insert Insert Grade Course Insert Tutor’s Name 13 January 2011 Executive Summary Businesses operate in complex and challenging environments that are influenced my macroeconomic factors such as government macroeconomic decisions. Fiscal and monetary policies formulated and legislated by the government influence and impact business. For instance, government increased deficit results into increased interest rates that in turn adversely affect private investments. Therefore, it requires adequate consultation and high involvement in formulating and implementing any particular fiscal or monetary policy. Nevertheless, this report looks at the nature of fiscal and monetary policy and implementation may affect business specifically with regard to investment. In the end, the report postulate that there is little effect resulting from expansionary fiscal policy and that it has little effect on demand, output, and employment. Also, the report notes the important role business community should play in fiscal and monetary policy making since they constitute the largest group that get affected by these policies. Governmental Discretion over Fiscal and/or Monetary Policy Introduction Business activities are affected by different factors macro and microenvironment operation environment. While microenvironment sometimes may be within the control of the organization, macro-environment –on the other hand involves external factors that affect the business, which in turn may define the success or the failure of the organization. For example, macro-environment spans politics, economics, social matters, technology, legislation, and eco-environment (Elearn Limited and Pergamon Flexible Learning 2005). Political environment particularly legislative environment constitutes specific set of external business environment that business communities in any given country have been forced to adhere to. For example, monetary and fiscal policy process in any country has affected business in the positive way or negative way given the nature of the particular legislation law. Therefore, the focus of this paper will dwell on investigating and finding out whether it is in the best interests of the business community for there to be constraints on government discretion over fiscal and monetary policy. Exploring the concept of fiscal and monetary policy Both fiscal and monetary policies are seen to be interrelated and key tools to the development of many countries especially the developing one. For instance, fiscal policy constitute all measures that are adopted in order to increase the general welfare through the public control of resources by means of public spending, resource mobilization and price fixation in public and semi-public enterprises (Elearn Limited and Pergamon Flexible Learning 2005). Today, fiscal policy has been embraced as a toll of development strategy when analyzed in broadest sense it can be seen that it provides a set of instruments to pursue both the best use of resources in terms of efficiency and equity and their maximum possible use in terms of employment, price stability and satisfactory rate of growth (Mukherjee 2007). Exhibiting characteristics of monetary policy, fiscal policy performs a very critical and beneficial role in the economy and analysis has shown this kind of policy performs two important roles in the economy with regard to raising financial resources for development (Mukherjee 2007). First, fiscal policy constitutes a set of mechanisms that ensure the country’s employment level is maintained at its full capacity and as such, the aggregate capacity to save does not go down (Mukherjee 2007). Secondly, it helps to raise the marginal propensity to save of the community above the average propensity to the maximum extent possible without discouraging work effort or violating the law of equity (Mukherjee 2007). Fiscal, together with monetary policy, are seen to be two important aspects in the economy of any nation. Fiscal expansionary policy that is boosted by increased government expenditure has the ability to enlarge the share of the public sector in the economy relative to that of the private sector, especially in circumstances crowding out is taking place (Fourie 2000). On the other hand, expansionary monetary policy does not in any sense affect the relative share of these two sectors even in circumstances of increased government role in the economy (Fourie 2000). On the other hand, expansionist fiscal policy is likely to cause some upward pressure on interest rates through monetary feedback effect. In such circumstances, capital formation (investment) is discouraged and in this way, the fiscal option if adopted may lead to constrain in production capacity growth in the long run, while the monetary policy option may be more growth promoting (Fourie 2000). Should business community support government effort to constraints fiscal and monetary policy? According to Keynesian postulation, reduction in budget deficit specifically after implementation of spending cuts regime has the capacity to lead to temporal slowdown of aggregate demand and of general economic activity (Afonso, 2001). On other hand, according to the understanding of neo-classic explanation, reduction in budget will results into no effect on economic activity since aggregate supply is believed and deemed the main stimulant of economic growth (Afonso 2001). Keynesian further postulates that, after a fiscal contraction, there is reduction in aggregate demand manifested through decrease in public consumption and investment and through indirectly from families’ reduction of consumption as a result of decrease in disposable income (Afonso 2001). Decrease in disposable income comes as a result of increased taxes or even reduction in public transfers. Convectional macroeconomics holds that fiscal contraction can be realized largely at the cost of reduced output and employment since tight fiscal policy has the tendency to reduce aggregate demand for goods and services (Hallet et al. 2003). With the existence of rigid prices, the decline in nominal demand results in a fall in real output where at the same time fiscal consolidation depends a lot on increased taxes which is a situation that might precipitate negative supply-side effects due to increases in labor costs (Hallet et al. 2003). Nevertheless, the above position was challenged by the ‘Germany View’ in early 1980s and according to their new view visionary investors in the private sector are convinced that a budgetary consolidation implies lower taxes in the long-run since the government has less debt to service in the long-run (Hallet et al. 2003). Assumption made is that, consumption in this particular circumstances depends on permanent income and investment demand ids forward looking, it turns out that investment and consumption will rise relative to the case where no fiscal consolidation takes place (Hallet et al. 2003). In such cases, consumers are assumed rationally anticipative to lower future tax burden. The success of this will largely depend on the assumption that before consolidation, fiscal policy is regarded to be ‘unstable’ in the sense that taxes will in future have to be raised relative to the current levels to service the government debt and in this way a fiscal contraction policy in real sense serves to increase aggregate demand (Hallet et al. 2003). Conclusion Business community’s sound judgment to make decision on whether to support government actions can be explained following analysis of fiscal policy and the crowding out effect. Keynesian conviction was that changes in the size of the budget deficit are likely to cause great impact on aggregate demand and output in general (Gwartney et al. 2008). Nevertheless, in recent times, economists believe that there exist secondary effects, which tend to weaken the potency of fiscal policy (Gwartney et al. 2008). On overall when the size of the budget deficit goes up, the government will need to borrow more money a situation that will ignite increase in the demand for funds in the loanable funds market (Gwartney et al. 2008). This particular episode will force interest rates to rise and subsequently have an effect on private spending (Gwartney et al. 2008). Impact to the private spending will result from the tendency of consumers to reduce their purchases of interest-rate-sensitive goods and other durables (Gwartney et al. 2008). Further, the higher interest rate will increase the opportunity cost of investment projects and business will tend to postpone spending on infrastructure and business expansions (Gwartney et al. 2008). In essence, real interest rate that is made to rise due to government increased deficit will results in retardation of private spending and this aspects among economists has been referred to as ‘crowding-out effect’ (Gwartney et al. 2008). The postulation of ‘crowding-out effect’ is that as more private investment is crowded out by higher interests rates, the output of capital goods decline and future work experienced reduced output. In sense, the increase in deficits will have negative effect on capital formation and in long run tend to stifle growth of productivity and income (Gwartney et al. 2008). In short, that ‘crowding-out effect’ justifies the argument that expansionary fiscal policy has little effect on demand, output, and employment (Gwartney et al. 2008). Reference List Afonso, A., 2001. Non-Keynesian Effects of Fiscal Policy in the EU-15. Lisbon, University of Lisboa. [Online]. Available from: http://pascal.iseg.utl.pt/~depeco/wp/wp72001.pdf [Accessed 13 January 2011]. Fourie, P. C., 2000. How to Think & Reason in Macroeconomics. South Africa, Juta and Company Ltd. [Online]. Available from: http://books.google.com/books?id=DH3dUDhaBusC&pg=PA328&dq=how+constraining+monetary+or+fiscal+policy++may+benefit+the+economy&hl=en&ei=fbEuTZfyKI_xsgbgwrnbBw&sa=X&oi=book_result&ct=result&resnum=9&ved=0CFMQ6AEwCDgK#v=onepage&q&f=true [Accessed 13 January 2011]. Elearn Limited and Pergamon Flexible Learning. 2005. Business environment. MA, Elsevier. [Online]. Available from: http://books.google.com/books?id=uyU2UV4H550C&pg=PA75&dq=macro-environment+of+the+business&hl=en&ei=SKguTducK8KSswasrdzYBw&sa=X&oi=book_result&ct=result&resnum=1&ved=0CCMQ6AEwAA#v=onepage&q=macro-environment%20of%20the%20business&f=false [Accessed 13 January 2011]. Gwartney, J. et al., 2008. Economics: Private and Public Choice. OH, Cengage Learning. [Online]. Available from: http://books.google.com/books?id=yIbH4R77OtMC&pg=PA245&dq=effects+of+an+expansionary+fiscal+policy+on+investment&hl=en&ei=dNQuTYewDuOAhAfG-LTnCg&sa=X&oi=book_result&ct=result&resnum=1&ved=0CCMQ6AEwAA#v=onepage&q=effects%20of%20an%20expansionary%20fiscal%20policy%20on%20investment&f=false [Accessed 13 January 2011]. Halett, A. et al., 2003. Fiscal policy in Europe, 1991-2003: an evidence-based analysis. Centre for Economic Policy Research. [Online]. Available from: http://books.google.com/books?id=ZQWriaVaTewC&pg=PA43&dq=effects+of+an+expansionary+fiscal+contraction+policy&hl=en&ei=_M0uTbTYNIGGhQfz9-jgCg&sa=X&oi=book_result&ct=result&resnum=3&ved=0CDAQ6AEwAg#v=onepage&q=effects%20of%20an%20expansionary%20fiscal%20contraction%20policy&f=false [Accessed 13 January 2011]. Mukherjee, S., 2007. Modern Economic Theory. New Delhi, New Age International. [Online]. Available from: http://books.google.com/books?id=4d6FmT2c13cC&pg=PA845&dq=how+constraining+monetary+or+fiscal+policy++may+benefit+the+economy&hl=en&ei=kqouTYewJYOMswbbIzzBw&sa=X&oi=book_result&ct=result&resnum=9&ved=0CFMQ6AEwCA#v=onepage&q&f=true [Accessed 13 January 2011]. Read More