Defining Fiscal and Monetary Policy - Essay Example

Explicitly define both fiscal and monetary policy. In our market economy, we have what we call a “Business Cycle”. A business cycle pertains to alevel of economic activity that has three phases. First is Expansion, characterized by growing businesses, rising employment and higher output or income. When expansion reaches its peak, it then slowly falls down into a Recession, the second phase, which is on the contrary characterized by falling employment, low output or income, and rising interest rates. And when recession even worsens, it hits a bottom point known as the “Trough”, and then after certain factors permit favorably the economy slowly swings back into a Recovery, the third phase. It is during periods of recession, however, that terms fiscal and monetary policies can best be appreciated. Fiscal policy is the policy advocated by John Maynard Keynes while monetary policy, on the other hand, is advocated by Milton Friedman. According to basic economics, the obvious traceable cause of a recession is a poor level in aggregate demand. When we say aggregate demand, it is the total demand for all goods and services produced in a particular period. Of course needless to say, when no one is buying anything, who would want to produce more? What reason there is for an employer to hire working men to manufacture his product when no one after all is demanding for it? It will only bring him a loss instead of income. According to Keynes, during periods of recession, the government must enter the game and play a very critical role --- to stimulate overall aggregate demand (which is a deemed solution to the problem). The government must cut taxes and spend more on worthy projects to support the public needs and the business sector. When taxes are low and more government projects are in harmony with business’ goals and visions, more investors are being lured to invest, thereby solving unemployment problem. Now assuming the opposite is happening as in the case of an overheated expansion, the government still has a role to play. It has to tighten taxes and spend less to counter balance the effects of economic boom. Whether the government cut or tighten taxes, spend more or less, these actions simply refer to the government’s fiscal policy. Monetary policy on the other hand is another perceived solution to the problem of recession. As the word suggests, monetary policy has to do with interest rates and money --- production, supply and circulation of money. According to Milton Friedman, the proponent of monetary policy, the supply and circulation of money in the market has a greater impact on the economy more than anything else. During a period of high unemployment the government must reduce the interest rate and increase the money supply. Likewise, when unemployment is low, the government has to raise interest rates and decrease the money in circulation. As compared to fiscal policy which is more of a function of the legislative branch of the government, take note that the implementation of monetary policies is vested in the hands of the Central Bank. They are independently implemented apart from fiscal policies of the government. 2. Compare and contrast the way Keynes and Friedman approach the economy. What are their key differences and similarities? John Maynard Keynes is a British economist who believes that the key to achieving a balanced economy, especially during a period of recession and economic downturn, is an effective government intervention that will cut on taxes and implement an expansionary fiscal policy (meaning, more government spending on worthy projects) or contractionary fiscal policy (increase in taxes and lesser government spending) as the case may be. Keynes’ economic framework focuses more on demand and spending. Absurd as it may sound but Keynes believed that spending, and not hoarding, helps the economy at large. The reason is that the spending of one person forms part of the income of another person, and when that person further spends his income, it forms part of the income of still another person, and so on and so forth. Keynes also believes that as far as the macro-economy is concerned, it is the total aggregate demand for goods and services that will ultimately determine economic growth and prosperity. Milton Friedman, a Nobel Prize awardee, on the other hand, added to Keynes’ framework a theory of prices and inflation. He believes that the key to stabilizing the economy is not through cuts in taxes and government spending or non-spending but through the effective circulation of money in the market and manipulation of interest rates. Of course, this is the function of our central bank. This strategy of economic intervention simply refers to the monetary policy of the government. That is why those who adhere to Friedman’s views are sometimes called “Monetarists”. Further, Friedman thinks that during a period of high unemployment, expansionary fiscal policy as suggested by Keynes is not at all a permanent solution to solve the problem, albeit there is a temporary trade-off between unemployment and inflation (consequential effect of expansionary fiscal policy). What can be achieved, according to Friedman, is only a little success. Eventually, unemployment will rise again even as inflation remained high. (Krugman, Paul. Quotations posted by Dirk. “Government spending causing inflation-Keynes vs. Friedman.” Discover It. Google.com. 25 May 2009. Web. 16 Apr. 2011) Although Keynes and Friedman differ in their significant views about the key to stabilizing the economy, they certainly converge on one thing --- both economists believed that an effective, strategic, and powerful yet limited government intervention is necessary in an effort to keep the economy on an even keel. 3. The following are five current or historical government actions dealing with macro-economic policy. For each scenario determine if it represents fiscal policy or monetary policy, and explain your answer. a. President Obama has proposed a budget for the next year and the House of Representatives has proposed their own budget that has major differences with the President’s. This scenario represents Fiscal policy. The major source of budget to defray government expenses for a certain calendar year is the taxes derived from the people. Large budget means large taxes imposition and lesser budget means tax cuts. When we speak of tax cuts, we are talking of fiscal policy. b. When President Clinton was in office during the 1990’s there was an intentional policy of reducing interest rates, both short and long-term. This pertains to monetary policy. An intentional reduction in interest rate is one aspect of a monetary policy of the government. c. Beginning with the Bush administration and continuing with the Obama administration there was a bailout of the financial system. A bailout of the financial system means a rescue by the government of financial institutions who have gone bankrupt. In order to do that the Federal government has to spend money to purchase distressed or mortgaged assets of certain corporations in order to save the credit market and avoid further erosion of the economy. Since this action involves government spending, this I believe pertains to Fiscal policy of the government. d. To avoid a stalemate with Congress that could have prevented any new legislation from being passed, the President and Congress, in December 2010, reached an agreement on extending the Bush era tax cuts for an additional two years. This represents a fiscal policy because again it involves tax cuts, and cuts in taxes is one feature of the fiscal policy of the government. e. Paul Volker was chairman of the Federal Reserve System in the late 1970’s and through most of the 1980’s. In the late 1970’s and into the early 80’s the United States was experiencing high inflation, reaching double digits of 10% and more. To reduce the inflation rate Mr. Volker dramatically increased interest rates to slow down the economy, and this plunge the U.S. into a steep recession. This is an example of a monetary policy because what was used as economic intervention method by the government is a reduction in interest rate instead of tax manipulation and is being implemented by the Federal Reserve System. 4. You have learned that Keynes and Friedman sharply differed on some basic ideas of how the Federal government should conduct economic policy. Which of the two economists do you agree with more, and explain why. Keynes economic policy is that the spending of one person forms part of the income of another person, and when that person spends his income, it further forms part of the income of still another person, and so on and so forth. Accordingly, this scenario must be encouraged to achieve a balanced and at least healthy, if not prosperous, economy. It is for this reason that I view Keynes economic policy as more humane and liberal in character than anyone else’s because it discourages the selfishness in hoarding and unfettered capitalism. In fact, during the great depression people tend to hoard for fear of running out of stock, which in effect only exacerbated the economy’s worst condition. I do not mean to say that Friedman’s views are without credence, but in my personal opinion Friedman’s theory on Interest rate manipulation which is also conducive to the economy is only supplemental and supportive to Keynes’ views, and the theory on money supply is in some respect already incorporated in Keynes’ spending framework and government intervention through tax cuts or increments, as appropriate. Thus, between the two I agree more with Keynes in so far as the manner of how the Federal government should conduct economic policy is concerned. Works Cited Krugman, Paul. Quotations posted by Dirk. “Government spending causing inflation – Keynes vs. Friedman.” Discover It. Google.com. 25 May 2009. Web. 16 Apr. 2011. “Fiscal vs. Monetary Policy.” n.p. Google.com. n.d. Web. 16 Apr. 2011. Read More