Federal Issues in Fiscal and Monetary Policy - Essay Example

? Essay: Macro & Micro economics Introduction Economic policies of a country may be implemented through two kinds of stabilization policies: the Fiscal Policy and the Monetary Policy. They aim at achieving a full employment in the economy concerned. While the Monetary policy is controlled by the Central Bank of a country, the Fiscal Policy is managed by the Government of that country and hence the Central bank of United States, The Federal Reserve Bank must work in tandem with the government in order to achieve a stable economy. Problem Statement: A government’s expansionary Fiscal and Monetary Policy and the consequences of these actions on the other Economic variables. Fiscal Policy By a Fiscal Policy the U.S. government would control the spending in form of government expenditure and earnings in form of taxes to manipulate the economy. These would affect the other economic variables which include Aggregate demand, Gross Domestic Product and Employment of a country. The Government would go for an Expansionary Fiscal policy in times of recession in which U.S. Government would spend more than they would collect taxes from the people. That is government spending would exceed taxes. The opposite would happen in case of a Contractionary Fiscal Policy where the government would increase the taxes more than it intends to spend. Now government spending may account for a variety of activities which include roads, education, healthcare, welfare activities and defense. This government spending is financed chiefly by taxation (Blanchard, 2010). There are other alternative ways of funding like printing money, external borrowings from foreign countries etc. The government may also borrow from the public which is called public debt. But this would be done by the government only when on the occasion of a deficit in the government budget. The U.S. Government utilizes the Fiscal policy in the endeavor to affect the aggregate demand along with full employment. When there is inadequate aggregate demand in the economy, the government would decrease the rate of taxation and increase the expenditures by making use of idle resources. This would lead to increase in the growth rate of the economy and would tend towards full employment by decreasing the rate of unemployment. As a result the output would increase. This kind of government spending has a multiplier effect because when a government starts a new project, along with the output of the project it generates employment for the workers and hence the consumption and savings. However Fiscal Policy might also be constrained by a crowding out effect which would happen if there is a rise in interest rates which would curb investment. However, if the economy is going through a recession then already a lot of resources are unused and hence this would not pose a problem for the economy explicitly (Froyen, 2005). Monetary Policy The monetary policy is implemented by the Central Bank with a control on the money supply with is undertaken with the help of several methods. This can be controlled mainly by purchase or sell of bonds which increases or decreases the supply of the money in the economy. Now bonds are debt instruments that guarantee the buyer the return of the principal along with an interest or the coupon at some specified date. This rate of interest or the coupon rate is determined by the Central Bank and one of the tools by which the Central Bank controls the supply of money in the economy (Mankiw, 2012). Now, when the bank wants to reduce the money supply of the economy or decrease the liquidity, it would go for a Contractionary Monetary policy wherein it would start increasing the interest rates. As a result, the coupon rates of the bonds would increase which would compel people to park their money with the banks, having less money in their hands. This would lead to a reduction in liquidity in the entire economic system. In contrary to this by an Expansionary Monetary policy, the Federal Reserve Bank would decrease the rates of interest and hence the people would start taking out money out of the banks and hence it would lead to an increase in the liquidity in the system. This is called Open Market Operations by a central bank which is mainly a short term strategy to control the economy with the assistance of Repo and reverse repo which are purchase and repurchase agreements to create and destroy money temporarily. This version of monetary policy would be used by the government to fight unemployment problem in times of recession by decreasing the rate of interest. Alternatively if the Central bank increases the reserve requirement ratio for the banks, it would lead to the same effect. This is because the banks would be forced to maintain a certain portion of their reserves with the Central Banks. Hence it would immobilize the funds which otherwise would have been borrowed or taken out by the people in the economy. The opposite would happen in an Expansionary Monetary policy where the Federal Reserve would cut the reserve requirement rates and hence more money can be mobilized by the banks by letting it out to the public and hence in the economy (Dornbusch and Fisher,2005). Comparison of the Expansionary Fiscal and Monetary policies In the context of recession, the main motive behind an expansionary fiscal policy is to increase the aggregate demand of the economy. On the other hand, monetary policy aims at controlling rates of interest and inflation in a recession struck economy. While the fiscal policies have an effect on the commodities market, its counterpart affects the money market. When these two policies are enacted together it has effect on the major two macroeconomic variables namely income and rate of interest. A question may arise whether these policies go hand in hand. If both the parties work in tandem and implement Expansionary policies, then they would benefit the economy. Keynes was of the view that by increasing the spending and reducing taxes, the people can be encouraged to invest which would result in an increase in the aggregate demand. In his opinion, this policy was best suited for the times of recession and retarded economic activities. He posited that in times of recession people prefer to keep cash money and the multiplier effect would blow up a small difference in consumption or savings. Conclusion Most economists accept the fact that monetary policy is a better tool for helping a country move out of recession because there would be less political intensions involved while formulating monetary policies as it involves the actions made by the Federal Reserve which is an independent body. Also monetary policies can be taken with immediate effect when the Fiscal policies would need time to implement. The Neo Classical Economists do not support fiscal policy on the ground that Fiscal policy has in it a crowing out effect which in turn would offset the positive effect of fiscal expansion to a certain extent as opposed to the views contributed by Keynes. The Classical Economists are also of the opinion that this kind of Fiscal policy would hinder the exports which would have an extenuating effect on the economy’s output. On the other hand, Economists like Friedman have supported the monetary policy stating that during recession, a deficit budget of a government should be financed by creation of money to create a drive on the aggregate demand. Thus these economists differ in their opinion while addressing these policy issues. Hence the optimum monetary or economic policy would be the one which would aim at the resultant macroeconomic variables and thereby increasing the aggregate demand and the GDP and would try to achieve full employment by reducing the rate of unemployment. References Mankiw N. G., (2012), Principles of Macroeconomics, Mason: Cengage Learning. Blanchard, O., (2000), Macroeconomics, Englewood Cliffs: Prentice Hall. Dornbusch R. and Fisher S., (2005), Macroeconomics, New York: Tata McGraw-Hill Education. Froyen R.T., (2005), Macroeconomics, New Jersey: Pearson Education. Read More