The Use of Monetary Policies - Coursework Example

MACROECONOMICS [Task] Outline 2. Use of monetary policies i. Open market operations ii. Reserve requirement iii. Moral suasion iv. Inflation targeting v. Fixed exchange rates 3. Fiscal policies i. Taxation ii. Spending iii. Transfer payments 4. Conclusion 5. Works Cited Abstract Macroeconomics is the branch of economics concerned with examining the behavior of the aggregate economy. It, therefore, deals with the behavior, structure, and performance of the whole economy. Rate of economic growth, inflation, unemployment, and national income are some of the factors examined in macroeconomics. The government and large corporations depend on macroeconomic models to formulate economic policies and to help in development. This paper will attempt to examine the effects of monetary and fiscal policies on unemployment, economic growth, and inflation and how the government employs the macroeconomic policies to influence economic growth. MACROECONOMICS Use of monetary policies It would be unimaginable to think of a control free world. All sorts of absurdities would crop up hence the need for control. An economy is no exception to this rule. This indicates the significance of macroeconomic policies in an economy. They are a necessary control of financial matters. Macroeconomic policies are tools used by the economic policy makers to exercise control in the economy. These tools can be either monetary or fiscal. Monetary policies As defined by Russell and Hearthfield, Monetary policies are a set of macroeconomic tools involving the use of interest rates to control growth levels and demand in the economy (60). As such, monetary policies control money demand and supply in the economy. Monetary policies work hand in hand with financial markets such as banks, private, and institutional investors. Financial markets help in distribution of funds in an economy. People with surplus money and wish to make profits from their money invest in the financial markets. The invested money is in turn distributed to those who are willing to use and have the capacity to pay. Various institutions in the financial markets are tailored to meet diverse needs present .For instance, commercial banks offer borrowing and lending services to individuals and cooperates. Stock exchange on the other hand allows for trading of shares. Firms that need money sell shares while individuals with interest to invest buy them. The government adopts various policies to gain full control of the economy. Some of these policies are discussed below. Open market operations Open market operations involves the buying or selling of government’s financial assets (Baumol and Blinder 647). The government’s involvement in buying and selling significantly influence the volume and price of credit available in the market .These operations affects monetary reserves available to banks. In essence, it is either the amount of money or its liquidity that it affects. Operations are made possible through the selling and buying of government bonds within commercial bank circles and the general public .In instances of inflation, the government sells bonds. This result to decrease in money supply, as the government collects the money in public and cooperate coffers. This results to a decrease in bank reserves. The little many left to the financial institutions, therefore, becomes the prime target for individuals and institutions interested in securing loans, which results to increase in interest rates consequently eradicating inflation. When there is deflation, the reverse happens. Government buys bonds, reserves increase, and money supply decreases hence deflation is controlled. Reserve requirement The government governs banks by a law that requires a stable relationship between reserve holdings and credit available to the public. It limits the amount of loans that can be given to the public alongside the fixed deposit that should be present in the bank. Whenever there is a high rate of inflation, the government increases reserve requirement. This has the effect of narrowing the amount of money available for financial institutions to issues as loans. With only little money available to issues, banks tend to tighten loan requirements to eliminate many people who would have otherwise qualified to secure loans. This helps in reducing the amount of money in circulation hence curbing inflation. In case of deflation, the government lowers reserve requirement to enable banks have more money to dispose hence increase in money circulation. This is, thus, a control tool to the supply of money in the economy at any given time. Moral suasion The central bank can dissuade commercial banks from certain practices that they would otherwise have engaged in. At the same time, it may persuade them to pursue risky financing options to meet its financial objectives. These practices may include promotion of exports through financing traders, credit expansion, or restraint and increased savings and mobilizations. In view of the risks present in these operations, the banks may decide not to comply but as a policy, they might have no other choice. By setting policies to finance such ventures, the central bank increases money circulation. Whenever there is deflation, the central government employs tactics aimed at discouraging financing of sectors in the economy considered less essential. Inflation targeting Inflation policy requires that inflation should be maintained within a desired range. It is within the central bank’s jurisdiction to watch over interest rates. Hence, necessity for periodic adjustment over a period of specified time in accordance with desired rates. Interest rates affect interbank dealings. One popular method of inflation targeting is the Taylor rule that adjusts interest rate as a response to changes in the output gap and changes in the inflation gap. Fixed exchange rates The fixed exchange rate policy targets a constant exchange rate of a foreign currency. It is maintained in different styles of exchange rates. Attaining a fixed exchange rate can be made possible through a system of fixed convertibility and through fiat fixed exchange rates. In both cases, it is the government or monetary body in charge that sets fixed target. The exchange rates fluctuate within a fixed band or level. In the former, the regulatory body actively participates in buying and selling of currency on a daily basis to achieve the set target. However, in fiat fixed exchange rates, things are different. The regulatory body does not actively participate in the foreign exchange trade. Instead, it uses the forces of black market that determine the market exchange. For total alignment with the fixed rules, the trading countries have to agree. This is a nondependent process. Economic factors such as credit mobility, market openness, and credit channels matter and may adversely affect exchange rates. Fiscal policies According to Perry, fiscal policies are the government spending decisions and the effects of the policies on the entire economy (27). Fiscal policies largely concentrate around the government. These policies include taxation, government spending, and government borrowing. They directly influence the level of economic growth, employment, and output in the economy. The government, through legislation, can choose to apply either expansionary or contractionary policies. How well the government controls fiscal policies determine how fast or slowly the economy of a country grows. Sound fiscal policies enhance cost effective spending and development. In a bid to encourage economic growth, the government may employ policies such as taxation, controlled expenditure, and transfer payments. Taxation There would never be a better income generating activity than taxation to the government. The most common method is direct taxation especially to income earners. Personal taxes, value added tax, and revenues levied on licenses and permits for different reasons are among the common forms of taxation. Taxation ranks among the most important fiscal tools in an economy. Taxation is a weapon the government can use to save a dwindling economy from collapsing. To curb the issue of unemployment, which is a threat to any successful economy, tax rates are reduced. Reducing taxes works like a two edged sword. First, it stimulates an increase in disposable income increasing purchasing power, which intern culminates into greater production, hence more employment for people. On the other hand, lowering business taxes increases profit margin, this leads to increased demand for laborers. When many people in an economy are earning, the economy grows. However, an economy ridden with unemployment can hardly grow. Taxation presents a great challenge in its implementation. Therefore, any tax decision requires consideration of many factors. By lowering taxes to open more employment opportunities, the government’s revenue is reduced. Reduced revenue limits the government’s involvement in infrastructure development and provision of social amenities. These are crucial requirements for economic development and neglecting them could prove suicidal. Spending Expenditure is another weapon the government may use to influence economic growth. A simple way of continued exercising of control is through increasing or decreasing expenditure as per the prevailing conditions in the economy. By increasing expenditure, the government aids economic development in many fronts. For instance, investing in infrastructure development requires skilled and casual laborers to complete. This creates direct employment opportunities for the people involved in construction work, and other indirect opportunities for those supplying services and logistics to the building process. The government may also increase spending on education to increase knowledge and skills among its citizens. This increases the chances of employment for the citizens. The importance of which cannot be ignored. Transfer payments These payments are among fiscal tools at the disposal of the government. These are payments made by the government and have no productive return. Transfer payments Include: unemployment benefits, social security funds to the elderly, and payments made to the poor. Increasing the amount of money spent on such payments increases the amount of disposable income to the individuals involved. This in turn boosts production activity resulting in more employment opportunities and income for people involved in the production. Macroeconomic policies as discussed have been proven beyond measure to be a necessary tool in the economy. It is, therefore, the mandate of all policy makers to use wisely the power vested in them by the state to maintain a stable economy. Stability hinges on the kind of macroeconomic policies made. Works Cited Baumol, William J., and Alan S. Blinder. Economics: principles and policy. 6th ed. Fort Worth: Dryden Press, 1994. Print. Perry, Guillermo Eduardo. Fiscal policy, stabilization, and growth: prudence or abstinence?. Washington, DC: World Bank, 2008. Print. Russell, Mark, and David F. Heathfield. Inflation and UK monetary policy. 3rd ed. Oxford: Heinemann, 1999. Print. Read More