Use of Fiscal and Monetary Policies to Stabilize Economy - Example

Use of Fiscal and Monetary Policies to Stabilize Economy Name: Instructor: Course: Date: Use of Fiscal and Monetary Policies to Stabilize Economy Introduction Governments adopt different methods to stabilize the economy during recession, with some of the major ones being fiscal and monetary policies. Factors that influence economy, such as changes in employment levels, demand for goods and services, as well as price stability, may fluctuate with time due to both internal and external forces. This will call for government interventions to bring about macroeconomic stabilization, using either or both fiscal and monetary policies. Fiscal policy refers to government policies on tax and expenditure aimed at increasing or decreasing aggregate demand through manipulation of government expenditures and taxation. A government can stimulate economic growth and employment through an increase in government expenditure, decrease in taxes or other manipulations that affect aggregate demand in the move to stabilize the economy. On the other hand, economic stability of a nation may be influenced through monetary policy in which the central bank controls the levels of national output and price levels through variations in money supply. For example, an increase in money supply result in lower interest rates that stimulates private and public spending with direct positive impact on the economic growth. In order to limit the growth rate in money supply, the central bank, or Federal Reserve must allow interest rates to increase to relatively high levels, making impossible to fix the amount of credit and costs independently. The fiscal and monetary policies are quite independent in that monetary policy falls under the central bank or Federal Reserve while the government controls fiscal policy to necessitate achievement of certain common goals. This paper seeks to expound on government’s application of fiscal and monetary programs in stabilizing the economy and effectiveness and limitations of these policies. Use of Fiscal Policy to Stabilize Economy The fiscal policy approach of stabilizing the economy finds its roots in Keynesian economics school of thought, which supports the use of government spending and taxation to help even out economy. Keynes discovered this policy during the Great Depression in which he believed that forces of supply and demand remained too low in recessions as well as unemployment that translated to low spending among the people. In such occasions, he suggested that government should intervene through increasing its spending to restore the economy to normal status. Governments have various ways of funding their spending including use of taxes and borrowing. Application of fiscal measures involves the nation’s annual budgets, which influences the total output and price level in the country. Governments may adopt several types of budgets such as balanced budget, deficit, and surplus budgets with diverse impacts on the country’s economy. A balanced budget has neutral effects on the economy because the government spending balance with the taxes and the total spending remain constant. Therefore, such budgets lack any form of expansionary effects in the economy. In contrast, deficit budgets increase the price levels or total income depending on the status of employment in the economy.1 Adoption of deficit budgets compel the government to spend more than revenue from taxes, hence resulting to borrowing of funds to cater for the extra spending. On the other hand, Surplus budgets feature when the government spends less than the taxes received from consumers and businesses, which results in net decrease in aggregate expenditure. This results in drag in the economic growth although the excess funds may play an important role in settling country’s national debt. How the Policy Works Fiscal policy role in stabilization of economy dwells on its influences in the economy aggregate demand as well as supply for goods and services. Government’s increase in its spending and provision of high income during recession play a critical role in influencing consumer spending that directly translate in increased demand for goods and services. Increased demand from the government result in companies’ higher profits and increased employment as well as consumer spending. Government purchases have a multiplier effect on the aggregate demand evident through major shifts in the demand curve for goods and services. Therefore, fiscal policy enables stabilization of the economy through restoring the declining demand for goods and services in times of economic recession. Consumer and private spending have direct influence on the economy of a nation and therefore fiscal policy play arises as an important tool in stabilizing the economy. Although economists have put major emphasis on the effects of fiscal policy on the economy’s aggregate demand, the policy also influence the supply of goods and services. For example, cuts in taxes act as an incentive to workers and producers to increase productivity in order to benefit from the reduced taxes.2 Moreover, government spending in areas such as roads construction may also play a critical role in influencing supply of goods and services. As noted earlier in this discussion, governments use revenues derived from taxations to fund their increased spending in the process of stabilizing the economy. However, governments may be forced to borrow additional capital facilitate this process especially where a deficit budget is adopted. Contrary, borrowings have several outcomes, which may have long-term negative effects on the economy as well. Excessive borrowing leads to increase in the national debt hence exposing the economy to external manipulations that may further affect its stability. Limitations of Fiscal Policy The major limitation in fiscal policy revolve around the crowding –out effect in which fiscal expansionary measures raise interests resulting in reduction in the economy’s aggregate demand. As the increase in government, purchases stimulate the aggregate demand for goods and services it also causes the interest rates to inflate thus reducing investment spending and a significant downward pressure on aggregate demand. The other problem associated with fiscal policy involves dependency on political process that may hinder its effectiveness in stabilizing the economy. In democratic states, such as United States, most changes in government spending must go through congressional committees, the Senate, as well as the requirement for presidential signature in order to before implementation. Such long processes make fiscal policy to work with a lag in stabilizing the economy. Sometimes political manipulations and interests may slow or completely hinder the implementation of the policy in time to allow stabilization of the economy before the situation become uncontrollable. Moreover, the unpredictability in economic changes or difficult in forecasting accurately on the future condition of the economy further downplay the effectiveness of fiscal policy in economic stabilization. Since major recessions and depressions occur without major warnings, this pose a great challenge in application of the fiscal policy leaving economic policy makers to respond to economic changes as they occur. In such scenarios, it would be difficult to adopt the fiscal policy effectively as the economic changes may revert before implementation of the policy. Application of Monetary Policy The use of monetary policy in economic stabilization entails pursuit of price stability and high employment through the control of money supply, credit condition, and interest rates. Prices and the general economy are directly connected in such a way that they move upward accordingly. Therefore, monetary policy directed towards stabilization of price levels consequently leads to stability of the employment levels. Monetary policy directly influences interest rates and credit conditions where changes in these variables lead to significant effect on the flow of credit and demand for mortgage financing. However, the use of monetary policy concerns itself with control of expenditure in the event of achieving short-term economy stabilization rather than the control of interest and credit conditions. Effectiveness of monetary policy faces major setbacks in circumstances where governments largely intervene as a guarantor of mortgage.3 Monetary policy when timely applied plays a critical role in controlling fluctuations in economy’s aggregate demand through preventing changes in the money supply. Central banks may rescue country’s declining aggregate demand by increasing money supply, which increases general output. Contrary, accelerating inflations may also compel the central bank to cut down money supply, which decreases the output in the event of slowing down the inflation. Inflation exacerbates the level of risk in economy by changing the real value of goods and assets thereby its control by monetary policy can lead to price stability to guarantee economic efficiency and growth. Furthermore, monetary policy may be useful in offsetting some of the economic disturbances such as baking panics and financial crisis achieved through central banks providing temporary liquidity to financial markets. Limitation in the Use of Monetary Policy Although the implementation of the monetary policy is assumed as a role of the central bank, it faces high risks of political pressures that may lead to adoption of expansionary monetary policy aimed at boosting the economic growth above its sustainable rates for short-term political gain. Through focusing on factors of economy such as interest rates, output, unemployment and other variables, monetary policy in some instances has contributed to destabilization of the economy.4 Lack of proper plans to control money supply in many countries seeking to stabilize their economy through monetary policy has culminated in acceleration of inflation rates further weakening the economy. However, focus on controlling the money supply by banks in times of economic crisis can play a critical role in keeping inflations low, reducing distortion created by inflation thereby increasing economic efficiency and stability. Effectiveness or the Extent to which the Two Policies Stabilize Economy Both policies can be valuable in achieving short-term economic stability if applied promptly. Fiscal policy through increase of government’s spending increases the economy’s aggregate demand amidst economic recession. Through this policy, the government stimulates economic growth by increasing both the public and private spending. Cuts in taxes may also stimulate increased production or output as people and business strive to benefit from the reduced taxes. However, fiscal policies may have negative long-term impacts on the economy resulting from increased borrowings to fund the increased government spending. The accumulation of the national debt due to increased borrowing by governments opens new avenues for manipulation of the internal economic stability by external factors. Other factors downing playing the effectiveness of fiscal policy involve manipulations from political powers resulting in adoption of some measures driven by political interest without putting into account the implications on the long-term economic impacts.5 Moreover, the timing for application of the policy may be limited by the difficult in predicting economic changes and the long processes followed before its implementation. On the other hand, monetary policy may rise as an effective way of stabilizing economy through its critical role in control of money supply. Money supply takes a center stage in controlling inflations whose acceleration may result from increased money supply in the event of economic crisis. An expansionary monetary policy increases aggregate demand resulting in increased price level, real output, and a consequent decrease in unemployment. With the right measures in controlling credit flows, interest rates, aggregate demand, and employment levels, monetary policy can help in stabilization of economy in times of recession. However, achievement of the objective is highly dependent on the extent of independence of the central bank as well as exposures to manipulations from political pressures. Conclusion In times of recession or financial crisis, governments adopt different macroeconomics policies such as fiscal and monetary policies to stabilize internal economy. Fiscal policy involves government interventions such as changes in government spending and reduction in taxes. These measures influence the economy’s aggregate demand through increasing both consumer and private spending. Governments use the revenue derived from taxes to expand their spending although in case of a deficit budget, governments borrow funds to support its increased spending. Although fiscal policy measures may have short-term stabilization of economy, excessive borrowing may result in adverse long-term effects on the internal economy. However, effectiveness of this policy faces limitations such as long legal processes and exposure to political pressures. Monetary policy plays a critical role in stabilization of internal economy through control of money supply, credit conditions, and interest rate that have direct impact on the economy. Through control of money supply, the policy ensures slowing down of the rates of inflations hence restoring economic stability in times of recession. Effectiveness of this policy dwells on the extent of the central bank independency as well as implementation of timely measures before the economic instability gets out of control. 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