Fiscal and Monetary Policy - Literature review Example

Fiscal and Monetary Policy Student’s Name Institutional Affiliation Course Name Date of Submission Fiscal and Monetary Policy The government has a critical role to play in intervening in the economy to ensure that the economy of a country takes the right path. In particular, the government usually plays an important role in ensuring that a country achieves its macroeconomic objectives, including stable economic growth, balance of payment, interest rates, unemployment and inflation among others (Conklin 2010, p. 56). Governments achieve these macroeconomic objectives with the help of fiscal and monetary policy initiatives. Although the use of fiscal and monetary measures have helped a great deal in the past in achieving the mentioned macroeconomic objectives, Mody (2013, p. 43) notes that the increased global interconnectedness is fast rendering the use of the government economic tools ineffective. This paper will evaluate the extent to which the increased global interconnectedness has rendered fiscal and monetary policy measures less effective tools in achieving a country’s macroeconomic objectives. Fiscal and Monetary Policies Fiscal and monetary policies are the economic tools widely used by governments across the globe in influencing the economic activities in a country. With the help of these economic tools, a government is able to achieve its macroeconomic objectives, such as inflation, economic growth, and balance of payment, interest rates and employment level. Monetary policy refers to the policy initiatives implemented by the government to control the total supply of money and interest rates so as to influence the aggregate demand (Vitek 2010, p. 31; Rabin 2001, p. 48). Firstly, the government usually introduces monetary policy initiatives as a way of stimulating economic growth when the economy of a country is stagnating or declining. Secondly, the government sometimes initiates monetary policy measures when there is growing fears of inflation getting out of hand (Shinnick 2008, p. 102; Persson 1994, p. 11). Thirdly, the government may opt to introduce monetary policy measure to help control the interest rates at acceptable level so as to encouraging borrowing by the population. Additionally, the government usually introduces certain monetary policy measures to control balance of payment and to encouraging spending so as to help spur faster economic growth. Fiscal policy, on the other hand, is an economic tool used by the government to influence the level of spending and business activity in a country (Eskesen 2009, p. 5). Fiscal policy is achieved mainly through government spending or taxation policy. For instance, if the government is of the view that spending is below the level expected or that there is a lack of enough business activity taking place in the economy, it might intervene by increasing its spending in what is commonly referred to as “stimulus” spending (Hossain 2009, p. 22). However, if the government feels that it lacks enough money to increase spending, it might opt to borrow money and accumulate debts. At the same time, the government might increase taxes in order to pull the money it needs to fund its projects from the economy (Urrutia, Ichimura, and Yukawa 1989, p. 24). Consequently, during hard economic times, the government might decide to lower its taxes as a way of encouraging more activity so as to be able to stimulate economic growth. Influence of Fiscal & Monetary Policies in Aggregate Demand Both the fiscal and monetary policies are implemented by the governments purposely to influence aggregate demand (AD = C + G + I + (X-M)), where “C” represents consumer spending; “I” representing investment spending by firms of capital goods; “G” representing government spending on public goods and services; “X” representing amount of exports and “M” the amounts of imports. The aggregate demand (AD), therefore, represents the total amount of goods and services in a given economy (Morgan 2012, p. 3; Mankiw 2008, p.5). Measuring aggregate demand is important because the value helps a government determine the overall health or growth of an economy. Fiscal policy influence AD for goods and services in an economy through changes in spending and taxation by the government (Gray, Lane & Varoudakis 2007, p. 104). In this respect, an increase in government spending will shift the AD curve to the right. Similarly, a decrease in taxation will result in an increase in disposable income, savings and consumption, thereby causing a shift in AD curve to the right. For instance, whenever there is a change in government taxation and spending, this usually has a huge influence on employment rate and household income of the population, which, in turn, influences consumer investment and spending. Contractionary fiscal policy, however, will cause a shift in the AD curve to the left (Konuki 2000, p. 34; Morton and Goodman 2003, p. 596). Influence of Expansionary and Contractionary Fiscal Policies on AD Expansionary Fiscal Policy Contractionary Fiscal Policy AD1 AD2 AD2 AD1 Source: Morton and Goodman (2003, p. 596). Monetary policy also influences the AD by influencing the supply of money in an economy, which in turn influences rates of inflation and interests (Alesina and Giavazzi 2013 p. 403). The expansionary monetary policy, for instance, triggers an increase in the supply of money in an economy, which effectively shifts the aggregate demand curve to the right (Hossain 2009, p. 117). In this respect, expansionary monetary policy promotes aggregate demand by affecting the consumption and investment in a country. For instance, by increasing the supply of money, this encourages private consumption. At the same time, when the central bank increases the supply of money in an economy, this cause a decline in the rates of interests, which in turn promotes lending and investment. Accordingly, the resultant growth in investment and consumption cause an increase in the aggregate demand, shifting AD to the right (Persson 1994, p. 45). Impacts of Global Interconnectedness on Fiscal and Monetary Policies The global economy is increasingly becoming interconnected as the world becomes a global village. Although the term global interconnected has become very prominent in the global economic study, many people still confuse it with globalization (Langdana 2013, p. 57). Whereas globalization refers to the integration of world markets, trade and finance aided by modern communication tools, global interconnectedness is a concept that implies that an event of or situation that occur in one part of the world can sometimes spillover and affect other parts of the world though not necessarily related to each other (Higginbotham 2014; Conklin 2010, p. 11). Such global interconnection scenario was witnessed during the 2007/2008 financial crisis that began in the U.S. as a result of housing bubbles. However, because of the interconnection between the U.S. and the European nations’ financial institutions, the crash spread to the European nations, such as Britain, Spain, Greece, Ireland and Italy all of which felt the brunt of the crash, with some countries, such as Greece still affected by the crash to date (Cottarelli, Gerson and Senhadji 2014, p. 13). Nevertheless, emerging countries, such as China, India, Brazil, Singapore, Taiwan and Malaysia were not affected by the crash of 2007/2008 because of the lack of interconnection between financial institutions between these countries and the United States or the European countries. At the same time, the economies of these emerging countries are different since, whereas Chinese economy is largely manufacturing, that of Brazil is export oriented while India’s economy is service oriented (Erdilek 2012; Cottarelli, Gerson & Senhadji 2014, p. 60). Although the impact of the crash was not immediate in the emerging markets, Dudley (2012, p. 87) reveals that they were affected later. For instance, because of the downturn in demand in the U.S. and Europe, this had an effect on the countries from whom they imported goods, such as Brazil, Russia, China and South Africa. The countries from which the U.S. and European countries imported goods from were affected in the sense that they experienced a balance of payment gap due to a decline in their exports (Morton and Goodman 2003, p. 595). Although governments all over the world have for years used fiscal and monetary policies as tools for achieving macroeconomic objectives, the increased interconnected of the global economies is fast rendering the use of these tool irrelevant. Firstly, for years now, most governments have relied on fiscal policy measure of increasing taxes for goods and services as a way of increasing revenue for financing government projects (Kopits and Symansky A1998, p. 23). Although this approach worked well in the past, such fiscal policy measures have become ineffective today because of global interconnectedness (Trairatvorakul 2013). Currently, whenever the government of a country increases the taxation on goods or services, investors will simply stop investing in such a country by moving to other economies that charge low taxes to enable them make profits. Therefore, governments are no longer assured that they can increase their revenue collections by increasing taxes (Konuki 2000, p. 78). For instance, most multinational countries are moving en masse to Ireland as a way of avoiding high taxes on their home country (Kohn 2015). The U.S. President Barrack Obama, for instance, did protest at the increased move by American companies, such as Wal-Mart, Apple and Pfizer to low-cost countries as a way of avoiding taxes. Accordingly, this implies that any move by a government to increase taxes may not help economy as business will simply move their operations to low-cost countries to avoid paying the high taxes because of the global interconnectedness (Dudley 2012). Inflation is another concern for governments all over the world, including the U.K. An increase in the inflation impacts the economy negatively since it causes an increase in the prices of commodities in the market. Therefore, to make life better and enhance the living standards of the Britons, the UK government has set a target of reducing inflation rates to 2% through monetary policy initiative (Martinelli 2005, p. 46). Recently, the inflation rate in the UK fell to zero following the fall in oil prices in the world market. However, in case the pump and food prices increase in the global market, this would result in an increase in the inflation rate in the UK through imported inflation. Such interconnectedness in the global economy renders monetary policy measures the British government might implement to tackle inflation in the sense that the direction that the inflation rate takes is determined not just by the economic conditions in the UK, but also in the world market, such as oil price volatility in the global market (Auerbach 1997, p. 64). Exchange rates also have a huge influence on trade between the UK and its trading partners (Tumpel-Gugerell 2011). Recently, the UK pound has been strengthening due to the growth of the economy. The scenario has caused export of goods from the country become expensive and imports cheaper. Contrastingly, because the Chinese currency is weak, this has made exports in the country cheaper and imports expensive (Perry, Serven & Suescun 2008, p. 203). The fact that exports from China are weak has seen the Chinese goods experience high demand in the recent past. However, because Britain has a floating exchange rate whose value is determined in the forex market, this means that the government has absolutely no control over it. Therefore, the changes that happen to the floating exchange rate usually affect the amount of exports and imports, thus aggregate demand (Alesina and Giavazzi 2013, p. 31). Additionally, big multinational companies also affect the economy of a country in the sense that they promote economic growth through corporate taxation and creation of employment (Dierks 2001, p. 53). For instance, Nokia has had a huge impact on the economy of Finland by generating huge revenue in the form of taxation and employment creation. Similarly, the economies of Middle East countries have been greatly affected by the fall in the pump prices. The OPIC Company, which is a major player in the oil industry in the Middle East, has an influence in the Middle East economies by controlling the prices of the oil in the industry (OPIC 2014). Conclusion Fiscal and monetary policies are important economic tools that governments use to ensure the achievement of macroeconomic objectives. However, as demonstrated, the growing interconnectedness of the global economy is fast rendering the use of these economic tools irrelevant. Therefore, there is a need for governments to find better ways of intervening in an economy other than relying on the fiscal and monetary policies to ensure the achievement of macroeconomic objectives of a country at any given time. References Alesina, A., & Giavazzi, F 2013, Fiscal policy after the financial crisis. University of Chicago Press, Chicago. Auerbach, J. A 1997, Fiscal policy: Lessons from economic research. MIT Press, Michigan. Conklin, D. 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