UK Governments Expansionary Fiscal and Monetary Policy Mix - Essay Example

UK Government’s expansionary fiscal and monetary policy mix Introduction Expansionary fiscal and monetary policy measures are adopted by governments in response to recessions or economic downturns. A recession, defined as two consecutive quarters of negative Gross Domestic Product (GDP) growth in a year, can be partially or wholly reversed by using a combination of macroeconomic measures or solutions such as fiscal or/and monetary policy measures. At least this is the belief among economists though there can be a lot of arguments to prove that it cannot be done as easily as it’s proposed. Analysis Every government has to deal with an annual budget. Fiscal policy comes into operation through this annual budget of revenue and expenditure. Fiscal policy involves budgetary measures in which the government carries through a deficit budget in order to stimulate the economy by charging lower corporate taxes. In other words fiscal revenue in the given fiscal year will be less than government expenditure on projects. These projects are naturalluy intended to stimulate spending and subsequent economic growth (Ertl, 2008). When the government spends more than what it collects by way of taxes, especially business taxes, more money would be left in the hands of the people and businesses to spend or/and save. When such money comes into circulation the economy gets a boost. Fiscal stimulus programs are intended to solve the problem of persistent unemployment and underemployment in the economy through government spending. However they don’t always produce the desired outcomes. For instance representative agent models in varying degrees point out to the fact that the outcomes of such fiscal stimulus programs might be negated without the slightest warning because some or all the variables in the model go awry due to some reasons which were not foreseen at the time of planning. The government might adopt a deficit budget approach and expect the economy to respond accordingly (Garrett, Graddy, & Jackson, 2008). However as many such fiscal policy alternatives suggest there can be unforeseen forces that would interfere with the macroeconomic variables and produce unexpected negative results. Harrod-Domar Model, for example, assumes that there is a surplus of labor so that general unemployment acts as a stimulus for the unemployed to accept jobs at the going wage rate. Secondly it assumes that all production is proportional to the capital stock. Given these two assumptions the econmy would be able to absorb the extra spending of the government and the private enterprise to fuel a new cycle of growth. However there is a snag by way of the prevalent real wage rate in the economy (Hemming, R., Kell, M., Mahfouz, S. & International Monetary Fund, 2002). Assuming that the real wage rate is either stagnant or grows at a rate less than the rate of inflation, then there is the crux of the matter. Will those unemployed be prepared to accept jobs at the existing wage rate? It depends on two outcomes. If there are more jobs than what unemployed people would want, then there could be an upward pressure on wages simply through the intervention of the economic law “when demand (for labor) is greater than supply (of labor), the wage rate would rise”. Secondly if there are more unemployed people than the available number of jobs, the reverse of the above law will apply. In the second instance, depressed wages would bring down costs of production and though the aggregate demand in the domestic economy would be lower there would be a greater demand for the country’s exports. In fact this argument has both a Keynesian/Neo-Keynesian and Classical/Neoclassical flavor. However if monetarist theoretical underpinnings were introduced into the argument through inflationary pressures that result from the government’s and private enterprise’s initial spending round, then those outcomes as predicted by the first representative agent models wouldn’t hold but a new set of outcomes would be present. Thus according to the monetarist viewpoint a fiscal stimulus package would be harmful because money supply in the economy would rise and lead to a scenario in which the value of money would deteriorate fast. As a corollary of the above when the stock of money as given by the following formula rises, inflationary pressures would develop in the economy. As the following formula illustrates money supply is expressed as an equation or rather as an identity. This identity as popularized by monetarists is perhaps the most convenient tool to express an otherwise difficult to understand relationship between money supply and inflationary pressures in the economy. Money supply = (MV=PT). This is the simplest of the money supply equations where M stands for the stock of money in circulation; V for the velocity: P for the price level; and T for the number of transactions. Assuming that the money supply increases due to the above mentioned fiscal stimulus program of the government, definitely according to the monetary theory there will be a lot of money chasing after too few goods, i.e. demand pull inflation (Callan et al, 2006). In other words aggregate demand in the economy would outstrip aggregate supply. Almost all representative agent models agree that there is a considerable time lag between the government spending programs, including those entailed by its tax cuts to the private enterprise, and the subsequent increase in the real output. What matters here is the real output of the economy and not the nominal output. Next the government would be forced to initiate anti-inflationary measures such as spending cuts, increases in corporate taxes and increases in expenditure taxes. This is not going to help the economy because already there is a problem of recession. In the first place the fiscal stimulus program was adopted to solve this problem (Hemming, Mahfouz, Schimmelpfennig & International Monetary Fund, 2002). For example an increase in government expenditure to stimulate spending by private enterprise can be regarded as a misdirected policy thrust because a number of other factors known as heterogeneous elements would not have been adequately taken into consideration by planners. Technology for instance doesn’t remain static. Technology keeps on changing from one period to another in such a manner that there is very little else that can be factored into the equation of a representative agent model to bring about a logical conclusion. Figure 1: Aggregate Demand and Supply Function The aggregate demand and supply function as given by the above graph shows how the government fiscal stimulus program would impact on the economy in the short run irrespective of the classical-Keneysian dichotomy on the long run variations. Even the structural constraints would have to be ignored conveniently to produce such smooth outcomes. In fact it’s the structural constraints that distort the outcomes of the representative agent model. In turn structural constraints are caused by inadequate ethnological developments to match the government’s fiscal stimulus program. Thus this paper specifically identifies the fiscal stimulus programs as the most significant form of government intervention in the economy while monetary policy can be used as an indirect method with a view to influencing a set of unknown outcomes such as exchange rates and the volumes of bank borrowings and lending. Conclusion Macroeconomic policies of the British government to tackle the current economic downturn include a mixture of both fiscal and monetary policy measures. Thus fiscal policy alternatives include such expansionary measures like reducing corporate taxation levels to stimulate investment and demand for labor by firms. However the real impact of such policies is not well known in times of uncertain economic developments as outlined above. In fact as already seen an appreciating Sterling would have a negative impact on net exports thus negating the fiscal stimulus programs and monetary policy measures advocating lower interest rates. Thus it’s not difficult to see where the fallacy of these representative agent models lie. Naturally the government’s fiscal stimulus policy works to produce the predictable outcomes in a vacuum-like situation where a lot of variables are removed. However such scenarios don’t exist in the real world. Therefore the inadequacies associated with representative agent models in explaining the outcomes of a governments’ policy change cannot be ignored in this instance. They are real and many in number though some models serve as near approximations to critical understanding of the real economy’s behavior. REFERENCES 1. Callan, T, Barrett, A, Barry, F, Horst, AVD, Kearney, I, Lane, P, Nolan, B, OBrien, M & Walsh, JR 2006, Budget Perspectives 2008, Economic and Social Research Institute & Foundation for Fiscal Studies, Dublin. 2. Ertl, AW 2008, Toward an Understanding of Europe: A Political Economic Précis of Continental Integration, Universal-Publishers, Florida. 3. Garrett, E, Graddy, E & Jackson, HE 2008, Fiscal Challenges: An Interdisciplinary Approach to Budget Policy, Cambridge University Press, New York. 4. Hemming, R, Mahfouz, S, Schimmelpfennig, A & International Monetary Fund 2002, Fiscal Policy and Economic Activity during Recessions in Advanced Economies, International Monetary Fund, Washington. 5. Hemming, R, Kell, M, Mahfouz, S & International Monetary Fund 2002, The Effectiveness of Fiscal Policy in Stimulating Economic Activity: A Review of the Literature, International Monetary Fund, Washington. Read More