Fiscal and Monetary Policy - Essay Example

HOW BRITAIN SHOULD TACKLE ITS RECESSION USING THE FISCAL AND MONETARY POLICY 2000wds: November, 2008 TABLE OF CONTENTS 1 Introduction 1.2 Fiscal Policy 1.3 Monetary Policy 1.4 Fighting the Recession using Fiscal Policy 1.5 Fighting the Recession Using Monetary Policy 1.6 Conclusion and the Way Forward 1.0 Introduction The goals of monetary policy are a low rate of inflation ("price stability") and a small gap between actual real GDP and potential real GDP (Farinha & Marques 2001). Inflation can be maintained at low levels by limiting the amount of money in circulation, that is, by sufficiently limiting the growth in the broad monetary aggregate over a long enough period. (Farinha & Marques 2001). The government often employs fiscal policy, monetary policy or a combination of both to sway the economy back to an equilibrium position. The manner in which the government employs both policies may result to either fiscal or monetary dominance. This paper is aimed at investigating and defining the best way through which Britain should tackle the present financial crisis. To achieve this objective, the IS/LM model will be employed to see how various policy measures affect the interest rate, national income and inflation rates. 1.2 Fiscal Policy Fiscal policy refers to a situation whereby the government restores equilibrium in the economy by making changes to taxes or government expenditure on public goods and services (Smullen & Hand 2005). When there is under-utilisation of capacity, the government can increase capacity utilisation by reducing taxes (that is through a reduction in tax rates or tax base) or by increasing spending on public goods and services as well as subsidising the production of certain goods and services (Smullen & Hand 2005; Visser 2004:43). Fiscal policy aimed at increasing money supply is referred to as easy fiscal policy (Smullen & Hand 2005). On the other hand, when there is over-utilisation of capacity, the government either increases taxes (through and increase in tax rates or tax bases) or reduces spending on public goods and services (Black 2002). It also reduces subsidies and transfer payments. This type of fiscal policy is referred to as tight fiscal policy (Black 2002). Fiscal dominance occurs when government can determine the stock of debt, and the path of total expenditures and taxation (Frantiani & Spinelli 2001: 255). Under these conditions, the government can influence the inflation rate, the future flow of monetary base by raising the permanent level of expenditures without at the same time raising taxes. Fiscal dominance is therefore a scenario whereby monetary policy is driven by fiscal policy 1.3 Monetary Policy Monetary policy is the means by which the Central Bank regulates the economy through changes in the supply of money. This can be done by either printing more money or withdrawing money from the economy through the sale of bonds or through the altering of short-term interest rates. There are two types of monetary policies including easy and tight monetary policy. Tight monetary policy is geared towards reducing the amount of money in supply while expansionary monetary policy leads to an increase in the supply of money. Inna (2006) notes that easy monetary policy leads to a fall in the real interest rate thus lowering the cost of capital causing an increase in investment spending, which increases aggregate demand, and, ultimately, output. According to Leviathan (2003:1), Monetary dominance refers to a situation whereby fiscal policy is influenced by monetary policy. Liviatan states, that: "the benchmark definition of monetary dominance is that the fiscal policy has to accommodate any monetary policy". This implies that fiscal policy must ensure that the liquidity of the government is maintained for any monetary policy. Bernanke and Gertler (1995) suggest that, at least in the short-run, monetary policy can significantly influence the cause of the real economy. For example, Friedman and Schwartz (1963) cited by Bernanke and Gertler (1995) had earlier suggested that monetary policy actions are influenced by movements in real output that last for two or more years. 1.4 Fighting the Recession Using Fiscal Policy The IS/LM Model The IS/LM model is made up of two curves, the IS curve and the LM curve (Visser 2004:40). The IS curve, which represents the equilibrium conditions of the real (investment-savings equilibrium) side of the economy (Visser 2004). For an open economy, the IS curve can be represented by the following equation (Visser 2004): (1) Where Y= national income, Z= private expenditure (consumption and investment), i = interest rate, T= taxes, G= government spending, Ex = exports (receipts on the current account of balance of payments), e= exchange rate, Im = imports (payments on the current account of balance of payments). The LM curve is influenced by balance of payments, because differences in imports and exports affect the money supply: Md = Ms Md = Md(Y,i) Ms = m.C Where Md = money demand, Ms = money supply, M = money multiplier, C = volume of base money. The central bank creates base money by granting domestic credit as well as through open market operations such as the purchase of foreign exchange. Following from Visser (2004:42), the base money supply at any point in time should be equal to the base money supply one period behind plus the change in the domestic credit supply D during that period and the change in the foreign-exchange reserves V. This change is equal to the balance-of-payments balance X of the non-financial sector (Visser 2004). C = C-1 + 'D + 'V 'V = X The central bank uses open-market operations through the sales and purchase of domestic debt instruments such as bonds and other debt issues as the instrument of monetary policy. The volume of this purchase can be denoted by H = 'D. Following from above C = C-1 + X+H Ms = m(C-1 +X+H) This gives us the equation for the LM curve as follows (Visser 2004): Md (Y, i) = m(C-1+ X+ H) (2) Equating the real side of the economy (equation (1)) to the monetary side (equation (2)) leads to the IS/LM model. Figure 1. Fiscal Policy a). Easy fiscal policy b). Tight fiscal policy At equilibrium, the equation for the IS curve is equal to that for the LM curve, that is the real side of the economy is equal to the monetary side of the economy and it is at this point that the LM curve cuts the IS curve (Visser 2004:42). It should be noted that the IS curve has a negative slope, while the LM curve has a positive slope. Figure 1 above represents the initial equilibrium position of the IS/LM model. The equilibrium national income is given by Y1; the equilibrium interest rate is i1. Lets assume that the government embarks on an easy fiscal policy and reduces taxes T, this will result in a shift in the IS curve to the right from IS to IS', establishing a new equilibrium point between the IS' curve and the LM curve at a higher level of national income Y2 and at a higher rate of interest i2. This is shown in the figure 1a above. Conversely if the government decides to embark on a tight fiscal policy by say increasing tax rates or the tax base so as to increase the overall tax liability, this will lead to a decrease in the national income from Y1 to Y2 and as well as a decrease in the interest rate from i1 to i2, resulting in a leftward shift in the IS curve from IS to IS'. This establishes a new equilibrium position to the left. This effect is shown in figure 1b above. While in a recent article published in the Financial Times, present action of the labour government to tackle the crisis was refered to as "a tax bombshell, it's a cruise missile aimed at the heart of a recovery", Osborne (2008) argues that, it is worth for the labour government actively consider reducing the cost of the guarantees on term lending that is costly when compared to other countries. Osborne (2008) further calls for the improvement in international regulation such as the Basel II. Citing Cameron, Osborne stated that, to solve the current situation "we need counter-cyclical capital adequacy rules as a means of managing asset prices and trying to prevent future bubbles". In his article, the researcher further calls for the regulation of those areas in the global financial systems that have gone unregulated. 1.5 Fighting the Recession Using Monetary Policy Mishkin (2005); Mishkin (1992) identify four different channels of monetary policy transmission. These include: the interest rate channel, the exchange rate channel, the credit channel through the bank lending channel, and the asset price channel (Bernanke & Blinder 1992). 1.5.1 The Interest Rate Channel. Tight money periods lead to an increase in short-term nominal interest rates. A combination of sticky prices1 and rational expectations lead to an increase in real interest rates. This higher real long-term interest rate lead to a decrease in real business fixed investment, residential housing investment, consumer durable expenditure and inventory investment, which leads to a decrease in aggregate demand or aggregate output. (Dystatat, 2003; Mishkin, 1996). On the other hand, the monetary policy transmission during easy money periods should be a decrease in interest real interest rates (since prices are sticky in the short-run). (Dystatat, 2003). This should result into an increase in interest rate sensitive components (e.g., investment spending), which ultimately should lead to an increase in output. (Dystatat, 2003). Basically, the interest rate channel transmits monetary policy shocks to the economy through the altering of short-term interest rates, which owing to sticky prices and rational expectations lead to changes in real interest rates, which in turn lead to changes in investment spending and ultimately, changes in aggregate output. 1.5.2 Transmission through the Asset-Price Channel The asset-price channel is another potential channel for the transmission of the effects of monetary policy shocks to the real economy. (Dystatat, 2003). The success of this channel depends on the fluctuations in asset prices. An expansionary monetary policy can make equity relatively more attractive to bonds owing to a decline in interest rates, as well as an increase in the earnings outlook of firms that come as a result of an increase in household spending. (Dystatat, 2003). This increase in equity prices can transmit monetary policy shocks in two ways: firstly, an increase in equity prices leads to an increase in the market value of firms relative to the replacement cost of capital, which is referred to as Tobin's q, thus leading to an increase in investment. This increase in investment will in turn increase wages and therefore aggregate spending and ultimately, aggregate output; secondly, an increase in equity prices leads to an increase in the financial wealth of households, which in turn leads to an increase in consumption. (Dystatat, 2003). Also, to the extent that higher equity prices lead to an increase in the net worth of firms and households, as well as the improvement of the access to funds, the effects captured would partly be reflected in the balance sheet channel of monetary policy as well. (Dystatat, 2003). 1.5.3 Regulation of the Banking System While interest rates, exchange rates and asset prices determine the transmission of monetary policy shocks to the real economy, Dystatat (2003) notes that the regulatory framework of banking, as well as the country specific banking practices, and the structure of assets and liabilities also play an important role in influencing the reactions of non-financial firms to changes in monetary policy and thus play an important role in the transmission of monetary policy shocks. Furthermore, the degree of liquidity constraints related to the practice of banking also influences the extent to which households and business expenditure are impacted the monetary policy shocks. For example, Dystatat (2003) suggests that placing a maximum level of indebtedness, as well as large down-payment requirements negatively affects the ability of consumers to substitute between present and future expenditure, which in turn limits the impact of monetary policy shocks on consumption. (Dystatat, 2003). 1.5.4 Exchange Rate Channel. Monetary policy shocks may be transmitted to the economy through the exchange rate channel. (Mishkin, 1992; Dystatat, 2003). Considering a small open economy, monetary policy can affect the real activity of the economy through its effects on the exchange rate. A depreciation in the nominal exchange rate that comes as a result of an easy monetary policy combined with sticky prices would result to a real depreciation in the real exchange rate in the short-run, which will in turn lead to an increase in net exports. (Mishkin, 1996; Dystatat, 2003). The exchange rate channel however depends on the responsiveness of the exchange rate to monetary policy shocks, the degree of openness of the economy, as well as the sensitivity of net exports to exchange rate fluctuations. However, substantial unanticipated depreciation can actually reduce output when a significant share of debt in the economy is foreign-currency denominated. (Mishkin, 1996; Dystatat, 2003). Figure 2 Monetary Policy. a). Easy monetary policy b). Tight monetary policy In the IS/LM model above, the intersection of LM and IS represent the equilibrium state of the economy. At this point, the national income is given by Y1, and the interest rate by i1. In the first case lets assume that the central bank embarks on an easy monetary policy by purchasing debt securities in the open market. This will lead to an increase in the supply of money and thus the national income. The LM curve will shift to the right creating a new equilibrium position at a higher national income Y2 and a lower interest rate i2. This is represented in figure 2a above. On the other hand, if instead the central bank decides to embark on a tight monetary policy by raising interest rates from i1 to i2, it will result to a decrease in the national income from Y1 to Y2 and a shift in the LM curve from LM to LM'. This is represented in figure 2b above. Conclusion From the foregoing, one can conclude that the Bank of England's main policy instrument is the interest rate. It rarely employs policies such as open-market operations and direct control over the money held by the non-financial sector. It therefore has limited instruments in targeting inflation. This is also an indication of monetary dominance whereby any fiscal policy must accommodate any monetary policy, which in this case is an influence on the interest rate. References Bernanke B. S. , Blinder A. S. (1992). The Federal Funds Rate and the Channels of Monetary Policy Transmission. The American Economic Review, vol. 82, No. 4, pp. 901-921. Bernanke B. S., Gertler M. (1995). Inside the Black Box: The Credit Channel of Monetary Policy Transmission, Journal of Economic Perspectives, vol. 9, No. 4, pp. 27-48. Black J. (2002). Easy fiscal policy.'A Dictionary of Economics.. Oxford University Press, 2002. Oxford Reference Online. Farinha L., Marques C. R. (2001). The bank lending channel of monetary policy: identification and estimation using Portuguese micro bank data. Working Paper NO. 102 European Central Bank Working Paper Series Liviatan N. (2003). Fiscal Dominance and Monetary Dominance in the Israeli Monetary Experience. Bank of Israel Research Department Discussion Paper No. 2003.17 Mishkin, F. S. ( 1996). The Channels of Monetary Transmission: Lessons for Monetary Policy. NBER Working Paper No. W5464. Smullen J., Hand N. (2005). Monetary Policy. A Dictionary of Finance and Banking. Oxford University Press. Oxford Reference Online. Visser, H. (2004). A Guide to International Monetary Economics: Exchange Rate Theories, Systems and Policies 3rd Ed. Cheltenham, UK, Northhampton, MA Edward Elgar Publishing, Inc. Read More