Question

2.EXERCISE 15.7 FISCAL OR MONETARY POLICY? Think back to the discussion of the government finances in Unit 14.

a. In the event of a financial crisis, would it be preferable for the government to stabilize the economy using fiscal or monetary policy?

b. What are the dangers of using fiscal policy?

c. When might the government have no choice but to use fiscal policy?

Answer 1

Monetary policy, the demand side of economic policy, refers to the actions undertaken by a nation's central bank to control money supply to achieve macroeconomic goals that promote sustainable economic growth.

• Monetary policy, the demand side of economic policy, refers to the actions undertaken by a nation's central bank to control money supply to achieve macroeconomic goals that promote sustainable economic growth.
• Monetary policy can be broadly classified as either expansionary or contractionary.
• Monetary policy tools include open market operations, direct lending to banks, bank reserve requirements, unconventional emergency lending programs, and managing market expectations (subject to the central bank's credibility).

A. the government to stabilize the economy using fiscal or monetary policy

When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two primary courses of action: monetary policy or fiscal policy.

Monetary policy involves the management of the money supply and interest rates by central banks. To stimulate a faltering economy, the central bank will cut interest rates, making it less expensive to borrow while increasing the money supply. If the economy is growing too rapidly, the central bank can implement a tight monetary policy by raising interest rates and removing money from circulation.

Fiscal policy, on the other hand, determines the way in which the central government earns money through taxation and how it spends money. To assist the economy, a government will cut tax rates while increasing its own spending; to cool down an overheating economy, it will raise taxes and cut back on spending. There is much debate as to whether monetary policy or fiscal policy is the better economic tool, and each policy has pros and cons to consider

• Central banks use monetary policy tools to keep economic growth in check and stimulate economies out of periods of recession.
• While central banks can be effective, there could be negative long-term consequences that stem from short-term fixes enacted in the present.
• Fiscal policy are the tools used by governments to change levels of taxation and spending to influence the economy.
• Fiscal policy can be swayed by politics and placating voters, which can lead to poor decisions that are not informed by data or economic theory.
• If monetary policy is not coordinated with fiscal policy enacted by governments, it can undermine efforts as well.

• Fiscal policy involves changing government spending and taxation. It involves a shift in the governments budget position. e.g. Expansionary fiscal policy involves tax cuts, higher government spending and a bigger budget deficit. Government spending is a component of AD.
• Monetary policy involves influencing the demand and supply of money, primarily through the use of interest rates.
  • Monetary policy can also involve unorthodox policies such as open market operations and quantitative easing.
  • Monetary policy is usually carried out by an independent Central Bank

if we use fiscal policy, it will involve higher taxes, lower spending. The advantage of using fiscal policy is that it will help to reduce the budget deficit.

In a country like the UK, with a large budget deficit, it might make sense to use fiscal policy for reducing inflationary pressures because you can reduce inflation and, at the same time, improve the budget deficit.

B.the dangers of using fiscal policy

When a country's economy is struggling, its government may attempt to stimulate economic growth through expansionary fiscal policy. This is done by lowering tax rates and by increasing government spending. A government should consider a fiscal expansion only after reviewing the negative consequences of this policy. These issues include increased debt, the crowding out of private investment, and the possibility of an ineffective recovery.

Recognition Lag

It takes time for a government to realize its economy is having problems. A recession is not officially recognized until there have been at least two quarters of consecutive negative growth. It also can take the government a considerable amount of time to create, discuss and enact an expansionary fiscal policy. The problem of recognition lag is that by the time a government recognizes and acts on a recession, the recession has already self-corrected. The fiscal expansion then may overheat the economy and set the nation up for another market crash.

Crowding Out

The theory of crowding out states that expansionary fiscal policy could lead to reduced investment in the private sector. Investors prefer government debt over corporate debt because it is considered safer. Government debt usually pays a lower interest rate than corporate debt. To fund a fiscal expansion, a government may need to raise more money through government bonds. It will raise the interest rates of government debt to attract more investors. This will reduce the demand for corporate debt and hurt the private sector's ability to grow.

Rational Expectations

Expansionary fiscal policy is used to provide a temporary boost to a lagging economy to increase consumption and investment to pre-recession levels. This fiscal expansion is often financed through borrowed funds that will need to be paid back. The theory of rational expectations states that consumers and businesses will realize that at some future date the government will raise taxes to repay the fiscal expansion's borrowed funds. The private sector will increase its savings level to prepare for a future tax increase. This will prevent the economy from growing and make the fiscal expansion useless.

Increased Deficit Levels

An expansionary fiscal policy financed by debt is designed to be temporary. Once a country's economy recovers, its government should increase taxes and reduce spending to pay off the expansion. This can be difficult to accomplish. Consumers may become accustomed to lower tax rates and higher government spending and vote against changing either. A risk of a temporary fiscal expansion is it becomes permanent due to political pressure. This higher level of spending could lead to a worsening deficit and a long-term debt issue.

C. the government have no choice but to use fiscal policy

Monetary policy can also be used to ignite or slow the economy and is controlled by the Federal Reserve with the ultimate goal of creating an easy money environment. Early Keynesians did not believe monetary policy had any long-lasting effects on the economy because:

• Since banks have a choice whether or not to lend out the excess reserves they have on hand from lower interest rates, they may just choose not to lend; and
• Keynesians believe consumer demand for goods and services may not be related to the cost of capital to obtain these goods.

At different times in the economic cycle, this may or may not be true, but monetary policy has proven to have some influence and impact on the economy, as well as equity and fixed income markets.

The Federal Reserve carries three powerful tools in its arsenal and is very active with all of them. The most commonly used tool is their open market operations, which affect the money supply through buying and selling U.S. government securities. The Federal Reserve can increase the money supply by buying securities and decrease the money supply by selling securities.

The Fed can also change the reserve requirements at banks, directly increasing or decreasing the money supply. The required reserve ratio affects the money supply by regulating how much money banks must hold in reserve. If the Federal Reserve wants to increase the money supply, it can decrease the amount of reserves required, and if it wants to decrease the money supply, it can increase the amount of reserves required to be held by banks.

Fiscal policy is the use of government spending and taxation to influence the economy. Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty. The role and objectives of fiscal policy gained prominence during the recent global economic crisis, when governments stepped in to support financial systems, jump-start growth, and mitigate the impact of the crisis on vulnerable groups. In the communiqué following their London summit in April 2009, leaders of the Group of 20 industrial and emerging market countries stated that they were undertaking “unprecedented and concerted fiscal expansion.” What did they mean by fiscal expansion? And, more generally, how can fiscal tools provide a boost to the world economy

Historically, the prominence of fiscal policy as a policy tool has waxed and waned. Before 1930, an approach of limited government, or laissez-faire, prevailed. With the stock market crash and the Great Depression, policymakers pushed for governments to play a more proactive role in the economy. More recently, countries had scaled back the size and function of government—with markets taking on an enhanced role in the allocation of goods and services—but when the global financial crisis threatened worldwide recession, many countries returned to a more active fiscal policy