Question

Describe the differences between fiscal policy and monetary policy. What fiscal and monetary policies might be prescribed for an economy in a deep recession? Be sure to distinguish between the monetary and fiscal policy solutions in your answer.

Answer 1

A nation’s economy can be controlled by way which either directly affect the money supply of the economy, or indirectly affects it. The process in which the government of an economy changes the level of government expenditure of tax revenue to affect output (and income Y) is called fiscal policy. Monetary policy on the other hand is an attempt by the central bank of an economy for managing the money supply through controlling interest rates. Both the fiscal and monetary policies are demand side policies which affect the variables of aggregate demand (AD).

The components of aggregate demand (AD) are as follows: AD (Or Y) = C+I+G+NX ---------------1 where C: Consumption, I: Investment, G: Government Spending, NX: Net Exports and Y: Output/Income. Both fiscal and monetary policies aim at impacting consumption, inflation, growth etc. There are a few basic functional differences between fiscal and monetary policies which are listed as follows:

• Firstly, fiscal policies are undertaken by the government through various laws and rules. Monetary policies are controlled by the Central bank of a country.
• Secondly, the tools of both these policies differ. Fiscal policy uses tools like government expenditure and tax. Monetary policy uses interest rates and open market operations to control the level of money supply.
• Thirdly, monetary policy directly affects exchange rates whereas fiscal policy has no direct effect on exchange rates. E.g. an decrease in interest rate causes the currency to depreciate but nothing that the fiscal policy does will directly lead to an appreciation or depreciation of the exchange rate.
• Fourthly, when the economy is in very deep recession and in facing liquidity trap, then fiscal policy is advised over monetary policy as dropping interest rates further doesn’t help during a liquidity trap.
• Lastly, under a fixed exchange rate regime, the monetary policy becomes ineffective in changing output and fiscal policy has to be used. On the other hand, under a flexible exchange rate regime, fiscal policy is ineffective in changing output levels and monetary policy has to be used.

When an economy is in recession, it essentially means that the economy has slowed down and needs to be given a forward push. Under such a scenario, the objective is to raise AD which in turn will raise output and income (Y). For this objective to be realized, expansionary policies have been proven productive, whether it is fiscal or monetary. Thus, the following fiscal and monetary policies might be prescribed for the economy:

• Expansionary fiscal policy of increasing government expenditure (G) increases aggregate demand as is visible from equation 1. An increase in G stimulates activities in other parts of the economy, creates jobs, creates income and stimulates AD.
• Expansionary fiscal policy of reducing taxes helps to push AD upward. This is because, when taxes payable are reduced, the disposable income of consumers increased which induces them to consume more. As the ‘C’ component increases, AD is stimulated and the economy makes a move away from recession.
• Expansionary monetary policy includes raising money supply in the economy to prevent interest rates from rising. If interest rates are low, investment demand increases because interest rates act as a cost of borrowing and lower the cost, higher the demand. As the ‘I’ component increases, AD is stimulated and the economy starts coming out of recession. However, tow things are noteworthy in this context. Firstly, increasing money supply in the economy increases inflation therefore a very close watch has to be kept on inflation rates.

Secondly, as was already mentioned above, if the country is in deep recession with high level of unemployment such that there is liquidity trap operating, then a monetary policy becomes ineffective. Liquidity trap is a situation which the interest rates are already very low and saving rates are high. Consumers do not opt for bonds and other financial assets but opt for savings and reducing the interest rate further has no effect in stimulating aggregate demand. Thus, in a situation where there is deep recession, the above mentioned expansionary fiscal policies will be helpful in getting the economy out of recession.