Question

Compare and contrast the strengths and weaknesses of fiscal policy and monetary policy.

Answer 1

The monetary policy is the function of the Federal Reserve Board of Governors, currently led by Alan Greenspan, to control the money supply. One of the Federal Reserve System's key duties is to control money supply so as to sustain steady demand, prices and employment. The "Fed" has three tools for controlling the money supply. They are the prerequisite for reserves, free market operations and the discount rate.

The reserve provision is the most powerful resource available. The reserve allowance is the amount of capital the bank can't lend out. If it is reduced, banks are forced to hold less money, and so more money is put into circulation. If it is increased, then banks may need to obtain some loans to fulfill the new demand for reserve.

The tool known as open market operations influences money and credit operations through the open market purchasing and selling of government securities. This is used for the control of the total supply of capital. If the Fed believes there isn't enough money in circulation, then member banks will buy the securities. If the Fed thinks the economy has too much liquidity, they'll sell the securities back to the banks. Since it is easier to make radical adjustments to the money supply, free market operations are used more frequently than monetary policy.

If member banks want to raise money, Federal Reserve Banks will borrow it. Just like other loans, the third tool of monetary policy is an interest rate, or a discount rate. If the discount rate is high, then fewer banks will be inclined to borrow, and if it is low, more banks will borrow from the reserve banks (theoretically). The discount rate is not used as much as it was in the past, but it does serve as an indication of the Fed's intentions to limit or expand the money supply to private bankers.

Monetary policy is a powerful way to control the supply of money but it has its drawbacks. One downside is that tight policy on money works better than loose policy on money. Tight government works to get government in and avoid inflation, but people have to want loans and want to invest money to get loose policies to actually work. Monetary velocity is another problem. The number of times a dollar changes hands for goods and services each year is entirely independent of money supply, and may often contradict the Fed's efforts. The benefits of the monetary system are that it can be introduced with timely results instantly.

The second way of controlling the money supply lies with the Fiscal Policy in government hands. Fiscal policy is made up of two principal instruments. Changing tax rates, and government spending rising. The key point of fiscal policy is to reduce the economy's surplus / deficit fluctuations by rising inflation and recession. If inflation is unusually high, a increase in tax levels is generally introduced, and high unemployment recession occurs. Taxes increase with high inflation, so that people have less to spend, thereby reducing demand and inflation. During a high-unemployment crisis, taxes are reduced to give more people money to spend and thereby raise demand for goods and services, and the economy is starting to recover.

A rise in government spending impacts the economy more profoundly than a change in tax rates. When the government wants to fight a recession, it will invest a large amount of money on goods and services, all of which are released into the economy.

It does have disadvantages, despite the Fiscal Policy 's effectiveness. The main problems are pacing and politics. Inflation and recession can be hard to foresee, so it can be a long period of time before the condition is even noticed. Because a tax cut can take a year to actually come into effect, the economy could recover from the recession and the new unnecessary tax cut could lead to inflation.

Politics is just another problem. Unlike the conservative Fed 's monetary policy , the government implements fiscal policy, and so politics plays a key role in the program. By observing the government's issues, it becomes clear that a balanced budget is not the primary goal, anyway. Fiscal policies can also be used as strategies for campaigning. When tax cuts are introduced and government spending decreases, then the president is more likely to be re-elected but first has to deal with the inflation generated by his policy.