Question

Suppose the economy is in a recession (and actual GDP is less than potential GDP). What fiscal policy actions that could be taken? On the other hand, suppose the economy is experiencing high levels of inflation (and actual GDP is higher than potential GDP)… what fiscal policy actions could be taken? Is it optimal for both the Federal Reserve and the Government to take actions at the same time to “influence” and improve economic conditions? Why or why not?

Answer 1

I.

1. To counter a recession: An expansionary policy should be used to increase the money supply and reduce interest rates. Fiscal policy uses the government's power to spend and tax.

When the country is in a recession, the government will increase spending, reduce taxes, or do both to expand the economy.

2. To counter an inflation: A contractionary monetary policy is used to reduce the money supply within an economy by decreasing bond prices and increasing interest rates.

This helps reduce spending because when there is less money to go around, those who have money want to keep it and save it, instead of spending it. It also means that there is less available credit, which can also reduces spending. Reducing spending is important during inflation, because it helps halt economic growth and, in turn, the rate of inflation.

II.

Fiscal policy is set by the Government and implies either government spending on things like infrastructure and public goods (expansionary) or budget cuts (contractionary).

On the other hand, monetary policy is controlled by the Central Bank with the goal of controlling inflation within the defined bands by influencing money supply through: policy rates (to set interbank lending and influence bank interest rates), open market operations (buying and selling securities) or changing the reserves requirements for Banks (the amount of money bank cannot lend but need to keep in their accounts), anything the Central Bank does to increase money supply is expansionary (decrease interest rates, buy securities or decrease reserve requirement) and the opposite is true for contractionary.

In theory, there shouldn't be overlap between the policy requirements for each due to the Independence of Central Bankers but in practice, many countries Monetary policy is heavily influence by the government (especially Developing economies).