Question

Monetary and fiscal policy are seen as appropriate tools to try to steer the macroeconomy. What are the current settings of these tools? Who makes the decisions to change one of these tools? Are the decisions based on democratically elected officials actions or appointees? What are the advantages and drawbacks of elected officials vs. Appointees?? Explain in detail.

Answer 1

1. Current settings of these tools:

Economic and Monetary Union (EMU) has caused a major change in the institutional economic policy setting of the member states (MS). A single currency area with thirteen (and soon more than twenty) different countries needs effective and operational rules to define the roles and responsibilities of the several policy actors. A clear definition is needed of the competencies obtaining at the national and the supranational level, as well as the respective institutions in charge of them. This new institutional policy setting, given its different levels of operation and responsibility, must also define the separation between the several powers in charge of economic policies so as to avoid destructive policy conflict and ineffectiveness.??

On the one hand, the ECB is the institution that singly conducts monetary policy in the Euro area since 1999. MS have delegated their monetary sovereignty to the ECB, a supranational and independent institution. In principle, there should be no conflict or controversy as to the institution responsible for the design and conduct of monetary policy in the Euro area. Moreover, granted its autonomy and independence by its own constitution, the ECB (with the rest of the National Central Banks of the Euro area) defines and implements a single monetary policy according to the tasks given in its statutes. Regarding monetary policy, the ECB has chosen a two pillar monetary strategy intended to achieve price stability in the mean term, a stability that it has defined as a year on year increase of the Harmonised Index of Consumer Prices (HICP) less, but close to, 2%. Clearly set in its statutes and confirmed by its recent policy-making, that is certainly its primary policy goal. This shows that the monetary Authority is aware of the ineffectiveness of monetary expansions as a consistent instrument to foster economic growth or job creation. The ECB has thus adopted a monetary target (that is, low inflation) as the best contribution of monetary policy for a sustainable and consistent growth in the Euro area.

On the other hand, fiscal policy is still a national competency in the EU, and therefore in EMU countries. The political traditions and the economic policy history and options of the MS are quite diverse, as can be seen in the varied fiscal paths they follow. However, all EU countries must abide by the SGP and must therefore aim at achieving medium and long term sound public finances. This obligation is backed by warnings and even penalties for the members of the Euro area.

In the absence of an effective fiscal rule that EU countries must balance their budgets one year with another, MS in the Euro area may have an incentive to spend themselves out of a temporary downturn or even to run permanent public deficits in longer periods of lacklustre growth. Policies that used to develop into currency crises before they adopted the euro would not harm them directly but impinge on the worth of the euro as a whole, especially if the errant country were a large one. Such free-riding ? These neo-Keynesian proposals are based on faulty theory. In technical terms, they unaccountably set aside rational expectations theory , long term Ricardian equivalence (Ricardo 1817, ch. 29), and the public service agency problem (Niskannen, 1971). Neither do they take into account the theory of the second best proposed by Lipsey and Lancaster (1956-57). ?? The Montesquieu doctrine of the separation of powers should be called the doctrine of concordant powers, since its essence is that no collective decision can be taken by one single power without the collaboration, backing, confirmation or revision of another. could be remedied in one of two ways: the first is to let it be known that deficit countries would be allowed to go bankrupt, as the city of New York was forced to do in the ´seventies´; the other is to monitor it and eventually penalise it. The bankruptcy way is not very credible. The second is a little more credible, despite the leniency with which infractions by France and Germany were treated in the past and the subsequent watering down of the SGP.

Since most prices tend to be temporarily sticky and do not adjust immediately to changed economic conditions, those MS incurring in more deficit may find it useful as a policy tool to expand aggregate demand in the short run, and so their national income. All this is on the assumption that fiscal expansion affords short run relief in an economic downturn. What is clear, however, is that such policies do not help long run growth, since the public is not finally taken in by discretionary monetary policies. As is well established in economic theory and supported by extensive empirical evidence, this is a time inconsistent policy (Kydland and Prescott, 1977), as well as an artificially created demand expansion, with no real effects in the medium and long term. In the last ten years data clearly show that recurrent deficit countries such as France, Italy or Portugal do not attain higher economic growth.

In the face of inflationary pressures and expectations coming from the need to finance growing fiscal deficits in the Euro area, the ECB would have to tighten monetary policy for the whole of the Euro area. There will be net winners and losers, as both prudent and errant countries will “pay the bill” in the form of higher interest rates; while the former have not obtained any short run policy “relief” nor output gain. The resulting higher interest rates for all will cause a worsening of MS public finances and more output volatility. In sum, running active fiscal policies in a monetary policy framework committed to maintain price stability could result in a consistent but inefficient equilibrium, incompatible with a sound and credible Eurosystem in the medium and long term.

Who makes the decision:

Monetary policy and fiscal policy refer to the two most widely recognized tools used to influence a nation's economic activity. Monetary policy is primarily concerned with the management of interest rates and the total supply of money in circulation and is generally carried out by central banks such as the U.S. Federal Reserve. Fiscal policy is the collective term for thetaxing and spending actions of governments. In the United States, the national fiscal policy is determined by the executive and legislative branches of the government.

Monetary Policy

Central banks have typically used monetary policy to either stimulate an economy or to check its growth. The theory is that, by incentivizing individuals and businesses to borrow and spend, monetary policy can spur economic activity. Conversely, by restricting spending and incentivizing savings, monetary policy can act as a brake on inflation and other issues associated with an overheated economy.

The Federal Reserve, also known as the "Fed," has frequently used three different policy tools to influence the economy: opening market operations, changing reserve requirements for banks and setting the discount rate. Open market operations are carried out on a daily basis where the Fed buys and sells U.S. government bonds to either inject moneyinto the economy or pull money out of circulation. By setting the reserve ratio, or the percentage of deposits that banks are required to keep in reserve, the Fed directly influences the amount of money created when banks make loans. The Fed can also target changes in the discount rate (the interest rate it charges on loans it makes to financial institutions), which is intended to impact short-term interest rates across the entire economy.

Fiscal Policy

Generally speaking, the aim of most government fiscal policies is to target the total level of spending, the total composition of spending, or both in an economy. The two most widely used means of affecting fiscal policy are changes in government spending policies or in government tax policies.

If a government believes there is not enough business activity in an economy, it can increase the amount of money it spends, often referred to as "stimulus" spending. If there are not enough tax receipts to pay for the spending increases, governments borrow money by issuing debt securities such as government bonds and, in the process, accumulate debt; this is referred to as deficit spending. (For details, see What is the role of deficit spending in fiscal policy?)

By increasing taxes, governments pull money out of the economy and slow business activity. But typically, fiscal policy is used when the government seeks to stimulate the economy. It might lower taxes or offer tax rebates, in an effort to encourage economic growth. Influencing economic outcomes via fiscal policy is one of the core tenets of Keynesian economics.

When a government spends money or changes tax policy, it must choose where to spend or what to tax. In doing so, government fiscal policy can target specific communities, industries, investments, or commodities to either favor or discourage production – and sometimes, its actions based on considerations that are not entirely economic. For this reason, the numerous fiscal policy tools are often hotly debated among economists and political observers.

Which is More Effective: Monetary or Fiscal Policy?

In terms of improving the real economy, expansionary fiscal policy is more effective. In terms of the financial economy, expansionary monetary policy is the better choice. Both types work through different channels and impact individuals and corporations in different ways.

Fiscal policy affects consumers positively for the most part, as it leads to increased employment and income. Essentially, it is targeting aggregate demand. Companies also benefit as they see increased revenues.

However, if the economy is near full capacity, expansionary fiscal policy risks sparking inflation. This inflation eats away at the margins of certain corporations in competitive industries that may not be able to easily pass on costs to customers; it also eats away at the funds of people on a fixed income. Fiscal policy can also have the effect of creating assetbubbles if the market and incentives become too distorted.

Monetary policy has less impact on the real economy. Case in point: the Great Depression, during which the Federal Reserve was particularly aggressive on a historical scale. Its actions prevented deflation and economic collapse but did not generate significant economic growth to reverse the lost output and jobs.

Expansionary monetary policy can have limited effects on growth by increasing asset prices and lowering the costs of borrowing, making companies more profitable. In addition, it has the psychological benefits of taking worse-case economic scenarios off the table. As with fiscal policy, extended periods of low borrowing costs can create asset bubbles that are only apparent in hindsight.

Another crucial difference between the two is that fiscal policy can be targeted, while monetary policy is more of a blunt tool in terms of expanding and contracting the money supply to influence inflation and growth.