Question

The recent tax cuts are the type of policy that typically used to stimulate an economy during a recession, but they have been implemented during an expansion. Make two arguments (using narrative and graphs, both), one in support of the policy and one against it. Use economic reasoning in your answers.

Answer 1

Economic policies will be effective only if monetary & fiscal policies work in sync.

For example, during economic recession, the policy goal is to increase aggregate demand. If the central bank decides to achieve this goal by increasing money supply, and at the same time the fiscal policy increases tax rate which lowers disposable income (and hence consumption demand), the two effects will offset each other.

Again, during an economic overheating and/or high inflationary pressure, the central bank wishes to reduce aggregate demand by lowering money supply in the economy using contractionary monetary policy. If, concurrently, the fiscal policy increases government spending, it will increase aggregate demand and will nullify the monetary policy measure.

Therefore, both policies have to be synchronized such that during a recession, both use expansionary measures and during an overheating, both use contractionary policy measures.

(2) Let us analyze this using an economy during a recessionary period.

Fiscal policy tools are tax and government spending. To boost aggregate demand, tax rate must be reduced and/or government spending must be increased. A tax cut has far-reaching economic effects, so it takes a longer time to finally affect AD. Similarly, government spending also should be arranged for and allocated to suitable categories, which will require time to implement. But when either (or both) of these are implemented, they immediately increase consumption demand (for tax cut) and increase aggregate demand directly (for government spending) without any time lag.

On the other hand, monetary policy tools are Open Market purchase of government securities, required reserves ratio and bank rate. To increase money supply, the most commonly used policy tool is the open market purchase, which is fastest to implement, since the magnitude of such purchase depends on target increase in money supply, and the required reserve ratio. But once the open market purchase is executed, leaving the public with more cash to spend, it takes higher time than fiscal policy, to have a final effect on total money supply. That is because money supply increases as an effect of infinite rounds of credit lending by commercial banks, through the money multiplier process. Therefore, time to increase overall money supply and thus affecting the economy is much higher.