Question

1. Discuss the current fiscal and monetary policy and its impact on future economy. Provide a meaningful write up of what the current fiscal and monetary policies are and what it means in terms of economic forecast.
2. Organization, citations, grammar and spelling

Include text citations or works cited if you need it.

Answer 1

There are two powerful tools our government and the Federal Reserve use to steer our economy in the right direction- fiscal and monetary policy. When used correctly, they can have similar results in both stimulating our economy and slowing it down when it heats up.

Fiscal policy

Fiscal policy is when our government uses its spending and taxing powers to have an impact on the economy. The combination and interaction of government expenditures and revenue collection is a delicate balance that requires good timing and a little bit of luck to get it right. The direct and indirect effects of fiscal policy can influence personal spending, capital expenditure, exchange rates, deficit levels and even interest rates, which are usually associated with monetary policy. Fiscal policy is often linked with Keynesianism. Keynesian theories have been used and misused over time, as they are popular and are often specifically applied to mitigate economic downturns. Keynesian economic theories are based on the belief that proactive actions from our government are the only way to steer the economy. This implies that the government should use its powers to increase aggregate demand by increasing spending and creating an easy money environment, which should stimulate the economy by creating jobs and ultimately increasing prosperity.

Just like monetary policy, fiscal policy can be used to influence both expansion and contraction of GDP as a measure of economic growth. When the government is exercising its powers by lowering taxes and increasing their expenditures, they are practicing expansionary fiscal policy. While on the surface expansionary efforts may seem to lead to only positive effects by stimulating the economy, there is a domino effect that is much broader reaching. When the government is spending at a pace faster than tax revenues can be collected, the government can accumulate excess debt as it issues interest-bearing bonds to finance the spending, thus leading to an increase in the national debt.

When the government increases the amount of debt it issues during expansionary fiscal policy, issuing bonds in the open market will end up competing with the private sector that may also need to issue bonds at the same time. This effect, known as crowding out, can raise rates indirectly because of the increased competition for borrowed funds. Even if the stimulus created by the increased government spending has some initial short-term positive effects, a portion of this economic expansion could be mitigated by the drag caused by higher interest expenses for borrowers, including the government. (For related reading, see: What Are Some Examples of Expansionary Fiscal Policy?)

Fiscal policy measures also suffer from a natural lag, or the delay in time from when they are determined to be needed to when they actually pass through Congress and ultimately the president. From a forecasting perspective, in a perfect world where economists have a 100% accuracy rating for predicting the future, fiscal measures could be summoned up as needed. Unfortunately, given the inherent unpredictability and dynamics of the economy, most economists run into challenges in accurately predicting short-term economic changes.

Monetary Policy

Monetary policy can also be used to ignite or slow the economy and is controlled by the Federal Reserve with the ultimate goal of creating an easy money environment. Early Keynesians did not believe monetary policy had any long-lasting effects on the economy because:

• Since banks have a choice whether or not to lend out the excess reserves they have on hand from lower interest rates, they may just choose not to lend; and
• Keynesians believe consumer demand for goods and services may not be related to the cost of capital to obtain theses goods.

At different times in the economic cycle, this may or may not be true, but monetary policy has proven to have some influence and impact on the economy, as well as equity and fixed income markets.

The Federal Reserve carries three powerful tools in its arsenal and is very active with all of them. The most commonly used tool is their open market operations, which affect the money supply through buying and selling U.S. government securities. The Federal Reserve can increase the money supply by buying securities and decrease the money supply by selling securities.

The Fed can also change the reserve requirements at banks, directly increasing or decreasing the money supply. The required reserve ratio affects the money supply by regulating how much money banks must hold in reserve. If the Federal Reserve wants to increase the money supply, it can decrease the amount of reserves required, and if it wants to decrease the money supply, it can increase the amount of reserves required to be held by banks.

Which Policy Is More Effective?

This topic has been hotly debated for decades, and the answer is both. For example, to a Keynesian promoting fiscal policy over a long period of time, the economy will go through multiple economic cycles. At the end of those cycles, the hard assets, like infrastructure, and other long-life assets, will still be standing and were most likely the result of some type of fiscal intervention. Over that same 25 years, the Fed may have intervened hundreds of times using their monetary policy tools and maybe only had success in their goals some of the time.

Using just one method may not be the best idea. There is a lag in fiscal policy as it filters into the economy, and monetary policy has shown its effectiveness in slowing down an economy that is heating up at a faster than desired, but it has not had the same effect when it comes to quickly inducing an economy to expand as money is eased, so its success is muted.