Question

1. If a nation were to attempt to restimulate its economy, would you advise the use of Monetary or Fiscal Policy to do so? Why? What are the strengths of each? What are the drawbacks of each?

Answer 1

In comparing the two, fiscal policy generally has a greater impact on consumers than monetary policy, as it can lead to increased employment and income.

To restimulate the economy government can use Expansionary Fiscal Policy.

It involves the government seeking to increase aggregate demand through higher government spending and/or lower tax.

If the government cut income tax, then this will increase the disposable income of consumers and enable them to increase spending. Higher consumption will increase aggregate demand and this should lead to higher economic growth. Alternatively, if the government increased investment in public work schemes, this government spending would create jobs, increase incomes and lead to greater aggregate demand.This injection of money into the economy can also cause a positive multiplier effect

Strengths of Fiscal Policy

Reduction in Unemployment.

When unemployment is high, the government can employ an expansionary fiscal policy. This involves increasing spending or purchases and lowering taxes. Tax cuts, for example, can mean people have more disposable income, which should lead to increased demand for goods and services. To meet the growing demand, the private sector will increase production, creating more job opportunities in the process.

Reduction in Budget Deficit.

A budget deficit occurs when expenditure is more than revenue. This results in increased public debt.By adopting Contractionary Fiscal Policy country will, therefore, reduce public spending and increase tax rates to raise more revenue and ultimately lower the budget deficit.

Increase in Economic Growth

The various fiscal measures a country employs facilitate expansion of the national economy. For example, when the government reduces tax rates, businesses and individuals will have a greater incentive to invest and steer the economy forward

Drawbacks of Fiscal Policy

Conflict of objectives

Sometimes government use mix of Expansionary and Contractio ary Fiscal Policy. This leads chaos and confusion. The desired objective cannot be achieved.  If the national government wants to raise more money to increase its spending and stimulate economic growth, it can issue bonds to the public. Since government bonds offer a range of benefits to buyers, individuals and businesses will buy them heavily. The private sector consequently will have little money left to invest. With reduced investment activity, the economy can slow down.

Lack of flexibility

Sometimes there is some delays in implementation of Fiscal Policy. This occurs because some measures recquire proper procedure and legislative processes.

Advantages of Monetary Policy

Stable Prices

When inflation rises Fed sells bonds to drain our the excess money supply from the system or raise short term interest rates. These actions may lead banks and other lending institutions to increase long-term rates. This reduces access to credit and slows consumer spending, countering inflation.

Long Term Perspective

Short-run action enables policy makers to assess economic conditions and promote sustainable growth and low inflation over the long term.

Drawbacks

Conflict of Goals

There is conflict between objective of economic growth and low inflation. In a growing economy, with lower unemployment, inflation may increase temporarily. This triggers monetary policy action to slow growth and reduce inflation. When inflationary pressures decrease, the jobless rate may rise for a brief period as the pace of the economy slows.

Time Lags

Monetary policy suffers from time lags. It may take several months or years or even longer for monetary policy decisions taken by Fed to become effective.