Question

Briefly explain the potential benefits of using monetary policy rather than fiscal policy to stabilise the economy (200 word limit).

Answer 1

The aims of fiscal and monetary policy are similar. They could both be used to:

• Maintain positive economic growth
• Aim for full employment
• Keep inflation low

The principal aim of fiscal and monetary policy is to reduce cyclical fluctuations in the economic cycle. In recent years, governments have often relied on monetary policy to target low inflation. However, in recessions, there are strong arguments for also using fiscal policy to achieve economic recovery.

• Fiscal policy involves changing government spending and taxation. It involves a shift in the governments budget position. e.g. Expansionary fiscal policy involves tax cuts, higher government spending and a bigger budget deficit. Government spending is a component of AD.
• Monetary policy involves influencing the demand and supply of money, primarily through the use of interest rates.
  • Monetary policy can also involve unorthodox policies such as open market operations and quantitative easing.
  • Monetary policy is usually carried out by an independent Central Bank

In a recession, monetary policy will involve cutting interest rates to try and stimulate spending and investment. It should also weaken the exchange rate which will help exports.

In an expansionary monetary policy, where banks are lowering interest rates on loans and mortgages, more business owners would be encouraged to expand their ventures, as they would have more available funds to borrow with affordable interest rates. The Federal Reserve can make use of a monetary policy to create or print more money, allowing them to purchase government bonds from banks and resulting to increased monetary base and cash reserves in banks.

As monetary policy would lower interest rates, it would also mean lower payments home owners would be required for the mortgage of their houses, leaving homeowners more money to spend on other important things.

One of the biggest perks of monetary policy is that it can help promote stable prices, which are very helpful in ensuring inflation rates will stay low throughout the country and even the world.

A monetary policy would oblige policymakers to make announcements that are believable to consumers and business owners in terms of the type of policy to be expected in the future.

Since the central bank can operate separately from the government, this will allow them to make the best decisions based upon how the economy is performing doing at a certain point in time. Also, the banks would operate based on hard facts and data, rather than the wants and needs of certain individuals. Even the Federal Reserve can operate without being exposed to political influences.

Monetary policy is most widely used for ‘fine-tuning’ the economy. Making minor changes to interest rates is the easiest way to influence the economic cycle. Deflationary fiscal policy is highly politically unpopular.However, in some circumstances, monetary policy has its limitations. In serious recessions, a combination of two policies may be needed.

However, in some circumstances, monetary policy has its limitations. In serious recessions, a combination of the two policies may be needed.