Question

Use economic theories and terminologies you learned to analyze and explain the questions step by step.  A single strong paragraph (not less than 200 words) for each question should be sufficient as long as it is done well.

What is the basic objective of monetary policy? What are the major strengths of monetary policy? Why is monetary policy easier to conduct that fiscal policy?

Answer 1

The monetary policy in developed economies has to serve the function of stabilization and maintaining proper equilibrium in the economic system. But in case of underdeveloped countries, the monetary policy has to be more dynamic so as to meet the requirements of an expanding economy by creating suitable conditions for economic progress. It is now widely recognized that monetary policy can be a powerful tool of economic transformation.

As the objective of monetary policy varies from country to country and from time to time, a brief description of the same has been as following:

(i) Neutrality of money

(ii) Stability of exchange rates

(iii) Price stability

(iv) Full Employment

(v) Economic Growth

(vi) Equilibrium in the Balance of Payments.

Inflation harms the value of money by reducing its purchasing power. When inflation rises faster than expected, the Fed may sell government bonds to take money out of circulation or raise short-term interest rates. According to The Federal Reserve Bank of San Francisco, 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.

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

With the banks lowering the interest rates on mortgages and loans, more business owners will be encouraged to expand their businesses since they are more available funds to borrow with interest rates that they can afford. On the other hand, prices of commodities will be lowered and the buying public will have more reason to buy more consumer goods. In the end, companies will profit while their customers are able to afford what they need like basic commodities, property and services.

Another advantage of monetary policy in relation to lowered rates is that it also affects the payments home owners need to meet for the mortgage of their homes. Reduced mortgage fees will leave home owners more money to spend. Also, they will be able to settle their monthly payments regularly. This is a win-win situation for merchandisers, creditors and property investors as well.

1. Monetary policy is usually implemented by independent monetary authorities. For example, in UK, monetary policy is implemented by the Monetary Policy Committee of the Bank of England. Therefore, they can take politically unpopular decisions such as increasing interest rates to reduce inflationary pressure. When governments set interest rates, it was a highly charged political decision. e.g. industry lobbying for rate cuts to avoid unemployment. Governments would often be tempted to cut interest rates before an election.
2. Fiscal Policy involves changing levels of taxation and spending. For example, deflationary fiscal policy may involve cutting spending. But, it is difficult to find a department willing to have its spending cut to help the macro-economy. Spending cuts tend to be very politically unpopular.
3. Increasing taxes will be unpopular no matter which tax you choose.
4. Increasing income and corporation tax may also have supply side effects, e.g. increasing income tax may reduce incentives to work, it could even encourage the rich to go and live abroad.
5. Expansionary fiscal policy is also not without difficulties. Cutting taxes to boost aggregate demand will be politically popular. But, then the government finds it difficult to reverse the tax cut when the economy starts to grow against.