Question

• Impacts of policy (Monetary and fiscal) under each regime

Answer 1

When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two primary courses of action: monetary policy or fiscal policy.

Monetary policy involves the management of the money supply and interest rates by central banks. To stimulate a faltering economy, the central bank will cut interest rates, making it less expensive to borrow while increasing the money supply. If the economy is growing too rapidly, the central bank can implement a tight monetary policy by raising interest rates and removing money from circulation.

Fiscal policy determines the way in which the central government earns money through taxation and how it spends money. To assist the economy, a government will cut tax rates while increasing its own spending; to cool down an overheating economy, it will raise taxes and cut back on spending. There is much debate as to whether monetary policy or fiscal policy is the better economic tool, and each policy has pros and cons to consider.

Monetary Policy Pros and Cons

Pro: Interest Rate Targeting Controls Inflation

A small amount of inflation is healthy for a growing economy as it encourages investment in the future and allows workers to expect higher wages. Inflation occurs when the general price levels of all goods and services in an economy increases. By raising the target interest rate, investment becomes more expensive and works to slow economic growth a bit.

Pro: Can Be Implemented Fairly Easily

Central banks can act quickly to use monetary policy tools. Often, just signaling their intentions to the market can yield results.

Pro: Central Banks Are Independent and Politically Neutral

Even if a monetary policy action is unpopular, it can be undertaken before or during elections without the fear of political repercussions.

Con: The Risk of Hyperinflation

When interest rates are set too low, over-borrowing at artificially cheap rates can occur. This can then cause a speculative bubble, whereby prices increase too quickly and to absurdly high levels. Adding more money to the economy can also run the risk of causing out-of-control inflation due to the premise of supply and demand: if more money is available in circulation, the value of each unit of money will be worth less given an unchanged level of demand, making things priced in that money nominally more expensive.

Con: Effects Have a Time Lag

Even if implemented quickly, the macro effects of monetary policy generally occur after some time has passed. The effects on an economy may take months or even years to materialize. Some economists believe money is "merely a veil," and while serving to stimulate an economy in the short-run, it has no long-term effects except for raising the general level of prices without boosting real economic output.

Con: Technical Limitations

Interest rates can only be lowered nominally to 0%, which limits the bank's use of this policy tool when interest rates are already low. Keeping rates very low for prolonged periods of time can lead to a liquidity trap. This tends to make monetary policy tools more effective during economic expansions than recessions. Some European central banks have recently experimented with a negative interest rate policy (NIRP), but the results won't be known for some time to come.

Pros and Cons of Fiscal Policy

Fiscal policy refers to the tax and spending policies of a nation's government. A tight, or restrictive fiscal policy includes raising taxes and cutting back on federal spending. A loose or expansionary fiscal policy is just the opposite and is used to encourage economic growth. Many fiscal policy tools are based on Keynesian economics and hope to boost aggregate demand.

Pro: Can Direct Spending To Specific Purposes

Unlike monetary policy tools, which are general in nature, a government can direct spending toward specific projects, sectors or regions to stimulate the economy where it is perceived to be needed to most.

Pro: Can Use Taxation to Discourage Negative Externalities

Taxing polluters or those that overuse limited resources can help remove the negative effects they cause while generating government revenue.

Pro: Short Time Lag

The effects of fiscal policy tools can be seen much quicker than the effects of monetary tools.

Con: Can Create Budget Deficits

A government budget deficit is when it spends more money annually than it takes in. If spending is high and taxes are low for too long, such a deficit can continue to widen to dangerous levels.

Con: Tax Incentives May Be Spent on Imports

The effect of fiscal stimulus is muted when the money put in to the economy through tax savings or government spending is spent on imports, sending that money abroad instead of keeping it in the local economy.

Con: May Be Politically Motivated

Raising taxes is unpopular and can be politically dangerous to implement.