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COMPARISON OF MONETARY AND FISCAL POLICIES OUTLINES Introduction Definition of fiscal policy Definition of monetary policy Policy Tools Fiscal policy Monetary policy Which is More Effective Monetary or Fiscal Policy? Comparison Similarities Differences 1 INTRODUCTION Economic policy-makers are said to have two kinds of tools to influence a country's economy: fiscal and monetary. Definition of Fiscal policy: It relates to government spending and revenue collection. For example, when demand is low in the economy, the government can step in and increase its spending to stimulate demand. Or it can lower taxes to increase disposable income for people as well as corporations. Definition of Monetary policy: it relates to the supply of money, which is controlled via factors such as interest rates and reserve requirements (CRR) for banks. For example, to control high inflation, policy-makers (usually an independent central bank) can raise interest rates thereby reducing money supply. These methods are applicable in a market economy, but not in a fascist, communist or socialist economy. John Maynard Keynes was a key proponent of government action or intervention using these policy tools to stimulate an economy in recession. POLICY TOOLS Both fiscal and monetary policy can be either expansionary or contractionary. Policy measures taken to increase GDP and economic growth are called expansionary. Measures taken to rein in an "overheated" economy (usually when inflation is too high) are called contractionary measures. Fiscal policy The legislative and executive branches of government control fiscal policy. In the United States, this is the President's administration (mainly the Treasury Secretary) and the Congress that passes laws. Policy-makers use fiscal tools to manipulate demand in the economy. For example: Taxes: If demand is low, the government can decrease taxes. This increases disposable income, thereby stimulating demand. Spending: If inflation is high, the government can reduce its spending thereby removing itself from competing for resources in the market (both goods and services). This is a contractionary policy that would lower prices. Conversely, when 2 there is a recession and aggregate demand is flagging, increased government spending in infrastructure projects would lead to higher demand and employment. Both tools affect the fiscal position of the government i.e. the budget deficit goes up whether the government increases spending or lowers taxes. This deficit is financed by debt; the government borrows money to cover the shortfall in its budget. Procyclical and Countercyclical Fiscal Policy In an article for VOX on the tax cuts vs. stimulus debate, Jeffrey Frankel, Economics professor at Harvard University has said that sensible fiscal policy is countercyclical. When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit. [There is] no reason to follow a pro-cyclical fiscal policy. A procyclical fiscal policy piles on the spending and tax cuts on top of booms, but reduces spending and raises taxes in response to downturns. Budgetary profligacy during expansion; austerity in recessions. Procyclical fiscal policy is destabilising, because it worsens the dangers of overheating, inflation, and asset bubbles during the booms and exacerbates the losses in output and employment during the recessions. In other words, a procyclical fiscal policy magnifies the severity of the business cycle. Monetary policy Monetary policy is controlled by the Central Bank. In the U.S., this is the Federal Reserve. The Fed chairman is appointed by the government and there is an oversight committee in Congress for the Fed. But the organization is largely independent and is free to take any measures to meet its dual mandate: stable prices and low unemployment. Examples of monetary policy tools include: Interest Rates: Interest rate is the cost of borrowing or, essentially, the price of money. By manipulating interest rates, the central bank can make it easier or harder to borrow money. When money is cheap, there is more borrowing and more economic activity. For example, businesses find that projects that are not viable if they have to borrow money at 5% are viable when the rate is only 2%. Lower rates 3 also disincentivize saving and induce people to spend their money rather than save it because they get so little return on their savings. Reserve requirement: Banks are required to hold a certain percentage (cash reserve ratio, or CRR) of their deposits in reserve in order to ensure that they always have enough cash to meet withdrawal requests of their depositors. Not all depositors are likely to withdraw their money simultaneously. So the CRR is usually around 10%, which means banks are free to lend the remaining 90%. By changing the CRR requirement for banks, the Fed can control the amount of lending in the economy, and therefore the money supply. Currency peg: Weak economies can decide to peg their currency against a stronger currency. This tool is usually used in cases of runaway inflation when other means to control it are not working. Open market operations: The Fed can create money out of thin air and inject it into the economy by buying government bonds (e.g. treasuries). This raises the level of government debt, increases the money supply and devalues the currency causing inflation. However, the resulting inflation supports asset prices such as real estate and stocks. WHICH IS MORE EFFECTIVE MONETARY OR FISCAL POLICY? In recent decades, monetary policy has become more popular because: Monetary policy is set by the Central Bank, and therefore reduces political influence (e.g. politicians may cut interest rates in desire to have a booming economy before a general election) Fiscal Policy can have more supply side effects on the wider economy. E.g. to reduce inflation – higher tax and lower spending would not be popular and the government may be reluctant to purse this. Also lower spending could lead to reduced public services and the higher income tax could create disincentives to work. Monetarists argue expansionary fiscal policy (larger budget deficit) is likely to cause crowding out – higher government spending reduces private sector spending, and 4 higher government borrowing pushes up interest rates. (However, this analysis is disputed) Expansionary fiscal policy (e.g. more government spending) may lead to special interest groups pushing for spending which isn’t really helpful and then proves difficult to reduce when recession is over. Monetary policy is quicker to implement. Interest rates can be set every month. A decision to increase government spending may take time to decide where to spend the money. However, the recent recession shows that Monetary Policy too can have many limitations. Targeting inflation is too narrow. This meant Central banks ignored an unsustainable boom in housing market and bank lending. Liquidity Trap. In a recession, cutting interest rates may prove insufficient to boost demand because banks don’t want to lend and consumers are too nervous to spend. Interest rates were cut from 5% to 0.5% in March 2009, but this didn’t solve recession in UK. Even quantitative easing – creating money may be ineffective if banks just want to keep the extra money in their balance sheets. Government spending directly creates demand in the economy and can provide a kickstart to get the economy out of recession. Thus in a deep recession, relying on monetary policy alone, may be insufficient to restore equilibrium in the economy. In a liquidity trap, expansionary fiscal policy will not cause crowding out because the government is making use of surplus saving to inject demand into the economy. In a deep recession, expansionary fiscal policy may be important for confidence – if monetary policy has proved to be a failure. 5 COMPARISON Fiscal Policy Fiscal Monetary Policy policy of Monetary policy is the process by which the and monetary authority of a country controls the revenue collection to influence supply of money, often targeting a rate of the economy. interest to attain a set of objectives oriented government Definition is the use expenditure towards the growth and stability of the economy. Manipulating level of Manipulating the supply of money to influence in the outcomes like economic growth, inflation, economy to achieve economic exchange rates with other currencies and objectives of price stability, full unemployment. aggregate Principle employment, the demand and economic growth. Policy- Government (e.g. U.S. Congress, Central Bank (e.g. U.S. Federal Reserve or maker Treasury Secretary) European Central Bank) Taxes; amount of government Interest rates; reserve requirements; currency spending peg; discount window; quantitative easing; Policy Tools open market operations; signalling Similarities They are both used to pursue policies of higher economic growth or controlling inflation. Both policies could be applied for contractionary and expansionary economic purposes 6 Both policies have common macroeconomic objectives such as stable economic growth. Differences between Monetary and Fiscal Policies S/N Monetary 1 Monetary Fiscal policy involves Fiscal policy involves the changing the interest rate government and influencing the money rates supply. changing tax levels of spending to and government influence aggregate demand in the economy. 2 Monetary policy is usually Fiscal Policy is carried out by carried out by the Central the government and involves Bank / Monetary authorities changing: and involves: Level of government Setting base interest rates spending (e.g. Bank of England in UK and Federal Reserve in US) 3 Better tool during economic boom 4 tool during economic recession Monetary policy has macroeconomic Better key policy Fiscal policy has macroeconomic policy objectives such as price objectives stability economic growth and full control and inflation such key as employment 7 CONCLUSION Economists and politicians rarely agree on the best policy tools even if they agree on the desired outcome. For example, after the 2008 recession, Republicans and Democrats in Congress had different prescriptions for stimulating the economy. Republicans wanted to lower taxes but not increase government spending while Democrats wanted to use both policy measures. References Fiscal Policy vs Monetary Policy - Dr. F. Steb Hipple, East Tennessee State University http://en.wikipedia.org/wiki/Fiscal_policy http://en.wikipedia.org/wiki/Monetary_policy 8