Fiscal and Monetary Policy

Introduction

There are several types of policies used to control economies around the world. However, the most common are the monetary and fiscal policies. Fiscal policy involves controlling the economy using government expenditure and revenue collection in form of taxes. The basis for this is that government expenditure and various forms of taxes impact differently on various aspects of the economy. Governments use this policy to regulate the economy by employing different tax mechanisms at different times to achieve specific results that are desired based on the circumstances.

Fiscal Policy

Fiscal policy comprises of two instruments that are key in achieving its objectives. First, is the government expenditure through which the government seeks to control the economy by varying its spending habits and how it allocates resources for furtherance of government activities (Brown, 1999). The second instrument is government taxation which is a mode used by governments to obtain revenue to finance its activities. There are various taxes imposed at various times depending on the circumstances and the desired effect in the economy at that particular time.

Fiscal policy is further broken down into three general types namely neutral, contractionary and expansionary. The first stance describes a situation where the government expenditure is fully funded by the revenue obtained from taxation (Rittenberg & Tregarthen, 2008). This is a situation of a balanced economy where the budget has no overall effect on the activity in the economy. The effect is said to be neutral because the revenue and expenditure is balanced. The contractionary stance describes a situation where the government spending happens to be lower than revenue whereas the third stance implies a fiscal policy whereby government spending exceeds the revenue generated by taxes.

Governments use fiscal policies to influence the average level of demand in the economy. This is achieved through decreasing and increasing taxes in order to achieve economic growth or stabilize prices in a volatile market economy. It has been suggested that these methods, when used prudently, comprise some of the best methods of economic control exercisable by government. These tools can be used to stimulate growth by government by influencing the aggregate demand in the economy through incentives to generate revenue. The logic behind this is that the deficits occasioned by recession of economic activity will be compensated by expanding the economy through such stimulus as occasioned by fiscal policy mechanisms. The use of fiscal policy to stimulate economic growth is widespread in many countries since it allows governments to dictate how the economies of their countries react depending on the circumstances and market forces at play.

Monetary Policy

Monetary policy, on the other hand, focuses on the relationship that exists between interest rates and money supply in an economy. Such policy may be said to be contractionary in instances where it is used to reduce the amount of money in supply in the economy. This reduction is usually achieved by governments raising the interest rates at which their central banks lend money to banks. On the other hand, the policy may be said to be expansionary if it is used to increase the amount of money in supply in the economy.

As in the case with a contractionary monetary policy, an increase in the supply of money in the economy may be achieved by the government manipulating the interest rates of the central bank. To achieve this effect, the government is required to lower interest rates of their central banks. This will have the effect of increasing the amount of money in supply in the economy.

Other descriptions used for monetary policies include accommodative which means the policy is set in order to achieve a positive trend in economic growth. Another description for monetary policy is neutral which describes policy that is aimed neither at increasing or reducing the amount of supply of money in the economy (Eveland, 2009). Tight monetary policy is used to describe policy that is leveled at taming high inflation rates by reducing the amount of supply of money in the economy.

Monetary policy makes use of the open market operations as its main tool of implementation. This mechanism involves the purchase and sale of financial instruments with the main aim of regulating and managing the quantity of money that is circulating in an economy. The instruments used affect the understanding of what the monetary policy is targeting since it lays down a basis for the distinction between different types of policies. Similarly, the target of the monetary policy forms a basis for distinction between the various types of monetary policies.

There exist various types of monetary policy regimes depending on their nature and what they seek to achieve in either their long-term or short-term objectives. These regimes include inflation targeting which involves maintaining the level of inflation within a specified level. The second regime is price level targeting is similar to inflation targeting the only difference being it is designed to be effected over a longer period of time. Monetary aggregates focuses on monetary quantities whereas the fixed exchange rate regime is poised on maintaining a constant rate of exchange with foreign currencies (Federal Reserve Bank of San Francisco, 2011).

Approaches to Management of Economies

In the management of economic policies, the Keynesian approach is of the opinion that the private sector of the economy may make decisions that eventually lead to outcomes that cause negative activity in the economy. This school of thought advocates for intervention by the government in such situations by active monetary and fiscal policy to correct the inefficiencies created by the private sector. This leads to an overall stabilization of the output of the economy over the business cycle.

The Friedman approach to the management of the economy was different from the Keynesian school of thought in that it provided for a more reserved approach adopted by the government in guiding the economy (Orley, 2011). This school is of the opinion that government control of the economy should be severely restricted to prevent catastrophes that may be occasioned by poorly advised monetary and fiscal policies.

It should be noted that some decisions made by government concerning the economy may or may not form part of the fiscal or monetary policy of that government. For instance, the increase of mileage requirements by the E.P. A¹ does not comprise monetary or fiscal policy since it does not relate to government expenditure, income by way of taxes or interest rates of the Federal Reserve Bank. Another instance that neither falls under monetary nor fiscal policy is the inspection of nuclear plants in the United States. The subsidies given for production of corn-based fuel may form part of fiscal policy since the subsidy is a form of tax relief given by the government. The elimination of tax deductions is a form of fiscal policy since it involves tax matters to maintain control over the economy. The reduction of interest rates, maintenance of interest rates at specified levels by the Federal Reserve Board of Governors, the financial bailout by government and the increase of interest rates to slow down the American economy all comprise monetary policy since they involve manipulation of interest rates in controlling supply of money in the economy.

References

1. Brown W. S. (1999, April). Is Economics Becoming a Hard Science? / Why Economists Disagree. Review of Political Economy. [Review of the book Is Economics Becoming a Hard Science?, by Antoine d’Autume & Jean Cartelier (Eds)]. Review of Political Economy, 11, 2.
2. Eveland JD (nd). Key terms for Module 1. Cypress, California: TUI University.
3. Federal Reserve Bank of San Francisco. (2009). Web.
4. Orley, A. (2008). PEDestrian’s Guide to Economics.
5. Rittenberg, L., & Tregarthen, T. (2008). Government and Fiscal Policy. In Principles of Macroeconomics.
6. Weil, D. N. (2002). Fiscal Policy. In The Concise Encyclopedia of Economics. Web.

Footnotes

1 Environmental Protection Agency.