Difference Between Monetary and Fiscal Policy
Difference Between Monetary and Fiscal Policy
?Monetary policy involves changing the interest rate and influencing the money supply.
?Fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy.
They are both used to pursue policies of higher economic growth or controlling inflation.
Monetary Policy
Monetary policy is usually carried out by the Central Bank / Monetary authorities and involves:
?Setting base interest rates (e.g. Bank of England in UK and Federal Reserve in US)
?Influencing the supply of money. E.g. Policy of quantitative easing to increase the supply of money.
How Monetary Policy Works
?The Central Bank may have an inflation target of 2%. If they feel inflation is going to go above the inflation target, due to economic growth being too quick, then they will increase interest rates.
?Higher interest rates increase borrowing costs and reduce consumer spending and investment, leading to lower aggregate demand and lower inflation.
?If the economy went into recession, the Central Bank would cut interest rates.
Fiscal Policy
Fiscal Policy is carried out by the government and involves changing:
?Level of government spending
?Levels of taxation
1.To increase demand and economic growth, the government will cut tax and increase spending
(leading to a higher budget deficit)
2.To reduce demand and reduce inflation, the government can increase tax rates and cut spending
(leading to a smaller budget deficit)
Example of Expansionary Fiscal Policy
In a recession, the government may decide to increase borrowing and spend more on
infrastructure spending. The idea is that this increase in government spending creates an injection of money into the economy and helps to create jobs. There may also be a multiplier effect, where the initial injection into the economy causes a further round of higher spending. This increase in aggregate demand can help the economy to get out of recession.
If the government felt inflation was a problem, they could pursue deflationary fiscal policy (higher tax and lower spending) to reduce the rate of economic growth.
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 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 i sn’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 kick-start 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.
Does Fiscal Policy Solve Unemployment?
It is an interesting question, and one that is likely to generate different views from within the ranks of Economists.
To give a very rough overview:
?Keynesians say yes, fiscal policy can be effective in reducing unemployment. In a recession, expansionary fiscal policy will increase AD, causing higher output, leading to the creation of more jobs.
?Classical Economics say no. Fiscal policy will only cause a temporary increase in real output. In the long run, expansionary fiscal policy just causes inflation and does not increase real GDP.
Classical economists argue that to reduce unemployment it is necessary to use supply side policies which increase the flexibility of labour markets (e.g. reducing power of trades unions)
So who is Right?
In a way I find the distinction between Keynesian and Classical economists rather artificial. I believe that under certain circumstances both can be right.
Firstly, I do believe that fiscal policy CAN reduce cyclical unemployment. In a recession, cutting taxes and increasing government spending can increase AD, and this injection into the economy is likley to create jobs.
Note: fiscal policy has many limitations such as:
?crowding out (government borrowing reduces size of private sector)
?Tax cuts may be saved not spent
?Time Lags
?See: Criticism of fiscal policy for more details
However, despite these limitations it can play a role in increasing AD and reducing cyclical
unemployment.
Can Fiscal Policy Solve Unemployment?
No, fiscal policy cannot solve supply side unemployment. If there is frictional or structural
unemployment, fiscal policy will not solve this. For example, suppose some former miners are unemployed. The problem here is lack of skills and geographical immobilities. Therefore, what is needed is supply side policies. Increasing AD and economic growth does not solve the mismatch of skills. Therefore, when the economy is at full capacity Classical economists are correct. My criticism of the classical model is that in the long run the economy always reaches full output, this is not the case.
Does Fiscal Policy Cause Inflation.
If you increase AD, it could cause inflation. In a recession, when there is spare capacity inflation is unlikely to be a problem. However, if AD increases too much, when the economy is close to full capacity then it will cause inflation.
Liquidity Trap and Fiscal Policy
Liquidity trap: When monetary policy becomes ineffective because, despite zero / very low interest rates, people want to hold cash rather than spend or buy illiquid assets.
Example: Cut in interest rates in early 2009, failed to revive economy.
?Liquidity trap explained
Keynesians argue that a liquidity trap means fiscal policy becomes very important for getting an economy out of a recession. Since interest rates are zero but aggregate demand is still falling, governments need to intervene to ‘crowd in’ resources left idle.
The argument is that the rise in private sector saving needs to be offset by a rise in public borrowing. Thus government intervention can make use of the rise in private saving and inject spending into the economy. This government spending increases aggregate demand and leads to higher economic growth
Monetarists are more critical of fiscal policy. They argue that government borrowing merely shifts resources from private sector to public sector and doesn’t increase overall economic activity. They argue the increase in government borrowing will push up interest rates and crowds out private sector investment. They point to the experience of Japan in the 1990s where a liquidity trap was not solved by government borrowing and a ballooning public sector debt.
Keynesians respond by saying, government borrowing may well cause crowding out in normal circumstances. But, in a liquidity trap, the excess rise in savings means that government borrowing won’t crowd out the private sector because the private sector resources are not being investe d, but just saved. Resources are effectively idle. By stimulating economic activity the government can encourage the private sector to start investing and spending again (hence the idea of ‘crowding in’)
Also, Keynesians say that as well as expansionary fiscal policy, it is essential that governments / monetary authorities make a commitment to inflation. If expansionary fiscal policy occurs during periods of deflation it is likely to fail to boost overall aggregate demand. It is only when people expect a period of moderate inflation that real interest rates fall and the fiscal policy will be effective in boosting spending.
Essay: Should the UK government try to increase the Rate of Economic Growth?
Currently economic growth averages 2.5% a year. If the rate of growth increased it would mean people saw a faster increase in their financial standard of living. They would be able to consume more goods and services.
The government would benefit from increased economic growth. It would see its tax revenues automatically increase. E.g. revenue from income tax and VAT would increase as people earnt and spent more. Also the government would pay less on unemployment benefits. The improvement in the fiscal position would enable them to spend more on important public services like health, transport, and education.
Higher rates of economic growth would create higher levels of employment, reducing unemployment. However, if unemployment is already quite low, firms may struggle to find staff to take on and this could cause wage inflation.
Increasing economic growth could cause a rise in inflation. This is because if growth is above the long run trend rate the economy does not have sufficient capacity to meet demand.
However it is possible to increase the growth rate without causing inflation. If the government increase economic growth by promoting productivity and the supply side of the economy then there will be an increase in AS as well as AD. Therefore the growth will be non inflationary. It depends upon the nature of economic growth.
A potential problem of increasing economic growth is that it could magnify environmental problems. Higher output will lead to higher levels of pollution and emissions of CO2 this would make the serious economic problem of global warming even worse. The recent Stern report suggests if we do not act to combat global warming then there could be serious economic and humanitarian costs in the future.
However it is possible that economic growth could be used to help environmental problems. For example economic growth may lead to improved technology which reduces pollution levels. The government could use tax revenues to find ways of reducing Carbon emissions. If growth came from using renewable energy supplies then it would not be problematic.
In conclusion it depends upon the nature of economic growth. With increasing concerns over global warming it is important for governments to manage growth in a sustainable way. There is little to be gained by increasing temporary growth rates if it results in both inflation and increased pollution levels. It is more beneficial to keep the growth rate close to the long run trend rate of 2.5% and work on improving living standards rather than just GDP figures.
Discuss some of the factors that might cause the natural rate of unemployment to change over time.
The Natural rate of unemployment occurs when the labour market is in equilibarium; it is mainly composed of frictional and structural unemployment. Therefore factors that affect these types of unemployment will alter the natural rate.
It is argued the level of unemployed benefits can affect the level of frictional unemployment. If the ratio of benefits to paid employment is high then there is little incentive to take a job. For example, since the early 1980s unemployment benefits have been index linked ( this means risen in line with inflation). Wages have tended to rise faster than inflation therefore the difference between benefits and paid employment has grown increasing the incentive to get a job and therefore reducing the natural rate of unemployment in the UK.
Similarly the wages of the lowest paid will greatly affect the incentives to take a job. In the UK the government has introduced a national minimum wage and it has steadily increased. This has made work relatively more attractive compared to staying on benefits. Also the New Deal has been
introduced to try and encourage the unemployed back into work. The New Deal involves giving workers retraining schemes and interviews to help them find work. Also if workers are offered a job after 6 months they have to accept it or risk losing benefits and hence they will be not counted as unemployed. This has helped reduce the natural rate.
A key factor affecting structural unemployment is the geographical and occupational mobility of labour. If workers were more mobile this would help reduce unemployment caused by a mismatch of skills and geographical location. For example in the past decade, the north south divide has been reduced in the UK, this is due to regeneration in areas, which used to suffer high unemployment. New industries have taken the place of former heavy industry which have closed down, this has enabled a reduction in geographical unemployment.
If workers became more skilled through education and retraining this would help reduce occupational immobility’s. To some extent the New Deal has helped retrain workers and give them the necessary skills to be effective in the labour market thus reducing structural unemployment.
The flexibility of the labour market is also a key feature for determining the natural rate. For example, if restrictive practices of trades unions were reduced or minimum wages abolished, then labour markets will becomes more flexible thus firms are likely to be more able and willing to hire workers. Arguably the UK labour market has become more flexible in recent years to some
extent explaining the fall in the natural rate. However the EU has seen rises in the natural rate, this is often blamed on inflexible working practices such as a max working week, restrictions on firing workers and minimum wages.
Another potential cause of the natural rate is the Hysteresis hypothesis this states that if unemployment increases (e.g. during a recession) then it is likely to remain high for a considerable period, this is because workers become de-motivated and de-skilled whilst remaining unemployed and therefore find it difficult to get a job in the future. For example after the recession of 1981 unemployment in the UK stayed close to 3 million for a long period despite a long period of growth, however this didn’t happen after the 1991 recession.
Why has unemployment fallen
More flexible labour markets (e.g. unions have less power)
Better education and training (reducing occupational immobilities)
Better information about getting jobs (lower frictional unemployment)
More difficult to get benefits JSA
Long period of economic expansion, creating jobs and reducing demand deficient unemployment