In the current paper, a discussion is presented regarding the meanings and effectiveness of fiscal and monetary policies. Various economic models are practiced across the world. Free market economies have been lauded as the most effective system of operations. In the current setup, the private sector provides the means of production while the government sets up regulatory frameworks to ensure a level playing ground. Besides the government’s regulatory role, it also provides sensitive goods and services that cannot be left to the private sector for various reasons. In open market economies, two policies have been used to spur economic growth, maintain stability and attain other determined economic objectives. Fiscal policy and monetary policy are some of the approaches employed by governments to control development. To provide a comparison of the effectiveness of the policies, each is analyzed.
Fiscal policy is an approach where a government uses taxation and its spending as tools to attain certain economic objectives. Taxation is the levying of money as payments to the governments for the consumption of various goods and services. Such regulations or directives are passed through legislative processes and assented into law by leaders of the executive. Various supreme laws have given governments powers to levy taxes. Therefore, exercise has a legal effect. Through the manipulation of taxes, governments are able to attain their economic objectives.
During a recession in an economy, governments can stimulate economic growth through changes in tax rates. Reducing the tax burden on the economy makes businesses easier to start and run. Investors will be attracted to open up in areas where taxes are low. Opening up of businesses has the potential of creating job openings or employment opportunities. Those employed are able to afford basic commodities given that their disposable incomes are improved. The economy will grow with the creation of employment opportunities arising out of the reduction in interest rates.
During economic booms, the government will contemplate an increase in taxes in order to control economic activities. An increase in taxes will reduce the prospects of the creation of new employment opportunities from new businesses. Such a mechanism is referred to as a contractionary fiscal policy measure. Hence, by utilization of taxes as tools, the government is able to achieve its desired goals in regard to economic activities.
The second tool under the fiscal policy framework by the government is applicable to spending. Expenditure in various sectors of the economy has an effect on the performance and response of microeconomic indicators. Governments spend on health, security, education and any other areas as deemed appropriate. Expenditure on infrastructure development has an effect on stimulating economic growth and activities. Investments in the improvement of roads, railway transport, airports, and security have an effect on attracting investments. Locations that are secure and readily accessible will be considered prime for investment purposes. Industries and other businesses will be created in such regions. Employment opportunities will result from such government initiatives. As a result, the government will have its economic stimulations achieved through spending programs.
A reduction of government spending in infrastructural sectors will serve to discourage investment in such areas. Investors will shy away from regions that lack infrastructure for carrying out their business. That will create a state of stagnation in economic activities. The reduction in government expenditure falls under contractionary fiscal policy measures as a response to an economic boom. The aim is to control economic performance and maintain stable inflation rates.
Monetary Policy is a program whereby the monetary authority exercises control over the amounts of money in circulation with the objective of attaining economic growth and stability. In most cases, the monetary authority is the central bank. Such an institution manipulates the amounts of money in circulation through three tools: interest rates, reserve requirements, and open market operations.
Interest rates may vary depending on the state of the economy and the required effect. Based on the state of the economy, the central bank can adopt either a contractionary policy or expansionary policy. In the event that the economy is in a boom, the contractionary system will be considered appropriate. The objective will entail reducing the levels of economic activities. Interest rates will be increased. The costs of borrowing will consequently rise. The result will be a few people borrowing, fewer investments and thereby reduction of money in circulation.
The reserve requirement by the central bank will also be raised. By raising the requirement, commercial banks or lenders will have fewer funds to lend. Transactions involving borrowing will be reduced. The effect will be a reduction in the amounts of money in circulation. Another strategy in the monetary contractionary policy is selling government bonds to the public in the open market operations. The selling of the bonds provides an avenue to collect money in the economy and, as a result, reduce the amount of money in circulation. Such contractionary monetary policy measures aim to attain stability in the economy through a reduction in inflation rates.
Expansionary monetary policy measures seek to stimulate the economy during a recession or immediately during the period preceding a recession. The aim is to jumpstart the economy. Central banks will reduce interest rates under such a scenario. Low-interest rates imply affordability in the cost of funds. Investors will be enticed with low rates. Many entrepreneurs and businesses will borrow to start investments. As new businesses emerge, employment opportunities are created. The foregoing has an effect on economic growth.
A central bank’s response during a recession in regards to reserve requirement will be to encourage a reduction. A low-level reserve requirement means that many funds will be available to commercial banks for lending. Where many people resort to borrowing, businesses and investments will be undertaken, hence creating opportunities for employment. A reduction in unemployment rates implies an improvement in economic growth and performance.
Open market operations will be reversed to encourage the central bank to buy government bonds. The effect will be increasing money amounts in circulation. The funds will, in turn, be used for investment purposes and, thereby, spur the economy. Such expansionary monetary policy measure aims at reducing unemployment rates and, thereby, stimulating economic performance.
Effectiveness of Fiscal Policy
As was explained above, the fiscal policy is a tool used by the government to achieve certain economic objectives. Such objectives are attained through the use of taxation and government spending. The undertaking and implementation of such policy measures remain the prerogative of the government. In a majority of countries across the globe, leaders elected through democratic processes head governments. The fairness in the implementation of the guidelines will depend on the political goodwill of those in power.
The adoption of taxation as an appropriate measure of economic growth and stability can be subjective. In the past, certain tax regimes have been discriminatory (Kendrick, 2009). Where the tax burden unfairly falls to a particular pre-determined class, the objectives of the policy may not be realized. In some tax jurisdictions, the poor are taxed more heavily than the rich. Some products or businesses have been subjected to heavy taxation, unlike the others. Provisions in-laws on taxation allow governments to exempt certain activities and products of taxation. Governments have abused the law by using loopholes for selfish gains. Therefore, as much as the concept of taxation seems noble in controlling and stimulating economic activities, it is sometimes ineffective. The use of taxation can only be effective where tax regimes are streamlined to ensure full compliance and utmost good faith in the policy administration. It has been elusive in many countries as corruption reigns supreme.
Government spending is the other tool for fiscal policy implementation. The use of government spending as a tool to spur economic growth can be effective where it is used objectively. As was pointed out, governments are headed by elected leaders. Vested interests come into play. Voting patterns, lobbying in government do influence policy on expenditure. The tool has widely been abused. Elected leaders use the fiscal policy to influence voters based on eras and nearness to elections. Regions that have in the past supported the government will be favored as opposed to electoral areas that have shown their support to leaders who failed at the ballot. The subjective implementation of the policy defeats the purpose for which it was designed. For government spending to be effective its planning and implementation should be fair from the outset till completion under the influence of the economic prosperity of a country.
Effectiveness of Monetary Policy
Monetary policy is exercised by central banks. It varies interest rates, reserve requirements and uses open market operations to influence the amount of money in circulation. The aim is to attain a certain determined level of economic activity. The applications and implementations of policies of the central bank have been noted to be objective, fair and consistent. Central banks are independent institutions.
A policy guideline by the central bank to commercial banks to vary interest rates is uniform to all lenders. The rates apply to all investors based on their credit rating and assessment. Commercial banks are also understood to be spread fairly across the country. Given that central banks are independent bodies, their services are fairly distributed and offered throughout the country, an aspect that makes their services effective. The use of interest rates directly affects each borrower, while the use of reserve requirements also has the same effect. The use of open market operations also has an effect on any holder, buyer or seller of a government bond. Hence, using monetary policy is far more effective than the use of the fiscal policy.
Both fiscal and monetary policies are crucial tools in the attainment of economic growth and stability. While the fiscal policy aims at influencing aggregate demand, monetary policy strives to vary amounts of money in circulation. The two programs present sound measures and avenues to attain economic prosperity in the country. While the structure and functioning of monetary policy seem appropriate and free of any prejudice, fiscal policy is surrounded by political influences that render the policy unable to meet the intended objective.
As cited above, the monetary policy’s implementation and its tools are objective and fair. The guidelines for planning and execution of fiscal policy are subjective and under the influence of elected leaders, who may behold back by various stakes. From the foregoing discussion, monetary policy is more effective than fiscal policy. The main reason for the difference lies in the subjective application and implementation of the policy provisions. If fiscal policy guidelines are fairly and objectively adopted and applied, the difference in effectiveness will be minimized, since both will be effective.