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 me