Contents
Q4. Critically assess the merits of
both fiscal policy and monetary policy as methods of controlling the level of
aggregate demand in the economy.
Introduction
Since the sliding of the American
economy into recession in the year 1929, the economics were found to be highly
dependent on the economics theory named as ‘Classical Theory’ which focused
mainly on the self correction of the economy in case there is no interference
by the government. But it was later found that with the recession deepening
further and converting into a great depression without any corrections being
made, the economists made suggestions about revising the theory which was
required. Keynes developed the theory which was known as ‘Keynesian Theory’
which focused on the government intervention which was required in correcting
the economic instability. One of the major roles of the government is to
control the recession and inflation in an economy. There are some of the major tools which are
used by the Bank of England and the congress in correcting the economic
problems and how these tools can be effective in handling the aggregate demand,
interest rates and money supply. The economic data can be further analyzed in
determining how the monetary and fiscal policy can be used in correcting the
economic problems.
Economic performance is said to be
illustrated with the help of concepts of aggregate demand and aggregate supply.
Aggregate supply can be defined as the total supply of services and goods which
are produced in an economy of the nation. It is found to be upward sloping as
the higher the prices are set, the firms are provided with an incentive in
producing more and at the lower prices the production level tends to fall down.
Aggregate demand is defined as the overall demand for the services and goods in
the economy of a nation. It is found to be a downward sloping as the higher the
prices are the government, foreign customers, firms and consumers are found to
be less willing in purchasing. On the other hand the lower prices encourage
them to purchase more. There are many shifts which can occur in the aggregate
demand and aggregate supply curves which show the changes in the economy’s
performance. If the confidence of the consumers falls in an economy and there
is reduction in the spending, there is a fall in aggregate demand. This can
lead to reduction in the prices and real output and can push the country
towards recession. However if the level of money supply increases, the
excessive demand of the consumers can easily push the aggregate demand upwards
which can raise the real price levels and output and also push the country
towards serious inflation (GREAT BRITAIN, 2004).
In order to keep the economy stable,
the economists set the annual goals of achieving the 2.5-3% of the growth in
GDP, 5% unemployment rate and 3-4% of inflation rate. However, there is still an economic cycle
which is seen to be expanding or falling into recession after every few
years. Keynes argued that there is no
need to wait for the potential problems in the economy to solve themselves. He emphasized on the government who need to
play an active role in the solution of such economic problems with the help of
two major policies known as fiscal and monetary policy.
Fiscal policy
Fiscal policy is the utilization of the taxes and spending by the government in order to bring stabilization in an economy. Keynesian theory brings in the recommendation that the congress should try increasing the government spending in priming the pump of an economy. Similarly the theory also recommended that there should be reduction in taxes to provide the households with higher amount of disposable income which allows easy purchasing of more of the products. Through these both ways of fiscal policy which are followed, the increasing aggregate demand can help in stimulating the firms to boost the production, increasing the household incomes and hiring workers. Keynesians focus on the opposite actions which must be taken in times of inflation. In slowing down an economy, the Keynesians recommended the congress that the government must decrease its spending levels in reducing the pressure on the overall aggregate demand. Similarly he also called for an increase in taxes in the times of inflation in reducing the disposable incomes of the consumers. This reducing aggregate demand through these actions can lead to firm producing the lesser products, slows the hiring and also brings reductions in an inflationary pressure. These both tools are considered as effective ones and the Keynesians pressurized on the government spending as much better tool of fiscal policy as any variation in the spending of the government brings a direct impact on the overall demand. However if there is the reduction in taxes, the consumers will not be interested in spending all their disposable income which have increased and will look to saving some proportion of their income. Similarly if the taxes are increased, the consumers are less like in reducing their consumption of goods by similar amount as tax. They are more likely to dip in the savings in covering some of the variation in rates of taxes (ESPINOSA, 1995).Monetary policy
Monetary policy is also used in bringing the
stabilization in an economy with the help of the utilization of the money
supply and credits. The increasing demand for the money comprises of the
borrowing from the consumers for items such as the homes and cars, firms also
borrow for items such as the equipment and factories and the borrowing by the
government in financing the national debt. Bank of England sets this money
supply and the demand and supply for money helps in determining the interest
rates which are required to be paid for the borrowed money use. If there is an
increase in the level of money supply, there will be a fall in interest rates
which will make it less expensive in borrowing the money. In that case there
will be more borrowing of money and increase in the spending by the consumers
on purchasing more products. On the other hand if there is the reduction in the
money supply level, there will be a rise in the interest rates which means there
will be less borrowings and spending as the cost of borrowing increases (EKPO,
2000).
There are 3 primary tools which are available for the Bank
of England in changing the level of money supply. In the times of recession,
the Keynesians recommends the Bank of England of purchasing the open market
bonds. Through this increase in the reserves which the bank is holding, they
have more amount of money which is available to provide with loans and reducing
the interest rates. At the lower rates of interests firms and consumers are
highly interested in borrowing to make more purchases and this can lead to
increasing the aggregate demand. The Keynesians also recommends the Bank of
England in lowering the rates of discounts. When the Bank of England brings
reduction in the rate of interests, member bans should be paying in borrowing
from the Bank of England, banks become highly interested in borrowing to make
the money available to loan at the lower rates of interest. In that case, the
firms and consumers will be greatly interested in borrowing and spending which
can increase the aggregate demand. Thirdly the Keynesians also recommend the Bank
of England to decrease the reserve requirements during the time of serious
recession. If banks are permitted in releasing more of the reserved funds for
loaning, the lower rates of interest will be enticing the firms and consumers
again in borrowing funds to buy and this can again increase the level of
aggregate demand. Keynesians suggests
the opposite actions which must be taken during the period of serious inflation
which can reduce the level of money supply in raising the interest rates which
will make it less likely for the firms and consumers in borrowing more in
purchasing the products. Although these
tools are found to be working in the same way but they might also differ in
terms of their power effects. The reserve requirement can be really powerful
and must be change only in case of serious problems in the economy. The
discount rate must be used as the Bank of England’s intentions towards the
monetary policy. Open market operations are considered as widely used monetary
policy tools (BEETSMA, 2004).
Conclusion
Economists learned greatly from the Great depression
experience and they focus on the advocating of government’s role in the
creation of the stabilization of economic policy. Although there is a
disagreement by the economists about which tool must be appropriate and the
strength or timing of such tools which must be used, most economists recognizes
the benefits of the monetary and fiscal policy to prevent the extreme
depression or inflation in an economy. The use of monetary and fiscal policy is
therefore really essential in controlling the level of aggregate demand and
supply. It must be used by the government in times of facing problems in terms
of economic stability which can be overcome through these two policies if used
effectively (LANGDANA, 2007).
References
BEETSMA,(2004). Monetary policy, fiscal policies and
labour markets: macroeconomic policymaking in the EMU. Cambridge [u.a.],
Cambridge Univ. Press.
EKPO, (2000). Fiscal and monetary policy during
structural adjustment in Nigeria: proceedings of a senior national policy
workshop. Uyo, Akwa Ibom State, ABBNNY.
ESPINOSA, (1995). Fiscal and monetary policy
interactions in an endogenous growth model with financial intermediaries.
Atlanta, Ga, Bank of England Bank of Atlanta.
GREAT BRITAIN. (2004). Monetary and fiscal policy:
present successes and future problems. London, Stationery Office.
LANGDANA, F. K. (2007). Macroeconomic policy:
demystifying monetary and fiscal policy. New York, Springer.
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