Monetary policy is a process by which the supply of money being an economy is controlled by the monetary authorities of a particular country, often meant to target interest rates for the sake of fostering economic stability and growth. The official goal of this process is to include low unemployment and precisely stable prices. Monetary theory shades light into the way of creating optimal monetary policy. Monetary policy can either be contractionary or expansionary, whereby they expand the supply of money slowly than the usual rate or increase the total supply of money in the economy faster than the usual way respectively.
Contractionary policy is used in slowing the rate of inflation hoping to avoid results of deterioration and distortion of asset values, while expansionary policy is primarily used in attempts of combating unemployment when there is a recession in economy and there is a need to lower the rates of interest. On the other hand, fiscal policy is the process of using the government budget in influencing the economic activities. In this case, the government employs the use of revenue collection and expenditure in influencing the economy of a country. Therefore, expenditure and taxation are the main instruments of fiscal policy. Changes in composition and level and taxation, as well as government expenditure, affect a number of variables in economy of a country namely:
- Income distribution
- The general pattern of allocating resources
- Level of economic activity and aggregate demand
In the recent past, a debate about fiscal and monetary policy has been aroused in need to determine the most appropriate measure a government needs to initiate in bailing out the economy. Fiscal policy is different from monetary policy on the grounds that it exclusively meant for banks and money circulation in a much more efficient way. This also changes annually supply and demand for money-making effect on the rates of interests on loans. Therefore, monetary policy plays a role of regulator through the main bank of a nation such as Federal Reserve System in the United States of America.
Monetary policy is normally executed by Central Bank or relevant monetary authorities and entails influence of money supply, for example, policy of quantitative easing for the purpose of increasing money supply or setting the base of rates of interest, for instance, Federal Reserve in the U.S. and Bank of England. Monetary policy works in different scenarios. If the Central Bank targets an inflation of 2% and feels that it is going to rise above the target, because of economic growth, it would consequently increase the rates if interests. When interest rates are high, the cost of borrowing increases, thereby reducing consumer investment and expenditure. This translates to lower inflation and aggregate demand.
In a case where the economy experiences recession, the Central Bank would chose to cut down the rates of interest. On the other hand, fiscal policy entails changing levels of taxation and expenditure by the government. For instance, to increase economic growth and demand, the government will chose to increase expenditure and cut tax paving way to a higher deficit in budget; and to reduce inflation and demand, the government can chose to cut down on expenditure and increase tax rates leading to a smaller budget deficit. For example, when there is a recession in economy, the government may decide to increase expenditure on infrastructure and increase borrowing. This underlies the fact that increase in government expenditure helps in job creation and injection of money in the economy. A multiplier effect may also results whenever the initial injection into the economy initiates a further round of higher spending. The aftermath of increase in aggregate demand is helping the economy in getting out of recession.
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In determining the most effective of the two, it comes out beyond doubt that monetary policy has been more popular in recent decades. First, it is the responsibility of the bank to set monetary policy hence reduces political include, for example, the politicians may choose to cut the rates of interest in a desire to ensure a booming economy prior to general economy. On the other hand, fiscal policy is seen to cause more supply side effects in the wider economy, for example, in bid to reducing the level of inflation, lower expenditure and higher tax would not be known easily hence the government may not show concerning in pursing such an occurrence. Additionally, lower spending could contribute to reduction in public services as well as higher income tax that could create impediments to work.
Actually, monetarists maintain that a larger budget deposit created by expansionary fiscal policy can cause crowing out. It means that higher government expenditure reduces spending in private sector, while higher government borrowing results in high rates of interests though still contended. Expansionary fiscal policy may cause special interest groups to push for spending, which is of no gain and is tedious to reduce once the period of recession has passed. It is assumed that monetary policy is quicker to implement that fiscal policy. This is because the rates of interest can be set monthly, while it is required a lot of time for government to come to a consensus or unanimous agreement to increase spending.
Nevertheless, with recent inflation, monetary policy has been proven to have a number of limitations. It is important to note that focusing exclusively on inflation is too narrow. It implies that Central banks ignored bank lending and housing market. Quantitative easing is also a limiting factor. This is because money creation may prove ineffective as long as banks intend to keep the excess money in their balance sheets. Liquidity trap also limits the policy, owing to the fact that during recessions, cutting the rates of interest may be insufficient, while seeking to boost demand, since banks are not willing and customers become too nervous about their expenditure. In March 2009, the rates of interest were cut by 4.5%, but never offered the required solution to recession in the United Kingdom. Besides, direct government expenditure arouses demand in the economy and can be a kick start to removing the economy out of recession. This implies that exclusive reliance on monetary policy may be insufficient in restoring equilibrium in the economy. When economy is going through a deep recession, expansionary fiscal policy can hardly be significant if monetary policy fails. In addition, considering liquidity trap, expansionary policy can never cause crowding out, owing to the fact that the government makes use of surplus saving in injecting demand in the economy.
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For fiscal policy, policy makers normally announce to relevant people the response of a policy regarding different situations that commit themselves. Unlike monetary policy, it is conduction by discretion. This implies as circumstances change and events occur, judgment and policy application may seem appropriate at the time. IS/LM is a tool is used in demonstrating the relationship between real output in commodities and money market. The figures are representing below.
Both monetary and fiscal policies can be problematic depending on the situation in place. Fiscal policy has been found to decrease net exports. This normally has mitigating effect on national income and output. With increased government borrowing, the interest rates increases, thus attracting foreign capital from investors. The policy dictates that companies in need of financing projects have to compete with the government in order for them to be able to offer higher return rates. On the same note, monetary policy has been found to have forecasting problem. Due to time lag, policy makes have to be familiar with the future economic conditions. The ability to forecast problems is normally limited, since the forecasting tools are helpful, but can sometime present incorrect signals. Politics is also a problem here in that at time, the policy can be driven by political considerations and egregious instead of need for stabilization.
Generally, monetary policy delineates attempts by the central bank to implement four primary principles in increasing or reducing the supply of money to change a structure. The primary principle is changing the ratio of cash reserve of commercial banks. This forces banks to maintain a certain amount of deposit at the central bank. Increasing ration imply the dearth of all the funds held by commercial banks, which results into difficulty in giving loans to consumers. In accordance to this, the rates of interest levied on short term, loans would have been settled. This process is also applied in buying or even selling bonds meant to control money supply in the market. Therefore, the basic differences between monetary policy and fiscal policy are: monetary policy controls money supply in the nation, while fiscal policy offers direction of managing economy for the nation; fiscal policy is also related to the economic position adopted by a nation, while monetary policy is geared on strategy; and fiscal policy administers the structure of taxation employed by a nation, while monetary help in stabilizing a country’s economy. In addition, monetary policy sets the program dictating operation of key banks in a country, while fiscal policy is concerned with economic program of the government. Therefore, fiscal policy aims at increasing the aggregate output of an economy, while monetary policies seek to control inflation and interest rates.