Fiscal and monetary policy - a comparison

fiscal and monetary policy - comparison

Introduction

Fiscal policy should not be seen is isolation from monetary policy.

For most of the last thirty years, the operation of fiscal and monetary policy was in the hands of just one person – the Chancellor of the Exchequer. However the degree of coordination the two policies often left a lot to be desired. Even though the BoE has operational independence that allows it to set interest rates, the decisions of the Monetary Policy Committee are taken in full knowledge of the Government’s fiscal policy stance. Indeed the Treasury has a non-voting representative at MPC meetings. The government lets the MPC know of fiscal policy decisions that will appear in the annual budget.

Impact on the Composition of Output

Monetary policy is seen as something of a blunt policy instrument – affecting all sectors of the economy although in different ways and with a variable impact

Fiscal policy changes can be targeted to affect certain groups (e.g. increases in means-tested benefits for low income households, reductions in the rate of corporation tax for small-medium sized enterprises, investment allowances for businesses in certain regions)

Consider too the effects of using either monetary or fiscal policy to achieve a given increase in national income because actual GDP lies below potential GDP (i.e. there is a negative output gap)

Monetary policy expansion

Lower interest rates will lead to an increase in both consumer and fixed capital spending both of which increases current equilibrium national income. Since investment spending results in a larger capital stock, then incomes in the future will also be higher through the impact on LRAS.

Fiscal policy expansion

An expansion in fiscal policy (i.e. an increase in government spending) adds directly to AD ...

This is a preview of the whole essay

Consider too the effects of using either monetary or fiscal policy to achieve a given increase in national income because actual GDP lies below potential GDP (i.e. there is a negative output gap)

Monetary policy expansion

Fiscal policy expansion

An expansion in fiscal policy (i.e. an increase in government spending) adds directly to AD but if financed by higher government borrowing, this may result in higher interest rates and lower investment. The net result (by adjusting the increase in G) is the same increase in current income. However, since investment spending is lower, the capital stock is lower than it would have been, so that future incomes are lower.

Differences in the Effectiveness of Monetary and Fiscal Policies

When the economy is in a recession (when business and consumer confidence is very low and perhaps where deflationary pressures are taking hold) monetary policy may be ineffective in increasing current national spending and income. The problems experienced by the Japanese in trying to stimulate their economy through a zero-interest rate policy might be mentioned here. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree – they argue that short term changes in monetary policy do impact quite quickly and strongly on consumer and business behaviour. Consider the way in which domestic demand in both the United States and the UK has responded to the interest rate cuts introduced in the wake of the terror attacks on the USA in the autumn of 2001

However, there may be factors which make fiscal policy ineffective aside from the usual crowding out phenomena. Future-oriented consumption theories hold that individuals undo government fiscal policy through changes in their own behaviour – for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this

Differences in the Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect the time lags are variable

Monetary policy in the UK is extremely flexible (rates can be changed each month) and emergency rate changes can be made in between meetings of the MPC, whereas changes in taxation take longer to organize and implement.

Because capital investment requires planning for the future, it may take some time before decreases in interest rates are translated into increased investment spending. Typically it takes six months – twelve months or more before the effects of changes in UK monetary policy are felt.

The impact of increased government spending is felt as soon as the spending takes place and cuts in direct and indirect taxation feed through into the economy pretty quickly. However, considerable time may pass between the decision to adopt a government spending programme and its implementation. In recent years, the government has undershot on its planned spending, partly because of problems in attracting sufficient extra staff into key public services such as transport, education and health.

Evaluation: Problems with the use of active "demand-management" policies

(1) The measurement of output: Where are we in the cycle? Where are we going? How fast? Will we know when we get there? Inaccuracies in estimating the possible trade-offs in macroeconomic policy

(2) Time lags in the policy process: measurement, decision, execution and then effectiveness of policy changes

(3) What kind of fiscal policy? Spending (on what?) or tax cuts (for whom?)

(4) Will spending (fiscal policy) ‘crowd-out’ other spending, either directly or indirectly?

(5) Will changes in fiscal or monetary policy affect other economic objectives - such as the exchange rate, the trade balance and the provision of public services?

(6) Fiscal policy is weak (ineffective) when investment is very sensitive to interest rates and when consumers pierce the veil and attempt to offset the actions of the government (e.g. saving a tax cut, or increasing their saving when higher government spending leads to expectations of higher taxes in the future)

(7) Monetary policy is weak (ineffective) when consumers are willing to hold large quantities of money rather than spend them even when interest rates are very low

Peer Reviews

Here's what a star student thought of this essay

groat

14th of Mar 2012

Quality of writing

As there is no argument, it is difficult to comment on the structure. The essay uses clear subheadings to separate points, which makes it easy to identify where marks should be allocated. Although I like the thought process in the last section, posing a lot of questions, it would be wise in an essay to explore some of these. These questions are superb, and will gain you the top marks for evaluation, but simply posing a rhetorical question will not! Spelling, punctuation and grammar are strong, and technical terms are used with confidence.

Level of analysis

The analysis in this essay is sound, but there is room for improvement. Knowledge is often asserted, rather than explained, which will lose you marks. For example "lower interest rates will lead to an increase in both consumer and fixed capital spending" needs to rather explain how lower interest rates mean mortgages are cheaper, etc, then resulting in more consumption. A common evaluative point for this would then follow, discussing the marginal propensity to consume and how much will be spent by individuals. If I were doing this essay, when comparing fiscal and monetary, I would talk about directness. The essay has picked up on fiscal policies being direct, but there isn't much discussion of the possibility of reduced taxes meaning increased spending on imports, etc. The effectiveness paragraph is very good, looking at how a recession differs. Whenever I look at effectiveness of monetary policies, I always like to weave in some current affairs and argue that below a certain level, a decrease in interest rates makes little to no difference to aggregate demand. Being able to talk about current affairs and apply knowledge will gain credit. As stated above, a few diagrams were needed to solidify the analysis, but the evaluative points are great!

Response to question

There isn't a clear question here, but this essay engages well with a comparison of fiscal and monetary policy. I liked how there was a progression from knowledge and understanding to evaluation. However, in my opinion there isn't enough analysis here. There needs to be a strong section which analyses how monetary and fiscal policies work, using aggregate demand and supply diagrams.

Did you find this review helpful? Join our team of reviewers and help other students learn