2. 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 Federal Reserve 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 prices 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.
3. 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. Federal Reserve 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).
4. There are 3 primary tools which are available for the Federal Reserve in changing the
level of money supply. In the times of recession, the Keynesians recommends the
Federal Reserve 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 Federal Reserve in lowering the rates of discounts. When the Federal
Reserve brings reduction in the rate of interests, member bans should be paying in
borrowing from the Fed, 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 Federal Reserve 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 Federal Reserve’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).
5. 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, Federal Reserve 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.
6. 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, Federal Reserve 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.
