Fiscal policy is an intervention in which the government uses its spending and taxes to influence economic activities in desired ways. It is concerned with the allotment of resources between the private and the public sectors with the aim of attaining the desirable level of growth and stability. The national government plays a vital role in regulating activities in the economy through the use of fiscal and monetary policies to influence various economic indicators such as inflation, investments and savings.
Discretionary fiscal policy pursues the Keynesian hypothesis where the central government manipulates demand to influence price levels, output and employment in the economy (Labonte and Gail, 24). Expansionary fiscal policy entails a deliberate increase in taxes or an increase in government spending, or a combination of the two options in an effort to combat recession in the economy. Contractionary fiscal policy stipulates an increase in taxes or a decrease in the government’s expenditure in an effort to combat inflation or achieve other macroeconomic goals.
The government affects the level of household’s disposable income by either decreasing or increasing taxes. Disposable income decreases as a result of an increase in tax because it takes way income from the household. Tax cut will increase disposable income hence it will induces more savings and investment.
Measures geared towards an increase in consumption are expansionary in the short run. However, growth may be detracted in the long run because deficit finances cause a decline in aggregate savings. Tax reductions and government spending offset by deficits have a propensity to crowd out investment. However, policies in the current economic status could be formed to stimulate investment; hence the long run negative effects on growth might be averted. Government investment spending, on areas such as infrastructure, can give a short run stimulus to the economy without negatively affecting long term growth. Business tax cut could also induce investment in the economy. This will promote price reduction in the short run and sustained investment in the long run. The accomplishment of such policies depends on the effectiveness of investment subsidies in promoting spending.
The central government should spend within the boundaries of their tax collection. Budget deficits which are financed through borrowing increases tax burden on citizens. Huge budget deficits could result in economic recessions which increase the rate of unemployment to populatio1n ratio, decreases investment and consumption relative to the gross domestic product. A larger portion of government’s budget should be channeled towards infrastructure development to support private investment rather on recurrent expenditure.
Monetary policy is regarded as the influence of money supply for the purpose of shifting aggregate demand. Money supply is usually under the control of Federal Reserve. Changes in a country’s money supply usually affect their interest rate. A reduction in interest rate is caused by an increase in money supply. An increase in interest rates results from a decrease in money supply. Monetary policy influences the economy through its impact on interest rates.
In the current state of the economy, tightening of interest rates will cause a major decrease in consumer and business purchases for expensive items. The cost of borrowing will be very high due to the increase in interest rates. Business and consumers will desist from borrowing to finance their purchases. This has the effect of reducing aggregate demand in the economy. This is a contractionary monetary policy which has the short run implication of a consequent tradeoff between the tribulations of inflation and unemployment (Kansas, 174)
Increase of money supply in the economy will reduce interest rate. This is regarded as an expansionary monetary policy. A decrease in interest rates in the short run will induce an increase in investment and consumption which will thereby increase output in the economy. In the long run, the level of real output will be at full employment. Employment and nominal wage will increase, which will raise the cost of production. Output will fall back to the initial point because of an increase in price level.
The Federal Reserve uses open market operations, reserve requirement and discount rate as it monetary policy tools to determine changes in short term and long them interest rates, the amount of credit and economy, and a range of economic variables including output, prices of services and goods and employment. The Federal Reserve use monetary policies to decrease or increase money supply in the economy. When the Federal Reserve increases their reserve requirement, money supply decreases because commercial banks have less money to lend. On the contrary, money supply increases in the economy when the Federal Reserve decreases their reserve requirement. This action presents commercial bank with more cash for lending. During the Great Recession the Federal Reserve decreased their lending rates almost zero with the aim of increasing borrowing.
The Federal Reserve plays a critical role in restoring the economy at equilibrium and full employment of capital and output in times of recession or depression. The economy is not immune to the business cycles of boom, trough and recession. Therefore the government uses both fiscal and monetary policies to restore the economy to the desired levels.
Works cited
Kansas, Dave. The Wall Street Journal guide to the end of Wall Street as we know it: what you need to know about the greatest financial crisis of our time-- and how to survive it. New York: Collins Business, 2009. Print.
Labonte, Marc, and Gail E. Makinen. Monetary policy and Fiscal policy. New York: Novinka Books/Nova Science Publishers, 2013. Print.
http://www.federalreserve.gov/monetarypolicy/fomc.htm
