Fiscal Policy vs. Monetary Policy as Methods for the Government to Manage the U.S.

Introduction

Economies have regular fluctuations in respect to the level of economic activities. This is referred to as the business cycle (Silvia, 2011). A business cycle is examined to be having three phases: expansion, recession and recovery. In the expansion phase, the economy grows along its long term trends in income, employment and output. However, at some point the economy suffer rising interest rates and prices until it reaches the peak, and shift downward into recession.   Recession is characterized by falling output, employment, prices, interest rates and income. Recession is typically marked with unemployment. An economy may hit low and rebound into recovery.  The recovery phase will enjoy rising income, employment and output while unemployment will fall. As the economy resumes its normal growth, recovery translates to expansion. In examining these aspects and economic policies, John Maynard Keynes argued that governments should be proactive to avoid mitigating economic problems. In his book ‘General Theory of Employment, Interest, and Money,’ he postulated that the government should take the central role of resolving economic issues through two policies: fiscal and monetary (Kuroki, 2013). According to Keynes, fiscal policy is a measure of using the government taxes and spending to stabilize the economy (Kuroki, 2013). On the other hand, he highlights monetary policy an approach of using credit and money supply to stabilize the economy. This paper highlights how the U.S. government uses the fiscal or monetary economic policies to manage its economy. It also outlines the advantages and shortcomings of each and their effectiveness in accomplishing the goals of low inflation, unemployment and a growing economy.

 

 

Fiscal Policy

The fiscal policy is marked with changes in taxing and spending of the federal government with an aim of contracting or expanding the level of aggregate demand. Aggregate demand refers to the total need in an economy from business, household and government (Kuroki, 2013). For example, when the aggregate demand is low in the United States, the government can intervene and increase its spending focused at stimulating the aggregate demand. Alternatively, the government can lower the taxes levied to increase disposable cash or income for its citizens, as well as, businesses and corporations. The main policy tools used under this approach are taxes and the amount of government spending. Fiscal policy is controlled by the executive and legislative branches of the government. A fiscal policy depends on the existing President’s administration and the Congress that passes it. Therefore, this active policy is influenced by the character of policymakers, discretion of policymakers and the targeted short-term or long-term goals. During a recession, the government pursues an expansionary fiscal policy. This involves increasing government spending and lowering taxes. Increased government expenditure in the infrastructural sectors of the economy would improve the aggregate demand and employment. During an overheated expansion, the U.S. government pursues a contractionary fiscal policy which dictates that the government spending is reduced while taxes are increased. Increased national budget deficit through borrowing usually increases the national debt which may impact negatively on globalization trends. According to Maynard Keynes, an overheated expansion should be addressed by a budget surplus while a recession needs deficit spending. In the recent severe recession, 2008-09, the federal government pursed discretionary fiscal policy by increasing spending (FBRSF, 2013). This approach created large deficits appropriate for stabilization in a severe recession.

 

Monetary Policy

Unlike the fiscal policy, monetary economic policy is administered by the Federal Reserve System and is totally discretionary (FBRSF, 2013). For example, for the government to control high inflation, the independent Central Bank raises interest rates and reserve requirements for financial institutions thereby reducing the money supply. The Federal Reserve changes the amount of the money supply and interest rates to contract or expand the aggregate demand. During a recession, the Fed will increase the money in circulation and lower interest rates. Low interest rates imply that entities can afford to borrow thus increasing the money in circulation. High interest rate discourages borrowing thus reducing the amount of money circulating in the economy. In the event that the U.S. economy is under overheated expansion, the Central Bank decreases the money supply and raises the interest rates. These approaches are decided by the Federal Open Market Committee (FOMC) (FBRSF, 2013).

The impact of implementing a monetary policy on aggregate demand usually takes several months. The monetary policy is considered to be advantageous over the fiscal policy in the sense that the Fed is independent and not influenced by the Congress or the President. The central bank is free and independent to pursue any approaches to meet its dual mandate:  low unemployment and stable prices (FBRSF, 2013). The key problems with this policy are the judgment and the discretion of rule makers and. The federal government uses the monetary as its core approach of discretionary contra-cyclical policy.

Conclusion

The United States is a full market economy thus can suffer extreme shifts in the level of economic activity due to extreme swings in the aggregate demand and supply of goods and services. This calls for proactive measures or the government intervention in the event of any shift. The economic policy approaches pursued to increase economic growth and GDP and are called expansionary. The measures implemented when inflation is too high (overheated expansion) are referred to as contractionary measures. If the government employs these policies to stimulate economic development during a recession, the government is said to be implementing expansionary economic policies. In the event of an overheated expansion and the government uses the fiscal and monetary policies to contract the economy, it is said that it is employing contractionary economic policies.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References

FBRSF. (2013). The Many Roles of the Fed: A Little More About the FOMC. Retrieved May 11, 2013, from Federal Reserve Bank of San Fransisco : http://www.frbsf.org/publications/federalreserve/fedinbrief/guides.html

Kuroki, R. (2013). Keynes and Modern Economics. New York: Routledge.

Silvia, J. (2011). Dynamic Economic Decision Making : Strategies for Financial risk, Capital markets, and Monetary policy. Hoboken, N.J.: Wiley.