The aims of fiscal and monetary policy are similar. They are both used to:
- keep inflation low (inflation target of 2%)
- maintain positive economic growth (close to long run trend rate of 2.5%)
- aim for full employment
The principle aim of fiscal and monetary policy is to reduce cyclical fluctuations in the economic cycle. Often it is inflation targeting which is stressed most for monetary policy.
- Fiscal Policy involves changing government spending and taxation. It involves a shift in the governments budget position. e.g. Expansionary fiscal policy involves tax cuts, higher government spending and a bigger budget deficit.
- Monetary policy involves influencing the demand and supply of money, primarily though the use of interest rates. It can also involves unorthodox policies such as open market operations and quantitative easing.
To reduce inflationary pressures, the monetary authorities will try to reduce the growth of AD. If we use fiscal policy, it will invovle higher taxes, lower spending, the advantage is that we help to reduce the budget deficit.
In a country like the UK, with a large budget deficit, it makes sense to use fiscal policy for reducing any inflationary pressure. Because you can reduce inflation and at the same time improve the budget deficit.
However, during normal periods of economic growth, deflationary fiscal policy may conflict with other objectives. For example raising taxes may affect incentives in the economy. Lower spending may adversely affect public services. It can be difficult to cut public spending for reasons of fiscal demand side management. This is why often we use monetary policy.
However, if we pursue deflationary fiscal policy and keep interest rates very low, savers may find they face negative real interest rates.
Raising interest rates is usually quite effective in reducing inflationary pressures (though there may be time lags, especially if confidence is very high).
- Raising interest rates also has an effect on the exchange rate. Due to hot money flows, the Pound is likely to rise. Therefore, deflationary monetary policy will have a greater effect on exporters.
- Also raising interest rates has a bigger proportionate effect on homeowners with variable mortgage payments. The high level of mortgage payments, means the UK is sensitive to interest rate changes. However, higher interest rates can be beneficial for savers who will gain a higher income.
- Therefore monetary policy doesn’t have an even impact throughout the economy; borrowers and savers will be effected differently.
Monetary Policy In Recession
In a recession, we will cut interest rates to try and stimulate spending and investment. It should also weaken the exchange rate which will help exports.
However, in some situations monetary policy may be insufficient. In the recession of 2008-09 there was a liquidity trap. Cuts in interest rates were insufficient to encourage spending and investment. For example:
- Banks had insufficient credit so were unwilling to lend despite low interest rates
- Confidence was very low.
- House prices were falling reducing consumer wealth
With deflation, interest rates may be insufficient, because falling prices can make real interest rates quite high. Therefore zero interest rates may not get an economy out of recession.
Extra Policies in Recession
In addition to cuts in interest rates it may be necessary to pursue quantitative easing and expansionary fiscal policy.
Quantitative easing helps to increase the money supply and avoid deflationary pressures. Expansionary fiscal policy can directly create jobs and economic activity by injecting money into the economy. Keynes argued expansionary fiscal policy is necessary in a recession because private sector saving can rise rapidly due to the paradox of thrift. Therefore government borrowing is necessary to maintain a reasonable level of economic activity.
The drawback of expansionary fiscal policy, is that it increases the budget deficit. Some argue this can lead to higher interest rates as markets require higher interest rates to fund borrowing.
However, if fiscal policy occurs in a recession it will be offsetting a rise in private sector saving. In many instances, government borrowing can increase in recessions without increasing bond yields. But, it is a balancing act, if borrowing increases too much, markets may fear borrowing is out of control. (see: European fiscal crisis)
Which is Best Monetary or Fiscal Policy?
Monetary policy is most widely used for ‘fine tuning’ the economy. Making small changes. However, monetary policy has its limitations. In serious recessions, we invariably need a combination of the two policies.