One aspect of economic policy: how fiscal and monetary policy work

A nodeshell that needed rescuing if ever I saw one: the four primary goals of macroeconomic are economic growth, low inflation, current account equilibrium and low unemployment. Other (perhaps less crucial) macroeconomic goals include, among other things, social equity and environmental concerns. Oh and this contains some of my randomly selected and oh-so-witty pipelinks.

Monetary Policy Monetary policy is usually controlled in countries by a central bank of some sort, whose main concern is ensuring financial stability within an economy, and maintaining the value of the country’s currency. Financial stability is achieved by setting interest rates that allow non-inflationary growth (because the bank can determine the money supply). The interest rate is effectively the ‘price of money’ and is crucial in maintaining low and stable inflation, and ensuring a strong currency (which in turn leads to a healthy balance of payments).

Firstly, what precisely is the transmission mechanism? A transmission mechanism is how a change affects the economy - that is, if we change interest rates how exactly does that lead to a rise in national income? Let's see that national income actually is - it's GDP - Gross Domestic Product. Take a scenario where interest rates rise; Aggregate Demand (AD) is defined as Consumer spending (C) + Investment (I) + Government Spending (G) + (Exports (X) – Imports (M)). Firstly, C is likely to fall because borrowing becomes more expensive, and consumption falls. Mortgage payments (which account for a large proportion of peoples’ incomes) rise, leaving less money for consumption and finally, the higher interest rates makes saving more attractive so consumption again falls. Then, 'I' should fall because borrowing to buy capital becomes more expensive, so investment decreases and furthermore, if higher interest rates have led to a fall in consumer spending as stated above, why should firms invest in equipment to make products that nobody wants to buy?

Lastly, ‘hot money’ will flow into the UK forcing the interest rate upwards, raising the price of exports, and causing 'X' (Imports, in case you've forgotten) to fall. Thus, it can be seen the overall effect of higher interest rates is to cause a fall in AD. Looking at a graph of AD, it is clear this fall can be shown as a shift to the left, and assuming that inflation is presently at a fairly high level (which it obviously would be, otherwise why would the central bank want to lower AD in the first place?), then the general level of prices will fall, and by definition, inflation has fallen - now why does inflation has to be present at a high level? Because, if we take a Keynesian viewpoint, the Aggregate Supply graph is flat for a while and then curves upwards, so if you're on the flat section, then a decrease in demand will only cause a fall in output - not a change in prices.

Look at the websites below for a better explanation of why demand changes will change prices depending on where you are on the aggregate supply curve. The aggregate supply curve can be shifted outwards using supply-side policies, but that's another story.

  • for the Keynesian explanation.
  • for the Monetarist (right wing) explanation.

The Bank of England, on their website, says, “Broadly speaking, interest rates are set at a level to ensure demand in the economy is in line with the productive capacity of the economy. If interest rates are set too low, aggregate demand may exceed supply - meaning that the output gap is too small - and lead to the emergence of inflationary pressures so that inflation is accelerating; if they are set too high, output is likely to be unnecessarily low and inflation is likely to be decelerating." Inflation that is too high imposes uncertainty, menu costs, instability and other negative economic consequences but inflation that is too low also be harmful, in that it prevents real wage flexibility (because workers generally strongly oppose nominal wage cuts, but will be more willing to accept real wage cuts which pose as nominal wage increases).

In addition, lowering interest rates can cause the aforementioned ‘hot money’ to flow out of the country (which should also have the effect of lowering demand for the sterling, causing it to depreciate in value against other currencies – shown on the diagram on the right). This shows how monetary policy affects three out of the four main macroeconomic goals; however, it can also affect unemployment. If inflation is high, AD is naturally high and thus firms will need to employ more labour to keep up with the rising AD. Thus, unemployment will be low, but this can pose problems: the NAIRU is the non-accelerating inflation rate of unemployment, and if unemployment falls beneath this level (which is by no means fixed) then inflationary pressures can build up within the system. The ‘Philips Curve’ on the right shows how the Bank of England risks inflation if it allows AD to rise excessively; the rise means firms may hire more workers lowering unemployment to potentially inflationary levels. Thus by raising interest rates the Bank of England can decrease inflation not only in the ways described above, but also by potentially lowering employment rates; why? Because when the AD falls, output will not need to be as large and firms may dismiss workers.

Fiscal Policy

Fiscal policy is the manipulation of government spending and/or taxation to influence the level of AD - what does that mean? Government spending is an injection into the circular flow of income and taxation is a withdrawal. Consider a situation where an economy is in a recession, and the government has lowered interest rates all it can; yet AD does not rise. If the country falls into this sort of liquidity trap (<-- it appears there isn't a node on the liquidy trap - I'll fix that soon enough) then fiscal policy may be the answer. Governments can lower taxation and increase spending which has the effect of increasing G (a component of AD) thus increasing AD (other things being equal, of course). Assuming that there is spare capacity in the economy (which there will be if there is a recession) then Keynesian demand-side policies can allow the economy’s capacity to increase without inflation.

A monetarist would disagree with the above argument, claiming that the only effect of government manipulation to increase AD will lead to inflation without economic growth. However, when governments do use spending and taxation to increase AD, this is known as discretionary fiscal policy.

If say, a government did want to run a budget deficit then it may need to borrow but it can borrow from the private sector (the amount being the PSNCR). Keynes even suggested paying workers to dig holes and re-fill them, and this is the beauty of monetary policy: the amount of money needed to close an output gap of a certain amount of money would be less than that amount because paying the workers would cause a cycle of re-spending (known as the multiplier effect). Thus, the government, using fiscal policy, can reduce unemployment, lower/raise inflation (because raising taxes has a similar effect to higher interest rates, in that it decreases consumer spending and investment although it has a much less significant effect on exports) and allow economic growth (by increasing AD). Social equity can also be pursued through fiscal policy by adopting a more progressive taxation system (say where the higher income brackets pay larger percentages of their income) or increase inheritance tax, promoting a meritocratic society.

One could argue against some of the points made above, though, given the modern economic climate: in Japan, discretionary fiscal policy to help close the massive output gap has failed because consumers, aware of the government’s massive budget deficit have saved larger proportions of their incomes in the knowledge that the government at a later date will raise taxes to close the deficit. This sort of mentality, however, undermines the very basis of fiscal policy because the cycle of re-spending is not initiated.

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