Introduction to Macro Economics
Monetary policy can have both a comprehensive and a narrow meaning. The broader meaning of monetary policy is conceived as all measures taken by the government or by private enterprises to alter the structure and operation of the financial system of the economy or the supply and use of money by the public (American Assembly). The most common instruments utilized by the government to achieve this control are interest rates. Through alteration of interest rates the economy is able to regulate the money supply and in turn control the levels of inflation. Managing the inflation rates of a country is critical in stabilizing a country’s currency.
On the other hand, Fiscal policy encompasses the employment of government spending, taxation and borrowing to sway both the economic activity and also the level and expansion of aggregate demand, output and employment. Fiscal policy is considered an instrument of demand management. The main proponents of the fiscal policy are the Keynesians, these argue that fiscal policy can greatly stimulate aggregate demand, increase output and create employment opportunities. The efficiency of these policies are best seen when an economy is operating below its full capacity. Keynesians are of the view that it is justifiable for the government to utilize fiscal stimulus to alter aggregate demand (Arnold, 2008).
Monetarists believe that these fiscal elements can indeed alter aggregate demand but their effects are short-lived and thus may not offer long-term solutions to the economy. According to this group of economists monetary policy is the most efficient instrument in addressing aggregate demand and inflationary pressure. Monetary policy is into two, expansionary and contractionary monetary policies. Expansionary monetary policy is implemented when the economy is performing badly, under such situations the Federal bank is prompted to increase the amount of money circulating within the economy. The Federal bank does this by reducing the Fed lending rates, this means lesser cost for borrowing and banks are able to lend more and also encourage intra borrowing. Reduction of Fed rates paves way for a reduction in other rates, such as mortgage rates and intra bank lending rates.
The spiral effect is business growth translating into more jobs which in turn means more consumption by these employees; these factors stimulate the overall economy (Arnold, 2008). Contractionary monetary policy results when the Federal Reserve utilizes its instruments to prevent inflation. The Fed Reserve does this by increasing the Fed funds rate. The effects of this increase is a similar effect on the interbank borrowing rates, the banks borrow to meet their obligations to the Federal bank. Increasing the fed funds rate reduces the amount of money in the economy as banks lend each other lesser amounts to cut on their interest expense. By increasing the funds rate which is the bench mark rate other rates increase as well, this raises the cost of borrowing forcing consumers to borrow less and spend less (Arnold, 2008).
Businesses on the other head borrow less, stops increasing salaries and this eventually leads to a reduction in the inflation rate. Friedman was a renowned economist whose most vibrant reign was as an advisor for Ronald Reagan. He was a Monetarist and believed utilization of monetary tools was the only way to stabilize an economy by keeping the inflation rates in check. He advocated for Keynesian approach in the 1930’s and 40’s but later on referred to these approaches as naive. He particularly differed in use of wage and price controls as economic stabilizers.
Unlike Keynes Friedman advocated for strong Monetarism as a way of initiating growth, he suggested natural unemployment rates could be increased by increasing aggregate demand. By the president increasing mileage requirements for automobiles in the US he is encouraging consumption. This is because automobile users will have to spend more on gas to meet the requirements for this increased mileage. This is a fiscal policy as it is geared to increasing consumption. Giving subsidies to corn farmers is geared towards increasing production, again increased production will avail more money and thus increase consumption, and this as well is a fiscal policy.
Increasing monitoring and enforcing more stringent rules in United States nuclear plants has no economic implications thus does not qualify as either a monetary or fiscal policy. A move by Federal Reserve Board of Governors to maintain interest rates at the current low levels is a monetary move. This is meant to encourage borrowing by both banks and individuals which spurs the economy. When President Clinton intentionally reduced interest rates, both in the short and long term he intended to spur growth. This was possible as the lending rates remained low and Americans were able to access money from banks at a cheaper rate, this was a monetary policy.
Bailing out financial institutions as was the case with the Bush administration and the Obama administration was an element of fiscal policy where the governments wanted to ensure the Financial Institutions remained afloat. Paul Volker’s move to dramatically increase interest rates was a monetary policy move. By increasing interest rates, banks would lend each other lesser amounts, and individuals would borrow lesser due to the increased cost of borrowing this would ensure the amount of money in circulation is checked. By limiting the amount of money in circulation Mr. Volker reduced people’s ability to spend and in turn this brought down the cost of goods, meaning inflation went down as well.