Monetary and Fiscal policy

monetary policy

• adjusting interest rates and money supply to influence AD

  • set by central banks

• used to help govs achieve macroeconomic objectives

  • low + stable rate of inflation

  • low unemployment

  • reduce business cycle fluctuations

  • promote stable economic environment for longterm growth

  • control level of exports and imports

real vs nominal interest rates

• nominal interest rate: headline rate presented by commercial banks, not adjusted for inflation

• real interest rate: nominal interest rate - rate of inflation

  • calculated using CPI

monetary policy instruments

• incremental adjustments to interest rate

• quantitative easing, increases supply of money in economy

expansionary monetary policy

• central bank wants to boost economic growth and lowers interest rates

• lower interest rates = investment and consumption increases, these are components of AD

• AD shifts right

• economy has higher price level and greater national output

contractionary monetary policy

• central bank wants to lower inflation toward its target, so increases interest rates

• higher interest = decrease in investment and consumption

• AD shifts left

• economy has lower average price level and smaller level of national output

strengths of monetary policy

• central banks can operate independently from gov

  • meaning they can consider the long term outlook

• contractionary policy useful in reducing inflationary gap

  • reducing inflation increase exports

• incremental and flexible, can be implemented/changed quickly by the central bank, allows for constant adjustments to macroeconomic variables

  • rate changes can be quickly reverse/amended

weaknesses of monetary policy

• conflicting goals

  • e.g economic growth puts an upward pressure on inflation

• expansionary policy less effective during a a recession

  • consumers/firms may not respond to low interest rates with consumption/investment when confidence is low

• time lags between policy and desired impact

• interest rate has limitations on downward adjustment

  • when interests rates are already close to 0, its hard to lower them further

• ineffective against cost-push inflation

  • can reduce demand-pull inflation, but cost-push depends on costs to produce

fiscal policy

• use of government spending and taxation to influence AD

sources of gov revenue

• taxation

  • direct taxes imposed on income and profits

  • indirect taxes imposed on spending

    • paid by supplier to gov

• sale of goods

  • gov owned firms charge for the goods they provide

• sale of gov owned assets

gov expenditure

• current expenditures

  • daily payment required to run gov and public sector

• capital expenditures

  • investments in infrastructure and capital equipment

• transfer payments

  • payment made by gov where no goods are exchanged

  • doesn’t contribute to AD

goals of fiscal policy

• maintain low and stable rate of inlation

• maintain low unemployment

• reduce business cylce fluctuations

• create stable economic environment for long term economic growth

• redistribute income to ensure equity

• control level of exports and imports

expansionary fiscal policy

• reducing taxes/increasing gov spending with aim of increasing AD

• gov wants to boost economic growth, lowers rate of income and corporation taxes

• lower taxes = increase in consumption and investment

• AD shifts right

• economy has higher average price level and greater national output

contractionary fiscal policy

• increasing taxes/decreasing gov spending with aim of decreasing AD

• gov wants to lower inflation, so raises rate of income tax

• higher tax = less disposable income = decrease in consumption

• AD shifts left

• economy has lower average price level, smaller level of national output

strengths of fiscal policy

• highly effective in restoring confidence in an economy during recession

• spending can be targeted at specific industries

• redistributes income through taxation

• reduces negative externalities through taxation

weaknesses of fiscal policy

• political pressures

  • policies may fluctuate significantly when new governments are elected

  • this can mean lack of follow-through for long term projects

• unsustainable debt

  • increased gov spending creates budget deficits

• time lags

  • takes a longer time to implement than monetary policy as it must be debated by government