Role of Fiscal and Monetary policy: American context (Part 1)

Hi friends,

I started off with the aim of exploring recessionary economics. I wanted to find out the different ways in which a recession is triggered and steps which can lead a nation out of it. But as I spent more time on it, the length and complexity of the scenarios to be considered kept increasing. I wanted to present a simple model which can explain different kinds of recession and give a clear picture of the phenomena which everybody can understand. But as I said earlier it’s now taking too much time. Let’s see when I complete it, if I complete it at all.

Right now I will give a quick over view of the role of fiscal and monetary policy and understand them in today’s context. I will also try to explore how they work in the American economic system.

We typically have two kinds of tools to bring changes in the economic condition of a country: fiscal policy and monetary policy. We use an expansionary fiscal/monetary policy to plough out of recession. Here is how they work and the basic difference between them.

Fiscal policy focuses on controlling the government spending in order to accelerate or retard economic growth. During recession, an expansionary fiscal policy is used which aims at increasing government spending to directly increase investment, employment and thus domestic demand. Expansionary fiscal policy is either financed through borrowing or tax increase.

Monetary policy aims at controlling the liquidity in the market to spur up or slow down the economy. It is implemented primarily through interest rate control (though there are other ways as well). Usually the central bank is responsible for fixing the interest rate. During recession, an expansionary monetary policy is implemented (easy money) which aims to bring down interest rate or make money cheaper. It is then expected that with cheaper money, the private sector will increase production, which will increase employment and then demand.

The effectiveness of the above tools depends a lot upon the source which triggered the recession, severity of the recession, objectives which the government/central bank is looking to achieve (like exchange rate stability, price stability, et al), financing options, how soon the results are desired, etc. Both got a validation and initial acceptance after the great depression. However, while recovery from the depression of 1933 saw the use of fiscal stimulus, the world today is seeing more of monetary policy being used to fight slumps in economy. There are various reasons for this

1.   1. Monetary policy is governed by independent central banks which don’t have to go through slow democratic process of fiscal policy and are thus implemented much more quickly.

2.   2. Shift in economic structure towards free market economy where government keeps off from influencing the market (laissez faire).

3.   3. Continued success of monetary policy to come out of previous slumps. In the last two slumps, US primarily used expansionary monetary policy to successfully come out of the slowdown triggered by IT bust and 9/11 attack in 2000-2001.

However, there is a catch with expansionary monetary policy. There is cheap money in the market which can be used by the producers but the consumption level is still low and unemployment is high. Cheap money alone is not sufficient for producers to increase supply. Producers don’t start increasing production without seeing a growth in demand.

Demand can come from two places, either domestic or foreign. Producers wouldn’t increase supply for the domestic market until there is a demand and consumers wouldn’t start spending unless they are employed back. This creates a tussle where private firms tread slowly resulting in slow progress. However, lower interest rate brings down the domestic currency and makes you more competitive in export market, thus giving the producers enough incentive to increase production to cater the foreign demand. This increase in production gradually increases the domestic employment level and then domestic demand. The process is simple and backed by top economists of our time. Loosen monetary policy, let your currency depreciate boost your export and plough back out of recession.

At this point I would like to stress upon the objective of creating demand. The ultimate objective of any recovery plan has to be the creation of demand (and not trade, inflation, employment, production, et al)which can then take care of production as well as employment. The importance of creating demand as the centre piece has to be understood and should be incorporated in policy decisions.

Continued in part 2.