Role of Fiscal and Monetary policy: American context (Part 2)

Welcome to part 2. (Click here to read the first part) I will begin this part with the modern panacea for recession. Loosen monetary policy, let your currency depreciate boost your export and plough back out of recession.

This looks efficient as well as effective in most cases. Although the sanity of increasing liquidity in the market was not suggested to the Asian tigers or the Argentinean government during the crisis, still it is now a well established fact to do so in order to fight recession. However, it might not give its usual results when we look at America.

The USA is a net importer with huge trade deficit and USD is the global trade currency. Many other countries are dependent hugely on trade with the USA and also dependent on the value of USD. This has propelled most of the developing countries to maintain the value of their domestic currency against dollar to keep them competitive in the export market and also to prevent losing the value of their forex reserves. These nations which include the likes of China, Russia and India, have chosen domestic inflation over stronger local currency (Click here to better understand this phenomenon). Another factor which plays a role in keeping the dollar strong against other currency is that US lies in the centre of today’s mono polar world. Thus no major economy across the world stays untouched from US recessions. You can see on the graph how Euro area follows US GDP growth rate.

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

Stocks, Gold or Treasuries?

Hey frns... I see this question popping up quite a bit more frequently now as compared to couple of months back. Perhpas the liquidity boost given by central banks have started to reach the pockets of individuals.

Well I believe that the excess liquidity in the market will surely ensure low returns from treasuries.

How about gold and stocks... excess liquidty can chase either of the two...

Below is my take on the situation...

We are still not out of the recession... at this unpredictable juncture, a greater affinity to gold is more likely. Gold has always been a safer bet, a reliable bet and should attract the liquidity when the confidence in the market is still far from upbeat. Also, greater investment in gold will act as a hedge against inflation and thus would be a desirable outcome for central banks as well. Thus, during our journey up the economic curve as we move out of recession, gold should get higher proportion of investment. However, as the haze clears up and the economy looks upbeat, stocks would lead the race. As the confidence in the business returns, stocks will start outperforming gold.

I am sorry for this unstructured and badly written post but I hope you would be able to make some sense out of it.

Just to summarise:

1. I won't put my money on treasuries for now.

2. Gold will outperform stocks now. It will remain the same for approx 5-6 months in Western markets. In India, the period should be shorter to about 3-4 months.

3. Stocks take the lead perhaps arnd 6-8 months down the line in Western market. Indian market would start seeing better returns on stock compared to gold slightly earlier.

For people trading in Gold, it would be a good idea to invest in stocks in order to hedge against the fall in gold prices which shoud come as we start seeing a steady rise in stock prices. This, I believe is the clue. Yes, "steady" is a very vague term and evrybody will have a different definition for it. However, keeping this fact in mind can help you to minimize any loss or build upon your profits as the investment shifts from a safer gold to a higher return stocks...

Hey pls do leave a comment if you think that my posts are not structured, not worded properly or you think that they don't properly explain the issues. I will try to improve them. I usually write them in a hurry and I end up with a not very smooth and lucid writeup.