Fiscal and Monetary policy HL Flashcards
Contractionary Fiscal Policy
Refers to fiscal policy usually pursued in an inflation, involving a decrease in government spending or an increase in taxes (or both).
What are the strengths of contractionary fiscal policy?
Demand-pull inflation – Since demand-pull inflation is caused by increases in aggregate demand that create an inflationary gap. Measures to correct it involve contractionary fiscal policy that attempts to bring about a decrease in aggregate demand, so that AD 1 shifts toward AD 2 to bring the economy back to potential output Yp. As AD shifts to the left, the inflationary gap shrinks, and demand-pull inflation falls until it reaches P2.
Ability to reduce government debt – When the economy is booming, governments may make use of contractionary fiscal policy in order to reduce the government’s budget deficit and the national debt, saving money for future times when expansionary policy may be necessary.
What are the constraints of contractionary fiscal policy?
Conflict Macroeconomic objectives – Manipulation of government expenditures and/ or taxes affects economic variables in conflicting ways. For example, if the government decreases spending and raises taxes to contract aggregate demand as a way of lowering the rate of inflation, this may be at the expense of higher rates of unemployment. Additionally, contracting aggregate demand also causes a contraction in real GDP, which indicates lower rates of short-term real GDP growth.
Increase unemployment
Political constraints – Fiscal policy is the responsibility of politicians and government spending and taxation face numerous political pressures. Spending for social services (merit goods) and public goods cannot easily be cut if a contractionary policy is required. On the other hand, tax increases are politically unpopular and may be avoided by the government even though they might be necessary. Remember, cutting expenditures and raising taxes do not appeal much to the median voter. Thus, contractionary policies may be blocked by political parties who do not want to raise taxes for fear of losing votes.
Time lags (delay) – Changing fiscal policy takes time. Not only will opposition politicians question the need for contractionary fiscal policy and stress its potential risks (ie, higher taxes and unemployment), but even if there is agreement for an austerity plan it can get stuck in further political debates. In addition, in most countries, changes to the tax structure will need to go through the democratic processes governing the country and it will take time to gain approval. This will slow down the implementation of fiscal policy.
Expansionary (‘Easy’) Monetary Policy
Refers to monetary policy usually pursued in a recession, involving a decrease in interest rates, intended to increase investment and consumption spending.
What are the strengths of expansionary monetary policy?
Effective at reducing cyclical unemployment – Since cyclical unemployment is caused by deficiencies in aggregate demand, measures to correct it involve expansionary monetary policy. Efforts by the central bank to shift the AD curve from AD1 to AD2 are intended to increase real GDP to Yp representing potential output. As AD shifts to the right, the recessionary gap shrinks, and cyclical unemployment falls until it is eliminated at potential (full employment) level of output (Yp).
Limited political constraints – Monetary policy does not face political pressures as fiscal policy does, since it does not involve making changes in the government budget, whether in terms of government spending that would affect merit and public goods provision or government taxes. Also, independence from the government means the central bank can take decisions that are in the best longer-term interest of the economy, and can therefore pursue policies that may be politically unpopular (such as lowering interest rates to correct unemployment at the expense of inflationary pressure).
Incremental – Interest rates can be adjusted in very small increments. For example, interest rates may be adjusted by as little as one-quarter of one percent, making monetary policy well suited to ‘fine tuning’ the economy (‘goldilocks’ economy). Fine-tuning is also helped by the speed of implementation and the lack of political involvement that has already been mentioned.
What constrains expansionary monetary policy from being effective?
Conflict between macroeconomic objectives – Manipulation of interest rates affects economic variables in conflicting ways. For example, if the central bank lowers interest rates to expand aggregate demand as a way of lowering the rate of unemployment, this may be at the expense of higher rates of inflation. This is the case when expansionary monetary policy is pursued for too long, aggregate demand may increase beyond what is necessary to eliminate a recessionary gap, and result in inflationary pressures.
Time lags (delay) – Monetary policy is subject to time lags (delays) as it takes time for interest rate changes to affect the economy. Changes in interest rates can take several months to have an impact on aggregate demand, real output and the price level. It is estimated interest rate changes take up to 18 months to have the full effect. This means monetary policy needs to try and predict the state of the economy for up to 18 months ahead, but this can be difficult in practice.
Ineffectiveness when interest rates are low – Expansionary monetary policy through cuts in the rate of interest cannot be used forever. Eventually, interest rates will start to approach zero and there will be no room left for further cuts to encourage spending by firms and consumers.
Low consumer and business confidence – If firms and consumers are pessimistic about future economic conditions, they may avoid borrowing and spending money, and may even reduce investment and consumer spending, so that aggregate demand will not increase (it may even decrease). This is especially the case if the economy is in a deep recession.
Contractionary (‘Tight’) Monetary Policy
Refers to monetary policy usually pursued during periods of high inflation, involving an increase in interest rates, intended to lower investment and consumption spending.
What are the strengths of contractionary monetary policy?
Effective at reducing demand-pull inflation – Since demand-pull inflation is caused by increases in aggregate demand that create an inflationary gap. Measures to correct it involve contractionary monetary policy that attempts to bring about a decrease in aggregate demand, so that AD1 shifts toward AD2 to bring the economy back to potential output Yp. As AD shifts to the left, the inflationary gap shrinks, and demand-pull inflation falls until it reaches P2.
Limited political constraints – Monetary policy does not face political pressures as fiscal policy does, since it does not involve making changes in the government budget, whether in terms of government spending that would affect merit and public goods provision or government taxes. Also, independence from the government means the central bank can take decisions that are in the best longer-term interest of the economy, and can therefore pursue policies that may be politically unpopular (such as raising interest rates to correct inflation at the expense of higher unemployment).
Incremental – Interest rates can be adjusted in very small increments. For example, interest rates may be adjusted by as little as one-quarter of one percent, making monetary policy well suited to ‘fine tuning’ the economy (‘goldilocks’ economy). Fine-tuning is also helped by the speed of implementation and the lack of political involvement that has already been mentioned.
What constrains contractionary monetary policy from being effective?
Conflict between macroeconomic objectives – Manipulation of interest rates affects economic variables in conflicting ways. For example, if the central bank raises interest rates to contract aggregate demand as a way of lowering the rate of inflation, this may be at the expense of higher rates of unemployment. Additionally, contracting aggregate demand also causes a contraction in real GDP, which indicates lower rates of short-term real GDP growth.
Time lags (delay) – Monetary policy is subject to time lags (delays) as it takes time for interest rate changes to affect the economy. Changes in interest rates can take several months to have an impact on aggregate demand, real output and the price level. It is estimated interest rate changes take up to 18 months to have the full effect. This means monetary policy needs to try and predict the state of the economy for up to 18 months ahead, but this can be difficult in practice.
Ineffective when dealing with cost-push inflation – Cost-push inflation is caused by an increase in costs of production, causing a leftward shift in the SRAS curve, and results not only in a higher price level but also a fall in real GDP and a rise in unemployment. When this occurs, monetary policy is not appropriate since it can only influence the level of aggregate demand. Sometimes, governments committed to a low rate of inflation use contractionary monetary policy (raising interest rates) to lower aggregate demand. However, this comes at the cost of more recession and therefore increased cyclical unemployment.
To calculate the Keynesian multiplier we use the following formula:
Multiplier =
change in real GDP/ initial change in expenditure
,
initial change in expenditure × multiplier = change in real GDP.
As a rule, the multiplier > 1; therefore, the change in real GDP is likely to be greater than the initial change in expenditure.
Keynesian Multiplier
Refers to the ratio of real GDP divided by a change in any of the components of aggregate spending.
Marginal Propensity to Consume (MPC)
Refers to the fraction of additional income spent on domestically produced goods and services.
Expansionary Fiscal Policy
Refers to fiscal policy usually pursued in a recession, involving an increase in government spending or a decrease in taxes (or both).
What are the strengths of expansionary fiscal policy?
Effective at reducing cyclical unemployment – Since cyclical unemployment is caused by deficiencies in aggregate demand, measures to correct it involve expansionary fiscal policy. Efforts by the government to shift the AD curve from AD1 to AD2 are intended to increase real GDP to Yp representing potential output. As AD shifts to the right, the recessionary gap shrinks, and cyclical unemployment falls until it is eliminated at potential (full employment) level of output (Yp).
Ability to directly impact aggregate demand through government spending – Both current and capital expenditures are included in the measurement of GDP. Therefore, changes in government spending impact directly on aggregate demand and real GDP, and this can be helpful to policy-makers who want to be reasonably certain that changes in spending are likely to stimulate aggregate demand to its full employment equilibrium (Yp).
Ability to target sectors of the economy – Fiscal policy can target spending in specific sectors according to government priorities. For example, it may focus on changing the amount of spending on education and particular levels within education; health care, focusing on particular social groups; infrastructure and particular types of infrastructure (airports, roads, hospitals) or the locations of infrastructure, focusing if necessary on economically depressed regions; a variety of public goods (police force, public parks, etc.).
What constrains expansionary fiscal policy from being effective?
Conflict between macroeconomic objectives – Manipulation of government expenditures and/ or taxes affects economic variables in conflicting ways. For example, if the government increases spending and cuts taxes to expand aggregate demand as a way of lowering the rate of unemployment, this may be at the expense of higher rates of inflation. This is the case when expansionary fiscal policy is pursued for too long, aggregate demand may increase beyond what is necessary to eliminate a recessionary gap, and result in inflationary pressures.
In a recession, tax cuts may not be very effective at increasing aggregate demand – Tax cuts are less effective in a recession than increases in government spending because they work by changing consumer disposable income and firm after-tax profits, and this poses some uncertainties about their effects on aggregate demand. If the proportion of income saved rises due to pessimism about the future, the impacts of tax cuts on aggregate demand are weaker.
Time lags (delay) – Changing fiscal policy takes time. Not only will opposition politicians question the need for expansionary fiscal policy and stress its potential risks (ie, deficits and inflation), but even if there is agreement for a stimulus plan it can get stuck in further political debates. In addition, in most countries, changes to the tax structure will need to go through the democratic processes governing the country and it will take time to gain approval. This will slow down the implementation of fiscal policy.
Also, once the fiscal changes have been made, even when successful, it is likely that it will take time before the aggregate demand begins to shift. It is possible that the economy may have already recovered for other reasons, by the time the fiscal policy effects take place, and so they become inflationary.
Political constraints – Government spending and taxation are often influenced by political factors, rather than economic factors. This presents some issues. Politicians aiming to maximize their re-election chances may push against expansionary fiscal policy for its sizable increases in government spending as well as for tax cuts. Even if the fundamentals of the economy indicate the need for expansionary fiscal policy, it may not be adopted because rising expenditures and cutting taxes results in budget deficits which, over time, accumulate into government debt. This may appeal to more fiscally responsible voters.
Sustainable debt – As explained above, deficits arise when government spending is more than government revenues, financed by borrowing, which contributes to the building up of debt. Sustainable debt refers to a level of debt where a borrowing government can meet its present and future debt obligations (interest payments plus repayment of capital) without accumulating overdue debt payments. Particularly if the economy is in recession, when tax revenues fall (as unemployment rises) and government spending increases (on unemployment benefits) deficits are likely to increase. Over an extended period these may create a problem of unsustainable debt possibly leading to default (inability to pay back debts).
