Fiscal and Monetary Policy

Fiscal Policy

Fiscus (in Latin) refers to a purse and ‘fisc’ (in English) is a royal or state treasury. Thus, ‘fiscal policy’ is that under which the government uses its revenue and expenditure programs to produce desirable effects on national income, production and economy. It is thus used as a balancing device in the economy. Two major elements of fiscal policy are taxation and public expenditure.

Objectives of fiscal policy

The role of fiscal policy in developed economies is to maintain full employment and stabilize growth. In contrast, in developing countries, fiscal policy is used to create an environment for rapid economic growth. The various aspects of this are:

1. Mobilization of resources: Developing economies are characterized by low levels of income and investment, which are linked in a vicious circle. This can be successfully broken by mobilizing resources for investment energetically.
2. Acceleration of economic growth: The government has not only to mobilize more resources for investment, but also to direct the resources to those channels where the yield is higher and the goods produced are socially acceptable.
3. Minimization of the inequalities of income and wealth: Fiscal tools can be used to bring about the redistribution of income in favor of the poor by spending revenue so raised on social welfare activities.
4. Increasing employment opportunities: Fiscal incentives, in the form of tax-rebates and concessions, can be used to promote the growth of those industries that have high employment-generation potential.
5. Price stability: Fiscal tools can be employed to contain inflationary and deflationary tendencies in the economy.

The limitations of Fiscal Policy

Fiscal policy has been a great success in developed countries but only partially so in developing countries. The tax structure in the developing countries is rigid and narrow. Thus, conditions conducive to the growth of well-knit and integrated tax policies are absent and sorely missed. Following are some of the reasons that are hindrances for its implementation in developing countries:

1. A sizeable portion of most developing economies is non-monetized, rendering fiscal measures of the government ineffective and self-defeating.
2. Lack of statistical information as regards the income, expenditure, savings, investment, employment etc. makes it difficult for the public authorities to formulate a rational and effective fiscal policy.
3. Fiscal policy cannot succeed unless people understand its implications and cooperate with the government in its implication. This is due to the fact that, in developing countries, a majority of the people are illiterate.
4. Large-scale tax evasion, by people who are not conscious of their roles in development, has an impact on fiscal policy.
5. Fiscal policy requires efficient administrative machinery to be successful. Most developing economies have corrupt and inefficient administrations that fail to implement the requisite measures vis-à-vis the implementation of fiscal policy.

Among the various tools of fiscal policy, the following are the most important

Reflationary Fiscal Policy

It may be used to boost the level of economic activity during periods of recession or deceleration in economic activity. This is done by lowering taxes or increasing government expenditure.

Deflationary Fiscal Policy

During a boom, i.e., when the economy is growing beyond its capacity, inflation and balance of payment problems might result. This can be achieved by increasing taxes or by reducing government expenditure.

It would perhaps be too simplistic to conclude that fiscal policy is the most important tool of financial correction and consolidation, especially that undertaken by the government. However, there is no reason to neglect this very powerful tool that is in the hands of governments and central banks the world over. Used properly, fiscal policy can determine the broad direction the economy of a given country is going to take.

Monetary policy

Monetary policy is the process to manage the supply of money in such that specific goals such price stability, employment etc are achieved. A central bank's measures to influence short-term interest rates and the supply of money and credit, to promote national economic goals are another way to define monetary policy. It has two basic goals: to promote maximum sustainable output and employment and to promote stable prices.

  It is given great notice by each country’s government and special bodies are appointed to achieve these goals. In general, these organizations are called central bank and typically serve a role of supervising the smooth operation of the financial system as well as monetary policy. They are generally given liberty to avoid interference of ruling government that can misuse it. It is said to be easy, loose or expansionary when the quantity of money in circulation is being rapidly increased and short-term interest rates are thus being pushed down. Monetary policy is called tight or contraction when the quantity of money available is being reduced and short-term interest rates are thus being pushed to higher levels.

The primary instrument of monetary policy is typically a short term interest rate. Interest rates on loan contracts or debt appliances such as treasury bills, bank certificates of deposit, or commercial paper having maturities less than one year often called money market rates are short term interest rates. In the future, the amount of goods and services the economy produces and the number of jobs it generates both depends on factors other than monetary policy. These include technology and people's preferences for saving, risk, and work effort. So, utmost output and employment mean the levels consistent with these factors in the long run. Currently all central banks in industrialized countries adopt monetary policy through market-oriented instruments geared to influencing short-term interest rates as operating targets. They do so mainly by determining the conditions that stabilize supply and demand in the market for bank reserves.

Factors to be considered

Money Stock

It is the total money available in a particular economy at a particular point in time. Various sorts of things may be serving as money at the same time in any particular economy, exact definition and measurement of the money stock presents some serious practical problems for the policy maker who needs to use manipulation of the growth of the money stock as a tool of economic policy.

Open market operations

Sales or purchases of government debt devices such as treasury bonds, treasury bills, treasury notes on the open financial markets by a nations central bank (in the U.S., the Federal Reserve) as part of its efforts to control the size of the money supply and the levels of interest rates. Central bank verdict to buy up government debt instruments make for an expansionary monetary policy, while sales of government debt instruments by the central bank represent a contractionary monetary policy.

Also a well functioning good and labor market form an important factor of competitiveness within the single monetary policy. Fiscal policy, also plays as an instrument of growth policy, through its effect on national saving by means of the structural budget deficit, through incentive effects on work, saving and investment via tax rates and tax structure, and through public investment in human capital and physical infrastructure.

Price stability is the unique objective for monetary policy for long term. The upsetting effects of price instability in the economy are felt in the form of Business Cycles. When there are rapid changes in the price level there are fluctuations in the level of economic activities also. Price stability means that the average price as found by the wholesale or Consumer Price index fluctuate within a narrow range. Both rise in price level and drop in price level cause disturbances and have bad effects on the economy. A monetary policy may reduce short-term interest rates by flooding the banks and financial markets with funds providing loan and yet at the same time may in fact raise longer-term interest rates by prompting fears among lenders that inflation will soon be speed up.

Sadly, medium and long-term interest rates have much more pressure on the rate of growth of the economy and on levels of unemployment than short-term interest rates do, because major new investment spending like research and development for new products or the construction of whole new factories are long-term projects that require financing, and they are less likely to be undertaken. Monetary policy should therefore very carefully plan and efficiently worked out since it decides the economic growth of a country.

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