Fiscal and Monetary Policy Effects on Economy

Fiscal and Monetary Policy Effects on Economy

Fiscal and monetary policies can ensure the smooth running of the economy of a country. Flexible policies that can be changed over time can make the economy strong and stable. Today, the world is going through terrible phases in terms of economic conditions, and many economies are in the downward period. In an economic crunch, only flexible monetary and fiscal policies can support the economic system as policies can easily be adjusted to fit what is best.

To really understand the impact of fiscal and monetary policy on the economy, understanding of the basic concepts of fiscal and monetary policies is mandatory. Here is a brief description of what fiscal and monetary policies are:

Fiscal Policy

Fiscal policies are pursued by state governments throughout the world and mainly related to spending and taxing programs. These policies can affect the overall business sectors in two dimensions: general legislation and targeted legislation.

The general legislation stimulates the entire economy while targeted legislation is aimed at a specific segment of the economy. In case of general legislation, the government focuses on tax or spending programs that will have a direct impact on the overall business and industry. While in targeted legislation sectors like energy, infrastructure projects are taken into consideration to benefit those firms that are involved in such projects.

Monetary Policy

Monetary policy is the action of concerned authorities that establish the rate and growth of money supply, keeping in view the interest rates. Actions like modification in interest rates, buying and selling of government securities or modifying the amount of reserve.

Monetary policy can be categorized into two types i.e. expansionary and contractionary. In an expansionary policy, a central bank increases the money supply to avoid unemployment issues and enhance consumer spending. The contractionary monetary policy is the opposite of expansionary policy and a central bank tries to slow down the money supply to curb inflation.

Impact of Fiscal and Monetary Policies on Economy

Fiscal and monetary policies are powerful tools that the government and concerned monetary authorities use to influence the economy based on reaction to certain issues and prediction of where the economy is moving. The monetary authorities need to make accurate predictions based on solid information to properly adjust the money flow and rates of interest. There is an inverse relationship in money flow and interest rates. Increasing money flow and decreasing interest rates can encourage spending and, as a result, stimulates the economy. More spending means more jobs and curbing unemployment.

For creating balance in the economy, normally a central bank uses various techniques of contraction and expansion. These techniques are helpful if based on accurate data and records.

A central bank buys and sells government securities to bring accurate momentum and money flow. Sometimes a central bank sets a required reserve ratio which bound other commercial banks to keep a certain amount of cash with them at all times. One of the techniques is to offer a discount or lower the interest rate to encourage borrowing, and as a result, involve more people in borrowing and spending. These are some of the quantitative techniques that central banks exercise to regulate economy properly. Apart from that, a central bank can exercise certain qualitative techniques like Regulation of consumer credit, Direct Action and Rationing of the credit to ensure the smooth running of the economy. It is a continuous process and changes with the requirements of the economy.

The fiscal and monetary policies have an impact on individual’s life too. If a government thinks the economy is overheating and growing very fast, there are chances of inflation so, the government may decrease spending. Decline in government spending means lowering the overall demand in the economy and, as a result, there will be lower production. Low production means lower hiring and investments. So, a cut in government spending will hurt general people as they will have less money in pockets to invest in their stores or shops and there will be a general decline in the economy.

Similarly, taxes play a vital role in fiscal and monetary policy. Decreasing in taxes can stimulate the economy as people will have more money in pockets to either invest or save. The investments will increase production and more people will be hired reducing the level of unemployment.

On the other hand if the extra amount is put into banks, the banks will further loan it and the borrowers will spend. Here, it is important to note that all of these techniques are effective only if the government has enough money to support the economy when it needs money. If the government is not able or doesn’t have enough revenue to support spending, these techniques will have a crowding out effects. It is because the government will borrow in case of lower revenue resources. Government borrowing can give boost to interest rates. Increasing of interest rates can discourage individual and businesses, from borrowing money from banks. Tight borrowing can affect investments negatively. So, the implementation of fiscal and monetary policies depends upon government’s financial strengths.

Inflation is one of the major issues that influence fiscal and monetary policies all over the world. When the financial authorities, for example, decide to reduce the main funds rate, the resulting stronger demands for goods and services will give birth to higher wages and other costs. The higher costs reflect higher demands for labors and materials that the primary requirements of production. The higher costs not only influence current inflation but also influence economic performance and expectations about prices and wages. All these expectation can influence inflation in the economy.

The Bottom Line…

Fiscal and monetary policies are extremely vital in keeping the economy strong and secure. Since the early nineteen hundreds, we can say the time of economic growth dominates the time of economic crunch or recession. Due to lack of proper implementation or political instabilities in the world the great depression (the 1930s) occurred and hopefully will not occur again, or will occur will lesser intensity like in 2008 onwards. Due to proper economic management and stable business cycles in the world the economies of various nations will enhance and maintain the level of stability that is satisfactory.