The fiscal and monetary policies are critical topic, which a layperson should be aware of and understand their significance, impacts and objects, since such policies generally reflect on the individual’s day-to-day affairs including feeling of price hikes, difficulty in obtaining a loan or imposition of new taxes, etc.
The implementation of fiscal and monetary policies by a state is intended to achieve the economic stability, which means realizing a higher rate of economic growth in view of prices stability and full utilization of resources and expenses.
The fiscal policy basically refers to the utilization or regulation employed by the State, represented by Ministry of Finance, in directing its economic programs. The fiscal policy tools include the government spending and taxes.
An appropriate fiscal policy to control the inflation resulting from increase in demand can be attained through increasing taxes, reducing governmental spending or both…
A tax increase may lead to decreasing the individuals’ purchasing power, which would result in reducing consumer spending; a component of overall expenditure. Therefore, a decrease in consumer spending will trigger a drop in overall expenditure, which would eliminate inflation in many cases, even if this occurs at different rates.
Furthermore, decreasing government spending leads to a decline in overall expenditure, which leads to shrinking the deflationary gap.
An appropriate fiscal policy to control recession (overall demand is lower than overall supply) can be attained through tax cuts, increasing governmental spending or adopting both approaches at different rates.
The impact of governmental spending on income is greater than that of taxes on income. That is why GCC countries have recently been focusing on the governmental spending.
Additionally, tax cuts result in increasing individuals’ purchasing power, which leads to increasing consumer spending and, accordingly, increasing overall expenditure that ultimately eliminates recession.
An increase in the government spending will result in increasing overall expenditure and hence, shrinking the recession gap.
Monetary policy refers to a set of actions and measures taken by a central bank to influence money supply and cost of funds in order to achieve the economic policy goals.
Influence on money supply takes place by employing open market policy, i.e. buying and selling bonds with view to reducing or increasing money supply.
If a state aims to increase the quantity of money, it will purchase bonds to individuals, which would lead to increasing bond prices. Further, purchasing bonds from individuals will lead to increasing bank deposits and hence, increasing the volume of lending extended to business people at a lower interest rate due to increased liquidity with commercial banks.
However, if a state aims to reduce the quantity of money, it will sell bonds from individuals, which would lead to increasing bond prices. Further, sales of bonds to individuals will lead to decreasing bank deposits and hence, interest rate will go up and the volume of lending will decline.
This policy is frequently employed by advanced countries such as USA given significant development of financial markets, which represents a prerequisite for the implementation of open market policy (daily trading volume in Wall Street Exchange is approximately USD 25 billion).
The most important monetary tools include the statutory reserve requirements, which are widely used in the developing countries due to absence of developed or weak financial markets.
If a state aims to expand the money supply, it will decrease the statutory reserve percentage, which would lead to increasing the capabilities of commercial banks to extend loans. However, if a state aims to reduce the money supply, it will increase the statutory reserve percentage, which would lead to limiting the commercial banks’ capabilities to extend loans.
To control economic downturn, a state will implement an expansionary monetary policy, where it will expand the money supply, which will lead to decreasing interest rates, and hence, promoting investments and ultimately increased overall demand.
On the other hand, to control inflation, a state will implement a deflationary monetary policy in order to reduce the money supply, which will lead to increasing the interest rates that will entail a decline in investments and hence, the overall demand will go down.
Which to adopt: fiscal policy or monetary policy?
Most countries use both policies concurrently to achieve economic stability and attain the desirable economic goals even though fiscal policies have long term impacts while monetary policies have quick short term impacts.
Adoption of expansionary or deflationary fiscal policies will be dependent on the economy condition and if a state suffers recession or inflation.
If an economy encounters a recession condition, an expansionary fiscal policy will be adopted, where the state will increase the governmental spending or reduce taxes in order to increase the overall expenditure. At the same time, an expansionary monetary policy will be implemented, which will lead to lowering interest rates, resulting in increased investments and higher overall demand.
However, if an economy encounters an inflation condition, deflationary fiscal policy will be adopted, where the state will decrease the governmental spending or increase taxes in order to decrease the overall expenditure. At the same time, deflationary monetary policy will be implemented, which will lead to increasing interest rates, resulting in decline in investments and lower overall demand.