Expansionary Fiscal and Monetary Policies
The fluctuations in the economic performances of any country lead to hardships in the lives of citizens and entire underperformance of the economy. Nowadays when the economy is experiencing strains, there are certain common features that arise including high level of inflations. Besides that, there are two interrelated phenomena of unemployment that act interchangeably within the economy. According to the Phillips curve, both unemployment and inflations are two unimpressive situations that economy tries to avoid at any particular time. Phillips also asserts that, in order to minimize inflation, the resultant effect is a rising level of unemployment and the reverse holds. Consequently, the economy experiences a condition of underperformance which means that the economy does not realize its full potential.
In essence, the potential GDP, which is the long term tendency of the economy to grow, does not materialize in the short-run. One of the major causes of inflation is an increased amount of money in circulation. In other words, the households hold a lot of money which is not a direct output from economic activities. In absolute terms, the inflation is an unfavorable economic condition that is characterized with high prices of consumer commodities and, therefore, a decline in the consumers’ purchasing power. Fiscal policy is a government policy with respect to borrowing, taxations, and expenditure (Hetzel, 2008).
Expansionary monetary policies are geared towards encouraging the growth of the economy through increasing the amount of money supply in the economy. Quite often money supply is under control of the central banks or the ministry of finance. However, the Neoclassical and Keynesian economics have a different perspective on how effective the monetary policies are with respect to their impact on the real economy. In this regard, the two do not share a common perspective with respect to the actual variables in the economy such as employment and aggregate income or outputs. However, both perspectives commonly accept the fact monetary policies affect the fiscal variables such as the price levels and interest rates which are key determiners of the economic performances. The government uses various variables in the economy which includes discount window lending, monetary base, rates of interests as well as the reserve requirements for the commercial banks as imposed by the central banks to steer positive changes in the economy (McConnell & Brue, et al., 2005).
Keynesian is a segment of the economy prior to its findings. Keynes regard the theory of total spending within the economy commonly referred to as the aggregate demand as well as the economic effect of the same towards output and inflation. According to Keynesian economy, the total demand in the economy is a function of many factors, which often act erratically towards the economy. According to some Keynesians, however, monetary policy is powerless in manipulating the economy while at the same time finds the powerlessness of the Fiscal Policies which in essence do not hold today. In addition, Keynesian also believes that changes in aggregate demands whether expected or not have their biggest short-run impact on the actual output and employment but not the prices as portrayed in the Phillips curve. Indeed, the monetarist views money demand as independent of the interest rates while the level of investments in the economy depends significantly on the interest rates (McConnell & Brue, et al. 2005).
It is clear in real economics that the monetary policies can result in real effect on economic output and employment rates if the nominal wages do not experience instant adjustments. As a result, injection of money into the economy would lead to a complete change in the commodity prices in the economy and a subsequent change in the consumer purchasing power. According to the standard economic theory, however, there is rigidity in real supplies and demands with proportionate fluctuations of all nominal prices. However, according to Keynesian, prices are relatively rigid. Consequently, a change in expenditure, for instance, government expenditure, leads to a subsequent fluctuation in the level of output in the economy (Corsetti, 2010).
The classical economics, on the other hand, takes a different perspective relative to monetary and fiscal policies. According to classical economics as well as the supply-side perspectives and, as opposed to Keynesians, the effect of the aggregate demand to the money supply is negligible in the long-run. On the contrary, the money supply is affected by the physical injection and expulsions in the economy such as the interest rates and taxations which are substantially aligned by central banks. However, Keynes argued that central banks were ineffective in the use of expansionary monetary policies in providing solutions to great depressions. In an attempt to verify their argument, Keynesian economist such as Milton Friedman, therefore, sought to substitute passive monetary policies with active one and imposed questions on the occurrence of great depressions despite the existence and use of the expansionary monetary policies. According to analytical view of Keynes from the empirical study of the United States, money supply fell drastically prior to the occurrence and during the great depression. According to Keynes, the main cause of the depressions is the Federal Reserve Systems since it supposedly implied contractionary policies other than the expansionary ones. Therefore, Keynes believed that expansionary policies improve the economic performance (Kumar & International Monetary Fund, et al. 2007).
However, classical economist puts heightened emphasis on the ability of the market to solve economic recessions through a downward push in real wage and commodity prices within the specific economy. According to the classical economists of the mid 1970s, the economic downturns can be attributed to misperceptions of households with regard to the happenings of the prices, for instance, the real wage. Such misperceptions come about as a result of people’s inability to conceptualize the prevailing market prices, as well as the level of inflation within the economy. Classical economists argued that the decline in money should only have minor if any effects on the real outputs of the economy. For instance, when the Federal Reserve as well as the Bank of England beefed up monetary policy with an aim of fighting inflation, the resultant effect was a rising level of recessions within the Bank’s jurisdiction. According to neoclassical economist, the tightened and restrictive policies of the Bank were anticipated, and perhaps that was the cause of escalating level of recessions in a member country (Kaminsky & Ve%u0301gh, et al. 2004).
Indeed, the old Keynesian theory affirms that any monetary restriction is essentially a contractionary policy which is firm with reality and quite consistent with the actual events and perceives businesses and individuals to have been locked up in pools of fixed price contracts. The federal government through the central banks undertakes expansionary monetary policies through the imposition of minimum reserve requirements for the commercial banks. The central bank undertakes expansionary policies by increasing the amount that banks hold in total assets by decreasing the amount of reserve requirements. This enables bank to retain a small amount of money for immediate withdrawals while the rest is invested as illiquid assets in the form of mortgages and loans. This step increases the amount of loanable funds and, therefore, increasing money supply (McConnell & Brue, et al. 2005).
In addition, through the discount window lending, federal banks by means of the central banks increase money supply through direct lending of discounted funds to financial institutions. Thus is done by advertising an increment in the future lending of the discount window. Furthermore, the authority has the discretion to raise money supply indirectly by raising risk-taking by banks. For instance, the US advertised an increase in discount window loans after the 2001 September, attacks aimed at increasing money supply and preventing unnecessary panics from fear of inadequate liquidity. Besides that, the federal government also indirectly raises the level of money supply through decrease in nominal rates, which leads the households to withdrawing most of their money from banks to liquid cash due to reduced incentives to save. Indeed, the Federal Reserve can be a pace setter of the discount rates which can also lead to the optimal Federal Funds Rates particularly in the US. Low interest rates daunt incentives to save and encourage lending, thus, raising money supply. However, the expansionary monetary policy does not necessarily mean an economic expansion (Kaminsky & Ve%u0301gh, et al. 2004).
Finally, the central banks, therefore, use various tools in setting up the monetary policies. These include the reserve requirements, fed fund rates, discount windows as well as the discount rates. Fed fund rate is the main tool used. It refers to the interest rates those depository institutions lend balances at Federal Reserve to other depository institution immediately. On the other hand, the discount rates refer to the interest rates that the Federal Reserve charges on the lending on discount windows. These are some of the tools used in defining the monetary policies. The government may also raise the amount of money supply through buying of securities to the public and financial institution. Therefore, money is pumped into the economy in exchange of securities. This is not effective at times of economic recession as it raises money supply. Furthermore, decrease in the discount rates encourages borrowing through the discount window lending and, therefore, a rise in the amount of money in circulation and economic growth (Corsetti, 2010). The overall effect of increased money supply is a rise in GDP and a subsequent increase in loanable funds.
Consequently, the interest rates decline to encourage borrowing while the rate of unemployment rises due to the rise in money supply. On the same note, the aggregate demand for liquid money declines. Besides that, the exchange rates downside in the long-run but swings back to almost normal in the long-run. This explains the various levels at which the expansionary monetary policies and fiscal policies may act in a given open economy.