Question

In your opinion, how effective is, and what are "economic risks and/or tradeoffs" of, fiscal and monetary policy in "controlling" or "moderating" the business cycle and does it matter whether we are considering such policies in the 'long run" vs. 'short run" and in a "open" economy vs. a "closed" economy?

Answer 1

The principal aim of fiscal and monetary policy is to reduce cyclical fluctuations in the economic cycle. In recent years governments have often relied on monetary policy to target low inflation. However, in recessions, there are strong arguments for also using fiscal policy to achieve economic recovery. Fiscal policy is a government's decision regarding spending and taxing. If a government wants to stimulate growth in the economy, it will increase spending for goods and services. This will increase demand for goods and services.

Fiscal policy can promote macroeconomic stability by sustaining aggregate demand and private sector incomes during an economic downturn and by moderating economic activity during periods of strong growth. An important stabilizing function of fiscal policy operates through the so-called " automatic fiscal stabilizers".These work through the impact of economic fluctuations on the government budget and do not require any short-term decisions by policymakers. The size of tax collections and transfer payments. for example, are directly linked to the cyclical position of the economy and adjust in a way that helps to stabilize aggregate demand and private sector incomes.

The short term stabilizing the function of fiscal policy can become especially important for countries that are part of a monetary union, as nominal interest rates and exchange rates do not adapt to the situation of an individual country but rather to that of the union as a whole. Fiscal policy can then become a crucial instrument for stabilizing domestic demand and output, which remains in the domain of individual governments. At the same time, however, the limitations of active fiscal policy may be greater when there is increased uncertainty about future economic developments.

Discretionary policies are needed to implement long -term structural changes in public finances and to deal with exceptional situations, particularly when the economy experiences extraordinary shocks.The Monetary policy is typically implemented by a central bank, while fiscal policy decisions are set by the national government. However, both monetary and fiscal policy may be used to influence the performance of the economy in the short run. In general, a stimulative monetary policy is expected to improve the economy's rate of growth of output(measured by Gross Domestic Product or GDP) in the quarters ahead; tight or restrictive monetary policy is designed to slow the economy in the future to offset inflationary pressures. Likewise stimulative fiscal policies, tax cuts, and spending increases are normally expected to stimulate economic growth in the short run, while tax increases and spending cuts tend to slow the rate of future economic expansion.

In a closed economy, an expansionary fiscal policy would drive up interest rates. In turn, this would reduce both residential and non-residential investment and reduce the interest -rate sensitive forms of consumption. In an open economy, the upward pressure on interest rates would be mitigated by inflows of foreign capital. These inflows would tend to cause an appreciation of the currency.This appreciation would cause a decline in exports and an increase in imports . The trade deficit would put downward pressure on aggregate demand that would partially offset the effects of the expansionary fiscal policy.

In an open economy with capital mobility , the effects of expansionary fiscal policy are not quite so clear. The initial effects of an expansionary fiscal policy cause the aggregate demand curve to shift to the right. However, this policy also causes the currency to appreciate and worsens the current account balance as exports decline and demand curve to the left.