The management of the economy of the economy is one of the responsibilities that the government of any country performs. A country could experience an economic boom or recession, or alternating periods of peaks and troughs. Each economy has a level of optimality that typically reflects full employment and macroeconomic stability (Leigh & Stehn, 2009). As such, the policies that the state adopts will inevitably aim for such a scenario that reflects optimality in the economy. When the economy is in recession, the state undertakes measures to boost spending and consequently, the country’s productivity, something referred to as an expansionary policy. At times when the economy has expanded too fast, the state may decide to slow it down by implementing contractionary policy. A government typically has two broad sets of policies to choose from in the form of fiscal and monetary policy, and each represents a different set of steps that it can use to kickstart an economy out of recession (Langdana & Cox, 2016).
One of the means that the government uses to influence the economy is by varying taxes and its spending. The framework follows the work of John Maynard Keynes, and many refer to fiscal policy as Keynesian economics. The Treasury, the body, tasked with coming up with and implementing fiscal policy makes pronouncements about changes in taxation or state spending in line with the desired outcomes (Leigh & Stehn, 2009). Usually, fiscal measures have a longer gestation period, and their effects may not manifest in the economy immediately. The Treasury announces a fiscal change at the start of the government’s financial year when it outlines the state’s spending plans. The idea of using fiscal policy to affect the economy is all about shifting consumption as need be to attain the required results. Typically, a fiscal change would see either an increase a simultaneous increase or decrease in both private and government consumption.
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Expansionary Fiscal Policy
When the economy is stagnant or undergoing a recession, the government responds by coming up with measures to expand economic productivity. The starting point is by implementing changes that increasing the average consumption in the economy. To this, the government can choose to either increase its consumption or reduce taxes to increase the disposable incomes among consumers. Increasing government spending is significant as the government is the largest consumer in the economy and thus increasing what it spends its money on will have a profound impact on the overall consumption level (Langdana & Cox, 2016). When the economy undergoes severe economic downturn, the state would usually respond by undertaking a raft of stimulus packages to stimulate spending and get the economy back on track. The multiplier effect amplifies the effect the stimulus and eventually gets the economy on a path of expansion.
Fiscal policy is a framework of demand management mechanisms. When the country undergoes a recessionary period, it effectively experiences a demand deficiency. The expansionary fiscal policy thus serves as a means of increasing the aggregate demand. The government buys more goods and services from the market by channeling more funds to areas such as infrastructure, health, and education, while at the same time increasing consumer spending via reduced taxes (Langdana & Cox, 2016). The increased spending creates demand for goods and services in the economy. Producers expand their production to meet the rising demand, and that creates employment for previously unemployed individuals. These people now earn wages and have the spending power that they previously did not possess. With the increase in the amount of money that consumers spend and the lower taxes, the aggregate demand in the economy increases, accompanied by the reigniting of the economy from a state of stagnation to being active again. The elevated spending levels thus lead to economic growth and thus an expanded GDP.
When implementing expansionary fiscal policy, the government must remain conscious of several factors that could determine the success of the chosen interventions. The most significant consideration is the fiscal space that the state has to carry out extra spending programs. That comes in the form of either the access that the state has to obtain affordable financing or the leeway to reorder its existing expenditures. If the federal government decides to respond with fiscal stimulus, it must have its creditors ready and willing to avail funds as need be and it also has to factor the possible inflationary effects of the spending programs. Additionally, the state has to be careful when borrowing from the private to avoid crowding out. In deciding to tap into the private lending markets where it would be competing with private investors for funds. Given that creditors prefer to lend to the government, the latter has to careful not to borrow too much and leave too little for everyone else.
Expansionary fiscal policy can restore the economy back on to the track of growth, but it can have possible downsides too, mainly in the form of increased inflation. When the state substantially boosts its spending, it is equivalent to pumping more money into the economy. The excessive supply of money could bear down on the value of the currency. Also, it is possible that people would see a spike in the prices of goods as a result of the increase in demand. Under such circumstances, there is the possibility that the general price level would skyrocket to unmanageable levels, something that would hurt the economy. Fiscal policy may prove impotent in an environment of high inflation as it would be rather counterproductive. Therefore, the government has to make several considerations before implementing expansionary fiscal policy.
Expansionary Monetary Policy
Each economy has a monetary authority that is in charge of its monetary policy. The US Federal Reserve System or “the Fed” is the body that takes care of the country’s monetary policy. The naming system refers to the unique system of the US central bank that sees twelve key US cities such as New York, St. Louis, Boston, Chicago, and Cleveland have a Federal Reserve Bank (Leigh & Stehn, 2009). As the monetary authority of the United States, the Fed has a critical role to play in the country’s economy. After the global economic meltdown and subsequent recession of 2008, the Fed found itself on the frontlines trying to get the US economy back on the path of growth. It did this by implementing expansionary policies meant to kickstart the economy and spur productivity.
The Fed has several tools that it can apply to achieve its targets for the economy and thus achieve its objectives. They include interest rates, bank reserve requirements, and open market operations, and in the event that the former three fail, it can resort to unconventional means. The Fed however predominantly uses the interest rates in its working. The critical rate that it uses is the Federal Funds rate, a benchmark it sets for commercial banks to follow. This rate is what the Fed would charge commercial bank if it lent to them. Expansionary policy sees the Fed lower its rate to ease the availability of credit to the economy (Langdana & Cox, 2016). Commercial banks form an important part of the Fed’s rate mechanism because they are the first institutions that expose people to money. As such, controlling the amount of money they have means being able to control the liquidity that the public has. The ability of the Fed to control the interest rates results in the regulation of money supply in the economy.
The Fed aims at easing liquidity so that consumers and businesses can spend more. Lower interest rates lead to reduced borrowing costs, and thus the various economic agents go to lenders to acquire funds which they use to spend for consumption or for investment. Interest rate cuts are common in periods of poor or unsatisfactory economic performance or when demand is weak (Langdana & Cox, 2016). A low cost of borrowing regime sees an expansion of the liquidity in the economy and encourages individuals to spend more. The increase in demand spurs producers to invest more to meet the surge in demand for goods and services. In the process, they need to employ more people to cope with the need for more output, thus leading to more employment.
While the Fed’s rate is an important tool for regulating the money supply, it may not always work and may thus be impotent in some situations. When a central bank continually cuts its rates, it may get to the point of a zero lower bound (ZLB) where the rate is next to zero (Hännikäinen, 2015). In such an instance, the Fed would face a huge dilemma. On the one hand, it would need to increase the liquidity in the economy to kickstart productions but on the other, moving into negative territory may prove detrimental to the economy. That goes to show that the Federal Funds rate is not a magical bullet and may have its limitations even though it has proven effective on most occasions.
In the aftermath of the events of the 2007 global economic meltdown that decimated the world economy, the Fed cut interest rates so low that they almost reached zero. In reducing the rates, the Fed’s intention was to make it easy for consumers to borrow from financial institutions for car loans, and mortgages, among other things, and spend more, thus boosting demand. Also, the reduced rates would raise the value of stocks and investors would move to equalize their risk- adjusted returns on their portfolio holdings (Langdana & Cox, 2016). The measures would not work because the economy was in a very critical state, with real GDP contracting by about 8.9% in the fourth quarter of 2008. The Fed found itself in a quagmire as it had cut interest rates to a point where it could no longer effect additional cuts. Conventional economics would have had the institution further cut its rates and even move into negative territory in which case depositors would be paying banks to place their deposits in the institutions. However, the Fed chose to avoid that path because it would have made households keep their cash holdings and not deposit them (Langdana & Cox, 2016).
Required Reserve Ratio
It is the responsibility of the Fed to ensure that a certain level of deposits is maintained by all the commercial banks. Being the last lender it has discretion over the portion of the liabilities the banks have to deposit with it. However, the amount is only set at minimum although banks can increase their limits over and above the statutory levels. Therefore, banks find themselves having to place part of the monies they receive from their depositers with the Fed. These deposits from the banking sector form the pool of funds from which the Fed would lend to those banks facing liquidity challenges or financial stress. As a policy tool, the Fed uses the reserves as a means of determining the total amounts that the banks may have to lend to their customers (Langdana & Cox, 2016).
When implementing an expansionary monetary policy, the Fed relaxes the requirements for the required reserve ratio. The situation would see banks having to deposit less with the Fed than before. As such, they would have more money to lend to their customers, and that means an increase in the money in circulation. In most cases, the Fed would also be implementing measures to lower interest rates in the economy in a bid to get more people accessing funds to invest in their businesses (Langdana & Cox, 2016). Having to put aside lower amounts of their deposits makes it possible for financial institutions to give out more in the form of loans and that has a positive impact on the economy. That is because consumers are able to borrow for their consumption needs while businesses obtain the funds to start or expand their operations to respond to the rising demand.
Open Market Operations
Another avenue for the Fed to carry out its monetary policy is through open market operations. If there is not sufficient liquidity in the market, the Fed will buy back government securities to free up more cash into the economy as part of the expansionary monetary policy. An expansionary monetary sees the Fed undertake a program to buy back Treasury Securities, usually those with short maturities, as a means of injecting liquidity into the economy (Hännikäinen, 2015). The Fed would typically carry out this measure alongside a slashing of interest rates so as to stimulate spending in the economy. The extra supply of money means that there is more to consume and invest, and that goes a long way towards stimulating demand. Again, the increase in demand serves as an incentive to producers to expand their production capacity to meet the needs of the prevailing situation and in the process, they employ more people, and the economy expands.
While the Fed constantly buys short- term securities as part of the ordinary monetary policy actions, it may turn to buying financial assets that mature over a longer period, something known as quantitative easing. Quantitative easing is form of open market operations that is larger in scale and intends to inject massive amounts of liquidity into the economy. It may prove more effective In November 2008; the Fed purchased assets including government- sponsored enterprises (GSE) debt as well as mortgage- backed securities (MBSs). The Fed, however, scaled the purchase of government debt and the mortgage- backed securities as well and at the end of March 2010, the Fed was holding over $1.5 trillion of Treasury securities and mortgage- backed securities (Hännikäinen, 2015). That was just the first round of quantitative easing, and the Fed would engage in further asset purchases with the intention of easing liquidity. As it is, the quantitative easing seems to have worked in accelerating the growth of the US economy following a brief period of contraction following the economic downturn. Aggregate demand has risen over the past several years, unemployment dropped, and the economy looks healthy again (Hännikäinen, 2015).
The government has an important to play in the economy. During times of economic downturn and depressed performance, the state has to come up with interventions to aid in economic recovery and get the country back on the growth trajectory. Fiscal and monetary policies represent two frameworks that the government may turn to whenever the economy is not performing as it should. Before settling on the measures, the authorities have to consider several factors such as the implications of each as well as the practicality to make the best decision and achieve the desired outcomes for the economy.
Hannikainen, J. (2015). Zero lower bound, unconventional monetary policy and indicator properties of interest rate spreads . Review of Financial Economics, 26, 47-54. http://dx.doi.org/10.1016/j.rfe.2015.03.002
Langdana, F. & Cox, W. (2016) Macroeconomic policy Switzerland: Springer.
Leigh, D. & Stehn, S. (2009). Fiscal and monetary policy during downturns Washington, D.C.: International Monetary Fund.