There are two main policies that are used to manage the national economy in capitalism: fiscal and monetary. Fiscal policy includes increase or decrease of taxation, increase or decrease amount of government purchases and appreciation or depreciation of domestic currency. Monetary policy is designed to control investment. For this purpose it uses open market operations of the central bank, manipulations with reserve ratio and discount rate. In this paper I am going to discuss how it is possible to manage the economy through these two policies. Besides I will examine which fiscal policy is more effective to finance budget deficit during economic recession: through increase of taxation or through borrowing from population.
In federal structure of the government, government is usually a responsible entity to conduct the fiscal policy. Since we assume that the Economy of the country experiences a recession, it implies that real Gross Domestic Products experienced a fall during two or more successive quarters of a year, and usually this state of economy is characterized by deflation. Assuming that the government is experiencing a budget deficit, the following presuppositions could be made.
If the government is going to generate money through the increase of levels of taxation, the following effects may occur: due to the increased level of taxation the level of GDP may fall, and therefore the unemployment rate might increase. The supply of money on the market will also decrease; therefore the interest rate may increase as well. This might lead to a further generation of budget deficit in the future and lead to the economic depression. Generally, the increase of taxation is a tool of concretionary policy and is usually used to help suppress the inflation. In case if the economic recession it is usually is not the best policy, if the deflation is taking place.
Another way to deal with the budget deficit with the help of fiscal policy, i.e. the way to fund it is borrowing from the population. This is usually performed through issuing bonds, like Treasury bills or consols. These bonds pay interest for a fixed period of time, or indefinitely. These borrowing, however, may reduce private-sector borrowing and investment due to the crowding out effect. This happens, due to the fact that increase of government borrowing leads to increase of interest rates (since the supply of money on the market decreases), this will certainly lead to the reduction of investment, due to a lower rate of return.
Nevertheless, there are ways to balance the effect of crowding out through government spending increase, which is a tool of expansionary policy. This action expands the market for the products of private-sector and thus stimulates fixed investment. This is also known as accelerator effect, which is very important during economic recession, which is assumed in our case, and depression. Therefore from my point of view, it is more effective to generate money for budget deficit with the help of borrowing from the population, taking into consideration the fact that the economy is at a recession in our case.
The monetary policy is a process that is aimed at regulation of money supply on the market. The process of managing money supply can be used for constraining inflation; maintaining an exchange rate, achieving full employment or economic growth. Central bank is responsible to carry out monetary policies. Monetary policy is conducted with the help of three main tools: Open market operations of the Central Bank, which is usually performed through buying and selling of securities; Reserve Ratio manipulation and Discount rate manipulation. If there is a need to stimulate the economy, it is possible to reduce the reserve ratio, thus increase the supply of money on the market. This would stimulate decline of the interest rates and investments, which in the end would lead to increase of GDP. Also central bank may reduce discount rate, which would automatically lead to decrease of interest rate, increase of Investments and increase of GDP.
Both fiscal and monetary policies are effective and necessary to manage the economy. If monetary and fiscal policies are wisely managed in the country, then the economic business cycles would be stable, and the risk of economic depression would be rather low. It is impossible to identify which policy is more effective, when speaking about managing the economy. Subjects of fiscal policy include Consumption, Government purchases, Export and Import. The subject of monetary policy is investment. All these subjects taken together are determinants of country’s Gross Domestic Product, and certainly cannot function without each other.
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Mankiw, Gregory. Principles of Macroeconomics (with Xtra!). 3rd ed. (2003). South-Western College Pub.
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