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Monetary and Fiscal Policy Combined

Friday, January 20th, 2012

In Chapter 9, we saw how the federal government’s Department of Finance uses fiscal policy to influence the level of aggregate demand in the economy. Since the monetary policy of the Bank of Canada discussed in this chapter also influences aggregate demand, we should review briefly how monetary and fiscal policies can interact so as to affect the performance of the economy.

During a recession, when aggregate demand is inadequate, a budget deficit (achieved through increased government spending and/or tax reductions) is usually combined with an easy-money policy consisting of lower interest rates and increased availability of loans. The objective of these policies is to increase the demand for goods and services by households and businesses. This increase in spending will be added to by the respending effect of the multiplier, and will be in large part financed by increases in the money supply resulting from increased bank lending. Also, it is possible that increased consumer spending may cause businesses to increase their investment spending (the accelerator effect), a process which would also be financed by the increased money supply through bank lending, encouraged by reductions in interest on loans. The overall result would be to stimulate output and employment in the economy.

During a period of inflation, aggregate demand for goods and services is so high that the supply of them cannot keep pace, with the result that prices rice with unusual rapidity. To combat inflation, a combination of a budget surplus (tax revenues in excess of government spending) and tight money, with loans relatively scarce and interest rates high, is appropriate. The objective of these policies is to depress the demand for goods and services, so as to relieve the pressure of excess demand on the supply and on the prices of goods and services. Government spending will be held down, while tax increases and high interest rates will restrain borrowing and spending by consumers and businesses. With total demand depressed in these ways, the rate of inflation will tend to decrease.

By combining the the fiscal policy of the Department of Finance and the monetary policy of the Bank of Canada in these ways, the effect can be considerably stronger than if either were used by itself.

In summary, then, tight-money policies are used to combat inflation by depressing the level of aggregate demand. While these policies will slow down inflation, they also tend to slow down the economy and increase unemployment, and they have particularly severe effects upon certain industries.

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Tags: Aggregate Demand, Bank Of Canada, Budget Deficit, Budget Surplus, Chapter 9, Consumer Spending, Department Of Finance, Easy Money, Excess Demand, Fiscal Policies, Government Spending, High Interest Rates, Monetary And Fiscal Policy, Money Policy, Money Supply, Multiplier, Rapidity, Tax Increases, Tax Reductions, Tight Money
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The Debate Over Demand Management by Government

Thursday, January 12th, 2012

During the 1960′s, Keynesian fiscal policies (also known as “demand management” policies, since the government uses them to manage the level of aggregate demand in the economy) were regarded as unquestionably beneficial to the economy. In the early 1960′s, US President John F. Kennedy had implemented major tax cuts. These lifted the North American economy out of a recession and can be given credit for the economic boom that lasted through most of the 1960′s.

Following the late 1960′s, however, experience with government monetary and fiscal policy was much less satisfactory. Excessive stimulation in the late 1960′s led to rapid inflation; in response, strong anti-inflation policies were applied, causing unemployment to rise to high levels. Again in the 1970′s, excessive stimulation generated very severe inflation, followed by anti-inflation policies and a recession.

Clearly, something had gone wrong: the monetary and fiscal policies that were supposed to be used to reduce economic instability were being applied in a stop-go fashion that actually created instability, wrenching the economy from rapid inflation to recession and back again. The bad economic effects of these policy decisions have led some economists to argue that the government should not actively manage the level of demand in the economy with its monetary and fiscal policies. They believe that, due to political pressures and the problems of time lags, government attempts at “demand management” tend to become mismanagement, with negative effects on economic stability and prosperity.

To remedy this, these economists argue, governments should be required to followed fixed rules for monetary and fiscal policy rather than be allowed to adjust the federal budget and rate of growth of the money supply as they see fit. In particular, it is sometimes argued, the money supply as they see fit. In particular, it is sometimes argued, the money supply should be allowed to grow at only a certain rate and the federal budget should always be balanced. Such rules, these people say, would prevent governments from making major errors in economic policy, especially in the direction of overstimulation.

Other economists disagree with this view. They point out that our economic system has a history of instability, culminating in the Great Depression of the 1930′s. They argue that the government can and should actively intervene in the economy growth has been more rapid and recessions less frequent and less severe than before. They also argue that, if mistakes were made in the use of these policies, we should learn from those mistakes rather than abandon the policies altogether in the blind hope that it will all work out somehow.

Which view is correct? There seem to be elements of truth in both views. Management of demand by government can have either beneficial or negative effects on economic stability and prosperity, depending on whether the policies are used with the proper timing and strength. For such policies to benefit the economy, the government must base its decisions on the effectiveness of policies intended to stimulate the Canadian economy. Because so much (about 30 percent) of the respending effect of the multiplier is drained off by imports when Canadian authorities inject additional demand into the economy, the multiplier effect is quite small. As a result, policies intended to stimulate the Canadian economy have less impact on output and employment in Canada than Canadian authorities would like.

In summary, the heavy exposure of the Canadian economy to international economic forces creates special difficulties for Canadian economic policy-makers. In particular, the importance of exports and of foreign capital inflows places significant limitations on Canadian authorities in deciding monetary and fiscal policies, forcing them to consider not only domestic Canadian problems, but also international factors, when formulating policies.

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Tags: Aggregate Demand, American Economy, Demand Management, Economic Boom, Economic Effects, Economic Instability, Economic Stability, Excessive Stimulation, Federal Budget, Fiscal Policies, Government Attempts, John F Kennedy, Management Policies, Mismanagement, Monetary And Fiscal Policy, Money Supply, Policy Decisions, Political Pressures, President John F Kennedy, Recession
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The Problem of “Inflation Psychology”

Sunday, January 8th, 2012

A more recent, but very serious problem for government policy-makers is the strong “inflation psychology” which has developed since the mid-1970′s, which causes people to seek large wage and salary increases in attempts to protect themselves against inflation. By adding substantially to cost-push inflationary pressures, “inflation psychology” creates special problems for monetary and fiscal policy.

First, by steadily increasing the cost of the GNP, these cost-push pressures force the Bank of Canada to continue to increase the money supply at inflationary rates in order to avoid an economic downturn due to inadequate demand, thus maintaining inflation at high rates. Furthermore, “inflation psychology” is strong risks touching off an explosion of wage demands and price increases, while strong cost-push pressures on prices make inflation very resistant to policies that depress aggregate demand.

Thus, “inflation psychology” tends to significantly reduce the effectiveness of monetary and fiscal policies in dealing with both inflation and recession. It is ironic that this problem resulted from excessive use of these policies in the late 1960′s and early 1970′s, when excessive monetary and fiscal stimulation in many nations generated the strong “inflation psychology” that has undermined the effectiveness of monetary and fiscal policies themselves.

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Tags: Aggregate Demand, Bank Of Canada, Crowns, Dentist, Early 1970, Economic Downturn, Explosion, Fiscal Policies, Gnp, Government Policy Makers, Inflation Rates, Inflationary Pressures, Monetary And Fiscal Policy, Money Supply, Price Increases, Psychology, Puerto Morelos, Recession, Salary Increases, Wage Demands
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How the Bank of Canada’s monetary policies affect the economy

Monday, August 8th, 2011

The effects of easy money

Easy-money policies are used to stimulate bank lending and spending by consumers and businesses at times when the economy is in a recession and unemployment is unusually high. If the easy-money policies cause aggregate demand to increase, real output will rise more rapidly and unemployment will decline.

These beneficial effects of easy money are, however, not automatic. If the economy is in quite severe recession and expectations regarding the future are gloomy, consumers and businesses may be reluctant to borrow and spend money. Also, the banks may choose to hold some excess reserves rather than make loans that might prove risky due to poor economic conditions. Thus, easy money merely increases the banks’ reserves and makes more loans possible; it does not automatically create money and boost aggregate demand. This problem has been likened to “pushing on a rope,” which suggests that easy money by itself may not always be sufficient to lift the economy out of a recession. For this reason, many people believe that easy money should be combined with federal budget deficit, which can provide a more direct boost to aggregate demand and can thereby start the economy on its way toward recovery.

When easy money does generate higher aggregate demand, the results are not totally beneficial: a side effect of the increased total spending may be more rapid inflation. While the reduced unemployment from the easy money policies may make some additional inflation acceptable, this side effect does place a limit on the use of easy money.

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Posts Tagged ‘Aggregate Demand’

Monetary and Fiscal Policy Combined

The Debate Over Demand Management by Government

The Problem of “Inflation Psychology”

How the Bank of Canada’s monetary policies affect the economy

Inflation since the early 1970′s

Combating cost-push Inflation

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