Friday, May 4, 2012

Fiscal Policy and Monetary Policy

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By manipulating government spending and taxes in order to stimulate or slow down growth, this economical management which effect of the aggregate or total demand for goods and services is called fiscal policy.

On the other hand, monetary policy attempts to control the amount of money in circulation or the cost and availability of credit. The objective is straightforward even if difficult to put into practice. If money is readily available because, say, interest rates are low, people can afford to borrow and spend. But unless production keeps pace, there will not be enough goods and services to meet the demand this borrowing and spending creates. In the face of the excessive demand, producers and suppliers have incentives to raise their prices. As time goes by, prices spiral upward, leading to uncontrolled inflation during which dollars lose their value. The key to keeping inflation in check is to maintain stable interest rates and not let the money supply grow too rapidly.

These two policies are the main macroeconomic instruments fiscal policy has traditionally been set in a medium term framework while monetary policy has been use for short term demand management.

These objectives recognise that while the primary purpose of fiscal policy is to ensure sustainable public finances, it can also be used to support monetary policy over the cycle. The objectives are given effect through two medium-term fiscal rules the golden rule states that, over the economic cycle, the Government will borrow only to invest and not to fund current spending; and the sustainable investment rule states that public sector net debt, as a proportion of GDP, will be held over the economic cycle at a stable and prudent level (other things equal, taken to be 40%). These fiscal rules were designed in response to lessons learned from past experience. In particular, the Government realised that a key factor behind the macroeconomic instability of the early 10s was the lack of clear principles for fiscal policy and a lack of well-defined objectives and targets. Temporary, cyclical improvements in the fiscal position were misinterpreted as permanent, structural improvements. Moreover, fiscal policy had not been supporting monetary policy to help dampen inflationary pressures in the late 180s and, after the economy returned to trend around 11, the fiscal position rapidly deteriorated. During the ensuing downturn significant tax increases and spending restraint were required to return the public finances to a sustainable path.

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