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Government controls their national economies in two ways i.e. by monetary policy as well as fiscal policy. Firstly, the monetary policy takes in adjusting the money supply (i.e. the quantity of money in circulation) and fixing the prime rate (i.e. the rate of interest which banks pay to one another on loans). Secondly, the fiscal policy makes use of government taxation, borrowing and spending in order to control the economy. An amalgamation of monetary and fiscal policy is usually used so as to guide the economy in a preferred direction. Even though, government guides fiscal policy, a number of nations hand over accountability for monetary policy to central banks. This particular approach precludes government from directing interest rates for short-run political benefit and encourages steadiness in the money supply and the price of products. For instance, in the U.S., this function is performed by the Federal Reserve whereas in the European Community, it is carried out by the European Central Bank. The continuing sections provide a detail description about the two i.e. fiscal policy and monetary policy along with their effectiveness.
Monetary Policy:
Initially, a central bank lays down monetary policy by influencing the money supply as well as the interest rate (particularly called the prime rate or price of money, in economics terms). These policies intend to even out an economy through promoting borrowing and investment along with managing the level of joblessness and inflation. Moreover, monetary policy is considered to be a means whereby a government influences the supply of money together with the cost of borrowing money by way of interest rate alterations (Friedman, 1968). A decrease in the interest rates increments the supply of money and borrowing within the economy. In contrary to this, an increase in interest rates has the opposite impact on money supply and borrowings. Notably, alterations in the money cost have an effect on its exchange value calculated against another currency. A variation in the exchange value calculated against the trading partners currency could motivate or discourage a nation’s export marketplace.
Moving ahead, the capability to control money supply and interest rates circulating within the economy is considered to be the chief objective of monetary policy. The devices employed encompass fixing the prime lending rate, which implies the rate at which the central bank loans money to commercial banks in its authority and modifying the monetary base, either by augmenting reserve needs for banks (i.e. the amount of funds a bank needs to have in reserve with respect to clients withdrawals) or printing money. Further, the supporters of monetary policy are of the view that central banks could control business procedures by making trustworthy declarations of their purposes regarding deciding interest rates, in manner that depositors and organizations would respond as per their prospects related to the cost of money in flow. The two components of monetary policy are explained in the below sections.
• Money Supply:
By means of managing the supply of money, the central bank decides the amount of money in the economy at a particular point in time. At the time when, supply increments, the worth of one unit of currency goes down and individuals pay out more. Whereas, when the money supply reduces, one unit of currency increases, maintaining inflation down. Moreover, the Central banks transform the supply of money through printing money or trading bonds.
• Interest Rate:
A central bank decides the minimum feasible rate of interest in a nation, known as the prime rate. The central bank indicts this rate on lending to commercial banks. The commercial banks charge one another a same rate on lending. Moreover, the banks charge clients an elevated interest rate; however it varies along with the price of money. Further, less interest rate motivates lending and savings, which are believed to be essential elements for a budding economy, while high interest rates promote cautiousness and restrict risk-taking.
Usefulness of Monetary Policy:
Monetary policy is believed to be more efficient device for economic incentive as compared to fiscal policy in a floating exchange rate structure i.e., an arrangement wherein the currencies of trading nations could increment or reduce in value (Bean, 2005). For instance, if a government tries to encourage economic growth through bringing down the price of money, the resulting outcome on the rate of exchange would motivate exports whereas creating imports more costly. This adds drive to the planned economic incentive.
Fiscal Policy:
To start with, the fiscal policy relates to government spending and taxation, borrowing and impacts the nation by way of aggregate demand. Fiscal policy is the means through which a government could create upshots in the economy by pronouncements associated with taxing as well as spending. There exist three kinds of fiscal policy namely; neutral, expansionary and lastly, contractionary. Government follows neutral fiscal policy at the time when they balance their budgets in order to make sure that revenue equals spending. Moreover, when government entities create budget surplus i.e. when revenue is more than spending they pursue a contractionary policy. While budgetary deficits implying revenue is less than spending indicates an expansionary policy. Further, the Fiscal policy can be brought into play to encourage economic growth.
• Aggregate Demand:
Aggregate demand is defined as the overall quantity of spending within an economy. Government could have an effect on aggregate demand by means of fiscal policy in two manners i.e. spending and taxation. Moreover, at the time when a government makes a decision regarding how much to tax, it impacts the economic action of the people. In common, tax reductions and tax enticements increment aggregate demand at the cost of government revenue, while rise in taxes effect in an opposite way (Aschauer, 1985). Furthermore, Government could also influence aggregate demand by the way they spend, aiming at particular industries with funding or government agreements in expansionary guidelines and limiting federal ventures and decreasing subsidies in contractionary guidelines.
Usefulness of Fiscal Policy:
Trying to accelerate the economy, by fiscal policy, calls for intensification in government spending and as a result an enhancement in the budget deficit. The ensuing augment in interest rates increases the price of fabricating products, resulting in greater costs and thus, making products difficult to export. Moreover, this has a discouraging impact on exports rather than imports, and therefore operates against economic motivation. Nevertheless, wherever a common marketplace of nations doing business with one another settles on a fixed exchange rate, fiscal policy is in reality more effectual at motivating economic growth as compared to monetary policy. This is for the reason that, if making use of monetary policy to trim down the price of money has no impact on the exchange rate, it performs nothing in order to prevent imports and stimulate exports.
In addition to this, though fiscal as well as monetary policies include the same objective i.e. sustaining a steady economy and nurturing sustainable degrees of employment, the two segments of economic policy are diverse. Comparing fiscal and monetary policy calls for recognizing who views which policy and the techniques they make use of to influence the economy. Also, the fiscal and monetary policy could involve distinct amount of time to operate.