Role of Monetary and Fiscal Policies. Development, Functions, Interactions and Effects

Term Paper, 2020

22 Pages

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Table of Contents

1. Introduction

2. Theoretical Literatures on Monetary and Fiscal Policies
2.1. Development in the Theory of Monetary Policy
2.2. Development in the Theory of Fiscal Policy
2.3. The Portfolio Approach to the Development of Macroeconomic Policies

3. How Monetary and Fiscal Policies Are Working

4. Case Studies on the Effect/Role of Monetary and Fiscal Policies

5. Conclusions

6. References

1. Introduction

Contemporary macroeconomic theories postulate that, macroeconomic policy focuses on limiting the effects of the business cycle to achieve the economic goals of price stability, full employment, and growth. Monetary and fiscal policies are usually considered as the two sets of tools to implement macroeconomic policy. Both forms of policies are used to stabilize the economy, which can mean boosting the economy to the level of GDP consistent with full employment, (William N., 2019).

According to Cochrane (2009), the primary mandate of macroeconomic policy is the achievement of stability and sustainable growth. Conventionally, there are two leading players responsible for these economic policies. The Fiscal agent, whose main objective is to achieve full employment of resources and the monetary agent who seeks to maintain price stability. While both fiscal and monetary policy ultimately aims at achieving sustainability, economic theory holds that the monetary and fiscal policy objectives are not mutually exclusive. Also, the existence of two autonomous policy agents raises an environment where policy makers have room to pursue conflicting objectives.

Macroeconomic policy concern is particularly important in developing economies because one of the key features is the dominance of the fiscal agent. Majority of developing countries’ agenda is dominated by infrastructural development forcing fiscal agents to rely on deficit financing (Togo, 2007). An overemphasis on expansionary fiscal policy burdens monetary policies to correct fiscal imbalances by tightening the monetary stance. Ultimately, this compromises the effectiveness of monetary policy and the credibility of the overall policy framework, (Lauren& Piedra, 1998; Tarawalie et al., 2013).

For Getachew (2017), the theory of modern monetary and fiscal policy and practice coincides with quantity theory of money and the writing of Keynes’s 1936 General theory of Employment, Interest and Money. In every corner of the world, these theories are being used as the core of any economic policies. The difference in the contemporary economic policies lays on the emphasis to which one is best either the monetary or fiscal policy. How can we altercate from fiscal to monetary or vice versa or how we use them simultaneously, are among the basic questions raised by policy makers.

In Economics, twentieth century can be classified in to two categories in which the first half led by John Maynard Keynes’s fiscal policy framework and the second half with the theory of monetary policy framework pioneered by Milton Friedman. For the last nearly ninety years, fiscal and monetary policy theories are prevailing all over the world. Though almost all countries of the globe used either of these policies or both at a time, we have got some developed and others developing economies. It is how we are using these policies that create economic and structural differences among countries. The great homework given for economists and policy makers is that how we reduce the negative impact of one policy measures taken on the other policy instrument, or which of the given policy is effective for the given economy and in what way we should use these policies are prominent policy questions (Sudhansh and Beena, 2014).

Since the sixties, there has been considerable debate with respect to the relative importance of monetary and fiscal influences on economic activity. The monetarists took the position that monetary policy was more important in the United State economy than fiscal policy. In contrast, the Keynesians held that fiscal policy was more efficacious. Substantial empirical focus has been on the United States, utilizing the St. Louis single equation model in which monetary policy has been found to be superior to fiscal policy. The findings for other developed countries have been mixed, (Bynoe, 1994).

Monetary and Fiscal policies have powerful influence on the pace and pattern of economic growth of a nation. In a developing country like Ethiopia the major concern of economic policy needs to be diverted and accelerated on the rate of development and in this process, monetary and fiscal policies have a strategic role to play, (Sudhansh and Beena, 2014). In this term paper an attempt has been made to examine some of the pertinent issues/theories of monetary and fiscal policies and their usage to role on economic growth and the workings of these policies; do they imply coordination or simple interaction, were discussed to give policy investigations for making an efficient use of monetary and fiscal measures to accelerate economic growth.

Methodologically this term paper is based on theoretical and empirical narrations about the theories, experiences and workings of monetary and fiscal policies. How monetary and fiscal policies are in work, what are the existing theories about these policies, and evaluation of their practical cases based on various case studies conveys the major methodological components of this term paper.

2. Theoretical Literatures on Monetary and Fiscal Policies

Three theoretical approaches have been advanced by economists for analyzing the influence of monetary and fiscal actions on economic activity. These approaches are the textbook Keynesian analysis derived from economic thought of the late 1930’s to the early 1950’s, the portfolio approach developed over the last two decades, and the modern quantity theory of money revised under the thought of Milton Friedman. Each of these theories has led to popular and familiar statements regarding the direction, amount, and timing of monetary and fiscal influences on economic activity (Andersen and Jordan, 1986).

For the purpose of this term paper, more emphasis has given for the theoretical approaches on the development and foundation of monetary and fiscal policies with some introductory discussion of portfolio approach to macroeconomic policy.

2.1. Development in the Theory of Monetary Policy

The new economics dictionary defines monetary policy as an instrument used by government and government agencies (especially the central bank) of interest rate adjustments and other levers (such as various banking regulations) to influence the flow of new credit in to the economy, and hence the rate of economic growth and job creation. Accordingly, a tight monetary policy tries to reduce the growth of new credit (through higher interest rates); a loose monetary policy tries to stimulate more credit creation and hence growth.

As stated by Milton Friedman (1968), there is wide agreement about the major goals of economic policy: high employment, stable prices, and rapid growth. There is less agreement that these goals are mutually compatible or, among those who regard them as incompatible, about the terms at which they can and should be substituted for one another. There is least agreement about the role that various instruments of policy can and should play in achieving these several goals. For Friedman monetary policy is one of such instrument and he considered as the virtuous policy instrument to settle macroeconomic problems.

The practice of monetary policy has evolved continuously for the last fifty years, and is still in the process of change. At least five phases can be roughly distinguished: Bretton Woods (1946 to 1972), Monetarism (1972 to 1982), Inflation Control (1982 to 1992), Inflation Targeting (1992 to 2007), and finally, The Response to the Crisis (2007 to 2013). Moreover, these phase changes in monetary policy have occurred in response to both changed circumstances (economic structure) and sometimes the mere fashion of beliefs (economic theory) (William, 2013).

For William (2013), an important factor conditioning the changing conduct of monetary policy has been continuous change in the structure of the economy itself. Both the real and financial sectors have evolved under the influence of new technology and the general trend (since the 1960’s) towards deregulation and liberalization. While international trade had been rising steadily since the end of World War II, the entry of previously planned economies into global markets (dating from the late 1980’s) was a particularly important event.

More generally, the importance of the Advanced Market Economies (AMEs) in the global economy has been increasingly complemented by the growth of the Emerging Market Economies (EMEs). Financial markets have also evolved. Initially, financial systems were largely limited by national borders, were bank dominated, and characterized by a high degree of cartelization and associated stability.

William (2013) in explaining mere fashion of beliefs discussed that, significant changes in accepted economic theory have also occurred over the last fifty years. Academic theorists played a significant role in this evolution, with the contributions of Milton Friedman being of seminal importance. Two general trends characterized the theoretical literature over the pre-crisis period.

First, it became increasingly accepted that the economy was inherently self-stabilizing, and that discretionary policies were either useless or harmful. In this regard, the academics drew more from Hayek than from Keynes.

Second, the role played by expectations, and particularly inflationary expectations, took on increasing importance. Indeed, the idea advanced by Friedman and Phelps, that changing inflationary expectations meant there was no long run tradeoff between inflation and output, was arguably the most influential theoretical insight of the post war period. Arguments put forward by Friedman also played a big role in legitimizing the shift towards floating exchange rates after the breakdown of the Bretton Woods regime (William, 2013).

Monetary actions involve primarily decisions of the Treasury and the central banking system on balancing the money demand and supply. Treasury monetary actions consist of variations in its cash holdings, deposits at central banks (Federal Reserve bank for USA, National Bank of Ethiopia for Ethiopian case and so on differently for different countries) and at commercial banks, and issuance of Treasury (in Ethiopia usually called ‘Yegimjabet Sened’) currency. Central bank monetary actions include changes in its portfolio of Government securities, variations in member bank reserve requirements, and changes in the central bank discount rate (Andersen and Jordan, 1986).

For Getachew (2017), Banks and the public also engage in a form of monetary actions. Commercial bank decisions to hold excess reserves constitute a monetary action. Also, because of differential reserve requirements, the public’s decisions to hold varying amounts of time deposits at commercial banks or currency relative to demand deposits are a form of monetary action, but are not viewed as stabilization actions. However they are taken into consideration by stabilization authorities in forming their own actions.

According to Andersen and Jordan (1986), the central banks reserve system is considered as the monetary base which is considered by both the portfolio and the modern quantity theory schools to be a strategic monetary variable. The monetary base is under direct control of the monetary authorities, with major control exerted by the central banking system. Both of these schools consider an increase in the monetary base, other forces constant, to be an expansionary influence on economic activity and a decrease to be a restrictive/contractionary influence.

The modern quantity theory holds that the influence of the monetary base works through changes in the money stock which in turn affect prices, interest rates, and spending on goods and services. Increases in the base are reflected in increases in the money stock which in turn result directly and indirectly in increased expenditures on a whole spectrum of capital and consumer goods. Both prices of goods and interest rates form the transmission mechanism in the modern quantity theory. The money stock is also used as a strategic monetary variable in each of the approaches to stabilization policies (Andersen and Jordan, 1986).

2.2. Development in the Theory of Fiscal Policy

Consideration of the evolving meaning of fiscal policy is preliminary to understanding both the rise of Macroeconomics and the development of modern public Economics. In brief, fiscal policy was conceived very differently in the period before 1936, and it was only in the 1930s that the meaning of fiscal policy even began to approach the modern narrow definition macroeconomic stabilization through the manipulation of taxation and government spending (Johnson and Marianne, 2018).

According to Keynes fiscal policy is able to directly impact effective demand, and so it can substitute private expenditures whenever they are reduced, preventing insufficient effective demand (Arestis, et. al, 2018).

Moreover, for Johnson and Marianne (2018) what is apparent from a survey of the early literature is that fiscal policy was analytically protean; it’s meaning varying to encompass an amalgam of topics including taxes, international trade policy, and public debt financing. Fiscal policy was intuitively understood to refer to the government purse and implied government action or intervention in the economy. What constituted fiscal policy at any point in time was highly responsive to the external pressure of politics and the public’s view of what economics is/was and should/could do. Thus, the history of fiscal policy is, in part, the history of changing conceptions of the government’s role in the economy.

Jason Furman, in the new view of fiscal policy and its application (2016) admitted the stylized facts about the origin of fiscal policy can be classified into old and new perspectives. For Furman, A decade ago, which means the Old View, the prevalent view about fiscal policy among academic economists could be summarized in to four admittedly stylized principles:

1. Discretionary fiscal policy is dominated by monetary policy as a stabilization tool because of lags in the application, impact, and removal of discretionary fiscal stimulus.
2. Even if policymakers get the timing right, discretionary fiscal stimulus would be somewhere between completely ineffective (the Ricardian view) or somewhat ineffective with bad side effects (higher interest rates and crowding-out of private investment).
3. Moreover, fiscal stabilization needs to be undertaken with trepidation, if at all, because the biggest fiscal policy priority should be the long-run fiscal balance.
4. Policymakers foolish enough to ignore (1) through (3) should at least make sure that any fiscal stimulus is very short-run, including pulling demand forward, to support the economy before monetary policy stimulus fully kicks in while minimizing harmful side effects and long-run fiscal harm.

On the other perspective of fiscal policy, Furman considers new views of fiscal policy as, the tide of experts’ opinion with shifting the other way to almost the opposite view on all four points raised above. This shift is partly the result of the prolonged aftermath of the global financial crisis and the increased realization that equilibrium interest rates have been declining for decades. It is also partly due to a better understanding of economic policy from the experience of the last eight years, including new empirical research on the impact of fiscal policy as well as observations of the reaction of sovereign debt markets to the large increases in debt as a share of GDP in the wake of the global financial crisis, (Furman, 2016).

Based on these observations by experts, Furman stated the New View of fiscal policy as largely reverses the four principles of the Old View—and adds a bonus one. In stylized form, the five principles of this view are:

1. Fiscal policy is often beneficial for effective countercyclical policy as a complement to monetary policy.
2. Discretionary fiscal stimulus can be very effective and in some circumstances can even crowd in private investment. To the degree that it leads to higher interest rates, that may be a plus, not a minus.
3. Fiscal space is larger than generally appreciated because stimulus may pay for itself or may have a lower cost than headline estimates would suggest; countries have more space today than in the past; and stimulus can be combined with longer-term consolidation.
4. More sustained stimulus, especially if it is in the form of effectively targeted investments that expand aggregate supply, may be desirable in many contexts.
5. There may be larger benefits to undertaking coordinated fiscal action across countries.

According to Andersen and Jordan (1986) the influence of fiscal actions on economic activity is frequently measured by government spending, changes in tax rates, or budget deficits and surpluses. The textbook Keynesian view has been reflected in many popular discussions of fiscal influence. The portfolio approach and the modern quantity theory suggest alternative analyses of fiscal influence.


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Role of Monetary and Fiscal Policies. Development, Functions, Interactions and Effects
Arba Minch University
Development Theories and Policies
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ISBN (eBook)
ISBN (Book)
role, monetary, fiscal, policies, development, functions, interactions, effects
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Endaylalu Solomon (Author), 2020, Role of Monetary and Fiscal Policies. Development, Functions, Interactions and Effects, Munich, GRIN Verlag,


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