There are two kinds of tools available to the economic policy-makers through which they tend to influence the economy of the country; these two tools are fiscal and monetary. The former policy related to the spending of the government and the collection of revenue like altering the disposable income of the people by lowering taxes or increasing the spending so that demand is stimulated. The latter which is the monetary policy is associated with the supply of money and is influenced by such factors like the rate of interest and the reserve requirements for the banks. Usually these policies are required in times of recession so that the economy can be stimulated by the intervention of the government; but in general, these tools are readily applicable in the market economy like the United States of America. So, fiscal policy relates to the decisions taken by government while the monetary policy refers to the actions taken by the central bank for the purpose of stabilizing the economy (Rotemberg, 2013). In times of low-growth, the Federal Reserve and the governments make use of the expansionary policies; it refers to the macroeconomic policy through which the supply of money is expanded so that either the inflation can be combated or the growth of the economy can be encouraged. There are two forms of expansionary policies including the fiscal policy and the monetary policy; similar to the tools used by policy-makers (Woo & Zhang, 2011). The federal government engages in the expansionary economic policies to move the economy out of recession. Recession is the time period when the economic activity is generally slow as defined in terms of economics. The government would take two actions in this regard: conducting the expansionary fiscal policy and conducting the expansionary monetary policy. Both these actions influence the elements like supply of money, rates of interest, spending, aggregate demand, gross domestic product and employment. The paper sheds light on the actions taken by the government to address the expansionary fiscal and monetary policies.
Expansionary Fiscal Policy
Expansionary fiscal policy is a form of policy which involves increasing the purchases by the government, while decreasing the taxes and increasing the payment transfers so that the issues pertaining to the contraction of the business cycle can be resolved. The basic goal behind designing this policy is to stimulate the economy in case a contraction is either anticipated or being experienced. In simpler words, this policy refers to when the expenditure by the government changes while altering the taxes so that the levels of economic activity can be influenced ensuring the growth of the economy (BLANCHARD & DELL’ARICCIA et al., 2013). With the intervention of the government and by the increase in aggregate expenditures, the aggregate demand is also increased; the result is a larger budget deficit for the government or a reduction in the budget surplus of the economy overall.
Generally, the expansionary fiscal policy works to close the recessionary gap and to decrease the rate of unemployment by stimulating the economy. There are two sides of the fiscal budget that play a role in implementing this policy; one is the government spending and the other is taxes. More concisely, these two can be divided in three tools which are necessary elements of the expansionary fiscal policy namely government purchases, taxes and transfer payments.
- Government Purchases: Government purchases refer to the expenditures incurred by the government sector on the final goods or services; in other words, this refers to the portion of the gross domestic product which is purchased by the government. The purchases of the government include everything ranging from the paper clips to carriers of aircraft or traffic light or even the salaries of the teachers. These purchases are done by the individual agencies of the government like the Department of Defense which would finance the aircraft carriers for example. When the federal government decides to make use of the expansionary fiscal policy, the funds appropriated for these agencies are increased; with the additional purchases made by these agencies, the overall production of the goods is stimulated and the income gets a boost which further results in increasing the level of employment in the relevant areas and the overall economy. With the increase in consumption of these goods or services, the GDP would rise; GDP refers to the value of the total output which is being produced in the economy at any given period of time (Ramie, 2011). The employment increase is due to the increase in the need for employees to meet the higher demand of the goods or services. Though this option is relatively successful but with more involvement of the government, the government sector tends to get larger this is why the second tool of taxes is chosen more.
- Taxes: In this category the emphasis is more on the level of personal income tax although the other taxes are also involved. Taxes refer to those involuntary payments which are imposed by the government sector on the economy so that revenue is generated; with this revenue, the government provides the economy with the public good and also uses the revenue to accomplish its functions. Personal income tax is that tax which is levied on the personal income which the members of the household sector receive. The Internal Revenue Service administers the system of federal income tax under which it applies a particular rate of tax to the income which the taxpayers receive. The taxes are withheld from the paycheck of the employee which is then paid by the employer to the government. When the federal government decides to make use of the expansionary fiscal policy, either the rate of income tax is reduced or a one-time rebate is paid for the previous taxes. The reduction in the taxes leads to the provision of additional disposable income for the household which provides them with more money to spend; when the consumption expenditure is increased, the gross domestic product increases and so does the demand for the good or services (Delong & Summers, 2012). So, by reducing the income tax, the aggregate demand is increased; to meet this demand, the aggregate production is stimulated and so does the requirement for more employees; with the rise in employment and the rise in level of productivity, a further increase results in income. As compared to the government purchases, it is easier for the government to change the rate of tax which is preferred when the expansionary fiscal policy is conducted.
- Transfer Payments: All the payments to the household sector made by the government sector without expecting any return are referred to as the transfer payments. These can be categorized in the social security benefits which are given to the disabled and the elderly, welfare spent for the poor and the unemployment compensation for the jobless. These payments are given based on a certain criteria and characteristics. With the expansionary fiscal policy, the payment schedule is increased or a lump sum payment is given to the people who qualify for it. In this case, either there could be an increase in the unemployment compensation overall by 5% or all the recipients of the Social Security would receive an extra payment of $500. Whatever the scenario, a rise in the transfer payment gives an additional disposable income to the household which means that they have additional money to spend and so the consumption expenditure would improve. Similar to the deduction in taxes, a rise in consumption means more GDP, more demand, more productivity, more employment and consequently more income overall (Afonso & Sousa, 2012).
The recessionary gap exists when the current level of total production is lesser than the level when all the resources are fully employed. When there is a contraction in the business cycle, the gap arises and further, increases the rate of unemployment. By conducting the expansionary fiscal policy, the instability of the business-cycle is addresses so that the recessionary gap can be closed.
Expansionary Monetary Policy
The expansionary monetary policy is that policy where the problems related to the contraction of business-cycle are rectified through the increase in the supply of money and by reducing the rate of interest. For example, the government can conduct the expansionary monetary policy by purchasing the U. S. Treasury Securities through the open market operations, reducing the discount rate and also reducing the reserve requirements (BLANCHARD & DELL’ARICCIA et al., 2013). Theoretically, the primary tool used for the expansionary monetary policy is the open market operations. This policy works in support to the expansionary fiscal policy.
In simpler words, expansionary monetary policy is conducted by raising the quantity of the money that is in circulation along with a corresponding decrease in the rates of interest so that the economy can be stimulated and the business-cycle contraction is rectified; this is also a chosen method to address the unemployment issue in the economy. In the past, more paper currency was printed whenever the monetary policy was undertaken. But in the modern era, the fractional-reserve banking is used to control the process of creating money. The monetary authority who has the responsibility of implementing the monetary policy is the Federal Reserve System otherwise known as the Fed (Gordon, 2012).
Fed also prefers using the open market operations for controlling the business-cycle contraction and unemployment. But there is also a significant side effect of conducting the expansionary monetary policy; with the increase in the money supply the interest rates offered by the banks for loans are lowered. When Fed sees that recession has hit the economy, it adds money to the system and lowers the rate of interest with the expansionary monetary policy. As defined by The Financial Times, it is “A policy by monetary authorities to expand money supply and boost economic activity, mainly by keeping interest rates low to encourage borrowing by companies, individuals and banks” (Duff, 2013). The three tools or methods involved in this policy are:
- Open Market Operations: In order to control the reserves of the bank, the rate of interest and the supply of money, the act of purchase or sale of the U. S. Treasury securities is termed as the Open market operations. This tool is administered by the Federal Open Market Committee while the Domestic Trading Desk of the New York Federal Reserve Bank implements it. The open market operations are considered as the primary tool of the Fed because of their flexibility, ease in implementation and also more effectiveness. When the Fed purchases the securities through the open market operations, the expansionary monetary policy is said to occur. The payment of these Treasury securities is done with the reserves of the bank, and consequently it leads to increasing the total amount of reserves which the banking system holds. These extra reserves available to the bank are then offered at lower interest rates to the borrowers; this means that not only the supply of money is increased but also the checkable deposits are raised.
- Discount Rate: The rate of interest charged by the Federal Reserve System to the commercial banks for the reserve loan is known as the discount rate. Actually the Fed has been established for the purpose of providing reserve loan to those commercial banks that are on the brink of failing. The Fed sets the discount rate which is then approved by the Board of Governors. When the discount rate is lowered by the Fed, the expansionary monetary policy is said to have occurred. Borrowing reserves becomes easier for the commercial banks from the Fed; similar to the open market operations, the additional reserve held by the bank stimulates more loans at a decreased rate of interest which further results in increasing the supply of money and the checkable deposits. When the discount rate is increased, there is not much impact on the supply of money because the banks do not borrow reserves from the Fed more often.
- Reserve Requirements: The rules of the Fed through which the authority specifies the minimum amount of reserves to be kept in the banks as the backup of deposits are referred to as the reserve requirements. The normal range of the reserve requirements is 10 percent of the checkable deposits and 0 percent of the savings deposits. The major reason why these requirements are in place is to ensure stabilizing the system of the banks and to make sure that banks do not run short of the reserves. When the expansionary monetary policies are implemented, the reserve requirements are lowered by the Fed. In other words, the requirement of reserves to back up the deposits decreases and so the banks have extra reserve available to them. This extra reserve can then be lent to the borrowers at a decreased rate of interest which not only results in raising the supply of money but also increases the checkable deposits. The reserve requirement is a critical component of the banking system; all the long-term loans are committed based upn the expected requirements of reserve by the Fed. The Fed cannot alter the reserve requirements more frequently, because it would directly influence the stability of the banks and so, this tool of monetary policy is used seldom by the Fed.
Regardless of whether all these three tools are used together or separately, they raise the amount of money that is in circulation and lower the rates of interest. The combination of the reduction in rates of interest and the rise in supply of money consequently stimulates the economy; the additional expenditures induce the overall production because not only the consumption is increased but also the investment expenditures. When money is added to the economy and the interest rate is lowered, the credit restrictions are eased for the banks to apply for loans. This makes it easier for the businesses as well as consumers to borrow money and so the expenditure is raised (Gordon, 2012). Especially when the consumers have more money to spend, the businesses earn more profits and revenues; this gives them the strength to update their facilities and to hire more employees.
Particularly, in times of expansionary monetary policies, the rate of unemployment declines because it becomes easier for the companies to borrow money which they require for the expansion of their business operations (Duff, 2013). With more hiring, rate of employment raises and so does the gross domestic products; people tend to have additional money to spend which further results in the revenue increase for business and generates more jobs to accommodate more employees. In times of recession, the expansionary monetary policy is the required stimulation for the economy; even when the business-cycle is reaching a downturn, this policy is recommended.
The federal government makes use of several stabilization policies when addressing the problems of recession. One of them is the expansionary fiscal policy which stimulates the economy by increasing the government expenditure and decreasing the taxes; while the other is the expansionary monetary policy where the economy is stimulated through increasing the supply of money and decreasing the rates of interest. Both can be used as an alternative to each other or even in complement.
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