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Difference between monetary and fiscal policy essay

Describe the difference between monetary and fiscal policy in the UK and explain how such policies can be used to achieve different macroeconomic government objectives.

The main and most obvious difference between monetary and fiscal policy is that monetary policy is set by the central bank and fiscal policy is implemented by the government. In the case of the UK, monetary policy is decided upon by the Bank of England which since 1997 has been independent from the government. It would be worth considering the two types of economic policy in more detail now before turning to look at how they can be used to help meet macroeconomic government objectives.

Monetary policy is the attempt to control macroeconomic variables through the setting of interest rates. It is a rather blunt policy tool as its effects can be felt throughout the economy as a whole. By changing interest rates, the Bank of England is trying to influence the overall expenditure in the economy as well as controlling inflation. Reducing interest rates makes borrowing the more attractive alternative to saving which then leads to more spending in the economy. Lowering interest rates can also make assets such as property increase in value which also leads to more spending as homeowners extend mortgages and consume more. By cutting interest rates, it is hoped that this increased spending feeds through to output and then to employment. Increasing interest rates on the other hand, has the opposite effect by making saving more attractive than spending and therefore overall spending in the economy is reduced.

Fiscal policy is controlled by central government. It can be defined as, “a government’s program with respect to (1) the purchase of goods and services and spending on transfer payments, and (2) the amount and type of tax” (Samuelson and Nordhaus, 1998). It involved the government changing levels of taxation and spending in order to influence the level of aggregate demand (AD). The purpose of fiscal policy is to reduce inflation, stimulate economic growth and to stabilise this growth and avoid periods of ‘boom and bust’ which characterised the economy during the 1980s and early 1990s. If monetary policy is described as a blunt instrument then fiscal policy is a precision tool that can target particular sectors of the economy and population in order to achieve the desired economic changes.

Both these different types of policy are working towards achieving different macroeconomic objectives. It would be worth looking at these in greater detail now. There are four major macroeconomic objectives that any economic policy should be working to achieve. These are full employment; price stability; sustainable economic growth and; keeping the Balance of Payments in equilibrium. These four different objectives compete with each other and all achieve different levels of importance depending on the priorities of the government.

During the 1960s, the Balance of Payments took centre stage. This was before the global economy made operating with a deficit a viable and sustainable option. Nowadays most governments operate with a budget deficit and the balance of Payments is no longer seen as a top priority for the government. In 2007/2008 the UK government showed a deficit of £38.7 billion which is around 2.7% of gross domestic product (GDP). The general government debt is around £614.4 billion which is around 43.2% of GDP (ONS, 2008). In the 1960s such levels of debt would be unthinkable but now they are just part of a global reality. In order to implement social programs and fulfil spending promises, the government is forced to borrow from global institutions. This has become a global reality. These current times of economic uncertainty only increases the amount of borrowing by governments all over the world.

Full employment enjoyed similar prominence in the period after the war until the 1980s. Full employment meant that more people were contributing to the economy both in terms of output and through taxation. It also meant that the government had to spend less on social programs. This full employment was aided by a largely industrial economy which started to decline in the 1980s. Thatcher wanted to restructure the economy to make it more efficient and move it away from its industrial base. Full employment is still an important objective and it is one that is gaining prevalence again but during this current recession it isn’t a realistic prospect. The current rate of employment stands at 74.1% (ONS, 2009) which is a slight decrease on the previous year. However, as the recession deepens, it is expected that this number will fall even further.

Perhaps the most two important objectives for the government at present are sustained economic growth and price stability by keeping inflation low. The government is trying to foster sustainable growth in the economy which means growth without inflation. However, the past year has seen the UK economy slip in to a recession, making any sort of growth impossible. During this recession the level of inflation has fallen but this has not translated into economic growth. It was hoped that that low inflation would mean that spending would increase. However, the current economic climate has seen prices fall so much that consumers are now waiting to see if prices fall even further before spending (Monaghan, 2009).

This essay will now turn to look at how the use of monetary and fiscal policy can be used to achieve these macroeconomic objectives.

Perhaps one of the most significant changes that the current government introduced was giving the Bank of England independence when it comes to setting interest rates. Before the government was dictating both monetary policy and fiscal policy. The Monetary Policy Committee (MPC) is now tasked with maintaining price stability and also supporting the government in meeting its objectives for growth and employment (Budd, 1998). The government still sets the goals of monetary policy but it is up to the Bank of England to decide how best to achieve this through. The independence of the central bank is considered important for a number of reasons. Firstly, politicians are not experts when it comes to monetary policymaking. Secondly, central banks are more likely to have the interest of the country at heart rather than politicians who may be motivated by implementing populist policies for the sake of winning votes. Thirdly, politicians are unlikely to want to keep to monetary policies when they have adverse affects like high unemployment, although this wasn’t the case with Thatcher. The final argument for having an independent central bank is that countries that have them tend to have lower levels of inflation (Alensina and Gatti, 1995).

This essay will now look at how the MPC goes about meeting it’s objective of maintaining price stability. The present recession has forced the committee to consider radical solutions to the unique problems that the economy is facing. For the past year, the bank has cut interest rates on six consecutive occasions to the current record low of 0.5%. It was hoped that cutting interest rates to this level would stimulate spending in the economy and that this would translate to economic growth and would keep inflation at the. However, this has not happened because the banks have stopped lending the money usually required to facilitate the spending. This has forced the Bank of England to consider other options. One such measure introduced in the past month was quantitative easing.

This idea is the equivalent of printing up large amounts of money, in the case of the UK it is estimated to be about £75 billion, and throwing it out of a helicopter so that the people below could pick it up and spend it (Elliot, 2009). This is a rather simplistic view of what the Bank of England is trying to achieve. This £75 billion will be used to buy government bonds and corporate debt over the next three months. By exchanging these bonds for cash that the bank has printed, it is hoped that this will increase the flow of money in the economy. With more cash, banks should start lending once again to other banks, businesses, and customers. This will increase spending in the economy which will lead to economic growth. However, the success of this measure rests on whether customers still want to borrow. The popular conception amongst the public is that we are in this position because we borrowed way above our means. It remains to be seen if once credit is made available again by banks whether people will take it up again. If they don’t, then the banks will be awash with money that will be doing nothing and this will not lead to economic growth but rather to inflation. The Bank of England has to achieve a fine balance. It has to provide enough money to banks to encourage them to lend again at competitive rates but it also has to make sure that there isn’t a surplus of money that will send inflation out of control (Kollewe, 2009).

Beyond cutting interest rates and printing there is little more that monetary policy can offer to delivering macroeconomic objectives. This essay will now look at how fiscal policy delivers macroeconomic objectives.

Fiscal policy can be more fine tuned to target particular sectors of the economy and the population. It does not take the rather blanket approach taken by monetary policy. Perhaps the most effective fiscal policy to achieving macroeconomic objectives is through borrowing and taxation. For example, the government recently cut the lower starting rate of income tax. This encourages people on lower incomes to work more hours because they will be able to keep more of what they earn. This they can either spend or save, based on the level of inflation that is determined by monetary policy.

Another measure introduced last year by the government was the 2.5% reduction of the rate of VAT. This was introduced at the end of last year as a way of boosting spending, especially in the run up to the busy Christmas period. However, this has not had the desired effect on household spending which is at it’s lowest level since 1991 (ONS, 2009).

It could be argued that fiscal policy is not as much use as monetary policy to meeting macroeconomic objectives at the present time. The government is trying to stimulate spending in the economy by borrowing more money in order to fund tax cuts and increased spending in social programs. However, the effect of this may be that people are realising that they may face a higher tax burden in the future because of this increased spending and so are saving more in anticipation of this.

The government is presently pumping money into sectors of the economy that provide large numbers of jobs. For example, it has just stated that it is prepared to make up to £2.3 billion available to car manufacturers. The Business Minister, Ian Pearson, stated that this level of investment was necessary to, “ensuring the industry comes out of the current downturn with the skills and technology needed to be competitive in the global automotive market”. However, the success of this initiative again rests with the consumer. Will they want to borrow to finance things such as cars in the future? The car industry may be facing a downturn that will not recover after the recession.

Because the economy is at present shrinking it means that the government is not getting as much income from tax revenues because less people are in work and those working aren’t getting as much. Welfare spending has had to increase to make sure that the standard of living does not fall in the UK. Those who have lost their jobs as a result of the recession have to be provided for by the state. All of this contributes to a much larger deficit which doesn’t fit in with meeting macroeconomic objectives.

With the global economic situation seemingly changing on an almost daily basis, it is hard to judge just how effective monetary and fiscal policies are in meeting macroeconomic objectives. It is also hard to judge which is the most effective way of delivering these objectives. This essay would argue that both policies are fairly weak at the moment. In order for monetary policy to work, it requires people to have the confidence to spend knowing that money is always going to be available to them. This could be just a person buying goods in the high street or a business buying services from another business. It would seem that UK consumers are willing to hold on to large quantities of money, even though the central bank has lowered interest rates to such an extent that it makes saving a very unattractive option. Consumer confidence is low, and when it is low people tend to hold on to their money rather than borrowing more. It remains to see just how effective this quantitative easing will be.

In many ways it seems that fiscal policy is working against monetary policy at present in achieving macroeconomic objectives. While on the surface it seems logical for the government to be borrowing big in order to fund tax cuts and create jobs, many people see this borrowing as storing up problems for the future because all this borrowed money will have to be repaid at some point. This means that people are saving more instead of spending which the government wants us to do to meet the objective of growth in the economy.

In a growing, sustainable economy, both monetary and fiscal policy should serve to benefit each other and they should work for each other in achieving macroeconomic objectives. In a receding economy such as is being witnessed in the UK, there needs to be a delicate balance struck between the two. It would seem that this balance has yet to be achieved and at present they are fighting against each other.

Bibliography and References:

  • Alensina, A. and Gatti, R. (1995). How independent should central banks be?, The American Economic Review, 85(2), 196-200.
  • Budd, A. (1998). The Role and Operations of the Bank of England Monetary Policy Committee, The Economic Journal, 108(451), 1783-1794.
  • Dunkley, J. (2009). UK given approval for £2.3bn auto bail-out, The Telegraph, 28 Feb.
  • Elliot, L. (2009). Quantitative Easing, The Guardian, 8 January.
  • Monaghan, A. (2009). UK inflation falls to lowest in lowest in almost 50 years, The Telegraph, 17 Feb.
  • Kollewe, J. (2009). Bank of England cuts rates to 0.5% and starts quantitative easing, The Guardian, 5 March.
  • Moore, E. and Warwick-Ching, L. (2009). Rate cut brings more misery to savers, The Financial Times, 5 March.
  • Office for National Statistics (ONS) (2008). UK Government Debt and Deficit [online] Available from: http://www.statistics.gov.uk/cci/nugget.asp?ID=277 [Date accessed: 10 March 2009]
  • Office for National Statistics (ONS) (2009). Employment [online] Available from: http://www.statistics.gov.uk/cci/nugget.asp?ID=12 [Date accessed: 10 March 2009]

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