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Impact on the economy of loosening fiscal policy

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“The impact on the economy of a loosening in Fiscal/Monetary policy depends more on the exchange rate regime than the slope of the IS/LM curves” Discuss

Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability". This is usually in the form of low unemployment, low inflation, economic growth, and a balance of external payment. Whereas Fiscal policy is a contrast to Monetary policy and other types of economic policies in the sense that it is a Government policy for dealing with their budget, which then determines how much it will spend on various goods and services. The amount of the budget is influence by tax returns and revenues as well as different areas of income for the Government such as Bonds and Loans to Banks. There are three main techniques used by the Government in balancing the economy. Firstly Neutral Fiscal Policy, this is when the Government is spending the same amount as it is receiving from the tax revenues collected, this them being in balance. Secondly there is the contradictorily fiscal policy; this is when the Government reduced their spending power whilst raising their taxes. Lastly there is expansionary fiscal policy, this is where the Government is spending more and decreasing the people’s taxes. The main difference between the policies mentioned is that monetary policy is largely concerned with the supply of money, launch of new interest rates, profitisation on “new” money and other factors that influence the nation’s currency. These two policies are often linked to one another however we have to reinstate that they are two different entities which are created by various individuals and agencies.

Exchange rate regimes are the way a country manages its currency in respect to other foreign currencies and the foreign market. The existence of the Exchange rate regime is in place to make sure that different currencies are in the same context of other major currencies used in the work. This type of regimes is used by the Government to ensure that is variety is taking place, however we must acknowledge the importance of the foreign exchange market. There are different types of exchange rate regimes. Firstly there is the floating exchange rate; this is when the values of different countries currencies are influenced by the shifts and fluctuations in the financial market. Secondly we have the pegged float exchange rate which is where the different exchange rates are fixed and consistent irrespective of the financial markets fluctuations. In their attempt to get more money to invest, foreigners tender up the price of the specified currency, causing an exchange-rate positive reception in the short run. In the long run, however, the increase of external debt that results from determined government deficits can lead foreigners to have doubts about the specified country’s or Governments assets and can cause a down-fall of the exchange rate.

Loosening the fiscal stance means the government borrows money to infuse funds into the economy so as to increase the level of aggregate demand and economic activity. In an open economy, the exchange rates and other factors such as trade balance are affected by the fiscal policy. In the case of a fiscal expansion which we are currently dealing with in this essay, the rise in interest rates which is a result of government borrowing attracts foreign investment. Loosening monetary policy is caused by an increase in money supply that shifts the LM curve to the right, thus shifting the economy from A to B with lower interest rates in the UK relative to world interest rated. Lower interest rates means a fall in the foreign exchange rate market as their is a fall in the demand for currency and an increase in the supply of pounds as UK residents now want to buy foreign financial instruments. There is therefore an excess supply of money and the Bank of England enters the foreign market and buys the excess Pounds ( i.e. selling the foreign exchange), consequently the money supply in the UK galls and the LM curve shifts back to the original position.

The ISLM model thus contains a “real” and a “monetary” side, consequently letting the economist to scrutinize the impact of fiscal and monetary policy correspondingly. However, the model cannot be used to analyse inflation; in the ISLM model, the general price level is set. Loosening in fiscal policy is caused by an increase in government spending and it causes the IS curve to shift to the right. With a fixed exchange rate a country cannot run an independent monetary policy as any change in the monetary policy is fully offset by flows of funds in the foreign exchange market. with a flexible exchange rate Shift in the IS curve to the right is because as the interest rate is higher than world interest rate, the IS returns back because the higher interest rate means that there is an increase in the supply of currency in place as well as the demand resulting in a high exchange rate thus shifting the IS to the left. Also an increase in the monetary supply shifts the LM curve to the right and the economy from point of equilibrium is raised with a lower interest rate means the exchange rates decrease in value. This has more of an effect because it causes a change in the trade balance and is influential too as it also improves the trade balance. It reinforces itself in that even after the initial loosening of the Monetary policy the depreciation in Exchange rates shifts the IS curve to the right thus reinforcing the loosening.

Fiscal policy is an important tool for managing the economy because of its ability to affect the total amount of output produced such as gross domestic product. An impact of a fiscal expansion is to increase the demand for goods and services. This greater demand leads to increases in both output and prices. The amount to which more demand increases output and prices depends, in turn, on the state of the business cycle. If the economy is in recession, with unemployed productive capability and unemployed workers, then increases in demand will lead mostly to more output without changing the price level. If the economy is at full employment, by contrast, a fiscal expansion will have more effect on prices and less impact on total output. This ability of fiscal policy to affect output by distressing aggregate demand makes it a probable tool for economic stabilization. In a recession, the government can run an expansionary fiscal policy, thus helping to restore output to its normal level and to put jobless workers back to work. During a boom, when inflation is believed to be a greater problem than unemployment. The government can run a budget surplus, helping to slow down the economy. Such a countercyclical policy would lead to a budget that was impartial on average.

Thus with the evidence supplied throughout this essay we can conclude that to a large extent the impact on the economy of a loosening in fiscal/monetary policy depends more on the slope of the IS/LM curves, however it has it’s limitation, in the sense that the “real world” outcomes are unpredictable and fluctuant to other vitiating factors in their respective environments.


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