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Fiscal and Monetary Policy - Essay Example

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Fiscal and Monetary Policy

This paper is aimed at investigating and defining the best way through which Britain should tackle the present financial crisis. To achieve this objective, the IS/LM model will be employed to see how various policy measures affect the interest rate, national income and inflation rates.
Fiscal policy refers to a situation whereby the government restores equilibrium in the economy by making changes to taxes or government expenditure on public goods and services (Smullen & Hand 2005). When there is under-utilisation of capacity, the government can increase capacity utilisation by reducing taxes (that is through a reduction in tax rates or tax base) or by increasing spending on public goods and services as well as subsidising the production of certain goods and services (Smullen & Hand 2005; Visser 2004:43). Fiscal policy aimed at increasing money supply is referred to as easy fiscal policy (Smullen & Hand 2005). On the other hand, when there is over-utilisation of capacity, the government either increases taxes (through and increase in tax rates or tax bases) or reduces spending on public goods and services (Black 2002). It also reduces subsidies and transfer payments. This type of fiscal policy is referred to as tight fiscal policy (Black 2002). ...
Fiscal dominance occurs when government can determine the stock of debt, and the path of total expenditures and taxation (Frantiani & Spinelli 2001: 255). Under these conditions, the government can influence the inflation rate, the future flow of monetary base by raising the permanent level of expenditures without at the same time raising taxes. Fiscal dominance is therefore a scenario whereby monetary policy is driven by fiscal policy

1.3 Monetary Policy
Monetary policy is the means by which the Central Bank regulates the economy through changes in the supply of money. This can be done by either printing more money or withdrawing money from the economy through the sale of bonds or through the altering of short-term interest rates.

There are two types of monetary policies including easy and tight monetary policy. Tight monetary policy is geared towards reducing the amount of money in supply while expansionary monetary policy leads to an increase in the supply of money. Inna (2006) notes that easy monetary policy leads to a fall in the real interest rate thus lowering the cost of capital causing an increase in investment spending, which increases aggregate demand, and, ultimately, output. According to Leviathan (2003:1), Monetary dominance refers to a situation whereby fiscal policy is influenced by monetary policy. Liviatan states, that: "the benchmark definition of monetary dominance is that the fiscal policy has to accommodate any monetary policy". This implies that fiscal policy must ensure that the liquidity of the government is maintained for any monetary policy. Bernanke and Gertler (1995) suggest that, at least in the short-run, monetary policy can significantly influence the cause of the real economy. For example, ...Show more

Summary

The goals of monetary policy are a low rate of inflation ("price stability") and a small gap between actual real GDP and potential real GDP (Farinha & Marques 2001). Inflation can be maintained at low levels by limiting the amount of money in circulation, that is, by sufficiently limiting the growth in the broad monetary aggregate over a long enough period…
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Fiscal and Monetary Policy essay example
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