Question

6. What are the strengths of monetary policy? What are the weaknesses? What are the strengths of fiscal policy? What are the weaknesses?

Answer 1

When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two primary courses of action: monetary policy or fiscal policy.

The aims of fiscal and monetary policy are similar. They could both be used to:

• Maintain positive economic growth (close to long-run trend rate of 2.5%)
• Aim for full employment
• Keep inflation low (inflation target of 2%)

The principal aim of fiscal and monetary policy is to reduce cyclical fluctuations in the economic cycle. In recent years, governments have often relied on monetary policy to target low inflation. However, in recessions, there are strong arguments for also using fiscal policy to achieve economic recovery.

• Fiscal policy involves changing government spending and taxation. It involves a shift in the governments budget position. e.g. Expansionary fiscal policy involves tax cuts, higher government spending and a bigger budget deficit. Government spending is a component of AD.
• Monetary policy involves influencing the demand and supply of money, primarily through the use of interest rates.
  • Monetary policy can also involve unorthodox policies such as open market operations and quantitative easing.
  • Monetary policy is usually carried out by an independent Central Bank

Overview of monetary and fiscal policy

	Monetary Poicy	Fiscal Policy
Tool	Interest rates	Tax and government spending
Effect	Cost of borrowing/mortgages	Budget deficit
Distribution	Higher interest rates hit homeowners but benefit savers	Depends which taxes you raise
Exchange rate	Higher interest rate cause appreciation	No effect on exchange rate
Supply side	Limited impact	Higher taxes may affect incentives to work
Politics	Monetary policy set by independent central bank	Changing tax and government spending higly poitical.
Liquidity trap	Cuts in interest rates may not wrk in liquidity trap	Fiscal policy advised in very deep recessions

Monetary Policy strengths and weakness

Strengths	Weakness
1.It is a way to effectively control inflation in the economy.	1.It comes with the risk of hyperinflation.
2.It is a policy that is fairly easy to implement.	2.It takes time for the changes in monetary policy to occur
3. It provides multiple tools to use so that the goals of monetary policy are achievable	3.It can boost the import levels for the national economy
4.It comes from a position of political neutrality.	4.It cannot guarantee economic growth.
5.It offers a way to promote transparency in the economic system.	5. It typically works on a national level, but not at a global level
6.It offers financial independence from government policies	6.It can discourage expansion opportunities for businesses.

Fiscal Policy strengths and weakness

Strengths	Weakness
1.Can Direct Spending To Specific Purposes	1.May Be Politically Motivated
2.Can Use Taxation to Discourage Negative Externalities	2.Tax Incentives May Be Spent on Imports
3.Short Time Lag	3.Can Create Budget Deficits
4.Unemployment Reduction	4.Conflict of Objectives
5.Economic Growth Increase	5.Adverse Effect on Redistribution of Income