Fiscal Policy and Monetary Policy

Fiscal Policy and Monetary Policy

The failure to manage the business cycle would hamper economic development due to uncontrolled fluctuations in inflation and business activities. For example, the lack of appropriate mechanisms to control the money circulation during an economic boom would lead to hyperinflation. The government controls the business cycle through various fiscal and monetary policies that influence desirable short-term and long-term economic reforms.

The policies help to control expenditures, taxes, inflation, money supply and other factors that can destabilize various economic sectors. The executive branch of the government controls the business cycle through the fiscal policy. A fiscal policy focuses on altering taxes and expenditures. These control mechanisms influence the inflation, employment and money supply in an economic system (Bade & Parkin, 2015).

For example, the government increases taxes during an economic boom as a measure to control inflation. On the other hand, the government reduces taxes to stimulate public spending during a recession. Taxes and expenditures are the main components of a fiscal policy. Taxes determine how much money an individual can spend.

Therefore, the government increases or reduces taxes to control public spending. The increase in taxes and reduced public spending reduces the amount of money in the hands of consumers. On the other hand, a reduction in taxes and increase in public spending stimulates the economy by putting more money in the hands of consumers.

The fiscal policy has two main limitations. First, the fiscal policy and monetary policy are dependent on each other. The complementing or substituting effects of the two policies depend on the level of independence of the policymaking process.

Therefore, the success of the expansionary goals of the fiscal authority depends on the expansionary goals of the monetary authority. The second limitation concerns the significant political differences surrounding the fiscal policymaking (Dwivedi, 2010). A monetary policy works by controlling credit and interest rates.

The high interest rates help to reduce the money supply during a period of inflation. On the other hand, reduced interest rates help to increase money supply during a recession.

The Federal Reserve is responsible for setting and implementing the monetary policy.            

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