Monetary Policy and Integration with Fiscal Policy Subject

Monetary Policy and Integration with Fiscal Policy

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Tableof Contents

Abstract 2

Introduction 3

Monetary Policy 4

Goals 4

Advantages of the monetary policy 5

Disadvantages or Challenges of the policy 5

Tools of monetary policy 6

The Fiscal policy 7

Implementation of Fiscal Policy 7

The New Consensus Macroeconomic Model, NCM 8

NCM model’s equation 8

Explanations 9

Importance of Fiscal Policy 10

Need to integrate Fiscal Policy 12

Conclusion 14

References 15

Abstract

Monetarypolicy has turned into strong use of interest rate as the essentialpolicy tool. The approach taken by the policy is closely related withthe new consensus in macroeconomics (NCM). This term paper undertakesimportant appraisal of the function of monetary policy particularlyin the context of the NCM. When the key features of the model arehighlighted, it is important to critically discuss the role ofmonetary policy and the model’s framework. The discussion explainsthe nature of the loss function, the role of the rate of interest andalso the Phillips` curve. A critical evaluation of the IS curve inthe model and the classical differences follows. The paper ends up byfinding out if interest rates have effects stated for them (Arestis,and Sawyer, 2008, p. 761-779). Fiscal and monetary policies do havevarying goals, and conflicting situations may raise practicaleconomic and political process of making a decision. Each policyoffers a different perspective when making a decision. The paper willexplain whether monetary and fiscal policies should be integrated ornot. It will highlight reasons if they are integrated and theassociated importance. Moreover, it will give the current milestoneof the integrated economy especially the ones analyzed.

Introduction

Incurrentyears,researchers in institutionshavecomeup with predictionandsimulation modelswith micro foundationsto investigatemonetarypolicy.Two modelshavebeenusedto explainthecurrentfinancialbusinesscycles,andthesemodelsare theGlobal Economy Model (GEM)developedby IMF andSIGMA fortheFederal Reserve Board. Somecountrieshavebeenapplyingsuchstandardsin its policymaking. Forexample,theCzech Republic usedtheGEMto evaluateTaylor rulesandinflation(Laxton &ampPesenti, 2003). Theywereableto assessthevariability of outputandlevel andeffectsinflationon themonetarypolicy.

Theconductof monetarypolicyin theeconomicenvironmenthas changedconsiderably over thepastyear.Theobjectiveis, to summarize,themonetarypolicyeffectiveness andchallengesof implementation. An integratedassessmentof monetaryandfiscalpoliciesis deemedappropriateto evaluatethepolicystandandmix. Theevaluation of bothmonetaryandfiscalpoliciesneedsmodelswith micro-foundations (Fontana, 2014). However,thefiscalpolicymaintainsits insignificantandrealrigidities of existingmodels.Thepaperattemptsto providea recap of therecentchangesof recognizedmodelsin macroeconomics, preciselytheNCM model.Itwill alsohighlight themonetarypolicy,strengths,andadvantages.Moreover,itexplainsthepossibilityof integrationof fiscalpolicyandits explicitroleto thegovernment.

MonetaryPolicy

Itis a macroeconomic toolusedby thecentralbanksandotherregulatorycommitteesto determinethegrowthrate,sizemoneysupplyandtheeffectson interestrates.Itis usedto attainwidermarketobjectivessuchas inflation,growthandliquidity andinflation.Thepolicycan eitherbe expansionary orcontractionary, whereexpansionary increasesthemoneysupplyin theeconomyduring thelaterincreaseamountof moneyveryslowlyorshrinksthesupply(Eijffinger, &amp Haan, J2000).

Goals

Toenhancethestabilityof priceorlowinflation:forexamplein US, theobjectiveis to ensureinflationrateis below 3% that would thenensureeconomicgrowth.Tolowerunemployment,thepolicykeepsunemploymentat thenaturalrateof 4%, which stoodat 5.7% in 2003. Another goal is committedto improvingeconomicgrowthby increasingrealGDP by 3%: in 2003, theratewas4%, alsotoensurefinancialmarketstability.Thetoolwill ensurethatfinancialmarketsare not toohighortoolowsoas to attractinvestors.

Advantages of the monetary policy

Speedandflexibility,monetarypolicyis veryflexiblesince theFederal Open Market Committee oftenmeetseverysix weeks.Theythusmakedecisionsimplementdecisionaccordingly.Cannot be affectedby politicalpressure,Central banksshould operatein a freeof politicalpressures.Ithas to makepolicydecisionson economicconditionsusingdata availableon economicperformance.Ascomparedto relying on politicalconsiderationsthat are short-term andsubjectto officialsin powerorpoliticalparties(Hix, &amp Høyland, 1999).

TheU.S. Federal Reserve operateswith a relativelysmalllevel of politicaldependencedespite beingaccountableto Congress. Ifcentralbankslackindependence,monetarypolicywill be subjectto politicalpressures.Harvard economistGreg Mankiw indicatedthat,` Centralbanksthat lackpoliticalindependencemay manipulatemonetarypolicyin a mannerfavorableto thepoliticalpartyin power’.Thepolicyis highlyimpersonalmonetarypolicyslightlyinterfereswith themarketfreedom.Atightmonetarypolicyreducestherateof totalspending increasebutcannot dictateexpenditures(Tcherneva, 2010).

Disadvantages or Challenges of the policy

Thetimelag,monetarypolicycan be inconsistentwith time,thisarisesfrom thebenefitsthat fiscalbodiescould havegotfrom theunpredicted risein priceifthepublicdebtrapidlygrows.Itleadsto a reductionin thecredibilityof monetarypolicy.Monetarypolicyoftentakestimesto be implementedandachievedin theeconomy,especiallyin a largeeconomy.Fiscalpolicycan stimulatethesupplyof moneyinto theeconomythrough increasedspending forgovernmentprogramsandpublicproject(Setterfield, 2007).Changesin velocityandcyclical asymmetry, thevelocityof moneyoftenchangesandkeepsitdifficultto monitorandforanalysis.Differentcyclesof theeconomymakeitdifficultto keeptrackthemoneysupply.Itonlytargets inflation,thepolicyaimsonlyon theinflationlevel andkeepingitalwaysdepressed.Monitoringthepricesystemis not an appropriatemethodto measureeconomyadequately(Tcherneva, 2009).

Formulationof monetarypolicyis alwaysa verydifficulttask.Avibranteconomythat has to be monitoredshould havewelldesignedmonetaryandfiscalpoliciesthat articulateandmergeeachotherwellwithout causingfrictions.Itachievedthrough prudentformulation andimplementation of effectivepolicytools.Itis a time-consuming anddifficulttaskthat requiresexpertsandeconomistssoas to achieveperfectstability(Setterfield, 2007). Monetarypolicyhas conflictinggoals.Thepolicyis usedto producelowinflationin thelongrun,andshort-term affecteconomicoutputandemployment.Reductionof interestratessoas to expandmoneysupplyandcurbrisingunemploymentratesmay leadto inflationin futureiftheexpansionary policyremainsin force.Thebestpolicyought to balancebetween short-andlong-term goalsin theeconomy.

Tools of monetary policy

Thetoolscommonlyusedare open-market operations,reserveratio,anddiscountrate.Openmarketoperations(OMO) involvetradinggovernmentsecuritieson secondarymarketsby theFederal Reserve Bank. Theaimis to manipulatetheinterestrateandthesupplyof basemoneyin orderto controlthesupplyof moneyin theeconomy.Reserveratiotool:banksraisethereserveratioby ensuringthatbanksholdmorereserves,decreaselending.Ultimately,thereductionofthe moneysupplywill beachieved.On theotherhand,thereservecan be loweredby ensuringthatmajoreconomyplayerssuchas banksholdfewerreservesandincreasetheamountof lending thusincreasingthemoneysupply(Rossi, 2012). Theuseof discountrate,itcan eithermakeeaseaccesseasyordifficultto themoneyin theeconomy.Easeaccessto moneyensuresby buyingsecurities,decreasingreserves.

TheFiscal policy

Thisisthemanagementof governmentrevenueandexpenditurein orderto influencethestate’seconomy.Thepolicyfocuseson theeffectof changesin thebudgeton theeconomy.Theplaninvolvesactivitiessuchas thepurchaseof governmentgoodsandservices,distributionof transferpaymentsandthecollectionof taxes(Bayoumi, &amp Masson, 1995). Thesignificanteconomicimpactof governmentbudgetchangesis feltby particulargroups,forexample,thetaxcutforfamilieswith childrenthat raisedisposable income.Changesin taxesorspending that donot affectrevenueinterpretedtooas fiscalpolicy.At times,itaffectstheaggregate activitylevel of outputby varyingtheincentives.Often,thefiscalpolicydescribestheeffectof spendinglevel andtaxationon theaggregateeconomy,anditalsolooksinto preexisting gapsbetween thesevariables (Eijffinger, &amp Haan, 2000).

Implementation of Fiscal Policy

TheFiscal policycan be eithertightorcontractionary. Surplus budgetoccurredwhentherevenueearnedhigherthan expenditurewhilein expansionary policywheregovernmentspending is greaterthan revenue,leadingto a deficitbudget.Forexample,a reductionin thedeficitfrom $400 billion to $150 billion is understoodto be contractionary fiscalpolicythoughthebudgetis in deficit.Economistsare interestedin thechange.

The NewConsensus Macroeconomic Model, NCM

TheNCM modelis thelatestandpossiblythemostappropriatemodelversionas comparedto otheroldestmacroeconomic models.Ithas mostlytakentheplaceof thestructuralmodelsin academia andpolicymaking, especiallythegovernment.Captivatingly, themodelpossessesessentialfeaturesof earlymacro economymodels(Hein, andStockhammer, 2007). Themodelis from a jointeffortof academicgiantsandpolicymakers itwasdevelopedexplicitly on a sharedtheoreticalframework.In fact,itis alsoreferredto as thenewneoclassical synthesismodel.Itsignifiestheoutcomeof successfullysharedeffortsin academics as wellas in policymaking.Thehelpof theauthenticbusinesscyclemethodology andtheNew Keynesian perspectiveto macroeconomics.

NCM model’s equation

(y-y)t= ao+ a1(y-y)t-1+a2E(y-y)t+1+a3Et(it– Et(t+1)+ s 1…………..1

t=b tt-1+b2Et(t+1)+ b2(y-y)t+s2 ………..…2

It=r* + c1T)+ c2(y-y) ……….…..3

Where:

03&lta and a orepresentsa constant that indicates the impact of fiscal variables on theoutput (y-y).

b1+b2=1, and b3&gt0 c1&gt1,andc2&gt 0 Etisexpectations operator that is the interest rate controlled by thefederal bank.

πstands for the rate of inflation prevailing.

πTrepresentsthe targeted inflation rate.

r*is the real interest at the equilibrium.

s1ands2showstochastic shocks.

Explanations

Equation1

Explainsan IS curvethat has thepresentoutputgapobtainedusingthepastandprojectedfutureproductiondeficitsandrealinterestrate.Itrecountstherealinterestrate,thelevels of outputandemployment.Thoughitslightlydifferswith thetraditionalIS curvewith thefollowingreasons.First,itis derivedfrom intertemporal utilization of a utilityfunctionthat reflectsoptimal expendituresmoothing. Itexplainsthefactthatan IS curvehas firmmicroeconomic foundations.Secondly,theNCM-IS curvehas laggedandadvanceelements.Thecurveis a forward-looking IS curve.Thirdly, thecurveinter-relates therealinterestrateto thegapof theoutputgapthatis thedifferencebetween currentandpotentialoutputlevels.

Equation2

ThePhillips curvecan determinetheinflationby theexistingoutputgap,thepast,andanticipatedfutureinflationrates.Itis usedto measurethedegreeof obligationandcredibilityof thefederalorcentralbankto thelong-term objectiveof pricestabilityindirectly.Itis consistentwith equationone thoughdifferentfrom theconventionalcurvePhillips curveof 1960s neoclassical synthesis.Currently, therateof inflationis obtainedby therecentoutputgapratherthan theproductionlevels (Arestis,&amp Sawyer, 2008).Equation3

Ontheotherhand,thethirdequationis themonetarypolicyrulethat is thestandardTaylor rule.Itexplainsthenominalinterestrateusingthecurrentoutputgap,thevariationof currentinflationfrom theoriginaltarget,andthebalancedrealinterestrate.Someof themodelsmay presentrathercomplicatedmonetarypolicyrules.Forexample,theadditionof thevariables to thestandardTaylor rules,suchas thelaggedinterestrate.Thevariables may indicatean interestrate“smoothing” procedurestrategyof thecentralbank(Arestis andMihailov 2009).

Theequationrepresentsthemajorinventionsof modernrecognizedmodelsof theeconomy.ItsubstitutestheoldLM curve,the1960s neoclassical synthesisthat implicatedmonetaryaggregaterathershort-term interestrateas thekeycontrolvariable usedby thecentralbank.Itimpliesthatthemodel’squantityof outstandingmoneyof themoneysupplyprocess(Fontana 2009). Moreover,theequationindicatesthatthemonetarypolicyhas a systematicresponseto inflationlevels andchangesas wellas theoutputperformanceof theeconomy.

Importanceof Fiscal Policy

Fiscalpolicychangesthecomponentsof theaggregate demand.Whenthegovernmentrunsa deficit,itought to issuebondssoas to meetits expenses.Suchinitiativesleadto competitionwith privateborrowers forthemoney.Ceteris paribus, a fiscalexpansioncan raiseinterestratesandalso“crowdout” otherprivateinvestmentsandultimatelyreducingtheportionof outputconstitutingtheprivateinvestment(Sims,2004).

Fiscalpolicyaffectstheforeignexchangerateandthetradeequilibriumorbalancein an openeconomy.Theypoolresourcesanddollarsto investandbidup thedollarprice,causingan appreciationof exchangeratein theshortrun.Thisappreciationleadsto cheapimportedgoodsin theUnited States whileexports becomemoreexpensiveleadingto a reductionof tradebalanceof merchandise.Itleadsto a declinein themerchandisetradebalance(Hsu, 2012).However,theaccumulationof externaldebt,in thelongrun,resultsfrom importunategovernmentdeficitsthat can leadto thedistractionof U.S. assets andcausingdepreciationin theexchangerate(Sims,1994).

Fiscalpolicyis an imperativetoolformanagingeconomydue to its capabilityto affecttheproducedamountof output.Theimmediateimpactof theexpansionpolicyis to increasethedemandforgoodsandservices.Higherdemandwould leadto an increasein bothoutputandprices.Thedegreeto which greaterdemandincreasesoutputandpricesrelies on thebusinesscycle.Ascomparedto a fullyemployedeconomy,a fiscalexpansionhas a greatereffecton pricesandlesseffecton totaloutput(Fontana, 2014).

Theabilityof fiscalpolicyto changeoutputlevels by affectingaggregate demandmakesita prospectivetoolforeconomicstabilization. In a recession,an expansionary fiscalpolicycan be affectedto helprestoreoutputto theaveragelevel andalsolowerunemploymentrate.In timesof boomeconomywheninflationis deemedto be a greaterproblemas comparedto unemployment,thegovernmentcan usea budgetsurplusthat will helpin reducingtrending economy(Favero, 2004).In thelongrun,a countercyclical policythat leadsto a balancedbudgetis established.

Needto integrateFiscal Policy

Theobjectiveof Macroeconomic policyis to attainsustainable economicgrowthanddevelopmentthrough pricestabilityandexternalaccounts.Effectivecoordination among decisionmakerswhointegratemonetaryandthefiscalpoliciesleadsto financialstabilitythat may leadto lowerinterestrates,idealexchangerates,controlled inflationandthefavorableimpacton theeconomicgrowth(Baldwin,Wyplosz, &amp Wyplosz, 2006).Policiescan be designedandimplementedby differentauthorities,integrationis deemednecessaryin orderto attainthestatedpolicyobjectivesin a decentway.Italsoensuresthecommitmentof thosemakingdecisionsto agreemutuallyon desiredgoalsthatin returnwill eliminatetimeinconsistenciesin themonetarypolicydesign.

Lackof integrationorcoordination between thetwo policiesandtherelevantauthorities’leadsto pooreconomicperformance.Weakpolicystanceburdensotherareasof theeconomywhich would, in thelongrun,be unsustainable. Forexample,a lenientfiscalpolicyputspressureto stiffenmonetarypolicy(Eijffinger,&amp Haan, 2000).An efficientintegrationtakesinto accounttheneedforpolicysustainability. Itis necessaryforeffectivecoordination of policiessothateachbe on an appropriateandsustainable course.Fiscalstancecan be difficultto be changed,andto contrastwith themonetarypolicythat can be adjustedto altermonetaryconditions(Davanzati, Pacella and Realfonzo, 2009).Policyintegrationought to bedoneat two differentlevels, to addressshort-term constraintsandthelong-term macroeconomic effectsas a resultof theunbalancedpolicymix. Thefiscaldeficitis limitedonlyto financecapitalmarketoperationswithout distractingallocation of resources,without centralbankfinancingandrelying on externalborrowing(Calmfors and Wren-Lewis, 2011).

Integrationof fiscalpolicywould leadto theformulation of objectivesandpoliciesforefficientmanagementof economicgrowth.Forexample,restrictivemonetarypolicyoffsets laxfiscalpolicyandmay crowdout privateinvestmentthatin turnraisesgovernmentborrowingcosts(InternationalMonetary Fund, 1998).In orderto reformthestructureandliberalizethefinancialsector,integrationof thepolicieswherethefiscalpolicywould providestability,fiscaldisciplineanduseof taxsystemsthat doesnot discriminatefinancialactivity.Ifthere is persistentof highfiscaldeficitswhentheauthoritiesare workingon financialsectorreforms,there might high chancesof high-interest rates,orifinterestskepttoolow,inflationmight crop in (Calmfors and Wren-Lewis, 2011). Thusindicatingthereformmay be unsuccessful.Thus,effectivecoordination of policiesis requiredto affectsuccessfullyfinancialreforms.

Effectsof Fiscal Policy integration

Thekeyreasonfortheinteractionof thepoliciesrelatesto financingof thedeficitsandthemonetarymanagement.Themonetarypolicystanceaffectsthecapacityto financebudgetdeficitsby alteringthecostof debtandeitherlimiting orincreasingtheavailablesourcesof finances.Also,thegovernment’sfinancialneedsandthefunding strategywill hinderthemonetarypolicyoperationandindependence(InternationalMonetary Fund, 2008).Thefiscalpolicyintegrationwith monetarypolicywould leadtothe growthof financialmarkets.Itopensup betteropportunitiesfordevelopedmonetaryandpublicdebtpolicyimplementation. Italsocoordinatesthepolicygoalsin achievingthem andas wellreducesthe costofan economyandpromotesthe growthof thedomesticfinancialmarket.Increaseof headlineinflationas seenin VAT,as waswitnessedin Germany in 2007 (Carare &amp Danninger, 2007). This may lead toinflation if other policies are not put in place curb the level oninflation. Theincreaseinthe taxesrateon wageswould leadto lowincomewherethehouseholdswill formsformtradeunionsadvocatingforthe wageincrease.Also, itdoesnot capturethe impactof taxcutsas wellas theaggregatepropensityto consume.

Conclusion

Thekeyobjectiveof integrationandcoordination of thepolicyis to attainsustainable growththrough pricestabilityandviable externalaccounts.Itis essentialforthegoverningauthoritiesto integratethetwo policiesforefficientmanagementof economytowards achievingsustainable growth.Effectiveintegrationensuresthatthecountryrealizesstatedobjectivesefficiently(Dixit,&amp Lambertini, 2001).Integrationisbestachievedifthecountryaspiresforaviableandcrediblepolicy.Adjustmentswhich operatein timesframesshould alsobetakeninto account.Thefiscalstanceswhich may be prolongedforitto be effectiveandthemonetarypolicythat can be rapidlyimplementedshould beadjustedin ordermeetbothpolicyandstandardsshould be adequately paired.

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