Monetary and Fiscal Policy Mechanics Explained
Economic Policy Fundamentals
Monetary Policy (MP)
Monetary Policy (MP): Refers to the decisions made by the central bank regarding the control of financial variables (mainly the money supply and interest rates), implemented by the European Central Bank (ECB).
Banking System
Banking System: Includes commercial banks, savings banks, and credit unions. They create the money supply by creating bank money through customer deposits.
Fiscal Policy (FP)
Fiscal Policy (FP): The economic authority of a country implements economic policies (FP) to influence the level of production. This is done by dampening periods of economic recession to prevent unemployment from rising too much. Generally, FP is applied to dampen the business cycle so that output does not fall significantly during recessions, and inflation does not rise excessively during expansions.
Limitations of Monetary Policy
1. Liquidity Trap
If economic agents only want to hold money (they do not want bonds given their low or zero returns), any increase in the money supply will translate into an equal increase in the demand for money. Changes in the money supply will not affect the bond market and will have no effect on the equilibrium interest rate. This situation is summarized as: Interest Rate Unaffected After Central Bank Action = Liquidity Trap.
2. MP Becomes Ineffective
When the interest rate is zero or very close to zero, the central bank cannot reduce the equilibrium interest rate by increasing the money supply. In this scenario, monetary policy becomes ineffective in influencing output.
Maintaining Equilibrium Interest Rate ($i_0$)
To maintain the initial interest rate ($i_0$): +FP (Fiscal Policy is required).
IS-LM Model
IS-LM: It represents the different combinations of interest rate ($i$) and output ($y$) for which the goods and financial markets are in equilibrium.
Transmission Mechanisms and Policy Choices
Mechanism of Transmission in the Banking System
The monetary policy transmission mechanism describes how the Central Bank influences the economy to achieve its inflation target, typically 2%. The process begins when the Central Bank adjusts the policy interest rate, which subsequently impacts market interest rates, asset prices, and expectations. These changes, along with fluctuations in the exchange rate, collectively determine domestic aggregate demand and net exports. Consequently, the resulting total aggregate demand interacts with import prices to create domestic inflationary pressures, which ultimately dictate the final level of inflation. In essence, the Central Bank manages short-term rates to steer demand and price expectations toward its long-term stability goal.
Government Spending vs. Transfer Payments
If the Government wants to increase output (Y): What is better than +FP?
- It is better to increase Transfer Payments (TR) because raising private consumption increases disposable income directly and immediately, whereas a decrease in taxes may be partially saved rather than spent.
Stimulating the Economy
- To Stimulate Economy: Increase Government Spending (G) OR Decrease Taxes (T).
- To Stimulate Economy Without Deteriorating Public Savings: Use a balanced-budget expansion: Increase G = Increase T, since public saving = T – G.
- Increase G vs. Increase TR to Increase Income: An increase in G is better because it directly increases Aggregate Demand (AD), while TR only increases consumption partially (depending on the marginal propensity to consume).
Interest Rate Changes During Recession
Why does the interest rate decrease during a recession? Because of an increase in Monetary Policy (+MP).
Crowding Out Effect
Crowding Out
This occurs when an increase in public spending is financed through the issuance of debt, offering more attractive interest rates. As the interest rate on interest-bearing assets increases, and since it is inversely related to induced investment, a crowding-out effect on investment occurs. Because the government spending multiplier is the same as the investment multiplier, the final effect on the income level (Y) will be zero, as public consumption substitutes for investment. Mathematically: $Y = DA = C + I + G$; $Y$ remains constant.