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Fiscal policy and Monetary Policy


Fiscalpolicy and Monetary Policy

Fiscalpolicy and Monetary Policy

Theshrinking of the US economy in the last quarter of 2012 might meanthat the economy could be headed for a recession even though it istoo early to predict. The figures from the Bureau of Statisticindicate some signs of an impending recession. A recession bydefinition is the downward trend in the growth of the real GDPcharacterized by negative growth in a consecutive period of twoquarters of a financial year (Fisher &amp Fisher, 2008). A recessionis caused by shocks that affect the demand side of the economy. Toexplain how the economy could be headed for another recession, thecauses of an economic recession seem to be largely present in theeconomy. The demand side of the economy is dictated by three mainfactors: The cost of capital, financial markets, and price of assets.In respect to the current economy, the reported slight increase inGDP by 0.1% is not commensurate with the rate at which the interestrates stand in the lending market. People still find it difficult toborrow because o f high interest rates, investments have thereforeslowed down in the last quarter. Asset prices went down due to thedrop of property permit and starts by 7.5% and 9.9% respectively. The rate of unemployment is still high at over 6.5% with growth inthe last quarter almost insignificant to increase aggregate demand.

Acombination of monetary and fiscal policies can ease economicproblems. They should be crafted carefully to avoid knock-offs thatmight make the economy worse-off.

Possiblefactors that cause a shrink in GDP

Ashrink in GDP is caused by factors that reduce the aggregate demandin the economy. These factors include,

Highinterest rates

Whenthe cost of borrowing is high through high interest rates, borrowingreduces and therefore fewer investments take place. When people donot invest they cause a fall in the overall demand of goods andservices because lacking the funds to purchase assets, securities,and commodities. The creation of goods and services also goes downand the rate of unemployment is likely to remain high.

Adecline in real wages of employed citizens

Realwages are the adjusted incomes of individual persons after accountingfor effects of inflation and their purchasing power. A fall in realwage is caused by increased inflation and a reduced purchasing powerof citizens. When this happens people will be able to buy less thanthey did before hence reducing aggregate demand in the economy.

Acredit crunch

Acredit crunch occurs when risk managers of lenders realize high riskin lending certain amounts of credit to investors due to the generaleconomic conditions. The conditions could be predisposing lenders t ahigh lending risk hence making them to reduce the amount of moneylent to investors in the economy. This negatively affects investmentshence reducing aggregate demand in the economy.


Deflationrefers to a constant fall in the general prices of products in theeconomy. When prices are on a decline, retailers and other sellersmay delay spending in anticipation of an increase in prices to makemore profits. This delay in spending reduces the aggregate demand ofgoods and services. Deflation increases the adjusted value of debtmaking debtors to pay more than they projected to pay when borrowing.It can make them stuck in debt stop more borrowing while creditorsmay record high rates of defaults.

Appreciationin exchanges rates

Highexchange rates make exports more expensive than imports. The demandfor exports is part of the aggregate demand that determines the levelGDP in every quarter of a financial year.

Howto prevent a recession

The appropriate fiscal policy to prevent recessions is to have thegovernment run a deficit by spending more and/or lowering tax(Persson &amp Tabellini, 2004). The policy will shift the aggregatedemand curve to a more suitable position. One of the cons of thisfiscal policy is that it also causes inflation. If the economy issuffering from stagflation, recession, and inflation the policy canonly prevent recession while making the other two worse off. Anotherlimitation of the policy is that crowding out and rationalexpectations can make it completely or partially infective. Crowdingout is the rise in the borrowing costs to firms and households afterthe government borrows to spend in a deficit. These higher costs ofborrowing can lead to fewer spending by households and firms thatwould therefore offset the expansionary fiscal policy. Rationalexpectations on the hand, assume that the expansionary fiscal policywill result in higher prices and wages. Households and firms decideto spend less while anticipating the rise in price. The reduction insupply ends up offsetting the expansionary fiscal policy.

Cuttingspending shrinks the economy in because it reduces the profitabilityof economic agents hence reducing the aggregate demand of theeconomy. Spending stimulates the economy while cuts reduce theeconomic activity (Hansen, 2009). As corporations decrease inprofitability they pay less corporate tax, lay off some employees,and a decrease in spending on products. This ends up cancelling theintended effects of the cut and the economy shrinks.

Thegovernment can avoid a recession by running a surplus (Musgrave &ampKacapyr, 2006). This is where taxes are slightly increased toacceptable levels that can accommodate inflationary pressures. Aftercollecting the taxes the government should spend less than it hascollected from taxes and use the surplus to pay off the borrowingsfrom the deficit. However, this has the effect of causing keepinginflation at a high level than expected by consumers.


Hansen,A. H. (2009). Monetarytheory and fiscal policy.New York: McGraw-Hill Book Co.

Fisher,D., &amp Fisher, D. (2008). Monetaryand fiscal policy.New York: New York University Press.

Musgrave,F., &amp Kacapyr, E. (2006). Barron`show to prepare for the AP microeconomics/macroeconomics advancedplacement examinations.Hauppauge, N.Y: Barron`s.

Persson,T., &amp Tabellini, G. E. (2004). Monetaryand fiscal policy: Volume 1.Cambridge, Mass: MIT Press.