When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two primary courses of action: monetary policy and fiscal policy. Monetary policy involves the management of the money supply and interest rates by central banks.
To stimulate a faltering economy, the central bank will tend to cut interest rates, making it less expensive to borrow while increasing the money supply. If the economy is growing too rapidly, however, the central bank can implement a ‘tight’ monetary policy by raising interest rates and removing money from circulation.
Fiscal policy determines the way in which the central government earns money through taxation and how it spends money. To assist the economy, a government will cut tax rates while increasing its own spending and to cool down an overheating economy; it will raise taxes and cut back on spending. There is much debate as to whether monetary policy or fiscal policy is the better economic tool, and each policy has a series of pros and cons to consider.
Monetary policy refers to the actions taken by a country’s central bank to achieve its macroeconomic policy objectives. Some central banks are tasked with targeting a particular level of inflation. In the United States, the Federal Reserve Bank (or simply ‘The Fed’) has been established with a mandate to achieve maximum employment and, at the same time, price stability. This is sometimes referred to as the Fed’s ‘dual mandate.’ Most countries separate the monetary authority from any outside political influence that could undermine its mandate or cloud its objectivity. As a result, many central banks, including the Federal Reserve, are operated as independent agencies.
In India RBI controls and regulates the monetary policies. RBI is an apex institute which monitor the working of monetary policies and fiscal policies.
When a country’s economy is growing at a fast pace such that inflation increases to worrisome levels, the central bank will enact restrictive monetary policy to tighten the money supply, effectively reducing the amount of money in circulation and lowering the rate at which new money enters the system. Additionally, raising the prevailing risk-free interest rate will make money more expensive and increase borrowing costs, reducing the demand for cash and loans. The bank can also increase the level of reserves that commercial and retail banks must keep on hand, limiting their ability to generate new loans, as well as sell government bonds from its balance sheet to the public in the open market, exchanging those bonds by taking in money from circulation. Economists of the Monetarist school adhere to the virtues of monetary policy.
When a nation’s economy slides into a recession, these same policy tools can be operated in reverse, constituting a loose or expansionary monetary policy. In this case, interest rates are lowered, reserve limits loosened, and instead of buying bonds in the open market, they are purchased in exchange for newly created money. If these traditional measures fall short, central banks can undertake unconventional monetary policies.
Pro: Interest Rate Targeting Controls Inflation
A small amount of inflation is healthy for a growing economy as it encourages investment in the future and allows workers to expect higher wages. Inflation occurs when the general price levels of all goods and services in an economy increases. By raising the target interest rate, investment becomes more expensive and works to slow economic growth a bit.
Con: The Risk of Hyperinflation
When interest rates are set too low, over-borrowing at artificially cheap rates can occur. This can then cause a speculative bubble whereby prices increase too quickly and to absurdly high levels. Adding more money to the economy can also run the risk of causing out of control inflation due to the premise of supply and demand: if more money is available in circulation, the value of each unit of money will be worth less given an unchanged level of demand, making things priced in that money nominally more expensive.
Pro: Can be Implemented Fairly Easily
Central banks can act quickly to use monetary policy tools. Often, just signaling their intentions to the market can yield results.
Con: Effects Have a Time Lag
Even if implemented quickly, the macro effects of monetary policy generally occur after some time has passed. The effects on an economy may take months or even years to materialize. Some economists believe that money is ‘merely a veil’ and while serving to stimulate an economy in the short-run has no long-term effects except for raising the general level of prices without boosting real economic output.
Pro: Central Banks Are Independent and Politically Neutral
Even if a monetary policy action is unpopular, it can be undertaken before or during elections without the fear of political repercussions.
Con: Technical Limitations
Interest rates can only be lowered nominally to 0%, which limits the bank’s use of this policy tool when interest rates are already low. Keeping rates very low for prolonged periods of time can lead to a liquidity trap. This tends to make monetary policy tools more effective during economic expansions than during recessions. Some European central banks have recently experimented with a negative interest rate policy (NIRP), but the results won’t be known for some time to come.
Pro: Weakening the Currency Can Boost Exports
Deflation occurs when the change in prices turns negative. Today, the economies of the Eurozone are combating deflation, and the European Central Bank (ECB) has even been taking the extraordinary measures of undergoing quantitative easing. But what’s the deal with deflation?
Changes in consumer prices are economic statistics compiled in most nations by comparing changes of a basket of diverse goods and products to an index. In the U.S. the Consumer Price Index (CPI) is the most commonly referenced index for evaluating inflation rates. When the change in prices in one period is lower than in the previous period, the CPI index has declined, indicating that the economy is experiencing deflation.
One might think that a general decrease in prices is a good thing because it gives consumers greater purchasing power. To some degree, moderate drops in certain products, such as food or energy, do have some positive effect on consumer spending. A general, persistent fall in prices, however, can have severe negative effects on growth and economic stability.
Deflation typically occurs in and after periods of economic crisis. When an economy experiences a severe recession or depression, economic output slows as demand for consumption and investment drop.
This leads to an overall decline in asset prices as producers are forced to liquidate inventories that people no longer want to buy. Consumers and investors alike begin holding onto liquid money reserves to cushion against further financial loss. As more money is saved, less money is spent, further decreasing aggregate demand.
At this point, people’s expectations about future inflation are lowered, and they begin to hoard money. Why would you spend a dollar today when the expectation is that it could buy effectively more stuff tomorrow? And why spend tomorrow when things may be even cheaper in a week’s time?
As production slows down to accommodate the lower demand, companies reduce their workforce, increasing unemployment. These unemployed individuals may have a hard time finding new work during a recession and will likely deplete their savings to make ends meet, eventually defaulting on various debt obligations such as mortgages, car loans, student loans and credit cards.
The accumulating bad debts ripple through the economy up to the financial sector that must write them off as losses. As banks’ balance sheets become shakier, depositors seek to withdraw their funds as cash in case the bank fails.
A bank run may ensue, whereby too many deposits are redeemed, and the bank can no longer meet its own obligations. Financial institutions begin to collapse, removing much-needed liquidity from the system and also reducing the supply of credit to those seeking new loans.
Central banks often react by enacting a loose, or expansionary, monetary policy. This includes lowering the interest rate target and pumping money into the economy through open market operations â€“ buying Treasury securities in the open market in return for newly created money.
If these measures fail to stimulate demand and spur economic growth, central banks may undertake quantitative easing by purchasing riskier private assets in the open market. The central bank can also step in as a lender of last resort if the financial sector is severely hindered by such events.
Governments will also employ an expansionary fiscal policy by lowering taxes and increasing government spending. However, the problem with lowering taxes in a period of low prices and high unemployment is that overall tax revenues will decrease, limiting the ability of government to operate at full capacity.
You may remember seeing news footage of the protests at the doors of the World Trade Organization’s (WTO) Third Ministerial Conference held in Seattle, Washington, in 1999. Similar demonstrations against the WTO have also occurred in Italy, Spain, Canada and Switzerland. What is the WTO, and why do so many people oppose it? The following article addresses these questions and concerns regarding the world’s only international organization that deals with the global rules of trade.
The WTO was born out of the General Agreement on Tariffs and Trade (GATT), which was established in 1947. A series of trade negotiations, GATT rounds began at the end of World War II and were aimed at reducing tariffs for the facilitation of global trade on goods. The rationale for GATT was based on the Most Favored Nation (MFN) clause, which, when assigned to one country by another, gives the selected country privileged trading rights. As such, GATT aimed to help, all countries obtain MFN-like status so that no single country would be at a trading advantage over others.
The WTO replaced GATT as the world’s global trading body in 1995, and the current set of governing rules stems from the Uruguay Round of GATT negotiations, which took place throughout 1986-1994. GATT trading regulations established between 1947 and 1994 (and in particular those negotiated during the Uruguay Round) remain the primary rule book for multilateral trade in goods. Specific sectors such as agriculture have been addressed, as well as issues dealing with anti-dumping.
The Uruguay Round also laid the foundations for regulating trade in services. The General Agreement on Trade in Services (GATS) is the guideline directing multilateral trade in services. Intellectual property rights were also addressed in the establishment of regulations protecting the trade and investment of ideas, concepts, designs, patents, and so forth.
The purpose of the WTO is to ensure that global trade commences smoothly, freely and predictably. The WTO creates and embodies the legal ground rules for global trade among member nations and thus offers a system for international commerce. The WTO aims to create economic peace and stability in the world through a multilateral system based on consenting member states (currently there are slightly more than 140 members) that have ratified the rules of the WTO in their individual countries as well. This means that WTO rules become a part of a country’s domestic legal system. The rules, therefore, apply to local companies and nationals in the conduct of business in the international arena. If a company decides to invest in a foreign country, by, for example, setting up an office in that country, the rules of the WTO (and hence, a country’s local laws) will govern how that can be done. Theoretically, if a country is a member of the WTO, its local laws cannot contradict WTO rules and regulations, which currently govern approximately 97% of all world trade.
The current head of the World Trade Organization decisions are made by consensus, though a majority vote may also rule (this is very rare). Based in Geneva, Switzerland, the Ministerial Committee, which holds meetings at least every two years, makes the top decisions. There is also a General Council, a Goods Council, Services Council, and an Intellectual Property Rights Council, which all report to the General Council. Finally, there are many working groups and committees.
If a trade dispute occurs, the WTO works to resolve it. If for example, a country erects a trade barrier in the form of a customs duty against a particular country or a particular good, the WTO may issue trade sanctions against the violating country. The WTO will also work to resolve the conflict through negotiations.