Monetary and Fiscal Growth - Assignment Example

MONETARY AND FISCAL GROWTH Name Institution Budget Deficits and Large Debt-to GDP ratio Accumulations The financial crisis has led to huge budget deficits and a large increase in debt-to-GDP ratios of advanced economies. The economic downswing witnessed in the 2008-2009 crises has led to unprecedented economic anxiety globally. The long-term impact of this crisis remains uncertain and is a concern for many governments and economies. The high debt-to-GDP ratio has made it difficult for many countries to pay external debts, and has led to investors seeking higher interest rates when lending. Consequently, when they are unable to pay their debt, governments are likely to default. Sovereign debt defaults are likely to cause a panic in the domestic and international financial markets which has devastating consequences globally. Financial crises have historically led governments to default on their debt obligations (Hilsenrath, 2010). Basically, the higher the debt-to-GDP ratio, the less likely a country will pay its debt, and the higher the risk of default. There is no ideal debt-to-GDP ratio but governments should focus on the sustaining certain stability as far as the debt levels are concerned. Stability in this case refers to cases where a government is able to finance its debts through payment of interest without harming its economic growth patterns or refinancing its economic expenditures. Notably, every government needs money to fulfill its obligations; this money comes from collection of taxes and from borrowing from investors and other agencies. Each year governments prepare budget estimates highlighting the expenses which are expected to be financed by tax revenues and borrowed money. According to Taylor (2012), advanced economies have over the past decades accumulated budget deficits because they have been unwilling or unable to collect sufficient amounts of taxes cover their expenses. This has lead to a situation whereby the investors and financial markets are jittery about the ability of the government to repay their debts. Hence they ask for higher interest rates to compensate for the increased risk. When the interest rates are high, they are likely to spark a financial crisis which may force governments to initiate some reforms. This is so especially if the debts are created because of high social costs (Taylor, 2012). Unlike war debts which are one –time costs and non- recurring in nature, social expenditures are recurrent and redistribute income and therefore require fiscal reforms. As stated by Sherwin (2000), the government can either reduce deficits rapidly by applying austerity measures through reducing expenditure or they can reduce the deficits slowly by focusing on economic growth and growing the GDP. By reducing the deficit quickly through austerity measures, the government reassures the financial markets that it has a clear plan to reduce the deficit hence they may invest more which may lead to low interest rates. Low interests rates on government bonds keep the cost of interest low that helps to avoid the debt spiral that makes reducing the core deficit difficult. On the other hand, spending cuts may lead to lower growth of the economy and the government will receive less tax. In addition, if the austerity measures are poorly timed and hurriedly implemented, they are likely lead to double dip recession. This is because there will be less investment by the government in development projects and also many people may loose jobs and eventually the government may spend more on paying benefits to the unemployed people. An IMF report dubbed the ‘Painful Medicine’ released in 2011 indicated that the debt-GDP ratio may fall more slowly than expected even when the drastic austerity measures are taken (International Monetary Fund, 2011). The spending cuts which are mostly targeted at the public sector are usually biased as they focus mainly on wages instead of profits this does more harm to the economy than good making the austerity measures self-defeating. The IMF report also predicts that spending cuts of 1 percent of GDP reduces incomes by 0.6 percent and raises the unemployment rate by 0.5 percent. This negative impact can still be worse when the measures are taken without the monetary stimulus. This means that quick reduction of the deficit may lead to reduction of GDP and increase unemployment rates. In fact, the IMF study suggests that austerity measures may affect unemployment for many years harming future economic activity in the long run. There is also evidence to dispute claims that quick deficit cuts lead to low bond yields and interest rates. For example, the austerity measures taken in Spain, Greece, and Italy caused higher bond yields in the respective economies (Chaturved, 2012). This means that austerity measures do not necessarily reassure markets. The interest rates can reduce because investors may prefer to invest in bonds rather than assets like shares which are riskier. Therefore low interest rates may not mean the economy is improving but may reflect the poor prospects of economic growth of a country. Recommendation The best approach to deal with a huge debt-to GDP ratio can be to reduce the deficits slowly and focus more on economic growth. This may however increase the interest rates and the investors may withdrawal from the country due to the increased risk of defaulting. However, targeting reasonable levels of economic growth will reduce the debt- to- GDP levels. A well thought out plan of systematically reducing the deficit while increasing economic growth is more appropriate and less counterproductive compared to the hurriedly implemented austerity measures. A monetary stimulus can also be helpful in boosting domestic demand. This can help in offsetting spending cuts and promoting economic growth. Austerity measures should also be made more palatable. For example some measures like reducing welfare benefits and increasing the age of retirement have little impact on the growth of the economy. The reason why a government may run a deficit is to hide the cost of government expenditures and services from the public. This is done through indirect taxation (inflation tax) or by delaying the costs (issuing bonds). Therefore the goal of the government in reducing the deficit is to create an indirect burden to the public along with imposing that cost to the political powerless in the society. Finally, reducing national debt is a political decision that is based on ideologies and interests. With low interest rates or economic growth, governments can continue to run deficits. Those that carry the burden of the government debt are determined by the political class. In essence, the interest groups that have the least influence in the politics of the day are the ones who pay the ultimate price of the national debt this includes taxpayer, government employees and bondholders. Monetary and Money Supply Targeting A country’s monetary policy plays a central role in determining its economic growth and stability especially if the country participates in international financial systems. Through the monetary policy a government’s Central Bank or monetary authority is able to control the availability of money, supply of money, cost of money and rate of interest to attain specific goals oriented towards the country’s economic growth and stability (Mishkin, 2007). In the 1970s, several countries adopted monetary targeting as monetary policy, notably countries like Switzerland, the United Kingdom, Germany, Japan, United States and Canada adopted the policy over the years. The money supply targets or monetary targets involve the use of monetary aggregates as an intermediate target to control inflation and achieve price stability. Going in the Keynesian directions, it presupposes that monetary policy is not dictated by fiscal considerations and that the exchange rate is flexible (Mishkin, 2007). Monetary targeting has its various advantages. To start with the policy enables monetary authorities to choose goals for inflation for that country that may differ with those of other countries. Monetary targeting also gives scope for the monetary policy to deal with transitory output fluctuations and external shocks which include unemployment and fluctuating international markets (Mishkin,2007). Since actual money aggregates are typically reported within a couple of weeks, monetary targeting is easy to monitor as central bank’s compliance with the targets is available. This also increases accountability of the Central Bank to meeting its targets. In comparing the targeted and the actual monetary targets, a timely and periodic indications concerning the monetary policy as well as the purpose of the authorities to maintain inflation is automated. In turn these indications may help consolidate inflation expectations and produce less inflation. It is however, important to note that all the above advantages of monetary targeting are based on balance of probabilities, that is, they can only be achieved if there is a strong relationship between inflation and the monetary target aggregate. This implies that shocks of domestic and foreign origin affect the attainment of the targets. When the relationship between monetary target and the goal variable (inflation) is weak, monetary targeting produces poor outcomes. In fact, this weak relationship between inflation and money targets has been the main problem affecting advanced economies in Europe. Inflation targeting is a strategy of periodically setting the inflation rate target of a country with the aim of attaining consumer goods price stability (Sherwin, 2000). Inflation targeting is characterized by a public announcement of the county’s official inflation targets over specific time horizons. It is based on the premise that low and stable inflation is the primary goal of the monetary policy. The monetary authorities communicate to the public about their monetary and economic objectives and the mechanisms that they have put in place to achieve their objectives. The monetary policy framework of Inflation targeting has a short history of about 25 years. Among the first countries to shift to inflation targeting are Australia, New Zealand, United Kingdom, and Sweden in the 1990’s. Since then the approach has been comparatively successful in reducing inflation rates and stabilizing economies (Chaturved, 2012). However, after the financial crisis in 2008 and the consequent slump in economic growth, there are concerns that a rigid commitment to low inflation may conflict with other more important macroeconomic goals. Inflation targeting has several advantages compared to monetary targeting as a medium –term strategy for monetary policy. As opposed to monetary targeting, it enables monetary policy makers put more focus on the domestic considerations as well as responding to both the domestic and foreign economic shocks. Another advantage of inflation target is that its success is not dependent on the stability of the relationship between inflation and money. It not only uses information on the variables but also allows monetary authorities to use all the available information to determine the best settings for instruments of monetary policy. By setting the inflation targets, Central Banks are held more accountable and transparency is encouraged. The independence of the country’s central bank from government in implementing the monetary policy is also a benefit of inflation targeting. There is also an increased accountability of the central bank because of the predetermined inflation target; it also reduces the likelihood of falling into the time-inconsistency trap of trying to expand output employment by trying to pursue overly ambitious monetary policies (Mishkin, 2007). Despite its apparent benefits, inflation targeting has been criticized for various reasons. To start with, inflation targeting policies have been accused of being too rigid, that is, central banks may become fixated on maintaining low inflation instead of dealing with social and economic problems like prolonged unemployment. For instance, in times of recession, the government’s priority is to deal with the pressing social economic problems and preventing the economic slump rather than maintaining low inflation. There are also concerns about increased output fluctuations, a policy that is too tight when inflation is higher than target may lead to higher output fluctuations. Finally inflation targets alone may not be sufficient in spurning economic growth, sometimes low inflation rates may disguise an asset and banking boom and bust. This implies that low inflation may not necessarily mean an underlying stability. Therefore, setting of inflation rates may even hamper economic growth when done blindly without appropriate considerations. Australia’s situation In 1993 Australia’s Reserve Bank made a significant policy switch to inflation targeting. The inflation target was set at 2-3 % over the years. The inflation targeting policy coincided with a period of low and stable inflation over the past two decades until the economic recession (Debelle, 2009). The policy appears to have been successful in its goal of letting the economy to grow as fast as possible in tandem with the inflation target. This can be attributed to inflation targeting characteristics which include increased accountability of the Reserve bank of Australia, increased communication which has built credibility of the bank and more importantly, its flexibility in practice and response to shocks. Australia’s ability to withstand the global financial crisis can to some extent be attributed to its inflation targeting economic policy. However, this framework is currently being severely tested and it seems to be doing reasonably well compared to the other alternative monetary policies. However inflation targeting needs to be supplemented by other instruments and tools to deal with the ever –present economic challenge In conclusion the benefits of inflation targets can not be over estimated especially during normal economic times. However after the prolonged recession in 2008, there is need to review the monetary policy so that its benefits are supplemented by other tools. Dual targeting can be a better approach whereby monetary policies embrace an equal weighting of inflation targets and unemployment targeting. This will pay attention to low inflation targets vis-à-vis the pressing economic and social problems of unemployment. References Chaturved, N.(2012) Spanish Bond Yields Reach Euro-Era High : Wall street journal july 2012 Debelle G., (2009) The Australian Experience with Inflation Targeting Banco Central do Brasil XI Annual Seminar on Inflation Targeting Rio de Janeiro - 15 May 2009 Grauwe, P. . (2012). Economics of Monetary Union. Hilsenrath, J., (2010). “Q&A: Carmen Reinhart on Greece, U.S. Debt and Other ‘Scary Scenarios’,” Wall Street Journal,February 5, 2010. International Monetary Fund ( 2011) Painful medicine finance and development- September 2011 retrieved on 20th April, 2014 from https://www.imf.org/external/pubs/ft/fandd/2011/09/PDF/ball.pdf Mishkin, F. S. (2007). Monetary policy strategy. Cambridge, Mass: MIT Press. Sherwin, M., (2000) Institutional Framework for Inflation Targeting, Reserve Bank of New Stevens G.R (1999) Six Years of Inflation Targeting Reserve Bank Australia Bulletin May 1999 Address by, Assistant Governor (Economic), to the Economic Society of Australia, Sydney, 20 April 1999 Taylor, B.( 2012) Paying Off Government Debt: Two Centuries of Global Experience retrieved 20th april 2014 from https://www.globalfinancialdata.com/news/articles/government_debt.pdf Read More