Explain how monetary and fiscal policy is implemented and how they can be used to influence GDP and the price level.

Assignment Brief

GLOBAL MACROECONOMIC POLICIES

SEEN CLASS TEST (Essay)

Global Macroeconomic Policy Seen Class Test 2021

Assignment Weighting

This assignment accounts for 40% of the module mark.

Word limit

2000 words

Date of submission

The coursework will be submitted through turnitin by 5pm on the 9th of August, 2021.

Referencing

Use the Harvard method to reference sources.

Class test

It’s probably fair to say that for many years fiscal policy has been the poor relation to monetary policy in macroeconomic policy making circles. Now it is back in vogue. In their recent assessment of the economic impact of the pandemic, the World Bank (p56, 2021) concluded, for advanced economies such as the United Kingdom (UK), that,

“With monetary policy increasingly constrained, fiscal policy has taken on a critical role in macroeconomic stabilization during the crisis, delivering unprecedented stimulus in 2020 in the form of cash transfers and income support to households and firms.”

• Firstly, explain how monetary and fiscal policy is implemented and how they can be used to influence GDP and the price level.
• Secondly, the quotation above highlights the unprecedented use that has been made of fiscal policy in countries such as the UK during the crisis. Briefly consider whether fiscal policy will remain the key policy instrument in these sorts of countries in the near future.

Guidance

This assignment has two elements.

The first part gives you the opportunity to display your understanding of how the main instruments of macroeconomic policy, namely monetary and fiscal policy, are implemented and take effect. Your explanation should make use of the aggregate demand and aggregate supply framework. In the case of monetary policy you might explore the link between the money market, economic output and prices. In the case of fiscal policy, you might want to contrast it with monetary policy, and to explore the significance of the distinction between discretionary and non-discretionary fiscal policy.

This should account for roughly 4/5ths of the words.

The second part of the explanation allows you to use your knowledge of monetary and fiscal policy to explore the options available to macroeconomic policy makers in countries such as the UK now and in the near future. How should the levers of macroeconomic policy be used to help the UK economy in these difficult times? In what way is monetary policy constrained? Might that constraint be relaxed? In the case of fiscal policy, how should it be altered to support economic recovery?

This should take up the remaining 1/5^th of the words.

Recommended Reading

To say the recommended reading is by no means exhaustive is understatement if ever there was one. I have tried to select material that is accessible to you given your stage of development and that hopefully will be of some interest but there is plenty more to explore should you wish to do so.

Mankiw, N.G. and Taylor, M.P., (2020) ‘Economics’, Chapter 29 (“The influence of monetary and fiscal on Aggregate Demand), 5th edition, Cengage.

The above chapter is where you should start. This will provide you with what you need to explain the basic theory examined in the assignment.

Mankiw, N.G. and Taylor, M.P., (2020) ‘Economics’, Chapters 24-28, 5th edition, Cengage.

The above chapters are closely related to chapter 29 and will help you with the key theory. 

N. Gregory Mankiw, The Covid-19 Recession of 2020, forthcoming in “Macroeconomics” 11e.

In the above paper the author of your textbook uses the AD/AS framework to analyse the economic impact of the pandemic.

World Bank (2021), “Global Economic Prospects 2021”, International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433
Telephone: 202-473-1000; Internet: www.worldbank.org *

Ramey, V.A. (2019) Ten Years After the Financial Crisis: What Have We Learned from the Renaissance in Fiscal Research? Journal of Economic Perspectives, Volume 33 (2), Spring, Pages 89–114*

Devereux, M.P et. al (2020) “Discretionary fiscal responses to the COVD-19 pandemic”, Oxford Review of Economic Policy, Volume 36, Number S1, pp. S225–S241*

Mishkin, F.S. (1995) “Symposium on the Monetary Transmission Mechanism”, Journal of Economic Perspectives, Vol 9(4) p3-10.*

Friedman, M. (1968), “The Role of Monetary Policy”, 
American Economic Review 58, March 1968, pp. 1-17 *

*Available on Moodle.

Tip: Start your answer by sticking to this question to get good marks which is explain how monetary and fiscal policy is implemented and how they can be used to influence GDP and the price level.

Sample Answer

Global Macroeconomic Policies: The Role of Monetary and Fiscal Policy in GDP and Price Level Management

Introduction

Macroeconomic policy seeks to stabilise the economy, promote growth, and maintain price stability. Two main tools are available to policymakers: monetary policy, which is primarily managed by a central bank, and fiscal policy, which is controlled by the government. For much of the late twentieth and early twenty-first centuries, monetary policy dominated the macroeconomic policy landscape, especially in advanced economies such as the United Kingdom. However, the COVID-19 pandemic prompted an extraordinary return of fiscal policy as a critical stabilisation instrument.

This essay first explains how monetary and fiscal policies are implemented and how they influence gross domestic product (GDP) and the price level, using the aggregate demand (AD) and aggregate supply (AS) framework. It then examines the recent prominence of fiscal policy in advanced economies and considers whether it is likely to remain the dominant policy tool in the near future.

Monetary Policy: Implementation, Transmission, and Impact on GDP and Prices

Monetary policy refers to the use of interest rates, money supply management, and other tools by a country’s central bank to influence economic activity. In the UK, the Bank of England is responsible for setting monetary policy, with the Monetary Policy Committee (MPC) meeting regularly to adjust the Bank Rate in line with the inflation target. The central objective is price stability, defined by the UK government as a 2% Consumer Prices Index (CPI) inflation rate, while supporting growth and employment.

Implementation takes two broad forms:

• Conventional monetary policy involves altering the policy interest rate. When the Bank of England lowers the Bank Rate, borrowing becomes cheaper, encouraging businesses and consumers to spend and invest, which shifts aggregate demand to the right. Conversely, raising the Bank Rate discourages borrowing and reduces demand, dampening inflationary pressures.

• Unconventional monetary policy includes measures such as quantitative easing (QE), forward guidance, and negative interest rates. QE, for example, involves purchasing government and corporate bonds to inject liquidity into the financial system, lowering long-term interest rates and stimulating investment.

The transmission mechanism operates through several channels:

1. Interest rate channel: Lower rates reduce the cost of borrowing and encourage spending.

2. Exchange rate channel: Lower rates often depreciate the currency, making exports cheaper and imports more expensive, thereby boosting net exports.

3. Wealth effect: Lower interest rates increase asset prices, such as housing and equities, which makes households feel wealthier and more likely to spend.

4. Expectations channel: Forward guidance can shape market and consumer expectations, influencing economic decisions today.

Using the AD–AS model, expansionary monetary policy shifts the AD curve to the right, raising GDP and the price level in the short run. Contractionary policy does the reverse, shifting AD leftwards, lowering inflation but potentially reducing output.

Fiscal Policy: Implementation, Types, and Impact on GDP and Prices

Fiscal policy refers to the use of government spending, taxation, and borrowing to influence economic activity. In the UK, it is set by the Chancellor of the Exchequer and approved by Parliament.

There are two main types:

• Discretionary fiscal policy involves deliberate changes to spending and taxation, such as stimulus packages or infrastructure investments.

• Automatic stabilisers (non-discretionary) adjust government spending and taxation automatically with economic conditions, for example, higher welfare payments during recessions and increased tax receipts during expansions.

Fiscal expansion, such as increased spending or tax cuts, directly increases aggregate demand. Government spending has a multiplier effect, as each pound spent generates additional economic activity through induced consumption. Tax cuts increase disposable income, encouraging household spending. Conversely, fiscal contraction (spending cuts or tax increases) reduces AD.

In the AD–AS framework, expansionary fiscal policy shifts the AD curve to the right, boosting output and prices in the short run. In the long run, the impact on potential GDP depends on whether the spending improves productive capacity (for example, investment in education, infrastructure, or technology).

Continued...