CFA L3 learning notes-CME-the effects of monetary and fiscal policy on business cycles
LOS-discuss the effects of monetary and fiscal policy on business cycles
Monetary Policy:
1.Countercyclical Tool: Central banks use monetary policy to intervene in the business cycle by moderating the cyclical behavior of growth and inflation. They aim to be countercyclical, implementing expansionary measures during downturns and restrictive measures during upswings.
2.Impact on Growth and Inflation: Monetary policy affects interest rates, which, in turn, influence borrowing costs, investment decisions, and consumer spending. Lower interest rates stimulate borrowing and spending, leading to increased economic activity and potentially higher inflation. Conversely, higher interest rates reduce borrowing and spending, curbing inflation but potentially slowing down economic growth.
3.Long and Variable Lags: The impact of monetary policy is subject to long and variable lags, meaning that there can be delays and uncertainties in its effectiveness. Central banks must carefully assess the economy’s momentum and the effects of their policies to avoid exacerbating the business cycle.
The Taylor rule links a central bank’s target short-term nominal interest rate to the expected growth rate of the economy and inflation, relative to trend growth and the central bank’s inflation target.
Fiscal Policy:
1.Automatic Stabilizers: Fiscal policy, including government spending and taxation, can also counteract cyclical fluctuations. Progressive tax systems and means-based transfer payments create automatic stabilizers that help mitigate fluctuations in disposable income for households. These stabilizers reduce the severity of economic downturns and soften the impact on vulnerable households.
2.Limited Timeliness: Fiscal policy adjustments usually take longer to implement compared to monetary policy. The decision-making process and the need for funding government services make frequent and timely adjustments challenging.
3.Impact on Aggregate Demand: Changes in fiscal policy, such as tax cuts or increased government spending, directly influence aggregate demand. Expansionary fiscal measures can boost economic activity during downturns by increasing government spending or stimulating consumer spending. Conversely, contractionary fiscal measures, like tax increases or reduced government spending, can dampen economic growth.
Both monetary and fiscal policies aim to stabilize the business cycle, but their effectiveness and implementation may vary. Monetary policy focuses on interest rates and is subject to lags and uncertainties, while fiscal policy addresses aggregate demand through government spending and taxation but requires longer lead times for adjustments. Understanding these policies is crucial for investment analysts to establish expectations for business cycles and asset classes.
01 Jul 2023 - by toptradeready.com