Impact of Fiscal and Monetary Policies on GDP

Fiscal policy is the means by which a government adjusts its level of spending in order to monitor and influence a nation’s economy, specifically the Gross Domestic Product (GDP). The two main instruments of fiscal policy are government spending and taxation. A change in taxation and government spending greatly affect consumer demand and therefore has implications for business.

Fiscal policy can be applied in two distinct ways:
Expansionary fiscal policy –this is when government runs a deficit or when government spending exceeds tax revenue. This happens during a recession.

Contractionary fiscal policy –this is when government spending is less than tax revenue or government accumulates surpluses. This usually happens during an economic boom.

Monetary policy, on the other hand, is when the central bank increases or reduces interest rates to boost economic activity. This is often done for the purpose of promoting economic growth. The official goals usually include relatively stable prices and low unemployment.

Also, monetary policy can either be expansionary or contractionary. An expansionary monetary policy is when the central bank lowers interest rates or increases the money supply. The central bank does this with the hopes that cheap money will encourage businesses to borrow, in order to spur economic activity, increase hiring and GDP. An expansionary monetary policy can also be called “inflating the economy.” When interest rates are lowered, the money supply increases which means that you have cheap money in the economy, the increase in money supply (as GDP expands) eventually drives up the rate of inflation.

A contractionary monetary policy is when the central bank raises interest rates or decreases the money supply. A higher interest rate discourages businesses from borrowing money to grow operations; this reduces inflation and eventually dampens economic activity. A decrease in money supply is typical when the economy is booming.

Monetary policy, however, differs from fiscal policy which is associated with taxation, borrowing and government spending.

Policy Implementation and Challenges
Fiscal Policy: Suppose an economy is undergoing a recession, unemployment is up and consumer demand is low. The government can increase GDP by lowering taxes. That way, consumers can have more money in their pockets to spend.

The government can also create jobs for the unemployed by increasing investment in public works, such as the building of infrastructure. That way, spending in the economy will increase. The major disadvantage of this policy is that government will run up deficits and inflation could rise. Typically, during a recession businesses lose profit. This loss of profit means less tax revenues to the central government. Government has no resources; whatever government has it gets through taxes or by borrowing. This means that government must borrow to grow the economy.

The consequence of borrowing is that it must be paid back when the economy improves. This development dampens economic recovery and reduces future growth because a significant chunk of income (in cases where debt levels are high) is used to service debt.

Eurozone Case Study
Another consequence is that the economy might not be as productive because of debt burden and investors might flee such countries. For example, the Eurozone countries growth prospects for the future is very bleak. Consumer demand will remain poor in the mid-term, because countries in Europe will spend a significant chunk of their earnings from any future growth paying off debt. This is debt that was accumulated because of the 2008 recession.

Another major problem with government spending on public works during a recession is that it is not backed by actual demand. So, it often leads to misallocation of resources and therefore reduces future growth.

Let say the government decides to open a brick making factory so the unemployed can work there. In actuality, the country is in a recession. A recession means that people have no jobs and there is little or no demand for housing and therefore construction. If the government does not create another avenue for the bricks to be purchased, then the factory will become another unsustainable enterprise which drains government resources. Production must be backed by real demand which depends on consumer spending pattern and the health of the economy. If government decides to arbitrarily create factories without strong real demand in the wider economy, it will lead to a prolonged recession.

Business Implications
Suppose you are a shoe manufacturer in Aba, and there is a recession in Nigeria; people have been laid off from their jobs and they do not have money to buy shoes. The manufacturer will have to lay off workers because of less revenue. What the government can do is reduces taxes for consumers and businesses in the economy. Lower taxes means more profits for businesses and more money for consumers to spend. Eventually, people will buy more shoes and businesses will increase hiring. By lowering taxes across the board, government has reduced the unemployment rate and increased consumption in the economy. Revenue to the government will also increase because, although taxes are lower, the volume of business activity is higher than it was before the recession. Therefore, government is able to collect higher tax revenue.

Monetary Policy: In order to end the dot com recession of 2001/2002 in the United States, the then Federal Reserve Bank chairman, Alan Greenspan, adopted an unusually aggressive monetary policy stance. He kept interest rates arbitrarily low (1%) for a prolonged time period. This aggressive lowering of interest rates caused excess money supply in the economy. Bankers were awash with cheap money to the extent that they started abusing it by giving out credit to entities that were not qualified for it. It simply shows that anything cheap can be abused.

The cost of money (1%) was so cheap that it was abused. On the supply side, business built excess homes because they had cheap credit, and homes where appreciating because of excess money supply. On the demand side, job creation and productivity were not keeping up with the growth in the housing market. Eventually, house prices had to crash –this is what typically happens when you have excess supply over demand.

The Credit Crunch of 2008
The US credit crisis of 2008 is a typical example of the pitfalls of monetary policy. Another problem with monetary policy is that when you arbitrarily lower interest rates you are printing money. A lower interest rate just means that you just devalued you currency; this is the same as money printing.

The US Federal Reserve Bank was not the only central bank guilty of money printing. Since 2008, central banks around the world lowered interest rates to spur economic growth. Today, we live in a world where we have an infinite supply of money at little or no cost.

Business Implications
Monetary policy is ineffective in Nigeria because of poor infrastructure. Objectives like inflation targeting and increasing the money supply for the availability of credit to the real sector is unattainable. Consumer inflation in Nigeria is caused by poor infrastructure and not monetary policy.

Let say a businessman wants to build a factory in Nigeria; he has to pay for infrastructure (water, electricity, security etc.). These expenses drive up production costs and increases business risk. If the businessman goes to a commercial bank to borrow money, the banker has to factor in these costs. The business must pay for the risk through high lending rates; that is if the credit is available at all.

In 2012, the Ugandan central bank lowered interest rates to spur lending in the economy, but commercial banks were unwilling to lend to businesses because of risks due to poor infrastructure. The poor link between the central bank and commercial lending rates also exists in other sub-Sahara African countries, as well as other parts of the developing world where there is poor infrastructure. For Nigeria, building new infrastructure will close the gap between monetary policy rates and commercial lending rates.

Nigeria ends up with high food price inflation because of poor infrastructure. The Food and Agricultural Organisation has stated that Nigeria produces excess food. However, the challenge of supplying agricultural produce to urban population centers and the lack of availability of produce during off-season reduces supply to the general populace and drives up food prices. Consequently, lending rates and inflation will remain high (at least for the next seven years) due to poor infrastructure and not due to the effectiveness or lack thereof of monetary policy.

Nigeria’s Monetary/Fiscal Policy and the 2008 Global Recession

Source: World Economic Oulook database April, 2012

Government’s net debt, spending and inflation increased between 2008 and 2010. This change is because the Nigerian government increased spending and borrowing to maintain economic growth due to the global recession of 2008.

Some measures the Nigerian government took include setting up the Asset Management Company of Nigeria (AMCON) to soak up bad debts banks accumulated in the runup to the recesion of 2008. Setting up AMCON was important because of the need to unclog the financial system so that banks can resume lending to the real sector.

The government also bailed out airlines and disbursed funds to State and Local Government. Because of the difficulty in implementating fiscal policy, it might still be too early to judge weather these stimulus measures worked. Lending to the real sector has not reached pre-2008 levels and the banking sector is still unstable. Banks are still merging with other banks and firing employees. The airline industry is still experiencing financial difficulties.

Other Challenges Around Monetary/Fiscal Policy
Fiscal and monetary policies, although very useful in influencing GDP in advanced countries, may not be very effective in Nigeria. Monetary policy does not help businessess because of poor infrastructure. While fiscal policy could be more useful, tax revenue as a percent of GDP is still very low because the tax code is antiquated, government lacks the resources to enforce tax laws and the current system of tax collection is very opaque and rife with curroption.These inefficiencies are very discouraging for the implementation of fiscal policy in Nigeria.

On the issue of increasing government spending, unfortunately, there is little or no means of monitoring government money in Nigeria to make sure it goes to the right sources. Even in advanced countries, it is very difficult to make sure government spending gets to the right sources not necessarily because of curruption (although it is part of the problem –lawmakers in developed countries have also used fiscal stimulus for white elephant projects) but because government is a poor resource manager. A businessman has a better knowledge about the pulse of the economy than any government planner.

One way of improving Nigeria’s fiscal/monetary policy implementation is to run a countercyclical economic policy. A countercyclical policy is when a country saves money by spending less than her earnings during an economic boom, so that she can have the capacity to increase spending without borrowing when there is a downturn in the economy.

This is the kind of policy Nigeria ran before the recession of 2008. Nigeria’s economic performance was very good during this period; unemployment reduced, there were inflows of foreign direct investment, expansion in the capital market and the reemergence of a Nigerian middleclass. However, questions will still remain about how to effectively disburse these funds during a recession.

Published in FinIntell Magazine, January-February 2014 Edition