No 175: About Loose and Tight Policy

AS YOU will know if you took the Module 2 exam on Wednesday, the first question in it asked about "loose" monetary policy.

It occured to me that the terms "tight" and "loose" may not be that familiar to you, since they don't always appear in textbooks.

But then I remembered all of you are of course doing lots of Economics reading, so have looked at this week's Economist........


This extremely relevant article (which you should read and all my students will be reading) starts:

THE script for 2011 had been well rehearsed. The Treasury’s fierce fiscal retrenchment would  undoubtedly hurt the economic recovery. But the Bank of England would add balm by maintaining an extraordinarily loose monetary stance. Just three weeks into the new year, however, surging inflation has disrupted the story. The worry is that this could endanger the recovery by forcing a premature tightening in monetary policy.

So exactly what do these terms "loose" and "tight" refer to, and in which situation can they be used appopriately to describe government policy?

The first thing to say is that "loose" policy is also often referred to as "expansionary" policy, and that "tight" policy is often called "deflationary" policy.

The second basic concept is that loose and tight as terms can be used to refer either to monetary policy or fiscal policy.

Imagine a government controls 2 "taps" called a monetary tap and a fiscal tap. 

The monetary tap works mainly by controlling credit in the economy through manipulation of interest rates.

The fiscal tap works by alterations in taxation, government spending, and any borrowing it requires.

Both taps influence the amount of demand that flows through the economy, which in turn affects the amount of goods and services produced, and therefore also the levels of profit, wages and jobs.

  

Here, the government (or in the UK, more accurately the Bank of England) has loosened the Monetary Policy tap. Lower interest rates encourage households and firms to take out credit and then spend it, increasing the flow of demand in the economy.









Here, fiscal policy has been loosened. Taxes have been cut, and/or government spending has been increased. This gives people more money, therefore adding to the flow of demand.

During the Credit Crunch, various factors - lack of bank lending, falling wealth, plunging confidence, lack of profits - all led to the total (or aggregate) level of demand being at an extremely low level.

So, it is generally agreed that the right government action in this situation to use both loose monetary and fiscal policy. It is hoped that the economy can recover from recession by the government causing demand to increase in the economy.

This is the current situation in the UK. The government has decided to tighten fiscal policy.

In its original (Keynesian) form, the idea was that loose fiscal policy in bad times would be paid for with money the government had saved up in the good times. Few governments do that now, meaning that money must be borrowed to pay for it.

However, at certain point, too much government debt endangers the ability of governments to borrow money in the future. This would be a disaster, since government would be unable to pay even for its most essential services such as health care and education.

Therefore, it was decided to tighten the fiscal policy tap. But some economists fear that fiscal policy has been tightened too early, and that this will damage the recovery.

If a recovery becomes a boom, a government will tighten monetary policy also. This is to avoid demand overflowing. If there is demand which is not realised (that is, there are not enough goods and services for everyone who want them), prices shoot up.

The resulting inflation is seen by many economists as an economic problem which can be even worse than unemployment.



There is increasing inflation in the UK at the moment, and this is worrying. However, the cause is not too much demand in the economy. Instead, it is due to rising prices of essential commodities such as food and oil, as well as a rise in VAT (part of the tightening in fiscal policy).

The government could decide to tighten the monetary policy tap to combat this.

However, the fear is that the economy is not strong enough to continue to recover by itself with both tight monetary and tight fiscal policy.

As with most economic policy decisions, it is not so much the policy you use as the time that you decide to use it.