1. Monetary Policy
Lower interest rates usually increase consumer spending and investment.
Lower interest rates:
- reduce cost of borrowing encouraging investment
- Reduce cost of mortgage payments increasing disposable income of homeowners
- Reduce incentive to save.
What are problems of cutting rates?
- Liquidity trap. Cutting rates may not encourage people to spend if confidence is very low. e.g. loans might be cheap, but who wants to invest when economy is in recession?
- Deflation. If an economy experiences deflation, even interest rates of 0% may be ineffective. This happened to Japan in 1990s and 2000s. (see: Japanese Crisis)
- Will Bank Lend? The problem at the moment is that banks don't want to lend mortgages and loans because of liquidity shortages. Reducing the cost of borrowing doesn't solve this problem.
- Depreciate exchange rate. lower interest rates reduce the value of exchange rate, which could cause inflation and increase cost of imports.
- Savers lose out. At the moment interest rates are lower than inflation. This means many savers will see a decline in their value of savings. Low interest rates help borrowers but harm those who are saving. Nevertheless, the cost to savers is relatively small compared to the cost of a very deep recession and mass unemployment.
- Time Lag. Lower interest rates can take 18 months to have an effect.
In theory Lower taxes and / or higher government spending should provide a boost to aggregate demand and increase economic growth.
The effectiveness of fiscal policy depends on a few factors:
- Income tax cuts may be saved. If you cut income tax for high earners they will probably save it. If you cut taxes for low income groups they will probably spend it. (poor people have a higher marginal propensity to consume)
- Borrowing must be low to start with. The problem is that governments find it easy to cut taxes. But, then in the boom years they don't increase them again. For example, Bush cut income taxes in 2001, this boosted economy. But, in boom years, these tax cuts were not reversed. Therefore, national debt increased even in times of an economic boom. It means the US has now little room for manoeuvre.
- This is not a failure of fiscal policy. It is a failure of politicians to do the other equally necessary aspect of fiscal policy which is increase taxes / cut spending in a boom.
- There will be a time lag for fiscal policy to have an effect.
Fiscal policy is not guaranteed to work. Japan tried to reflate the economy in the 1990s and 2000s. They were remarkably ineffective. Instead Japan has been left with a national debt approaching 190% of GDP. Many economist see this as evidence that fiscal policy is a failure. But, it is not as simple as that. In Japan everything failed - Interest rates of 0%, tax cuts. The problem is that with deflation, falling money supply, deflating asset prices ordinary policy becomes less effective. Consumers didn't want to spend the tax cuts, because prices would be lower in 12 months.
See also: Problems of Fiscal Policy
See also: Recession of 1981 - caused by tight fiscal policy.
3. Increase Money Supply
In periods of deflation, the authorities have to do something radical. They need to increase the money supply. They need to create some inflationary expectations.
The problem is that this concept is too radical for many monetary authorities to contemplate. They are so well versed in trying to control inflation, the idea of creating inflationary expectations is too much. It is hard to believe that Japan was reluctant to increase money supply, despite deflation and economic recession, because of this overwhelming fear of inflation.