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As an economic driver and policy advanced by the central bank, inflation targeting is indeed an effective principal for controlling the level of inflation and maintaining it a set level (Bernanke & Mishkin, 1997). More often than not, the federal government fixes the inflation level of the consumer price index (CPI) at a given margin. In America for example, the Federal Reserve consistently ensures that the inflation margin spans between 1.7 percent and 2 percent. According to Rudebusch and Svensson (1999), the relationship between the inflation rate and interest rate is indirect though in the real sense it does not mean that adjusting the interest rates will automatically and immediately influence the persisting inflation. In other words, though the main reason for zero inflation targeting is to keep check of the inflation level, it tends to curtail the central bank’s flexibility. In this case, a fall in the inflation level below the targeted range prompts the FED to cut on the interest rates and consequently increase the monetary supply (Debelle, 1997). On the contrary, when the inflation rate rises above the inflation target, the FED has to raise the interest rate and subsequently lower the money supply level in an attempt to stifle the increased inflation level.
Economic trends show that the federal government cannot autonomously act on its own without the input of the central bank. For the economy to survive, fiscal policy as well as monetary policy ought to play interactively be engaged by both parties (Davar, 2013). During a recession, for example, the demand for goods and services is suppressed, and consumers have to lower their expenditures which consequently not only leads to an increase in the saving level but also a reduction in the spending level of the private sector. As a result, the private investors lower their production level by curbing their investments and retrenching workers. It goes without saying that more and more enterprises join reducing the production level as well as retrenching employees since they are not able to sustain them in employment. On the other side of the economy, the government income which is obtained from taxes rapidly decrease. Mitchell (2005) postulates that the effect of the unsustainable high cost of living is felt by the taxpayer who is forced to do away with essential services such as law enforcement, emergency services, household shopping etcetera.
Mitigating this downward spiral requires the increase in the spending level in the economy. Ideally, this means that recovering the economy out of the recession requires the government to increase its expenditure without necessarily increasing the tax rate (Barro, 1990). The private sector at this instance is incapable of spiking an increase in the spending level, and therefore the government has to step in. The implication is that the government has to spend significantly to warranty recovery from the recession. Some of the expansionary fiscal policies that the government can adopt include tax cuts and government spending. To achieve a balanced budget, the amount of taxes collected should equal with the government expenditures. Moreover, to obtain a deficit in the budget, the government has to spend more that it receives from tax income. For a surplus, the government ought to spend less than it collects from taxes (Zhang & Zou, 1998). However, it is indispensable to note that, only an effective fiscal stimulus has the potential of boosting the economic growth out of recession. Scholars in support of the economic stimulus proposition postulate that increased government spending has the following benefits to the economy:
Job creation. Increased public spending on capital projects such as the construction of industries, education, communication networks as well as other infrastructural projects creates employment opportunities for the youth to work in the sectors. During the great depression in the 1930s, TVA was formed, and this created jobs thereby helping catapult the economy out of the recession.
Multiplier effect. Availing jobs to the unemployed lot has a multiplier effect in that the income obtained from the new employment opportunities increases the demand for goods and services by consumers thereby prompting business to expand their operations to accommodate the demand. Purchasing more and more products helps the government collect a higher income arising out the taxes it collects from the value added taxes as well as the business taxes collected from enterprises. On the overall, the rise in the aggregate demand and income level in the economy leads to an increase in the gross domestic product (GDP) thereby translating to the economic growth. The government can then utilize the tax revenues collected in financing any budget deficit in the economy (The Economist, 2015).
Opponents, however, postulate that increase in government spending leads to payment of hefty taxes in the future (Lin, 1994). According to them, attempting to increase the spending may prompt the government to purchase goods and services of little value to the public. Expanding the government expenditure is also synonymous with increased inflation levels as well as inefficient resource allocation especially when the state is not in a position to efficiently spend public funds (Devarajan, Swaroop & Zou, 1996). Increasing the government spending in an economy operating at full capacity would nevertheless crowd out the private sector leading to an insignificant increase in the aggregate demand – an action which would substantially suppress economic growth.
According to Mishkin and Schmidt-Hebbel (2001), inflation targeting is essential for a nation since it helps control the inflation levels especially when the economy is on the brink of hyperinflation. However, it is a fact that for the economy to thrive, a certain level of inflation should be permitted and with inflation targeting, economic growth is assured while the price level is controlled. Moreover, inflation targeting helps establish the customer’s expectation thereby making it easier maintain the inflation level, and in the long term, economic planning is not only enhanced but also determinable since price movements are easily be monitored (Svensson, 2000). However, it is important to note that a low inflation rate is a precise cause for deflation.
The adverse effects of deflation are that the real value of debt and interest rate increases. With a rising interest rate, borrowing and investing is substantially inhibited, and instead, investors opt to save. The rising interest rates are a significant disadvantage to a depressed economy since the monetary policy is completely ineffective in stimulating growth. Recovery is difficult especially because the price level is always pressurized to be maintained at a level which still promotes growth. Opponents of zero inflation targeting suggest that inflation is not directly linked to all the economic variables and hence ineffective to use it in causing impact (Debelle, 1997). In a situation where the firms lower their inflation level, zero inflation rate is entirely otiose. However, the central bank should consistently put a check on the inflation level and refrain from raising the interest rates when the inflation level rises above the target level.
Increasing the spending by the FED is indeed the surest way of extinguishing recession out of the economy (Davar, 2013). Deficit government spending, especially during the recession period, can be considered to be a feasible debt since it meets all conditions of what constitutes a good debt. The deficit is indispensable for investments to take place (The Economist, 2015). A government with a robust, comprehensive and critical plan of how to pay back the debt should be encouraged to increase its expenditures. When the economy is not in recession, the government ought not to lower taxes.
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