Wisdom of tight monetary policy and reduced government spending

International Monetary Fund (IMF) insists on tight monetary policy and reduced government spending when advancing credit to countries with financial crisis. The European Union member countries have also faced the same policies due to the Euro crisis which led member countries to be unable to repay their government debts. These policies have challenges and long-term solutions to Europe and other regions of the world.

When financial crisis such as Euro zone debt crisis occurs, contraction or tight monetary policies are applied. Some of the tools of tight monetary policies include: increasing interest rates, raising reserve requirements, and reducing monetary base. The IMF exercise tight monetary policies by raising the interest rates for the loans provided for countries with financial or debt crisis. Tight monetary policies have various effects on the real economy. It causes challenges such as decreased output, income and employment (Corsetti and Pesenti, 2005). This happens through the influence of tight monetary policies on price levels and interest rates.

Lending institutions such as the central bank and IMF target interest rates by increasing short-term market rates. This leads to a decline in capital costs and real interest rates. As a result, the investments decrease. Consumers save more and opt for future consumption as opposed to current consumption. Demand decreases leading to decrease in prices and wages in the economy. This contractionary monetary policy is important for countries with financial crisis because reduced prices and wages, and increased savings will enable the countries to pay back their debts (Clarida et al, 2002). Increased interest rates also lead to lower expectation of strong economic activity. Assets such as stocks become less attractive. Therefore, asset prices decrease.

Reduction in government spending is a fiscal policy with the same effects as increased interest rates. It leads governments to cut on spending in various sectors. As a result, the economic activity reduces, savings increase and prices of commodities decrease. These challenges in the economy are similar to the challenges of using tight monetary policies. Reduction in government spending also means that the government will reduce its purchase of government bonds and treasury bills from the public. As a result, money supply in the economy will reduce and the economy will be suppressed with low inflation, low prices and low wages. In this case, even income and economic growth of the economy will decrease.

The above are just short term challenges, but there are long-term solutions that will be enjoyed by the economies of Europe and elsewhere if they use tight monetary policies and reduced government spending. One of the long term effects is stabilization of the economy. In this case, inflation rates in the economy will be stabilized and price fluctuations will be minimized (Clarida et al, 2002). Furthermore, government debts will reduce. As a result, budget deficits will reduce leading to improved economic performance in the long term. Savings that result from reduced government spending and tight monetary policies will also boost the economy in future because they will finally be used to invest in future when the economy will be stable.

In light of the above challenges, foreign firms can maximize their competitive position by cutting on their costs or expenses by spending on the most important projects. The companies should also reduce their spending on investments and channel their income to savings and advertising. This will stabilize the company amidst competition in the market and enable them to avoid investments on less attractive projects. Purchase of long assets is also recommendable because the prices of assets are low in this transition time. When the economy stabilizes, the prices will rise and the companies will enjoy the benefits of reduced prices.

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