The Effectiveness of Fiscal and Monetary Policies during COVID-19

This essay critically examines the economic impact of the COVID-19 pandemic and the responses of governments worldwide, focusing on the effectiveness of expansionary fiscal and monetary policies in mitigating the resulting recession and promoting economic growth. The essay explores fiscal measures such as government spending, job retention schemes, and tax cuts implemented in the UK, US, Italy, and China, analyzing their impact on unemployment, consumer spending, and overall economic recovery. It also investigates monetary policy tools like interest rate adjustments and quantitative easing, evaluating their role in maintaining inflation targets, supporting businesses, and stimulating investment. The analysis considers the challenges and risks associated with these policies, such as potential inflation and the effectiveness of low-interest rates, while highlighting the importance of confidence in the economy for successful recovery. The essay concludes by assessing the overall effectiveness of these policies in addressing the unprecedented economic shock caused by the pandemic, considering the varying responses across different countries and the long-term implications for economic stability and growth.

‘The COVID-19 pandemic and the attempts by governments across the world to halt its
spread represent a standard macroeconomic shock. Critically discuss the ability of
expansionary fiscal and monetary policy to limit the current economic recession and promote
economic growth’.
The outbreak of the current COVID-19 pandemic has delivered an unprecedented shock for
economies around the world and has brought along with it fears of entering a global
recession. Restrictions to contain the spread of the virus have put pressure on economic
activity as all over the world, supply chains and production have been disrupted and demand
has weakened causing expectations for future interest rates and inflation to fall even further.
Consequently, the fall in real GDP in 2020 is forecast to be the deepest recession experienced
by the UK for over 300 years (Giles, C., 2020.) In this essay, I will compare the responses of
economies including the United Kingdom, China, Italy, and the United States from a
governance perspective and how they have used fiscal stimulus measures and monetary
stimulus from central banks to meet these economic challenges.
Fiscal policy is a stabilization strategy that is carried out by governments to reduce
inflationary gaps and is often used when an economy is in recession and producing below its
probable GDP. Expansionary fiscal policy is used to avoid a recession by stimulating the
economy by increasing aggregate demand levels to full capacity. This response is through
maximising government expenditure or increasing consumers purchasing power by raising
disposable income through tax cuts. The success of fiscal policy measures depends on the
size of the multiplier which is the total change in the output caused by an initial change in
government spending. If the multiplier effect is significant, then changes in government
expenditure will have a greater impact on overall demand.
Measures designed by governments to tackle the pandemic, such as a nationwide lockdown
and social distancing have led to a rapid decline in economic activity as closed businesses
have caused a widespread strain on households through sharp reductions in incomes and jobs.
High unemployment means there is an excess supply in the labour market and indicates the
economy is operating below capacity and is unproductive. According to the Bank of England,
a surge in new universal credit claims suggests the unemployment rate has risen from 4% to
9% (Saunders, M 2020) because 32% of businesses in the UK will have temporarily laid-off
staff by early April. (Shretta, R, 2020) One way the UK government has tackled
unemployment is through fiscal policy methods like The Job Retention scheme. The Job

Retention scheme cost £54 billion as the government continues to pay 80% of employee
salaries who were kept on by their employer while unable to work. As a result, 8.9 million
workers were covered by the scheme at its peak in May 2020 and since then it has shrunk to
3.3 million. (Cabinet Secretary for Finance and the Economy, 2020) Consequently, millions
of jobs have been protected, conveying those wage subsidies have been an effective way of
delivering income support and curbing the number of job losses. This response will help
speed up recovery, therefore, promote economic growth as it means businesses will be able to
retain their employees through the pandemic and will avoid the costly process of rehiring and
retraining workers once normal life resumes. Moreover, the fiscal policy has shown signs of
being effective as the UK economy is expected to expand by 7.25% this year (Chan, S.P.
2021) and N.I Jobs suggests that employers are planning to recruit as lockdown comes to an
end with job listings up by 40% compared to the final quarter of 2020. (Campbell, J 2021)
However, so far, the scheme has been financed by the government and it is not yet clear
whether some businesses will still retain staff once the costs start to fall directly on the
owners, therefore, unemployment numbers will rise but nowhere near as high as it could have
been.
Likewise. another useful policy tool to promote economic growth is income transfers. In the
U.S, the Biden Administration has passed a $2 trillion stimulus package to mitigate the
impact of the pandemic by providing immediate support to households. Consequently, relief
money, extended unemployment subsidies and qualified households given sent one-off
cheques for $1400 have been effective as the economy grew at an annualised rate of 6.4% in
the first quarter of 2021. (Sherman, N 2021) As well, fiscal stimulus measures have primed
the economy for a consumer boom with customer spending hitting a 14-month high and
personal income increased in the second quarter of 2020. Additionally, the government of
Hong Kong used targeted cash benefits of HK $10,000 to deliver support quickly to all
residents financially affected by the pandemic. Subsequently, peoples purchasing power will
increase, leading to a growth in GDP. (Woodhouse, Lockett, Wong, Liu 2020) However,
economic growth depends on people feeling safer and more confident about spending as
more than half of those surveyed said they would keep the money in savings, suggesting that
many households remain cautious about the economic outlook. (Chan, S.P. 2021). On the
other hand, economist Keynes argued in a recession, there are surplus savings, so there will
be no crowding out and fiscal policy will be effective in boosting demand and preventing
recession. Ultimately, the pros outweigh the cons as vulnerable people will get by and

households will be confident enough to spend once regulations ease, thus, promoting
economic growth.
Nationwide lockdowns have led many businesses to experience a severe fall in revenue and
related cash flow problems. Consequently, to provide additional support to sectors affected
by the pandemic, the UK government has pledged £330 billion through the government-
backed Covid-19 emergency loan scheme to support companies that were running out of
cash. The Bounce Back Loans Scheme announced in April 2020 offers all smaller businesses
loans up to £50,000 and is 100% backed by the UK Government. These schemes have
provided an important lifeline as 1.6 million companies in the UK have been successful in
applying for one of the four loan schemes launched by the Treasury during the first
lockdown. (HM Treasury, 2021) Resultantly, supporting businesses will allow owners to be
able to pay their rent, salaries, suppliers, or buy stock which will help lessen the adverse
economic impact of the COVID-19 crisis.
Similarly, an additional fiscal policy tool used in recession to encourage consumption and
thus, GDP growth is reducing taxation. Lowering income tax will increase the spending
power of consumers, which is an element of aggregate demand, leading to higher economic
growth. In Italy, the government cancelled the first semi-annual payment of the IRAP tax for
all SMEs in 2020 which amounted to just under four billion. Consequently, reducing the
financial burden on SMEs and providing liquidity support. Furthermore, the Italian
government also introduced a tax credit for the tourism sector giving 500 euros per family for
private spending in 2020. (KPMG, 2020) Likewise, a similar method has been used in
Northern Ireland where 1.4 million adults will be eligible to apply for a pre-paid card worth
£100 to spend in their local high street. (Rothwell,C. (2020) As a result, the scheme is
designed to stimulate local businesses and will have a multiplier effect that will help
encourage customers back, which will allow the economy to recover strongly once lockdown
eases. Moreover, in China, local governments allowed businesses to retain 5% more tax
revenue from May to June last year and promises to reduce taxes by an additional 550 billion
yuan this year to consolidate its economic recovery. As a result, massive tax cuts costing a
total of 2.37 trillion yuan (KPMG, 2020) have played a key role in China’s rapid recovery as
the economy grew by 2.3%, the only major economy to report a growth in 2020. (Vaswani, K
2021) However, there is growing concern about a more sustained acceleration in inflation,
which could lead to having to raise interest rates sooner than expected.

On the other hand, monetary policy is an initiative passed by a central bank or a government
that plays a crucial role in influencing economic activity through changing interest rates or
the price of financial assets. Expansionary monetary policy is used to promote economic
growth when a recession occurs by reducing interest rates to lower borrowing costs, leading
to an increase in the money supply which in turn heightens investment, consumption, and net
worth. Therefore, when aggregate demand is low, lowering the interest rate will shift the
aggregate demand curve to the left, stimulating growth. The Monetary Policy Committee in
recent months has had two key aims: to ensure inflation returns to the 2% target (Saunters, M
2020) as too little inflation can impede economic growth and to alleviate the long-term
damage to the economy through financial support.
One major monetary policy role is interest rates. As of March 2021, MPC cut Bank rates to a
record low of 0.1% to create cheaper loans for businesses and households, thus, reducing the
costs they will face. (Saunters, M 2020) Low interest rates have the advantage of reducing the
incentives to save because cheaper borrowing increases the propensity of consumers to spend
their disposable income, resulting in higher aggregate demand and promoting economic
growth because investors have incentives to take risks. Even more than that, low interest rates
help to reduce the risk of price deflation especially after the severe negative economic shock
caused by the pandemic. In addition, it also benefits the Government, as it can borrow
cheaply when financing its investment spending. However, there are risks from a long period
of low interest rates such as the risk of hyperinflation as overborrowing at artificially cheap
rates can lead to prices rapidly rising to absurd levels which may cause a speculative bubble.
Moreover, it can lead to excessive amounts of consumer debt which can be damaging for the
economy when a recession is occurring. Ultimately, the effectiveness of cutting interest rates
to boost economic growth depends on the level of confidence in the economy. If confidence
levels are low when sectors reopen, then businesses may simply choose not to borrow, and
economic growth will not improve. Subsequently, the use of forward guidance in addition to
a cut in interest rates might be one way that a Central Bank could raise business confidence
and make the interest rate more effective.
However, this shock is different than before because many high-income countries entered this
crisis with very low interest rates and people cannot spend much of any extra income they
receive, therefore, more is required to stimulate economic growth. An unconventional fiscal

policy measure is quantitative easing. QE is the purchase of financial assets by central banks
aimed at reducing interest rates when conventional monetary policy is ineffective because the
policy interest rate is at the zero-lower bound. QE is meant to be used when the economy
may be in a liquidity trap which is when interest rates are low, but people remain unwilling to
borrow and aims to boost aggregate demand by increasing private sector spending to keep the
economy close to the inflation target of 2%. As a result, the UK government announced a
further £200bn increase in asset purchases including both government bonds and investment-
grade corporate bonds. (Giles, C. 2020) These bonds once bought will lead to the creation of
additional capital as they infuse the economy with extra money. This increase of lending
from banks lifts incomes and spending in the economy, therefore, promoting economic
growth through a rise in consumption and investment. Furthermore, in March 2020, the ECB
launched the Pandemic Emergency Purchase Programme to buy government and company
debt. The asset purchasing scheme costing 750 billion euros brought an instant rebound in
European debt markets, boosting the price of sovereign bonds from Italy to Germany, which
had been under pressure from investors selling assets in response to fears about the pandemic.
(European Central Bank, 2021) Consequently, the scheme will help absorb the economic
shock and prevent a financial crisis, which would intensify economic damage. However,
ultra-low interest rates can distort the allocation of capital and keep alive ‘zombie’ companies
which, crowd out investment in valuable firms, therefore, impact aggregate productivity
growth.
Moreover, central banks intentionally altering exchange rates to increase demand in the
economy can be regarded as a further expansionary monetary policy response. Currency
manipulation refers to a government’s intervention in the foreign exchange market by selling
or buying currencies to depreciate its exchange rate. Consequently, depreciation of an
exchange rate helps to make a country’s exports cheaper when priced in another currency and
increases the prices of imported products. If demand is elastic, this will lead to higher
variable costs for UK producers, resulting, in increased profits and investment spending.
Moreover, a fall in sterling will promote faster economic growth as it will stimulate exports
and weaken import demand thus leading to a rise in net exports, and an outward shift of
aggregate demand. Ultimately, promoting economic growth depends on the scale of any
change in the exchange rate and the price elasticity of demand for imports and exports. On
the other hand, rapid devaluation may make investors lose incentives to hold government
debt as exchange rate depreciation reduces the real value of their holdings and causes the

price of products in that country to become more expensive, leading to a fall in sales and
profit, therefore, impacting economic growth.
A nonconventional monetary policy response is negative interest rates, which arise when a
nation’s central bank lowers the nominal monetary policy interest rate below zero. Negative
interest rates on banks’ deposits are supposed to stimulate the economy by encouraging banks
to lend out the deposits they were keeping at the central bank, thereby, encouraging
households and businesses to spend more and causing the aggregate demand curve to shift to
the right. Subsequently, in Switzerland, a negative interest rate of -0.75% have helped keep
the collapse in GDP relatively small in comparison to Italy and Spain. (Jones, S. 2019)
Furthermore, negative interest rates are creating beneficial financing conditions for firms
according to SNB Governing Board member Andréa Maechler. (Credit Suisse, 2020)
Nonetheless, charging banks interest on their deposits might be very costly if they still must
pay positive interest rates to their depositors. This may lead to bank profitability to fall and
make banks less likely to lend. Additionally, the UK economy may not be equipped to handle
negative interest rates as high street lenders would push up their mortgage rates to protect
profitability (Partington, R.J. 2021), hurting consumers and the wider economy which would
be counterproductive for economic growth.
In conclusion, monetary and fiscal policies have played a key role in countering the economic
impact of the pandemic. Support measures such as increased government spending, tax relief
and cash transfers have cushioned the economic shock of restrictions imposed to curb the
virus and, wage subsidy schemes and loans have helped sustained businesses and protect
livelihoods. That said there are limits to the effectiveness of monetary and fiscal policy in
stabilizing and stimulating demand. We have seen this when economies entered the crisis
with already very low-interest rates and how people could not spend the extra income, they
received. In addition, despite generous support packages, public debt will soar and a rise in
business failures is inevitable leading to job losses on a substantial scale. Ultimately, fiscal,
and monetary relief measures have been effective in heightening aggregate demand and
economic growth in the short term, however, Governments will need long term solutions to
address their budget deficits and promote economic growth in the long run.
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