Monetary policy

Monetary policy is the policy used by the central bank to regulate the supply of money in the economy.
The central bank of India that is Reserve bank of India plays the controlling authority here. This is a tool
used to control even the inflation and the interest rates to ensure price stability and trust in the
currency of a nation. The goals of monetary policy also include the contribution to the economic growth
and stability, to lower unemployment rates and to maintain stability in the exchange rates with the
currencies of other nations. The best monetary policy is termed as the optimal monetary policy for
which optimal inflation rate should be applicable in a nation.

Monetary policies are generally of two types: 1) Expansionary Policy- This type of policy increases the
total supply of money in the economy. This was traditionally used to remove unemployment during
recessionary period by lowering the interest rates having the belief that easy credit will help business
expand.

2) Contractionary Policy- This policy increases or expands the money supply but at a pace less even less
than the normal and in certain cases even shrinks it. It is intended to slow inflation and to avoid the
resulting distortion of asset values.

Meaning and objectives of Monetary Policy.

Monetary Policy refers to the mechanism through which the monetary authority regulates the supply of
money in the economy by using instruments such as that of interest rates to maintain the price stability
and achieve better economic growth. This monetary authorityis generally the central bank of the
country. RBI (Reserve Bank of India) is the central bank of India.

Objectives of Monetary Policy Beside price stability monetary policy accomplish the following tasks as
well

1) Full employment- Full employment is a situation favorable for any economy not only because it
increases output but also for the credit standing of a nation. Monetary policy helps achieving this target.

2) Price stability- Another main objective of monetary policy is the price stability. Price stability is
promoted to reduce the fluctuations in prices as these fluctuations in prices bring uncertainty and
instability in the economy. The focus of monetary policy is to facilitate the enviournment which is
favorable to the economic development to run the projects swiftly along with maintaining the stability

3) Economic Growth- Economic growth is a situation where real GDP of a nation that is the per capita
income of the nation increases over a period of time. Monetary policy aims at it

4) Balance of Payment- This objective of monetary policy tries to achieve the equilibrium between the
exports and the imports

5) Expansion of bank credit- One another important function of RBI is the controlled expansion of credit
to commercial banks according to their seasonal requirements without affecting the output
6) Fixed Investment- This objective of RBI focuses on the productivity of investments by having a control
on non essential fixed investment.

7) Promote Efficiency-RBI tries to increase the efficiency in the financial system by regulating and
deregulating interest rates, ease operational constraints, introduce money market instruments, etc.

8) Restriction of inventories and stocks-Excess stocking of inventories is not beneficial for any economy
as it may make the stock outdated over a period oftime and hence may lead to a loss. To avoid this kind
of problem the central bank carries out this special function of regulating the economic inventories.

9) Reducing the rigidity- RBI bring flexibility in the operations which provide autonomy. It maintains its
control on all the areas where prudence is required in the financial system.

Instruments of Monetary Policy.

Changes in Reserve Ratios- This is suggested by Keynes. This method says that every bank is required to
keep certain reserves with them as well as with the central bank from the total deposits in the form of
reserve fund. When prices rise, the central bank raise the reserve ratios as well, now as more money is
in the form it reduces the money in circulation and hence economy moves towards the equilibrium. In
the opposite, when the reserve ratio is lowered, the reserve with the commercial banks is reduced but
their lending ratio increases which in turn bring more money in circulation. Equilibrium is achieved.

Inflation Targets

Reserve bank of India uses inflation targeting as a tool of monetary policy to regulate the medium term
inflation target. The underlying assumption in this is that the long term economy is the be maintained
and a price stability is desired. The central bank uses interest rates as its short term monetary
instrument. In inflation targeting central bank keeps revising the interst rates to achieve the target, like
they raise the interest rates based on above target inflation and lower the interestrates based on below
target inflation. The basic principle is raising interest rates cools the economy and lowering it accelerates
the same.

Benefits Inflation targeting give the following benefits to the economy:

Helps monetary policy to focus on domestic considerations and face the economic shocks in a better
way, which is difficult under fixed exchange rate system. Investors uncertainty gets reduced. More
transparency is the system is the key benefit of inflation targeting. This is possible because the inflation
targeting tends to maintain regular channels of communication with the public. It helps in better
decision making by individuals, households and businesses. Reduces financial and economic
uncertainty. Helps in increasing the accountability of central bank. Leads to a higher economic
growth.

Limitations
Inflation targeting has been criticized on various grounds. One of the major amongst them is as follows:
Being criticized on neglecting the output shocks as it solely focuses on the price level.

Lucas critique
Lucas was very critical of the econometric based macro-economic models used for policy evaluation in
the sixties. In this respect he made an argument (Lucas, 1976), popularly known as the ‘Lucas Critique’,
in which he stated that a well specified economic model has two kinds of parameters. These are the
structural parameters such as time preference, the tendencies of risk aversion, the parameters of
production functions etc.; which are likely to remain stable over time. These parameters actually do not
change with the change in policy stances. Then there is a second set of parameters which unlike the
structural parameters quickly respond to the policy changes e.g. during recession people respond very
quickly if they expect a strong counter-cyclical monetary policy. The first set of parameters are called the
‘deep parameters’ and the second set is known as the ‘expectational parameters’. Lucas says that the
models based on the interaction of IS and LM curves are faulty in their methodology as with monetary
and fiscal changes, the slope as well as the positions of the IS and LM curves change with the complex
interaction of deep and expectational parameters. Since the IS-LM approach ignores these interactions,

therefore, the results of these models cannot be relied upon. Lucas emphasizes on understanding the
micro-foundations of the macro economics in order to have a deep analysis of macro-economic policy.
The micro-economic analysis tells us the dynamics of any macro-economic policy and how the
expectations are formed. Understanding these dynamics is very important for a deeper probe of
macroeconomic policy and its effects. Lucas therefore says that the expectations should not be treated
as exogenous but as endogenous to the model that they influence.

3. Active policy
The government use monetary and fiscal tools to drive the economy. Monetary policy includes
performing open market operations, changing reserve requirement and the interest rate by changing
money supply. On the other hand, fiscal policy uses the tools of taxes, transfer payments and
government spending. All of these tools can be controlled actively. The government if it decides to
pursue an expansionary policy, can simply select a tool from the policy toolbox and use it. Active policy
includes all those actions by the government that are done in response to economic conditions. It means
that the government choose to respond to something in the economy by undertaking a specific policy.
As the choice of this policy depends upon the existing state of economic problem therefore this policy is
called as discretionary policyActive policy allows policymakers to respond to shifts in a complex
economy and drive the economy in the optimal direction. For instance, an excellent policymaker may be
able to keep the economy growing steadily without inflation if she is given complete control of
macroeconomic policy. Active policy responds swiftly to the shifts from optimal, as against the natural
adjustment which takes too long. However, the role of expectations is very important in getting the
desired results of any active policy Not only this, the active policy has a number of difficulties associated
with it. As it relies on the actions and experiences of the policymakers and the government, the
weaknesses or prejudices of these policymakers can be translated into official economic policy. For
instance some active policies that enables the economy to grow in the short run, regardless of the long-
term effects, are undertaken to serve the interests of some influential class. Similarly, it may be possible
for the policymakers to pursue policies that achieve their selfish ends rather than those that are best for
the economy at large. With active policy, policymakers can say one thing but may find incentive to
renege on their commitments. There may be benefits to making the public believe that something
different is occurring in the economy rather than what actually is occurring. For instance, if the
government wants to increase investment, it could use deception by claiming that it raised interest rates
while not actually doing so. In this scenario, private investors would save more but investment would
remain at the old level or even increase. Thus, it is reasonable to claim that active policy leaves
monetary policy and fiscal policy open to not only accidental human error but also to malicious and self-
serving acts. Also, for the success of these active policies accurate forecasting is a prerequisite otherwise
costs may surpass the desired benefits of adopting such policies. Apart from this, the problem of lags
make the execution of active policies all the more difficult.

Passive policy
In contrast to active policy, which is discretionary, passive policy is based on policymaking by rule. Under
this system, macroeconomic policy is conducted according to a predefined set of rules. These rules take
into account many macroeconomic variables and dictate the best course of action given these
conditions. For instance, a passive policy may follow the rule that in order to stabilize the economy the
interest rate must be dropped one point whenever the nominal GDP falls one percent. The passive
policy is advantageous as it takes out all those policies which consider the short-term desires of
policymakers, from the list of possible goals of macroeconomic policy. Instead, the focus of policymakers
is simply to carry out the macroeconomic policy aiming to ensure the smooth running of the economy.
Policy by rule uses policymakers to implement, rather than design, macroeconomic policy. The approach
of passive policy is based on optimizing the economy in the long run and are less likely to trade short run
prosperity for long run growth. The passive approach to policy making is more stable than the
discretionary.

Lags in Effects of Policies

Policy lag means delay in policy making and its implementation which in turn delays the attainment of
ultimate objective for which the policy was made. Policy lags can be categorized as inside lag (lag in
getting the policy activated) and outside lag (the subsequent impact of the policy). The three specific
inside lags are recognition lag, decision lag, and implementation lag. An important outside lag is impact
lag. In an economic system at first it takes time to identify that a problem exists. This recognition lag is
all the way present. In the application of some solution for the encountered problem there come
decision lag and implementation lag. Policy lags arise because government actions are not
instantaneous. The use of any stabilization policy encounters time lags between the onset of an
economic problem and the full impact of the policy designed to correct the problem. For instance, for
correcting a business cycle contraction, the adopted stabilization policy cannot correct the problem
instantly. The use of any stabilization policy, especially fiscal policy and monetary policy, takes time to
work through the system. Policy lags, especially inside lags, are often different for monetary policy than
for fiscal policy. The decision lag as well as implementation lags are comparatively shorter for monetary
policy as compared to fiscal policy. This is because the decisions about the monetary policy are taken by
central bank along with a small committee while the fiscal policy decisions are made involving ruling
party, opposition and by passing the laws which takes so much time. Also, monetary policy is
implemented because it works through financial markets which tend to operate and adjust quickly.
Fiscal policy on the other hand takes a long implementation lag as it needs to pass through various
bureaucratic hurdles. Once implemented, the output and aggregate demand tend to change relatively
slowly (impact lag), thereby enlarging the lag. Policy lags can reduce the effectiveness of business-cycle
stabilization policies and can even destabilize the economy. The goal of stabilization policies is to
stabilize the business cycle, to counter contractions and expansions. However, policy lags can actually
make stabilization policies destabilizing. That is, they can worsen the ups and downs of the business
cycle.

Policy Rules vs. Discretion

This has always been a topic of debate that whether economic policies especially the monetary policy be
conducted by rules known in advance or by the policy maker’s discretion. In the previous sections, active
(discretionary) and passive (rule based) policies along with their pros and cons have been discussed. In
recent times, modern central banks and monetary authorities have increasingly shed secrecy and
mystique to engage in communicating to the public their policy framework and rationale, their goals and
why they chose them, and the manner in which they intend to achieve their stated objectives. This
reflects highly discretionary policy being in place. The public have shown a preference for a monetary
policy that is disciplined by principles of systematic conduct so that the temptation of higher inflation
can be resisted, accountability and credibility can be earned, and policy uncertainty among market
participants can be reduced. This reveals a conscious effort to mitigate the problem of dynamic
inconsistency to some kind of pre-commitment to a policy rule. Rule based economic and monetary
policies work efficiently under a given set of conditions. In real world, economic conditions are not static
but purely dynamic, so a given rule which works in one set of conditions may not work that much
effectively in another. One monetary policy rule is better than another only if it results in better
economic performance according to some criteria such as inflation or the variability of inflation and
output. Neither theory nor evidence points convincingly to any of the numerous competing models as
superior in explaining the interaction of nominal and real variables as occurs in actual practice. The
relevance of expectations of the future and events of the past to current decisions gives the modern-day
rules a dynamic feature. Changes in preferences or technology make the decision rules stochastic. The
rules pertain to the whole economy, not to an individual sector, and this makes them general
equilibrium rules. There have been many simple and complex rules like Taylor rule, McCullum rule which
have guided the policies. Simple policy rules work well; their performance is surprisingly close to that of
fully operational policies and more robust than complex rules across a variety of models. Although policy
rules can be written down algebraically, they will probably be more useful as guidelines than as
mechanical formulae for policy makers to follow exactly at least for the near future. The advantage with
rule based policies is that they promote transparency and bring in certainty in the policy environment.
Rules that have optimal properties help to deal with the uncertainty inherent in the monetary policy
process, uncertainty about the current state of the economy and about where the economy would be
going with no change in the policy rate

More generally, policy tools that are based on rules leave less room for policy error. Moreover, once in
place, they act as an effective pre-commitment device. A rule-based approach requires a very high
degree of confidence that the predefined variables would always correctly perform as intended, without
noise. This is difficult to achieve for inflation targeting, much more so for identifying financial instability.
In fact, the adoption of a purely rule-based framework focusing on a macroeconomic indicator has faced
several drawbacks including, for instance, the inability to face unexpected structural changes. A
discretionary framework comes to the rescue to addresses this issue, by allowing policymakers to
actively learn from observing the interaction of relevant stakeholders. Flexibility and adaptability of
discretion have some costs associated as they involve limited predictability of decisions and they come
along with an incentive for policymakers to postpone backfiring decisions, particularly if they are subject
to some form of political pressure – including the pressure of public opinion. Thus, rules would be the
everyday framework, while discretion would represent an extreme resort.

Provided that the two are extremes and there is a trade-off between ex-ante efficiency of discretion and
ex-post efficiency of rules, hybrid regimes of constrained discretion willserve the objectives of monetary
policy. This hybrid setting can put more emphasis on rules and changing the discretion as and when
required. In order to mitigate the possible dangers generated by discretion, central banks may opt for a
clearly stated, transparent and accountable decision making process.

Credibility and Time Consistency

Time consistent policy is policy that will be sustained as circumstances change over time. These policies
will be purely rule based. If the authorities adhere to a policy rule, it may require pursuing a policy at a
particular point in time that is not optimal at that time. In contrast, policy that is time inconsistent will
be reversed in the future due to predictable developments over time. Time consistency is easier to
understand in terms of its opposite concept of time inconsistency. Time inconsistency refers to the
situation in which some agent, planner or objective maximizers must make a choice about an action or
decision in some future plan and in which what is optimal initially is no longer optimal at a later date.
This change in what is optimal occurs despite the fact that nothing new has happened and no physical
circumstances change, except that decisions of the past are locked in place. It means this problem arises
when a decision maker, especially a policy maker, prefers one policy in advance but a different one
when the time to implement arrives. Knowing this, others will not find the commitment to the first
policy credible. This problem is encountered when the policymakers devise some policy for instance, a
monetary expansion with the focus on raising growth but when the actual policy is implemented,
expectations change and the resulting monetary expansion results only in inflation while the original
goal gets defeated. Thus, there can be many situations where monetary or fiscal authorities might
announce some policy change and do not implement it at the later date. But continuously reneging on
its pre commitments may lead to falling credibility for the policies of the government and these policies
may not be able to influence the economic outcomes at the time of crisis when they are actually
implemented for the welfare of the economy. From an economic perspective, the issue of time
consistency emphasizes the problem of predictably changing incentives over time.

There are two approaches that can be adopted to achieving time consistency in government policy:

1. To limit policy to rules that the government will have an incentive to pursue in all normal future
circumstances. 2. To develop capacity for commitment or raising credibility to a policy path. A
commitment mechanism is a means for removing the risk of opportunistic policy in particular
contingencies. Commitment mechanisms are closely related to more general factors that enhance policy
credibility. There can be many actions that may raise the credibility or strengthen the commitment of
economic policies of the government. For instance, Integration into the world economy can strengthen
commitment to policies that foster private investment. A government can enter into agreements with
other governments or international institutions to make deviations from prudent trade and
macroeconomic policy more difficult for itself. If a country enters into bilateral agreements with other
countries it raise the government commitment to free trade. Just as countries, domestic institutions can
also foster policy commitment. A valued reputation for pursuing particular types of policies can also
serve as an assurance that such policy will be pursued consistently despite adverse short-term
incentives. Along with policy commitment, policy credibility has emerged as an important recent
development in both the theory and practice of macroeconomic policy. From a theoretical perspective,
new analyses recognize that government policy-making responds to incentives and constrains. Thus the
structure of government incentives and constrains affect policy choices. Experience has also shown that
similar policies can produce different outcomes, depending on the extent to which economic agents
believe that the given policy will be continued. Thus, recognizing economic agent’s likely assessment of a
proposed policy has become an important issue for policy makers. While full commitment to a policy
stance is not feasible in the real world, economics can provide alternative ways to limit discretion and tie
the hands of policymakers with rule based policies, thereby yielding better economic outcomes. Time-
inconsistency problems are inherent in economic policy and these cannot be eliminated by making the
process of policy making independent. Time consistent policy will remain a problem for government and
central banks because current and future policymakers will not conduct policy in a systematic manner
without credible commitments to explicit rules. Wide empirical evidence exists to support the view that
limiting discretionary behavior yields better economic outcomes over the long run. In the Keynesian
framework, discretionary monetary policy is essential to offset output fluctuations. While the
monetarists propose a tight, fixed rule to ensure price stability. However, the time consistency literature
shows that discretion-based solutions would be the first-best strategy in terms of raising agents’ utility,
but they are not time-consistent. In fact, strategic responses of rational, utility-maximising agents lead
to an ex-post suboptimal arrangement, but rules ensure that in the long run at least a second-best is
achieved.
Meaning of Random Walk Theory

The Random-Walk Hypothesis is due to Robert Hall (1978) and is based on Fisher’s model & Permanent
income hypothesis, in which forward-looking consumer’s base consumption on expected future income.
To this Hall adds the assumption of rational expectations, that people use all available information to
forecast future variables like income. In the permanent income hypothesis as doctrine by Milton
Friedman and Life cycle hypothesis as doctrine by Modigliani, basically specified that household base
their consumption on their permanent income and not on the transitory income. Thus, if PIH is correct
and consumers have rational expectations, then consumption should follow a random walk that is
changes in consumption should be unpredictable. A change in income or wealth that was anticipated
has already been factored into expected permanent income, so it will not change consumption. Only
unanticipated changes in income or wealth that alter expected permanent income will change
consumption. The independence of consumption changes from expected changes in income is known as
the random-walk hypothesis of consumption. Notice that the random-walk hypothesis is not a separate
theory but rather an implication of the neoclassical model. It was first explored in a seminal study by
Robert Hall (1978).

The discussion of random walk hypothesis would be like, simple discrete-time model with a zero rate of
time preference and a zero interest rate. The zero interest rate implies that the consumer can trade
current for future consumption at a one-for-one rate in the market. The zero rate of time preference
assures that a consumer who is smoothing consumption is indifferent about making that trade.

In the context of random walk hypothesis, Romer expresses the first-order condition for utility
maximization the marginal utility of consumption in period one must equal the consumer’s expectation
of the marginal utility of consumption in each future period. Assuming rational expectations, we can
associate the consumer’s expectations with the mathematical expectation of the variable. Carrying the
expectation operation through this we can conclude that the expected value of consumption in all
future years equals the level of consumption in period one. According to this, it means that the
consumer chooses a perfectly flat consumption path from years 1 through T. It is simple due to the
assumptions that both the interest rate and the rate of time preference are zero. As we know from our
consumption analysis in the Ramsey growth model, utility-maximizing consumers select a rising, flat, or
falling time path of consumption depending on whether the interest rate is greater than, equal to, or
less than the consumer’s rate of time preference. Thus, the model is complicated even more when these
assumptions are relaxed, but the main idea still holds, that is, changes in consumption from one period
to the next do not depend on correctly anticipated changes in income. Romer explained what causes
change in consumption from period 1 to period 2. The change in the household’s expectation of its
future income is based on information that becomes available in period two. Thus, changes in
expectations of income (even if they are changes that are expected to happen in future periods) will
cause the household to revise its consumption path and make second-period consumption differ from
first-period consumption

Summary of random walk hypothesis:

Theory of random walk is based on the Friedman's permanent income hypothesis and theory of rational
expectations. According to Friedman's permanent income hypothesis, consumption depends primarily
on permanent income. At any point of time in theirlifetime, consumption is chosen by consumers based
on their current expectations about lifetime incomes. They would then change their consumption when
they receive news that causes them to change their expectations about their lifetime income. For eg., a
person getting an unexpected promotion would revise his expectations about lifetime income upwards
and thus consume more. As long as consumers use all the existing information to assess their lifetime
income, as long as they have rational expectations, then they should only be surprised by events that
were entirely unpredictable. Therefore, changes in their consumption should be unpredictable as well.
Hall (1978) tests this theory using postwar aggregate US data and finds that past consumption data have
no power to predict future consumption as he was not able to reject the hypothesis that lagged values
of either income or consumption cannot predict the change in consumption. Hall's theory is based on
several assumptions that he uses in testing the stochastic version of life-cycle & permanent income
hypotheses and which can be challenged. Firstly, there is the simplifying assumption of a quadratic
utility function, which implies that marginal utility is linear in consumption. As a consequence, the
individual consumption choice shows certainty equivalence, which means that individuals ignore the
variation of consumption and act as if future consumption was as the conditional mean. Hall further
assumes that consumer want to keep marginal utility & therefore consumption constant over time.

Modigliani’s life cycle hypothesis

Consumption function plays an important role in the theory of income and employment. There are 4
basic kinds of macro consumption functions:

Keynes’s, Absolute income hypothesis: Here Keynes laid stress on the absolute size of the income as
determinant of consumption. According to him as income increases, consumption also increase, but less
than proportionate to rise in income. This can simply be interpreted as marginal propensity to consume
being greater than 0 but less than 1.

Duesenberry’s, Relative income hypothesis: According to Duesenberry’s relative income hypothesis,

consumption of an individual is not the function of his absolute income but of his relative position in the
distribution in a society. That is, his consumption depends on his income relative to the income of others
individuals in the society. For example, suppose the income level of all individuals in the society increase
by the same percentage, then his relative income would remain same, though his absolute income has
increased. According to him, because relative income has remained same the individual will spend the
same proportion of his income on consumption as he was doing before the absolute increase in his
absolute income

Modigliani’s, Life cycle hypothesis: According to Modigliani’s life cycle hypothesis, individual’s
consumption is not the function of his current income but his expected future income throughout his life
time. Individual wants to maintain steady or slightly increasing consumption pattern throughout their
life time, and for this they base their spending on consumption on future expected income instead of
current income.
Friedman’s, Permanent income hypothesis According to Friedman’s permanent income hypothesis,
consumption of an individual depends on his long term expected income which is called by Friedman as
permanent income on the basis of which people make their consumption plans he argued that an
individual would prefer a smooth consumption flow per day rather than plenty of consumption today
and little consumption tomorrow.

Friedman’s PIH which differs from LCH primarily in that it models rational consumption and saving
decisions under the “simplifying” assumption that life is indefinitely long. Accordingly, the notion of life
resources is replaced by that of “permanent income”, while the discrepancy between current and
permanent income is labeled “transitory”.

Life cycle theory today=

For a theory that is so central to economic analysis, and that has been worked on by so many people,
the life-cycle hypothesis has aged well. And although the ways in which the theory is used have
changed, the hypothesis continues to provide the framework in which economists think about
intertemporal issues at both the individual and economywide levels.

The LCH affects the understanding of the working of the economy and of the effectiveness of fiscal and
monetary policies. Like, LCH provides a direct linkage between the monetary policy, interest rate and
consumption, because a change in the interest rate affects the market value of assets and therefore
consumption. In case of a fiscal policy, LCH suggests that expenditures financed by deficit tend to be
paid by future generations; those financed by taxes are paid by current generations. National debt is
hence a burden: as it reduces the stock of private capital, which in turn reduces the flow of output, if
capital is productive

This basic model led to a number of implications which were at that time quite novel and surprising -
almost counter intuitive. They included the following:

1. The saving rate in a country is completely independent of the country's per capita income. 2. The
national saving rate is not simply the result of differential thrift of its citizens, in the sense that different
national saving rates are consistent with an identical individual (life cycle) behavior. 3. In countries
having identical individual behavior the aggregate saving rate will be higher, the higher is the long run
growth rate of the economy. It will be zero for zero growth. 4. The wealth-income ratio is a decreasing
function of the growth rate, thus being largest at zero growth. 5. A country can easily accumulate a
substantial stock of wealth relative to income even if no wealth is passed on by bequests. 6. The main
parameter that controls the wealth-income ratio and the saving rate for given growth is the prevailing
length of retirement

Some of the major areas of applications with a brief statement of the LCH implications:

1. Short run stabilization policy:

i) The monetary mechanism: The fact that wealth enters importantly in the short run consumption
function means that monetary policy can affect aggregate demand not only through the traditional
channel of investment but also through the market value of assets and consumption

ii) Transitory income taxes: Attempts at restraining (or stimulating) demand through transitory income
taxes (or rebates) can be expected to have small effects on consumption and to lower (raise) saving
because consumption depends on life resources which are little affected by a transitory tax change

2. Long run propositions:

i) Consumption Taxes: A progressive tax on consumption is more equitable than one on current income
because it more nearly taxes permanent income (quite apart from its incentive effects on saving.)

ii) Short and long run effects of deficit financing: Expenditures financed by deficit tends to be paid by
future generations; those financed by taxes are paid by the generation living today. The conclusion is
based on the proposition that private saving, being controlled by life cycle considerations, should be
(nearly) independent of the government budget stance, and therefore private wealth should be
independent of the national debt.

Monetary Approach to Balance of Payments

Introduction

Monetary Approach to balance of payment came up in the years of 1950s and 1960s by the
International Monetary Fund’s research department under Jacques J. Polak, and by Harry G. Johnson,
Robert A. Mundell, and theirstudents at the University of Chicago.According to this theory, “a balance of
payments deficit is always and everywhere a monetary phenomenon.”, hence, it can only be corrected
by monetary measures. According to Humphrey (1981), “The monetary approach is a framework for
analyzing how integrated open national economies eliminate their excess money supplies and demands”

Purpose of Monetary approach to balance of payments

Monetary approach to balance of payment, as a theory came up as a criticism to earlier theories of

achieving balance of payments. The purpose of this approach was to consider money supply as an
important determinant in the balance of payment, and to understand the role of monetary policy in the
adjustment of prices at the international level or the world prices. Johnson (1977) writes, “the purpose
of the ‘monetary approach’ is to develop a theory of the balance of payments based on the fact that the
balance of payments is a monetary phenomenon in a monetary international economy, and requires
analysis in terms of monetary concepts, and especially the concept of money as a stock and of monetary
adjustments as adjustments of actual to desired stocks, rather than in terms of international money
flows as the residuals of ‘real’ flows determined by real relative prices and incomes.” Thus, giving a
monetary angle to the balance of payments is the motive behind the monetary approach to balance of
payments.
. Criticism=The monetary approach to balance of payments has been criticized on two major counts.
First, it completely neglects short run analysis, and money demand is assumed to a stable function of
income, prices and interest rates which may not be true in the short-run. Second, there are some
market imperfections, trade regulations, and information asymmetries because of which law of one
price may not hold.

. Signaling

This acts as a proxy measure to communicate information about unobservable characteristics of the
good or service traded. This is generally seen as an attempt by the informed side of the market to
communicate valuable information to the unknown party. For example, in the market for lemons, the
seller is better informed about the quality of car and can signal his superior product from lemons by
giving warranty to the buyers for the quality of the car. This acts as a signal for the buyer to pay higher
price for the plum (good-quality car) rather than paying the average price. Similarly, in the insurance
market, those at the lower side of risk will be less willing to pay high premium. Signaling thus is a useful
tool to lessen the problem of asymmetric information. Warranties, discounts, guarantees, educational
levels all these are the means of signaling, used to eliminate information asymmetries.

theory of second best

The theory of second best concerns a situation when one or more optimality conditions cannot be
satisfied. Arrow’s Impossibility Theorem also says that any Social Welfare Function (SWF) cannot satisfy
all the optimality conditions simultaneously. These optimality conditions include Non- Dicatatorship,
Unrestricted domain, Weak Pareto criterion and Independence of Irrelevant Alternatives. Rawls’ theory
of justice builds on the social contract tradition to offer an alternative to utilitarianism. Rawls singles out
justice – not maximum welfare or efficiency – as “the first virtue of social institutions”.

When one optimality condition in an economic model cannot be satisfied, then opting the next best
solution involves changing other variables away from the values that would otherwise be optimal. In an
economy with some un-correctable market failure in one sector, government intervention to correct
market failures in another related sector with the intent of increasing overall economic efficiency may
actually decrease overall economicefficiency. So, practically it is always better to let two market
imperfections cancel each other out rather than making an effort to fix either one. Thus, it may be
optimal for the government to intervene in the second market in a way that does not affect the first
market. Therefore the theory advises that there is a need to study the details of the situation before
jumping to the theory-based conclusion because an improvement in market perfection in one area may
not necessarily imply a global improvement in efficiency. For Example: There exists a monopoly that
created pollution as an outcome of its production process and this pollution causes harm to the river
nearby affecting the outcome of the fishery industry in a negative way. Suppose in addition that there is

nothing at all that can be done about the pollution without also reducing production. The government
can however break up the monopoly of the firm creating pollution. But, if the government does this i.e.
increasing competition in this market increases production and because pollution is an outcome of the
production so, with increase in production, pollution also increases. Thus, it is not clear that eliminating
the monopoly increases efficiency. Gains from trade in coal will increase, but externalities from pollution
will increase as well, possibly outweighing the gains from trade.

Arrow’s Impossibility Theorem

Arrow’s Impossibility Theorem shows that there is no perfect way to “aggregate” individual preferences
to make one social preference. It is pointed out by Arrow that a social decision mechanism (way of
aggregating preferences), should have the following features: Given any set of complete, reflexive, and
transitive individual preferences, the social decision mechanism should result in social preferences that
satisfy the same properties. If everybody prefers alternative x to alternative y, then the social
preferences should rank x ahead of y. The preferences between x and y should depend only on how
people rank x versus y, and not on how they rank other alternatives. Arrow’s theorem says that the
three very plausible and desirable features of a social decision mechanism are inconsistent with
democracy: there is no “perfect” way to make social decisions. In order to find a way to aggregate
individual preferences to form social preferences, we will have to give up one of the properties of a
social decision mechanism described in Arrow’s theorem. The most probable feature of social welfare
function, described above, that can be dropped is the property 3. Actually, if the property that social
preference between two alternatives only depends on the ranking of those two alternatives, then
certain kinds of rank-order voting become possible.

Sources of monopoly power

Monopolies derive their market power from barriers to entry - circumstances that prevent or greatly
impede a potential competitor's entry into the market or ability to compete in the market. There are
three major types of barriers to entry; economic, legal and deliberate.
Economic barriers: Economic barriers include economies of scale, capital requirements, cost
advantages and technological superiority.

Economies of scale: Monopolies are characterised by declining costs over a relatively large range of
production. Declining costs coupled with large start up costs give monopolies an advantage over
would be competitors. Monopolies are often in a position to cut prices below a new entrant's
operating costs and drive them out of the industry. Further the size of the industry relative to the
minimum efficient scale may limit the number of firms that can effectively compete within the
industry. If for example the industry is large enough to support one firm of minimum efficient scale
then other firms entering the industry will operate at a size that is less than MES meaning that these
firms cannot produce at an average cost that is competitive with the dominant firm. Finally, if long
run average cost isconstantly falling the least cost way to provide a good or service is through a
single firm.
Capital requirements: Production processes that require large investments of capital, or large
research and development costs or substantial sunk costs limit the number of firms in an industry.
Large fixed costs also make it difficult for a small firm to enter an industry and expand.
Technological superiority: A monopoly may be better able to acquire, integrate and use the best
possible technology in producing its goods while entrants do not have the size or fiscal muscle to use
the best available technology. In plain English one large firm can sometimes produce goods cheaper
than several small firms.
No substitute goods: A monopoly sells a good for which there is no close substitutes. The absence
of substitutes makes the demand for the good relatively inelastic enabling monopolies to extract
positive profits.
Control of Natural Resources: A prime source of monopoly power is the control of resources that
are critical to the production of a final good.
Network Externalities: The use of a product by a person can affect the value of that product to other
people. This is the network effect. There is a direct relationship between the proportion of people
using a product and the demand for that product. In other words the more people who are using a
product the higher the probability of any individual starting to use the product. This effect accounts
for fads and fashion trends. It also can play a crucial role in the development oracquisition of market
power. The most famous current example is the market dominance of the Microsoft operating system
in personal computers.
Legal barriers: Legal rights can provide opportunity to monopolise the market in a good.
Intellectual property rights, including patents and copyrights, give a monopolist exclusive control
over the production and selling of certain goods. Property rights may give a firm the exclusive
control over the materials necessary to produce a good.
Deliberate Actions: A firm wanting to monopolise a market may engage in various types of
deliberate action to exclude competitors or eliminate competition. Such actions include collusion,
lobbying governmental authorities, and force.
In addition to barriers to entry and competition, barriers to exit may be a source of market power.
Barriers to exit are market conditions that make it difficult or expensive for a firm to leave the
market. High liquidation costs are a primary barrier to exit. Market exit and shutdown are separate
events. The decision whether to shut down or operate is not affected by exit barriers. A firm will
shut down if price falls below minimum average variable costs.

Arrow-Pratt measures of risk-aversion

It is sometimes important to know how averse to risk a certain individual is. To this effect there
are a set of tools to measure risk in a quantitative way. The most common and frequently used
measure of risk aversion are the Arrow-Pratt measures of absolute and relative risk-aversion.
Named after John W. Pratt’s paper “Risk Aversion in the Small and in the Large”, 1964,
and Kenneth Arrow’s “The Theory of Risk Aversion”, 1965, these are the measures:Arrow-Pratt
measure of absolute risk aversion:

Arrow-Pratt measure of relative risk aversion: 

Where x is the payoff of a given lottery and U(x) the utility derived from that payoff.