Filamer Christian University

College of Teachers Education

Accredited Level IV – ACSCU – AAI
Roxas Avenue, Roxas City

COMPARATIVE ECONOMIC PLANNING

Ma. Kissiah L. Bialen

Activity #7
Discuss monetary policy

Monetary policy is a central bank's actions and communications that manage the

money supply. The money supply includes forms of credit, cash, checks, and money
market mutual funds. The most important of these forms of money is credit. Credit
includes loans, bonds, and mortgages. Monetary policy increases liquidity to create
economic growth. It reduces liquidity to prevent inflation. Central banks use interest
rates, bank reserve requirements, and the number of government bonds that banks must
hold. All these tools affect how much banks can lend. The volume of loans affects the
money supply. Monetary policy increases liquidity to create economic growth. It
reduces liquidity to prevent inflation. Central banks use interest rates, bank reserve
requirements, and the number of government bonds that banks must hold.

All these tools affect how much banks can lend. The volume of loans affects the money
supply. The goals of monetary policy are to promote maximum employment, stable prices and
moderate long-term interest rates. By implementing effective monetary policy, the Fed can
maintain stable prices, thereby supporting conditions for long-term economic growth and
maximum employment. Monetary policy consists of the process of drafting, announcing, and
implementing the plan of actions taken by the central bank, currency board, or other
competent monetary authority of a country that controls the quantity of money in an economy
and the channels by which new money is supplied. Monetary policy consists of management
of money supply and interest rates, aimed at achieving macroeconomic objectives such as
controlling inflation, consumption, growth, and liquidity. These are achieved by actions such as
modifying the interest rate, buying or selling government bonds, regulating foreign exchange
rates, and changing the amount of money banks are required to maintain as reserves.

Economists, analysts, investors, and financial experts across the globe eagerly await the
monetary policy reports and outcome of the meetings involving monetary policy decision-
making. Such developments have a long lasting impact on the overall economy, as well as on
specific industry sector or market. Monetary policy is formulated based on inputs gathered
from a variety of sources. For instance, the monetary authority may look at macroeconomic
numbers like GDP and inflation, industry/sector-specific growth rates and associated figures,
geopolitical developments in the international markets (like oil embargo or trade tariffs),
concerns raised by groups representing industries and businesses, survey results from
organizations of repute, and inputs from the government and other credible sources. Monetary
authorities are typically given policy mandates, to achieve stable rise in gross domestic
product (GDP), maintain low rates of unemployment, and maintain foreign exchange and
inflation rates in a predictable range. Monetary policy can be used in combination with or as an
alternative to fiscal policy, which uses taxes, government borrowing, and spending to manage
the economy. The Federal Reserve Bank is in charge of monetary policy in the United States.
The Federal Reserve has what is commonly referred to as a "dual mandate": to achieve
maximum employment while keeping inflation in check. Simply put, it is the Fed's responsibility
to balance economic growth and inflation. In addition, it aims to keep long-term interest rates
relatively low. Its core role is to be the lender of last resort, providing banks with liquidity and
serve as a bank regulator, in order to prevent the bank failures and panics in the financial
services sector. Some monetary policy examples include buying or selling government securities
through open market operations, changing the discount rate offered to member banks or
altering the reserve requirement of how much money banks must have on hand that's not
already spoken for through loan.

Fiscal Policy

Fiscal policy is the use of government spending

and taxation to influence the economy. When the
government decides on the goods and services it
purchases, the transfer payments it distributes, or the
taxes it collects, it is engaging in fiscal policy. The
primary economic impact of any change in the
government budget is felt by particular groups—a tax
cut for families with children, for example, raises their
disposable income. Discussions of fiscal policy, however, generally focus on the effect of
changes in the government budget on the overall economy. Although changes in taxes or
spending that are “revenue neutral” may be construed as fiscal policy—and may affect the
aggregate level of output by changing the incentives that firms or individuals face—the term
“fiscal policy” is usually used to describe the effect on the aggregate economy of the overall
levels of spending and taxation, and more particularly, the gap between them. Fiscal policy is
said to be tight or contractionary when revenue is higher than spending (i.e., the government
budget is in surplus) and loose or expansionary when spending is higher than revenue (i.e., the
budget is in deficit). Often, the focus is not on the level of the deficit, but on the change in the
deficit. Thus, a reduction of the deficit from $200 billion to $100 billion is said to be
contractionary fiscal policy, even though the budget is still in deficit. The most immediate effect
of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion, for
example, raises aggregate demand through one of two channels. First, if the government
increases its purchases but keeps taxes constant, it increases demand directly. Second, if the
government cuts taxes or increases transfer payments, households’ disposable income rises,
and they will spend more on consumption. This rise in consumption will in turn raise aggregate
demand.

Fiscal policy also changes the composition of aggregate demand. When the government
runs a deficit, it meets some of its expenses by issuing bonds. In doing so, it competes with
private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion
will raise interest rates and “crowd out” some private investment, thus reducing the fraction of
output composed of private investment. In an open economy, fiscal policy also affects the
exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates
due to government borrowing attracts foreign capital. In their attempt to get more dollars to
invest, foreigners bid up the price of the dollar, causing an exchange-rate appreciation in the
short run. This appreciation makes imported goods cheaper in the United States and exports
more expensive abroad, leading to a decline of the merchandise trade balance. Foreigners sell
more to the United States than they buy from it and, in return, acquire ownership of U.S. assets
(including government debt). In the long run, however, the accumulation of external debt that
results from persistent government deficits can lead foreigners to distrust U.S. assets and can
cause a deprecation of the exchange rate.

Fiscal policy is an important tool for managing the economy because of its ability to
affect the total amount of output produced—that is, gross domestic product. The first impact of
a fiscal expansion is to raise the demand for goods and services. This greater demand leads to
increases in both output and prices. The degree to which higher demand increases output and
prices depends, in turn, on the state of the business cycle. If the economy is in recession, with
unused productive capacity and unemployed workers, then increases in demand will lead
mostly to more output without changing the price level. If the economy is at full employment,
by contrast, a fiscal expansion will have more effect on prices and less impact on total output.
This ability of fiscal policy to affect output by affecting aggregate demand makes it a potential
tool for economic stabilization. In a recession, the government can run an expansionary fiscal
policy, thus helping to restore output to its normal level and to put unemployed workers back
to work. During a boom, when inflation is perceived to be a greater problem
than unemployment, the government can run a budget surplus, helping to slow down the
economy. Such a countercyclical policy would lead to a budget that was balanced on average.
Budget Deficits and Surpluses

Present when total government spending exceeds total revenue from all sources. When
the money supply is constant, deficits must be covered with borrowing. Budget surplus: Present
when total government spending is greater than total revenue. Surpluses reduce the magnitude
of the government’s outstanding debt. Changes in the size of the deficit or surplus are often
used to gauge whether fiscal policy is stimulating or restraining demand. Changes in the size of
the budget deficit or surplus may arise from either: A change in the state of the economy, or, a
change in discretionary fiscal policy. The budget is the primary tool of fiscal policy. Discretionary
changes in fiscal policy: deliberate changes in government spending and/or taxes designed to
affect the size of the budget deficit or surplus.

Keynesian View of Fiscal Policy

The multiplier effect is one of the chief

components of Keynesian countercyclical fiscal policy.
According to Keynes's theory of fiscal stimulus, an
injection of government spending eventually leads to
added business activity and even more spending. This
theory proposes that spending boosts aggregate output
and generates more income. If workers are willing to
spend their extra income, the resulting growth in
the gross domestic product ( GDP) could be even
greater than the initial stimulus amount. The magnitude
of the Keynesian multiplier is directly related to the
marginal propensity to consume. Its concept is simple.
Spending from one consumer becomes income for a
business that then spends on equipment, worker wages, energy, materials, purchased services,
taxes and investor returns. That worker's income can then be spent and the cycle continues.
Keynes and his followers believed individuals should save less and spend more, raising
their marginal propensity to consume to effect full employment and economic growth. In this
way, one dollar spent in fiscal stimulus eventually creates more than one dollar in growth. This
appeared to be a coup for government economists, who could provide justification for
politically popular spending projects on a national scale. This theory was the dominant
paradigm in academic economics for decades. Eventually, other economists, such as Milton
Friedman and Murray Rothbard, showed that the Keynesian model misrepresented the
relationship between savings, investment, and economic growth. Many economists still rely on
multiplier-generated models, although most acknowledge that fiscal stimulus is far less
effective than the original multiplier model suggests.
 The fiscal multiplier commonly associated with the Keynesian theory is one of two broad
multipliers in macroeconomics. The other multiplier is known as the money multiplier. This
multiplier refers to the money-creation process that results from a system of fractional reserve
banking. The money multiplier is less controversial than its Keynesian fiscal counterpart.

Fiscal Policy and the Crowding-Out Effect

The crowding out effect is a prominent economic theory

stating that increasing public sector spending has the effect
of decreasing spending in the private sector. In other
words, according to this theory, government spending may
not succeed in increasing aggregate demand because
private sector spending decreases as a result and in
proportion to said government spending. The government
is effectively taking a greater and greater percentage of all
savings currently usable for investment; eventually, when
the interest rate gets high enough, only the government is able to afford the cost of borrowing–
private firms are then “crowded out” of the market. The crowding effect is a monetarist
criticism of expansionary fiscal policy. (As a refresher, monetarists are those who primarily
attribute shifts in the overall health of the economy to money supply changes; thus, in their
eyes, improving economies’ performance is most effectively achieved when governments make
smart adjustments to the monetary supply.) The idea gained popularity in the 1970s and 1980s,
as economists who valued a free market above all else chose to raise warnings about the
increasing portion of the GDP for which the public sector was becoming responsible.

How Does the Crowding Out Effect Work?

When the government of a large country raises its overall borrowing, this can cause a
major effect on the economy in the form of a concurrent increase in that economy’s real
interest rate. As a result, the economy’s lending capacity is absorbed so that businesses are less
likely to want to invest capital in new ventures. This is because firms typically rely on financing
in order to be able to afford these kinds of investments; when the opportunity cost of relying
on financing (of borrowing money) increases, investments that would be financially worthwhile
become excessively costly and therefore unprofitable.

Crowding Out Effect Graph

A rise in interest rates would discourage private

investors from investing, and private consumption may
also decrease as many large purchases are made on credit. So the result could be a rise from
AD1 to AD2, instead of AD1 to AD3.

Impact of the Crowding Out Effect

Increasing taxes if the government increases the tax on the private sector (for instance,
by raising income taxes or increasing corporate taxes), the effect will be that this reduces the
disposable income of consumers and firms. All other things remaining equal, raising taxes on
consumers will lead to lower consumer spending. Therefore, higher government spending
financed by the higher tax should not have the effect of increasing overall aggregate demand
because the increase in G (which denotes government spending) is counterbalanced by a
decrease in C (which represents consumer spending). Increasing borrowing when governments
increase their borrowing, they must do this borrowing from the private sector. In order to
finance this increased debt, a government ends up selling bonds to the private sector through
the central bank. This activity is referred to as open market operations. These bonds could be
sold to private individuals, pension funds, or investment trusts. If the private sector buys these
government securities, they will not be able to the same funds to invest in the private sector.
Therefore, government borrowing ends up crowding out private sector investment–hence the
use of the term “crowding out effect.”

Fiscal Policy as a Stabilization Tool: A Modern Synthesis

During the 1960’s, the basic Keynesian view was widely accepted. Fiscal policy was
thought to be highly potent. Furthermore, it was widely believed that political decision makers,
with the assistance of their economic advisers, were fully capable of instituting discretionary
fiscal policy changes in a matter that would help stabilize the economy. During the 1970s and
1980s, however, fiscal policy and its efficacy as a stabilization tool were analyzed and hotly
debated by economics. A synthesis view has emerged from that debate. Most macroeconomics
both Keynesian and non- Keynesian now accept the following four elements of the modern
synthesis view.

1. Proper timing of discretionary fiscal policy is both difficult to achieve and crucially
important. Given our limited ability to forecast ups and downs in the business cycle, and
the political delays that inevitably accompany a change in fiscal policy, the effectiveness
of discretionary fiscal policy as a stabilization tool is limited. In addition, the incentive
structure confronted by elected political officials reduces the likelihood that fiscal policy
 changes will be instituted in a stabilizing manner. Therefore, most macroeconomists
now place less emphasis on the use of fiscal policy as a stabilization tool.
2. Automatic stabilizers reduce fluctuations in aggregate demand and help direct the
economy toward full employment. Since they are not dependent upon legislative action,
automatic stabilizers are able consistently to shift the budget toward a deficit during a
recession and toward a surplus during an economic boom. They add needed stimulus
during a recession and act as a restraining force during an inflationary boom. Although
some economists question their potency, nearly all agree that they exert a stabilizing
influence.
3. Fiscal policy is much less potent than the early Keynesian view implied. The current
debate among macroeconomics concerning the impact of fiscal policy during normal
times is not whether crowding-out take place, but rather how it takes place. The
crowding-out and new classical models highlight this point. Both models indicate that
there are side effects of budget deficits that will substantially, if not entirely, offset their
impact on aggregate demand. In the crowding-out model, higher real interest rates and
a decline in next exports as the result of currency appreciation reduce private demand
and offset the expansionary effects of budget deficits. In the new classical model, higher
anticipated future taxes lead to the same result. Both models indicate that fiscal policy
will have little, if any, effect on current aggregate demand, employment, and real output
during normal economics times.
4. Each of the three demand-side models of fiscal policy is valid under some circumstances
but not others. During normal times, when is a strong demand for loanable funds, the
crowding-out view is largely correct. Under these conditions, budget deficits will lead to
higher interest rates and appreciation in the foreign exchange value of the domestic
currency, which will tend to offset the expansionary effects of the budget deficits, just as
the crowding-out model implies. However, when the demand for loanable fund is weak,
as it is likely to be during a recession, deficits will not raise interest rates much, and
expansionary fiscal policy can stimulates demand and increase output as the Keynesian
model implies. Finally, when it is announced that tax cut is temporary or that taxpayers
will be given a “one-time-only” tax rebate, the key will be in a better position to pay the
higher future taxes. In this case, the budget deficit will exert little impact on either
interest rates or aggregate demand, just as the new classical model implies. Thus,
depending on the current conditions, each of the three demand-side models can add to
our understanding of how policy works.