Assignment on Macroeconomics-202

(Fiscal Policy & Monetary Policy)

Submitted to:
Syed Shah Saad Andalib Lecturer in macro economics.

Bangladesh University of Business & Technology

Submitted by:
Aysha Haider ID: 40, Sec: 02, Intake: 20th BBA.

Bangladesh University of Business & Technology

Submission date: 03/01/2011

SL. No: 1

Name of Topic Fiscal Policy & Monetary Policy

Page. No: 3

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Fiscal Policy Mathematically Example of Fiscal policy Monetary Policy

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Types of monetary policy Importance of Monetary Policy Fiscal Policy V/S Monetary Policy - - The Difference Three possible positions of fiscal policy

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Fiscal Policy & Monetary Policy

In 1936 Jhon Maynhord Keynes wrote a book General theory of employment interest & money for reducing unemployed rate. He gives two policies they are Fiscal policy & Monetary policy

Fiscal Policy
Economy depends on investment position. If investment decreases then the economy falls. On the other hand when investment increases then the economy goes to a good position. Fiscal policy deals in govt. spending and revenue collection by the way of tax. Whereas Monetary Policy is a process which controls the demand and supply of money. Fiscal policy is changes in the taxing and spending of the federal government for purposes of expanding or contracting the level of aggregate demand. In a recession, an expansionary fiscal policy involves lowering taxes and increasing government spending. In an overheated expansion, acontractionary fiscal policy requires higher taxes and reduced spending. According to Keynes, a recession requires deficit spending and an overheated expansion requires a budget surplus.

We have, Y= C+I+G Where, C=C0+CY

Y= C0+CY +I+G

There, Y= Income
C= Consumption I= Investment G= Govt. Spending C0= Autonomous Consumption CY= Marginal propensity to consume.

Mathematically Example of Fiscal policy:

Given, C= 100+0.8yd T= 0.2y I= 40 G= 50 1. What will be national income? Show the effect of the national income if tax rate change to 0.18y 2. If national income is 500 then compute the disposable income. 3. If disposable income is 400 then find the tax rate.

1) We know, Y= C+I+G
Y= (100+0.8Yd)+I+G Y= 100+0.8(Y-T)+I+G [Yd= Y-T] Y= 100+ 0.8Y-0.8T+I+G Y= 100+0.8Y-0.8(0.2Y)+40+50 100+0.64Y+90 Y-0.64Y= 190 Y(1-0.64)= 190

Y= Y= Y= $ 527.78

2)

Y=C+I+G Y=100+0.8Yd+I+G 500=100+0.8Yd+40+50 500-190=0.8Yd 0.8Yd= 310

Yd= Yd= 387.5

3)

Y=C+I+G Y=100+0.8Yd+40+50 Y=100+0.8*400+90 Y=190+320 Y=510

& We know,
Yd=Y-T => 400= 510-T => 400-510= -T => T= 110

ANS
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If, C0= 70
I= 20 G= 10 & C= 0.8 Then, Y= C0+CY +I+G Y- CY= C0+I+G Y(1-C)= C0+I+G Y= Y= Y= Y= 500 In this position everything is perfect but when the investment will reduce then the effect goes to an economy. If the investment reduces from 20 to 10 then the situation is less. Y= = = = 450.

In this position the economy is decreasing but the govt. can take step in this position. Govt. has to invest more in the market. When govt. spending increases from 10 to 20 then they can solve the problem. Y= = = 500

By this fiscal policy taken by the govt. can solve the problem arise in the economy. This is possible because money goes from on hand to another hand with the following chain relationship. 10+8+6.4+5.12+. 10+ (1+0.8) + (10*0.8*0.8) + (10*0.8*0.8*0.8) + 10 + (1+0.8+0.82+0.83+0.84+.) 10*1/1-0.8 10/0.2 50 Indicates that (when people earn $10 then they spend $8).

Monetary Policy
When the interest rate is high then money demand is low & when the interest rate is low then the money demand is high. Therefore, the investment of macroeconomic policies of monetary policy which is conducted through the management of the nations, money, credit & Banking system. This tool is actually used to control the money circulation.

money

From the above fig. we can see that when interest rate decreases then demand of money increases. & when interest rate increase then the demand of money falls. It is also seen that when interest rate is low then the investment of economy increases. When interest rate is high then investment decreases. For instance money supply increases result the money supply shift to the right side. Consequently interest rate decreases to increases the investment. Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy is generally referred to as either being an expansionary policy, or a contractionar policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation.

Types of monetary policy

In practice, all types of monetary policy involve modifying the amount of base currency in circulation. This process of changing the liquidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations. Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy: Inflation Targeting Price Level Targeting Monetary Aggregates Fixed Exchange Rate Gold Standard Mixed Policy

Target Market Variable: Interest rate on overnight debt Interest rate on overnight debt

Long Term Objective: A given rate of change in the CPI

A specific CPI number

The growth in money supply A given rate of change in the CPI The spot price of the currency The spot price of gold Usually interest rates

The spot price of the currency Low inflation as measured by the gold price Usually unemployment + CPI change

Importance of Monetary Policy

The growing importance of monetary policy and the diminishing role played by fiscal policing economic stabilization efforts may reflect both political and economic realities. Fighting inflation requires government to take unpopular actions like reducing spending or raising taxes, while traditional fiscal policy solutions to fighting unemployment tend to be more popular since they require increasing spending or cutting taxes. Political realities, in short, may favor a bigger role for monetary policy during times of inflation.

One other reason suggests why fiscal policy may be more suited to fighting unemployment, while monetary policy may be more effective in fighting inflation. There is a limit to how much monetary policy can do to help the economy during a period of severe economic decline, such as the States encountered during the 1930s. The monetary policy remedy to economic decline is to increase the amount of money in circulation, thereby cutting interest rates. But once interest rates reach zero, the Fed can do no more. The United States has not encountered this situation, which economists call the "liquidity trap," in recent years, but Japan did during the late 1990s. With its economy stagnant and interest rates near zero, many economists argued that the Japanese government had to resort to more aggressive fiscal policy, if necessary running up a sizable government deficit to spur renewed spending and economic growth.

Fiscal Policy V/S Monetary Policy - - The Difference

Monetary Policy is being implemented by the central bank i.e. the RBI where as the Fiscal policy decisions are set by the National Govt. Both these policies are adopted to control the economic growth of the country.

A monetary policy is expected to improve the economy's rate of growth of output (which is measured by GDP. Tight or restrictive monetary policy is designed to slow the economy in the future to offset inflationary pressures. Likewise, fiscal policies, tax cuts, and spending increases are normally expected to stimulate economic growth in the short run, while tax increases and spending cuts tend to slow the rate of future economic expansion.

Fiscal Policy and Monetary Policy both are the major terms used in the economics and both deal in the overall demand and supply of India. Fiscal policy deals in govt. spending and revenue collection by the way of tax. Whereas Monetary Policy a process which control the demand and supply of money. Fiscal Policy can affect monetary policy. Fiscal policy can affect the inflationary rates also through its effect on aggregate demand. For E.g. As now we know that fiscal policy deals in govt. spending and taxation, so if govt. start levying extra tax then the consumer will have less money in their hands and thus less spending. Less spending means less demand that means more supply and less demand which will ultimately result in cheaper goods and thus the inflation rates will start to lower. This is only the one case I have explained which can be in either case as well. That means if more liquidity is in the market then more money will be there in the hands of the consumer which will surge the demand and when too much of money is running for too few goods this will result in higher prices of the goods and thus higher inflation.

For fiscal policy there are three possible positions:

1. Neutral Position 2. Expansionary Position 3. Contractionary Position 1) A Neutral position applies when the budget outcome has neutral effect on the level of economic activity where the govt. spending is fully funded by the revenue collected from the tax. 2) An Expansionary position is when there is a higher budget deficit where the govt. spending is higher than the revenue collected from the tax. 3) An Contractionary position is when there is a lower budget deficit where the govt. spending is lower than the revenue collected from the tax.

[Note that expansionary monetary policy is commonly called "easy money" while contractionary monetary policy is called "tight money". Other terms are also used].

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