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2229 - Lecture 7 - Policy

Monetary and fiscal policy are the two main tools that policymakers use to influence the economy. [1] Monetary policy is regulated by central banks and involves adjusting interest rates and money supply. [2] Fiscal policy involves government taxation and spending decisions and is influenced by governments. [3] Both aim to achieve goals like stable inflation, economic growth, and low unemployment.

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38 views13 pages

2229 - Lecture 7 - Policy

Monetary and fiscal policy are the two main tools that policymakers use to influence the economy. [1] Monetary policy is regulated by central banks and involves adjusting interest rates and money supply. [2] Fiscal policy involves government taxation and spending decisions and is influenced by governments. [3] Both aim to achieve goals like stable inflation, economic growth, and low unemployment.

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NASIF BIN NAZRUL
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Hum- 2229

Lecture 7
Monetary and Fiscal policy
• When policymakers want to influence the economy, they mainly have two tools at
their disposal
• Monetary policy and
• Fiscal policy.

The monetary policy is regulated by the central banks. Money supply in the market is
adjusted by tweaking the interest rates, bank reserve rates, sale and purchase of
government securities and foreign exchange.

On the other hand, fiscal policy is influenced by the governments by adjusting the
nature and extent of the taxes, government spending and borrowing.
Monetary Policy

• Monetary policy refers to the actions taken by a central bank to control the supply of
money and interest rates in an economy, aiming to achieve macroeconomic goals such as
stable inflation, low unemployment, and economic growth.
Tools of Monetary Policy
a) Bank Rate: Bank rate is the rate charged by the central bank for lending funds
to commercial banks.
Increase in bank rate increases the cost of borrowings. which reduces commercial
banks borrowing from the central bank.
b) Cash Reserve Ratio: Cash Reserve Ratio (CRR) is a specified minimum
fraction of the total deposits of customers, which commercial banks have to hold
as reserves either in cash or as deposits with the central bank.
The central bank needs to increase or decrease CRR for financial stability.
c) Open market operation: Open market operations refer to the selling and
purchasing of the treasury bills and government securities by the central bank of
any country in order to regulate money supply in the economy.
Sale of government securities and bonds by the central bank
Expansionary vs. Contractionary Monetary Policy

Depending on its objectives, monetary policies can be expansionary or contractionary.


• Expansionary Monetary Policy
This is a monetary policy that aims to increase the money supply in the economy by –
• Decreasing interest rates,
• Purchasing government securities by central banks and
• Lowering the reserve requirements for banks.
It lowers unemployment and stimulates business activities and consumer spending. The
overall goal of the expansionary monetary policy is to fuel economic growth. However, it
can also possibly lead to higher inflation.
• Contractionary Monetary Policy
The goal of a contractionary monetary policy is to decrease the money supply in the
economy.
It can be achieved by
• Raising interest rates which increased the cost of borrowing loans. This will
discourage consumption; borrowings, investments.
• Selling government bonds, and
• Increasing the reserve requirements for banks.
The contractionary policy is utilized when the government wants to control inflation
levels.
Objectives of Monetary Policy
1. Controlling Inflation
If inflation is high, a contractionary policy can address this issue.
2. Reducing unemployment
An expansionary monetary policy generally decreases unemployment because the higher
money supply stimulates business activities that lead to the expansion of the job market.
3. Controlling Currency exchange rates
The exchange rates between domestic and foreign currencies can be affected by monetary
policy. With an increase in the money supply, the domestic currency becomes cheaper than
its foreign exchange.
Fiscal policy

Fiscal policy is the use of government spending and taxation to influence the economy.
Governments typically use fiscal policy to promote strong and sustainable growth and
reduce poverty.
The Objective of Fiscal Policy
• Stimulate economic growth in a period of a recession.
• Keep inflation low.
• Fiscal policy aims to stabilize economic growth, avoiding a boom and bust economic
cycle.
Tools of fiscal policy

• Changing the tax rate


• Changing the level of government spending: when the government spends
money purchasing goods and services, affecting aggregate demand for those
goods and services. When aggregate demand goes up, so does output to meet the
new level of demand and prices. The opposite is true when aggregate demand is
decreased.
• Altering government transfers: payments that the government makes through
the social security systems. Transfer payments ensure a minimum level of income
for low-income individuals. Also, they provide ways in which the government can
change the distribution of income in society.
Expansionary vs. Contractionary fiscal policy
• Expansionary (or loose) fiscal policy
This involves increasing aggregate demand.
Increase government spending: Spending in a number of areas, including
infrastructure, education, defense and so on. This can boost the economy’s demand
and generate jobs.
Reduce taxes: Lower taxes will increase consumers spending because they have
more disposable income (C)
Implement transfer payments: Transfer payments, like social security or
unemployment benefits, which put money in the hands of those who are likely to
spend it, are another way for governments to boost demand.
• Deflationary (or tight) fiscal policy
This involves decreasing aggregate demand.
Reduce government spending: Governments have the option of reducing their
expenditures on a range of products and services, including infrastructure, training, and
defense. This might lower economic demand.
Tax increases: Governments can raise taxes on citizens or corporations to reduce
disposable income and deter expenditure. This can lower demand and cause a slowdown
in the economy.
Implement austerity measures: Governments can also enact austerity measures to
lower spending and demand, such as reducing social safety programs.
Therefore the government will cut government spending (G) and/or increase taxes.
Higher taxes will reduce consumer spending (C)
• Tight fiscal policy will tend to cause an improvement in the government budget deficit.
Trade Policy
Trade policy is a set of rules and regulations applied to trade.
Instruments of Trade policy:
• Tariff: A tariff is a tax imposed by the government of a country or by a trade
union on imports or exports of goods.
Reason to impose tariff: Tariffs may be levied either to raise revenue or to protect
domestic industries.
Tariffs are specially two types-
1. Specific Tariff: A fixed fee levied on one unit of an imported good is referred to as a
specific tariff. For example, a country could levy a $15 tariff on each pair of shoes
imported, but levy a $300 tariff on each computer imported.
2. Ad Valorem Tariffs: This type of tariff is levied on a good based on a percentage of
that good's value. An example of an ad valorem tariff would be a 15% tariff levied by
Japan on U.S. automobiles. The 15% is a price increase on the value of the
automobile, so a $10,000 vehicle now costs $11,500 to Japanese consumers.
• Subsidies: Export subsidy definition refers to government policies that are aimed
at supporting local companies to export goods that are produced locally.
A trade subsidy to a domestic manufacturer reduces the domestic cost and limits
imports.
Examples of export subsidies include regulatory changes to incentivize certain
companies to export more, direct payments to companies to cover the difference
between the local price and world price, changes in taxes, and low-cost loans.

Other instruments of trade policy


Import Quota: Restrictions on quantity imports. It has the same effect like tariff.
Voluntary Export Restrictions: It is a quota imposed on the side of exporting
country. Often imposed by the request of importing countries.

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