2015, Study Session # 5, Reading # 19

MONETARY AND FISCAL POLICY

LOS 19.a

Fiscal Policy:

Use of Spending and Taxation by government to stimulate
economic activity
T GE > 0 Budget Surplus
T GE = 0 Balanced Budgets
T GE < 0 Budget Deficit

Monetary Policy:
It refers to central bank activities to stimulate economic activity
through quantity of money (MS) & credit in an economy.

Expansionary
Quantity of
Money & Credit

Contractionary
Quantity of
Money & Credit

Money: Medium of exchange

LOS 19.b

Qualities of Money:
i) Acceptance
ii) Divisibility
iii) High value relative to weight
iv) Difficult to counterfeit

Functions of Money:
i) Medium of exchange
ii) Store of value
iii) Units of account

Fractional Reserve System:

New money created is a multiple of new excess reserves available for lending
by banks
1




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reserve requirement Mulplier

reserve requirement Multiplier

LOS 19.c

Reasons for Holding Money

Transactionsrelated

Precautionary

Speculative
Demand

Central bank determine the level of Ms with the objectives of

managing inflation & economic activities

LOS 19.d
Fisher Effect:
Nominal interest rate = RReal interest rate + Expected inflation
RNOM = Real + E (I)

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2015, Study Session # 5, Reading # 19

LOS 19.e
Roles of Central Bank

Sole supplier of
currency

Banker to
Government and
bankers bank

Regulator and
supervisor of
payment system

Lender of last resort

Managing their
countrys gold &
foreign exchange
reserves

Conductor of
Monetary Policy

Objectives of Central Banks

Controlling inflation

Currency stability

Full employment

Positive sustainable
economic growth

Moderate interest
rates

Central Bank Tools

Policy rate

Reserve
Requirements

Open Market
Operations

Policy rate
Reserve requirements MS Expansionary Policy

LOS 19.g

Essential Qualities

Independence

Los 19.h

Market interest
rates

Credibility

Transparency

Monetary Transaction Mechanism

Asset Prices

Growth
Expectations

Influence domestic and net external demand

affect economic growth & inflation

Los 19.i
Neutral interest rate = real trend rate of economic growth + inflation target
Real trend rate long-term sustainable real growth rate of an economy
Policy rate > neutral rate Contractionary Monetary Policy
Policy rate < neutral rate Expansionary Monetary Policy

Los 19.j

Limitations of Monetary Policy

Long-term interest rates may move opposite to short-term interest rates

Greater cash holding (liquidity trap)
Unwillingness of bank to lend greater amount.
Short-term rates cant fall below zero

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Exchange rates

2015, Study Session # 5, Reading # 19

LOS 19.k

Fiscal Policy: Government use of taxes &

government spending policies

Budget Surplus
(T > GE)

Budget Deficit
(T < GE)
Objectives of Fiscal Policy

Influence level of
economic activity

Distributing
Wealth/Income

Resource allocation
among sectors and
economic agents

Fiscal Policy Tools

LOS 19.l

Spending Tools
i) Transfer payments
ii) Current spending
iii) Capital spending

Revenue Tools
i) Direct taxation
ii) Indirect taxation

Fiscal Policy

Advantage:
i) Quickly implement social policies
ii) Quickly raise revenue at low cost

Indirect Taxes

Disadvantage:
i) Implementation time lag regarding
in direct taxes
ii) Delayed impact of changes in capital spending

Size of Fiscal Deficit

LOS 19.m

Arguments for being concerned:

i) Higher deficit leads to higher taxes
ii) If market loses confidence, central bank may
need to finance govt. debt.
iii) Crowding-out effect

Argument against being concerned:

i) Debt financed by domestic citizens
ii) Deficit due to capital spending may increase
productive capacity of the economy
iii) Tax reform needed
iv) Ricardian equivalence
v) If there is unemployment in the economy, debt
can be used to increase employment; thus
crowding out effect is not triggered.

Causes of Delay

LOS 19.n

Recognition lag:

Unable to recognize needed
changes

Action lag:

Time taken by government
in discussing, voting, &
enacting policy

Impact lag:

Policy takes time to
stimulate economic activity

LOS 19.o
() government budget surplus Contractionary (expansionary) fiscal policy
() government budget decit Expansionary (contractionary) fiscal policy

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2015, Study Session # 5, Reading # 19

LOS 19.p

Policy
Monetary
Contractionary
Expansionary
Contractionary
Expansionary

Particulars
Fiscal
Expansionary
Contractionary
Contractionary
Expansionary

Interest Rates

Particulars
Private Sector Spending

Public Sector Spending

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Output

Variable