2016, 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 Contractionary
Quantity of Quantity of
Money & Credit Money & Credit

LOS 19.b Money: Medium of exchange

Qualities of Money: Functions of Money:

i) Acceptance i) Medium of exchange
ii) Divisibility ii) Store of value
iii) High value relative to weight iii) Units of account
iv) Difficult to counterfeit

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

Transactions- Precautionary Speculative

related Demand

Central bank determines the level of money supply 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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 2016, Study Session # 5, Reading # 19

LOS 19.e
Roles of Central Bank

Sole supplier of Banker to Regulator and Lender of last resort Manage countrys Conductor of
currency Government and supervisor of gold & foreign Monetary Policy
bankers bank payment system exchange reserves

Objectives of Central Banks

Controlling inflation Currency stability Full employment Positive sustainable Moderate interest
economic growth rates

Central Bank Tools

Policy rate Reserve Open Market

Requirements Operations

Policy rate
Reserve requirements MS Expansionary Policy

LOS 19.g Essential Qualities

Independence Credibility Transparency

Los 19.h Monetary Transaction Mechanism

Market interest Asset Prices Growth Exchange rates

rates 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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 2016, Study Session # 5, Reading # 19

LOS 19.k Fiscal Policy: Government use of taxes &

government spending policies

Budget Surplus Budget Deficit

(T > GE) (T < GE)

Objectives of Fiscal Policy

Influence level of Distributing Resource allocation

economic activity Wealth/Income among sectors and
economic agents

LOS 19.l Fiscal Policy Tools

Spending Tools Revenue Tools

i) Transfer payments i) Direct taxation
ii) Current spending ii) Indirect taxation
iii) Capital spending

Fiscal Policy

Advantage: Disadvantage:
i) Quickly implement social policies i) Implementation time lag regarding
in direct taxes
Indirect Taxes
ii) Quickly raise revenue at low cost ii) Delayed impact of changes in capital spending

LOS 19.m Size of Fiscal Deficit

Arguments for being concerned: Argument against being concerned:

i) Higher deficit leads to higher taxes i) Debt financed by domestic citizens
ii) If market loses confidence, central bank may ii) Deficit due to capital spending may increase
need to finance govt. debt. productive capacity of the economy
iii) Crowding-out effect iii) Tax reforms 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.

LOS 19.n Causes of Delay

Recognition lag: Action lag: Impact lag:

Unable to recognize needed
Time taken by government
Policy takes time to
changes in discussing, voting, & stimulate economic activity
enacting policy

LOS 19.o

() government budget surplus Contractionary (expansionary) fiscal policy

() government budget decit Expansionary (contractionary) fiscal policy

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 2016, Study Session # 5, Reading # 19

LOS 19.p

Policy Particulars
Monetary Fiscal Interest Rates Output
Contractionary Expansionary
Expansionary Contractionary Variable
Contractionary Contractionary
Expansionary Expansionary

Particulars
Private Sector Spending Public Sector Spending

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