Laffer Curve

REVIEWED BY WILL KENTON

Updated Apr 4, 2018

What is the Laffer Curve
The Laffer Curve is a theory developed by supply-side economist Arthur Laffer to
show the relationship between tax rates and the amount of tax revenue collected
by governments. The curve is used to illustrate Laffer’s main premise that the
more an activity — such as production — is taxed, the less of it is generated.
Likewise, the less an activity is taxed, the more of it is generated.

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Laffer Curve

BREAKING DOWN Laffer Curve

The Laffer Curve suggests that, as taxes increase from low levels, tax revenue
collected by the government also increases. It also shows that tax rates
increasing after a certain point (T* on the diagram below) would cause people not
to work as hard or not at all, thereby reducing tax revenue. Eventually, if tax rates
reached 100 percent, shown as the far right on his curve, all people would
choose not to work because everything they earned would go to the government.
Governments would like to be at point T* because it is the point at which the
government collects maximum amount of tax revenue while people continue to
work hard.

The Laffer Curve Explained

The first presentation of the Laffer Curve was performed on a paper napkin back
in 1974 when its author was speaking with senior staff members of President
Gerald Ford’s administration about the state of economic malaise that had
engulfed the country. At the time, most economists were espousing a Keynesian
approach to solving the problem, which advocated more government spending to
stimulate demand for products. Laffer countered that the problem isn’t too little
demand. Rather, it was the burden of heavy taxes and regulations that created
impediments to production, which impacts government revenue.

Laffer argues that the more money was taken from a business in the form of
taxes, the less money it has to invest in the business. A business is more likely to
find ways to protect its capital from taxation or to relocate all or a part of its
operations overseas. Investors are less likely to risk their capital if a larger
percentage of their profits are taken. When workers see an increasing portion of
their paychecks taken due to increased efforts on their part, they will lose the
incentive to work harder. For every type of tax, there is a threshold rate above
which the incentive to produce more diminishes, thereby reducing the amount of
revenue the government receives.

The theory later became a cornerstone of President Ronald Reagan’s economic

policy, which resulted in one of the biggest tax cuts in history. During his time in
office, tax revenues received by the government increased from $517 billion in
1980 to $909 billion in 1988.

Is the Laffer Curve Too Simple a Theory?

There are some fundamental problems with the Laffer Curve — notably that it is
far too simplistic in its assumptions. While the curve assumes that societies
function on a single tax rate and a single supply of labor, that can’t be further
from the truth. In reality, public finance structures are much more complex. The
curve does not take into account how revenue is affected by multivalued tax
rates. Simply, the fact that any increase in the tax rate to a certain percentage
may not necessarily equate to the same revenue as a decrease in the tax rate.
The curve also does not take into account any avoidance of taxes at any level.

There is also the assumption that an increase in revenue from tax cuts will likely
lead to more jobs. That isn’t necessarily true in today’s environment. More
companies are becoming technology-focused and are relying less on human
labor. And that means more and more businesses are likely using these tax
reductions to buy computers rather than go on a hiring spree. We also didn’t see
that following the 2007-2008 financial crisis. Many of the companies that
benefited from government bailouts following the crisis did not use them to create
jobs; they saved the money to increase their dividends or make capital
investments.

What is Austerity
Austerity is defined as a set of economic policies a government implements to
control public sector debt.
Austerity measures are the response of a government whose public debt is so
large that the risk of default, or the inability to service the required payments on
its debt obligations, becomes a real possibility. Default risk can spiral out of
control quickly; as an individual, company or country slips further into debt,
lenders will charge a higher rate of return for future loans, making it more difficult
for the borrower to raise capital.

Monetary Policy
The primary objective of BSP's monetary policy is to promote a low and stable inflation conducive to a balanced
and sustainable economic growth. The adoption of inflation targeting framework for monetary policy in January
2002 is aimed at achieving this objective.

Monetary policy of the Philippines

From Wikipedia, the free encyclopedia

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Monetary policy is the monitoring and control of money supply by a central bank, such as
the Federal Reserve Board in the United States of America, and the Bangko Sentral ng Pilipinas in
the Philippines. This is used by the government to be able to control inflation, and stabilize currency.
Monetary Policy is considered to be one of the two ways that the government can influence the
economy – the other one being Fiscal Policy (which makes use of government spending, and
taxes).[1] Monetary Policy is generally the process by which the central bank, or government controls
the supply and availability of money, the cost of money, and the rate of interest.

Monetary policy of the Philippines

From Wikipedia, the free encyclopedia

Jump to navigationJump to search

Monetary policy is the monitoring and control of money supply by a central bank, such as
the Federal Reserve Board in the United States of America, and the Bangko Sentral ng Pilipinas in
the Philippines. This is used by the government to be able to control inflation, and stabilize currency.
Monetary Policy is considered to be one of the two ways that the government can influence the
economy – the other one being Fiscal Policy (which makes use of government spending, and
taxes).[1] Monetary Policy is generally the process by which the central bank, or government controls
the supply and availability of money, the cost of money, and the rate of interest.
 Contents

 1Money Supply Indicator

o 1.1M2: Broad Money
o 1.2M3: Broad Money Liabilities
o 1.3M4: Liquidity Money
o 1.4Implications
 2Monetary Policy Instruments
o 2.1Open Market Operations
o 2.2Acceptance of Fixed-Term Deposits
o 2.3Standing Facilities
o 2.4Reserve Requirements
 3Philippine Monetary/Currency Policy
o 3.1Bangko Sentral ng Pilipinas
o 3.2Philippine Monetary Framework I: 1980s to early 1990s
o 3.3Philippine Monetary Framework II: June 1995 to Present
o 3.4Current Approach: Inflation Targeting
 4Monetary Policy Issues
o 4.1Exchange Rate
o 4.2Role of Monetary Aggregates
o 4.3Measurement of Inflation and Liquidity Trap
o 4.4Budget Deficit and External Debts
o 4.5Fiscal Dominance
 5References

Money Supply Indicator[edit]

The New Generation Philippine Banknotes

Money supply indicators are often found to contain necessary information for predicting future
behavior of prices and assessing economic activity. Moreover, these are used by economists to
confirm their expectations and help forecast trends in consumer price inflation. One can predict, to a
certain extent, the government's intentions in regulating the economy and the consequences that
result from it. For example, the government may opt to increase money supply to stimulate the
economy or the government may opt to decrease money supply to control a possible mishap in the
economy.[2]
These indicators tell whether to increase or decrease the supply. Measures that include not only
money but other liquid assets are called money aggregates under the name M1, M2, M3, etc.
M1: Narrow Money
M1 includes currency in circulation. It is the base measurement of the money supply and includes
cash in the hands of the public, both bills and coins, plus peso demand deposits, tourists’ checks
from non-bank issuers, and other checkable deposits.[3] Basically, these are funds readily available
for spending. Adjusted M1 is calculated by summing all the components mentioned above.[2]
M2: Broad Money[edit]
This is termed broad money because M2 includes a broader set of financial assets held principally
by households.[2] This contains all of M1 plus peso saving deposits (money market deposit
accounts), time deposits and balances in retail money market mutual funds.[3]
M3: Broad Money Liabilities[edit]
Broad Money Liabilities include M2 plus money substitutes such as promissory notes and
commercial papers.[3]
M4: Liquidity Money[edit]
These include M3 plus transferable deposits, treasury bills and deposits held in foreign currency
deposits. Almost all short-term, highly liquid assets will be included in this measure.[3]
Implications[edit]
If the velocity of M1 and M2 money stock has been low, this indicates that there is a lot of money in
the hands of consumers and money is not changing hands frequently.[4]
Generally we would expect that when money supply indicators are growing faster than interest rates
plus growth rate or inflation, whichever is higher, interest rates should possibly be increased. This
should only generally apply when broad measures of money supply growth are higher than narrow
measures, to rule out some of the measurement error issues that could emerge.[5]

Monetary Policy Instruments[edit]

Open Market Operations[edit]
Open Market Operations consist of repurchase and reverse repurchase transactions, outright
transactions, and foreign exchange swaps.

 Repurchase and Reverse Repurchase

This is carried out through the Repurchase Facility and Reverse Purchase Facility of the
Bangko Sentral ng Pilipinas. In Purchase transactions, the Bangko Sentral buys government
securities with a dedication to sell it back at a specified future date, and at a predetermined
interest rate.[6] The BSP's payment increases reserve balances and expands the monetary
supply in the Philippines. On the other hand, in Reverse Repurchase, the government acts
as the seller, and works to decrease the liquidity of money. These transactions usually have
maturities ranging from overnight to one month.

 Outright Transactions
Unlike the repurchase or reverse repurchase, there is no clear intent by the government to
reverse the action of their selling/buying of monetary securities. Thus, this transaction
creates a more permanent effect on our monetary supply. "When the BSP buys securities, it
pays for them by directly crediting its counterparty's Demand Deposit Account with the
BSP."[6] The reverse is done upon the selling of securities.

 Foreign Exchange Swaps

This refers to the actual exchange of two currencies at a specific date, at a rate agreed upon
the deal date and the reverse exchange of the currencies at a farther ate in the future, also at
an interest rate agreed on deal date.[7]
Acceptance of Fixed-Term Deposits[edit]
To expand its liquidity management, the Bangko Sentral introduced this method in 1998.
In the Special Deposits Account, or SDA, consists fixed terms deposits by banks and
institutions affiliated with the BSP.[6]
Standing Facilities[edit]
To increase the volume of credit in the financial system, the Bangko Sentral ng Pilipinas
extends loans, discounts, and advances to banking institutions. "Rediscounting is a
standing credit facility provided by the BSP to help banks meet temporary liquidity needs
by refinancing the loans they extend to their clients." There are two types of
rediscounting in the BSP: the peso rediscounting facility and the Exporter's dollar and
Yen Rediscount Facility.
Reserve Requirements[edit]
In banking institutions, there are required amounts that banks cannot lend out to people.
They always need to maintain a certain balance of money, which are called "reserves".
Once these reserve requirements are changed and are varied, changes in the monetary
supply will be observed greatly.[8]
Two Forms:

1. Regular or Statutory Reserves

2. Liquidity Reserves

Philippine Monetary/Currency Policy[edit]

Bangko Sentral ng Pilipinas[edit]
In accordance with Republic Act No. 265,[9] The Bangko Sentral ng Pilipinas or BSP is
the central monetary authority of the republic of the Philippines. It provides policy
directions in the areas of money, banking and credit and exists to supervise operations
of banks and exercises regulatory powers over non-bank financial institutions. It
keeps aggregate demandfrom growing rapidly with resulting high inflation, or from
growing too slowly, resulting in high unemployment.[10]
The primary objective of BSP's monetary policy is to promote price stability because it
has the sole ability to influence the amount of money circulating in the economy. In
doing so, other economic goals, such as promoting financial stability and achieving
broad-based, sustainable economic growth, are given consideration in policy decision-
making.[11]
Philippine Monetary Framework I: 1980s to early 1990s [edit]
In the past, the BSP followed the monetary aggregate targeting approach to monetary
policy. This approach is based on the assumption that there is a stable and predictable
relationship between money, output and inflation.
In particular, all money aggregates, with the exception of reserve money, are
incorporated with output and interest rate. This means that there is a long-run
relationship between money on one hand and output and interest rate on the other so
that even if there are shocks in the economy, the variables will return to their trend
equilibrium levels.[12]
This means that changes in money supply (on the assumption that velocity is stable
over time) are directly related to price changes or to inflation. Thus, it is assumed that
the BSP is able to determine the level of money supply that is needed given the desired
level of inflation that is consistent with the economy's growth objective. In effect, under
the monetary targeting framework, the BSP controls inflation indirectly by targeting
money supply.[13]
Philippine Monetary Framework II: June 1995 to Present[edit]
The BSP employs a modified framework beginning the second semester of 1995 in
attempt to enhance the effectiveness of the monetary policy by complementing
monetary aggregate targeting with some form of inflation targeting, placing greater
emphasis on price stability.
Certain key modifications include:

 Allows base money levels to go beyond target as long as the inflation rates are met
 An excess of one or more percentage points of inflation over the program induces
mopping up operation by the BSP to bring down base money to the previous
month's level[13]
Under an aggregate targeting framework, the BSP fixes money growth so as to
minimize expected inflation. On the other hand, under the new framework, BSP sets
monetary policy so that price level is not just zero in expectation but is also zero
regardless of latter shocks.[13] Moreover, the framework was changed because BSP
wanted to address the fact that aggregate targeting did not account for the long-run
effects of monetary policy on the economy.
With this approach, the BSP can exceed the monetary targets as long as the actual
inflation rate is kept within program levels and policymakers monitor a larger set of
economic variables in making decisions regarding the appropriate stance of monetary
policy.[12]
Current Approach: Inflation Targeting[edit]
As mentioned earlier, Inflation Targeting requires a public announcement of an inflation
rate that a country will target for the coming years, or in a given period of time. It focuses
on maintaining a low level of inflation, that which is considered to be optimal, or at least
would allow the country to have ample economic growth. Its main desire is to achieve
price stability as the ultimate end goal of the monetary policy.[12] The Philippines formally
adopted Inflation Targeting as the framework for Monetary Policy on January 2002.
The Philippines’ inflation target is measured through the Consumer Price Index (CPI).
For 2009, inflation target has been set to be 3.5 percent, having a 1% tolerance level,
and 4.5 percent for 2010, also having 1% tolerance. Also, the Monetary Board of the
Philippines announced a target of around 4±1 percent from 2012 to 2014.[14]
Monetary Policy Issues[edit]
Exchange Rate[edit]
Exchange rates play a significant role in monetary transmission mechanism and at the
same time, it can have a large impact on inflation rates. Although the BSP has adopted
the inflation targeting approach, it may be tempted to inexplicitly target exchange rate to
achieve its low inflation target. The issue here is the extent of the exchange rate pass-
through or ERPT to domestic prices since higher ERPT would require the BSP to shift
its attention to exchange rate movements to stabilize prices.[15]
Role of Monetary Aggregates[edit]
Since the shift to inflation targeting, BSP has already abandoned monetary aggregates
because its information content has apparently declined in the recent years. Moreover, it
is also assumed that a shift of approach was necessary because money aggregates are
normally not good indicators of future economic policy requirements due to unreliability
of measurement.[15]
Measurement of Inflation and Liquidity Trap [edit]
Since inflation targeting leads to lower and stable inflation rates, more improvement
should then be given to the measurement of the consumer price index since few
percentage points have greater repercussions when rates are low. Errors in CPI
measurement could lead to ineffective and unsuitable monetary policy response by the
BSP which definitely result to detrimental effects to the economy.[15]
Another issue arising from monetary policies is the liquidity trap. This happens when
inflation rate declines too much leading to a threat of deflation. Liquidity trap is defined
as a situation in which there are zero nominal interest rates, persistent deflation and
deflation expectations. In the event this occurs, bonds and money earn the same real
rate of return thus making people indifferent to holding bonds or excess money.[15]
Budget Deficit and External Debts[edit]
Given high budget deficits, the government is concerned about two closely related
issues: it does not want to pay very high interest on its borrowings and it does not want
to crowd out the market. Ideally, the government could raise tax revenues to avoid
borrowing huge sums from the market. However, the government opted to borrow from
the international capital market and though rates are low, these have shorter maturity
and country's outstanding external debt has continued to move towards a less ideal
position.[15]
Fiscal Dominance[edit]
According to the fiscal theory of the price level, it is not the non-interest bearing money
but the total nominal liabilities including interest bearing notes and future fiscal surpluses
that matter for price-level determination. In the absence of fiscal discipline, an
independent central bank such as the BSP cannot guarantee a stable nominal anchor.
In other words, for the BSP to successfully focus on price stability, there must be a
credible commitment on the part of the National Government to reduce total fiscal
deficits by a meaningful amount.[16]

References[edit]
1. ^ "Monetary Policy". Retrieved May 19, 2011.
2. ^ Jump up to:a b c Bheda, Disha. "An Overview of Key Money Supply Indicators - M0, M1,
and M2". Data360. Retrieved May 18, 2011.
3. ^ Jump up to:a b c d "Monetary Policy - Glossary and Abbreviations". Bangko Sentral ng
Pilipinas. Retrieved May 18, 2011.
4. ^ "Other Money Supply Indicators". Data360. Retrieved May 18, 2011.
5. ^ "Money Supply- (27.06.04)". Retrieved May 19, 2011.
6. ^ Jump up to:a b c "Inflation Targeting: The BSP's Approach to Monetary Policy".
Retrieved May 19,2011.
7. ^ "Currency Swap Definition". Retrieved May 19, 2011.
8. ^ "FRB: Reserve Requirements". Archived from the original on 2010-02-19.
Retrieved May 19, 2011.
9. ^ "Republic Act No. 265: An Act Establishing the Central Bank of the Philippines,
Defining its Powers in the Administration of the Monetary and Banking System,
Amending the Pertinent Provisions of the Administrative Code with Respect to the
Currency and the Bureau of Banking, and for Other Purposes". The Corpus Juris. The
Corpus Juris. Retrieved 4 March 2016.
10. ^ "MANDATE". Retrieved May 20, 2011.
11. ^ "Primer on Inflation Targeting" (PDF). Department of Economic Research.
Retrieved May 19, 2011.
12. ^ Jump up to:a b c "Primer on Inflation Targeting" (PDF). Department of Economic
Research. Retrieved May 20, 2011.
13. ^ Jump up to:a b c Gochoco-Bautista, Maria Socorro. "What Drives Monetary Policy?".
University of the Philippines Diliman. Retrieved May 18, 2011.
14. ^ "Inflation Targeting: The BSP's Approach to Monetary Policy". Retrieved May
18, 2011.
15. ^ Jump up to:a b c d e Lamberte, Mario. "Central banking in the Philippines: Then, Now
and the Future" (PDF). Philippine Institute for Development Studies. Retrieved May
19, 2011.
16. ^ Mariano and Villanueva, Robert and Delano. "Monetary policy approaches and
implementationin Asia: the Philippines and Indonesia". Retrieved May 20, 2011.