Monetary policy:

Monetary policy is the policy adopted by the monetary authority of a country that
controls either the interest rate payable on very short-term borrowing or
the money supply, often targeting inflation or the interest rate to ensure price
stability and general trust in the currency.
How monetary policy works?
 The Central Bank may have an inflation target of 2%. If they feel inflation is
going to go above the inflation target, due to economic growth being too
quick, then they will increase interest rates.
 Higher interest rates increase borrowing costs and reduce consumer
spending and investment, leading to lower aggregate demand and lower
inflation.
 If the economy went into recession, the Central Bank would cut interest
rates.

Goals of monetary policy:

 Policy are usually to contribute to the stability of gross domestic product.
 To achieve and maintain low unemployment.
 To maintain predictable exchange rate with other currencies.
 Provides insight into how to craft an optimal monetary policy.

Types of monetary policy:

In developed countries monetary policy has been generally formed separately
from fiscal policy, which refers to taxation, government spending and associated
borrowing, monetary policy is referred to as being either expansionary or
contractionary.

 Expansion Monetary policy:

Expansionary policy occurs when a monetary authority uses its tools to
stimulate the economy. An expansionary policy maintains short-term
interest rates at a lower than usual rate or increases the total supply of
money in the economy more rapidly than usual. It is traditionally used to
try to combat unemployment in a recession by lowering interest rates in
the hope that less expensive credit will entice businesses into expanding.
 o This increases aggregated demand (the overall demand for all goods and
services in an economy), which boosts short-term growth as measured by
gross domestic product (GDP) growth.
o Expansionary monetary policy usually diminishes the value of the currency
relative to other currencies (the exchange rate).
 Contractionary monetary policy:
Contractionary monetary policy is a form of economic policy used to fight
inflation which involves decreasing the money supply in order to increase
the cost of borrowing which in turn decreases GDP and dampens inflation.
There are the following effects of contraction monetary policy
o Maintains short-term interest rates higher than usual or which slows
the rate of growth in the money supply or even shrinks it. This slows
short-term economic growth.
o Contractionary monetary policy can lead to increased unemployment
and depressed borrowing and spending by consumers and
businesses, which can eventually result in an economic recession if
implemented too vigorously.
o Lessens inflation.

Tools of monetary policy:

Central bank have three main monetary policy tools: open market operations, the
discount rate, and the reserve requirement.

 Open Market Operations:

Open market operations are when central banks buy or sell. Securities.
These are bought from or sold to the country's private banks. When the
central bank buys securities, it adds cash to the banks' reserves. That gives
them more money to lend. When the central bank sells the securities, it
places them on the banks' balance sheets and reduces its cash holdings.
The bank now has less to lend. A central bank buys securities when it wants
expansion monetary policy and it sells them when it executes contraction
monetary policy.
  Reserve Requirement:
The reserve requirement refers to the money banks must keep on hand
overnight. They can either keep the reserve in their vaults or at the central
bank. A low reserve requirement allows banks to lend more of their
deposits. It's expansionary because it creates credit. A high reserve
requirement is contractionary. It gives banks less money to lend. It's
especially hard for small banks since they don't have as much to lend in the
first place. That's why most central banks don't impose a reserve
requirement on small banks. Central banks rarely change the reserve
requirement because it's difficult for member banks to modify their
procedures.
 Discount Rate:
The discount rate is the third tool. It's the rate that central banks charge its
members to borrow at its discount window. Since it's higher than the fed
funds rate, banks only use this if they can't borrow funds from other banks.
Using the discount window also has a stigma attached. The financial
community assumes that any bank that uses the discount window is in
trouble. Only a desperate bank that's been rejected by others would use
the discount window.

Objectives of Monetary Policy:

The goals of monetary policy refer to its objectives such as reasonable price
stability, high employment and faster rate of economic growth. The targets of
monetary policy refer to such variables as the supply of bank credit, interest rate
and the supply of money. Most important objectives of monetary policy are the
following:
 Stabilizing the Business Cycle:
Monetary policy has an important effect on both actual GDP and potential
GDP. Industrially advanced countries rely on monetary policy to stabilize the
economy by controlling business. But it becomes impotent in deep
recessions.
 Reasonable Price Stability:
Price stability is perhaps the most important goal which can be pursued
most effectively by using monetary policy. In a developing country like
Pakistan the acceleration of investment activity in the face of a fall in
agricultural output creates excessive pressure on prices. The food inflation
is a proof of this. In such a situation, monetary policy has much to
contribute to short-run price stability.
Price stability is also important for improving a country’s balance of
payments.
In the opinion of C. Rangarajan:
“The increasing openness of the
economy, the need to service external debt and the necessity
to improve the share of our exports in a highly competitive external
environment require that the domestic price level is not allowed to
rise unduly”.
 Faster Economic Growth:
Monetary policy can promote faster economic growth by making credit
cheaper and more readily available. Industry and agriculture require two
types of credit
o short-term credit to meet working capital needs
o Long-term credit to meet fixed capital needs.
The need for these two types of credit can be met through commercial
banks and development banks. Easy availability of credit at low rates of
interest stimulates investment or expansion of society’s production
capacity. This in its turn, enables the economy to grow faster than before.
 Exchange Rate Stability:
In an ‘open economy’—that is, one whose borders are open to goods,
services, and financial flows— the exchange-rate system is also a central
part of monetary policy. In order to prevent large depreciation or
appreciation of the rupee in terms of the US dollar and other foreign
currencies under the present system of floating exchange rate the central
bank has to adopt suitable monetary measures.
 In the context of C. Rangarajan:
“It is price stability which provides
the appropriate environment under which growth can occur and social
justice can be ensured.”
However, in the short run there is a trade-off between price stability and
economic growth. Faster economic growth is achieved by increasing-the
availability of credit at a lower rate of interest.

Fiscal policy:
Fiscal policy refers to the use of government spending and tax policies to
influence economic condition, including demand for goods and
services, employment, inflation, and economic growth.

History:
Fiscal policy is largely based on the ideas of British economist John Maynard
Keynes (1883-1946), who argued that governments could stabilize the business
cycle and regulate economic output by adjusting spending and tax policies. His
theories were developed in response to the Great Depression, which defied
classical economics' assumptions that economic swings were self-correcting.
Keynes' ideas were highly influential and led to the new deals in the U.S., which
involved massive spending on public works projects and social welfare programs.

Goals:
 Fiscal policy refers to the use of government spending and tax
policies to influence economic conditions.
 Fiscal policy is largely based on ideas, argued governments could
stabilize the business cycle and regulate economic output.
 During a recession, the government may employ expansionary
fiscal policy by lowering tax rates to increase aggregate
demand and fuel economic growth.
 In the face of mounting inflation and other expansionary
symptoms, a government may pursue contractionary fiscal policy.
Types of fiscal policy:
There are the following types of fiscal policy:

 Expansionary fiscal policy:

The government can use fiscal policy to affect the economy, consider an
economy that's experiencing a recession. The government might lower tax
rates to increase aggregated demand and fuel economic growth. This is
known as expansionary fiscal policy.
The logic behind this approach is that:
o When people pay lower taxes, they have more money to spend or
invest, which fuels higher demand. That demand leads firms to hire
more, decreasing unemployment, and to compete more fiercely for
labor. In turn, this serves to raise wages and provide consumers with
more income to spend and invest. It's a virtuous cycle.
o Rather than lowering taxes, the government may seek economic
expansion through increases in spending. By building more highways,
for example, it could increase employment, pushing up demand and
growth.
 Contractionary fiscal Policy:
Contractionary fiscal policy is a form of fiscal policy that involves increasing
taxes, decreasing government expenditures or both in order to fight
inflationary pressures. Due to an increase in taxes, households have less
disposal income to spend. Lower disposal income decreases consumption.
Explanation:
In the face of mounting inflation, a government can pursue contractionary
fiscal policy, perhaps even to the extent of inducing a brief recession in
order to restore balance to the economic cycle. The government does this
by reducing public spending and cutting public-sector pay or jobs. Where
expansion typically leads to deficits, contractionary fiscal policy is usually
characterized by budget surpluses. This policy is rarely used.
 When fiscal policy is neither expansionary nor contractionary, it is
neutral.
Tools of fiscal policy:
There are the following tools of fiscal policy

 Taxation:
The first tool is taxation. That includes income, capital gains from
investments, property, and sales. Taxes provide the income that funds the
government. The downside of taxes is that whatever or whoever is taxed
has less income to spend on themselves, which is why taxes are
unpopular.
 Government spending:
The second tool is government spending—which includes subsidies, welfare
programs, public works projects, and government salaries. Whoever
receives the funds has more money to spend, which increases demand and
economic growth.

Objectives of Fiscal Policy:

The objective of fiscal policy is to maintain the condition of full employment,
economic stability and to stabilize the rate of growth. For an under-developed
economy, the main purpose of fiscal policy is to accelerate the rate of capital
formation and investment. There are the following are the objectives of a fiscal
policy in a developing economy:

1. Full Employment:

The first and foremost objective of fiscal policy in a developing economy is to

achieve and maintain full employment in an economy. In such countries, even if
full employment is not achieved, the main motto is to avoid unemployment and
to achieve a state of near full employment. Therefore, to reduce unemployment
and under-employment, the state should spend sufficiently on social and
economic overheads.

2. Price Stability:
In a developing country, economic instability is manifested in the form of
inflation. Therefore, in developing economies, inflation is a permanent
phenomenon where there is a tendency to the rise in prices due to expanding
trend of public expenditure. As a result of rise in income, aggregate demand
exceeds aggregate supply. Capital goods and consumer goods fail to keep pace
with rising income. Fiscal measures as well as monetary measures go side by side
to achieve the objectives of economic growth and stability.

3. To Accelerate the Rate of Economic Growth:

Primarily, fiscal policy in a developing economy, should aim at achieving an
accelerated rate of economic growth. But a high rate of economic growth cannot
be achieved and maintained without stability in the economy. Therefore, fiscal
measures such as taxation, public borrowing and deficit financing etc. should be
used properly so that production, consumption and distribution may not
adversely affect. It should promote the economy as a whole which in turn helps to
raise national income and per capita income.

4. Equitable Distribution of Income and Wealth:

Generally, inequality in wealth persists in such countries as in the early stages of
growth, it concentrates in few hands. It is also because private ownership
dominates the entire structure of the economy and extreme inequalities create
political and social discontentment which further generate economic instability.
For this, suitable fiscal policy of the government can be devised to bridge the gap
between the incomes of the different sections of the society. To reduce
inequalities, the government should invest in those productive channels which
incur benefit to low income groups and are helpful in raising their productivity
and can help development of human capital which in turn possesses positive
effects on income distribution.

5. Capital Formation and Growth:

Capital assumes a central place in any development activity in a country and fiscal
policy can be adopted as a crucial tool for the promotion of the highest possible
rate of capital formation. A newly developing economy is encompassed by a
‘vicious circle of poverty’. Therefore, a balanced growth is needed to breakdown
the vicious circle which is only feasible with higher rate of capital formation.
6. To Encourage Investment:
Fiscal policy aims at the acceleration of the rate of investment in the public as
well as in private sectors of the economy. Fiscal policy should aim at rapid
economic development and must encourage investment in those channels which
are considered most desirable from the point of view of society. The government
must try to build up economic and social overheads such like transport and
communication, irrigation, flood control, power, ports, technical training,
education, hospital and school facilities, so that they may provide external
economies to induce investment in industrial and agricultural sectors of the
economy.

Difference between monetary and fiscal policy:

 Monetary policy involves changing the interest rate and influencing the
money supply.
 Fiscal policy involves the government changing tax rates and levels of
government spending to influence aggregate demand in the economy.
They are both used to pursue policies of higher economic growth or controlling
inflation.

Which is more effective monetary or fiscal policy?

In recent decades, monetary policy has become more popular because:

 Monetary policy is set by the Central Bank, and therefore reduces political
influence (e.g. politicians may cut interest rates in the desire to have a
booming economy before a general election)
 Fiscal policy can have more supply side effects on the wider economy.
E.g. to reduce inflation – higher tax and lower spending would not be
popular, and the government may be reluctant to pursue this. Also, lower
spending could lead to reduced public services, and the higher income tax
could create disincentives to work.
 Expansionary fiscal policy (e.g. more government spending) may lead to
special interest groups pushing for spending which isn’t really helpful and
then proves difficult to reduce when the recession is over.
  Monetary policy is quicker to implement. Interest rates can be set every
month. A decision to increase government spending may take time to
decide where to spend the money.
However, the recent recession shows that monetary policy too can have many
limitations.

 Targeting inflation is too narrow. During the period 2000-2007, inflation

was low but central banks ignored an unsustainable boom in the housing
market and bank lending.
 Cutting interest rates may prove insufficient to boost demand because
banks don’t want to lend and consumers are too nervous to spend. Interest
rates were cut from 5% to 0.5% in March 2009, but this didn’t solve
recession in the UK.
 Even quantitative easing – creating money may be ineffective if banks just
want to keep the extra money on their balance sheets.
 In a liquidity trap, expansionary fiscal policy will not cause crowding out
because the government is making use of surplus saving to inject demand
into the economy.
 In a deep recession, expansionary fiscal policy may be important for
confidence – if monetary policy has proved to be a failure.