A Project Report Of Macro-Economics

Session : 2018-22

“Project Members”

Noor Ul Huda Bilal : (BS-IAS-163-S-F-18)

Maaz Akram : (BS-IAS-135-S-F-18)

Mobeen : (BS-IAS-144-S-F-18)

Ayesha Awan : (BS-IAS-127-S-F-18)

Submitted To : Mam Ayesha Sarfraz

 Table of Contents:

 What is fiscal policy?

 Primary tools of fiscal policy
 Stances
 Methods of fiscal policy funding
 Major functions of fiscal policy
 Fiscal policy of Pakistan (2015-16)
 Effect of fiscal policy on economic growth
 What is monetary policy?
 History of monetary policy
 Examples of monetary policies
 How it works?
 Effects of monetary policies on economy
 Policy lags
 Types
 Inside lag
 Response lag
 Conclusion
What is policy?

“A policy is a set of ideas or plans that is used as a basis for

making decisions, especially in politics, economics, or business.”

 Policies are generally adopted by a governance body within an organization.

What is fiscal policy?

 Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and
influence a nation's economy.
 It is the sister strategy to monetary policy through which a central bank influences a nation's money supply.
 Using a mix of monetary and fiscal policies, governments can control economic phenomena.

When did fiscal policy began?

In the 1930,s with the United States reeling from the Great Depression the
government began to use fiscal policy not just to support itself or pursue social policies but to promote overall
economic growth and stability as well

The Roots of fiscal policy:

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 Deal in the U.S., which involved massive spending on public works projects and
social welfare programs.

Primary tools of fiscal policy:

There are two main tools of fiscal policy of any government .These are:

1. Taxes :

This is the main tool through which the government collects money from the public. The
government collects money from the public through income taxes, sales taxes, and other indirect
taxes. Without taxes, a government would have very little room to collect money from the public.

2. Government spending :
To ensure economic growth, the government needs to spend money on
projects that matter. The projects can be creating a subsidiary, paying the
unemployed, pursuing projects that are halted in between etc.

Stances of fiscal policy:

The three main stances of fiscal policy are:

 Neutral fiscal policy :

 Fiscal neutrality occurs when taxes and government spending are neutral, with
neither affecting demand. Fiscal neutrality creates a condition where demand is
neither stimulated nor diminished by taxation and government spending.

A balanced budget is an example of fiscal neutrality, where government spending is covered almost
exactly by tax revenue – in other words, where tax revenue is equal to government spending.

 Expansionary fiscal policy:

Expansionary fiscal policy is when the government expands the money supply in the

economy. It uses budgetary tools to either increase spending or cut taxes. That provides consumers
and businesses with more money to spend.

The two major examples of expansionary fiscal policy are tax cuts and increased
government spending. Both of these policies are intended to increase aggregate demand while
contributing to deficits or drawing down of budget surpluses.

 Contractionary fiscal policy :

Contractionary fiscal policy is when the government either cuts spending or raises taxes.

It gets its name from the way it contracts the economy. It reduces the amount of money available
for businesses and consumers to spend.

For example, if the government decides to lower tax rates to foster more spending, an
influx of cash and demand may increase inflation, which will decrease the value of the money. For
this reason, the other side of fiscal policy is, unsurprisingly, contractionary

Functions of fiscal policy:

There are four major functions of fiscal policy:

1. The Allocative function

2. The distributive function
3. The stabilization function
4. Economic growth

1. The allocative function :

The allocation function concerned with the provision of social goods inevitably depart from the market
process but nevertheless posses the type of problem with which economic analysis has traditionally been concerned
i.e. the efficient use of resources given a prevailing distribution of income and pattern of consumer preferences.

There are two basic types of goods that can be explained under this section. One is
private good and the other one is public good. We know that the private goods have the property of rivalry and
excludability. In the case of private goods, those who pay enjoy the benefits and others are excluded from this
service. On the other hand public goods are of the nature of excludability and non rivalry. The government has to
decide the type and quality of goods to be produced and how much a particular consumer should be asked to pay.
 2. The distributive function :

The issue of distribution is more difficult to handle. Yet distribution issue is a major point of
controversy in the budget database. In particular, they play a key role in determining tax and transfer
policies. There are large disparities of income and wealth in a capitalist economy between ‘haves’ and
‘have- not’ which are not conducive to maintain peace and tranquility in a country. In the absence of policy
adjustments, the distribution of income and wealth depend first of all on the distribution of factor
endowment, including personal learning abilities and the ownership of accumulated and inherited wealth.
Secondly it is determined by the process of factor pricing.

3. The stabilization function :

A capitalist economy is generally bedeviled by the frequent operation of business cycle,

according to which the country is visited by booms and depression at almost regular intervals. By
causing instability these, fluctuations inflict untold damage on the economy. The function of
public finance is to eliminate or reduce these business fluctuations by correlating its taxation,
expenditure and public debt policies.

4. Economic growth :

Moreover, the problem is not only one of maintaining high employment or of curtailing
inflation within a given level of capacity output. The effects of fiscal policy upon the rate of growth of potential
output must also be allowed for. Fiscal policy may affect the rate of saving and the willingness to invest and may
thereby influence the rate of capital formation .Capital formation in turn affects productivity growth, so that fiscal
policy is a significant factor in economic growth

Fiscal policy of Pakistan:

Budget of Pakistan (2015-16)

Budget: An estimate of costs, revenues and resources over a specified period reflecting a reading of future
financial conditions and goals

Revenues:

 4.451 economic growth is expected (direct tax 13457 billion) and (indirect tax 1755 billion )

Expenses:

 Pension increases by 7.5%

 Rs 20.88 billion for health sector
 Rs 71.5 billion for education
 Rs 159.6 billion for national highway authority
 Rs 20.5 billion for HEC
 Rs 112.28 for wapda
 Rs 19600mw for electricity
Government expenditure:

 Government expenditure is the spending made by government to achieve fiscal objectives and increase
general welfare of people
 Basic objective of these spending is the welfare of society
 Total expenditure incurred during 2015-16 is Rs 4,451 billion

Monetary Policy:

Definition:

Policies adopted by any country’s Central Bank and monetary authorities that influence interest
rates and credit conditions, which in turn, influence consumer and business spending, is termed
as “Monetary Policy”. Monetary policy is amongst the key tools which a Government uses to
influence its economy. The government with its authority to control the supply of money in the
economy, it influences the overall level of economic activity.

History of Monetary Policy:

State Bank of Pakistan Act 1956 provides legal setup for monetary policy framework in Pakistan. It entrusts upon
SBP to regulate the monetary and credit system of Pakistan and to foster its growth to secure monetary stability and
fuller utilization of country's productive resources.

TYPES OF MONETARY POLICY:

There are two types of monetary policy:

 • Expansionary monetary policy

• Contractionary monetary policy

Expansionary monetary policy: When a central bank uses its tools to stimulate the economy. That
increases the money supply, lowers interest rates, and increases aggregate demand. It boosts growth as measured by
gross domestic product. It is the opposite of contractionary monetary policy.

Examples of expansionary monetary policy:

Decrease in the discount rate, purchases of government securities, and reductions in the reserve ratio. All of these
options have the same purpose to expand the country's money supply.

Contractionary monetary policy: It 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.

How it works:

Monetary policy works on the expansion and Contraction of investments and is associated with consumption and
expenditure. An increase and decrease of interest rates changes the pattern of economic activity.

A “Central Bank” appointed by the Government usually controls the monetary policy.

Many economists believe that monetary policy is a far more powerful tool than fiscal policy for controlling inflation.
It involves changing the value of the exchange rate which results in fluctuations in the currency.

EFFECT OF MONETARY POLICY ON ECONOMY

Monetary policy is one of the fundamental tools of government used to stabilize the economy, it’s a process through
which government or the central bank i.e. State Bank of Pakistan control or administer the supply of money in the
economy. Monetary policy works on the expansion and Contraction of investments and is associated with
consumption and expenditure. The impact of monetary policy on economy basically regulates the flow of money in
the economy, & to control inflation, the goal of monetary policy is to excel economic growth without the change in
price level.

Monetary policy regulates the interest rates which affect the economy on whole. An increase and decrease of interest
rates changes the pattern of economic activity. A decrease in interest rate would encourage more borrowing from
banks as the cost of borrowing is reduced, there would be more investments, more employment would be generated,
consumer spending would increase resulting in raising household resulting in increase of money supply in the
economy concluding to increase in price level.

A decrease in interest rate accelerates the economy but its results in Inflation and to accommodate it
government increases the interest rate which shrinks the money supply in the economy and minimal the
economic activities.
 Policy Lag:
A policy lag is the lag between the time an economic problem arises, such as recession or inflation, and the effect
of a policy intended to counteract it.

Types:

1. Recognition lag:

Once the problem is finally available it takes time to figure out what it is saying. Is the downturn in employment in
this month's data temporary, or the beginning of a longer term trend? If it's temporary, no need to act, but if it's
permanent, then action may be needed.

2. Legislative lag:

Once we've obtained the necessary data and concluded something must be done, there can be considerable lags in
the legislative process as legislators debate the exact form of the package, or oppose it altogether.

3. Implementation lag:

Once a policy is passed, it takes time to put it into place, e.g. to setup the administration of the money, to deliver it
to the right agencies, to make the plans needed to spend it, etc.

4. Effectiveness lag:

After all of that, and the policy is finally put into place, it takes time for policy to hit the economy and take effect.
For monetary policy if can be a year to a year and a half before the peak effect of the policy is felt (though the
legislative lags are much shorter since the FOMC can act faster than congress). The effectiveness lag for fiscal
policy is a bit shorter, but still considerable, six months at least.
 Inside Lag:

The inside lag is the amount of time it takes for a government or a central bank to respond to a shock in the
economy. It is the delay in implementation of a fiscal policy or monetary policy. Its converse is the outside lag (the
amount of time before an action by a government or a central bank affects an economy). The inside lag comprises
the recognition lag (the time taken to recognize the shock) and the decision lag (the time taken to decide on and
pursue a response).

The inside lag is generally a more severe problem for fiscal policy (government spending and taxation policy) than
for monetary policy. Monetary policy is conducted by a central bank that is devoted substantially to monitoring and
responding to economic shocks, whereas fiscal policy is conducted by a law-making body that has many other issues
to confront as well as a highly deliberative process with which to confront them. Nevertheless, a central bank may
often experience a substantial recognition lag prior to its becoming clear just what the latest economic figures imply
for policy needs. Indeed, even after a central bank implements a policy response, its critics may still argue that it
recognized the situation incorrectly.

Response Lag:

Response lag, also known as impact lag, is the time it takes for corrective monetary and fiscal policies, designed to
smooth out the economic cycle or respond to an adverse economic event, to affect the economy once they have been
implemented.

Understanding Response Lag:

Response lag is one of four policy lags that make it hard for policymakers to improve the performance of the
economy—and can even destabilize it. Because of recognition lag, it may take months or even years before
politicians acknowledge that there has been an economic shock or a structural change in the economy. Then there is
decision lag, with policymakers debating the appropriate policy response, followed by implementation lag before
any fiscal or monetary policy action is taken.

How Response Lag Works:

In popular imagination, central banks can control the economy at will by manipulating the money supply and
interest rates. In reality, it is difficult to determine how effective monetary policy has been, never mind knowing
how tight monetary policy should be. When the Federal Reserve cuts the federal funds rate, it can take 18 months
before there is any evidence of that changes’ impact, and central banks can find themselves pushing on a string. This
inability to fine-tune the economy, with the aim of evening out business cycles, is perhaps why many tightening
cycles in the Fed's history have been followed by a recession or depression.

CONCLUSION
Monetary policy: Monetary policy is the macroeconomic policy laid down by the central bank. It involves
management of money supply and interest rate and is the demand side economic policy used by the government of a
country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
Explanation: 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.

Further goals of a monetary policy are usually to contribute to the stability of gross domestic product, to achieve
and maintain low unemployment, and to maintain predictable exchange rates with other currencies. 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. 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. This increases aggregate 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. Expansionary monetary policy usually diminishes the value of the currency relative to other
currencies (the exchange rate).
The opposite of expansionary monetary policy is contractionary monetary policy, which 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 and lessens inflation. 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 vigorous.
Fiscal policy:

Definition: Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor
and influence a nation's economy. It is the sister strategy to monetary policy through which a central bank influences
a nation's money supply. These two policies are used in various combinations to direct a country's economic goals.

Explanation: In economics and political science, fiscal policy is the use of government revenue collection
(mainly taxes) and expenditure (spending) to influence a country's economy. The use of government revenues and
expenditures to influence macroeconomic variables developed as a result of the Great Depression, when the
previous laissez-faire approach to economic management became discredited. Fiscal policy is based on the theories
of the British economist John Maynard Keynes, whose Keynesian economics indicated that government changes
in the levels of taxation and government spending influences aggregate demand and the level of economic activity.
Fiscal and monetary policy is the key strategies used by a country's government and central bank to advance its
economic objectives. The combination of these policies enables these authorities to target the inflation (which is
considered "healthy" at the level in the range 2%–3%) and to increase employment. Additionally, it is designed to
try to keep GDP growth at 2%–3% and the unemployment rate near the natural unemployment rate of 4%–5%.[1]
This implies that fiscal policy is used to stabilize the economy over the course of the business cycle.
Changes in the level and composition of taxation and government spending can affect macroeconomic variables,
including:

 aggregate demand and the level of economic activity

 saving and investment
 income distribution
 Allocation of resources.
Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government
spending and is often administered by a government department; while monetary policy deals with the money
supply, interest rates and is often administered by a country's central bank. Both fiscal and monetary policies
influence a country's economic performance.
Monetary policy vs. fiscal policy:

Monetary policy and fiscal policy together have great influence over a nation's economy.

Monetary policy Fiscal policy

• Monetary policy involves changing the interest
rate and influencing the money supply.
• It is controlled by Central bank of the country.
• It is comparatively less complex.
• Monetary policy doesn’t change as per a
particular period; rather it changes whenever the
economy needs the change.
• Focus of a monetary policy is to maintain the
economic stability of a country.
• Monetary policy works on the flow of money in
the economy and the credit control.
• Fiscal policy involves the government changing
tax rates and levels of government spending to
influence aggregate demand in the economy.
• It is controlled by Ministry of Finance of the
country.
• It is comparatively more complex.
• Fiscal policy changes every year after reviewing
the previous year’s results.
• Focus of a fiscal policy is to ensure the
development and growth of an economy.
• Fiscal policy works on government’s spending
and government’s collections.

• Fiscal policy has political influence.

• Monetary policy has no political influence.
• Tools used in the fiscal policy are tax rates,
• Tools used in the monetary policy are cash
demonetization.
reserve ratios, repo rate, interest rate etc.

Role of fiscal policy in economic growth:

1. Contractionary fiscal policies:

• Try to decrease aggregate demand. This will reduce the growth of economic output.

• The government tries to slow down the economy because fast-growing demand can exceed supply.

• Fiscal policies aimed at slowing growth of total output generally fall into either or both of two
categories.
 ® Decreasing Government spending: if the government spends less, it triggers a chain of events that
may lead to a slower GDP growth.

® Increasing taxes: if the government raises taxes, individuals have less money to spend.

2. Expansionary Fiscal policies:

• The government uses expansionary fiscal policy to encourage growth, either when the economy is in a
recession or to try to prevent a recession.

• Expansionary policies fall into either or both of two categories:

 Increasing Government spending:

-Raises output and increases jobs.
-Increases aggregate demand which causes prices to rise.
 Cutting taxes: if government cuts taxes, people have more money to spend.

Role of Monetary policy in economic growth:

Monetary policy is referred to as either being an expansionary, or a contractionary policy

1. Contractionary monetary policy:

o Contractionary policy decreases the total money supply, or increases it slowly.

o Contractionary policy involves raising interest rates to combat inflation

2. Expansionary monetary policy:

o Expansionary policy increases the total supply of money in the economy rapidly.
o Expansionary policy is used to combat unemployment in a recession by lowering interest rates.

Economic Growth through Fiscal and Monetary policy:

Both monetary and fiscal policies are used to regulate economic

activity over time. They can be used to accelerate growth when an economy starts to slow or to moderate growth
and activity when an economy starts to overheat. In addition, fiscal policy can be used to redistribute income and
wealth. Fiscal policy and monetary policy are the two tools used by the state to achieve its macroeconomic
objectives. While for many countries the main objective of fiscal policy is to increase the aggregate output of the
economy, the main objective of the monetary policies is to control the interest and inflation rates.

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