LECTURE FOUR:

MONETARY POLICY (CENTRAL BANKS AND THEIR FUNCTIONS) AND FISCAL POLICY

BY
MR. B. M. SIMAUNDU
LECTURE OUTLINE

 What is the Central bank?

 The Bank of Zambia
 Monetary Policy
 Fiscal policy
WHAT IS A CENTRAL BANK
 Definition:
 A Central Bank is a generic term given to a country's primary monitory authority. It is the entity
responsible for overseeing the monetary system of a nation (or group of nations in the case of the
European Union) and has a wide range of responsibilities such as issuing currency, regulating the credit
system, managing exchange reserves etc.
 “A Central Bank is the bank in any country to which has been entrusted the duty of regulating the volume
of currency and credit in that country” - Bank of International Settlement.
 According to Kent : “Central Bank may be defined as an institution which is charged with the responsibility
of managing the expansion and contraction of the volume of money in the interest of general public
welfare.”
 Bank of England was the world’s first effective central bank that was established in 1694.
 As per the resolution passed in Brussels Financial Conference, 1920, all the countries should establish a
central bank for interest of world cooperation.
THE BANK OF ZAMBIA (BOZ)

 The Bank of Zambia (BoZ) is the Central Bank of the Republic of Zambia and derives its functions and powers from
the Bank of Zambia Act, no,43 of 1996 and the Banking and Financial Services Act, Chapter 387 of the Laws of Zambia.
 The Mission Statement of the Bank is to achieve and maintain price and financial system stability to foster
sustainable economic development.
 The Bank of Zambia has origins in the 1938 formation of the Southern Rhodesia Currency Board, which was based in
Harare, in present-day Zimbabwe. The Board's jurisdiction included Northern Rhodesia, now called Zambia and
Nyasaland, known as Malawi today.
 In 1954 the Southern Rhodesia Currency Board was renamed the Currency Board of Rhodesia and Nyasaland, and as
the winds of change were strong in Africa at the time, the currency board was transformed into the Bank of Rhodesia
and Nyasaland in 1956.
 In 1964 the Bank of Zambia was created from the Bank of Northern Rhodesia, which itself had only formed a year
earlier in 1963 from the Lusaka branch of the Rhodesia and Nyasaland bank.
CONT’D

 In 1991, the Movement for Multiparty Democracy (MMD) came to power in Zambia,
replacing the United National Independence Party (UNIP) which had ruled for 27
years. The new government's fiscal priorities included liberalization and privatization,
which included the Zambian copper industry and Zambian Consolidated Copper
Mines (ZCCM), the big company that controlled copper production in Zambia
 The Bank of Zambia has fourteen departments: Banking, Currency and
Payment Systems, Bank Supervision, Board Services, Economics, Finance, Financial
Markets, Human Resources, Information and Communication Technology, Internal
Audit, Legal Services, Non-Bank Financial Institution Supervision, Procurement and
Maintenance Services, Strategy and Risk Management, and the Security Division.
LIST OF BOZ PAST GOVERNERS

 Francis Nkhoma, 1987-1989

 H. C. Harret, 1964-1967
 Jacques Bussières, 1990-1992
 Justin B. Zulu, 1967-1970
 Dominic Mulaisho, 1992-1995
 Valentine Musakanya, 1970-1972
 Jacob Mwanza, 1995-2002
 Bitwell Kuwani, 1972-1976
 Caleb Fundanga, 2002-2011
 Luke Mwananshiku, 1976-1981
 Michael Gondwe, 2011-2015
 Bitwell Kuwani, 1981-1984
 Denny Kalyalya, 2015-2020
 David Phiri, 1984-1986
 Christopher Mvunga, 2020- DATE
 Leonard Chivuno, 1986-1987
FUNCTIONS OF CENTRAL BANK
FUNCTIONS OF CENTRAL BANK
 Traditional Functions : Which are generally performed by central banks all over
the world, are classified into two groups;
 1. Primary Functions: including issue of notes, regulation of financial system, and
conduct of monetary policy
 2. Secondary Functions: including management of public debt, management of foreign
exchange, advising the government on policy matters, and maintaining close
relationships with the international financial institutions
 Non-Traditional Functions: these functions are performed by the Central Bank
include development of financial frame work, provision of training facilities to bankers,
and provision of credit to priority sectors.
FUNCTIONS OF CENTRAL BANK

 The common functions of central banks are as below :

 The main functions of a central bank are common all  1. Regulator of currency
over the world.
 2. Banker,Agent and Adviser to the Government
 But the scope and content of policy objectives may vary
from country to country and from period to period  3. Custodian of cash Reserves of commercial
depending on the economic situations of the respective banks
country.  4. Custodian and Management of Foreign
 Generally all the central banks aim at achieving Exchange reserves
economic stability along with a high growth rate and a  5. Lender of the last resort
favorable external payment position through proper
monetary management.  6. Clearing house Function
 7. Controller of credit
1. REGULATOR OF CURRENCY
 The issue of paper money is the most important function of a central bank.
 The central bank is the authority to issue currency for circulation, which is a legal tender money.
 The issue department of the central bank has the responsibility to issue notes and coins to the
commercial banks. The central bank regulates the credit and currency according to the economic
situation of the country.
 In the methods of note issue, the central bank is required to keep a certain amount or a fixed
proportion of gold and foreign securities against the total notes issued.
 Having the monopoly of note issue, central bank gains advantages as Ensuring uniformity of the notes
issued and a proper control over the supply of money can be exercised.
 Bring stability in the monetary system and creates confidence among the public.
 Government is able to earn profits from printing currencies
2. BANKER, AGENT AND ADVISER TO THE GOVERNMENT
 The central bank of the country acts as the banker, fiscal agent and advisor to the government.
 As a banker, it keeps the deposits of the central and state governments and makes payments on
behalf of governments.
 It buys and sells foreign currencies on behalf of the government.
 It keeps the stock of gold of the country.
 As a fiscal agent, the bank makes short-term loans to the government for a period not exceeding 90
days.
 It floats loans and advances to the State governments and local bodies.
 It manages the entire public debt on behalf of the government.
 As an adviser, the bank gives useful advice to the governments on important monetary and economic
problems like devaluation, foreign exchange policy and budgetary policy.
3.CUSTODIAN OF CASH RESERVES OF COMMERCIAL
BANKS

 Commercial banks are required to keep a certain percentage of

cash reserves with the central bank.
 On the basis of these reserves, the central bank transfers funds
from one bank to another to facilitate the clearing of cheques .
4. CUSTODIAN AND MANAGEMENT OF FOREIGN EXCHANGE
RESERVES

 The central bank keeps and manages the foreign exchange reserves of
the country.
 It fixes the exchange rate of the domestic currency in terms of foreign
currencies.
 If there are any fluctuations in the foreign exchange rates, it may have to
buy and sell foreign currencies in order to minimize the instability of
exchange rates.
5.LENDER OF THE LAST RESORT

 By giving accommodation in the form of re-discounts and

collateral advances to commercial banks, bill brokers and their
financial institutions, the central bank acts as the lender of the
last resort.
 The central bank lends to such institutions in order to help
them when they are faced with difficult situations so as to save
the financial structure of country from collapse.
6.CLEARING HOUSE FUNCTION

 The central bank acts as a 'clearing house' for other banks and
mutual obligations are settled through the clearing system.
 Since it holds cash reserves of commercial banks, it is easier for
the central bank to act as a 'clearing house'.
7.CONTROLLER OF CREDIT
 The most important function of the central bank is to control the credit creation power of
commercial banks in
order to control inflationary and deflationary pressures within the economy.
 Controlling credit in the economy is amongst the most important functions of the Central Banks
around the world.
 The basic and important needs of credit control in the economy are-
 To encourage the overall growth of the "priority sector" i.e. those sectors of the economy which is
recognized by the government as "prioritized" depending upon their economic condition or
government interest.
 To keep a check over the channelization of credit so that credit is not delivered for undesirable
purposes.
CONT’D

 To achieve the objective of controlling inflation as well as deflation.

 To boost the economy by facilitating the flow of adequate volume of
bank credit to different sectors.
 To develop the economy.
For this purpose, the central bank adopts
1. Quantitative methods
2. Qualitative (selective) methods, these methods will be discussed in
the next chapters.
OTHER FUNCTIONS:

 Besides the above functions, the central bank performs many additional functions. It
has to study all problems relating the;
 I ) credit,
 ii) fluctuations in price level
 iii) fluctuations in foreign exchange value.
 It has to collect monetary and financial statistics, conduct research and provide
information. It has to look after the matters relating to IMF and the World Bank. All
together, the central bank is the financial and monetary guardian of the nation.
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.
 Monetary policy consists of the actions of a central bank, currency board or
other regulatory committee that determine the size and rate of growth of the
money supply, which in turn affects interest rates. Monetary policy is maintained
through actions such as modifying the interest rate, buying or selling
government bonds, and changing the amount of money banks are
required to keep in the vault (bank reserves).
TYPES OF MONETARY POLICY
 Broadly speaking, there are two types of monetary policy, expansionary and contractionary.
 Expansionary monetary policy increases the money supply in order to lower unemployment,
boost private-sector borrowing and consumer spending, and stimulate economic growth. This is often
referred to as "easy monetary policy," this description applies to many central banks since the 2008
financial crisis, as interest rates have been low and in many cases near zero in developed countries.
 Contractionary monetary policy slows the rate of growth in the money supply or outright
decreases the money supply in order to control inflation; while sometimes necessary, contractionary
monetary policy can slow economic growth, increase unemployment and depress borrowing and
spending by consumers and businesses.
 An example would be the Federal Reserve's intervention in the early 1980s: in order to curb inflation
of nearly 15%, the Fed raised its benchmark interest rate to 20%. This hike resulted in a recession, but
did keep spiraling inflation in check.
CONT’D
 Central banks use a number of tools to shape monetary policy. Open market
operations directly affect the money supply through buying short-term government
bonds (to expand money supply) or selling them (to contract it). Benchmark interest
rates, such as the LIBOR and the Fed funds rate, affect the demand for money by raising
or lowering the cost to borrow—in essence, money's price.
 When borrowing is cheap, firms will take on more debt to invest in hiring and
expansion; consumers will make larger, long-term purchases with cheap credit; and savers
will have more incentive to invest their money in stocks or other assets, rather than earn
very little—and perhaps lose money in real terms—through savings accounts. Policy
makers also manage risk in the banking system by mandating the reserves that banks
must keep on hand. Higher reserve requirements put a damper on lending and rein
in inflation.
OBJECTIVES 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.
 Four most important objectives of monetary policy are the
following:
1. 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. Keynes pointed out that monetary
policy loses its effectiveness during economic downturn for two reasons:
 (i) The existence of liquidity trap situation (i.e., infinite elasticity of demand for
money) and
 (ii) Low interest elasticity of (autonomous) investment.
2. 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 Zambia the acceleration of investment activity in the face of a fall in
agricultural output creates excessive pressure on prices.
 The food inflation in India is a proof of this.
 In such a situation, monetary policy has much to contribute to short-run price stability.
 Mild inflation or a functional rise in prices is desirable to give necessary incentive to producers
and investors.
 As P. A. Samuelson put it, mild inflation at the rate of 3% to 4% per annum lubricates the
wheels of trade and industry and promotes faster economic growth.
 Price stability is also important for improving a country’s balance of payments.
3. 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—short-term credit to meet
working capital needs and 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.
4. 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 local
currency 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.
CONFLICTS AMONG OBJECTIVES
 In the long run there is no conflict between the first two objectives, viz., price stability and
economic growth.
 In fact, price stability is a means to achieve faster economic growth.
 In the context of the Indian economy C. Rangarajan writes, “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.
 This amounts to an increase in the money supply.
CONT’D

 But an increase in the money supply and the consequent rise in consumer demand tends to generate a high
rate of inflation.
 This raises the question of what is the minimum acceptable rate of inflation which does not act as a
growth-retarding factor.The question still remains unanswered.
 There is also a conflict between exchange rate stability and economic growth.
 If the Kwacha depreciates in terms of the dollar, then Bank of Zambia has to tighten its monetary screws,
i.e., it has to raise the interest rate and reduce excess liquidity of banks (from which loans are made).
 On the other hand in order to promote faster economic growth the Bank of Zambia has to lower interest
rate and make more credit available for encouraging private investment. Thus the Bank of Zambia often
faces a dilemma situation.
ULTIMATE VERSUS INTERMEDIATE TARGETS

 Intermediate targets apply to any economic variable which is vital to the economy
and not under the direct control of the Central Bank.
 Examples include items such as the supply of money or interest rates.
 While these targets are part of the central bank’s monetary policy goals, they are
only influenced indirectly through the BoZ’s monetary policy decisions. Intermediate
targets help to guide policy as a step between the BoZ’s actual tools and its goals.
 In general, intermediate targets change quickly to match new policy decisions and
behave in a predictable manner relative to the BoZ's stated economic goals.
 These targets often relate either to monetary growth or interest rates.
CONT’D

 The ultimate target over which the central bank of a country wants to exercise
control are three major macroeconomic variables such as the rate (level) of
employment, the general price level (or the rate of inflation) and the rate of growth
of the economy which is measured by the annual rate of increase of real GDP.
 Now the question is how effectively does the Bank of Zambia act on such targets?
The truth is that Bank of Zambia is not in a position to act on them directly. The
main reason for this is its imperfect monitoring of the operation of the economy. This
is attributable to lack of adequate, necessary and timely information about the key
variables.
CONT’D
 So what does the Bank of Zambia do then? It has no other option but to
control intermediate targets exert indirect influence on the ultimate targets
and, of course, in a predictable manner.
 Important intermediate targets are the three money supply concepts
(aggregates), viz., M1, M2 or M3 and, of course, the interest rate.
 While the Bank of Zambia seeks to control the rate of inflation by controlling
the money supply, it exerts influence on economic growth by altering the
interest rate structures which alter the incentives to invest in physical capital
as opposed to that in financial (liquid) assets.
THE GOALS AND TARGETS OF MONETARY POLICY IN THE
MAJOR ECONOMIES

 Monetary policy targets

 Values of specific economic variables that the monetary authority seeks achieve with monetary policy.
 The three most noted monetary policy targets are interest rates, monetary aggregates, and exchange
rates.
 These targets are usually intermediate targets that can be quickly achieved and easily measured, but then move
the economy toward the ultimate macroeconomic goals of full employment, stability, and economic growth.
 Monetary policy targets are specific values of macroeconomic variables, including interest rates, monetary
aggregates, and exchange rates, that a monetary authority pursues in the course of conducting monetary policy.
 The presumption, based on extensive economic theory, is that attaining a monetary policy target subsequently
results in achieving one or more of the macroeconomic goals.
CONT’D

 For example, achieving a particular Federal funds interest rate value might be
presumed to induce the level of investment expenditures and aggregate
production that results in a business-cycle expansion with low rates of both
unemployment and inflation. Alternatively, the monetary authority might deem
that targeting a specific growth rate of the M1 monetary aggregate attains this
state of the economy.
 In a perfect world, the monetary authority could target a variable like M1 or
the Federal funds rate to simultaneously achieve full employment, stability, and
economic growth. However, in the real world, targeting one variable over
others invariably means the pursuit of one goal over others.
INTEREST RATES
 Interest rates are charges for borrowing or returns from lending through financial markets.
 A complex economy like that in the United States has a large slate of interest rates, from
credit cards to corporate bonds, from savings accounts to government securities.
 One of the most important interest rates is the Federal funds rate, the interest rate
commercial banks charge each other for lending bank reserves. The fed funds rate is the
interest rate that depository institutions—banks, savings and loans, and credit unions—
charge each other for overnight loans.
 The discount rate is the interest rate that Federal Reserve Banks charge when they make
collateralized loans—usually overnight—to depository institutions. This rate is commonly
targeted by the U.S. monetary authority (Federal Reserve System) because:
CONT’D
 It is directly affected by Federal Reserve System monetary policy, specifically open
market operations. It is a benchmark interest rate that influences the values of most
other interest rates in the economy.
 Federal Reserve System monetary policy is observed almost immediately as a change
in the Federal funds rate. Because open market operations affect the amount of
reserves, banks are willing to extend loans to other banks at a higher or lower
Federal funds rate.
 However, changes in the Federal funds rate filter throughout the economy, inducing
corresponding changes in other interest rates, which then affect macroeconomic
activity and the pursuit of full employment, stability, and economic growth.
MONETARY AGGREGATES
 Monetary aggregates as discussed in unit one, labelled M1, M2, and M3, are measures of
money and highly liquid assets, especially accounts maintained by banks. M1 is the basic
money supply, the financial assets used for actual payments, including currency and checkable
deposits. M2 is a broader measure of the money supply and includes highly liquid near
monies (savings deposits) in addition to currency and checkable deposits. M3 is a broader
measure that includes M2 plus slightly less liquid assets.
 A monetary authority like the Federal Reserve System might be inclined to target one of
these monetary aggregates. Over the years, the U.S. Federal Reserve System has targeted
both M1 and M2 at different times.
 Targeting is typically implemented by identifying a desired growth rate of the monetary
aggregate, which is then translated as a specific value of the aggregate at the end of a period.
CONT’D
 If, for example, the current level of M1 is $1 trillion and a 5 percent annual growth
rate in M1 is deemed appropriate to achieve the desired macroeconomic goals, then
the Federal Reserve System targets a value of M1 at $1.05 trillion by the end of
the year.
 Although M1, which contains the actual assets used for transactions, would seem to
be the logical monetary aggregate target, the Federal Reserve System has
preferred to target M2 in recent years. Focus has shifted because M2 has a more
stable connection to overall macroeconomic activity.
 The Federal Reserve System has concluded that achieve a specific M2 value is more
likely to generate the desired macroeconomic goals.
EXCHANGE RATES

 Exchange rates are the prices one nation's currency in terms of the currencies of
other nations. For example, the exchange rate between U.S. dollars and Zambian
Kwacha might be something like 21 Kwacha per dollar. One dollar can buy 21
Kwacha or you need 21 Kwacha to buy one dollar.
 Exchange rates depend, in part, on the quantity of money an economy has. If an
economy has more money in circulation, then like any commodity that is relatively
abundant, the price declines. This means that the exchange rates for a country fall.
That is, one dollar might be purchased with 25 Kwacha rather than 21 Kwacha.
 Exchange rates are commonly targeted by a monetary authority with an eye toward
foreign trade. Lower exchange rates induce exports and limit imports, which
stimulate economic activity. Higher exchange rates have the opposite effect.
CONT’D

 Some modern nations, especially smaller countries, take this a step

further by fixing exchanges rates. In particular, a smaller country
implements monetary policy that ensures the exchange rate between
their domestic currency and that of another country, usually a larger
country like United States, is essentially fixed.
 A fixed exchange rate provides a direct link between the two countries,
meaning any monetary policy by the larger country affects the smaller
one, as well. The smaller country has thus relinquished all monetary
policy control to the larger country.
A MIX OF TARGETS

 While monetary authorities can and do pursue one

target to the exclusive of others, most monetary policy
generally works with a mix of targets, keeping an eye
on interest rates, monetary aggregates, and exchange
rates at the same time.
MONETARY POLICY STRATEGIES

 There are four basic types of monetary policy strategies, each of which
uses a different nominal anchor: 1)
 exchange-rate targeting; 2) monetary targeting; 3) inflation targeting; and
4) monetary policy with an explicit
 goal, but not an explicit nominal anchor (what I call the "just do it"
approach.)
NOMINAL ANCHOR OF MONETARY POLICY
 A nominal anchor for monetary policy is a single variable or device which the central
bank uses to pin down expectations of private agents about the nominal price level
or its path or about what the central bank might do with respect to achieving that
path.
 Monetary regimes combine long-run nominal anchoring with flexibility in the short
run. Nominal variables used as anchors primarily include exchange rate targets,
money supply targets, and inflation targets with interest rate policy.
 A nominal anchor helps promote price stability by tying inflation expectations to low
levels directly through its constraint on the value of money. It can also limit the time-
inconsistency problem by providing an expected constraint on monetary policy.
CONT’D
 In practice, to implement any type of monetary policy the main tool used is modifying
the amount of base money in circulation. The monetary authority does this by buying
or selling financial assets (usually government obligations).
 These open market operations change either the amount of money or its liquidity (if
less liquid forms of money are bought or sold). The multiplier effect of fractional
reserve banking amplifies the effects of these actions on the money supply, which
includes bank deposits as well as base money. Constant market transactions by the
monetary authority modify the supply of currency and this impacts other market
variables such as short-term interest rates and the exchange rate.
 The distinction between the various types of monetary policy lies primarily with the
set of instruments and target variables that are used by the monetary authority to
achieve their goals.
TYPES OF MONETARY POLICY
CONT’D

 The different types of policy are also called monetary regimes, in parallel to
exchange-rate regimes.
 A fixed exchange rate is also an exchange-rate regime; the gold standard
results in a relatively fixed regime towards the currency of other countries on
the gold standard and a floating regime towards those that are not.
 Targeting inflation, the price level or other monetary aggregates implies
floating the exchange rate unless the management of the relevant foreign
currencies is tracking exactly the same variables (such as a harmonized
consumer price index).
FISCAL POLICY
 Fiscal policy refers to the use of government spending and tax policies to influence
macroeconomic conditions, including aggregate demand, employment, inflation and
economic growth.
 Fiscal policy is largely based on the ideas of the 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.
FISCAL POLICY

 To illustrate how the government could try to use fiscal policy to affect the economy,
consider an economy that's experiencing recession.
 The government might lower tax rates to increase aggregate demand and fuel
economic growth; this is known as expansionary fiscal policy.
 The logic behind this approach is that if people are paying lower taxes, they have
more money to spend or invest, which fuels higher demand.
 That demand in turn leads firms to hire more – decreasing unemployment – and
compete for labor, raising wages and providing consumers with more income to
spend and invest: a virtuous cycle.
FISCAL POLICY

 Rather than lowering taxes, the government might decide to

increase spending. By building more highways, for example, it could
increase employment, pushing up demand and growth as described
above.
 Expansionary fiscal policy is usually characterized by deficit spending,
when government expenditures exceed receipts from taxes and
other sources. In practice, deficit spending tends to result from a
combination of tax cuts and higher spending.
CONT’D

 Economic expansion can get out of hand, however, as rising wages lead to inflation
and asset bubbles begin to form. In this case a government might pursue
contractionary fiscal policy – similar in practice to austerity – perhaps even forcing a
brief recession in order to restore balance to the economic cycle. The government
can do this by reducing public spending and cutting public sector pay or jobs.
 Contractionary fiscal policy is usually characterized by budget surpluses. It is rarely
used, however, as the preferred tool for reining in unsustainable growth is monetary
policy.When fiscal policy is neither expansionary nor contractionary, it is neutral.
 Aside from spending and tax policy, governments can employ seigniorage – the
profits derived from printing of money – and sales of assets to effect changes in fiscal
policy.
CONT’D

 Many economists dispute the effectiveness of expansionary fiscal policies,

arguing that government spending crowds out investment by the private
sector.
 Fiscal stimulus, meanwhile, is politically difficult to reverse; whether it has
the desired macroeconomic effects or not, voters like low taxes and
public spending.
 The mounting deficits that result can weigh on growth and create the
need for austerity.
CONTRACTIONARY POLICY

 Contractionary policy refers to either a reduction in government spending, particularly deficit spending, or a
reduction in the rate of monetary expansion by a central bank.
 It is a type of policy or macroeconomic
tool designed to combat rising inflation or other economic distortions created by central bank or government
interventions.
 Contractionary policy is the opposite of expansionary policy.
Contractionary policy sounds as though it is designed to slow down economic growth, although this is not the
case. Instead, contractionary policies are used to slow down potential distortions, such as high inflation from an
expanding money supply, unreasonable asset prices or crowding-out effects in capital markets.
 As such, the initial effect of contractionary policy might be a reduction in nominal gross domestic product (GDP),
but the final result could be higher and more sustainable economic growth and a smoother business cycle.
EXPANSIONARY POLICY

 An expansionary policy is a macroeconomic policy that seeks to expand the money supply
to encourage economic growth or combat inflationary price increases.
 One form of expansionary policy is fiscal policy, which comes in the form of tax cuts, transfer
payments, rebates and increased government spending.
 Another form is monetary policy, which is enacted by central banks and comes about
through open market operations, reserve requirements and interest rates.
 The most common form of expansionary policy is the implementation of monetary policy.
 The Bank of Zambia employs expansionary policies whenever it lowers the benchmark BoZ
funds rate or discount rate, decreases required reserves for banks, or buys Treasury bonds
on the open market.
CONT’D

 For example, when the benchmark BoZ funds rate is lowered, the cost of
borrowing from the central bank decreases, giving banks greater access
to cash that can be lent in the market.
 When reserve requirements decline, it allows banks to lend a higher
proportion of their capital to consumers and businesses.
 When the government purchases debt instruments, it injects capital
directly into the economy.
FISCAL NEUTRALITY

 Fiscal neutrality occurs when taxes and government spending are neutral, with neither having an effect
on 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.
 A situation where spending exceeds the revenue generated from taxes is called a fiscal deficit and
requires the government to borrow money to cover the shortfall.
 When tax revenues exceed spending, a fiscal surplus results, and the excess money can be invested for
future use.
ECONOMIC STIMULUS

 Economic stimulus consists of attempts by governments or government agencies to financially

stimulate an economy.
 An economic stimulus is the use of monetary or fiscal policy changes to kick start growth during a
recession. Governments can accomplish this by using tactics such as lowering interest rates, increasing
government spending and quantitative easing, to name a few.
 Over the course of a normal business cycle, governments may try to influence the pace and
composition of economic growth using various tools at their disposal.
 Central governments, including the Zambian government, may utilize fiscal and monetary policy tools
to stimulate growth.
 Similarly, state and local governments can also engage in stimulus spending by initiating projects or
enacting policies that encourage private sector investment.
FISCAL MULTIPLIER

 The fiscal multiplier is the ratio in which the change in a nation's income level is affected by
government spending.
 The fiscal multiplier is used to measure the effect of government spending (fiscal policy) on
the subsequent income level of that country.
 In theory, increased fiscal spending can lead to increased consumption, which then leads to a
cycle of consumption and wealth creation.
 A multiplier greater than one shows that government spending on a national income levels is
deemed to have been enhanced.
 As consumption grows in this model, demand grows from initial levels as well and results in
the multiple effect of wealth as demand keeps growing and subsequently matches
consumption.
THE END QUESTIONS???