Chapter 17

Fiscal, Monetary and Exchange

Rate Policies

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
 Business Cycles

• Fluctuations in economic activity.

- low level of economic activity: Recession
- Peaking levels of economic activity: Boom
• Economic activity is measured by rate of
change in GDP
• Policy interventions are called for to reduce the
severity of fluctuations and to stabilize the
economy

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
 SINE CURVE

There is a cycle
eg. If sales comes with
many order – everthing
grows – bank give loan –
high earnings- more
employment – but slowly
demand decreases –
recession - no order - bank
demands repayment-
unemployment

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
 Stabilization Policies
• Reliance on Demand management Policies in
the Short Run.
(if eco. Is growth condition demand is controlled so that
period is long lasting – if recession demand is increased)

Fiscal Policies Monetary Policies

could be ‘expansionary’ ( in this inc. the demand)
could be ‘restrictive’ (in this control the demand)
All rights reserved
 Fiscal Policy
• 4 instruments – (most imp. Have to write)
1. govt. earnings, - public places tickets, navratnas, taxes (indirect, direct ,
gst), customs, tolls. In fiscal policy focus is how to increase or manage
such earnings – Budget n economic survey have inc. or dec. of tax
2. govt. spending – if govt does not spend eco. Will shackle - it leads to
growth as returns will come. Eg. Roads, bridge, rail tracks, housing
society (& other planned dev). Leads to increase in demand in various
industry like if roads made vehicle demand will inc.. Eg. Bihar situation.
Some non planned spending – salaries given to govt. employee
3. govt. loans & Borrowing both international n domestic. - take loans on
basis of earnings. Govt. Bonds – take money from public and give return
to public. RBI, WB (IBRD – WW2 destruction)(long period loan), IMF
(short)
4. govt. fiscal deficit - spending more than earning. The difference is
covered by minting money. But it causes inflation i.e. buying power from
existing money is reduced
 Fiscal Policy
• Instruments: Taxes and Government Spending

• These two instruments don’t work through the

market.

• Both these are reflected in the Budget.

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
 Monetary Policy

• The central bank of a country is the sole authority.

• Interest Rate is the instrument which is

manipulated by changes in Money supply.

• Interest rate is the price of funds.

• Fiscal & monetary policy should go hand in hand
to achieve growth & stability
Managerial Economics, 2e All rights reserved
©Oxford University Press, 2010
 Money Supply

• Is primarily determined by the central bank.

• The banking sector plays a key role through the

‘fractional reserve system’ and the ‘multiple
expansion of deposits’.

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
 Money Multiplier

• High powered money = Cu + RR + ER

• M = Cu + D
• Money Multiplier is given by :

Cu /D + 1
-----------------------------
Cu/D + RR/D + ER/D
Where Cu is the currency, RR is Required reserves and ER
is Excess Reserves.

All rights reserved

 Measurement of Money
• M1 – Currency with the public, demand deposits
and other checkable deposits. Deposit of which u have
instruments bonds, certificate. This money u will get back
• M2- M1 plus saving deposits, time deposits and
mutual funds. Not sure money will come back M. funds market
risk, time deposit as bank can collapse
• In India, we also have M3. Time deposits of less
than 1 year are included in M2 and those of
greater than 1 year are included in M3.

All rights reserved

 Deficits
• Fiscal Deficit: Excess of expenditure over
sources of Revenue. In other words, all
financial liabilities of the government
• Primary deficit: Fiscal deficit minus
expenditure on interest payment
• Govt. Borrowing from the central bank of
the country is monetized debt.

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
 Exchange Rate Policies

• Fixed Exchange rate Policy- not allow the exchange

rate to fluctuate – continuous intervention by the central
bank – is suitable when exchange rate is ‘unstable’

• Market determined Exchange rate Policy- works well if

the exchange rate is ‘stable’.

• Between these two, there is a system of “Managed

Floats”

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
 Stability of Exchange Rates
• ‘Stable’ when the exchange rate tends back to
equilibrium.
• Depends on elasticities of imports and exports.
• An elastic import basket and an elastic export
basket results in stable rates.
• An inelastic import basket and a relatively highly
elastic export basket also results in stable rates.
• An inelastic import basket and a not so elastic
export basket results in instability in exchange
rates.

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
 Devaluation

• A reduction in the value of a currency.

• Devaluation is done when:

- a country cannot maintain the Fixed Exchange
rate due to scarcity of Reserves.
- a country chooses to consciously improve trade.

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
 Exchange Rates

• Nominal Exchange Rate: No correction for

inflation.
• Real Exchange Rate:
-Nominal rate * Foreign price level / Domestic
Price level
PPP (Purchasing Power Parity) rate is that exchange
rate which makes the dollar price of a commodity
the same across all countries.

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
Relationship between Monetary policies
and Exchange rate Policies

• Fixed Exchange Rate Policy:

monetary Policy’s role is exclusively to maintain
the fixed rate for which it requires reserves of
foreign and domestic currencies.
Flexible Exchange rate policy lets the exchange rate
fluctuate to the desirable extent; gives freedom to
use monetary policies for other purposes.

Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010