monetory poilicy and fiscal policy

7/27/2019 Monetory Poilicy and Fiscal Policy

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Monetary Policy

Monetary policy is one of the tools that a

national government uses to influence its

economy. Using its monetary authority to

control the supply and availability ofmoney, a government attempts to influence

the overall level of economic activity.

Usually this goal is macroeconomic

stability- low unemployment, low rate ofinflation, economic growth, and balance of

external payments.


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Fiscal Policy

Fiscal policy is used by the

governments to influence the level of

aggregate demand in the economy, in

an effort to achieve economic

objectives of price stability, full

employment and economic growth.


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Operation of a modern central bank

As we stated earlier that central bank

attempts to achieve economic stability

by varying the quantity of money in

circulation, the cost and availability ofcredit, and the composition of a

countrys national debt. The central

bank has three instrumentsavailability to it in order to implement

monetary policy:


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Open market operation

Reserve requirements

The discount window


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Open Market Operation

Open market operations are just that, thebuying or selling of government bonds bythe central bank in the open market. If thecentral bank were to buy bonds, the effectwould be to expand money supply andhence lower interest rates, the opposite istrue if bonds are sold. This is the mostwidely used instrument in the day to day

control of the money supply due to its easeof use and the relatively smooth interactionit has with the economy as a whole.


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Reserve Requirements

Reserve requirements are a percentage of commercialbanks and other depository institutions demand depositliabilities (i.e. chequing accounts) that must be kept ondeposit at the central bank as a requirement of bankingregulations. Though seldom used, this percentage may bechanged by the central bank at any time , thereby affecting

the money supply and credit conditions. If the reserverequirement percentage is increased, this would reduce themoney supply by requiring a larger percentage of the banks,and depository institutions, demand deposits to be held bythe central bank, thus taking them out of supply. As a result,an increase in reserve requirements would increase interestrates, as less currency is available to borrowers. This type ofaction is only performed occasionally as it affects moneysupply in a major way. Altering reserve requirements is notmerely a short-term corrective measure, but a long term shiftin the money supply.


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Discount Window

Discount window is where the commercialbanks, and other depository institutions,are able to borrow reserves from thecentral bank at a discount rate. This rate is

usually set below short term market rates(T-bills). This enables the institutions tovary conditions (i.e. the amount of moneythey have to loan out), there by affectingthe money supply. It is of note that the

discount window is the only instrumentwhich the central banks do not have totalcontrol over.


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While fiscal policy is dependent on public

debt, tax and deficit financing, Keynesian

economics suggests that adjusting

government spending and tax rates are thebest ways to stimulate aggregate demand.

This can be used in times of recession or

low economic activity as an essential tool

in providing the framework for strongeconomic growth and working toward full

employment.


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During periods of high economic growth, a

budget surplus can be used to decrease

activity in the economy. A budget surplus

will be implemented in the economy ifinflation is high, in order to achieve the

objective of price stability. The removal of

funds from the economy will, by Keynesian

theory, reduce levels of aggregate demandin the economy and contract it, bringing

about price stability.


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Cooperation of monetary and fiscal

policy

An appropriate monetary and fiscal policy isneeded for achieving targets and stability ofeconomic activities, some special features ofthese two policies are:

Monetary policy has less inside time lag so thereis less difference in making the policy andimplementing it whereas it has more outside timelag means there is more difference inimplementing the policy and its outcome while

fiscal policy has more inside time lag incomparison to outside time lag because there ispolitical system for finalizing the policy but oncethe policy is implemented the result comes faster.


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Due to lesser inside time lag it is easy to

make the monetary policy and implement it

so for day to day activities monetary policy

is more effective. But for long run targetsfiscal policy is more effective.

Simply it is believed that fiscal policy is

effective for economic growth and

monetary policy is effective for stability.


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So now it is clear that there is

difference in the tools of monetary

and fiscal policy and the impact ofthese two are also different on the

economy but it does not mean that

the two policies are independent ofeach other but they are dependent.

Say for example if government is

taking public debt for spending itwill increase inflation which will

create problems for stability in this

situation monetary policy is needed


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Monetary policy is dependent on

fiscal policy for for price stability,

interest rate and total liquidity.

Because till the government will notreduce its fiscal deficit central bank

can not implement appropriate

monetary policy.


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monetory poilicy and fiscal policy

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