For Managerial Economics June 2018

1. MONETARY, FISCAL &
BUDGETARY POLICYECONS 5501: MANAGERIAL ECONOMICS
SEMESTER JUNE 2018
Prepared by:
NUR ZATULITRI BINTI MD YUSOF (173019534)
MASTER OF BUSINESS ADMINISTRATION

2. MONETARY POLICY
• Monetary policy consists of the actions of a central bank, currency board or
other regulatory committees that determine the size and rate of growth of the
money supply, which in turn affects the 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).

3. Definition
• The process by which the monetary authority of a country, typically the
central bank or the currency board, controls either the cost of very short-term
borrowing or the monetary base, often targeting an inflation rate or 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.

4. • Monetary economics provides insight into how to craft an optimal monetary
policy. In developed countries, monetary policy has generally been formed
separately from fiscal policy, which refers to taxation, government spending,
and associated borrowing.

6. Types of Monetary Policy
• Broadly speaking, there are two (2) 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.
• 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.

7. • 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).

8. • 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 slows the rate of growth in the money supply
or outright decreases the money supply in order to control inflation.
• While sometimes necessary, contractionary policy can slow economic growth,
increase unemployment and depress borrowing and spending by consumers
and businesses.

9. History of Monetary Policy
• Monetary policy is associated with interest rates and availability of credit.
Instruments of monetary policy have included short-term interest rates and
bank reserves through the monetary base. For many centuries there were only
two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to
print paper money to create credit. Interest rates, while now thought of as part
of monetary authority, were not generally coordinated with the other forms of
monetary policy during this time.

10. • Monetary policy was seen as an executive decision, and was generally in the
hands of the authority with seigniorage, or the power to coin. With the advent
of larger trading networks came the ability to set the price between gold and
silver, and the price of the local currency to foreign currencies. This official
price could be enforced by law, even if it varied from the market price.

11. • Paper money originated from promissory notes called "jiaozi" in 7th
century China. Jiaozi did not replace metallic currency, and were used
alongside the copper coins. The successive Yuan Dynasty was the first
government to use paper currency as the predominant circulating medium. In
the later course of the dynasty, facing massive shortages of specie to fund war
and their rule in China, they began printing paper money without restrictions,
resulting in hyperinflation.

12. Monetary Policy Instruments
• Central banks use a number of tools to shape the 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).
• Unconventional monetary policy has become more common. This category
includes quantitative easing, the purchase of varying financial assets from
commercial banks.

13. • Most central banks are independent from other policy makers. This is the case
with the Federal Reserve and Congress, reflecting the separation of monetary
policy from fiscal policy, the latter refers to taxes and government borrowing,
and spending.

14. FISCAL POLICY & BUDGET
• Fiscal policy refers to any uses of the government budget to affect the
economy. This includes government spending and levied taxes.
• Like monetary policy, there are two (2) types of fiscal policy, expansionary
and contractionary.
• Policy is said to be expansionary when spending increases or when taxes are
lower. Conversely, policy is said to be contractionary when spending
decreases or taxes rise.

18. • Government can spend beyond their tax-based budgetary constraints by
borrowing money from the private sector. The US government issues
Treasurys to raise funds, for example. To meet its future obligations as a
debtor, government must eventually increase tax receipts, reduce spending or
print more dollars.
• Not all economists agree about the net effect of expansionary fiscal policy on
the budget in the long run. The Keynesian revolution and the demand-driven
macroeconomics made it politically feasible for governments to spend more
than they brought in. Government could borrow money and increase spending
as part of a targeted fiscal policy.

19. • The accounting for government budgets is performed much like personal or
household budgets. A government runs a surplus when it spends less money
than it taxes, and it runs a deficit when it spends more money than it taxes.

20. • The three stances of fiscal policy are:
• Neutral fiscal policy is usually undertaken when an economy is in neither
a recession nor a boom. The amount of government deficit spending (the excess not
financed by tax revenue) is roughly the same as it has been on average over time, so
no changes to it are occurring that would have an effect on the level of economic
activity.
• Expansionary fiscal policy involves government spending exceeding tax revenue by
more than it has tended to, and is usually undertaken during recessions.
• Contractionary fiscal policy occurs when government deficit spending is lower than
usual.

21. • However, these definitions can be misleading because, even with no changes
in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic
fluctuations of tax revenues and of some types of government spending,
altering the deficit situation; these are not considered to be policy changes.
Therefore, for purposes of the above definitions, "government spending" and
"tax revenue" are normally replaced by "cyclically adjusted government
spending" and "cyclically adjusted tax revenue". Thus, for example, a
government budget that is balanced over the course of the business cycle is
considered to represent a neutral and effective fiscal policy stance.

22. Methods of Funding
• Governments spend money on a wide variety of things, from the military and
police to services like education and healthcare, as well as transfer
payments such as welfare benefits. This expenditure can be funded in a
number of different ways:
• Taxation
• Seigniorage, the benefit from printing money
• Borrowing money from the population or from abroad
• Consumption of fiscal reserves
• Sale of fixed assets (e.g., land)

23. • It should be noted that even though printing has not been mentioned above,
some countries have actually used it, an example is Zimbabwe and Germany.
The method is however inflationary.

24. Borrowing
• A fiscal deficit is often funded by issuing bonds, like treasury
bills or consols and gilt-edged securities. These pay interest, either for a fixed
period or indefinitely. If the interest and capital requirements are too large, a
nation may default on its debts, usually to foreign creditors. Public
debt or borrowing refers to the government borrowing from the public.

25. Consuming prior surpluses
• A fiscal surplus is often saved for future use, and may be invested in either
local currency or any financial instrument that may be traded later once
resources are needed.

26. Economics effects
• Keynesians argue that expansionary fiscal policy should be used in times of
recession or low economic activity as an essential tool for building the
framework for strong economic growth and working towards full
employment. In theory, the resulting deficits would be paid
• Governments can use a budget surplus to do two things: to slow the pace of
strong economic growth, and to stabilize prices when inflation is too high.
Keynesian theory posits that removing spending from the economy will
reduce levels of aggregate demand and contract the economy, thus stabilizing
prices.for by an expanded economy during the boom that would follow.

27. • Changes in the level and composition of taxation and government spending
can affect the following macroeconomic variables, amongst others:
 Aggregate demand and the level of economic activity;
 Saving and investment;
 Income distribution.

28. Keynesian economics
• Keynesian economics (/ˈkeɪnziən/ KAYN-zee-ən; sometimes
called Keynesianism) are the various macroeconomic theories about how in
the short run – and especially during recessions – economic output is strongly
influenced by aggregate demand (total demand in the economy). In the
Keynesian view, aggregate demand does not necessarily equal the productive
capacity of the economy; instead, it is influenced by a host of factors and
sometimes behaves erratically, affecting production, employment,
and inflation.

29. • Keynesian economics developed during and after the Great Depression, from
the ideas presented by John Maynard Keynes in his 1936 book, The General
Theory of Employment, Interest and Money. Keynes contrasted his approach
to the aggregate supply-focused classical economics that preceded his book.
The interpretations of Keynes that followed are contentious and
several schools of economic thought claim his legacy.

30. • Keynesian economics served as the standard economic model in
the developed nations during the later part of the Great Depression, World War
II, and the post-war economic expansion (1945–1973), though it lost some
influence following the oil shock and resulting stagflation of the 1970s. The
advent of the financial crisis of 2007–08 caused a resurgence in Keynesian
thought, which continues as new Keynesian economics.

31. Fiscal straitjacket
• The concept of a fiscal straitjacket is a general economic principle that
suggests strict constraints on government spending and public sector
borrowing, to limit or regulate the budget deficit over a time period. Most US
states have balanced budget rules that prevent them from running a deficit.
The United States federal government technically has a legal cap on the total
amount of money it can borrow, but it is not a meaningful constraint because
the cap can be raised as easily as spending can be authorized, and the cap is
almost always raised before the debt gets that high.

32. Use of Monetary Policy (MP) and Fiscal
Policy (FP) to control inflation
• Inflation can be reduced by policies that slow down the growth of AD and/or boost
the rate of growth of aggregate supply (AS)
Fiscal policy:
• Controlling aggregate demand is important if inflation is to be controlled. If the
government believes that AD is too high, it may choose to ‘tighten fiscal policy’ by
reducing its own spending on public and merit goods or welfare payments
• It can choose to raise direct taxes, leading to a reduction in real disposable income
• The consequence may be that demand and output are lower which has a negative
effect on jobs and real economic growth in the short-term

33. Monetary policy:
• A ‘tightening of monetary policy’ involves the central bank introducing a
period of higher interest rates to reduce consumer and investment spending
• Higher interest rates may cause the exchange rate to appreciate in value
bringing about a fall in the cost of imported goods and services and also a fall
in demand for exports (X)

34. • The most appropriate way to control inflation in the short term is for the
government and the central bank to keep control of aggregate demand to a
level consistent with our productive capacity
• AD is probably better controlled through the use of monetary policy rather
than an over-reliance on using fiscal policy as an instrument of demand-
management.

35. Use of Monetary Policy (MP) and Fiscal
Policy (FP) to reduce unemployment
• Fiscal Policy
• Fiscal policy can decrease unemployment by helping to increase aggregate
demand and the rate of economic growth. The government will need to pursue
expansionary fiscal policy; this involves cutting taxes and increasing
government spending. Lower taxes increase disposable income (e.g. VAT cut
to 15% in 2008) and therefore help to increase consumption, leading to higher
aggregate demand (AD).

36. • With an increase in AD, there will be an increase in Real GDP (as long as
there is spare capacity in the economy.) If firms produce more, there will be
an increase in demand for workers and therefore lower demand-deficient
unemployment. Also, with higher aggregate demand and strong economic
growth, fewer firms will go bankrupt meaning fewer job losses.

37. • Monetary policy
• Monetary policy would involve cutting interest rates. Lower rates decrease the
cost of borrowing and encourage people to spend and invest. This increases
AD and should also help to increase GDP and reduce demand deficient
unemployment.
• Also, lower interest rates will reduce exchange rate and make exports more
competitive.
• In some cases, lower interest rates may be ineffective in boosting demand.

38. Thank you.