UNIT THREE

MONETARY AND FISCAL POLICIES

Section One
Monetary Policies and Issues
 Understanding Monetary Policy and
Important Concepts
Definition of Monetary Policies
Monetary policy is a set of economic principles &
programmes adopted by a gov’t to manage the
growth of its money supply, the availability of
credit, & interest rates.
By ‘money’, we are referring to any medium
of exchange that is widely accepted in payment
for goods & services & in settlement of debts.
It serves as a standard of value for measuring the
relative worth of different goods and services.
The number of units of money required to buy a
commodity is the price of the commodity.
 Definition of Monetary Policies…ctd
The functions of money as a medium of exchange
and a measure of value greatly facilitate the
exchange of goods & services & the specialization
of production.
Without the use of money, trade would be
reduced to “barter”
In a money economy, the owner of a commodity
may sell it for money, which is acceptable in
payment for goods, thus avoiding the time and
effort that would be required to find someone
who could make an acceptable trade.
Money may thus be regarded as a keystone of
modern economic life.
 Definition of Monetary Policies…ctd
The amount of money circulating in the
economy really matters in determining how
better the system is functioning.
Thus, government measures should be
devised in such a way to influence the growth
of money and credit as well as the levels of
interest rates in the economy.
These are what we often call monetary
policies
 Definition of Monetary Policies…ctd
Governments use monetary policy, along with
fiscal policy to maintain eco’c growth, high
employment, & low inflation.
The main goals for monetary policy are to
maintain price & exchange rate stability &
safeguard the soundness of the financial
system.
In most countries, the monetary policy is
largely, but not fully, determined by the
central banks (e.g. USA- Federal Reserve, in
Ethiopia- the National Bank of Ethiopia).
 Monetary Base and Money Supply
 The monetary base is often termed as high
power money.
 It refers to the currency in circulation and the
commercial banks’ reserve held with the central
bank.
 Money supply is amount of money freely
circulating in an economy
 Money supply is made up of currency (paper bills
and coins) and bank deposits
 Money supply is an important aspect of gov’t
monetary policy.
Exogenous versus Endogenous money
• The issue of whether money is exogenous or
endogenous is a critical interpretation of the monetary
policy.
• Money is said to be endogenous when it responds
passively to expenditure decisions. In this case, money
will have no independent influence on economic
activity.
• On the other hand, with exogenous money supply, an
increase in monetary base leads to an increase in
currency in circulation.
• It implies a rise in money supply, which is greater than
the initial increase in the monetary base by the money
multiplier (mm).
 Instruments of Monetary Policy
• In most economies, the basic instruments of
monetary policy are:
o Market based approach, which includes two
policy instruments: open-market operations &
commercial bank reserve requirement
o Interest rate intervention
o Credit control
 Market based approach
 The market based policies are the most flexible &
most frequently used instrument of controlling
the money supply.
 Open market instruments operate under a
situation, for instance, whereby the gov’t bonds
are either sold to or bought from the public by
the central bank to influence the deposit with the
commercial banks.
 A “tight” monetary policy based on such sales of
gov’ bonds will automatically see a shrinking of
the monetary base, thus, a contraction of bank
credit leading to rise of interest rates.
 Market based approach…ctd
 Similar results can be achieved by changing
the required reserve ratio, i.e. the percentage
of deposits that banks must maintain on
reserve as cash deposits at the central banks

 The increase of the reserve ratio, under

ceteris paribus, will reduce the money supply
and vice versa, as the fall of reserve
requirements tend to increase deposit and
thereby the expansion of credits
 Interest rate intervention
Interest is a payment made for the use of the
principal, i.e. the sum of money loaned, for a
given time, usually a year
The determination & change of interest rate
have a direct bearing on the money supply in
the economy
Putting a direct ceiling of charges on
borrowers will not only curtail the growth of
credit from banks but also the demand of
borrowers for credit
 Interest rate intervention…ctd
Central banks use two types of interest rates
known as repo rate and reverse-repo-rate

Repo rate is rates at which the central bank

reserve deposits from the commercial banks

Reverse-repo-rate is the rate of interest that

commercial banks pay for the credit they
obtain from the central bank
 Credit control
Finally, gov’ts can regulate monetary supply via
credit control mechanisms & regulating
operations of the stock (share business) market
It is used as a means of controlling various types
of consumer credit in a way of directly putting
limits or ceiling on total credit or patterns of
credit allocation to specific borrowers within the
limited framework
The central banks may selectively lower or raise
the margin of the requirement, which is the
percentage of a stock price that must be
provided in cash by someone who buys the stock
on credit
 Section Two
Fiscal Policies
Definition and Elements of Fiscal Policy
o Fiscal matters apply to the whole of public
finance - including expenditure, taxes &
borrowing that help to further national
economic objectives.
o From this definition, it can be inferred that a
fiscal policy, also called budgetary policy, is
gov’t policy that directs the whole body of
public finance.
 Definition and Elements of Fiscal Policy…ctd
o This implies that fiscal policy is related to those
activities of the state that are concerned with
raising financial resources & spending them
o Fiscal policies generally differ from monetary
policies in that they are concerned with
aggregate impacts taxation, expenditure &
public debt as designed by appropriate organ of
a government
o Fiscal policy is concerned with the type, time &
the procedure to be followed in making gov’t
expenditure and in obtaining gov’t revenues.
 Definition and Elements of Fiscal Policy…ctd
• Functions of modern gov’ts are broadening
due to socio-political reasons
• To discharge these increasing functions, the
gov’t has to increase its expenditure
• To cope with an ever rising amount of
expenditure, it has to mobilize funds with the
help of fiscal policy
 Definition and Elements of Fiscal Policy…ctd
 The state by its policy of taxation & regulated
expenditure can influence the economic
activities and development
 Fiscal policy is concerned with the use &
impact of gov’t tax, expenditure & debt policy
on the levels of production, income & prices
 Fiscal policy can also be regarded as an
element of the government’s approach to
‘demand management’
 Definition and Elements of Fiscal Policy…ctd
• Fiscal policy is an instrument through which
gov’t undertakes its stabilization role by
manipulating the aggregate demand in the
economy towards a path of economic growth
and full employment
 Definition and Elements of Fiscal Policy…ctd
• A fiscal policy consists of the following three
conventional components
i. Taxation policy and tax related issues
ii. Public expenditure and other issues pertaining
to government spending
iii.Public debt issues (both the manner and
amount of government borrowing and its
management)
 Definition and Elements of Fiscal Policy…ctd
Basically, fiscal policy in these d/t facets deal
with the flow & transfer of funds out of the
private spending & saving stream into the
hands of gov’t & the recycle funds from
government into the private economy
 Determinants of Fiscal Policy
To determine its fiscal policy, a gov’t must
make judgments about a number of factors:
 The first factor is the level of economic
growth or unemployment in the future
 These factors will affect the amount of
revenue raised through taxes & the amount of
money required for gov’t programs
 Once these parameters are determined, the
government can decide on how to raise
revenue and how to allocate it
 Determinants of Fiscal Policy…ctd
Another important decision is whether or not to
run a budget deficit by spending more money than
the government obtains
Deficits can be financed in two ways: borrowing or
printing more money
If the gov’t borrows money, it will decrease the
supply of money available in the economy for
lending; while the cost of borrowing money & the
interest rate may rise
If the gov’t prints more money, it will increase the
supply of money in the economy; without a
corresponding increase in available goods, prices
are likely to rise leading to inflation
 Determinants of Fiscal Policy…ctd
Thirdly, decisions on fiscal policy are inevitably
influenced by political considerations, such as
beliefs about the size of the role that gov’ts
should play in the economy, or the likely public
reaction to a particular course of action
Few gov’ts will find it easy to raise taxes or to
decrease funding for programs that have
strong support from the public, such as social
security or defense
 Determinants of Fiscal Policy…ctd
o Fiscal policy decisions can be influenced by factors
outside the national boundary as well.
o In today’s global economy, a gov’t also needs to
consider the fiscal policies of other countries, w/c
may tempt companies to relocate by offering
them generous tax programs or other government
controlled benefits
o Many of the developing countries find their fiscal
policy decisions constrained by the requirements
of the IMF, which often grants aid packages
subject to conditions relating to fiscal policy, often
known as austerity measures
 Classifications of Fiscal Policies
• Fiscal policy can be either expansionary or
contractionary
 A fiscal policy is said to be expansionary or loose
when taxation is reduced or public spending is
increased with the aim of stimulating total
spending in the economy, known as aggregate
demand
 Expansionary policy is often used when a gov’t
feels its economy is not growing fast enough or
unemployment is too high
 Classifications of Fiscal Policies…ctd
Expansionary…
 By increasing spending or cutting taxes, the
gov’t leaves individuals & businesses with
more money to purchase goods or invest in
new equipment
 When individuals or firms increase their
purchases, they raise demand, which requires
additional production, creating jobs &
generating more spending
 The result is higher employment and a
growing economy
 Classifications of Fiscal Policies…ctd
o On the other hand, fiscal policy is contractionary
or tight when taxation is increased or public
spending is reduced in order to restrict demand
& slow down the economy
o A tight fiscal policy is more likely at work when
inflation is high.
o A contractionary fiscal policy reduces the
amount of money in the economy available for
purchasing goods, thus decreasing spending,
demand, and, ultimately pressure on prices
 Role of Fiscal Policy in Economic Development
• Some of the common roles that a fiscal policy
plays, particularly in the developing countries are:
Resource allocation
Today, dev’t is the main concern of nations
throughout the world, especially in the developing
countries.
The primary task of fiscal policy in underdeveloped
countries is, therefore, to allocate more resources
for investment and to restrain consumption
Private sector is not interested in investing in
social and economic overheads
 Role of Fiscal Policy in Economic Dev’t…ctd
Investments in social & eco’c overheads like
education, medical facilities, infrastructure,
dams etc. are very essential to generate more
employment and to accelerate the rate of
economic growth
 Role of Fiscal Policy in Economic Dev’t…ctd
Reducing inequality
 Fiscal policy should reduce the inequalities of
income and wealth
 This can be achieved by taxation and public
distribution measures.
 Therefore, fiscal policy should attempt
economic development of the socially
unfortunate to bring about national unity
 Moreover, fiscal policy should aim at reducing
regional social imbalances by directing
investments to less developed regions
 Role of Fiscal Policy in Economic Dev’t…ctd
Resource mobilization
 In order to attain growth with stability, the goal
of fiscal policy should be promotion of highest
possible rate of capital formation & should
reduce the actual & potential consumption
 Fiscal policy should encourage private investment
& attract foreign funds for dev’t projects
 In developing countries, fiscal policy has to be
used as an instrument of resource mobilization -
raising the level of investments & savings rather
than keeping the consumption level
 Role of Fiscal Policy in Economic Dev’t…ctd
Rising the levels of investment
The existing pattern of investment may differ
from the optimum pattern of investment
A small increment in investment can bring
manifold employment due to multiplier effect
Thus, it becomes a responsibility of gov’t to
undertake investments in such a way that it is
most beneficial for the people of the country
 Role of Fiscal Policy in Economic Dev’t…ctd
Controlling inflation
 Fiscal policy should aim at controlling inflation
within tolerable levels since inflation mostly
affects the poor segment of the society
particularly in underdeveloped economies
 Desirable changes in the state of the economy
can be gained via using fiscal policy by
adjusting public expenditures and taxes if the
gov’t hopes to reduce unemployment through
an increase in GDP without causing
inflationary pressures to increase