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Principles of UNIT III MACROECONOMIC POLICIES – MONETARY AND FISCAL BABY THOMAS 2016 6/15/2016 BABY THOMAS 2016 1 UNIT III – MACROECONOMIC POLICIES – MONETARY AND FISCAL 1. Meaning of macroeconomic policy, need of macroeconomic policies 2. Meaning of monetary policy, instruments of monetary policy 3. Meaning of fiscal policy, instruments of fiscal policy 4. Fiscal policy and macroeconomic goals 6/15/2016 BABY THOMAS 2016 2 Meaning of macroeconomic policy • Macroeconomic policy is the set of government rules and regulations to control or stimulate the aggregate indicators of an economy. • Aggregate indicators involve national income, money supply, inflation, unemployment rate, growth rate, interest rate and many more. 6/15/2016 BABY THOMAS 2016 3 Need of macroeconomic policies • A central issue in macroeconomics is whether markets automatically bring about long run economic equilibrium or not if it is left alone. If the free operation of market forces eventually resulted in a full employment level of national income with stable prices and economic growth, there would be no need for government intervention in the macro economy - no need for fiscal or monetary policies. The reality is that all governments intervene through their macroeconomic policies in a bid to achieve certain policy objectives and improve the overall performance of the economy. • Need of macroeconomic policies are: 1. 2. 3. 4. 5. 6. Sustained economic growth Stable prices (low inflation) A high level of employment A rise in average living standards Sustainable position on the balance of payments Sound government finances 6/15/2016 BABY THOMAS 2016 4 Macroeconomic policies Macroeconomic policy is usually implemented through two sets of tools: 1. Monetary policy 2. Fiscal policy 6/15/2016 Monetary policy involves the use of interest rates to control the level and rate of growth of aggregate demand in the economy Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic activity and also the level and growth of aggregate demand, output and employment. BABY THOMAS 2016 5 Instruments of Monetary Policy 1. 2. 3. 4. 5. 6. Bank Rate of Interest Cash Reserve Ratio Statutory Liquidity Ratio Open market Operations Margin Requirements Deficit Financing 6/15/2016 BABY THOMAS 2016 6 Bank Rate of Interest It is the interest rate which is fixed by the central bank to control the lending capacity of commercial banks . During inflation, the central bank increases the bank rate of interest due to which borrowing power of commercial banks reduces which thereby reduces the supply of money or credit in the economy. When money supply reduces it reduces the purchasing power and thereby curtailing consumption and lowering prices. 6/15/2016 BABY THOMAS 2016 7 Cash Reserve Ratio CRR, or cash reserve ratio, refers to a portion of deposits (as cash) which banks have to keep/maintain with the central bank . During Inflation the central bank increases the CRR due to which commercial banks have to keep a greater portion of their deposits with the central bank . This serves two purposes. It ensures that a portion of bank deposits is totally risk-free and secondly it enables that the central bank control liquidity in the system, and thereby, inflation. 6/15/2016 BABY THOMAS 2016 8 Statutory Liquidity Ratio Banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements . If SLR increases the lending capacity of commercial banks decreases thereby regulating the supply of money in the economy. 6/15/2016 BABY THOMAS 2016 9 Open market Operations It refers to the buying and selling of Govt. securities in the open market . During inflation the central bank sells securities in the open market which leads to transfer of money to the central bank . Thus money supply is controlled in the economy. 6/15/2016 BABY THOMAS 2016 10 Margin Requirements • During Inflation the central bank fixes a high rate of margin on the securities kept by the public for loans. If the margin increases, the commercial banks will give less amount of credit on the securities kept by the public thereby controlling inflation. 6/15/2016 BABY THOMAS 2016 11 Deficit Financing • It means printing of new currency notes by the central bank. If more new notes are printed, it will increase the supply of money thereby increasing demand and prices. • Thus during Inflation, the central bank will stop printing new currency notes thereby controlling inflation. 6/15/2016 BABY THOMAS 2016 12 Fiscal Policy • Fiscal policy refers to the revenue and expenditure policy of the government, which is generally used to cure recession and maintain economic stability in the country. 6/15/2016 BABY THOMAS 2016 13 Instruments of Fiscal Policy 1. 2. 3. 4. Budgetary surplus and deficit Government expenditure Taxation- direct and indirect Public debt 6/15/2016 BABY THOMAS 2016 14 Budgetary surplus and deficit • Budgetary surplus and deficit is a fiscal policy instrument An accumulated deficit over several years (or centuries) is referred to as the government debt. A deficit is a flow. And a debt is a stock. Debt is essentially an accumulated flow of deficits 6/15/2016 BABY THOMAS 2016 15 Government expenditure • It includes: • Government spending on the purchase of goods and services. • Payment of wages and salaries of government servants • Public investment • Transfer payments 6/15/2016 BABY THOMAS 2016 16 Taxation • Non quid pro quo transfer of private income to public coffers by means of taxes. • Classified into • 1. Direct taxes- Corporate tax, Tax, Personal Income Tax, Fringe Benefit taxes, Banking Cash Transaction Tax • 2. Indirect taxes- Central Sales Tax, Customs, Service Tax, excise duty. 6/15/2016 BABY THOMAS 2016 17 Public Debt • Internal borrowings: • Borrowings from the public by means of treasury bills and govt. bonds • Borrowings from the central bank ( monetized deficit financing) • External borrowings • foreign investments • international organizations like World Bank & IMF • market borrowings 6/15/2016 BABY THOMAS 2016 18 Fiscal policy and macroeconomic goals • Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes. Fiscal policy influences saving, investment, and growth in the long run. • Fiscal policy affect macroeconomic goals in the following ways: 1. Economic growth: By creating conditions for savings and investments 2. Employment: By using labor-absorbing technology 3. Stabilization: By fighting with depression trends and booming indications in the economy 4. Economic equality: By reducing the income and wealth gap between the rich and the poor 5. Price stability: By containing inflationary and deflationary tendencies in the economy 6/15/2016 BABY THOMAS 2016 19 Principles of UNIT III MACROECONOMIC POLICIES – MONETORY AND FISCAL BABY THOMAS 2016 6/15/2016 BABY THOMAS 2016 20