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Objectives for Chapter 10

1. How is the government purchases multiplier


calculated? How is the taxation multiplier calculated?
Given some gaps and marginal propensities to
consume, calculate how much government
purchases, taxes, or transfers should be changed.
2. What is meant by "automatic stabilization"? What are
the main automatic stabilizers?
3. What are the three functions of money? What is
"barter"?
4. What is "liquidity"? Define "reserves", "required
reserves", and "excess reserves".
5. What is meant by "monetary policy"?
6. Define the open market operations, discount rate,
and reserve requirements.
8. Explain why an increase (decrease) in the money
supply will cause interest rates to fall (rise).

Chapter 10

Economic Tools: Fiscal and Monetary


Policies
There is nothing about money that cannot be understood
by the person of reasonable curiosity, diligence and
intelligence.
- John Kenneth Galbraith

From the previous chapters, we have discussed about


various economic indicators that may describe or tell us
what is going on in the economy. Unemployment rate,
inflation rate, the GDP growth rate, and so on, may tell us,
whether the economy is in a recession, expansion or
depression period. We can simplify this as knowing
whether the economy is well or the economy is sick or in
trouble. This is making good use of positive economics or
descriptive economics. However knowing what is going on
in the economy is not an end in itself, it is just a way of
understanding the economy so that we, as members of the
nation, moreover the government may be able to provide
solutions of economic problems in hand. Just like how a
doctor, would need complete laboratory results, patients
history, and clinical observations before he/she can
prescribed a medication.
Monetary and fiscal policies are tools that we can utilize to
help resolve economic problems. We are now going to
study about normative economics or prescriptive
economics. However, bear in mind that these prescriptions
does not constantly work objectively, as most expected
them to.

Fiscal Policy
The government has a very important role to play in the
nations economic performance. It is responsible to
promote maximum employment,
production,
and
purchasing power.
The President is mandated to issue a report each year
explaining how he/she will achieve or what he/she has
done to achieve these goals, this report is called State of
the Nation Address (SONA). An agency, the National
Economic and Development Authority, was created to
advise the President in writing this report. Any President
who failed to achieve good economic performance would
be considered a failed President. Good economic
performance requires low rates of unemployment, low
rates of inflation, and high rates of economic growth. In the
United States, Presidents Ford, Carter, and Bush were
defeated in their re-election campaigns in large part
because they did not achieve good economic

performance, while in the Philippines, GMA would


constantly brag about how she uplifted the economic
performance of the country during her 10 years in the
office.
The main tools available to the President and the Congress
to achieve good economic performance are those of fiscal
policy. Fiscal policy involves changes in government
spending and in taxes. The difference between government
spending and tax revenues determines the amount of
budget deficit or budget surplus.
Fiscal policy is of two types: discretionary and
automatic. Discretionary fiscal policy, which involves
deliberate decision-making by the government, receives
most of the publics attention. But as we will see,
discretionary fiscal policy has generally not been very
successful in achieving good economic performance. While
the public pays little attention to automatic fiscal policy, it
has been the more effective of the two types.
Discretionary Fiscal Policy
Discretion refers to deliberate choice on the part of
government agencies. One such choice involves the
amount of discretionary government spending --purchases and transfers. Let us begin with government
purchases and discuss the government purchases
multiplier.
Assume that government purchases are deliberately
increased by 100,000. Assume that if there is a 100
addition to income, people will spend an additional 80
and save an additional 20. We say that the marginal
propensity to consume is 0.8. (change in consumer
spending divided by change in income --- 80 divided by
100).
Assume that the government spent the additional
100,000 buying computers from Samsung. This gave
Samsung 100,000 of additional income. That additional
income went to the companys workers, owners, and
suppliers. What did they do with their additional 100,000
of income? With a marginal propensity to consume of 0.8,
they would increase their consumer spending by 80,000 (.8

times 100,000). The other 20,000 of additional income


was saved. The workers, owners, and suppliers of Samsung
spent an additional 80,000 buying goods at Bench.
This provided an additional 80,000 of income for the
workers, owners, and suppliers of Bench. What did these
people do with this additional income? The answer is that
they spent 64,000 of it (0.8 times 80,000) and saved the
other 16,000. The workers, owners, and suppliers of Sears
spent 64,000 of additional income buying food at Jollibee.
This gave the workers, owners, and suppliers of Vons an
additional 64,000 of income.
What did they do with this additional income? The answer
is that they spent an additional 51,200 (0.8 times
64,000) and saved the other 12,800. In each succeeding
round, consumers spent 80% of the addition to their
income and saved the rest. When all rounds were
completed, total spending rose by 500,000. We say that
total spending rose by a multiple of the increase in
government purchases. That multiple, in this case, is 5
(100,000 times 5 equals 500,000).
Let us summarize. +1000 Purchases by the Government
+ 80,000 Consumption by Samsung
+ 64,000 Consumption by Bench
+ 51,200 Consumption by Jollibee
. _______
= +500,000 Increase in Equilibrium Real GDP
We know the multiplier is 5 because there is a formula to
calculate it.
Multiplier =

1
.
1 Marginal Propensity to Consume

(Take the marginal propensity to consume, subtract it from


1, and then divide the result into 1. So take 0.8, subtract it
from 1, and the result is 0.2. Take 0.2 and divide it into 1
and the result is 5.) There is no substitute to deal with this
formula except to remember it.
Now let us examine a second discretionary fiscal policy --reducing taxes.

Assume that taxes are reduced by the same 100,000.


Those who receive that tax reduction will now have
100,000 more in disposable income. What will they do
with this 100,000?
With a marginal propensity to consume of 0.8, they would
increase their consumption by 80,000 (.8 times
100,000). They would save the other 20,000 of their
additional disposable income. Assume they spent the
additional 80,000 buying goods at Bench. This provided
an additional 80,000 of income for the workers, owners,
and suppliers of Bench. What did these people do with this
additional income? The answer is that they spent 64,000
of it (0.8 times 64,000) and saved the other 16,000.
From this point on, the story is the same as it was for
government purchases.
Let us summarize + 800 Consumption by Those Receiving
the Tax Reduction
+ 640 Consumption by Bench
+ 512 Consumption by Jollibee
.
_______
What does this total? Compare it to the numbers for
government purchases. You can see that all of the numbers
are the same except for the first 100,000. Therefore, the
sum must be 400,000 (100,000 less than for
government purchases). Therefore, we have a different
multiplier. We call it the tax multiplier. The tax multiplier is
a number that multiplies a change in taxes in order to
calculate the change in Real GDP. In this case the tax
multiplier is equal to 4, that is (100,000 times 4 =
400,000).
Change in Taxes x Tax Multiplier = Change in Real GDP
(100,000) (4)= (400,000)
To calculate the tax multiplier, there is a new formula. As
with the government purchases multiplier, it is best to just
remember it. The denominator is the same as before but
the numerator is different.
Tax Multiplier =

Marginal Propensity to Consume


1 Marginal Propensity to Consume

(Take the marginal propensity to consume, subtract it from


1, and then divide it into the marginal propensity to
consume. Since the marginal propensity to consume is
equal to
0.8, the calculation becomes:
Tax Multiplier =
=
=

0.8 / 1-(0.8)
0.8 / 0.2
4

Historically in most nations such as the Philippines and the


United States, discretionary fiscal policy has not played
much of a role in achieving good economic performance.
The Kennedy tax cut of 1964 of the United States may be
the only example of a successful discretionary fiscal policy.
The problem comes from what are called time lags.
Generally, recessions develop quickly and are not
expected. It takes time to be certain that there is indeed a
recession. For example, the recession that is now officially
designated as having begun in March of 2011 was not fully
recognized as a recession until October of 2011. And most
recessions do not last for much over one year.
The fiscal policy during the time of President Marcos was
primary focused on indirect tax collection and on
government spending on economic services and
infrastructure development. The tax system during his
administration was generally regressive as it relied a great
deal on indirect taxes. When President Corazon Aquino
assumed her office, she inherited a large fiscal deficit
heightened by the low tax effort due to a weak tax system
of the previous administration.
The process of changing tax laws or of changing
discretionary government spending typically takes six to
nine months. If government spending is to be increased,
people will argue about what areas should be increased. If
taxes are to be reduced, people will argue about whose
taxes should be reduced. By the time the government
spending is actually raised or the taxes are actually
reduced, the recession is likely to be over. In the
Philippines, our knowledge is lacking and our
institutions are not appropriate for us to utilize
discretionary fiscal policy in a timely manner.
Therefore, it has been fortunate that we have automatic
fiscal policy.

Automatic Fiscal Policy


Generally, since the end of World War II, the recessions
experienced in the United States have not been as severe
as those that had existed before 1940. Certainly nothing
like the Great Depression has occurred. Part of the reason
for this fortunate occurrence has been the existence of the
automatic stabilizers. Remember that we want actual
Real GDP to be equal to the Potential Real GDP.
Something is stabilizing if it increases actual Real GDP
when it is too low (that is, when there is a recessionary gap
and actual Real GDP is below the Potential Real GDP) and
decreases actual Real GDP when it is too high (that is,
when there is an inflationary gap and actual Real GDP is
above the Potential Real GDP). And something that does
this without the need for government action is called an
automatic stabilizer. Certain aspects of fiscal policy
tend to act as automatic stabilizers. Remember that fiscal
policy involves government spending and taxes. Let us
consider each in turn.
Certain types of government spending act as automatic
stabilizers. Those types are examples of what are called
entitlements. In an entitlement program, the
government does not specify an amount it will spend.
Instead, the government specifies who is entitled to certain
benefits and how much that person is entitled to. Three
examples of entitlements that are automatic stabilizers are
unemployment benefits, welfare spending, and Social
Security spending.
Income taxes also act as an automatic stabilizer. In
fact, taxes are the largest automatic stabilizer. Assume
there is a recessionary gap. Production has fallen and
unemployment has risen. As a result, peoples incomes
have fallen. What will happen to the tax payments people
will make to the government? With lower incomes, people
will pay less in taxes. But remember that the income tax is
progressive. When incomes fall, not only do people pay tax
on lower income, they pay a lower percent of a lower
income. So, tax revenues fall proportionally more than
incomes fall. The fall in taxes give consumers greater
disposable income than they would otherwise have. With

greater disposable income, consumers will spend more.


Greater consumer spending is stabilizing; it is just what is
needed to help increase production during a period of
recessionary gap.

Monetary Policy
Every society that we know anything about has had
something to serve as money. To understand what money
is we need to imagine how the world would operate
without money. How would people deal with each other?
The answer is that people would barter with each other.
Barter means that people would have to trade
goods for goods.
What is Money?
If you desire credit in Introduction to Economics, you would
have to provide me goods that I want --- food, housing, and
so forth. If you cannot produce the goods I want, we would
have to do a more complicated arrangement. You would
produce goods for Mang Pandoy. Mang Pandoy would then
produce goods that I desire. I would provide you with credit
for Introduction to Economics. When more than three
people have to be involved, you can imagine how
complicated this can become. As a result, all societies
developed something to serve as a medium of
exchange. I accept this something in exchange for
teaching Introduction to Economics. If you produce food,
you will accept this something from me in exchange for
your food. Because we have something to serve as a
medium of exchange, trade between us is much easier.
This trade allows us to specialize in producing the goods or
services that we produce best. With trade, there are more
goods and services available and both of us have a higher
standard of living.
There are certain characteristics that a good needs to be a
good medium of exchange.
First, the good needs to be durable. Having ice serve as a
medium of exchange in the Philippines would present
many problems. Indeed, almost anything that is durable
has served as money somewhere in the world. Tobacco was
money in and around the American colony of Virginia for

about 200 years. Rice, indigo, wheat, and maize (corn) also
served as money in the American colonies. Seashells
(wampum) were money among Native American tribes in
the Northeast. Tree bark, bones of dead animals, eggs,
feathers, jade, pigs, and so forth have served as money.
Second, the good needs to be high in value in relation
to its weight. This means that one will need only a small
amount of it in order to be able to exchange for the goods
and services one desires. Cotton would not be a good
candidate for a medium of exchange because one would
require trucks of it just to buy weekly groceries. A good
that is high in value in relation to its weight is portable.
Because one does not need much of it in order to exchange
for goods and services, it is easy to carry around.
Third, the good needs to be scarce. Something that is
easily available will not have any value. Finally, the most
important characteristic for a good to serve as a medium of
exchange is that it is acceptable. Indeed, money is
whatever people will accept as a medium of exchange.
All of the money discussed so far have been what are
called commodity money. This means that the value
of the coin as money was equal to its value as a
commodity. One could melt down a coin and sell the metal
for the same worth as the coin. For centuries, countries
have also used what is called fiat money or token
money. This means that the metal in the coin is worth
less than the value of the coin. So, if you were to take an
American quarter today and melt the coin down, you would
have some copper and some nickel. If you sold this metal,
you would receive less than one cent.
Yet the quarter coin is worth 25 cents in exchange for
goods and services. Again, something is money if it is
accepted as money. The 25 cent token coin is accepted in
exchange for 25 cents worth of goods and services even
though the metal in the coin is not worth 25 cents. Today,
nearly all money is fiat money. Commodity money is
extremely rare.
So far, we have considered only one function of money --acting as a medium of exchange. There are two other
functions that money serves.

First, money is a store of value. This means that


money is one way of holding wealth. Wealth is the
value of everything you own. Think of everything you own
--- your car, your clothes, your stereo, your home, your
summer home, your private plane, your yacht, and some
money. Money is part of your wealth. Later, we will
consider how you determine the part of your wealth that
you will hold in the form of money. You can have more
money as part of your wealth (and less of something else)
if you choose. You can do so by selling something you own.
And you can have less money as part of your wealth (and
more of something else) if you choose. You can do so by
buying something. As we shall see, your decision as to how
much of your wealth you choose to hold in the form of
money has a role to play in determining what interest rates
will be.
Second, money acts as a unit of account. This means
that money is a unit of measurement of value. So,
just as we have pounds or grams to measure weight and
we have miles or kilometers to measure distance, we have
dollars to measure value. If I tell you that I live in a million
dollar home, you have a good idea as to where and how I
live. (What about a million peso home? What about a
million ruble home?)
The Money Supply in the Philippines Today
So what comprises the money supply in the Philippines
today? In the late 1970s, there was a commission created
to study this question. The commission came up with four
definitions of money that we use today. These are called
M-1, M-2, M-3, M-4, and L.
We will not elaborate this technical definitions of money.
However, you should know that L stands for Liquidity. It
includes everything that is considered liquid. What does
this mean? An asset is considered liquid if it can be
easily converted into money without risk of loss. We
will encounter many liquid assets as we discuss the
financial system below.

The Bangko Sentral ng Pilipinas

Earlier, we said that the Bangko Sentral ng Pilipinas is the


central bank of the Philippines. A central bank is simply
a bank for banks. It does for commercial banks what the
commercial banks do for you. You have an account at your
bank, say Metrobank. Metrobank has an account at its
bank, the Bangko Sentral. You call your account at
Metrobank a checking account. Remember that your
checking account represents the IOU of Metrobank. Unlike
you, Metrobank does not write checks against its account.
But otherwise, reserves are to Metrobank what your
checking account is to you. You also are able to borrow at
your bank, Metrobank. You can borrow to buy a car, buy a
home, and so forth. Metrobank is also able to borrow from
its bank, the Bangko Sentral. This borrowing is called
discounting.
The Role of the Bangko Sentral ng Pilipinas
The central bank is the central monetary authority which
provides monetary policy directions that covers the areas
of money, credit, and banking. It also supervises the
operations of banks and regulates the activities of nonbank
financial institutions and intermediaries.
The BSP focuses on three main areas or pillars to carry out
its objectives. These areas are:
1. Price Stability. This refers to the condition of low
and stable inflation rate. The BSP uses monetary
policy to help keep inflation low and stable. With
price stability, prices of goods and services do not
rise too quickly. There would be less uncertainty
when deciding how to spend, invest, or save their
money.
2. Financial Stability. The BSP makes sure that
financial institutions follow the prudential rules and
regulations. It also ensures the protection of
depositors and investors and the prevention of
financial institution failures.
3. Efficient Payment and Settlement Systems. The
BSP guarantees that the settlements of financial
transactions of the general public are safe, timely,
and accurate.
Monetary Policy Stance

The economy sometimes can be compared to a running


car; the BSP can be compared to the driver. The driver can
either choose to speed up the car, or slow it down, just like
how the BSP can choose to either increase the money
supply (thus speeding up the economy) or decrease the
overall money supply (thus slowing down the economy).
These are called expansionary monetary policy or
contractionary monetary policy, respectively.
If the economic growth is in a slow pace, it could mean low
aggregate output and demand. An expansionary monetary
policy can lead to an increase in the money supply that
circulates the economy, this more money is available to
the households and firms for consumption thus stimulating
economic activity.
On the other hand, if the economy is in fast-track mode,
wherein there is too much money chasing too few goods,
this could lead to demand-pull inflation, so the BSP should
decrease the money supply, which can reverse the effect
of the cause of high inflation rate, thus stabilizing the
aggregate price.
Monetary Policy Tools
In order to take its monetary policy, The BSP uses the
following monetary policy tools or instruments in order to
influence the desired level of liquidity in the economy:
1. BSPs Policy Interest Rates. These policy interest
rates are used by the BSP when it lends or borrows to
or from banks with government securities as
collateral. When the BSP lends to banks with
government securities as collateral, its corresponding
policy rate is called overnight repurchase rate. On
the other hand, when BSP borrows from banks with
government securities as collateral, its corresponding
policy rate is called overnight reverse repurchase
rate.
2. Reserve Requirement. It refers to the mandatory
proportion of the deposits and deposit substitute
liabilities of the banks that they hold as reserves. The
BSP requires all banks to hold reserves for liquidity
purposes.
3. Special Deposits Account Facility. This facility
allows banks and trust entities of BSP-supervised

financial institutions to have fixed-term deposits with


the BSP.
4. Rediscount Rate. This is the interest rate that BSP
uses when it lends money to a financial institution.
This lending of money made by the BSP is under its
rediscounting facility, a special refinancing facility,
where promissory notes and other loan papers of the
borrowers of the financial institutions are used as
collateral.
5. Open Market Operations. It involves the outright
sale or purchase of government securities by the BSP.
Government securities may be treasury bills or
treasury bonds.

Summary

Fiscal policy refers to the government actions that


affect the total government spending activities, tax
rates, and revenues.
Two types of fiscal policy are discretionary fiscal
policy and automatic stabilizers.
Monetary policy is the deliberate control of the
money supply and in some cases, credit conditions
for the purpose of achieving macroeconomic goals.
A central bank is the central monetary authority
which provides monetary policy directions that
cover the areas of money, credit, and banking. It
also supervises the operations of banks and other
nonbank financial institutions.
The central bank in the Philippines is known as The
Bangko Sentral ng Pilipinas. Its first governor was
Miguel Cuaderno Sr. The BSP was created during

Questions for Review and Application


1. Differentiate monetary policy from fiscal policy.
2. What is the role of the Bangko Sentral ng Pilipinas in
controlling the money supply?
3. Explain the role of contractionary and expansionary
monetary policy.
4. How do we apply discretionary fiscal policy and
automatic stabilizers?
5. How can monetary policy and fiscal policy promote
economic development?

Quiz for Chapter 10. Fiscal and Monetary Policy


Name:
___________________________
_________________
Section:
___________
Date:
________
_______________

Score:
Professor:

Direction: Multiple Choice: Choose the best answer.


1. The function of money that is defined as money is
one way of holding wealth is the ______function.
A. medium of exchange
C. store of value
B. unit of account
D. barter
2. Which of the following has been commodity
money?
A. gold
B. a dime
C. a dollar bill
D. a CD
E. all of the above
3. Which of the following is part of M-1?
A. Gold
B. checkable deposits C. CDs
D.
credit cards
4. Which of the following is the most liquid?
A. a savings account
C. a house
B. a CD
D. a mortgage loan
5. The Highest post in the Bangko Sentral ng Pilipinas
A. FOMC B. FDIC
C. Treasury Bill D.
Governor
6. The sum of currency in circulation and total bank
reserves equals the:
A. monetary base
C. money
supply (M-2)
B. total required reserves
D. money
supply (M-1)
7. A commercial bank creates money when it:
A. makes a new loan C. accepts a checkable
deposit
B. buys gold
D. holds reserves
8. A commercial bank can make a new loan only if it
has:
A. required reserves
C. Treasury securities
B. excess reserves
D. gold
9. If people choose to hold less currency and more
checkable deposits, the money supply:
A. increases
B. decreases C. remains

11.
The interest rate charged by a commercial
bank to the least risky borrower is the:
A. discount rate
C. prime rate
B. interest funds rate
D. Treasury bill rate
12.
The interest rate charged by a commercial
bank to another commercial bank is called the:
A. discount rate
C. prime rate
B. federal funds rate
D. Treasury bill rate
13.
If the price of a security is falling, the interest
rate on it must be:
A. rising
B. falling
C. staying the
same
14.
If the Bangko Sentral increases the money
supply, interest rates will:
A. rise
B. fall
C. be
unaffected

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