Macro Economic Policy, Monetary and Fiscal Policy

Macro economic Policies(Monetary and Fiscal Policy)
Objective of this unit:
To define monetary and fiscal policy,
To state objectives of monetary and fiscal policy,
To explain tools or instruments used in monetary and fiscal policy,
To discuss about types of monetary and fiscal policy and
To analyze role of monetary and fiscal policy in underdeveloped economies.
N.K.Neupane STX/GCM 1
1. Monetary Policy
Public policy: Discretionary power used by government and formulated, designed
and implemented to keep society in better off situation.
Economic Policies: Most vital public policies which are used to make overall socio
economic development of the nation.
Economic policies are of different types which are designed to achieve macro
economic goals of the nation.
Major macro economic goals ?

Economic growth with equity, economic development and economic stability.
Meaning or definition of monetary policy:
Amount of money and cost of capital plays significant role to achieve macro
economic goals of the nation.
Monetary authority of the nation i.e. central bank which is apex monetary
institution of the nation, makes an exercise to expand and reduce money supply in
the economy.
This exercise or practice made by central bank of the nation is called monetary
policy.
In another word,
Monetary policy is one of the most important economic policy of the nation,
Designed and implemented by central monetary authority of the nation,
To achieve macro economic goals like economic growth with equity, economic
development and economic stability,
Through change in amount of money as well as availability of money in society and

cost of capital or credit.
Objectives of monetary policy
Main objective of monetary policy is to maintain high level of economic
growth and equity.
But some other equally important objectives of monetary policy are ;
 To maintain economic and price stability in the economy,
To maintain stability in exchange rate
To maintain equilibrium in BOP
To achieve full (high level) employment.
Instruments or tools used in monetary policy
To achieve its objective, monetary policy uses various tools or
instruments.
These tools are categorized in two types.
1. Quantitative instruments or general instruments.
2. Qualitative instruments or selective instruments.
Quantitative instruments:
Quantitative instruments are those which are designed to affect money

supply, cost of money (or capital) and availability of credit in the
economy.
Specially this tool is used to affect credit creation power of commercial
banks.
Under quantitative instruments mainly three measures are used.
a. Open Market operation (OMO) : Purchase and selling of securities
like treasury bills, bonds and equity in the market openly,
Democratic measure to affect money supply,
But does not work properly in underdeveloped economies due to lack
of development of financial market.
In time of inflation, Central bank sells treasury bills, bond and equity in
the market, people purchase those, there will be reduction in amount
of money in hand of public, their purchasing power declines and
inflation will be controlled.
Just opposite in time of recession or depression.
b. Bank Rate Policy:
Bank rate is the rate which central bank charges to commercial banks in time of providing loan or the rate
which commercial banks have to pay to central bank in time of borrowing.
In time of inflation, Central bank increases bank rate.
From which borrowing from central bank becomes expensive for commercial bank and they reduce their
borrowing.
Lending rate of commercial bank also rises since they borrow from central bank at high rate.
From which demand of credit declines in the economy and inflation will be controlled.
Just opposite will be there in time of recession and depression.
c. Change in cash reserve ratio (CRR):
Specific proportion of deposited amount which commercial banks are obliged to keep in
central bank in form of cash is called cash reserve ratio.
When commercial banks have to keep huge amount of money in form of cash, they will not
be able to issue more credit.
So, in time of inflation, central bank increases CRR from which credit creation made by
commercial banks decline and inflation will be controlled.
Just opposite will be there in time of depression or recession.

2. Qualitative instruments or selective instruments:
By using this instrument central bank tries to affect availability of credit

among various users rather than affecting general availability of credit.
Some popular measures under this method are:
a. Regulation of consumer credit: Increase in volume of dawn

payment and reduction in time of repayment in hire purchase
finance.
Hire purchase? Purchase of durable goods by consumers through bank

finance in installment basis.
b. Rationing of credit: Change in maximum limit of credit which central bank gives to
commercial banks.
c. Credit ceiling: change in maximum limit of credit which commercial banks can issue to its
customer.
d. Change in margin requirement: Margin requirement is the difference between value of

collateral (which commercial banks accept in providing loan) and actually lended amount.
For example, Value of collateral is 10,000.
Loan issued by commercial bank against same collateral is 8,000.
Then 2,000 is called lending margin.
e. Others : direct direction, Publicity and moral suasion.
Types of Monetary Policy
Monetary policy is of two types:
1. Expansionary monetary policy:
Monetary policy which is designed to increase money supply in society to enhance
aggregate demand in time of recession or depression ,
In this policy central bank gives encouragement to commercial banks to create more
credit and there will be much more money in hand of public.
When expansionary monetary policy is implemented then central bank
Purchases treasury bills, bond and equity from market,
Reduces CRR and bank rate,
Reduces margin requirement,
Removes or expands credit ceiling and credit rationing etc.
In time of depression or recession when money supply rises through expansionary monetary
policy,
There will be reduction in rate of interest and availability of fund
Investment increases
Employment rises
Income level also rises
Aggregate demand rises and economy moves toward prosperity.
2. Contractionary or restrictive monetary policy:
Monetary policy which is designed to decrease money supply in society to decrease aggregate
demand in time of high inflation,
In this policy central bank discourages commercial banks to create more credit and there will be less
amount of money in hand of public.
When contractionary monetary policy is implemented then central bank

Sells treasury bills, bond and equity,
Increases CRR and bank rate,
Increases margin requirement,
Imposes credit ceiling and credit rationing etc.
Significance or objectives of monetary policy in
context of underdeveloped nations
Main features of underdeveloped nations?
Low level of economic growth and development
High rate of inflation
High unemployment,
Inequitable distribution of income and wealth
Unfavorable BOP etc.
Monetary policy is designed to correct all these phenomenon.
1. Price stability:
High rate of inflation and deflation affects economy negatively in underdeveloped

economies.
So, one of the objective of monetary policy is to control inflation through contractionary
monetary policy and to control deflation through expansionary monetary policy.
When MS falls then rate of interest rises, investment declines, AD falls and price also falls.
When money supply rises rate of interest falls investment rises AD also rises and price
increases.
2. Economic Growth:
Economic growth = rise in level of output .
Volume of money has direct impact upon growth.
When money supply rises rate of interest falls investment will be encouraged
AD rises, price rises and output also rises.
3. High level of employment
4. Equity or fair distribution of income and wealth:
Through soft loan for poor and cost free lending for poor.
5. Development of financial and banking sector
6. Correction of BOP
2. Fiscal Policy
Meaning or concept of fiscal policy:
Fiscal policy: another one equally important macro economic policy formulated,
designed and implemented by government of the nation.
In classical and neo classical age there was no any scope of fiscal policy.
At those days monetary policy is taken as single stabilization policy.
After great economic depression of 1930, significance of fiscal policy was realized.
In very simple sense, fiscal policy is the policy which is related with public revenue
and public expenditure.
According to Arthur Smithies, “ Fiscal policy refers to a policy under which the
government uses its expenditure and revenue programs to produce desirable
effects and to avoid undesirable effects on the national product and employment.”
According to another economist Musgrave, “Fiscal policy is concerned with those

aspects of economic policy which arise in the operations of public budget.”
So, fiscal policy is
Another equally important macro economic policy of the nation,
Formulated, designed and implemented by government of the nation,
To achieve macro economic goals like growth, equity and stability
Through use of various tools like budget, public revenue, public
spending and public borrowing.
In another words, when government decides on
taxes that it collects,
the transfer payments which it gives out,
the goods and services which it buys through spending and
debt which it receives, then it is engaging in fiscal policy.
Objectives of fiscal policy:
Objectives of fiscal policy becomes different from time to time and from economy to economy.
But some most common and major objectives of fiscal policy are as follows:
Price and economic stability
High level of economic growth with equity
Achievement of high level of employment
Correction of unfavorable balance of payment.
Instruments or tools of fiscal policy:
To achieve macro economic goals of the nation, fiscal policy uses following 4 tools or
equipment:
A. Budget
B. Public revenue (taxation)
C. Public spending or expenditure
D. Public borrowing.
A. Budget
What is budget?
Budget is simply a short term financial plan of the government, which includes
Estimation of public revenue which government will collect from various sources,
Estimation of public spending which government will make in various purposes,
And financial policies which government is going to implement in upcoming year.
In another word budget is short term plan of government related to public revenue,
public expenditure and public borrowing.
Generally budget is classified as
Balanced budget: In which size of estimated public revenue is equals to estimated

public expenditure,
Deficit budget: In which government makes estimation of more expenditure in

comparison of revenue collected and
Surplus budget: In which government plans to collect more revenue and plans to
spend less than that of collected revenue.
Budget of the nation directly or indirectly affects private investment in the
nation.
Again government expenditure is major component of aggregate demand

in the economy.
Budgetary policy of the government plays significant role to change macro

economic environment of the nation.
So, budget is one major tool used in fiscal policy of the nation.
B. Public revenue:
Public revenue: Revenue obtained by government of the nation through various sources to meet
its increasing expenditure.
Sources of public revenue: Two sources, Tax source and non tax source
a. Tax source: If revenue is collected from imposition of various types of tax,
Tax?
Compulsory payment made by individuals and institution of the nation to government of the
nation without receiving direct benefit in hand.
Direct tax?
Tax which is to be paid by those upon whom tax has imposed, tax and its burden can not be
shifted upon others. E.g. income tax, property tax, profit tax etc.
Indirect tax?
Tax which is imposed upon one but paid by others, tax and its burden can be shifted upon others.
E.g. sales tax, enjoyment tax, import tax etc.
Progressive tax: The tax in which rate of tax rises with rise in income level and vice versa.
Proportional tax: the tax in which rate of tax remains constant or same at any level of income.
Regressive tax: The tax in which rate of tax rises with fall in income and vice versa.
Opposite of progressive tax = Regressive tax.
b. Non tax source: Source of the public revenue through which revenue is collected without imposing tax. E.g.
fine and penalty, fee and charges, prices, grants, gifts and donations, dividends etc.
Because of imposition of tax and collecting the revenue by government in the economy, aggregate demand
will be affected and macro economic scenario will be changed.
So, public revenue is another tool used in fiscal policy.
C. Public Expenditure
Public expenditure?
Expenditure made by government of the nation for smooth operation
of the nation as well as overall socio economic development of the
nation,
e.g. expenditure made by government to make defense, to maintain

peace and security as well as law and order, to perform administrative
functions, to develop health, education and drinking water facilities, to
develop infrastructure like transportation, communication, electricity,
banking services etc.
Classifications of public expenditure?
Recurrent (Consumption) and capital(development) expenditure,
Direct and indirect expenditure,
Productive and unproductive expenditure etc.
Expenditure made by the government creates spill over effect in the economy and
macro economic environment will be affected.
So, public expenditure is another tool used in fiscal policy.

D. Public debt:
Public debt?
Debt or loan received by government of the nation through various sources from
different objectives like
To finance war expenses, to finance development expenses, to stabilize the
economy etc.
Sources?
a. Internal source
If government receives loan or debt within the nation from various ways,
Market borrowing: loan received by selling bond and equity in market
Non market borrowing: loan received by government of the nation through various
financial and non financial institutions including central bank .
b. External source: Loan received from outside the nation through various ways.
Bilateral loan: loan received by foreign nations or foreign governments
Multilateral loan: loan received from various regional and international
institutions like world bank, IMF, ADB, UNDP etc.
When government decides about public debt

it affects amount of money available in hand of consumers for consumption
purpose and
In hand of investors for investment.
From which macro economic environment of the nation will be affected.
Kinds of fiscal policy
Different economies have different type of macro economic scenario
and problems.
So, different types of fiscal policies are used in different economies and
in different time to achieve macro economic goals of the nation.
Mainly fiscal policies are explained 3 types:
A. Automatic stabilization fiscal policy
B. Compensatory fiscal policy
C. Discretionary fiscal policy
A. Automatic stabilization fiscal policy
As we know main economic indicators of economy are income and
employment level,
Fluctuation in these indicators is common specially in capitalist

economy,
If government has formulated the fiscal policy in such a way from which
there is automatic adjustment in government revenue and expenditure
in response to rise or fall in level of national income and employment
then the policy becomes automatic stabilization policy.
In this policy, change in government revenue and expenditure becomes automatic and
flexibility in revenue and expenditure is built by the economic fluctuation of the economy itself.
So, it is called built in flexibility policy.
Profit tax, income tax, sales tax, transfer payments specially unemployment allowance are
taken as automatic stabilizer in this policy and all they depend upon level of national income
and national employment.
In this policy provision is made in such a way from which tax or public revenue changes
positively with change in level of income and public expenditure , I.e. transfer payment changes
negatively with change in level of employment.
For example, government decides to collects 5 % tax from national income,
Then when level of income rises amount of tax collection automatically rises but
There will be reduction in level of unemployment along with rise in income
From which there is no necessity to give more unemployment allowance and public
expenditure automatically declines.
That means to say there is automatic stabilization of revenue and expenditure of the
government in the economy along with change in income and employment.
B. Discretionary fiscal policy:
Government?
Is the institution having discretionary power to formulate and implement public policies to
promote socio economic welfare of the nation.
If government makes deliberate change in its revenue, expenditure and debt policies by using
its discretionary power then the fiscal policy becomes discretionary fiscal policy.
For example government may use its discretionary power
 To increase or decrease tax rate,
 To introduce new taxes and to remove old taxes,
 To increase base of tax
 To change size and composition of public expenditure
 To change system of transfer payment
 To change sources of financing etc.
C. Compensatory fiscal policy:
In economy deficiency in aggregate demand and excess of aggregate demand
are common specially in capitalist economy.
Fluctuation in aggregate demand creates fluctuation in macro economic
environment of the nation.
So, government formulates and implements fiscal policy to compensate
deficiency in aggregate demand and excess of aggregate demand by using its
discretionary power and the policy is called compensatory fiscal policy.
In time of inflation government uses surplus budget from which AD declines
(negatively compensated ).
In time of recession or depression government uses deficit budget from which
AD rises (positively compensated.)
Tight or contractionary fiscal policy?
Fiscal policy designed to reduce or contract AD,
Methods:
Increase in rate of direct tax,
Reduction in public expenditure
Increase in public borrowing
Use of surplus budget
Loose or expansionary fiscal policy?
Just opposite of tight fiscal policy i.e. fiscal policy designed to expand
AD
Method:
Reduction in rate of direct tax,
Increase in public expenditure
Reduction in public borrowing and repayment of public debt
Use of deficit budget.
Significance of fiscal policy in underdeveloped
economies like Nepal
1. Capital formation:
Suitable public expenditure policy makes development of socio
economic infrastructure in the economy,
Suitable tax policy of government encourages saving and discourages
luxurious as well as imported consumption,
Public investment increases AD in the economy directly and private
investment also rises,
From all of which income rises, saving rises and capital formation takes
place in the economy since saving is first step to make capital formation
in the economy.
2. High level of employment:
Appropriate tax policy of government will not discourage private investment,
Through effective use of fiscal policy there will be high level of capital formation
in the economy,
Through public expenditure made upon social economic overheads in the nation
private investment will be encouraged in the economy,
Through public expenditure made upon public works people will get job
opportunity,
Through appropriate fiscal policy Ad as well as level of income rises.
All these phenomenon create more job opportunity in the nation and high level
of employment is achieved.
3. Price stability:
Price instability is most common in underdeveloped economies,
Price and economic instability creates negative impact upon macro
economic environment of the nation,
Those instability can be controlled
by using expansionary fiscal policy in time of recession and
by using contractionary fiscal policy in time of inflation.
This shows the significance of fiscal policy in underdeveloped
economies.
4. High level of growth with equity:
High level of economic growth is most important weapon to make overall progress of
the economy,
But high, broad based and equitable growth is the major concern of present time,
To achieve the situation government may use various tools like
progressive taxation,
Redistribution of income in favor of poor,
Development of socio economic overheads through its expenditure policy,
Soft and easy loan for poor class people,
Appropriate tax policy to divert resource from one are to another are etc.
So, fiscal policy is significant to achieve high broad based and equitable growth.
5.Favorable balance of payment:
Balance of payment? Simply an account which shows total receipt and
payment made through export and import of visible goods as well as
non visible services by a nation with rest of the world, generally in one
year time period.
Trade balance (which shows monetary value of export and import of
goods made by a nation with other nations) is major component of
BOP,
To make BOP favorable it is required to make balance in trade balance,
For that government may impose high import tax to reduce import and
Government may reduce tax in export, may give subsidy in export etc.
Again because of tax policy and public expenditure policy of
government, foreign capital will be attracted in the nation.
From all of which there will be correction in balance of payment of the
nation.
The End
Thank You for your
participation, presence
and patience.

Macro Economic Policy, Monetary and Fiscal Policy

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Macro Economic Policy, Monetary and Fiscal Policy

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Macro economic Policies(Monetary and Fiscal Policy)

Objective of this unit:

To define monetary and fiscal policy,

To state objectives of monetary and fiscal policy,

To explain tools or instruments used in monetary and fiscal policy,

To discuss about types of monetary and fiscal policy and

To analyze role of monetary and fiscal policy in underdeveloped economies.

Major macro economic goals ?

Designed and implemented by central monetary authority of the nation,

Through change in amount of money as well as availability of money in society and

These tools are categorized in two types.

1. Quantitative instruments or general instruments.

2. Qualitative instruments or selective instruments.

Quantitative instruments are those which are designed to affect money

In time of inflation, Central bank increases bank rate.

Just opposite will be there in time of recession and depression.

Just opposite will be there in time of depression or recession.

By using this instrument central bank tries to affect availability of credit

a. Regulation of consumer credit: Increase in volume of dawn

Hire purchase? Purchase of durable goods by consumers through bank

d. Change in margin requirement: Margin requirement is the difference between value of

There will be reduction in rate of interest and availability of fund

Income level also rises

Aggregate demand rises and economy moves toward prosperity.

When contractionary monetary policy is implemented then central bank

Monetary policy is designed to correct all these phenomenon.

High rate of inflation and deflation affects economy negatively in underdeveloped

At those days monetary policy is taken as single stabilization policy.

According to another economist Musgrave, “Fiscal policy is concerned with those

Price and economic stability

High level of economic growth with equity

Achievement of high level of employment

Correction of unfavorable balance of payment.

B. Public revenue (taxation)

C. Public spending or expenditure

Estimation of public spending which government will make in various purposes,

And financial policies which government is going to implement in upcoming year.

Balanced budget: In which size of estimated public revenue is equals to estimated

Deficit budget: In which government makes estimation of more expenditure in

Again government expenditure is major component of aggregate demand

Budgetary policy of the government plays significant role to change macro

So, public revenue is another tool used in fiscal policy.

e.g. expenditure made by government to make defense, to maintain

Direct and indirect expenditure,

Productive and unproductive expenditure etc.

So, public expenditure is another tool used in fiscal policy.

When government decides about public debt

Fluctuation in these indicators is common specially in capitalist

So, it is called built in flexibility policy.

There will be reduction in level of unemployment along with rise in income

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