Lesson 3 - Finance and Fiscal Policy LESSON 3

1. Monetary Policy

Monetary policy
- activities of a central bank designed to influence financial variables such as the money supply
and interest rates.

View this video (until 8:05 only) on how Monetary Policy works and how it can affect the economy through
the change in money supply and interest rates.

Two types of monetary action

1. Monetary Expansion - which is increase the money supply and
2. Monetary Contraction - decrease money supply.

----- VIDEO: MONETARY POLICY -------

CENTRAL BANKS
 RULES
1. They regulate and oversee the Nation’s Commercial Banks by making sure that Banks have
enough money in reserve to avoid Bank runs
2. Conduct Monetary Policy which is increasing or decreasing the money supply to speed up
or slow down the overall economy.

MONETARY POLICY

 Interest Rates
- is the price of borrowing money
- percentage of the principle to cover inflation and to make some profit
 Interest rate are LOW - Borrowers will find it easier to pay back loans to they will Borrow
more and spend more.
 Interest Rates are HIGH - Borrowers borrow less, and therefore, spend less.
 The Fed doesn’t have the power to tell banks what rate to charge customers. So instead, the
Fed manipulates interest rates by changing the money supply.
- The Fed increases the money supply - plenty of money for banks to loan out.
- Banks forced to lower interest rates because they’re gonna have to complete or else no
one’s gonna borrow from them.
- Less money supply = Higher Interest Rates

 Expansionary Monetary Policy

 If the central Banks wants to speed up the economy,
- they can increase the money supply.
- which will decrease interest rates
- and lead to more borrowing and spending.
  Contractionary Monetary Policy
 If central banks wants to slow down the economy
- they decrease the money supply
- Less money
- will increase interest rates
- Decrease spending
 Drove down inflation, but with the downside of increasing unemployment.

 Two things that keep the Banking system healthy

1. Confidence
2. Liquidity

THREE WAYS THE CENTRAL BANK CHANGE THE MONEY SUPPLY

1.
 Fractional Reserve Banking
- Deposit money, bank holds a portion of deposits and loans the rest out

 Reserve Requirement
- The fraction deposits the banks are required to hold in reserves is conveniently.
- The fed can change the money supply is by changing that requirement
- Decreasing the Reserve Requirement will increase the money supply.
- Increasing the Reserve Requirement will decrease the money supply.

2. Discount Rate
- Change the Interest Rates
 Decreasing the Discount Rate
- will make it easier for banks to borrow, and
- that’ll increase the money supply
 Increasing the rate
- will decrease the money supply

3. Open Market Operations - used most often

- This is when the Federal Reserve Buys or Sells short term Government Bonds.
- Bonds less risky than stocks

 The Fed buys these previously issued Government bonds from a bank,
- it increases that banks liquidity
- increases the money supply
 If the fed issued more bonds
- Banks have less liquidity
- Less money to loan out
- decrease the money supply

 Quantitative Easing / Q. E.
- Increase its monetary stimulus
- Central bank buy up longer term assets from banks. Buying Mortgage Backed Securities
- HAS RAISED WORRIES ABOUT MASSIVE INFLATION.
- when add a lot of made-up money to the economy, prices will rise.

“Inflation is always and everywhere a monetary Phenomenon” - by Milton Friedman observed

  Excess Reserves - banks have to hold 90% of their deposits in reserve.
- which the amount that banks are free to loan out.

 Holding money doesn’t make money.

FISCAL POLICIES
- Changing Government spending or taxes

MONETARY POLICY
- Changing the money supply

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Differences between Developed and Developing-Country in view of Monetary/Financial Policy

Basically, action of the central bank can influence the money supply and interest rates thereby controlling
the economic condition of a country.

Monetary Expansion
- can increase of investments generates economic growth or
- it expands economic activity (lowers unemployment).

Excess demand or high inflation rate

- the central bank needs to implement monetary contraction to mitigate the undesirable condition.

They play a vital role in promoting of long-term economic growth

- Central Banks
- Financial Banks/ Intermediaries

 However according to Todaro and Smith (2015), such role of the Central Bank and financial
banks/intermediaries is more applicable for Developed countries only and NOT in the
developing countries.
(Read below on why this is so (excerpted from Economic Development by Todaro and Smith, 2015):
2, Fiscal Policy

Fiscal Policy focuses on the changes made by government in view of taxation and their expenditures to
influence the economic condition.

View this video (start at 2:52) on how Fiscal Policy works and how it can affect the economy through the
change in taxes and government expenditure:

----- VIDEO: Fiscal Policy -----

FISCAL POLICY
- The way a Government adjusts its spending levels and tax rates to monitor and influence a
nation’s economy.
- That’s a job of Congress and the President

 Expansionary Fiscal Policy

- Stimulates the economy during in anticipation of a business-cycle contraction.
- When the economy falls into a deep recessionary Gap. The government can increase Government
spending, cut taxes, or do some of both.
- Ex. Transactions
- Funded new roads, bridges, and upgrades to the electric grid
- Those projects created Jobs

 Government Spending
- Creates jobs
- Increases income
- Therefore, workers spend more of their additional income, increasing consumers spending
and boosting the entire economy
 Cutting Taxes
- Increase disposable income for consumers
- that will increase consumers spending
- and boost the entire economy

 Contractionary Fiscal Policy

- Enacted by a Government to reduce the money supply and ultimately the spending in a country.
- When the economy has an inflationary gap
- Government Cut spending or raise taxes or do some combination of the two.

 Higher Taxes
- Lead consumer with less money to spend
 Lower Government Spending
- will mean fewer Public Jobs
“all that will should reduce consumer spending, cooling off the economy and reducing inflation.”
  Contractionary Policy is not see very often in practice
- because politics rarely want to hit their voters with a slower economy
- its a hard sell, and it could cost policy makers their job.

“Does stimulating the economy with spending and tax cuts actually make the economy grow?”

Classical Theories assumed

- that the economy will fix itself in the long run, and that Government Intervention will, at best,
lead to unintended consequences and , at worst, cause massive Inflation and Debt.

John Maynard Keynes

- most influential and controversial economist of the 20 th century
 Invented
- Modern Economics
- Developed theories and models about spending in production
- He is the one suggesting using Expansionary Fiscal Policy to speed up the economy
 He argue
- Government spending can make-up for a decrease in consumer spending.

Keynesian Policy
- perfect solution to fix a sluggish economy
- if consumer spending falls, the Government can spend instead.
- HARM ON THAT: The Government needs to pay for all that spending. They can’t just raise tax to
cover because that would cause the decrease in consumer spending and defeat the purpose.

Deficit Spending
- The Government spending more money than it collects in tax revenue
- To stimulate the Economy The Government needs the Deficit spending
 To achieve this:
- The Government needs to borrow money, which will result in Debt
 Crowding Out
- where increased public sector spending replaces or drives down, private sector spending
- Technical argument against deficit spending is that it lead to Crowding Out.
- “If the Government borrows a lot of money that increases interest rates, making it harder for
business to borrow money and buy things like factories and tools”.
- This weakens the economy while increases Government Debt.

“But Keynesian Economists maintain that crowding out is only a problem if the economy is operating at full
capacity, where all corkers are employed and we’re producing as much as we can.”

 Keynesian’s argue
- That Government stimulus when the economy is below capacity can actually raise private
spending.
Austerity Policy - Opposite of stimulus
- Raising Taxes and cutting Government spending to reduce Debt
- most European country
 Since 2011
- EURO-ZONE GDP -1%US VERSUS ECONOMY + 2.5%
- UNEMPLOYMENT +12% VERSUS 5.5%

Multiplier Effect
- Strong Economy is 1x Multiplier
- Public sector output increases
- But Private Sector output falls
- GDP is unchanged

 Recession 2x multiplier
- lots of unemployed workers
- lot of unused capital
- the multiplier Is around 2

 Spending on infrastructure, and aid to state and Local Government, also seems to have a Fairly High
Multiplier, about 1.5.
 But General cuts to payroll and income Taxes seem to have a multiplier of about 1:
 If the Government cuts $100 in taxes, the economy going to Grow by about $100

More target cuts and tax credits

- have lower multiplier, since they tend to benefit those who have higher incomes
- who often save rather than spend additional income

Fiscal Stimulus
- maybe an important tool at least when it comes to a recession
- but its not easy to do or that all stimulus is created equal

Fiscal Policy
- has advantages and Drawbacks

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Economic Effects of Deficit ( too much fiscal stimulus/expansion )

Deficit will occur when government spends more than its income/revenue. This will lead to:
 Burden of Debts - countries will borrow money to finance their deficit
 this may lead to crowding out effect
 Refinancing - The issuance of new debt in payment of debt issued earlier
 Debt Service -The interest required to be paid each year on outstanding debt
  The future generations will bear some of the debt burden and may hurdles economic growth

There are developed countries who are having budget deficit such as
1. USA,
2. Greece and
3. Japan,
 should they be worried about this?
 What about those developing countries who are experiencing budget deficit and debts/huge
borrowings, can this affect their development?

View this video to have an idea on the disadvantages of budget deficit (at 4:10) and to know when budget
deficit and debt is not anymore tolerable.

----- VIDEO: Deficits and Debt -----

Budget Deficit
- The amount by which a Government’s spending exceeds its income over a particular period of time
- Spends more than it brings in tax revenue

Debt
- The accumulation of budget deficit

 Debt as Percent of GDP

Default
- Higher interest rates would make it harder to pay back the loan, which could likely lead to more
debt
- And it basically terrible for everyone
- The investors who loaned the government money lose Billions, and the Government losses all
credibility, and it causes a Massive Recession

Debt Ceiling
- Limit on the amount of national debt than can be issued by the US Treasury
- debt ceiling does nothing to cut spending or raise revenue
The end part of the video on "Deficit and Debt" published 2015 states that:
"Right now health care spending is driving the debt higher, but if a massive pandemic kills of half of
the world,....And frankly, in that case national deficit spending will be the least of our worries".

The pandemic - Covid-19 condition can drive the country to have a higher budget deficit and debt
(probably).

"Analysts and health experts agree that, until an effective treatment becomes available or a vaccine for
COVID-19 is developed, the threat of new wave of infections remains (Gopinath, 2020; Schwab and Vanham,
2020; OECD, 2020; Moore et al, 2020). In response to this, the Philippine government has a 4-pillar strategy
against COVID-19 called the Philippine Program for Recovery with Equity and Solidarity (PH-PROGRESO) that
requires Php 1.7 trillion-worth (9.1 percent of GDP) of fiscal, budgetary and monetary measures". (BSP,
2020, p.3)

Study the reading below on PH-PROGRESO to know on how Philippine government address the Covid19
through monetary and fiscal policy.

/files/7355397/We-Will-Rise-As-One-brochure-as-of-May-17-2020.pdf.