5 FISCAL AND MONETARY POLICY

PRINCIPLES OF

MACROECONOMICS

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

In this chapter, we will be able to know-

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 ECONOMIC POLICY
 Actions designed to influence the economy by
controlling the level of aggregate demand and
money supply.
 implemented and administered by the
government.
 Examples
• taxation,
• government spending and borrowing,
• interest rate and
• exchange rate changes etc.
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 Objectives of Economic Policy
 Economic growth:
 Overall increase in economic activities, level of income
and peoples standard of living.
 Full employment:
 Every member of the labor force who wants to work is
able to find work.
 Price stability:
 Prevent frequent changes in general price level in the
form of inflation and deflation.

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 Types of Economic Policy

The governments can affect the macro economy through

two policy channels.
1)Fiscal policy
2)Monetary policy

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 1) FISCAL POLICY

This is referred to as government expenditure and taxation

policy.

TYPES OF FISCAL POLICY

1)Expansionary Fiscal Policy
2)Contractionary Fiscal Policy

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 TYPES OF FISCAL POLICY
1) Expansionary fiscal policy –

Expansionary fiscal policy –

•It is designed to control deflation
• by increasing the level of aggregate demand.
•For that government reduces taxes and increases the
public expenditure.
•It will increase the purchasing power
•When people spend more aggregate demand will
increase and then prices will start to increase.
• So there is no deflationary pressure.

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 TYPES OF FISCAL POLICY
2) Contractionary fiscal policy –

Contractionary fiscal policy –

1)It is designed to control inflation
by decreasing the level of aggregate demand.
2)For that government increases taxes and decrease the
public expenditure.
3)It will decrease the purchasing power;
4)When people spend less aggregate demand will
decrease and then prices will start to decrease.
So there is no inflationary pressure.

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 2) MONETARY POLICY
MONETARY POLICY
 Monetary policy refers to the policy through which the monetary
authority expands or contracts the money supply in the economy.
 In other words, it relates to changes in the rate of interest and the
availability of credit in the economy.

TYPES OF MONETARY POLICY

1) Expansionary Monetary Policy
2) Contractionary Monetary Policy

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 TYPES OF MONETARY POLICY
1) Expansionary Monetary Policy –
Expansionary Monetary Policy –
Expansionary monetary policy increases the supply of money.
It aims to control deflation.
For that the central bank reduces the bank rate, rate of interest and
reserve requirements.
Then the lending capacity of banks will be increased and hence
peoples purchasing power increases and thus the problem of deflation
may disappear.
Buying of government securities in the open market by the central
bank also creates the same effect because people get their money
back.

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 TYPES OF MONETARY POLICY
2) Contractionary Monetary Policy
Contractionary Monetary Policy –
Contractionary monetary policy reduces the supply of
money. It aims to control inflation.
For that the central bank increases the bank rate, rate of
interest and reserve requirements.
Then the lending capacity of banks will be decreased and
hence peoples purchasing power decreases and thus the
problem of inflation may disappear.
Selling of government securities in the open market is
another method of contractionary policy.

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 The Budget

 A budget may be defined as a financial plan or statement

of the government which shows in details the estimated
receipts and proposed expenditures and disbursements
(payments) under various heads for the coming year.
 In other words, a budget is a description of the fiscal
policies of the government–taxation and expenditure
policies—and the financial plans in accordance to these.
 A budget indicates the revenue and expenditure of the
last completed financial year, the probable revenue and
expenditure estimates for the current year and the
estimates of the anticipated revenue and proposed
expenditure for the next financial year

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 Types of Budget
Balanced Budget and Unbalanced Budget
A budget can be balanced or unbalanced.
According to Dalton, “a balanced budget is that, over a
period of time, revenue does not fall short of expenditure. If
expenditure exceeds revenue, the budget is said to be
unbalanced.”
In other words, a budget is balanced when government’s
tax revenue and expenditure are equal. Thus, in case of
balanced budget:
Revenue = Expenditure

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Surplus Budget and Deficit Budget
When a budget shows that government income
and expenditure are not equal, it is said to be an
unbalanced budget.
This imbalanced may be due to an excess of
expenditure over income or an excess of income
over expenditure.
In the former case, it results in deficit budget and
in the latter case, a surplus budget.
Thus, excess of income over expenditure is
called a surplus budget.
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 A surplus budget decreases liabilities of the
government. Hence, in case of surplus budget:
Revenue > Expenditure
 A deficit budget increases liabilities of the
government. Therefore, in case of deficit budget:
Revenue < Expenditure

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CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 16
CHAPTER 5 FISCAL AND MONETARY POLICY

REVIEW QUESTIONS
1) What is budget?
2) Distinguish between surplus budget and deficit budget.
3) Define economic policy. Explain its objectives.
4) What is fiscal policy?
5) Explain the tools and types of fiscal policy.
6) What is monetary policy?
7) Explain the tools and types of monetary policy.

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