Economic policies refer to the monetary and fiscal policies that influence the economy's growth rate and price stability. Economic policies can be either expansionary or restrictive. Monetary policy affects the money supply, whereas fiscal policy affects the government's spending and taxation policies.
Fiscal
policy
Fiscal Policy is a tool
that the government can use to influence the level of GDP in the short run by
using taxes and government spending. It is about changing taxes and spending in
order to affect demand for goods and services, and thus output, in the short
run. The budget deficit is the difference between what the government spends
and what it collects in taxes. When a government increases spending or cuts
taxes to stimulate the economy, the government's budget deficit rises.
Fiscal policy is a
crucial tool in macroeconomic policy. It is also an important tool for economic
stabilization, i.e. overcoming recession and controlling inflation. So fiscal
policies are essentially a set of guidelines for the government's earning and
spending. Fiscal policy aims to control aggregate demand through appropriate
changes in these two variables.
Expansionary
fiscal policy is used to alleviate recession. This
policy increases government spending while decreasing taxes. Both of these
policies increase the money supply, which raises aggregate demand in the
economy. Contractionary fiscal policy,
on the other hand, calls for a reduction in government spending and an increase
in tax rates. This would reduce the money supply, causing a drop in aggregate
demand and the general price level, thereby controlling inflation. A
contractionary fiscal policy reduces the budget deficit while an expansionary
fiscal policy increases it.
Monetary
policy
Monetary Policy is a
tool that includes the Central Bank's actions to influence the level of GDP. In
the short run, the Central Bank can influence output through open market
operations, changes in reserve requirements, or changes in the discount rate.
These tools can be used to develop an appropriate monetary policy during
periods of both recession and inflation. During a recession, an expansionary or
easy monetary policy can be used to boost aggregate demand, while a
contractionary or tight monetary policy can be used to control inflation.
Monetary policy governs an economy's money supply. It is concerned with credit cost and availability. Monetary policy's broad objectives are as follows:
- To establish equilibrium at full employment level of output
- Ensure price stability by controlling inflation and deflation
- Promote economic growth of an economy
- Control Credit Availability
- Stability of Exchange Rate
- Control of Money Supply
Instruments
of monetary policy
The Central Bank
employs a variety of methods and instruments. Some are general or quantitative
methods for controlling and adjusting the total quantity, size, or volume of
commercial bank deposits. Others are known as selective or qualitative controls
because they regulate specific types of credits. The former controls the
availability (flow) of money and credit, while the latter controls the volume
(stock) of money and credit.
General
or quantitative controls
These are the controls
that relate to the volume and cost of bank credit in general without regard to
the particular economic activity for which the credit is used. There are three
instruments in this method:
Bank
rate or discount rate: This is the interest rate that the
Central Bank charges commercial banks for loans. When a commercial bank has
little or no cash reserves above the legal minimum, it may obtain cash reserves
from the Central Bank at the bank rate.
If the economy
experiences more inflation, the bank rate is raised. This causes commercial
banks to raise their interest rates as well. This is the increase in loan
interest rates, which results in less business activity. This causes a
contraction in income and expenditure, which reduces demand for goods and
causes prices to fall.
Open
market operations: Open market operations refer to the
Central Banks direct buying and selling of government securities and bills in
the money market with the goal of expanding or contracting credit and economic
activity. If the securities are purchased, there will be a cash outflow.
Income, employment, output, and prices will all rise as a result.
Reserve
requirement: Commercial banks are required by law
to keep a portion of their total deposits with the Central Bank. This is
referred to as the Statutory Liquidity
Ratio (SLR). Changes in reserve requirements have an impact on the amount
of reserves that commercial banks are required to keep as deposits with the
Central Bank, and thus the amount available for lending or investing. The
Central Bank can reduce the volume of bank credit by increasing the reserve
ratio that each bank must maintain, and it can increase the volume of bank
credit by decreasing the reserve ratio. As a result, changes in reserve
requirements are a potent tool for influencing the volume of bank deposits and
the money supply.
Selective
or qualitative controls
There are several
methods by which selective controls can be imposed:
Margin
requirements: The Central Bank can direct commercial
banks to lend less than the value of the security. If the margin requirement is
40%, commercial banks can only lend up to 60% of a security's value.
Control
through Directives: The central bank may direct commercial
banks' lending policies regarding the purpose for which advances may be made
and the margin to be maintained on secured loans.
Moral
suasion: It denotes the central bank's request and
persuasion of commercial banks to follow the central bank's general policy.
Regulation
of consumer credit: The Central Bank has the authority to
regulate the terms and conditions under which banks provide consumer credit.
Rationing
of credit: Credit rationing is a method of controlling and
regulating the purpose for which credit is granted by the banks. The central
Bank may fix maximum amount of loans for every commercial bank. This is known
as variable portfolio ceiling.
Direct
Action: It refers to all of the lending and investment
controls and guidelines that the central bank may impose on all banks or any
bank in particular.
Monetary policy can thus be used to alleviate recession by requiring the central bank to conduct open market operations and purchase securities in the open market from banks and the general public. This would increase the availability of credit and currency among the general public. Lowering the bank rate can increase credit availability. Reducing the reserve ratio frees up bank funds that would otherwise be used to make loans. A tight monetary policy, on the other hand, aids in the draining of credit from the market. The money supply will contract, and credit costs will rise. The general price level would fall, and inflation could be kept under control with this policy.
