Fiscal and Monetary Policies of the Bank - Term Paper Example

Supervisor: Why is money supply not under the tight control of central banks? By: January, 2008 1 Introduction The central bank is the central referee in the financial system. It is keeper of the government receipts and payments, act as last resort to bail the economy out of recession. The central bank is at the front of government fiscal and monetary policy objective. It does not compete with other banks for ordinary business transactions but however ensures a fair play (Black 2000, Visser 2005, Smullen & Hand 2005). Example of central banks includes the bank of England. An on going debate between businesses and politicians, not noticeably contradicted by academics, is that one of the main functions, or the main function, of the central bank is to analyse the progress of the economy, and then to steer it with skilful judgment towards health and growth, by making decisions to change their base interest rate, with carefully chosen timing, amount and direction. One of these objectives is the control of money supply ((Black 2000, Visser 2005, Smullen & Hand 2005). Fiscal and monetary policies are among the most important public policies available in promoting growth and stability within the institutional framework of a free, competitive society (Black 2000, Visser 2005, Smullen & Hand 2005). By definition, fiscal policy is customarily defined as a manipulation of the government financial transactions, why on the other hand monetary policy is governmental control over the quantity of money or its terms of exchange (Winston, Holt &Hall 1960). In other words, these are tools being manipulated by the government to achieve desired economic and government objectives. One of these objectives is to control the supply of money. 1.2 Monetary Policy Monetary policy is referred to as a means by which the central bank tries to sway the economy to equilibrium by influencing the supply of money (Black 2000, Smullen & Hand 2005). This is achieved through four main approaches, which include: printing more money; direct controls over money held by the money sector; open market operations and influencing the interest rate. Both tight and easy monetary policies can also be identified. Like easy fiscal policy, easy monetary policy is one whereby the central bank embarks on a policy to increase the supply of money. On the other hand tight monetary policy is a policy whereby the central bank embarks on a policy to limit the circulation of money such as increasing interest rates. 1.3 Fiscal Policy Fiscal policy refers to a situation whereby the government restores equilibrium in the economy by making changes to taxes or government expenditure on public goods and services (Smullen & Hand 2005; Visser 2004: p. 43). When there is under-utilisation of capacity, the government can increase capacity utilisation by reducing taxes (that is through a reduction in tax rates or tax base) or by increasing spending on public goods and services as well as subsidising the production of certain goods and services (Smullen & Hand 2005; Black 2000; Visser 2004: p. 43).. Fiscal policy aimed at increasing money supply is referred to as easy fiscal policy (Smullen & Hand 2005). On the other hand, when there is over-utilisation of capacity, the government either increases taxes (through and increase in tax rates or tax bases) or reduces spending on public goods and services (Black 2002). It also reduces subsidies and transfer payments. This type of fiscal policy is referred to as tight fiscal policy (Black 2002). 1.3.1 ILM Curve and Fiscal Policy The IS/LM model is made up of two curves, the IS curve and the LM curve1. The IS curve, which represents the equilibrium conditions of the real (investment-savings equilibrium) side of the economy2. For an open economy, the IS curve can be represented by the following equation3: (1) Where Y= national income, Z= private expenditure (consumption and investment), i = interest rate, T= taxes, G= government spending, Ex = exports (receipts on the current account of balance of payments), e= exchange rate, Im = imports (payments on the current account of balance of payments). The LM curve is influenced by balance of payments, because differences in imports and exports affect the money supply: Md = Ms Md = Md(Y,i) Ms = m.C Where Md = money demand, Ms = money supply, M = money multiplier, C = volume of base money. The central bank creates base money by granting domestic credit as well as through open market operations such as the purchase of foreign exchange. Following from Visser4, the base money supply at any point in time should be equal to the base money supply one period behind plus the change in the domestic credit supply D during that period and the change in the foreign-exchange reserves V. This change is equal to the balance-of-payments balance X of the non-financial sector5. C = C-1 + ∆D + ∆V ∆V = X The central bank uses open-market operations through the sales and purchase of domestic debt instruments such as bonds and other debt issues as the instrument of monetary policy. The volume of this purchase can be denoted by H = ∆D. Following from above C = C-1 + X+H Ms = m(C-1 +X+H) This gives us the equation for the LM curve as follows6: Md (Y, i) = m(C-1+ X+ H) (2) Equating the real side of the economy (equation (1)) to the monetary side (equation (2)) leads to the IS/LM model. Figure 1. Fiscal Policy a). Easy fiscal policy b). Tight fiscal policy At equilibrium, the equation for the IS curve is equal to that for the LM curve, that is the real side of the economy is equal to the monetary side of the economy and it is at this point that the LM curve cuts the IS curve7. It should be noted that the IS curve has a negative slope, while the LM curve has a positive slope. Figure 1 above represents the initial equilibrium position of the IS/LM model. The equilibrium national income is given by Y1; the equilibrium interest rate is i1. Lets assume that the government embarks on an easy fiscal policy and reduces taxes T, this will result in a shift in the IS curve to the right from IS to IS’, establishing a new equilibrium point between the IS’ curve and the LM curve at a higher level of national income Y2 and at a higher rate of interest i2. This is shown in the figure 1a above. Conversely if the government decides to embark on a tight fiscal policy by say increasing tax rates or the tax base so as to increase the overall tax liability, this will lead to a decrease in the national income from Y1 to Y2 and as well as a decrease in the interest rate from i1 to i2, resulting in a leftward shift in the IS curve from IS to IS’. This establishes a new equilibrium position to the left. This effect is shown in figure 1b above. Figure 2 Monetary Policy. a). Easy monetary policy b). Tight monetary policy In the IS/LM model above, the intersection of LM and IS represent the equilibrium state of the economy. At this point, the national income is given by Y1, and the interest rate by i1. In the first case lets assume that the central bank embarks on an easy monetary policy by purchasing debt securities in the open market. This will lead to an increase in the supply of money and thus the national income. The LM curve will shift to the right creating a new equilibrium position at a higher national income Y2 and a lower interest rate i2. This is represented in figure 2a above. On the other hand, if instead the central bank decides to embark on a tight monetary policy by raising interest rates from i1 to i2, it will result to a decrease in the national income from Y1 to Y2 and a shift in the LM curve from LM to LM’. This is represented in figure 2b above 1.4 Conflicting Policy Objectives Despite governmental efforts, policy instruments and tools available to the government, the issue of healthy economic growth and other objectives continue to be a nightmare to most national governments. Christiano et al. (2005) contend that interest rate and the money growth rate move persistently in opposite direction after a monetary policy shock. In their study, they found that investment adjustment costs and habit formation were not central to inflation inertia and output persistent but were however accountable for the dynamics in the other variables. One problem that has persistently put Economists in to dilemma – is the tendency for continuous fluctuations in the economy. The tendency of any movement, whether upward or downward, to develop in a cumulative, self-perpetuating fashion is quite common to both developing and developed economy (Hansen 1949). This is one of the problem affecting government monetary and fiscal policies goals attainment. For example, once an upward (or downward) movement is started in an economy, why will it not go on and on, feeding on itself until the end result turns out to be either a progressive inflation or deflation? The achievement of one objective creates the next one. Or why will an inverse effect not take place in the case of movement in opposite directions? Thus government objectives turn to conflict with each other. An attainment of economy growth will result to an inflationary situation this is the same dilemma, the central bank being government representative faced in the control of money supply. Using the classical doctrine as an example, any flow of income will perpetuate into the future. A rising income will keep on rising while a falling income will keep falling (Hansen., H.A. 1949). This is because the elasticity of expectations tends to be unity. Increasing sales will be subsequently followed with a rise in production thus raising income further. One will be easily lured into thinking that, the situation will be different if full employment and full output for the economy as a whole has been reached. In such situation, the will instead be competition for the limited factors of production, thus raising money income and prices. On the basis of future-oriented consumption theories, it has been argued that individuals through changes in their own behaviour undo government fiscal policy – for example, an increase in government spending (money supply) and borrowing will increase people speculation on the future tax burden and individuals will consequently increase their current savings in anticipation of this (Visser 2004).. But lower costs raise profits. Wage earners working in plants making large profits may demand a share in the proceeds. If prices are cut, however, aggregate gross sales will rise if the elasticity of demand is greater than unity. Since this is typically the case with all new products, there is a tendency in a dynamic society in which many new products are continuously coming on the market, a persistent secular fall in prices and money supply. Cyclical interruptions in growth originate both within and without the economic system. Cyclical and erratic interruptions tend to be an integral part of the natural growth process (Winston. Rinehart. & Hall (1960). To achieve sustained money supply, growth and stability, the government through its fiscal and monetary (central bank) policy must counteract these volatile forces as well as resolve those contradictions which in most situations appear among the secular forces (Winston. Rinehart. & Hall 1960) The bank of England uses the interest rate to fight inflation. It has raised interests’ rates 5 times since the beginning of the year 2007( Kennedy 2007, Blackden 2007). The last increase in interest rates was on 5th July 2007, which saw an increase in the interest rate from 5.5% to 5.75% (Kennedy 2007, Blackden 2007). Inflation in the UK is currently running at 2.5% and the bank of England is targeting 2% in the course of the year (Kennedy 2007, Blackden 2007). Frequent instruments and methods used by monetary authorities include:- The interest rate, money supply or the exchange rates During recession and period of economic slump, the government through the central bank uses its monetary policy instrument to restore the economy back into normalcy. That is by lowering the interest rate. When an economy is over heated, that is during period of inflationary tendency, the same move is being spark up by the government through raising of the interest rate. As a matter of monetary policy rule, the government prefers lower rate of inflation, rather than lower rate of unemployment. Government policy objective are conflicting. This rational explain the difficulties in achieving all monetary and fiscal policies objective at any one time. The government through the Bank of England by lowering the interest rate, its aggregate spending and demand will be stimulated. Aggregate demand and aggregate spending tends to be expansionary in nature and will consequently lead to depreciation of currency and higher level of prices over time. On the other hand, higher interest rate tends to be contractionary. This is so because an action by the central bank in this direction will be followed closely by a fall in aggregate demand and spending. The currency will consequently appreciate as higher prices follows (Chrystal & Simon 1994). References Christiano L.J.et al. (2005).Nominal Rigidities and the Dynamics effects of a shock to monetary policy. Journal of Political Economy, 113(1) p.3 Hansen. A.L., (1949). Monetary Theory and Fiscal Policy. McGraw-Hill Book Company, Inc. K. A.Chrystal and Simon Price (1994). Controversies in Macroeconomics, Harvester Wheatsheaf, chapter 6. Winston. Rinehart H. & Hall A.C. (1960). Fiscal Policy for Stable Growth: A Study in Dynamic Macroeconomics. Smullen J., Hand N. (2005). Monetary Policy. A Dictionary of Finance and Banking. Oxford University Press. Oxford Reference Online. Visser, H. (2004). A Guide to International Monetary Economics: Exchange Rate Theories, Systems and Policies 3rd Ed. Cheltenham, UK, Northhampton, MA Edward Elgar Publishing, Inc. Read More