Monetary policy is the attitude of the political authority towards the monetary system of the community under its control. It is the process a government, central bank, or monetary authority of a country uses to control (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Monetary policy is referred to as either being an expansionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply.
Objectives of monetary policy:
To save guard the country’s gold reserve: The gold standard is a better monetary system. The far right advocates the gold standard because it gets government out of the business of controlling the money supply. They fear that printing money creates inflation, and retracting money causes recessions.
To maintain price stability: The benefits of price stability are substantial. Maintaining stable prices on a sustained basis is a crucial pre-condition for increasing economic welfare and the growth potential of an economy
To maintain exchange stability: It shows that fixing the exchange rate to a basket of currencies instead of a single currency serves to promote long-term stability to which the Bank remains strongly committed. A stable exchange rate imposes a constraint on domestic monetary policy which could be regarded as a useful safeguard against unsound policies.
Elimination of cyclical fluctuation: In recent years the problems of monetary policy have been approached more and more with a view to both stabilizing the value of the monetary unit and eliminating fluctuations in the economy. To attempt at explaining and publicizing these most difficult economic problems. It may perhaps be appropriate to speak of fashions in economics.
Achievement of full employment: Needlessly high levels of unemployment are a contributing factor to a wide range of social ills, which would be substantially alleviated by driving unemployment. This will require substantial increases in government deficits and debt.
Acceleration of economic growth: Expansionary monetary policy is monetary policy that seeks to increase the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry. There is no clear consensus on how monetary policy affects real economic variables. Both economic schools accept that monetary policy affects monetary variables
Fiscal policy goes ahead of monetary policy-Explain.
Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy. On the other hand, Fiscal policy is the conscious policy of the government to achieve some predetermined objectives by public expenditure, public revenue & public debt.
Explanation of the statement:
Monetary policy affects income & expenditure through cost & availability of money, whereas fiscal policy affects income & spending through government revenues & government expenditure. Monetarists assign more important role to monetary policy than to fiscal policy.
Fiscal policy plays an important role in rapid economic growth, achieving full employment, maintaining price stability, implementing social justice & equal distribution of income, expansion of basic industries, removing of regional disparity, balanced regional development, mobilizing of capital, optimum distribution of productive resources among various sectors, & attaining & maintaining optimum consumption level.
Monetary policy has limitations. It cannot, for example, simultaneously stimulate economic demand to reduce unemployment and restrain demand to combat inflation. Nor can the Bank of Canada increase money growth rates to reduce interest rates below US levels while at the same time successfully stabilizing the Canadian-US exchange rate. Therefore, monetary policy decisions often require painful choices ("trade-offs"). Sometimes these trade-offs involve conflicts between the short-term and long-term effects of a particular policy. For example, a sustained rise in money-supply growth may cause an initial increase in both jobs and production, but eventually it will lead to a correspondingly higher inflation rate with little or no permanent effect on employment or output.
Similarly a major reduction in the rate of money-supply expansion ultimately will reduce even strongly entrenched inflation, but this accomplishment may take several years during which output and employment both fall. These inter temporal conflicts can be complicated by a third limitation - ignorance - for there are still many unresolved questions concerning the mechanisms whereby changes in monetary policy affect the economy, the nature of the interrelations between real and financial variables, and the exact determinants of wage- and price-setting decisions.
Finally, monetary policy is restricted by the impact of other government actions, especially fiscal policy, i.e., decisions about government expenditures and taxation. Fiscal policy also influences overall economic demand, and if fiscal and monetary policy are not co-ordinate, they can work at cross-purposes.
The creation of monetary policy is often a highly contentious issue. Disagreements sometimes occur because of differing factual judgments about current economic circumstances or because of conflicting value judgment whether it is more unfair to have inflation erode the value of fixed pensions or to have recession cause the loss of jobs. Frequently, however, debate reflects broad conceptual differences about the appropriate strategy for monetary policy. Although there are many alternative (and intermediate) viewpoints, 2 general approaches can be distinguished.
What is Dear money, Narrow money, Shift money and Broad money?
Dear Money: When the borrowing rate of interest is high in the money market it is called dear money. Dear money policy is persuaded when there is hectic speculation in the economy leading to hyperinflation.
Narrow Money: When the borrowing rate of money is low or the rate of interest is low it is called narrow money. Narrow money policy is persuaded by the central bank when deflation prevails in the economy.
Broad Money: In economics, broad money is the widest measurement of the money supply. It is generally
One measure of the money supply that includes M1, plus savings and small time deposits, overnight repos at commercial banks, and non-institutional money market accounts. This is a key economic indicator used to forecast inflation, since it is not as narrow as M1 and still relatively easy to track. All the components of M2 are very liquid, and the non-cash components can be converted into cash very easily.
broad money can have different definitions depending on the situation of usage, usually it is constructed as required to be the most useful indicator in the situation. More generally, broad money is just a term for the least liquid money definition being considered and less a fixed definition across all situations.
What sorts of monetary policy is followed during inflation, deflation and stagflation?
Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy.
Different sorts of monetary policy is followed during inflation, deflation, stagflation which is discussed below:
Monetary Policy that is followed During Inflation:
Dear money policy is advocated when there is a state of hyper inflation; hectic speculation; reckless investment by industrialists; credit creations by bank has crossed all prudent bounds; balance of payment heavily against the country.
Monetary Policy that is followed during deflation:
Cheap money policy is followed by the central bank when deflation prevails in the economy.
When the business enterprise is groaning under the benumbing & baneful effect of depression, when banks are shy of lending, when the low price level is killing economic incentive, when there is widespread unemployment, & when a comprehensive building programme has to be put through, & so on, a cheap money policy is advocated.
Monetary Policy that is followed during stagflation:
The stagflation is the result of policy-initiated excessive stimulation of spending so that the unemployment rate falls below the natural rate initially and then rises along with inflationary expectations, policymakers need to admit their error and to convince people that they should not build higher inflation rates into contracts. The problem, of course, is that people will be skeptical, so that the policymakers will need to establish credibility that they are truly adverse to inflation.
The suitable response to stagflation caused by aggregate supply shocks is less clear. One response is to do nothing and let the economy adjust as best it can to the shock. If energy prices will be permanently higher, the economy needs to make the changes to the new environment. The likely outcome is a short burst of inflation and a rise in unemployment followed by a gradual return to lower unemployment and stable prices. If energy price increases are temporary, policymakers may choose either to reduce the unemployment effects or to reduce the inflation effects.
Beginning in the early 1990s, inflation targeting by central banks has been advocated as a solution to the first cause of stagflation. If adopted, however, this policy will make the unemployment effects of supply shocks more severe because the response of policymakers will be to reduce spending growth in order to slow the inflation rate. A flexible inflation target that allows for short-run bursts of inflation from supply shocks is one possible remedy.
What are the dangers of money?
Money has not only merits but also demerits --------
• It may cause economic instability, saving investment crisis which causes economic fluctuation. That means rise and fall in the business cycle.
• Over issue of money causes economic disparity.
• Abundance of money leads to moral degration.
• Mal distribution of money creates economic disparity.
What is trade cycle? Discuss the stage of a trade cycle.
When recovery starts & how?
There are upwards swings and downward swings in the business. Its prosperity and adversity comes in term, the boom is followed by a slump and vice versa. This called trade cycle or business cycle. If prefers to a whole course of trade activities which posses through all phases of prosperity and adversity. When adversity leads to bank failure it is called financial crisis.
Stages of trade Cycle:
Depression: We might start a point when business is at the lowest ebb and the economy is engulfed in depression. The lucky ones, who are employe , get distressingly low wages. The purchasing power of money is high but that of man low. The general purchasing power of community being very low, the productive activity, both in the production of consumers , ‘ goods and producers’ goods especially the later, is at a very low level.
Recovery: After the depression has lasted for some time, rays of hope appear on the business horizon. The depression contains within itself the germs of recovery. Wages are low for efficient workers, sufficient number of whom is now available. Money is cheap and so are the other materials and the factors of production. Prices may be low but the costs too are low. This induces an entrepreneur, who may have sufficient financial backing ,to take the risk.
Boom: Recovery once started gathers momentum. The revival of investment in one industry leads to a revival in another. With the general revival of demand, prices show an upward trend. The businessman’s income takes a forward jump while wages , interest and other costs lags behind. Profit margins are thus widened.
End of the Boom: All idle factors have been employed and further demand for them must raise their prices, but the quality available now is inferior. Rate of interest rises and so, also the prices of essential materials. As the consequences, costs take an upward swing. They overtake prices and the margins are first narrowed and then begin to disappear. The boom conditions are thus almost at the end.
Crisis: Fearing that the era of profits and has come to a close, businessman stop ordaring further equipment and materials. The government applies the axe mercilessly. The bankers insist on repayment. The bottlenecks appear and stock accumulate .This accumulates are depression. Just as the recovery is self-reinforcing, the forces of depression are also self-accumulating . There is general distress. This phase of the trade cycle is known as the crisis-a point of critical convulsions.
Slump: The crisis is the period of utmost suffering for businessman. But they recover in course of time from the stunning blow .Their commitments are liquidated somehow and business enters into the stage of what has already been described as depression or slump or a state of stagnation.
When Recovery Starts
The economic conditions which we have described in depression phase do not remain as such forever. After sometime revival or recovery sets in under the influence of a variety of factors. The revival phase develops when the accumulated stock of commodities with the businessmen are exhausted. The cost under the impact prolonged depression begins to fall. The prices which have reached its lowest level stop falling further there is then complete harmony between costs and price relationship. When profits begin to reappear, the businessmen are induced to invest their hoarded money in some enterprise. In order to steal a march over other industrialists, they start repairs, renewal and replacements of their capital equipments and stocks. The capital goods industries resume activities. There is gradual re-employment of labor. The money incomes begin to increase and the effective demand is revived. The government also tries to break the spell of depression by starting construction or expanding some public works with a view to give more employment. The commercial banks which have accumulated large reserve offer credit on favorable terms. The marginal efficiency of capital begins to rise and investment opportunities brighten up. The consumers start buying commodities to avoid the rise. Due to increase in demand for commodities, investment in various industries is stimulated and thus the revival takes place.
What is the fiscal policy? Discuss the objectives of fiscal policy.
Fiscal policy plays an important role in macro economics and it is an important macro economics tool. It is quite ahead of monetary policy to achieve desire economic goal. It refers to a conscious policy of the government to achieve some predetermine social economic objectives with the help of public revenue, public expenditure and public debt. Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation. In short, fiscal policy is concerned with the determination of type and procedure to follow in making government expenditure and obtaining government revenue. Fiscal policy involves the Government changing the levels of Taxation and Government Spending in order to influence Aggregate Demand and therefore the level of economic activity.
Objectives of fiscal policy:
• Rapid economic growth.
• Full employment.
• Price stability.
• Social justice and equal distribution of income.
• Expansion of basic industries.
• Removing of regional disparity.
• Balanced regional development.
• Mobilizing capital.
• Optimal distribution of productive resources among various sectors.
• To attain and maintain optimum consumption level.
What leads to cost push inflation and demand pull inflation?
Cost push inflation:
Where there is no increase in aggregate demand price may still rise. This may happen when cost, especially wage cost rises. As the level of employment rises the demand for labor goes up progressively. As a result there bargaining capacity increases and labor asked for more wages. Aggregate demand being constant increase in the cost of shift production causes and upward shift to the left of the supply curve. Push inflation may even occur before full employment as it is related to supply. For this it is also called supply inflation. Three such autonomous increases in costs which generate cost push inflation have been suggested, they are,
(a) Wage-push inflation; (b) Profit-push inflation; (c) Increase in prices raw materials, especially energy inputs such as rise oil prices
Wage-push inflation: It is suggested that the growth of powerful trade union is responsible for the spread of inflation, especially in the industrialized countries. When trade unions push for higher wages which are not justifiable either on grounds of a prior rise in productivity they produce a cost-push effect.
Profit push inflation: Besides the increase in wages of labor without any increase in its productivity, there is another factor responsible for cost-push inflation.
Rise in raw material prices or oil price shock: In addition to the rise in wage rate of labor and increase in profit margin, in the seventies the other supply shocks causing increase in marginal cost of production become more prominent in bringing about cost-push inflation.
Demand pull inflation:
Demand pull inflation occurs when demand is rising rapidly. Buyers bid eagerly for goods and services pulling up their price. Demand pull inflation happens when price level goes up with the rise of effective demand, supply of goods and services remaining constant. Demand pull inflation is a situation where there the basic factor at work is the increase in aggregate demand for output either from the government or the entrepreneurs or the households. Keynes explained the inflation arises when there occurs an inflationary gap in the economy which comes to exist when aggregate demand exceeds aggregate supply at full employment level of output. Basically inflation is caused by a situation where by the pressure of aggregate demand for goods and services exceed the available supply of output.
If the government is insistent on securing additional to get more of the national output than production has provided. This is the basic cause for the Demand pull inflation to start and when aggregate demand for all purposes consumption, investment and government expenditure, exceeds the supply of goods at current prices.
What is shifting of tax?
The burden of tax can be transferred to others through a process of shifting. Initial burden of tax is an impact of tax then it is shifting and called shifting of tax. Finally who bears tax is called incident of tax. It may be noted that the whole burden of the tax may not be shifted to others. As a matter of fact, a part of the tax burden rests on all the persons to a larger or smaller degree in the chain of transferring the burden so that ta the ultimate end only a small burden rests. The process of shifting burden of a tax goes on so long as different persons who come in the chain are able to pass on the burden to other till it ultimately rests of persons who can’t shift this unwelcome baby further. An individual or a firm can shift the burden of tax if there occurs exchange relations which are conducted on the basis of prices of goods and factors.
Whether shifting of tax can take place on a number of factors. They are,
The nature of a tax: The nature of a tax as to whether it is tax on the production or sale of some commodities or it is personal income or property tax. Tax shifting can easily take place in the case of axes on the production and sake of commodities. The burden of taxes such as income or wealth taxes can’t not be shifted.
Market conditions: Whether commodity is being produced under conditions of perfect competition, monopolistic competition goes to determine the extent to which the burden of tax can be shifted. A monopolist who has a full control over the supply of a commodity is in a better position to shift the burden of a tax on the commodity produced.
Physical condition of production: The shifting of the tax burden on a commodity also depends upon whether the commodity is being produced under increasing, constant or diminishing returns.
Inflation is bad, recession is worst - Explain.
Explanation of the Statement:
Inflation is a process of continuous increase in the prices of most goods and services in a country. This does not necessarily mean that all prices increase. There may be some exceptions, such as computer prices which have actually declined in recent years. Inflation can therefore be described as a persistent general increase in prices.
Inflation is bad:
Sure, they say inflation means same amount of money can buy less things and that is bad. But that is a mantra which doesn't really explain, why it seems to me the chief purpose of the Fed is to fight inflation, and not fight deflation. All periods of economic growth will have a degree of inflation. As we have seen from Japan's 14 year experience from 2000 to only recently, deflation can be bad too, with no jobs and low GDP growth. So explain to me why inflation is bad, in detail. A little bit of inflation is like a tax on idle money. It prompts people to get their money out of the mattress (or low interest accounts) and put it to work on investments. A lot of inflation prompts people drives money out of economy-driving investments and into inflation-proofing investments (gold, collectibles, etc). For instance, if you knew inflation was going to be 12% and you were getting 10% on your investment, you might pull your money and buy gold (which does nothing for the economy).
Losses to savers:
If you save your money by hoarding cash, inflation erodes the purchasing power of the amount saved. For instance, R100 put underneath a mattress ten years ago can now purchase only one third of the goods and services that it could have done in 1987. Even if you save in the form of savings deposits which pay interest, the interest may not be enough to compensate you in full for inflation. This also applies to pension planning, where a person may, for example, save for a pension during his entire working life, just to find at the end of his career that his savings have been eroded by inflation. Losses to people with fixed incomes: People with fixed incomes (such as the interest on a fixed deposit, or a fixed salary) find that the purchasing power of their income diminishes over time. The wealthy, in contrast, can usually partly protect themselves against inflation by investing in assets, such as shares or property, which increase in value during periods of inflation. Inflation therefore leads to an increase in the disparity between the wealth of the "haves" and the "have-nots", or the rich and poor. Losses to taxpayers: If your salary increases in line with inflation, and no adjustments are made to income tax, you will shift into a higher tax Bracket and end up paying a larger share of your salary to the taxman. This means that Government gains control over an increasing proportion of society's resources without formally getting the approval of Parliament to raise taxes. Confusing price signals to producers and slower expansion of businesses:
Recession is worst:
First things first: Even though it may seem obvious to most that this is the worst downturn since the Great Depression, the economy has experienced other serious recessions in the past, particularly in the mid-1970s and early 1980s. But this recession dwarfs those two for several reasons.
In terms of length, the longest post-Depression economic decline was 16 months, which occurred in both the 1973-75 and 1981-82 recessions. This recession began in December 2007, which means that it will enter its 17th month next Wednesday.
The current recession is also more widespread than any other since the Depression. The Federal Reserve's readings show that 86% of industries have cut back production since November; the most widespread reduction in the 42 years the Fed has tracked this figure.
What's more, every state reported an increase in unemployment this past December, the first time that has happened in the 32 years that records for unemployment in each state have been kept.
What is inflation? What are the causes of inflation?
Inflation:
When too much money changes to little commodity it is called inflation.
For example:
Commodity 100 = Money 100 here, price 1
When, 100 = 200 here, price 2 { it is inflation where price level rise }
Inflation exists when money income is expending more than in proportion to income earning activity. By inflation we mean a time of generally rising prices for goods and factors of production.
Causes of inflation:
Rising imported raw materials costs
Rising labor costs
Higher indirect taxes imposed by the government
A depreciation of the exchange rate
A reduction in direct or indirect taxation
The rapid growth of the money supply
Rising consumer confidence and an increase in the rate of growth of house prices
Faster economic growth in other countries
Paradox of value
This phrase was first used by Scots economist Adam Smith (1723-1790). In his theory he wonders how a diamond can be so tremendously valuable, but have no inherent worth i.e. it is not necessary to life, whilst water which is central to living is practically worthless.
He recognised that it was possible that this was the case because water is plentiful but diamonds are not, but this would not account for the price of the commodity not the value. Yet we would all value a diamond more than a jug of water.
He concluded that the difference in value was caused by the fact that diamonds are labour intensive in the sense that they have to be extracted cut, shaped and polished, whereas water can be esaily obtained by anyone. This means that water may have a greater use value than diamonds, but it has a much lower exchange value and this was his paradox of value!
The paradox of value addresses why absolute necessities such as water are valued (priced) so cheaply, while frivolities like diamonds are highly valued and command outrageous prices.
The paradox of value refers to the fact that very useful goods (e.g., water) can have very low prices, whereas goods that are not necessary for survival (e.g., diamonds) can command high prices.
