Macroeconomic Policy

Instruments
Monetary Policy
Fiscal Policy
 Why we need policy instruments?
• If there is a recession...
• If there is an inflation
• If there is a need of providing rapid/high
economic growth.
• To provide full employment
• BUT in general to provide stability in the
economy!!!
Fluctuation in the economy and need of
policy instruments
 Policy Instruments
• There are two types of policies for
macroeconomic stability.
– Monetary Policy
– Fiscal Policy
 Monetary Policy
• Monetary policy refers to the actions undertaken by a
nation's central bank to control money supply and achieve
sustainable economic growth. Monetary policy can be
broadly classified as either expansionary or contractionary.
• Expansionary: If there is a recession monetary policy
instruments are used to expand the production by
providing low cost for investment
• Contractionary: If there is a need to lower the economic
output monetary policy instrument can be used to
increase the cost of production. This results with low
levels of production.
 Monetary Policy
• According to Prof. Harry Johnson, "A policy
employing the central banks control of the supply
of money as an instrument for achieving the
objectives of general economic policy is a monetary
policy."
• According to A.G. Hart, "A policy which influences
the public stock of money substitute of public
demand for such assets of both that is policy which
influences public liquidity position is known as a
monetary policy. "
 Objectives of Monetary Policy
• Economic Growth
• Price Stability
• Exchange Rate Stability
• Balance of Payments (BOP) Equilibrium
• Full Employment
• Control of business cycle
• Control of Inflation and Deflation.
 Economic Growth
• It is the most important objective of a monetary
policy. The monetary policy can influence economic
growth by controlling real interest rate and its
resultant impact on the investment. If the central
bank opts for a cheap or easy credit policy by
reducing interest rates, the investment level in the
economy can be encouraged. This increased
investment can speed up economic growth. Faster
economic growth is possible if the monetary policy
succeeds in maintaining income and price stability.
 Price Stability
• All the economics suffer from inflation and
deflation. It can also be called as Price
Instability. Both inflation are harmful to the
economy. Thus, the monetary policy having an
objective of price stability tries to keep the
value of money stable. It helps in reducing the
income and wealth inequalities.
 Exchange Rate Stability :
• Exchange rate is the price of a home currency expressed in
terms of any foreign currency. If this exchange rate is very
volatile leading to frequent ups and downs in the exchange
rate, the international community might lose confidence in
our economy. The monetary policy aims at maintaining the
relative stability in the exchange rate. The CB by altering the
foreign exchange reserves tries to influence the demand for
foreign exchange and tries to maintain the exchange rate
stability.
• Exchange rate policy is concerned with how the value of the
domestic currency, relative to other currencies, is
determined.
 Full Employment :
• The concept of full employment was much discussed
after Keynes's publication of the "General Theory" in
1936. It refers to absence of involuntary
unemployment. In simple words 'Full Employment'
stands for a situation in which everybody who wants
jobs get jobs. However it does not mean that there is a
Zero unemployment. In that senses the full
employment is never full. Monetary policy can be used
for achieving full employment. If the monetary policy
is expansionary then credit supply can be encouraged.
 Control of business cycle:
• - Boom and depression are main phases of business
cycle, monetary policy puts a check on boom and
depression.
• During recession CB increases money supply to lower
the interest rate. With the low cost of borrowing
investors will borrow and make investment to expand
the economy.
• During inflation CB decreases money supply to increase
interest rate and increase the cost of borrowing to
lower the investment. This will contract the economy.
 Money Market
• Money market equilibrium occurs at the
interest rate at which the quantity of money
demanded equals the quantity of money
supplied. All other things unchanged, a shift in
money demand or supply will lead to a change
in the equilibrium interest rate and therefore
to changes in the level of real GDP and the
price level.
 The Demand for Money
• The demand for money is the relationship
between the quantity of money people want to
hold and the factors that determine that quantity.
• When interest rates rise relative to the rates that
can be earned on money deposits, people hold
less money. When interest rates fall, people hold
more money. The logic of these conclusions about
the money people hold and interest rates depends
on the people’s motives for holding money.
• Assume there are only two ways to hold wealth:
• as money in a checking account, or
• as funds in a bond market mutual fund that purchases
long-term bonds on behalf of its subscribers. A bond fund is
not money.
• The advantage of checking accounts is that they are highly
liquid and can thus be spent easily.
• Demand for money is a curve that represents the outcomes
of choices between the greater liquidity of money deposits
and the higher interest rates that can be earned by holding
a bond fund.
 Demand Curve
• An increase in the interest rate reduces the
quantity of money demanded. A reduction in
the interest rate increases the quantity of
money demanded.
• The demand curve for money shows the
quantity of money demanded at each interest
rate, all other things unchanged.
• Interest rate and income are the two main
determinants of demand for money.
 The Supply of Money
• The supply curve of money shows the
relationship between the quantity of money
supplied and the market interest rate, all other
determinants of supply unchanged.
• The quantity of money is determined by
Central Bank.
• Why supply of money is vertical????
 Money Market Equilibrium
• Money market equilibrium has an impact on
economic stability.
• Central Bank can use instruments to change
the quantity of money supply to increase or
decrease the interest rate.
• When interest rate increases quantity of
money demanded will decrease and savings
will increase.
 Changes in Quantity of Money Supply
• If Central Bank increases the quantity of
money supply, MS shifts right and interest rate
decreases.
• If Central Bank decreases the quantity of
money supply, MS shifts left and interest rate
increases.
 Increase in Money Supply
• The increase in the money supply is mirrored
by an equal increase in nominal output, or
Gross Domestic Product (GDP). The increase in
the money supply will lead to an increase in
consumer spending. ... Increased money
supply causes reduction in interest rates and
further spending and therefore an increase in
AD (aggregate demand).
Increase in Money Supply
 Increase in Money Supply as a Policy
Instrument
• It is expansionary policy instrument.
• While Central Bank increases the quantity of
money, interest rate decreases and
investment increases, employment increases
and consumption increases which leads to
high economic growth!!!!
 Decrease in Money Supply
• The decrease in the money supply is mirrored
by an equal decrease in the nominal output,
otherwise known as Gross Domestic Product
(GDP). In addition, the decrease in the money
supply will lead to a decrease in consumer
spending. This decrease will shift the
aggregate demand curve to the left.
Decrease in Money Supply
Money market equilibrium and investment

• When interest rate is high the cost of

investment is also high so real investment
decreases and production desreases.
• This has a negative impact on GDP growth.
• It increases unemployment and decreases
consumtion as well.
• Central Bank gives the right decision according
to the current economic reality of the country.
f
 Monetary Policy Tools
• How CB changes the quantity of money?
• 1. Open market operations

• 2. Discount policy

• 3. Reserve requirement
 Open market operations (OMO)
• Open market operations (OMO) refers to when
the Central Bank buys and sells primarily
Treasury securities on the open market in order
to regulate the supply of money that is on
reserve in the national banks, and therefore
available to loan out to businesses and
consumers. It purchases Treasury securities to
increase the supply of money (expansionary) and
sells them to reduce the supply of money
(contractionary).
 Discount Rate
• This is to change the interest rates and/or the
required collateral that the central bank
demands for emergency direct loans to banks
in its role as lender-of-last-resort.
• Charging higher rates and requiring more
collateral, an example of contractionary
monetary policy, will mean that banks have to
be more cautious with their own lending or
risk failure.
 Reserve requirement
• It refer to the funds that banks must retain as a
proportion of the deposits made by their
customers in order to ensure that they are able
to meet their liabilities.
• Lowering this reserve requirement releases more
capital for the banks to offer loans or to buy
other assets. Increasing the reserve requirement,
meanwhile, has a reverse effect, curtailing bank
lending and slowing growth of the money supply.