<p>This course is a part of CFA Level I syllabus. You will learn the following:</p>



<ul><li>Monetary and fiscal policy</li><li>Money and process of money creation</li><li>Demand and supply of money</li><li>Fisher effect</li><li>Role of central banks</li><li>Expected and unexpected inflation</li><li>Monetary policy</li><li>Fiscal policy</li><li>Interaction of monetary and fiscal policy</li></ul>

Monetary and Fiscal Policy

<p>Monetary and Fiscal policies are the two economic policies employed by the government in an economy to control the aggregate demand.</p>



<p>Using the fiscal policy, the government controls their own expenditure and revenue collection in order to control the economy.</p>



<p>Using the monetary policy, the central bank of the country influences the money supply and interest rates in the economy to stimulate demand, control inflation, and stabilize currency.</p>



<p>The following video by Khan Academy explains the basic mechanics of monetary and fiscal policy.</p>



<figure class="wp-block-embed aligncenter is-type-video is-provider-youtube wp-block-embed-youtube wp-embed-aspect-16-9 wp-has-aspect-ratio"><div class="wp-block-embed__wrapper">
https://www.youtube.com/watch?v=ntxMOKXHlfo
</div></figure>

Mechanics of Monetary and Fiscal Policy

<p>Money as we know it has been around for a very long time. The currency notes and coins that we carry with us everyday are all forms of money.</p>



<p>In most simple terms, money can be defined as the medium of exchange. Anything that can serve as a medium of exchange can be called money.</p>



<p>Money has three important functions: it's a medium of exchange, it's a unit of account, and it's a store of value.</p>



<p><strong>Medium of Exchange:</strong> In olden period, people used to exchange goods and services directly for other goods and services. For example, someone who had wheat could exchange it with someone else who had, say, rice. In today's context, you could exchange a burger for a movie. This is called the barter system. The money in its current form (currency notes, and coins) is called fiat money.</p>



<p><strong>Unit of Account:</strong> Another important characteristic of money is that it's a unit of account. For example, if we do our calculations in terms of dollars, we know that a burger costs $2, while an ice cream costs $4. We can immediately draw the conclusion that one ice cream costs two burgers. This is the opportunity cost of buying one good over the other. However, if everyone quoted prices of their goods and services in terms of other goods and services,, life would become miserable. Having all prices listed in terms of dollars and cents makes our calculation much easier.</p>



<p><strong>Store of Value:</strong> The money is also a store of value because we can store it and exchange it for goods and services at anytime. We can carry money in our pocket and confidently go anywhere and exchange it for any goods or services. However, the value of money does change over time, for example, if inflation is high, the value of money falls. So, if you have a dollar, you can buy an apple today, or you can store this dollar for a few months. Now when you go to the market to buy apples, you may get only half an apple for one dollar.</p>



<p>Apart from these three, money acts as a measure or qualifies as a standard for a contract involving future payments, such as loan repayments.</p>



<h3><strong>Forms of Money</strong></h3>



<p>Since the beginning money has taken three forms:</p>



<p><strong>Commodity Money:</strong> Common examples are precious metals such as gold, silver and copper. This was a common form of money in ancient times. Even in the US, gold coins were used as money till 1933. The value of the money is equal to the value of material in it, for example, 10 grams of gold.</p>



<p><strong>Fiat Money: </strong>This the money declared by the government as legal tender. This is the current form of money in circulation today, i.e., notes and coins.</p>



<p><strong>Fiduciary Money: </strong>A modern example is the bank deposit. In this case, the bank promises the depositor to pay an equivalent value in the form of fiat money. People can use bank deposits to make payments in the form of checks and wire transfers.</p>

What is Money?

The process of money creation and the evolution of our current banking system are best explained using stories. One such popular story is the story of a goldsmith. Let's assume a goldsmith by the name Mark, operating from a small city.

Mark is the only goldsmith in his city, and has a strong vault where he stores his own gold and also other people’s gold. For safekeeping, people will come and deposit their gold with Mark, for which Mark will charge them a small fee. For record purpose, Mark will issue them a receipt, which they can come and produce anytime to Mark and take their gold back. Many people deposited their gold with Mark and held these receipts. As time passed, people started using these receipts for payment purposes or for paying their debt. For example, someone may buy food from a shop and pay using Mark’s receipt. The shopkeeper will then go to Mark and exchange the receipt for gold. The receipts were actually circulating as money. These receipts can be called bank loans.

One day Mark realized that on any given day only a small percentage of these receipts were cashed in for gold. This means that Mark could easily loan out a portion of the gold to people who need money without disturbing his daily gold needs. One day, Denis, a neighbor, came and asked him for a loan. Mark assessed his situation and the purpose of the loan, and after he was convinced, gave him a loan in the form of a receipt. Note that this is a loan because Mark did not take gold for him to issue the receipt. The receipt was given on the promise that Denis will come back and return the receipt after a few days along with a profit in the form of interest. &nbsp;This way Mark started lending out portions of deposits to earn interest. Mark was actually able to create money on the basis of trust. This is what became the foundation of the modern banking system, called “Fractional Reserve Banking.”

Let’s now look at how it works in the modern world.

In the fractional banking reserve banking system, the bankers will keep a percentage of deposits as reserve. Each country stipulates a minimum percentage that must be kept as reserve.

The rest of the money can be given as loans. When a borrower borrows money from a bank, he may spend it to buy something, and the seller who receives the money from the buyer/borrower may again deposit it in the bank. This money is again available with the bank to loan out (except the portion that must be kept as reserve). This process of lending, spending, deposits, and again lending can continue in cycles and finally the money loaned out will be a multiple of the original deposit amount.

Assume that a bank receives a deposit of $1,000, and it’s required to keep a reserve of 10% (reserve requirement). The bank will keep $100 in reserve and loan out $900. The borrower pays this money to someone and that person deposits this money back in the bank (the same or other bank). From this $900, the bank keeps $90 as reserve, and loans out $810.

As this process continues, using this initial deposit of $1,000, the bank will be able to expand this money to a total of $10,000 ($1,000 + $900 + $810 + $640 + … = $10,000).

The amount of money that can be created depends of the reserve requirement. The higher the reserve requirement, the less money can be created. For example, if the reserve requirement were 20%, the bank would have been able to expand the initial deposit of $1,000 only up to $5,000.

How much money can be created can be easily calculated using the concept of money multiplier, which is the reverse of the reserve requirement. For example, if the reserve requirement is 10%, then the money multiplier is 1/10%, or 10. So a cash deposit of $1000 can create money of 10 times that.

How is Money Created?

There are two official measures of money known as M1 and M2.

According to New York Fed:

“The money supply measures reflect the different degrees of liquidity—or spendability—that different types of money have. The narrowest measure, M1, is restricted to the most liquid forms of money; it consists of currency in the hands of the public; travelers checks; demand deposits, and other deposits against which checks can be written. M2 includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.”

These two forms of money are summarized in the below table:
<table class="mytable">
<tbody>
<tr>
<th scope="colspan"><strong>&nbsp;</strong></th>
<th scope="colspan"><strong>M1</strong></th>
<th scope="colspan"><strong>M2</strong></th>
</tr>
<tr>
<td valign="top" width="142">Currency and traveler's checks</td>
<td valign="top" width="142">Yes</td>
<td valign="top" width="142">Yes</td>
</tr>
<tr>
<td valign="top" width="142">Checking deposits</td>
<td valign="top" width="142">Yes</td>
<td valign="top" width="142">Yes</td>
</tr>
<tr>
<td valign="top" width="142">Time deposits</td>
<td valign="top" width="142">&nbsp;</td>
<td valign="top" width="142">Yes</td>
</tr>
<tr>
<td valign="top" width="142">Savings deposits</td>
<td valign="top" width="142">&nbsp;</td>
<td valign="top" width="142">Yes</td>
</tr>
<tr>
<td valign="top" width="142">Money market mutual funds and other deposits</td>
<td valign="top" width="142">&nbsp;</td>
<td valign="top" width="142">Yes</td>
</tr>
</tbody>
</table>
The European Central Bank has defined a narrow aggregate (M1), an "intermediate" aggregate (M2) and a broad aggregate (M3). These aggregates differ with regard to the degree of moneyness of the assets included. The following table summaries this:
<table class="mytable">
<thead>
<tr>
<th scope="colspan"></th>
<th scope="colspan">
<p align="center"><strong>M1</strong></p>
</th>
<th scope="colspan">
<p align="center"><strong>M2</strong></p>
</th>
<th scope="colspan">
<p align="center"><strong>M3</strong></p>
</th>
</tr>
</thead>
<tbody>
<tr>
<td valign="top" width="146">Currency in circulation</td>
<td valign="top" width="50">X</td>
<td valign="top" width="120">X</td>
<td valign="top" width="107">X</td>
</tr>
<tr>
<td valign="top" width="146">Overnight deposits</td>
<td valign="top" width="50">X</td>
<td valign="top" width="120">X</td>
<td valign="top" width="107">X</td>
</tr>
<tr>
<td valign="top" width="146">Deposits with an agreed maturity up to 2 years</td>
<td valign="top" width="50">&nbsp;</td>
<td valign="top" width="120">X</td>
<td valign="top" width="107">X</td>
</tr>
<tr>
<td valign="top" width="146">Deposits redeemable at a period of notice up to 3 months</td>
<td valign="top" width="50">&nbsp;</td>
<td valign="top" width="120">X</td>
<td valign="top" width="107">X</td>
</tr>
<tr>
<td valign="top" width="146">Repurchase agreements</td>
<td valign="top" width="50">&nbsp;</td>
<td valign="top" width="120">&nbsp;</td>
<td valign="top" width="107">X</td>
</tr>
<tr>
<td valign="top" width="146">Money market fund (MMF) shares/units</td>
<td valign="top" width="50">&nbsp;</td>
<td valign="top" width="120">&nbsp;</td>
<td valign="top" width="107">X</td>
</tr>
<tr>
<td valign="top" width="146">Debt securities up to 2 years</td>
<td valign="top" width="50">&nbsp;</td>
<td valign="top" width="120">&nbsp;</td>
<td valign="top" width="107">X</td>
</tr>
</tbody>
</table>
<strong>Quantity Theory of Money</strong>

The quantity theory of money states that the money supply has a direct relationship with the price levels.
<div class="formula1">If P is the price levels, and Q is the real output, then P*Q is the total spending. If M is the money supply, then:

M*V = P*Q

V is the velocity, that is, the number of times each unit of money is used to buy goods and services.

This equation is called the equation of exchange.

</div>
This equation helps us understand the relationship between money supply and price levels. Assume that the real output and velocity remains constant, a 10% increase in money supply will result in a 10% increase in average price levels. This is the reason why monetarists believe that monetary policy can be used to control inflation.

Official Measures of Money: M1 and M2

<h2>Demand of Money</h2>
The demand for money refers to the total amount of wealth held by the household and companies. The demand for money is affected by several factors such as income levels, interest rates, price levels (inflation), and uncertainty.

The impact of these factors on the demand for money is explained in terms of the three primary reasons to hold money. The three reasons are:

<strong>Transactions:</strong> This is the money needed for fulfilling transactions. As the total number and size of transactions increases in an economy, the transaction demand for money also increases.

<strong>Precautionary:</strong> This is the money needed for uncertain future needs, for example, unexpected medical expenses. The precautionary demand for money increases as the size of economy increases.

<strong>Speculative:</strong> People also hold money for speculative purposes so that they can take advantage of investment opportunities in the future. If the current returns on financial products are high, people will rather invest than hold money with a speculative motive. We can say that the demand for money for speculative motive increases with the increase in perceived risk in other financial instruments.

There is an inverse relationship between the short-term interest rates and the demand for money that households and firms want to hold. If the interest rates are low, the demand for money is high and if the interest rates are high, the demand for money is low. This is because as interest rates increase, the opportunity cost of holding money increases, and people will be better off by investing in other financial instruments than holding money.
<h2>Supply of Money</h2>
The supply of money in an economy is controlled by its central bank, for example, Fed in the US. The Fed may change the money supply by using open market operations or by changing reserve requirements.

<strong>Demand and Supply Curve</strong>

The demand and supply curve for money can be represented as follows:
<p style="text-align: center;"><img class="aligncenter  wp-image-7417" title="money-supply-demand" src="https://financetrain.com/wp-content/uploads/money-supply-demand.png" alt="" width="570" height="413"></p>
As you can see, the money supply curve is completely inelastic. The money demand curve is downward sloping, i.e., the demand for holding money increases with decrease in interest rates.

The short-term interest rate (i) is determined by the equilibrium of the supply and demand for money. If the interest rates are above the equilibrium, there is excess supply of money. This means the households and firms are holding more money and they will purchase securities to lower their money balances. This will lead to an increase in security prices and a drop in interest rates. Similarly, if interest rates are lower than the equilibrium rate, there is excess demand for money and people desire to hold money than they actually have. To do so, firms and households will sell securities, which will decrease the security prices and increase the interest rates.

The central bank can change the money supply, which will influence the interest rates. An increase in money supply will create excess supply, which will put a downward pressure on interest rates.

Demand and Supply of Money

Fisher effect is an important exchange rate model developed by Irving Fisher in 1930.

The Fisher effect provides the relationship between the nominal interest rates, inflation and real interest rates. According to Fisher effect, the nominal interest rate is the sum of real interest rate and expected inflation. It can be expressed as below:
<div class="formula1">[latex size="3" background="#f0f0f0"] R_{Nom}=R_{Real}+E[I] [/latex]

Where,

R<sub>Nom</sub> is the nominal interest rate

R<sub>Real</sub> is the real interest rate

E[I] is the expected inflation

</div>
It is important to understand the difference between the nominal and real interest rates. Nominal interest rates are what people see everyday as published by banks and other institutes. For example, when a bank says that you will earn 6% on savings deposits, they are talking about the nominal interest rate. On the other hand, real interest rates take purchasing power parity into consideration. That’s the rate, which tells how much more you will be able to buy with your grown investment after one year.

Assume a bank is offering you an interest rate of 5% on your deposits and the expected inflation is 3%, then the real interest rate you earn is just 2% keeping the inflation in mind. In terms of real value of money, your investment will grow only by 2%. If you deposit $100 at the beginning of the year, your deposit will grow to $105 by the end of the year. However your $105 will not buy you 5% more stuff. It will buy you only 2% more stuff. This is because due to inflation, all the stuff has become expensive by 3%.

The idea here is that the real interest rates are fairly stable and the changes in interest rates are influenced by changes in inflation.

Note that we are referring to expected inflation. The investors also face the risk that the actual inflation will be different from the expected inflation, and they demand an additional premium for this risk.
<div class="formula1">[latex&nbsp;size="3" background="#f0f0f0"] R_{Nom}=R_{Real}+E[I] +RP [/latex]

Where RP is the risk premium for uncertainty in inflation rate

</div>
An important point to note is that Fisher effect is a long-term phenomenon and may not be present in the short run.

Fisher Effect

<p>A central bank, also called a reserve bank, is an institution responsible for managing the currency, money supply and interest rates in a country. Central banks also supervise the banking system within a country. Some examples of central banks are Federal Reserve Board in the US, European Central Bank (ECB), People's Bank of China, and Reserve Bank of India (RBI).</p>



<p>In this article we will take a look at the roles and responsibilities, and goals of central banks.</p>



<h3>Roles and Responsibilities</h3>



<p>The central banks perform several key roles.</p>



<ol><li><strong>Implement monetary policy:</strong> The central bank is responsible for managing the monetary policy of the country. This involves controlling the quantity of money supplied in the economy through various actions such as managing interest rates, setting reserve requirements, etc.</li><li><strong>Supplier of currency:</strong> Central banks are the sole suppliers of currency in a country. Central banks create money by printing and issuing currency notes and selling them to public in exchange for debt instruments such as government bonds.</li><li><strong>Determine interest rates:</strong> A central bank controls the short-term interest rates, which in turn affects the stock markets, bond markets, and other financial markets.</li><li><strong>Manage the country's foreign exchange and gold reserves:</strong> The central banks are also the holders or safe keepers of the foreign exchange and gold reserves of the country.</li><li><strong>Banker for the Government and other banks:</strong> The central banks also act as the banker for the government and other banks. They also supply money to other banks with shortages, to avoid any runs on the banks. This way they keep the banking system from failing and act as the lender of last resort.</li><li><strong>Regulate and supervise the banking industry:</strong> The central banks regulate the banking system by imposing capital requirements, reserve requirements, and other regulations. They also manage a country's payment system to ensure smooth transactions.</li></ol>



<h3>Goals of Central Banks</h3>



<p>Central banks have several goals.</p>



<ul><li>Control inflation to ensure price stability</li><li>Stabilize exchange rates</li><li>Improve employment</li><li>Achieve sustainable economic growth</li><li>Moderate long-term interest rates</li></ul>



<p>Most countries try to achieve a target inflation rate of 2-3%. A 0% inflation rate is not desired as it increases the risk of deflation.</p>



<p>Some countries are not able to achieve their goals because of several factors. For example, Japan has had a persistent problem of deflation. India is currently facing a very high inflation rate of 7.2%.</p>



<p>Some developing countries peg their exchange rate of currencies to other countries, mostly the US dollar. This also pegs their inflation rate to the inflation rate of the country to which the exchange rate is pegged.</p>

What do Central Banks do?

<p>The central bank of a country employs several tools to implement the country's chosen monetary policy. This article discusses the three primary policy tools used by central banks.</p>



<h3>Open Market Operations</h3>



<p>Under its open market operations, the central bank engages in buying and selling government securities to increase or decrease the monetary base.</p>



<ul><li><strong>Open Market Purchases:</strong> The central bank buys government securities to increase the monetary base.</li><li><strong>Open Market Sales:</strong> The central bank sells government securities to decrease the monetary base.</li></ul>



<p>In the US, open market operations are the most important tool used by the Fed, under which it buys and sells US government securities, especially the US Treasury bills. These trades are executed at the Open Market Desk of Federal Reserve Bank of New York.</p>



<p>Such open market operations permanently affect the monetary base in the country. However, sometimes there may be a need to change the monetary base only temporarily. In such case, the following types of transactions are used.</p>



<ul><li><strong>Repurchase Agreements (Repos):</strong> Under repo transactions, the central bank (Fed in US) purchases securities with a promise that the seller will repurchase them on a specific date at a specific price. The time period is usually two weeks. A repo temporarily increases the money base.</li><li><strong>Reverse Repos:</strong> This is the reverse of a repo, where the central bank (Fed in US) sells securities with a promise that the buyer will sell them back on a specific date at a specific price. A reverse repo temporarily decreases the money base.</li></ul>



<p>Open market operations have several advantages such as, it is in direct control of the central bank, can be conducted quickly, in any size they want, and are easily reversible.</p>



<h3>Discount Rates</h3>



<p>When banks have temporary shortage of funds, they borrow funds from the central bank. Such a loan is called a discount loan and the bank is said to have received a loan at the "discount window".</p>



<p>The central bank (Fed in US) can change these discount rates to influence the volume of these discount loans. An increase in the discount rate makes these loans less attractive and the volume decreases, and vice verse.</p>



<p>These discount loans have the advantage that they allow the central bank to become the lender of last resort during financial crisis. However, they also have the disadvantage that it's not in full control of the central bank. Even if the rates are increased, the central bank cannot be sure of how much discount loans will be demanded.</p>



<p>In the US, this is called the discount rate, while in Europe the ECB called it refinancing rate. This rate should not be confused with the Fed Fund rate, which is the rate at which the banks lend to each other.</p>



<h3>Changes in Reserve Requirements</h3>



<p>The central bank can also change the required reserve ratio, which will change the money supply in the economy. An increase in reserve requirement decreases the funds available for lending, which tends to increase the interest rates. Similarly, a decrease in reserve requirements leads to an increase in funds available for lending, which tends to decrease interest rates.</p>



<p>A disadvantage with this method is that if reserve ratio is increased, the banks may not have enough funds in reserve and will have to borrow, sell securities or reduce loans to increase their reserves. This can be costly and disruptive.</p>



<p>Among these three methods, the open market operations are considered the best monetary policy tool.</p>

Tools for Implementing Monetary Policy

<p>The central bank of a country has the core function of managing the monetary policy of the country. They have the challenge of controlling inflation and maintaining price stability. In order to be effective in their core functions, central banks need to have three essential qualities:</p>



<h3>Independence</h3>



<p>In order to be effective, a central bank must be able to operate independently, and should specially be free from any political influence.</p>



<p>Political parties and central banks may sometimes have opposing goals. For example, if inflation is high, the central banks will want to curb it by reducing the money supply. This can decrease economic growth and may also affect employment. However, politicians may want to boost economic activity and increase employment. If these politicians can influence the central bank, then it will fail in effectively curbing inflation.</p>



<p>Independence should be both operational independence and target independence. Operational independence means the central bank can independently determine the policy rate. Target independence means the central bank can independently set the target inflation rates, time period to achieve it, etc.</p>



<h3>Credibility</h3>



<p>The second important feature is credibility. People of the country should believe the measures taken by the central bank. To do so, the central banks should also follow their own stated goals.</p>



<h3>Transparency</h3>



<p>Transparency also helps the central bank in gaining credibility. Transparency means that the central bank periodically discloses the economic environment by publishing reports with important statistics. In the reports, the effective central banks also provide their views on the economic indicators used in setting their monetary policy and how they will be used.</p>

Features of Effective Central Banks

Since the central banks can directly influence the short-term rates (discount rates), it affects the economic growth and inflation through transmission mechanism. The transmission mechanism is illustrated below:
<p style="text-align: center;">&nbsp;<img class="aligncenter  wp-image-7451" title="transmission" src="https://financetrain.com/wp-content/uploads/transmission.png" alt="" width="668" height="418"></p>
The process begins with the transmission of open market operations to market interest rates, either through the reserves market or through the supply and demand for money more broadly. From there, transmission may proceed through any of several channels.

<strong>Interest Rate Channel</strong>

The interest rate channel is the primary mechanism at work in conventional macroeconomic models. The basic idea is straightforward: given some degree of price stickiness, an increase in nominal interest rates, for example, translates into an increase in the real rate of interest and the user cost of capital. These changes in turn lead to a postponement in consumption or a reduction in investment spending. This leads to a decrease in aggregate demand, which decreases inflation, employment, and real GDP.

<strong>Wealth Channel</strong>

An alternative path is the wealth channel, in which households’ wealth is a key determinant of consumption spending. The connection to monetary policy comes via the link between interest rates and asset prices: a policy-induced interest rate increase reduces the value of long-lived assets (stocks, bonds, and real estate), shrinking households’ resources and leading to a fall in consumption.

<strong>Broad Credit Channel</strong>

In the broad credit channel, asset prices play an important role as they determine the value of the collateral that firms and consumers may present when obtaining a loan. In “frictionless” credit markets, a fall in the value of borrowers’ collateral will not affect investment decisions; but in the presence of information or agency costs, declining collateral values will increase the premium borrowers must pay for external finance, which in turn will reduce consumption and investment. Thus, the impact of policy-induced changes in interest rates may be magnified through this “financial accelerator” effect.

<strong>Narrow Credit Channel</strong>

Under this channel, the essential insight is that because banks rely on reservable demand deposits as an important source of funds, contractionary monetary policy, by reducing the aggregate volume of bank reserves, will reduce the availability of bank loans. Because a significant subset of firms and households relies heavily or exclusively on bank financing, a reduction in loan supply will depress aggregate spending.

<strong>Exchange Rate Channel</strong>

The exchange rate channel is an important element in conventional open-economy macroeconomic models, although it is often neglected in the closed-economy models typically applied to the United States. The chain of transmission here runs from interest rates to the exchange rate via the uncovered interest rate parity condition relating interest rate differentials to expected exchange rate movements. Thus, an increase in the domestic interest rate, relative to foreign rates, would lead to a stronger currency and a reduction both in net exports and in the overall level of aggregate demand.

<strong>Monetarist Channel</strong>

The monetarist channel focuses on the direct effect of changes in the relative quantities of assets, rather than interest rates.

The logic here is that because various assets are imperfect substitutes in investors’ portfolios, changes in the composition of outstanding assets brought about by monetary policy will lead to relative price changes, which in turn can have real effects. According to this view, interest rates play no special role other than as one of many relative asset prices. Although this mechanism is not part of the current generation of New Keynesian macro models, it is central to discussions of the likely effects of policy when, as in the case of Japan, there is a binding zero lower bound on nominal interest.

<em>This article is created with references taken from New York Fed website.</em>

The Monetary Policy Transmission Mechanism

The central bank of a country can adopt an expansionary or contractionary monetary policy. An expansionary monetary policy is focused on expanding, or increasing, the money supply in an economy. On the other hand, a contractionary monetary policy is focused on decreasing the money supply in the economy. The central bank uses its monetary policy tools to increase or decrease the money supply.

So, how does one determine whether a monetary policy is expansionary or contractionary? To do so, we need to understand the economy's real trend rate and the neutral interest rates.

The real trend rate, also called just the trend rate, is the long-term sustainable real growth rate for an economy. This is the rate an economy can maintain without inflationary pressures. This rate is not directly observed and needs to be estimated. The rate also changes as the economic conditions change. For example, if an economy was consumption oriented backed by debt for a few years, and then the focus shifts towards reducing debt and increasing savings, the trend rate will reduce.

The neutral interest rate is the growth rate at which the growth rate of the money supply remains constant. This implies that the real GDP is growing at the trend rate and the inflation is stable.
<div class="formula1">Neutral interest rate = Real trend rate + Inflation target</div>
We can compare the discount rate (policy rate) with the neutral interest rate. If the discount rate is above the neutral interest rate, we can say that the monetary policy is contractionary, and vice verse. This means that the central bank is trying the decrease the money supply.

The adjustment to monetary policy usually reflects the source of inflation. If the inflation is above target because of increase in aggregate demand, contractionary policy is suitable. However, if inflation is high because of supply shocks, then a contractionary monetary policy is not suitable.

Expansionary vs. Contractionary Monetary Policy

We learned about the <a title="Tools for Implementing Monetary Policy" href="https://financetrain.com/tools-for-implementing-monetary-policy/">monetary policy</a>, the <a title="The Monetary Policy Transmission Mechanism" href="https://financetrain.com/the-monetary-policy-transmission-mechanism/">transmission mechanism</a> and how monetary policy can be use to control inflation and bring price stability. However, monetary policies have several limitations and may not always work as intended. One reason is that the monetary policy is not the only thing affecting output, employment and prices. There are many other factors affecting the aggregate demand and supply and therefore the economic positions of households and firms. Below are a few examples explaining how monetary policy decisions can go wrong.

<strong>Example 1</strong>

Assume that the government is reducing money supply with the intention of reducing inflation. If people believe that, they will expect lower future inflation. However, the long-term rates carry a premium for inflation. For this reason, the long-term rates can actually fall, stimulating the economy, even though the central banks increased short-term rates, which was expected to slow down economy. Similarly, an increase in money supply can increase the long-term rates, even as the short-term rates fall.

<strong>Example 2</strong>

Another example is a liquidity trap. According to New York Fed, a liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. In this case, many argue, increasing money in circulation has no effect on either output or prices. The liquidity trap is originally a Keynesian idea and was contrasted with the quantity theory of money, which maintains that prices and output are, roughly speaking, proportional to the money supply. According to the Keynesian theory, money supply has its effects on prices and output through the nominal interest rate. Increasing money supply reduces the interest rate through a money demand equation. However, this theory is defied in case of a liquidity trap.

<strong>Example 3</strong>

The third example is the case of deflation, which is much more difficult to control compared to inflation. If a country is facing deflation, the best a central bank can do is to reduce its policy rate to zero. It cannot stimulate the economy beyond this.

<strong>Example 4</strong>

Another example is a situation where the banks decrease their lending even if the money supply is increasing, they have excess reserves and short-term rates are falling. This could be because of prevailing business conditions or other factors, such as recent losses suffered by them.

In reality, monetary policy makers do not have up-to-date information on the state of the economy and prices. Although policymakers will be able to offset the effects of demand shocks on the economy, it takes time for shocks to be fully recognized. And it can take even longer time to counter these shocks. Along with this we have to deal with the uncertainty about how the economy will respond to an expansionary and contractionary policy. All of this can easily set the economy and prices on the wrong path.

Limitations of Monetary Policy

Fiscal policy is the use of government revenue (taxes) and expenditure (spending) to influence the economy, and meet the macroeconomic goals.

The government's revenue and expenditure form its budget. If the revenue collection in the form of taxes equals its expenditure, it's a balanced budget. If revenue exceeds expenditure, the government has a budget surplus. On the other hand, if expenditure exceeds revenue, it's a budget deficit.

A government follows a neutral fiscal policy when the economy is in equilibrium. In such a case, the government's expenditure is fully funded by the tax revenue. A government follows expansionary fiscal policy during times of recession. It may reduce taxes or increase expenditure in order to stimulate the economy - to increase demand, growth and employment.&nbsp; The government may follow contractionary fiscal policy to reduce fiscal deficit or pay down government debt. To do so, it may increase taxes or decrease expenditure, which will decrease demand, growth and employment.

Fiscal policy is based on Keynesian economics, which believes that the government can influence the macroeconomic productivity levels by changing the taxes and spending. Such influence can curb inflation, increase employment rate, and stabilize the value of money. Monetarists, however, believe that the effects of fiscal policy are only temporary, and they advocate use of monetary policy to control inflation.

Fiscal policy can be discretionary or nondiscretionary (automatic stabilizers). A discretionary fiscal policy refers to the deliberate changes in government spending and taxes in order to stabilize the economy; for example, the government decides to increase its capital expenditure on road infrastructure. On the other hand, automatic stabilizers are the automatic changes in the tax and spending levels because of the changes in economic conditions. They help stabilize business cycles. For example, when the economy is expanding, the tax revenue increases, and vice verse. There will also be lower government spending in the form of unemployment benefits. Economists have observed that automatic stabilizers can reduce the volatility of the economic cycle by up to 20%.

Role of Fiscal Policy

The government has two primary fiscal tools to influence the economy. They are revenue tools and spending tools. Let’s look at each of these tools.

<strong>Revenue tools</strong>

Revenue tools refer to the taxes collected by the government in various forms. The taxes can be direct or indirect. Direct taxes are taxes levied on the income or wealth individuals and firms. This includes income tax, wealth tax, estate tax, corporate tax, capital gains tax, social security tax, etc.

Indirect taxes are taxes levied on goods and services. This includes sales tax, value added tax, excise duty, etc.

<strong>Spending Tools</strong>

Spending tools refer to increasing or decreasing government spending/expenditure to influence the economy. Government spending can be in the form of transfer payments, current spending and capital spending.

Current spending includes expenditure on essential goods and services such as health, education, defense, etc.

Capital spending is the public investment in infrastructure such as roads, hospitals, schools, etc.

The above two also include subsidy or direct provision of merit goods and public goods, which would otherwise be underprovided.

Transfer payments are the redistribution of income from taxpayers to those requiring support, for example, unemployment benefits. It also includes interest payments on government debt.

Fiscal policy tools have several advantages.

Spending tools enable services such as defense to benefit everyone in the country and build infrastructure that propels growth. Spending tools also ensure a minimum standard of living for the residents. Subsidies in research and development also help in future economic growth.

Taxes help government in meeting their fiscal needs. By levying high indirect taxes, the government can also discourage use of items such as tobacco, and alcohol.

Tools of Fiscal Policy

<strong>Fiscal Multiplier</strong>

As a part of its expansionary fiscal policy, when the government of a country decides to increase spending, it has a multiplier effect on the aggregate demand, i.e., the aggregate demand increases much more than the actual increase in spending.

The actual increase in the aggregate demand depends on the tax rate (again set by the government), and the marginal propensity to consume (MCP), i.e., how much will the consumption increase with an increase in disposable income.

Let’s take a simple example to understand this multiplier effect. Assume that the government increases its spending by $100. Assume that the tax rate and MCP for those who receive this money is 30% and 90%. So, a $100 increase in government spending increases income by $100*(1-0.30) = $70. From this disposable income of $70, people will spend $70 *0.90 = $63. This $63 will become income for other people, and their disposable income will be $63*(1-0.30) = $44.1, out of which they will spend $44.1*0.90 =&nbsp; $39.69. This process will continue till the additionally created disposable income becomes close to zero.

The actual increase in aggregate demand due to increased spending can be calculated using the fiscal multiplier.

Fiscal Multiplier = 1/(1-MCP(1-t))

Where, t is the tax rate.

With t = 30% and MCP = 90%, the Fiscal multiplier will be:

Fiscal multiplier = 1/(1-0.90*(1-0.30)) = 2.7

With a fiscal multiplier of 2.7, a $100 increase in spending will increase the aggregate demand by $270.

As you can see, fiscal multiplier is directly related to MCP and inversely related to the tax rate.

<strong>Balanced Budget Multiplier</strong>

When the government increases spending, it may also want to increase taxes to balance its budget. If the spending is increased by $100, then it may also increase the taxes by $100 to offset the increase in spending. However, even the taxes have a multiplier effect on the aggregate demand. With an MCP of 90%, when the taxes are increased by $100, the aggregate demand will initially reduce by $100*0.90 = $90. This again will have multiple iterations, and the total decrease in aggregate demand will be $100*0.9*2.7 = $243.

So, a $100 increase in spending and taxes each will have a net effect of increase in aggregate demand by $27 ($270 - $243). This means that the balanced budget multiplier is positive. The government can increase the taxes a little more to make the net increase in aggregate demand zero.

Fiscal Multiplier and Balanced Budget Multiplier

The Ricardian equivalence is a proposition named after the economist David Ricardo. The key idea behind Ricardian equivalence is that the choice of financing the current deficit by the government (increase in tax, or spending with debt) is irrelevant. This is because effect of this choice on aggregate demand is the same.

Let's explore this idea in detail. When the government has a deficit, it has two choices to raise money: increase tax, or issue bonds. The second option of using debt is also related to the first option, because the bonds represent debt that needs to be repaid in the future. To repay the debt, the government is likely to raise taxes. So, the real choice is whether to increase taxes now or in the future.

Assume that the government issues debt to finance its extra spending, that is, it has chosen to increase taxes later. The tax payers will now expect that they will have to pay higher taxes in the future. To offset this additional future cost, they will reduce their consumption and increase saving. Therefore, the effect on the aggregate demand will be the same, as if the government had chosen to increase taxes now.

Ricardian equivalence depends on how well the taxpayers are able to predict their future increase in liability.

Ricardian Equivalence

The government has <a title="Tools of Fiscal Policy" href="https://financetrain.com/tools-of-fiscal-policy/">two tools to implement its fiscal policy</a>, namely, taxes and government spending. If the economy is in recession, the government may decide to increase aggregate demand, or decrease taxes to stimulate the economy and increase aggregate demand. Similarly, if the economy is facing inflationary economic boom, it may decrease spending or increase taxes.

When the government takes specific actions to influence aggregate demand, it’s called the discretionary fiscal policy.

The discretionary fiscal policy does not always work as intended by the government. There are many reasons as to why the fiscal policy may not be as effective as desired, or sometimes even be counterproductive. Some of these reasons are discussed below:
<ol>
 	<li>If the government relies on inaccurate statistics, then it’s likely to make wrong policy decisions in the first place.</li>
 	<li>There could be a lag in implementing a policy decision, and/or the impact of a policy decision. For example, by the time the policymakers recognize the problem and take decision to do something, it may already be too late (Recognition lag and action lag). Once the government implements a policy, there may be a time lag till the policy has an impact on the economy (impact lag).</li>
 	<li>&nbsp;An expansionary fiscal policy may end up decreasing aggregate demand because of crowding-out effect. &nbsp;Increased government borrowing leads to an increase in interest rates, which leads to a decrease in aggregate demand.</li>
 	<li>The economy may be slow because of shortage of resources rather than lower demand. In this case, fiscal policy will not help (it may actually increase inflation).</li>
 	<li>Since expansionary fiscal policy increases fiscal deficit, there is constraint over how much deficit the government can tolerate.</li>
 	<li>While fiscal policy solves one problem, it may aggravate another problem.</li>
</ol>
&nbsp;

Challenges in Implementing Fiscal Policy

A government’s fiscal policy involves increasing/decreasing spending and taxes to control the economy. The governments fiscal actions are reflected in the fiscal budget.

When the taxes collected are more than the spending, there’s a budget surplus. Similarly when spending exceeds tax collection, there’s a budget deficit.

Whether the fiscal policy is expansionary or contractionary can be gauged by whether there is budget surplus or budget deficit. The basic rules are given below:
<ul>
 	<li>Increase in surplus indicates contractionary fiscal policy</li>
 	<li>Decrease in surplus indicates expansionary fiscal policy</li>
 	<li>Increase in deficit indicates expansionary fiscal policy</li>
 	<li>Decrease in deficit indicates expansionary fiscal policy</li>
</ul>
An increase in surplus indicates that the increase in tax revenue is more than the increase in spending, which indicates contraction.

Even though the fiscal deficit provides some indication about the direction of fiscal policy, it may not indicate the true intention of the government with respect to its fiscal policy. For example, if the government is in recession, and its taking actions to expand the economy, the government is aiming for an expansionary policy. However, the current economic conditions may not truly reflect that. Therefore, to understand the true impact of the fiscal policy, the economists adjust the budget for cyclical issues.

&nbsp;

Expansionary Vs. Contractionary Fiscal Policy

Fiscal policy is implemented by the government and the monetary policy is decided by the central bank of the country. Both the policies can be expansionary or contractionary. In this article, we will take a look at the combined effects of monetary and fiscal policy on the economy in different scenarios:

<strong>Expansionary Fiscal Policy plus Expansionary Monetary Policy</strong>
<ul>
 	<li>Economy will highly expand.</li>
 	<li>Interest rates will be low.</li>
</ul>
<strong>Contractionary Fiscal Policy plus Contractionary Monetary Policy</strong>
<ul>
 	<li>Economy will contract.</li>
 	<li>Interest rates will be high.</li>
</ul>
<strong>Expansionary Fiscal Policy plus Contractionary Monetary Policy</strong>

This happens during a negative supply shock, i.e., a sudden decrease in supply. The government will follow expansionary policy to increase output, and monetary authorities will follow contractionary policy to reduce inflation, that was induced by shortage of output.
<ul>
 	<li>Aggregate demand will be higher (fiscal policy)</li>
 	<li>Interest rate will be higher (monetary policy)</li>
</ul>
<strong>Contractionary Fiscal Policy plus Expansionary Monetary Policy</strong>
<ul>
 	<li>Interest rates will fall</li>
 	<li>Consumption and output will increase</li>
</ul>
The following table summarizes the effects of Monetary and Fiscal policy.
<table class="mytable" width="535">
<tbody>
<tr style="border-tio:1px solid #C1DAD7;">
<td valign="top" width="150"></td>
<td valign="top" width="113"><strong> Shift of <em>IS</em></strong></td>
<td valign="top" width="76"><strong>Shift of <em>LM</em></strong></td>
<td valign="top" width="126"><strong>Movement </strong>
<strong> in Output</strong></td>
<td valign="top" width="69"><strong>Movement in Interest Rate</strong></td>
</tr>
<tr>
<td valign="top" width="150"><strong>Increase in taxes</strong></td>
<td valign="top" width="113">Left</td>
<td valign="top" width="76">None</td>
<td valign="top" width="126">Down</td>
<td valign="top" width="69">Down</td>
</tr>
<tr>
<td valign="top" width="150"><strong>Decrease in taxes</strong></td>
<td valign="top" width="113">Right</td>
<td valign="top" width="76">None</td>
<td valign="top" width="126">Up</td>
<td valign="top" width="69">Up</td>
</tr>
<tr>
<td valign="top" width="150"><strong>Increase in spending</strong></td>
<td valign="top" width="113">Right</td>
<td valign="top" width="76">None</td>
<td valign="top" width="126">Up</td>
<td valign="top" width="69">Up</td>
</tr>
<tr>
<td valign="top" width="150"><strong>Decrease in spending</strong></td>
<td valign="top" width="113">Left</td>
<td valign="top" width="76">None</td>
<td valign="top" width="126">Down</td>
<td valign="top" width="69">Down</td>
</tr>
<tr>
<td valign="top" width="150"><strong>Increase in money</strong></td>
<td valign="top" width="113">None</td>
<td valign="top" width="76">Down</td>
<td valign="top" width="126">Up</td>
<td valign="top" width="69">Down</td>
</tr>
<tr>
<td valign="top" width="150"><strong>Decrease in money</strong></td>
<td valign="top" width="113">None</td>
<td valign="top" width="76">Up</td>
<td valign="top" width="126">Down</td>
<td valign="top" width="69">Up</td>
</tr>
</tbody>
</table>
&nbsp;

Combined Effects of Monetary and Fiscal Policy

This quiz is a part of the CFA Level 1 study session 'Monetary and Fiscal Policy'. 

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