Impacts of Fiscal andMonetary Policies onMacroeconomic Variablesof Sri LankaDouble the per capita income by 2016UWU/SCT/11/00442/22/2013Fiscal and monetary policies produce different effects on macroeconomic variables of srilankaneconomy. It is discussed the about the impacts of those policies and which policies are favorable todouble the per capita income of Sri Lanka by the year2016
Circular Flow of Four Sector EconomyA circular flow model of the macro economy containing four sectors(business,household, government and foreign)and three markets(product, factor andfinancial) that illustrates the continuous movement of the payments for goodsand services between producers and consumers, with particular emphasis onexports and imports.
During past several years Sri Lanka was able to maintain a strong growth. Thoughgrowth dropped to3.5% in 2009 during final military campaign now It is hasobtained a growth rate of 8.3% dramatically. Agricultural land in conflict affectedareas could once again be cultivated; double shifts in manufacturing becamepossible as workers no longer had to worry about security restrictions, servicesrelated to tourism also picked up as tourist arrival increased after the war. Furtherunder the vision “miracle of Asia” Srilankan government has the goal of doublingthe per capita income by the year 2016.
Fiscal and monetary policies produce different effects onmacroeconomic variables of Sri Lankan economy. The government plans todouble the per capita income by 2016 can be helped by those policies.Sevarelways of obtaining that goal can be explained through the following graphs.Aggregate demandAggregate supplyp2p1GDP1 GDP2Figure 1: By increasing the aggregate demand GDP can be doubled, when this isdone price levels go up.Aggregate demand Aggregate supplyP1P2GDP1 GDP2
Figure 2: By increasing the aggregate supply GDP can be doubled. When theexpected goal is achieved through increasing aggregate supply price level alsogoes down in this method. Therefore this method is better comparing to theincreasing the aggregate demand.Aggregate demand Aggregate supplyp1GDP1 GDP2Figure 3: Through this method a same price level can be maintained by changingboth. (Increasing aggregate supply and increasing aggregate demand)GDP=C+I+G+(X-M)On the left side is GDP the value of all final goods and services produced ineconomy. On the right side are the sources of aggregate spending or demand-private consumption(C),private investment(I),purchases of goods and services bythe government affect economic activity(GDP) controlling G directly andinfluencing C,I and (X-M) indirectly, through changes in taxes,transfers,andspending.
How Does Fiscal Policy Impacts onMacroeconomic Variables of the CountryThe economy can be impacted through two major types of economic policy.The first type is called fiscal policy. Mainly it is focused on taxation law andgovernment spending. The most immediate effect of fiscal policy is to change theaggregate demand for goods and services. If the government increases itspurchases but keeps taxes constant, it increases demand directly. Second if thegovernment cuts taxes or increase transfer payments, households’ disposableincome rises, and they will spend more on consumption. The rise in consumptionwill in turn raise the aggregate demand.By changing tax laws, the government can effectively modify the amountof disposable income available to its tax payers. For example if taxes were toincrease, consumers would have less disposable income and in turn would haveless money to spend on goods and services. This difference in disposable incomewould go to the government instead of going to consumers, who would pass themoney onto companies or the government could choose to increase governmentspending by directly purchasing goods and services from private companies. Itwould increase the flow of money through the economy and would eventuallyincrease the disposable income available to customers. Simply when the housesare having more money because of less taxation that money is spent in localmarket, to import or to save. Through this money is received to investors andwhen they also have to pay less taxes money can be spent more on economy.This is a better way since supply and demand both are influenced by a tax cut.When the government is maintained a deficit budget, it can have apositive macroeconomic effects in the long run if it is used to increase the stock ofnational assets. For example, spending on the transport infrastructure improvesthe supply capacity of the economy. And increased investment in health andeducation can bring positive effects on productivity and employment.
When the government is maintained a surplus budget the amount ofcollected taxes are higher and it stabilize the economy.On the other hand a fiscal expansion affects the output level in the longrun because it affects the country’s saving rate. The country’s total saving iscomposed of two parts: private saving (by individuals and corporations) andgovernment saving. When the spending is increased or taxes are lowered itdecreases the government saving. Lower saving means, that the country willeither invest less in new plants and equipment or increase the amount that itborrows from abroad. Lower invest will lead to a lower capital stock and totalreduction in a country’s ability to produce output in the future. Increasedindebtedness to foreigner’s means that a higher fraction of a country’s output willhave to be sent abroad in the future rather than being consumed at home.Thereby monetary policy is far more agile than fiscal policy.
How Does Monetary Policy Impacts onMacroeconomic Variables of the CountryThe second way the government can impact the economy is throughmonetary policy. Monetary policy is instigated by the central bank of a Sri Lankato control the supply of money within the economy. By impacting the effectivecost of money, the central bank can affect the amount of money that is spent byconsumers and business.Central bank influences the economy by influencing the money supplythrough adjustments to interest rates, bank reserve requirements, and thepurchase and sale of government securities and foreign exchange. A monetarypolicy decision that cuts interest rate, for example, lowers the cost of borrowing,resulting in higher investment activity and the purchase of consumer durables(cars, TV ...Etc.)Banks may also prompt to ease lending policy, with theexpectation of economic activity will strengthen. In turn this enables business andhouseholds to spend more money to economy. When a low interest rate ismaintained stocks become more attractive to buy, raising households’ financialassets. This may also contribute to higher consumer spending, and makescompanies’ investment projects more attractive. Low interest rates also tend tocause currency to depreciate because the demand for domestic goods rises whenimported goods become more expensive. The combination of these factors raisesoutput and employment as well as investment and consumer spending.