2. Content
I. Introduction : Market Failure & Role of Government
II. Overview of Economic Policy
Microeconomic Policies
Macroeconomic Policies
III. Stabilization Policies
Monetary Policy
Fiscal Policy
IV. Impact of Economic Policy on Economic Performance
V. Economic Policy Management
Monetary Policy Strategies
Fiscal Policy Management
Exchange Rate Management
• Group Works (Discussion) 2
4. Government intervention is recommended only if
likely government failure to intervene perfectly is less
than the market failure under assessment.
4
5. 1. Monopoly or Monopsony Power
Monopoly
• A monopoly is the market structure that exist when there is
imperfect competition and when a single company or seller
produces a unique goods/product with no close substitute.
5
7. Monopsony
• A monopsony is a market condition in which there is only one buyer, the
monopsonist.
• A single buyer dominates a monopsonized market while an individual
seller controls a monopolized market.
7
Monopsony Power in the Labor Market
Amazon's monopsony power reveals
itself is through Amazon's labour market
activity. Amazon has around 798,000
employees in the US alone.
8. 8
Externality
Positive
Negative
Production
Consumption
Production
Consumption
Being vaccinated against contagious
diseases protects not only you, but people
who visit the salad bar or produce section
after you. R&D creates knowledge others
can use. People going to school raise the
population’s education level, which reduces
crime and improves government.
Air pollution from a factory. The neighbor’s
barking dog. Late-night stereo blasting from
the dorm room next to yours. Noise pollution
from construction projects. Health risk to
others from second-hand smoke. Talking on
cell phone while driving makes the roads less
safe for others.
2. Externalities
9. • An externality is a cost or benefit caused by a
producer that is not financially incurred or received
by that producer. The costs and benefits can be both
private (an individual or an organization) or social
(meaning it can affect society as a whole).
If one person’s TB is treated and cured, others are not
infected. If vaccination is received by the majority, the
unvaccinated minority may also be protected. The
beekeeper gets a good source of nectar to help make
more honey.
Air pollution, water pollution, soil pollution & noise
pollution result in a cost to a third party.
9
13. Positive externality in production and consumption
13
Production: Government grants and subsidies to producers of
goods and services that generate external benefits will reduce
costs of production, and encourage more supply.
Consumption: Subsidy reduces the price of the good and
should encourage more consumption.
15. The effect of a Tax
15
P
Q
D
S
PS
PB
QE
QT
A
B C
D E
F
CS = A
PS = F
Tax revenue
= B + D
Total surplus
= A + B
+ D + F
Deadweight loss
C + E
16. 16
If negative externality
market quantity larger than socially desirable
If positive externality
market quantity smaller than socially desirable
Role of Government to remedy the problem,
“internalize the externality”
The government taxes the goods with negative externalities
The government subsidizes the goods with positive externalities
Effects of Externalities: Summary
External Cost
External Benefit
19. Traditional roles: Legislation (law making), Execution
(law implementation), Jurisdiction (law enforcing).
Economic roles: Increasing Efficiency, Promoting Equity,
Fostering Economic Stability and Growth.
Irreducible minimum roles: to keep the peace, enforce
the laws, and assure a stable environment.
Every country has been rethinking of the extent,
direction, and exercise of the role of the state. (due to
globalization, end of Cold War, ICT revolution)
What and how should the government do?
- Direct provision and Indirect involvement (Regulation).
Role of Government
19
27. 4. Information Asymmetries
• How does asymmetric information cause market failure?
Asymmetric information causes an imbalance of power.
A lack of equal information causes economic imbalances
that result in adverse selection and moral hazards.
All of these economic weaknesses have the potential to lead
to market failure.
27
31. II. Overview of Economic Policy
Microeconomic Policies
Macroeconomic Policies
31
32. What is Economic Policy?
32
Note: The foreign trade policy (FTP) also known as EXIM (export-import) policy
33. •What is Economics?
• Economics is a social science concerned with the production,
distribution, and consumption of goods and services. It studies how
individuals, businesses, governments, and nations make choices
about how to allocate resources.
33
34. • What is Microeconomics?
Microeconomics is a branch of economics that studies the
behavior of individuals and firms in making decisions
regarding the allocation of scarce resources and the
interactions among these individuals and firms.
The objective of microeconomics is to analyze how
individual decision-makers, both consumers and
producers, behave in a variety of economic environments.
The key microeconomic goals are the efficient use of
resources that are employed and the efficient distribution
of output. (‘Efficiency' means society gets the most from
its scare resources and ‘Equity‘ means the benefits of scare
resources are distributed fairly in society)
34
35. Microeconomic Policies
• What is meant by microeconomic policy?
Microeconomic policy is action taken by government
to improve resource allocation between firms and
industries in order to maximize output from scarce
resources.
These policies have been discussed in Introduction. 35
36. •What is Macroeconomics?
Macroeconomics is a branch of economics dealing with
performance, structure, behavior, and decision-making
of an economy as a whole.
• Macroeconomic policy is central to the government's
long term policy of reducing constraints on growth such
as inflation while improving long -term growth.
• The objective of macroeconomic policies is to maximize
the level of national income, providing economic growth
to raise the utility and standard of living of participants in
the economy.
• The three main types of government macroeconomic
policies are demand-side policies (fiscal policy, monetary
policy) and supply-side policies.
36
38. Supply-side policies
• Supply-side policies are government attempts to increase
productivity and increase efficiency in the economy. If
successful, they will shift aggregate supply (AS) to the right
and enable higher economic growth in the long-run.
• Supply-side policies include a range of policies designed to
reduce costs, improve efficiency, productivity, and
international competitiveness so that the economy can
grow without experiencing inflation.
• There are two main types of supply-side policies.
Free-market supply-side policies involve policies to
increase competitiveness and free-market efficiency. For
example, privatization, deregulation, lower income tax rates,
and reduced power of trade unions.
38
39. 39
Interventionist supply-side policies involve government
intervention to overcome market failure. For example, higher
government spending on transport, education and
communication.
42. OBJECTIVES INSTRUMENTS
1. Output: 1. Fiscal policy:
High level of output Government expenditure
Rapid growth rate Taxation
2. Employment 2. Monetary policy
High level of Employment Control of money supply
Low involuntary Unemployment Control of interest rates
3. Price stability 3. Incomes policies:
4. External balance 4. International economics
Trade Balance Trade policies
Exchange-rate Stability Exchange-rate intervention
Policy Objectives & Instruments
44
43. Economic policy is a government’s plan on how to conduct economic
operations in accordance with the demands of current national and
global economic conditions. It delineates the parameters and factors to
consider when deciding for taxation, spending, budgeting, money
supply, and interest rate levels.
These economic operations are divided into two main categories (or)
two stabilization policies:
Fiscal Policy: taxation, spending, and budgeting
Monetary Policy: money supply and interest rates
Together, fiscal and monetary policies help the government to monitor
and adapt the nation’s economy and money supply. Fiscal Policy is
managed by relevant governmental departments, while the monetary
policy is managed by the country’s central bank. They are designed as
guides to achieve the national economic goals such as optimum rates of
inflation (2-3%), growth (2-3%), and (4-5%).
45
44. Fiscal and Monetary Policies: expansion/contraction in times of
unemployment (recession)/ inflation
Requirements of Monetary Policy (developed countries)
1.An independent central banking authority
2.Well organized financial market with banks and saving and loan
institutions
3.Strong link between interest rate and investment demand
4.A floating exchange rate
In LDCs: financial markets & institutions are highly unorganized, often
externally dependent, and spatially fragmented.
Because of weak CB independency; financial dualism (organized &
unorganized); structural inflation; currency substitution problem
(dollarization), most LDCs have had to rely primarily on fiscal policy to
stabilize the economy and to mobilize domestic resources.
Macroeconomic Stability
46
46. “Use of government budget to stabilize the economy”.
(Government Budget = G Revenue – G Expenditure)
In brief, B = G – T ; GDP = C + I + G +X - M
G Revenue = Direct & Indirect Taxes + others
G Expenditure = G purchases & Transfer payments
A Budget Surplus = (B = T – G > 0) Public Debt Repayment
A Budget Deficit = (B = T – G < 0) Public Sector Borrowing
The National Debt is the sum of deficits minus the sum of surpluses since
Independence. (or) The national debt is the accumulation of
the nation's annual budget deficits.
Fiscal Policy
48
47. “Control over Money Supply (MS) to stabilize the economy”.
In almost all countries, monetary policy is conducted by (a partially) independent
institution called central bank.
1. Base Money (M₀) = Currency in Circulation (CIC) + Reserves of the banks
2. Narrow Money (M₁) = M₀ + Demand deposits
3. Broad Money (M₂) = M₁ + Time deposits
4. (Near) Quasi Money = Liquid assets such as Certificates of Deposit (CDs) and
Treasury bills (T-bills)
MS can have both good and bad impacts on the economy.
Economy = Real sector + Money sector, must be in balance.
Money creation is essential for economic growth, but it should be monitored and
controlled so as not to outpace the capacity of the economy to satisfy the
increasing demands (C + I). 49
Monetary Policy
48. • Expansionary fiscal policy tools
include increasing government
spending, decreasing taxes, or
increasing government transfers.
• Doing any of these things will
increase aggregate demand, leading
to a higher output, higher
employment, and a higher price
level. These policies are intended to
increase aggregate demand while
contributing to budget deficits or
drawing down of budget surpluses.
• The goals of EFC are to reduce
unemployment, raise consumer
demand, to kick-start the economy
during a recession and stop the
recession.
50
49. • Contractionary fiscal policy
decreases the level of aggregate
demand, either through cuts in
government spending or
increases in taxes.
Contractionary fiscal policy is
most appropriate when an
economy is producing above its
potential GDP.
• Contractionary fiscal policy
occurs when the government
raises tax rates or cuts
government spending, shifting
aggregate demand to the left.
• The goal of contractionary fiscal
policy is to reduce inflation
(price level).
51
50. • Expansionary monetary policy
is a monetary policy that lowers
interest rates and stimulates
borrowing.
• Expansionary monetary policy is
when a central bank uses its tools
to stimulate the economy.
• That increases the money supply,
lowers interest rates, and
increases demand. It boosts
economic growth. It lowers the
value of the currency, thereby
decreasing the exchange rate.
• An expansionary monetary policy
is used to increase economic
growth, and generally decreases
unemployment but it may
increase inflation.
52
51. • Contractionary monetary
policy is a monetary policy that
raises interest rates and reduces
borrowing in the economy.
• It decreases the money supply
and consumer spending but may
rise unemployment.
• A central bank uses CMP tools to
fight inflation.
• The goal of a contractionary
policy is to reduce the money
supply within an economy by
decreasing bond prices and
increasing interest rates.
• So spending drops, prices drop
and inflation slows.
53
53. IV. Impact of Economic Policy on
Economic Performance
55
54. 56
Economic
Policy
Growth and well-being go together because of
a sustained increase in real GDP per capita.
The standard of
living, consumption
of food, clothing,
housing, education
and leisure
activities, feelings
of safety and
security, household
net wealth & so on
NX= X – M
trade surplus/
trade deficit
55. Impact of Demand Side Policy on Real GDP
57
when interest rates are low, the
economy grows, and inflation
increases.
when interest rates are high,
the economy slows, and inflation
decreases.
57. 59
GDP =
real wages high
during periods
of low inflation.
The decrease in value of one
currency in relation to another,
usually by action of the government.
When a currency is devalued, it buys
less in foreign markets.
59. 61
Impact of Expansionary Fiscal Policy
A situation when increased interest rates lead to a
reduction in private investment spending such that it
dampens the initial increase of total investment spending
is called crowding out effect.
If the government raises its spending and it requires to fund part
or all from the sector of finance, the move will increase the
demand for money. This, in turn, will lead to an increase in the
interest rates
61. 63
Expansionary Monetary Policy Contractionary Monetary Policy
Problem: Recession & Unemployment Problem: Inflation
Measure:
CB buys securities through OMOs
It reduces Cash Reserve Ratio (CRR)
It lowers bank rate
Measure:
CB sells securities through OMOs
It raises CRR & Statutory Liquidity Ratio(SLR)
It raises bank rate
Money supply increases Money supply decreases
Interest rate falls Interest rate raises
Investment increases Investment declines
Aggregate demand increases Aggregate demand declines
Aggregate output increases Price level falls
Impact of Monetary Policy
SLR is used to control the bank's leverage for credit expansion.
62. 64
Overview on Impact of Monetary Policy and Fiscal Policy
A liquidity trap is when monetary policy becomes ineffective due to very low interest rates combined
with consumers who prefer to save rather than invest in higher-yielding bonds or other investments.
63. Impact of Demand Side Policy and Supply Side Policy on
Reducing Unemployment
65
Demand Side Policy Supply Side Policy
Reduce
Unemployment
65. Monetary Policy Strategies
Three main objectives of monetary policy are controlling inflation,
managing employment levels, and maintaining long-term interest rates.
The Federal Reserve/Central Bank uses monetary policy to manage
economic growth, unemployment, and inflation.
It does this to influence production, prices, demand, and employment.
Expansionary monetary policy increases the growth of the economy, while
contractionary policy slows economic growth.
The Fed/Central Bank implements monetary policy through open market
operations, reserve requirements, discount rates, the federal funds rate,
and inflation targeting.
67
70. Policy Management
72
Investment + Import + Subsidies = Saving + Export + Taxes
Internal Balance
External Balance
Macroeconomics: Stable equilibrium of National
Income at full employment
Stable in foreign exchange market
Expenditure = Income
If Expenditure > Income, Inflation occur
If Expenditure < Income, Unemployment occur
Exchange rate Export price Import price AD Output
Interest rate MS Inflation Unemployment Income
If exchange rate , depreciation in domestic
currency in relation to foreign currency.
If exchange rate , appreciation in domestic
currency relation to foreign currency.
71. 73
Effect of Depreciation
Imports more expensive Exports cheaper
Decreased quantity of imports Increased quantity of exports
Current Account
Balance of payments improves
Exchange rate Currency Depreciation
Policy Management
73. Exchange Rate Management
• Exchange-rate management the use of official policies
to influence the exchange rate that emerges in the foreign-
exchange market
75
74. 76
A Floating Exchange Rate System
A floating or flexible exchange-rate system is a
monetary system that allows the exchange
rate to be determined by supply and demand.
75. 77
Fixed rate is the system where the
government decides the exchange rate
76. 78
A Managed Exchange Rate System
To avoid the volatility and
uncertainty that often
accompany a floating
exchange rate, some
governments and central
banks choose to manage or
peg their currency.
