Monetary policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation's banks, its consumers, and its businesses.

1. FISCAL POLICY
June 13, 2022
DBA - PHIHUA

3. WHAT IS

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•Definition: manipulations by the government of its own
expenditures and taxes in order to influence the level of AD.
•Government receives revenues from income and business taxes, T.
•Government expenditures: G
• If G=T: balanced budget
•If G>T: budget deficit Gov needs to borrow
•If G<T: budget surplus
•Public/Government Debt is the gov’s accumulation of deficits
minus surpluses.
FISCAL POLICY

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•What’s it: Potential GDP refers to
the maximum output an
economy can produce using its
existing economic resources. It
represents an economy’s long-run
aggregate supply. At this level of
output, the economy will fully
utilize all its resources and work
full employment.
The Supply Side: Employment and Potential GDP

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•Potential GDP rises along with the
increased quantity quality and
improved quality of production
factors and technology. Its increase
does not result in inflationary
pressures in the economy.
Therefore, in a graph, it will form a
vertical line.
•Another term for potential GDP is
potential output, total output at full
capacity, long-run output, or output
at full employment.
The Supply Side: Employment and Potential GDP

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•The potential output is an
important indicator. It is useful
for measuring how much an
economy can produce goods and
services. By comparing real GDP
and potential output, you will
know whether production can
increase and how this will result
in inflationary pressures and
unemployment.
Why potential GDP matters?

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•As an alternative, the
government can also use fiscal
tools to close the output gap.
The government increases its
spending or cuts taxes. Higher
spending or lower taxes will
also increase aggregate
demand.
Why potential GDP matters?

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• Investment of the private sector to economic growth. This reciprocal causality comes
from investment were observed. Empirical evidence also reveals that private corporate
sector saving does not Granger cause economic growth. savings and investment in the
short run. The feed backs to GDP are absent in the long run
• The increase in saving raises investment and the quality of investment improves. The
Role of the Savings Rate in Growth Models This section presents a review of the role
played by saving rates in different growth models.
• Economic growth can be defined as the increase or improvement in the
inflation-adjusted market value of the goods and services produced by an economy over
a certain period of time. Statisticians conventionally measure such growth as the percent
rate of increase in the real gross domestic product, or real GDP.
The Supply Side: Investment, Saving and Economic Growth

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•Fiscal policy is a key tool of macroeconomic policy, and consists of
government spending and tax policy. When government expenditure on
goods and services increases, or tax revenue collection decreases, it is called
an expansionary or reflationary stance.
•Higher taxes or lower government expenditure is called contractionary
policy.
•The effects of fiscal policy can be revenue neutral, which means any change
in spending is balanced by an equal and opposite change in revenue
collection. Even with a revenue neutral fiscal policy stance, however, the
government has a powerful tool to affect both individuals and business by
the type of spending or tax policy changes it makes.
The Effects of Fiscal Policy

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•Expansionary policies may result in a government budget deficit, though not
always. If the economy is fairly healthy when spending increases, any budget
surplus will be reduced, but not necessarily eliminated. A contractionary
policy stance can result in budget surpluses, especially if the budget is
already balanced. The effect on the budget deficit in either case, however,
depends on the original budget as well as the magnitude and direction of
the change in fiscal policy.
•If payroll taxes and individual income tax rates are lowered, consumers will
have more income to spend on all types of goods and services, boosting
aggregate demand. If corporate tax rates are lowered, businesses are likely
to expand and hire more workers, expanding aggregate supply as more
goods are produced.
The Effects of Fiscal Policy

13. BUSINESS CYCLE
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•Expansion (Growth)
•Peak (Top)
•Contraction (Shrinking)
• Trough (Bottom
Phases of the Business Cycle

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•High demand for goods
•More jobs
•People are optimistic and spend money
•Businesses start
•More profits and higher stock value
•Higher wages
•Lower unemployment
Expansion

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•Economy stops growing
•GDP reaches its maximum
•Businesses stop hiring
•Cycle begins to contract (or shrink)
Peak

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•Businesses cut production and lay off workers
•Number of jobs declines
•Unemployment increases
•People are pessimistic and stop spending money
•Banks limit loans
Contraction

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•The Economy “bottoms-out” (reaching its lowest
point)
•High unemployment
•Stock prices drop
Trough

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•A prolonged contraction is called a recession
(contraction for over 6 months)
•A recession of more than one year is called a
depression
Recession/Depression

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• 4 variables cause changes in the Business Cycle:
• Business Investment When the economy is expanding, sales and profit keep rising, so
companies invest in new plants and equipment, creating new jobs and more expansion.
In contraction, the opposite is true
• Interest Rates and Credit Low interest rates, companies make new investments, adding
jobs. When interest rates climb, investment dries up and less job growth
• Consumer Expectations Forecasts of an expanding economy fuels more spending, while
fear of a recession decreases consumer spending
• External Shocks External Shocks, such as disruptions of the oil supply, wars, or natural
disasters greatly influence the output of the economy
• Ex. 1992-2000 was the longest period of expansion in U.S. history. Early in 2001, signs of contraction
appeared, though the Bush administration denied it. The Sept. 11th 2001 terrorist attacks quickly
caused the business cycle to shift into a contraction.
What keeps the Business Cycle Going?

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•Monetary policy is the policy adopted by the monetary authority of a nation
to control either the interest rate payable for very short-term borrowing
(borrowing by banks from each other to meet their short-term needs) or the
money supply, often as an attempt to reduce inflation or the interest rate, to
ensure price stability and general trust of the value and stability of the
nation's currency
•The main monetary policy instruments available to central banks are open
market operation, bank reserve requirement, interest rate policy, re-lending
and re-discount (including using the term repurchase market), and credit
policy (often coordinated with trade policy). While capital adequacy is
important, it is defined and regulated by the Bank for International
Settlements, and central banks in practice generally do not apply stricter
rules.
MONETARY POLICY AND FRAMEWORK

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• As China’s economy develops and becomes more market oriented, and as its integration with the world
economy continues, monetary policy will need to shoulder an increasingly large burden in ensuring stable,
noninflationary growth. Rising integration, for instance, implies greater vulnerability to external shocks, and
monetary policy is typically the first line of defense against such shocks. Although deeper structural
reforms may be the key determinants of long-term growth, monetary policy has an important role to play
in creating a stable macroeconomic environment that is essential for those reforms to take root
• Monetary policy in China has in recent years operated under difficult constraints, including a fixed
exchange rate regime, an underdeveloped financial system and numerous institutional weaknesses. Having
an independent monetary policy is of course the first order of business. Maintenance of an exchange rate
regime with limited de facto flexibility exposes the economy to significant risks of macroeconomic
instability. While capital controls provide some room for maneuver for monetary policy even under such a
regime, this room tends to be quite limited in practice and could result in inadequate control of investment
growth and inflationary/deflationary pressures. Furthermore, the effectiveness of capital controls
inevitably erodes over time as domestic and international investors find channels, including expanding
trade, to evade them..

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Three key principles of good monetary policy
• Monetary policy should be well understood and systematic. The objectives of monetary
policy should be stated clearly and communicated to the public. The Congress has
directed the Federal Reserve to use monetary policy to promote both maximum
employment and price stability; those are the objectives of U.S. monetary policy. Fed
policymakers' understanding of that statutory mandate is summarized in Monetary
Policy: What Are Its Goals? How Does It Work? To be systematic, policymakers should
respond consistently and predictably to changes in economic conditions and the
economic outlook; policymakers also should clearly explain their policy strategy and
actions to the public, and they should follow through on past policy announcements and
communications unless circumstances change in ways that warrant adjusting past plans.
Following this principle helps households and firms make economic decisions and plan
for the future; it also promotes economic stability by avoiding policy surprises.
Principles for the Conduct of Monetary Policy

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Three key principles of good monetary policy
• the central bank should provide monetary policy stimulus when economic activity is
below the level associated with full resource utilization and inflation is below its stated
goal. Conversely, the central bank should implement restrictive monetary policy when
the economy is overheated and inflation is above its stated goal. In some
circumstances, the central bank should follow this principle in a preemptive manner. For
example, economic developments such as a large, unanticipated change in financial
conditions might not immediately alter inflation and employment but would do so in the
future and thus might call for a prompt, forward-looking policy response. Conveying how
monetary policy would respond to irregular future events is not easy, but the overarching
principle remains the same: Policymakers should strive to communicate how these
events may affect the future evolution of inflation and employment and set monetary
policy accordingly.
Principles for the Conduct of Monetary Policy

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Three key principles of good monetary policy
• the central bank should raise the policy interest rate, over time, by more than
one-for-one in response to a persistent increase in inflation and lower the policy rate
more than one-for-one in response to a persistent decrease in inflation. For example, if
the inflation rate rises from 2 percent to 3 percent and the increase is not caused by
temporary factors, the central bank should raise the policy rate by more than one
percentage point. Such an adjustment to the policy rate translates into an increase in
the real policy rate--that is, the level of the policy rate adjusted for inflation--when
inflation rises and a decrease in the real policy rate when inflation slows.
Principles for the Conduct of Monetary Policy

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• The transmission of monetary policy describes
how changes made by the Reserve Bank to its
monetary policy settings flow through to
economic activity and inflation. This process is
complex and there is a large degree of
uncertainty about the timing and size of the
impact on the economy. In simple terms, the
transmission can be summarized in two stages.
• Changes to monetary policy affect interest rates in
the economy.
• Changes to interest rates affect economic activity
and inflation.
The transmission of monetary policy

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Monetary Transmission Mechanism

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Monetary Policy Strategy

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