j



    j
 j
 

j
  j
 j


  
  
c
ô Study Guide 4, you will be i troduced to the co cept of mo ey at the local, regio al a d i ter atio al
levels. You will also lear of ways used by gover me ts to ma ipulate mo etary i strume ts to achieve
macroeco omic objectives. O completio of this Study Guide you will k ow how gover me t uses
mo etary a d fiscal policies to deal with problems affecti g the eco omy.


  j
O completio of this Study Guide, you should:

1.c appreciate the role of the ce tral ba k i he eco omy;

2.c u dersta d mo etary a d fiscal policy a d the applicatio s;

3.c u dersta d the ature a d burde of the atio al debt.

c
c
j  j
You should be able to:

1.c explai the co cept of mo ey;

2.c outli e the fu ctio s of mo ey;

3.c explai mo etary policy;

4.c explai how the mo ey supply is co trolled;

5.c explai the co cept of fiscal policy;

6.c evaluate the limitatio s of fiscal policy;

7.c disti guish betwee discretio ary a d o
discretio ary fiscal policy;

8.c outli e the causes a d effects of the Natio al Debt;

9.c evaluate ways used by Gover me ts to ma age the Natio al Debt.

c 96
   
c
Àc go cept of Mo ey

Àc u ctio s of Mo ey

Àc Mo etary Policy a d Natio al ô come

Àc he Mo ey Supply

Àc iscal Policy

Àc ñimitatio s of iscal Policy

Àc he burde of the Natio al Debt

c
c


  
 j
  j
Before mo ey came i to existe ce the form of excha ge was based o barter. Barteri g i volved the
excha ge of goods for other goods. ôt is fou ded o the pri ciple of mutual desire.

Barteri g as a system of excha ge was disco ti ued for three substa tive reaso s:

1.c ôt was difficult to satisfy the double coi cide ce of wa ts which is a importa t base criterio for
excha ge to take place i a system of barter.

2.c ôt was difficult to determi e excha ge rates, that is, how much kid ey bea s per calf.

3.c Some commodities were ot easily divisible.

he use of a mo etary u it helped to get rid of all the above problems i that:

1.c here was o lo ger a eed for a double coi cide ce of wa ts as mo ey could ow be used to
pay for goods.

2.c Mo ey was ow the medium through which excha ge took place.

3.c Mo ey could be used to facilitate a y size of tra sactio .

 !"#$%$&! 
c
here are esse tially two types of mo ey, toke mo ey a d commodity mo ey.

oke Mo ey 1 was the term used to describe the cou ters or toke s origi ally issued by traders a d
ba kers as a record of mo ies deposited by the public. oday the term is used to describe the curre cy i
circulatio a d i cludes otes a d coi s2.

ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
1
http://e .wikipedia.org/wiki/oke mo ey
2
http://www.1911e cyclopedia.org/oke Mo ey

c 97
Simply, commodity mo ey 3 refers to a medium of excha ge that has value both as a commodity as well
as mo ey. ô particular, furs, shells a d tobacco which have bee used as a medium of excha ge i the
past are examples of commodity mo ey. Other examples4 i clude gold, silver, copper, salt a d alcohol.


  j  

he good money has to perform the following functions:

1.c ! '! () # # $&'  *%+#, : Mo ey facilitates the excha ge of goods a d
services withi a eco omy. Workers i various segme ts of the eco omy accept mo ey as a
form of payme ts for goods a d services because it ca be excha ged for goods a d services
withi the eco omy.

2.c
&!#%%'!: his mea s that the price of goods a d services ca be quoted i mo etary
terms. Mo ey therefore provides us with the flexibility to value the vast miscella y of thi gs that
make up the eco omy.

3.c j!()#-': Mo ey allows wealth from o e period to be available i a other time period. ôt
provides the most co ve ie t mea s to set aside part of curre t i come for savi gs. Specifically,
i stead of putti g aside sea shells or cor cobs u der a o mo etized eco omic system, o e ca
ow set aside mo ey to meet expe ses later o .

4.c !'!#%!##!#$#($$(($#! : Mo ey allows eco omic age ts to draw up

hire purchase arra geme ts a d mortgage agreeme ts. Mo ey makes these types of payme ts
at a future date possible.

o perform these fu ctio s, mo ey must possess the followi g seve attributes:

1.c
%%!#.&-&!: mo ey must be acceptable as a mea s for the settleme t of debt.

2.c '(#.&-&!: mo ey should ot wear out quickly so that wealth ca be tra sferred from o e time
period to a other.

3.c ,&!: Mo etary u its should be ide tical so that each dollar bill should be same as the
previous o e.

4.c &)&&.&-&!: Mo ey should be divisible so that both expe sive a d lowly price commodities ca
be easily valued.

5.c (!#.&-&!: Mo ey should be easy to tra sport arou d, for example, i o eƞs wallet or purse
without bei g excessively bulky or heavy.

6.c j!#.&-&!)#-': Overtime mo ey should mai tai its value.

7.c &&%'-! ! (,: mo ey should ot be easy to duplicate, or this could erode its worth as a
medium of excha ge.

ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
3
http://www.philadelphiafed.org/mo eyi motio /lesso s/Mo eyGrades3
5.pdf
4
http://e .wikipedia.org/wiki/gommoditymo ey

c 98
 
%!&)&!/0

ô dicate which fu ctio of mo ey is demo strated i EAg of the followi g activities.

(i)c armer Brow puts his cash i his mattress.

(ii)c Mr. ñee, a salesma , buys $ 100 worth of gasoli e per week.

$.#%"

(i)c j
e
 value

(ii)c Medium
 Exchange

&1'&$&!((% +(

he heory of ñiquidity Prefere ce was i troduced by Joh May ard Key es, i his book, he Ge eral
heory of Employme t I terest a d Mo ey, published i 1936.

he heory of ñiquidity Prefere ce shows that the dema d for mo ey is determi ed by the
ra sactio ary motive (
), Precauctio ary
otive (P
) a d the speculative
otive (S
). hese three

otives ca be co
bi ed to give a si gle de
a d curve by addi g o to the de
a d for active bala ces
(
+ P
), which is ot i flue ced by the rate of i terest, to S
, which is i flue ced by the rate of
i terest.

c

c
c

 c
cc


/c (##%!&$#$( 

his refers to mo ey held for the explicit purpose of meeti g ru of the mill or expected eco omic
expe ses. hese would i clude mo ey dema ded for the purpose of purchasi g food, travelli g to a d
from work. he amou t of mo ey held for tra sactio ary purposes is a fu ctio of the level of i come of
the household. go seque tly, a d as the diagram below shows, a i crease i i come from Y0 to Y1
leads to a i crease i the amou t of i come held for tra sactio ary purposes from 0 to 1.

c 99
 Dema d for Mo ey &,'(/0  (##%!&#$(  
for ra sactio ary
Bala ces

 c

1


c

Y0 Y1 ô come

/c (%#'!&#($#$( 

his precautio ary dema d for mo ey refers to the dema d for mo ey to meet u foresee
co ti ge cies. or example, a you g lady may carry a tra sactio ary amou t of mo ey, with her o a
date with her boyfrie d to help pay half of the bill, if this is a average of US$20, she may choose to walk
with US$40. he extra US$20 ca be co sidered a precautio ary bala ce or Ɲvexƞ mo ey. his extra
mo ey would allow her the flexibility of calli g a taxi if a y u comfortable situatio s were to arise o the
date. ñike the tra sactio ary dema d for holdi g mo ey, o eƞs precautio ary bala ce is a positive
fu ctio of i come. ôf this argume t is exte ded it would mea that a low i come household will hold a
lower precautio ary bala ce (say P0) as compared to a higher i come household (P1).

Dema d for Mo ey &,'(/2 (%#'!&#$( 

for Precautio ary
Bala ces

Precautio ary
Bala ce

P1

P0

0
Y0 Y1 ô come

c 100
/c j%'-#!&)!&)

People may hold mo ey because they may feel that holdi g mo ey is safer tha holdi g other assets.
Stocks, bo ds a d real estate all fluctuate i price, a dollar o the other ha d is always worth a dollar,
Key es argued that if people expected bo d prices to fall, they would try to sell the bo ds a d build up
some mo ey holdi gs.

ôf mo ey is put i to assets it provides utility, for example, from fur iture we get pleasure. ôf we put
mo ey i a bo d we get a divide d. hus holdi g mo ey i pure liquid form carries some type of
opportu ity cost which may be labelled as the rate of i terest, a d so before people hold mo ey i a
liquid form they have to co sider this cost. As the rate of i terest i creases, the greater will be the cost
of holdi g mo ey. Buildi g o this logic, Key es argued that people hold idle bala ces to take adva tage
of cha ges i the price of bo ds. e called this motive for holdi g mo ey the speculative motive (Sm ).

o simplify the discussio for this Study Guide, the a alysis shall focus o u dated bo ds but it is
assumed that all security prices move i the same directio . At a y o e poi t the price of some bo ds
may i crease a d some may decrease. At other time periods, however, bo d prices may be movi g i the
same directio together. o explore the speculative motive for holdi g mo ey let us proceed as follows.
ôf eco omic age ts expect that the price of bo ds will i crease, by virtue of falli g i terest rates, the
they will buy bo ds ow a d sell them i the future to make a capital gai . ôf they thi k the price of
bo ds will decrease, by virtue of risi g i terest rates, they will sell bo ds a d keep mo ey as mo ey will
ow represe t a better store of value.

Give that bo d prices a d the rate of i terest are i versely related, it follows that o e ca relate the
dema d for mo ey to the dema d for speculative bala ces as show below. he curve i igure 4.3
below, shows that whe i terest rate is at a level such as r0, the speculative dema d for mo ey bala ces
is lower tha if the i terest rate was at r1.

&,'(/3 j%'-#!&)#$( 

roi

r0

r1 Dema d for
Speculative bala ces

Md
s0 s1

igure 4.4 overleaf illustrates the dema d curve for mo ey bala ces which is simply a horizo tal
summatio of the ra sactio motive, Precautio motive a d the Speculative motive for holdi g mo ey.

c 101
 &,'(/ (&)&,!+&1'&$&!((%'()

 m + Pm
r r Sm r
ñiquidity
Prefere ce gurve

+ =

Qm a Qm b Qm a + Qm b
Qty Md Qty Md Qty Md
he dema d for active
bala ces, that is, Speculative dema d he total dema d for
ra sactio ary a d for mo ey is mo ey curve, the
precautio ary dema d for i versely related to liquidity prefere ce curve
mo ey ƛ u respo sive to the dema d for is the horizo tal
i terest rate cha ges mo ey bala ces summatio of m , Pm a d
Sm at each i terest rate.


 j
 04 2
he mo ey supply refers to the qua tity of curre cy i circulatio i a eco omy at a particular time. he
mo ey supply also i cludes dema d deposits.

ô tryi g to disti guish mo etary assets i terms of their liquidity, eco omists have produced several
defi itio s of the mo ey supply, these i clude M1 a d M2.

M1: Defi ed as arrow mo ey a d refers to the total of all curre cy, travellersƞ cheques dema d deposits
a d other checkable deposits. gurre cy i cludes both coi a d paper mo ey i circulatio .

M2: he M2 mo ey supply i cludes assets i less liquid form tha M1. he M2 mo ey supply co sists o
M1 together with savi gs deposits a d small de omi atio time deposits.5 (ô some cou tries a third
compo e t of M2 is retail mo ey market mutual fu d bala ces). able 4.1 overleaf shows the tre ds i
some of the differe t types of deposits at commercial ba ks. Note that betwee 1995 a d 2007 the
bala ces i dema d deposits, savi gs deposits a d time deposits i creased sig ifica tly.

ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
5
Savi gs deposits i clude all ordi ary savi gs accou ts, also k ow as Ɲpassbookƞ type savi gs accou ts, held at
commercial ba ks as well as mo ey market deposit accou ts. A time deposit, also referred to as a term deposit
refers to mo ies deposited i to a y accou t held at a commercial ba ki g i stitutio which ca ot be withdraw for
a specified period of time. A small de omi atio time deposit is therefore a deposit u der a certai defi ed threshold.
or example i the US the threshold is $100, 000.
c

c 102
 #.-/0  (&&$#$#$ .#,(%&#-#"j%!( 
otal Dema d Savi gs ime
Date Deposits Deposits Deposits Deposits
($M ) ($M ) ($M ) ($M )
1995 12,349.91 2,827.98 4,827.47 4,694.46
1996 12,888.06 3,052.71 5,320.55 4,514.80
1997 14,168.09 3,567.10 6,066.09 4,534.90
1998 16,202.42 3,757.41 6,754.50 5,690.52
1999 16,463.18 3,993.36 7,132.31 5,337.52
2000 18,516.71 4,959.39 7,561.28 5,996.04
2001 21,430.05 6,510.28 8,509.48 6,410.29
2002 22,503.98 8,075.68 8,843.06 5,585.24
2003 23,817.70 8,262.93 10,575.79 4,978.98
2004 27,647.57 10,563.44 11,525.77 5,558.36
2005 34,306.11 13,277.05 13,001.10 8,027.96
2006 42,282.73 14,563.09 15,677.23 12,042.41
2007 47,705.71 15,521.95 17,629.66 14,554.10
Source: ge tral ba k of ri idad a d obago

able 4.2 below shows tre ds i the mo ey supply aggregates for the  eco omy. Note that each
compo e t of the mo ey supply i creased, implyi g that the overall mo ey supply also i creased over
the period 2003 to 2007.

#.-/2  5  j'-
,,(,#!
gurre cy i Active Narrow Mo ey M

Date Base Mo ey M
0 Mo ey Supply M
2
girculatio 1A
2003 1,708.60 4,663.80 7,309.40 18,593.30
2004 1,957.40 4,739.90 8,377.60 20,841.20
2005 2,425.40 7,097.90 12,316.10 28,012.40
2006 2,654.40 8,342.40 13,507.90 32,859.90
2007 3,182.80 9,269.30 15,122.10 37,323.10
Source: ge tral Ba k of ri idad a d obago


%!&)&!/2

ô dicate whether EAg of the followi g could be i cluded i the M 1 ( arrow mo ey) or M 2 (broad
mo ey) defi itio of the mo ey supply.

(i)c A dema d deposit i irst Natio Ba k

(ii)c A savi gs accou t i Norther Savi gs Ba k

$.#%"


c 9

c 9







c 103

c

c
Mo etary Policy gai ed asce da cy i the eco omics literature duri g the 1980ƞs whe mo etarism as a
arm of macroeco omic theory became more popular. Mo etary policy refers to the deliberate actio s of
the mo etary i stitutio s to ma ipulate mo etary i strume ts to achieve macroeco omic objectives.
Some of these objectives i clude:

1.c ull employme t

2.c Stable prices

3.c A co siste t but satisfactory level of eco omic growth

4.c Equilibrium i the Bala ce of Payme t

Some of the mo etary i strume ts i clude the i terest rate, the reserve requireme t, the discou t rate
a d ope market operatio s. Ma ipulatio of these variables affect the mo ey supply, a d he ce the
level of aggregate dema d. Mo etary policy i this regard ca be ma ipulated to i crease the mo ey
supply a d thereby i crease the level of aggregate dema d, i which case this is k ow as expa sio ary
mo etary policy. Expa sio ary mo etary policy ca i volve loweri g the i terest rates, the reserve
requireme t a d the discou t rate, or the purchase of securities from the public. Additio ally, mo etary
policy ca be used to lower the level of aggregate dema d, i which case co tractio ary mo etary policy
would i volve a i crease of the i terest rate, reserve requireme t a d discou t rate as well as the sale
of securities to the public. 

he mai target variables of Mo etary Policy are the rate of i terest a d the Ms. hese are ot
i depe de t variables, that is, it is ot possible to fix both the supply of mo ey a d the price of mo ey.
Specifically i the diagram below the mo etary authorities ca either choose a target level of mo ey
supply, say Ms 0 a d give the ñP i the eco omy will the eed to accept a rate of i terest of r0. ô tur if
the mo etary authority wa ted a rate of i terest of r1 they would have to accept a mo ey supply of Ms 1.

c
&,'(/6  + #(,! !#(-&% 
roi

r0 E0
E1
r1
ñP

 QM
 Ms 0 Ms 1


c 104
 +(-!+%!(#-.#"&%(#!&,+&,+7($ 

Professor Milto riedma oted that to co trol the mo ey supply it was ecessary to co trol the size of
the mo etary base, where the mo etary base is defi ed as mo etary assets which are highly liquid such
as cash, dema d deposits a d checki g accou ts. o co trol the issui g of loa s, the gover me t could
proceed as follows: the sig ifica t part of the mo etary loa s is the supply of high powered mo ey. he
mo etary authorities ca reduce the amou t of cash that is available to the ba ki g system, say through
ope market operatio s or i creasi g the legal reserve requireme t.

ô order for a strategy of co trol to have a predictable effect o the mo ey supply, a d he ce the
eco omy, the mo ey multiplier must be stable. Specifically, the commercial ba ks must ot simply
adjust their cash to reserve ratio i respo se to a cash squeeze.

or a system of mo etary base co trol to be effective the ce tral ba k must reli quish its role as a le der
of last resort, otherwise mo ey squeezed out of the system ca re
e ter through the discou t market.

 c
c
c


c

1.c Ope market operatio s

2.c ñegal reserve requireme t

3.c Discou t rate

4.c i a ci g iscal deficits

5.c Moral Suasio

6.c Selective credit co trol

7.c ô terest rates

#("!(#!& : Ope market operatio s are i refere ce to the sale or purchase of

securities o the Mo ey Market by the gover me t. Gover me ts use OMO whe they wa t to i flue ce
the mo ey supply i a eco omy. OMO ca either give the ba k more reserves or take away reserves
from them a d i so doi g, this ca expa d or co tract the mo ey supply as the case may be. ô
particular, whe the gover me t is of the opi io that the mo ey supply is too low, it ca issue
i structio s that lead to the i crease i the purchase of securities a d treasury bills. ô so doi g the
gover me t pumps mo ey i to the ba ki g system. Similarly, but from the opposite positio if the
gover me t wa ts to decrease the mo ey supply it ca sell securities o the ope market a d as
eco omic age ts purchase these securities, mo ey flows out of the system promoti g a co tractio i the
supply of mo ey.

,#- (() (1'&(!: gommercial ba ks are required by law to keep a proportio of their
deposits with the ge tral Ba k. his is referred to as the legal mi imum reserve requireme t. Suppose
that the gover me t of say Guya a decides its mo ey supply is too low, the it ca decrease the reserve
requireme t of commercial ba ks so that there is a expa sio i the proportio of mo ey ba ks have
for le di g. he reverse is also true, that is, if the ge tral Ba k wishes to decrease the mo ey supply, it
ca simply i crease the reserve requireme t a d take mo ey out of the system.

c 105
 +()1'&(!## - !#(!(-&!+#(&..# 

he reserve requireme t is o e of the o ly direct tools of mo etary co trol that Ɲce tral ba ksƞ i the
garibbea use. ô particular the reserve required as defi ed above is that proportio of deposits which
commercial ba ks must Ɲkeep o ha dƞ i order to facilitate the daily tra sactio s of its customers. ô this
regard the reserve requireme t therefore imposes stipulatio s o the amou t of credit facilities that
commercial ba ks ca exte d to the public, a d by exte sio ca be used ma ipulate the mo ey supply.

+()1'&(!& (&&$#$#$ .#, 

here has bee a co scious policy directio o the part of the ge tral Ba k to reduce the reserve
requireme t for commercial ba ks. ô 2003 the Ba k u dertook the first of three phases to impleme t
this strategy:

1.c Phase 1: reductio i the reserve requireme t from 18% to 14% of deposits ƛ impleme ted
October 2003.

2.c Phase 2: reductio i the reserve requireme t from 14% to 11% of deposits
impleme ted
September 2004.

3.c Phase 3: reductio i the reserve requireme t from 11% to 9%
yet to be impleme ted.

+()1'&(!&##&%# 

With regards to the cha ges i the reserve requireme ts imposed by the Ba k of Jamaica, o gommercial
Ba ks the followi g is a chro ological list of the cha ges i the Ba kƞs operatio s:

1.c 01/08/02: he ñiquid Asset ratio for commercial ba ks was reduced from 27% to 23%.

2.c 10/01/03: Each commercial ba k was required to lodge 5% of all deposits at the Ba k of
Jamaica.

#"'##

he Ba k of Guya a, the foremost mo etary i stitutio i Guya a has published its required reserves o
a weekly basis. he followi g table provides a summary of this i formatio a d also shows that the
actual amou t of reserves lodged with the Ba k of Guya a over the period Ja ƛ Dec 2007 has always
bee greater tha the stipulated amou t.

#.-/31'&($()(!+#"'##2889

:
Required Actual Reserves
Reserves
th
Ja uary 05 18882.2 25488.2
12th 18991.8 27146.2
19th 19304.0 25806.0
26th 19444.6 25956.1
April 06th 19528.7 22215.7
13th 19721.5 23857.8
20th 19990.6 27355.7
th
27 20133.0 25175.8
August 03rd 20024.7 25173.8
10th 20127.0 25366.9

c 106
 #.-/31'&($()(!+#"'##2889
:
17th 20187.8 24931.6
24th 20042.6 23754.3
31st 19979.1 23952.8
December 07th 21599.4 28295.1
14th 21802.4 25268.4
21st 21640.3 23322.1
28th 21477.4 22808.6
Source: Ba k of Guya a

&%'!#!: he discou t rate refers to the i terest rate at which commercial ba ks ca borrow from
the ge tral Ba k. By varyi g the discou t rate, that is, by varyi g the cost of borrowi g loa s from the
ge tral Ba k, the gover me t ca regulate how much mo ey is at the disposal of the commercial ba ks,
that is, they ca i flue ce the mo ey supply. ôf the ce tral ba k decreased the discou t rate,
commercial ba ks will borrow more a d the mo ey supply will i crease whilst if the ce tral ba k
i creased the discou t rate, they ca decrease the amou t of mo ey at the disposal of the ce tral ba k
a d i so doi g i crease the mo ey supply.

&#%&, &%#- &%&! 6: he gover me t may use the tools of mo etary fi a ci g to cover fiscal
deficits. hese may i clude i creasi g the mo ey supply or actually pri ti g more mo ey this practice is
k ow as seig iorage
. Fi a ci g deficits i this way however ca exert i flatio ary pressures o the
e tire eco omy, a d may also result i the crowdi g out of the private sector. Accordi g to the World
Ba k 2006
7 ƠMo etary policy eeds to be i sulated from the pressures created by the gover me t's
eed to fi a ce its fiscal deficit. he authorities eed to curtail mo etary fi a ci g of the fiscal deficit,
a d the gover me t should pay market rates of i terest o its debt a d refrai from pressuri g the
ce tral ba k to keep i terest rates lowơ. ô this regard all efforts should be made to mai tai the political
i depe de ce of the mo etary authorities.

-&$ !#(-&%& (&&$#$#$  .#, 

!&-#!&#(j!(#!,

he i flatio rate reached 10% by the third quarter of 2006. go seque tly the ge tral ba k of ri idad
a d obago shifted its Ɲa ti i flatio ƞ strategies towards moppi g up the excess liquidity i the system.
he existe ce of excess liquidity i the system reduced to level of effective ess of i terest rate policy.
he ge tral ba k opted for a more directed approach, through the auctio i g of securities, desig ed to
lower the rate of spe di g a d to e courage lo ger term i vestme t.

Over the period November 2006 to November 2007, the amou t of gover me t bo ds sold amou ted to
$3,103 millio , the total of which ge tral ba k sterilized. hese bo ds are estimated to mature betwee
5.5 to 10 years time. Other a ti i flatio ary strategies used by the ge tral ba k i cluded the followi g:

1.c e


n
 a ec
nda eee equ e
en ;

.c a ec  nnce
 g
en
en ec e  e bnk; nd

3.c n n en  ed 



en


e
e
n.


  ee
ee e gen  bn

  n  n 
b
w be
ee e ee

    n e  e
b $6, 649

n n
007  

e
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6

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6
https://www.imf.org/exter al/pubs/ft/pam/pam49/pam4901.htm
7
http://www.worldba k.org/fa dd/e glish/0396/articles/010396.ht m

c 107
he diagram below maps out the various liquidity ma ageme t measures that the ge tral Ba k of
ri idad a d obago imposed betwee 2006 a d 2008.

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(#- j'#&: his refers to persuasio that takes the form of letters, verbal stateme ts , that the
ce tral ba k uses to try to persuade commercial ba ks to take a particular li e of actio that they
co sider ecessary.

j-%!&) ($&!!(-: Selective credit co trol refers to a o traditio al tech ique that the ce tral
ba k ca use to discourage particular types of i vestme ts. A ce tral ba k may wish to limit spe di g o
say co sumer durables a d may offer prefere tial treatme t (i terms of favorable discou t rates) to
those commercial ba ks that adhere to its directive.

c 108
 
%!&)&!/3

(a) ñist WO of the MAJOR mo etary policy i strume ts available to a ce tral ba k.

(b) State how EAg of the policy i strume ts you listed i (a) above could be used to i crease
the mo ey supply. 

(c) ow will a i crease i the i terest rate affect the dema d for mo ey?

$.#%"

(a) wo major mo etary policy i strume ts available to a ce tral ba k are

. Ope Market Operatio

. Reserve reuireme t

(b) he Ope Market Operatio ca be used to i crease the mo ey supply by issui i structio s
that the mo ey supply be expa ded throu h the purchase of securities like treasury bills from
private i dividuals a d ba ks that wish to sell. o reduce the mo ey supply securities ca be
sold to private i dividuals a d or commercial ba ks

he reserve reuireme t ca be use to ma ipulate the mo ey supply; by loweri the reuired
mi imum reserves ba ks ca issue more loa s a d he ce, the mo ey supply will i crease. If
the reserve reuireme t is i creased o the other ha d the mo ey supply will fall.

(c) A i crease i the i terest rate will cause the ua tity dema ded of mo ey to fall. his is so
because at hi her i terest rates it becomes more attractive to hold more o liuid assets such
as bo ds.


*%(() ;
c
his refers to the reserves held by commercial ba ks i excess of the stipulated reserve requireme t.

($&!%(#!&
c
gredit creatio refers to the process by which commercial ba ks, through a system of fractio al reserve
ba ki g, creates mo ey by issui g loa s. ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
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8
http://www.i vestopedia.com/terms/e/excessreserves.asp
9
Eco omics, hird Editio , by Walter J Wessels. Barro s 2000

c 109
 c

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cc

or the purpose of this Study Guide, a commercial ba k may be defi ed as a i stitutio which ca
accept deposits from the ge eral public a d creates deposits for the ge eral public whe it makes loa s
to the ge eral public. o illustrate how a commercial ba k ca create mo ey we ca proceed as follows,
for simplicity, this Study Guide assumes that there is o ly o e commercial ba k i existe ce.

ñet us assume that the ba k receives a cash deposit a d that it has historically deduced that a customer
would ot, at a y poi t i time, dema d all of its cash deposits. his mea s that a prude t ba ker would
o ly eed to keep a certai proportio of the i itial deposit to meet customer dema ds for cash. he
remai i g bala ce ca be loa ed to borrowers.10 o i vestigate some of the specifics i volved i the
credit creatio process assume that a i dividual deposited $1000 cash i to the ba k.

After the i itial deposit, the commercial ba kƞs bala ce sheet may be prese ted as:

ñiabilities Assets

gustomers deposits $1000. gash $1000.

Assumi g a reserve requireme t of 10%, the ba k ca le d the extra $900. After the first loa is issued,
a d a additio al accou t is created for the first borrower, the Ba kƞs Bala ce Sheet would be
represe ted as:

ñiabilities Assets

ô itial Deposits 1000 gash 1000

greated deposits (first Borrower) 900 ñoa s 900
otal liabilities 1900 otal Assets 1900

Recall that the reserve requireme t is 10%, which implies that the Ba k is o ly obligated to hold $90 for
the first borrower, a d as such the ba k ca issue a other loa up to $810. ôf this is do e, the ba k
creates a other accou t for the seco d borrower, to whom was issued a loa o $810. After the seco d
loa is issued the Ba kƞs Bala ce Sheet ca be represe ted as:

ñiabilities Assets

ô itial Deposits 1000 gash 1000

greated deposits (first Borrower) 900 ñoa s 900
greated deposits (seco d Borrower) 810 ñoa s 810
otal liabilities 2710 otal Assets 2710

Agai , the ba k is o ly obligated to hold 10% of the deposit as reserves which implies that a third loa
ca be issued for up to $729 (810 ƛ (10%* 810)). his process by which the Ba k co ti ues to issue
loa s a d create deposits co ti ues. hrough this co ti uous reiterative process the commercial ba k
would create a additio al $9000 i deposits, equivale t to the amou t of loa s that were issued. At the
e d of this process, the ba kƞs Bala ce Sheets will ow read:

ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
10
ôf the ba k does ot le d out a y of the $1000 the it i s simply a safe deposit i stitutio . Whilst ba ks do perform
safety deposit activities, they also le d mo ey out to customers.
c

c 110
ñiabilities Assets

ô itial Deposits 1000 cash 1000

greated deposits 9000 loa s 9000
otal liabilities 10000 otal Assets 10000

hus, we see that the ba k has expa ded the amou t of mo ey, by $9000 give a i itial deposit of
$1000. ô a multi ba k system, the same type of credit creatio process ca work, providi g all the
ba ks are prepared to expa d credit fully. his pri ciple of credit creatio , i our example , may be
co de sely represe ted as follows:

1 = mo ey multiplier = 10
10%

he mo ey multiplier shows that with a $1000 deposit total ba k deposits ca i crease to 10,000 of
which:

New deposits = total deposits = i itial deposits

9000 = 10,000 ƛ 1000



 
j
j 
 j
 


he useful ess of mo ey as a store of value is compromised by high rates of i flatio . ô eco omies i
which the i flatio rate is high a d risi g mo ey loses value quickly.

ô these eco omies high i flatio rates quickly erode the purchasi g power of mo ey a d some eco omic
age ts look for some other mea s of stori g wealth. ô ma y cases people use a other curre cy to store
their wealth; this phe ome o is k ow as curre cy substitutio .

able 4.4 below shows the tre ds i the amou t of foreig curre cy assets a d foreig curre cy deposits
held by gommercial Ba ks i . he able 4.4 also provides i formatio o the excha ge rate with the
US. Notice that as the excha ge rate i creased, implyi g that the  dollar depreciated i value relative
to the US, the amou t of foreig curre cy assets a d foreig curre cy deposits i creased. ô particular,
the amou t of foreig curre cy assets held at commercial ba ks i creased by over 450%, while the
amou t of foreig curre cy deposits i creased by over 350%.

#.-/ &#-*%+#,#!4(&,'((%

!#$(&,'((%
&!#!(%&#-#"& 5 0886=288>
Excha ge Rate with the US oreig gurre cy Assets(US$M ) oreig gurre cy
Deposits(US$M )
1995 5.95 545.26 414.85
1996 6.04 764.33 496.21
1997 6.28 914.94 549.28
1998 6.30 910.04 654.51
1999 6.30 1,079.70 687.80
2000 6.30 1,214.23 866.95
2001 6.23 1,480.53 854.70
2002 6.25 1,575.00 987.13
2003 6.30 1,583.87 976.38
2004 6.30 2,262.46 1,265.38
2005 6.30 2,498.35 1,296.80
2006 6.31 2,974.08 1,798.51
2007 6.32 3,071.19 2,025.91
ge tral ba k of 

c 111
Mo ey hoardi g refers to the te de cy to hoard mo ey as it i creases i value. his is Greshamƞs law at
work. Greshamƞs law is amed after homas Gresham, a successful British busi essma who was a
advisor to the Quee Elizabeth ô. Gresham argued that if we have two coi s worth the same extri sic
amou t, say $ 1.00 but o e was made from brass a d the other silver, that is, they had differe t i tri sic
values, the the cheaer coi will be used for excha ge, whilst the te de cy would be to hoard the more
exe sive coi . ô this regard, Gresham seculated that Ơbad mo ey drives out good mo eyơ. What
Greshamƞs law i fers is that eco omic age ts would use the low commodity value for the urose of
excha ge while the mo ey which has high commodity excha ge will be hoarded.

+?'#!&! +(
c
he first equatio of excha ge which ide tified the relatio ship betwee the mo ey supply a d the
mo etary value of tra sactio s was addressed by Joh Stuart Mill11 who expa ded o the work of David
ume12 i 1848. ñater the qua tity theory was explicitly developed a d refi ed by Simo Newcomb13,
Alfred de oville 14, ôrvi isher15 a d ñudwig vo Mises16 duri g the 19th a d 20th ce turies. Additio ally,
the qua tity theory was later restated by Milto riedma 17 i 1956 i the post
Key esia era.

he Qua tity heory of Mo ey was challe ged i the 1930ƞs by Key es as part of the Key esia cou ter
revolutio a d subseque tly fell out of fashio u til it was revived i the 1950ƞs by Milto reidma . ô
its simplest format, the Qua tity heory of Mo ey ca be explored through the equatio of excha ge.
he equatio of excha ge ca be prese ted as:

VM = P
Where:
M: mo ey supply
P: price level
: total umber of tra sactio s
V: velocity of circulatio of mo ey.

he term V shows the amou t of times a give amou t of mo ey has to cha ge ha ds to facilitate this
level of tra sactio . hus, V = 4, mea s that the available mo ey supply cha ges ha ds 4 times to
facilitate the value of the total umber of tra sactio s (P) i the eco omy.
c
c
c
c
c

cc


/c &,+!!#(-&% 0; 
c
ight mo etary policy refers to a deliberate course of actio take by the ce tral mo etary authority to
restrict the amou t of spe di g i a eco omy. ô particular tight mo etary policy is impleme ted to
co trol the rate of i flatio , a d i cludes raisi g i terest rates which effectively reduces the
attractive ess of borrowi g.


ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
11
Joh Stuart Mill (1848), Pri ile o Politial Eo o

12
David u
e (1748), ƠO ô teret,ơ "O ô teret" i Ea Moral a d Politial
13
Si
o Newo
b (1885), Pri ile o Politial Eo o

14
Alred de oville (1907), La Mo aie
15
ôrvi g iher (1911), he Purhai g Power o Mo e,
16
vo Mie, Ludwig ei rih; heorie de Gelde u d der U
lau
ittel [he heor o Mo e a d Credit]
17
Milto ried
a (1956), Ơhe Qua tit heor o Mo e: A Retate
e tơ i Studie i the Qua tit heor o
Mo e, edited b M. ried
a .
18
htt://www.i vetoedia.o
/ter
/t/tight
o etaroli.a

c 112
/c #!#(-&%

Easy mo etary policy is desig ed to simulate eco omic activity i a eco omy. ô particular, it is
desig ed to i crease the level of employme t by maki g borrowi g more attractive.

/c #-#%#!

Mo etary policy also affects the bala ce of payme ts accou t. or example, expa sio ary mo etary
policy (easy mo etary policy) would te d to exert dow ward pressure o the excha ge rate (assumi g
flexible or ma age float), which would weake the capital accou t but improve the curre t accou t. O
the other ha d, co tractio ary mo etary policy would te d to exert upward pressure o the excha ge
rate, thereby resulti g i a improveme t o the capital accou t but worse s the curre t accou t.


 

 
 

Mo etary policy affects the level of atio al i come by affecti g aggregate dema d. ô particular,
mo etary policy as me tio ed above is targeted towards co trolli g either the i terest rate or the mo ey
supply. Recall that the liquidity prefere ce theory evaluates the dema d for mo ey bala ces agai st the
mo ey supply to determi e equilibrium i terest rate. ô this regard, co sider the effect of expa sio ary
mo etary policy which will effectively i crease the mo ey supply as show i igure 4.6 below. With a
i crease i the mo ey supply (Step 1), domestic i terest rate falls (Step 2) the co seque ce of which is
that aggregate dema d i creases as i vestme t a d co sumptio i creases (Step 3). Natio al i come
also i creases (Step 4).

&,'(/> !#(-&%#$#!&#-% 
r 1. ge tral ba k p SRAS0
i creases the
mo ey supply
MS0 MS1 3. Aggregate
dema d
rises as
i vestme t
a d
co sumptio
i creases

r0
4. Natio al
r1 i come AD1
2. ô terest
i creases AD0
rates fall

Qua tity of Natio al ô come

Mo ey bala ces Y0 Y1


 
 j  
 

Mo etary policy has several limitatio s. ô particular, give that mo etary policy is i direct i its approach
to the macroeco omic fu dame tals, policy makers must be careful to co sider all possible effects of the
impleme tatio of a particular policy. ô this regard, mo etary policy has bee criticized as bei g
permissive a d ot compelli g because of its Ɲha ds
offƞ approach to macroeco omic ma ageme t.
c

c 113
Additio ally, mo etary policy ca ot be ma ipulated to set the priorities for gover me t fiscal operatio s
or does it have a y co trol of either labour or product markets. he effective ess of mo etary policy
has also bee questio ed i situatio s where foreig ow ed commercial ba ks, whose policies a d
actio s are exoge ously determi ed, operate i the eco omy.

c

j 
 

here are a variety of reaso s i the literature why mo etary policy does ot have a immediate effect
o the eco omy. hese are as follows

1.c Deposits take time to be created: Suppose the ge tral Ba k e gages i Ope Market Operatio s
a d cha ges the amou t of reserves at the disposal of the ge tral Ba k, this occurs very
quickly. owever, the full i crease i the mo ey supply takes time for the commercial ba ki g
system to properly expa d to the full amou t give the prevaili g reserve ratios i the ba ki g
system. Altogether, this ca take a very lo g period of time.

2.c o expa d the capital stock it takes time: ôf the gB were to i crease the mo ey supply a d
promote a lower market rate of i terest this would i crease the level of i vestme t. owever, it
takes time for i vestme ts to be made a d so a fall i the rate of i terest whilst expa di g the
level of i vestme t will do so o ly with a time lag.

3.c A i crease i the level of i vestme t i a eco omy worki g through the multiplier expa ds
the size of the atio al i come. owever, this process takes time to work through the system.
Agai we see that there is a time lag betwee the impleme tatio of mo etary policy a d its
effect o atio al i come.

A#"$.&%#-&$&%&-& 
c
Mo etary policy may ot be as effective as pla ed if gover me tƞs fiscal policy strategies do ot have
the same objective. or example tight mo etary policy, which is aimed at curbi g the i flatio rate, ca
be egated by a i crease i gover me t spe di g, as o the o e ha d tight mo etary policy would
restrict co sumer spe di g but the i crease i gover me t spe di g ca swamp the fall i co sumer
dema d a d actually worse macroeco omic co ditio s.


j
 
iscal Policy i volves the deliberate i terve tio by gover me t to ma age gover me t expe diture a d
gover me t i come to achieve particular eco omic a d social outcomes. he i strume ts of fiscal policy
are taxatio (t) a d gover me t expe diture (G). hese cha ges i t a d G ca be made i terms of:

1.c the level;

2.c the timi g of cha ges i t a d G;

3.c the structure of t a d G.


ccc

Public expe diture refers to the expe diture by gover me t which is fed from taxatio reve ues or from
gover me t borrowi g. Gover me t expe diture ca take two (2) pri cipal forms, curre t a d capital
a d may be u dertake by the ce tral gover me t, local gover me t a d/or by atio al i dustries.

c 114
able 4.5 below shows the tre ds i gover me t spe di g as a perce t of GDP. Note that for Jamaica
this proportio i creased from 22.2% i 1992 to 38.7% i 2007, whilst for  the proportio fell from
26.9% i 1991 to 22.4% i 2006.

#.-/6 )(!*$&!'(
#@
ri idad a d
Jamaica obago
1991 .. 26.9
1992 22.2 27.2
1993 30.4 26.5
1994 29.4 24.2
1995 33.3 24.7
1996 39.4 26.4
1997 33.6 24.4
1998 34.4 24.6
1999 35.8 24.6
2000 35.4 22.2
2001 35.0 22.9
2002 38.0 24.1
2003 39.1 21.3
2004 37.9 22.3
2005 33.9 23.5
2006 38.7 22.4
Source: World Developme t i dicators

Public expe diture is expe ded i two disti ct areas:

(a)c j$&,,$#$()&%: he gover me t is a huge employer a d also purchases a

vast amou t of goods a d arises from a wide variety of sources. or example, co sider igure 4.7
below, which shows the tre ds i gover me t expe diture of goods a d services for the period
1991 to 2007. he average for the e tire period is 11%, with the proportio i 2007 bei g
14.9%.

&,'(/9 !(#-)(!*$&!'( 
Mc
$5j()&%@!!#- 
rc
c
c
c
c
c
c
c

c
c
rc
c c rc 
c c c c rc 
c

c 115
)(!-!

ô ma y developi g cou tries, gover me t is o e of the major employers of the labour force. ô ri idad
a d obago this situatio is o differe t. Gover me t employme t is categorized as show below, i to
Public Service a d Statutory Board a d Gover me t E terprises. gollectively, for the give period,
employme t i these sectors accou t for a average of 26% of total employme t. Additio ally, whereas,
the total umber of perso s employed i creased by some 14% betwee 2000 a d 2005, employme t i
the Public Service i creased by 32%. Employme t i Gover me t E terprises, however decli ed by 19%.

#.-/> -!&!+,)(!%!(88 
otal Gover me t/Public Gover me t E terprise
Employed Service Statutory Board
2000 5029 993 253
2001 5139 1059 273
2002 5251 1115 286
2003 5341 1148 252
2004 5623 1244 198
2005 5740 1309 204
Source: gSSP (various years)
c
ô terms of gover me t expe diture o wages a d salaries, co sider the i formatio i able 4.7 below.
he total expe diture o wages a d salaries i creased by over 100% betwee 2000 a d 2006, but as a
proportio of total spe di g fell by 4 perce tage poi ts.

#.-/9 )(!*$&!'(A#,#$j#-#(&
ge tral Gover me t Expe diture o ge tral Gover me t Expe diture o Wages 
Wages  Salaries ($000s) Salaries Share of otal
2000 3,190,098 27.96
2001 4,091,262 32.48
2002 4,176,512 31.25
2003 4,627,866 30.49
2004 4,998,280 27.11
2005 5,304,481 23.63
2006 5,492,650 20.38
2007 6,576,093 23.47
Source: ge tral Ba k of ri idad a d obago

(b)c (#( #!: hese are disburseme ts made by the gover me t that represe t a
redistributio of i come. igure 4.8 overleaf maps the tre ds for tra sfers a d subsidies as a
perce tage of total gover me t expe diture. Note that i 1991, this proportio was 21% a d by
2007, tra sfers a d subsidies accou ted for 35% of gover me t expe diture. ô 2006 though,
this ratio stood at 40%.

c 116
 &,'(/; !(#-)(!*$&!'( 
(#(5j'.&$&#@ !#- c
Gover me t Expe diturec
45c
40c
35c
30c
% c 25c
20c
15c
10c
5c
0c

1991c 1993c 1995c 1997c 1999c 2001c 2003c 2005c 2007c

&#%&,'.-&%*$&!'( 
Gover me t expe diture is fi a ced i a variety of ways:

1.c taxes levied by ce tral gover me t;

2.c taxes by local authorities, for example, la d taxes;

3.c borrowi g;

4.c sale of assets.


+'%!&)(!*$&!'( 

he fu ctio s of gover me t expe diture depe d o the philosophy of the gover me t by the day. hus,
a comma d type gover me t will spe d much more tha a gover me t with market based ideals. he
major fu ctio s of gover me t ge erally i volve the followi g:

1.c ()&$&, '.-&% #$ (&! $: Public a d merit goods, are goods that the free market
would ot provide i adequate amou ts, for example, primary health care or primary educatio .
he state typically provides public goods a d provides some amou t of merit goods.

2.c j%&#-j%'(&!: Social security refers to a framework of social protectio agai st the socials ills
associated with poverty, u employme t, disability a d agi g19. he state also has to make
ra sfer Payme ts i some eco omies such as the UK. his is o e of the larg est claims o
gover me t expe diture. A list of Social Security facilities 20 offered i ri idad a d obago is
i cluded below.

i.c Oil Age be efits: Mi imum old age pe sio $1, 000 per mo th.

ii.c Disability be efits: Average betwee $1, 050 a d $1,150 per mo th.

ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
19
http://e .wikipedia.org/wiki/Socialsecurity
20
http://www.socialsecurity.gov/policy/docs/progdesc/ssptw/2004
2005/americas/tri idadtobago.pdf

c 117
 iii.c Survivorsƞ pe sio s: Widow(er) receives up to 40% of the deceased average weekly
ear i gs.

iv.c Sick ess Be efit: Up to 60% of average weekly ear i g, payable for a maximum of 52
weeks.

v.c Mater ity Be efit: Up to 60% of average weekly ear i gs, payable for a maximum of 13
weeks.

vi.c Work ô jury
emporary disability be efits: Up to 66.6% of average weekly ear i gs,
payable for a maximum of 52 weeks.

vii.c Work ô jury ƛ Perma e t disability pe sio : pe sio is depe de t o the degree of
disability.

3.c ,'-#!&  %&%

%!&)&!&: he state also provides a umber of services that ca
help to e sure that the activities of the private sector are properly regulated. ô ma y eco omies
the state also allocates part of its resources to guide the resource allocatio a d i dustrial
developme t process. ô this regard, the work or Sir Arthur ñewis 21 who i 1955 published he
heory of Eco omic Growth, is still releva t today. ñewis advocated that the state was ot o ly
to create the preco ditio s ecessary for developme t but to overseer the allocatio process
thereby e suri g that the actio s of the gover me t are compleme tary to a d facilitative of the
private sector e trepre eurs22. 

&%#--&%#$ #%(%&% ##,! 
c
&%#--&%#$
,,(,#!$#$ 
c
iscal policy ca be used to ma ipulate aggregate dema d. ô particular gover me ts ca i crease its
ow spe di g or reduce taxes i order to i crease the level of aggregate dema d or reduce its spe di g
a d i crease taxes i order to reduce the level of aggregate dema d. he diagram 7.3 below shows how
a expa sio i aggregate dema d ca achieve a i crease i eco omic activity a d a co seque t
reductio i the rate of u employme t. 

c
&%#--&%#$
-!

ô a eco omy i which there is a high level of u employme t, the gover me t ca use fiscal policy i a
variety of ways to improve the employme t situatio . his ca i clude two mai types of respo ses
i crease G or decreasi g . ô igure 4.9 overleaf a i crease i gover me t expe diture from G0 to G1
shifts the aggregate dema d curve from AD0 to AD 1 a d leads to a i crease i the level of eco omic
activity from Y0 to Y1. Similarly, a fall i the level of taxatio will lead to a i crease i co sumptio .

ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
21
(1955). he heory of Eco omic Growth, omewood, ôlli ois, Richard D. ôrwi
22
http://www.eco .yale.edu/growthpdf/cdp891.pdf

c 118
 &,'(/< &%#--&%#$
-! 

AD1
P
SRAS
AD0

0
ô crease i G
or fall i axes

Æc
Y0 Y1 ô crease i ô come, output
a d employme t



%!&)&!/

Suppose that as ghief Eco omic Advisor, the Mi ister of i a ce calls you i to his office a d says the
followi g :

Ơ U employme t is too high. We eed to lower it by i creasi g both output a d i come.

Right ow the euilibrium level of i come/ output is 900 billio , but perhaps a acceptable
u employme t rate ca be achieved if aggregate output i creases to some, $  billio . Note
however that the margi al prope sity to co sume is .75, a d taxes must remai at the prese t levels.
So, adjusti g taxes 
is out of the uestio .ơ

U der the circumsta ces outli ed above, explai how the gover me t ca use fiscal policy taxes a d
spe di g
to i crease the euilibrium level of output from $9 billio to $  billio .

$.#%"

he gover me t ca use fiscal policies to i crease the euilibrium level of output from 9 to  by
i creasi g spe di g by the appropriate amou t. It is assumed that taxes remai at the prese t level
.
Gover me t spe di g, which is a i ectio i to the eco omy will cause aggregate output to i crease
via the multiple pri ciples.

Multiple =
mpc



c 119
c
$.#%"%!A$

e 

 n   e en

- 9C = .75

- e e e nee n n

e  $
 b 
n   ƛ 9

ee
e n
en
en en n
 be e e
ne n nee n  e  e
  b

$
 b 
n.


9  e =
 
‰


=  



Inee n
en
en en n
 be e


= b 
n


= 5 b 
n

ee
e, e
en
en
 nee en n b $5 b 
n
 ee e e e nee n
 e  e
 
$  b 
n.

&%#--&%#$-#!&
c
ô order to reduce dema d led i flatio the gover me t of a eco omy may deploy a deflatio ary fiscal
strategy. hus, if a gover me t i creases i come taxes the this would lead to a decrease i
co sumptio . A reductio i i vestme t may also follow if the gover me t i creases fiscal taxes a d this
reduces the attractive ess of i vestme t optio s. Whe gover me t impleme ts these types of cha ges
it leads to a egative multiplier effect o the eco omy a d ca close the i flatio ary gap. his is show i
igure 4.10 overleaf, where a i crease i t or a decrease i G leads to a leftward shift of the AD curve
from AD 0 to AD1 a d a decli e i the price level from P1 to P0.

c 120
 &,'(/08 &%#--&%#$-#!& 

P1

P0
AD0

AD1

Y0 Yr

-#!&#$.#-#%#! 23 
c
In
n,  e ne b
e, ee
e e  en  e n e 

e   e ee. A  e  e,


e  
n
e be n
b  e e

e exen e 

e  
e

 n e e

 e e e ee

 .   n e  
en n
 e bne
 
en  

n.

A
n  e  e
 ex
  nee 
e n 
n
e 
 
be n
b  e

ee  en e n 
neen  e ee
 ex
   n e bne
 
en  
en.

+.'$,! !#*#!&4()'4*$&!'(#$!(#( 

B e  n e e be n  e 
 n bne. A B e De 
 en G
en
en
Exen e (GE) > G
en
en Reene (GR). A b e  
 en GE < GR.
G
en
en 
 n 

 n e
 b e   n 

 n e
 b e  e  . A
e
n b e  
 en
en
en e
en
en exen e
een e
e
n

 


ee n . B e n
en
en exen e n ene  e  e e
n

en
en n  b e  .   e
 b e    
e  e
n
. A   
 en b
n e
n

    

en
en

e



e x eene n  ee 
 n  b e  nn n 
e.

A e
n e 
 en n e
n

  e

 e  e  e e
n n n 

n
ee e ee
 ne


en n 


e e ee
 e
n

   . e

ne
 nne e
b e 

e 

xe n ene.

 e 4.11
ee 
 e b e  

n
 n e
n

   ee (3)  en e b e 


n B1 B2 n B3.

ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
23
http://www.solhaam.org/articles/i flatio .html

c 121
 &,'(/00 
-!(#!&)'$,!#(&!& 
Budget
positio

B2
B1
cccB 3

S2

Æc
ccccccccccY*
ccc
D3

Y* i igure 4.11, represe ts the full employme t level of i come. With a budgetary positio of B 1, the
eco omy is i full employme t with a bala ced budget. ôf the gover me t is ru i g a budgetary
surplus, the at the full employme t level of i come Y*, if the gover me t were to ru a deflatio ary
budget the it would have a budgetary surplus of S2. ôf the gover me t ru s a budgetary deficit, the
the gover me t with a full employme t positio of Y* e gages a deflatio ary budgetary sta ce, with a
deficit of
$D3 at Y*.

Symbolically, we have

G ƛ  > 0 budget surplus

G
 < 0 budget deficit
G ƛ  = 0 bala ced budget

+#-#%$'$,! '-!&-&(

ôt is i teresti g to u dersta d the implicatio of ru i g a bala ced budget i terms of its effect o the
multiplier. A bala ced budget occurs whe

Gƛ=0
or ö  ö

Assumi g that co sumptio expe diture is determi ed by the level of disposable i come, the with a
i crease i G equal to a equivale t cha ge i , that is, ö  ö , we have,



ö  ö  ö



c 122
ô a bala ce budget fiscal sta ce, ö  ö a d so we ca write,

1 c
ǎY = ( )+( ) ǎG

1 c 1 c

ǎY = ǎG

hat is, the Bala ce Budget multiplier is equal to 1 a d a cha ge i gover me t expe diture equivale t
to ö will cha ge Y o ly by
. ǎ

his is a importa t derivatio as it mea s that gover me ts tryi g to reflate a eco omy will be much
better off by ru i g a budgetary deficit or by borrowi g.

*#-

ôf the Jamaica gover me t were to spe d US$10m o reflati g its eco omy by a public
i frastructure developme t program a d its gover me t spe di g multiplier is k = 5 the ,

ǎY + (5)(10)
= US $50m

But with a bala ced budget a d K = 1, equilibrium i come i creases by the i crease i gover me t
spe di g.


%!&)&!/6

1.c Explai the term Ɲfiscal policyƞ. 


2.c State briefly what is mea t by EAg of the followi g:

(i)c A budget deficit; 


(ii)c A bala ced budget. 

3.c ñist WO ways by which a cou try ca reduce its budget deficit.

$.#%"

.c F  
   e e
 e
en
en  x n en n 
  e n n e

e  e e
e
n

.

.c 
A b e e     
n ee en exen e exee en eene.


c  bne b e    
n ee en exen e e en eene.

3.c  
n  n ee b e e  b


c Ine n  x  e n/
 ne n e xbe n

e n e 
n .


c e n
en
en en n .

c 123

-!(#!&)&#%&, %+#&#'$,!&%&!

Mo etarists have argued that it is critical to u dersta d the mo etary effect of expa sio ary fiscal policy.
here are two mai optio s available to a gover me t to fi a ce a budgetary deficit, these are:

(i)c i creasi g the mo ey supply; or

(ii)c i creasi g i terest rates.

ôf the budget deficit is fi a ced by borrowi g from the local ba ki g sector the this expa sio i the
mo ey supply ca cause i flatio . Specifically, whe gover me t borrows this mo ey a d spe ds it, it
gets re
circulated to the ge eral public. Whe the ge eral public spe ds this mo ey it pulls the domestic
price level upwards. hus, borrowi g form local ba ks, which effectively i creases the domestic i flatio
rate.

ôf i stead the gover me t fi a ces the budget by selli g gover me t bo ds the i order to e courage
the public to fi a ce the deficit, the it would have to i crease the attractive ess of these gover me t
bo ds. he co seque ce of this, however, is a ge eral i crease i the ge eral i terest rate. Whe the
ge eral i terest rate i creases this will crowd out domestic private sector i vestme t a d make it more
difficult for private sector firms to i crease private sector i vestme t. go seque tly, gover me tƞs use of
a deficit fi a ci g strategy, fi a ced by a strategy which raises domestic i terest rates will be i effective
to stimulate levels of eco omic activity i the eco omy.

#,#$!%&%#--&% 

iscal Policy, whether expa sio ary or co tractio ary i ature, takes time to be effected i a eco omy
o accou t of lags i the deliberatio a d the executio processes. ô particular, a d as co cer s fiscal
policy, a cha ge i the level of taxatio a d i certai type of gover me t expe diture has to be debated
i parliame t a d approved by gabi et. owever, because taxes a d gover me t expe ses have a
impact o the basic well bei g of most eco omic age ts, politicia s will be careful a d deliberate for
co siderable periods of time i determi i g the exact ature of a i terve tio . his lag is k ow as a
decisio lag.

Eve whe a policy agreeme t to cut the tax rate for example is eve tually agreed, the system still has to
deal with the executio lag. he executio lag is the time period betwee the maki g of a decisio a d
the actual impleme tatio . ôt is likely that by the time a policy cha ge have bee impleme ted that the
situatio have cha ged so much that the policy itself is redu da t .

'!#!&%!#.&-&B(

ôt is difficult for gover me t to slash gover me t expe diture whe a eco omy is i a recessio . ô fact
expe diture slashi g by gover me t especially o social programs ca lead to social u rest.

go seque tly, some eco omists have suggested that rather they use automatic stabilizers to regulate
eco omic activity duri g period of booms a d slumps.

With a fall i aggregate i come, the u employme t rate i a eco omy i creases a d i states with
welfare programs there is a rise i welfare payme ts. With taxatio systems fou ded o progressive
taxatio , the fall i Y leads to a rapid fall i tax reve ues at a pace faster tha atio al i come. heses
two automatic stabilizers te d to help to reflate the eco omy.

c 124
 U employme t i creases Gover me t
u employme t
AD ϊ Љ Y ϊ c be efits i crease

go sumptio
axatio reve ues fall i creases

Automatic stabilizers also help to dampe eco omic activity where the eco omy is i a buoya t state.
Specifically, whe i come i creases a d u employme t decrease there is a reductio i payme ts of
welfare be efits a d with a progressio taxatio system a greater amou t of i come is paid i tax that
the rate of expa sio of co sumptio expe diture is kept i check. he co seque ce is a reductio i
the size of the multiplier.24

he ge eral effect of automatic stabilizers is to dampe fluctuatio s i busi ess cycles.

&,'(/02 '&%-7&!+'&-!&

'!#!&%j!#.&-&B( 
Real GDP

he system of progressive

taxatio effectively reduces
go tractio the spe di g multiplier.

 Expa sio
c
c
c Welfare payme ts are
c i creased i order to
c dampe the effects of
c
risi g u employme t
c
c
c ccPeak rough
c ime
c

ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
24

ô a four sector model k  as t i creases, k decreases.
s  t m

c 125
 
 
#!&#-$.! !%"#$- 7

(a)c Stock/low

he Natio al Debt refers to the debt of the ge tral Gover me t. ñet DB; represe t the Gover me tƞs
budgetary deficit i Year 1. hus, for years 1, 2 a d 3 we have:

BD1= GR1 ƛ GE 1 i ND1= BD 1

BD2= GR2 ƛ GE 2 i ND2= BD 1 + BD 2
BD3= GR3 ƛ GE 3 i ND3= BD 1 + BD 2 + BD3

Each of BD 1, BD2, a d BD3 has to be fi a ced. ôf i itially, the Natio al Debt is Zero (o) the with the first
budget deficit of BD 1 if the Gover me t fi a ces it by borrowi g the Natio al Debt i creases to BD 1.
Suppose i the very ext the Gover me t ru s a budgetary deficit agai of size BD2 if fi a ced by
borrowi g is a other flow that i creases the stock of the Natio al Debt to ND2 a d so o .

&,'(/03 #!&#-.!

ND3

c


c c
BD3
BD2
BD1
ND1

Stock
low

ô the abse ce of sufficie t savi gs, gover me ts te d to borrow both locally a d abroad. Borrowed
resources are sometimes wasted but eve whe they are used to expa d the cou tryƞs i frastructure the
retur s are ot immediately forthcomi g. gompleme tary i vestme ts by private i vestors are also
sometimes ecessary to make full use of i frastructural developme ts. ô the abse ce of proper debt
ma ageme t, debt servici g ca become a major problem worse i g fiscal deficits. gurre t fiscal deficits
are a otable feature of most gARôgOM eco omies. ô 1990 the deficit as a perce t of GDP ra ged from
mi us 25% for Guya a to a surplus of 4.8% i Jamaica. By 2000, the cou try with the largest fiscal
deficit as a perce tage of GDP was St. Kitts (
14.2%) with  havi g the largest surplus of 1.6% (see

c 126
able 4.8). O average per a um for the period 1990
2000, Guya a had the largest fiscal deficit as a
proportio of GDP whilst ri idad  obago had the smallest. ô 2000, the average fiscal deficit as a
perce tage of GDP across all gARôgOM cou tries had worse ed to ƛ5.15%. or Guya a, eco omic
reforms i the 1990s have helped to improve the fiscal bala ce to a deficit of 8.3% i 2000. he fiscal
bala ce i Jamaica co ti ues to be a cause for co cer .

#.-/; &%#-#-#%##(%!& 
 .(!#!40<<8C2880
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
A tigua 1.2
1.9
0.5
1.4
2.8
2.9
3.1
4.3
4.4
2.5
2.2 .a.
Bahamas .a. .a. .a. .a. .a.
1.2
0.9
3.2
1.1
0.3 0.4
0.8
Barbados
8.4
1.8
1.9
2.5
1.2
0.9
3.8
1.4
1.0
2.3
1.5
3.5
Belize 0.3
5
7.5
9.1
7.6
4.3
0.4
2.2
2.3
2.1
9
11.0
Domi ica
10
3.3
5.7
0.3
4.8
5.7
1.9
2.3
1.2
9.9
5.5 .a.
Gre ada
15
4.8
0.6
0.9
1.9 0.3
2.7
2.2
3.2
2.8
3.4 .a.
Guya a
25
27
20
8.1
1.8 0.1
1.6
7.0
7.4
5.7
6.6
8.3
Jamaica 4.8
5.6
6.6
2.7
11
5.4
24.6
8.3
8.1
6.1
0.3
6.9
St. Kitts
0.3
2.3
1.2
1.4
3
6.6
3.8
3.1
6.2
11
14.2 .a.
St. ñucia 1 0.7
1.8
0.7
0.8
1.2
2.2 .a. .a. .a. .a. .a.
St. Vi ce t
0.8
0.2
4.3
4.8
0.3
2.4 0.6
4
3
1.5
5.8 .a.
Suri ame .a. .a.
8.7
9.4 5.1 4.3 0.8 .a. .a. .a. .a. .a.
ri idad
1.2
0.2
2.7
0.2 0 0.2 0.5 0.1
2
3.2 1.6
0.4
Source: UNEñAg (2002).

&%#-$&%&-&

As explai ed above, it is the excess of Gover me t expe diture over Gover me t reve ue that lead to a
i crease i the flows to the Natio al Debt. Whe Gover me t expe diture is greater tha Gover me t
reve ue eco omists say that the Gover me t was ot fiscally prude t or alter atively, they were fiscally
i discipli e.

able 4.8 above shows the fiscal deficit of selected gARôgOM eco omies as a % of GDB.

!&%#$(&,.!

he compositio of the atio al debt is importa t. ô particular, if o e segme t of the eco omy is i
debt to a other segme t of the eco omy, the the wealth of the eco omy as a whole is ot cha ged a d
a y i terest payme ts o the debt is a i ter al matter a d is made withi the eco omy. Whe the
debt, however, is exter ally ow ed it mea s that the i terest payme ts a d repayme t o the capital
have to be made i foreig curre cies the the debtor atio will have to export goods a d services to
ear this foreig curre cy. his servici g a d repayme t of the foreig debt represe t a loss of real
output from the debtor atio that could be used to help repay the debt.




c 127


jj 
 
 

In ne n n e e
 e n
n eb   
ne n e e
 e  en  

e  

1.c O e of the mai reaso s for borrowi g i ma y ñDgs i cludi g those of the gARôgOM sphere is
to cou ter the adverse effects of exter al eco omic shocks a d atural disasters. As show i
U it 1 gAPE Micro Eco omic Study Guide, i the aftermath of a hurrica e or other such atural
disaster the rebuildi g of these eco omies require substa tial amou t of resources, some of
which is borrowed from the i ter atio al commu ity. Adverse moveme t i the terms of trade
also makes borrowi g ecessary to meet various fiscal eeds.

2.c A other causative factor of the accumulatio of debt i the regio is the eed to mai tai the
level of public sector co sumptio eve i thee prese ce of stag a t or decli i g fiscal reve ues.
Alter atively said, the debt problem i the gARôgOM sphere is partly because of fiscal
misma ageme t. As show i able X, NEARñY all gARôOgM eco omies are i a positio of
fiscal deficit.

3.c A other reaso for the build up of debt i the gARôgOM regio is to speed up the eco omic
growth a d developme t process. A good case i poi t is the  eco omy. ƞs atio al
debt i creased from US$42.6m i 1955 to US$2,790.3m i 1999, with the exter al debt
obligatio i 1999 represe ti g just over 53% or US$1,482.9m. ôt should be oted though, that
duri g the period 1955
73 the ce tral gover me t debt i creased by a mere US$261.4m.
owever, from US$304m i 1973 the ce tral gover me t debt would escalate to US$712.1m i
1980 although the sums of the surpluses o the fiscal a d exter al curre t accou t bala ces
duri g this time period were US$552.5m a d US$1,434m respectively! his emphasizes the
importa t poi t that  borrowed freely to speed up the eco omic growth a d developme t
process although they ideally did ot eed to do so.

 j 
 
     
c

/c &%#-.'($&!(!#!#$&!%!'!'!#$&)!!$%&& 

ô terest payme ts deprive i debted atio s of resources to fi a ce educatio (creati g huma capital)
a d health (preservi g huma capital). Resources targeted at i terest payme ts could also have helped
to e courage the growth of o
traditio al dy amic comparative adva tage i export commodities o the
upswi g of the i ter atio al product cycle or i the creatio of a eve better i frastructural base to
attract foreig direct i vestme t i flow i export orie ted sectors.

/c #!&#-$.!#$*%+#,(#!('( 

Natio al debt ca hamper cou tryƞs ability to fi a ce curre t accou t deficits as debt servici g esse tially
reduces the amou t of foreig reserves that a cou try posses. Additio ally debt servici g ca exhaust
export reve ues thus worse i g the overall bala ce of payme ts positio which co seque tly results i a
depreciatio of the domestic curre cy.

/c #!&#-.!#$-#!& 

Whe measuri g Natio al Debt it is import to look at it i real terms as compared to omi al terms. ñet
us co sider the followi g illustratio . ñet the real a d omi al debt i 2005 be US$100mm (that is, the
price deflator to deflate the omi al debt had a base year of 2005). ñet the omi al debt i 2006 i come

c 128
by US$8mm to give a total omi al atio al debt of US$108mm at the e d of 2006. ôf the i flatio rate
i 2006 was 5% it mea s that the real atio al debt at the e d of 2006 was:

(US$106/105)*100 = US$101mm

What we see here is that although Gover me t omi al debt i creased its real debt actually fell. he
a alysis above assumed o i terest payme t o the omi al debt. ôf we assume that i 2006 the budget
was bala ced but i terest payme ts o the debt caused it to accumulate to US$108mm the with a
i flatio rate of 10% the gover me t gai s a d debt holders lose. Alter atively stated, i flatio led to a
redistributio of wealth from le ders (debt holders to the gover me t). ô this type of situatio
eco omists say that the real burde of the debt has falle .

/c (7$&,'!#$%(7$&,&

U sustai able levels of atio al debt ca adversely affect the eco omic growth process i developi g
eco omies. Suppose, for example, a heavily i debted gover me t ca ot lower its co sumptio levels i
order to free up resources to make debt service payme ts, the they may borrow resources from the
domestic commercial ba ki g system. he co seque ce of this could be a i crease i dema d for
i vestible resources, a rise i the domestic i terest rates a d a crowdi g out of private sector
i vestme ts.

A Ɲcrowdi g i effectƞ would take place i the reverse situatio if a i crease i atio al debt is
successfully used to stimulate eco omic growth a d developme t i the borrowi g eco omy.
Specifically, if the domestic eco omy is expa di g a d eco omic activity is growi g so that busi ess
expectatio s are buoya t, the domestic i vestors would i vest more.

j j   

  

he respo sibility of debt repayme t really refers to the burde of the public debt. hese pri cipal issues
arise whe discussi g the burde of the public debt. hese are:

1.c the size of the debt i relatio to the ability to repay;

2.c who pays the debt, that is, whether o e Gover me t borrows a d a other Gover me t pays
i terest payme ts.

j&B.!

ô assessi g the burde of the Natio al Debt o e has to make a assessme t i terms of supporti g the
debt. Ma y people argue that whe eco omic age ts borrow they are actually imposi g a burde o
future ge eratio s to repay. ô particular it is said that borrowi g a d i creasi g prese t spe di g has to
be carried by future ge eratio s who will eed to make i terest payme ts a d to take respo sibility from
repayi g the debt. owever, this is ot e tirely correct.

Specifically, if a Gover me t borrows US$xmm today the the Gover me t i which the borrowi g takes
place carries the burde . ow so? his is because it is this ge eratio that has to go without co sumer
goods so that capital goods ca be purchased (i movi g eco omies, whe Gover me ts borrow to
fi a ce war, real resources are directed away from co sumer goods to war materials).

Whe mo ey is borrowed by Gover me ts a d used to fi a ce corrupt a d fiscally irrespo sible activities

the the whole eco omy suffers. ôf the Natio al Debt is held locally the the wealth of the eco omy
remai s the same, although equity co sideratio s ca arise if the mo ey borrowed is from a small

c 129
segme t of the atio al commu ity. Whe the mo ey is borrowed exter ally a d resources, therefore,
leave the eco omy to service a d repay the debt i foreig curre cy, the exports are made without a y
excha ge for imports.


    
 
 


/c !(#-#$*!(#-.((7&, 

Whe a gover me t has to borrow resources to cover its fiscal deficit it ca tur to either foreig or
atio al sources. he be efit of tur i g to atio al sources is that it keeps the wealth level of the
eco omy i tact as it represe ts a redistributio of resources. ô co trast whe mo ey is borrowed from
abroad it mea s that the repayme t of this mo ey would represe t a et leakage of resources from the
system.

ô additio whe a gover me t borrows from abroad it usually comes with co ditio alities some of which
may create problems of its ow . or example, o e of the co ditio ality attached to borrowi g fi a cial
resources from the ôM or WB is that the state has to play a smaller part i the ru i g of the eco omy.
owever, because the state is a large employer i ma y developi g eco omies a dow sizi g of the
stateƞs participatio is typically associated with a rise i u employme t a d this has social implicatio s.

/c #*#!&

ô ma agi g the atio al debt a critical part of this whole process is boosti g domestic reve ues. his
ca be do e by reformi g the tax machi ery i the releva t eco omy.

/c .!(%+$'-&,

he exter al debt crisis of most developi g eco omies is a profou d challe ge i to the 21st ce tury.
Eatwell a d aylor (2000) have argued that the i ter atio al debt crisis Ơi ter atio al debt crisis has
become a defi i g feature of the co temporary world eco omyơ. owards the e d of the 1980s a d i to
the period thereafter ma y developi g eco omies that are heavily i debted have bee u able to meet
their debt servici g requireme ts a d this has prompted some eco omists to promote the case for a
greater degree of debt rescheduli g. As o e eco omist oted rescheduli g is

ơa mecha ism which ot o ly allows debtors ot to default o their loa s a d remai i thei ter atio al
fi a cial system but also preve ts creditors from faci g the whole co seque ces of a fi a cial crisisƠ.

(9archesi 2000).

here are a umber of factors both i ter atio al a d domestic that i flue ce whether a i debted atio
may require debt rescheduli g. he i ter atio al factors are:

1.c imports expe ditures that ca ot be reduced eve if the capacity of the eco omy to import has
falle because of say falli g export reve ues. his may be goods like capital equipme t eeded
to build bridges a d medici e for hospitals;

2.c deterioratio i the terms of trade so that the major export items from the i debted atio ow
bri gs i less export reve ues. his may be viewed as a fall i exports as capacity to import;

3.c A recessio i the desti atio market for exports from the heavily i debted eco omies which i
tur lowers their dema d for the export goods a d i so doi g compromisi g the export reve ue
ear i gs of the i debted eco omy. (he stude t should bear i mi d that the heavy focus o
export reve ue ear i gs is critical because it co ditio s the ability of the developi g eco omy to
repay its exter al debt).

c 130
ô ter al factors which affect the ability of developi g eco omies to repay their debt i clude:

1.c A disruptio to the productive capacity of the i debted eco omy for eco omic or o eco omic
reaso . or example, the coup detat as occurred i the  eco omy i 1990 virtually brought
all productive activity to a sta dstill while the defe se force sort to restore order.

2.c Poor eco omic ma ageme t by the i debted atio ca quickly use up valuable foreig excha ge
i the pursuit of pet projects some of which may be eco omically u feasible.

3.c A i creased amou t of i vestible resources leave the i debted eco omy to go to other
eco omies that offer more stable eco omic co ditio s.

What occurs is that the list of distortio s i the domestic eco omy adversely impact productio a d,
he ce, exports reve ues a d these i tur ca pote tially the ability of the i debted eco omy to repay
their debt.

/c .!(,&) 

As the debt of less developed eco omies i the world i crease, some eco omists are of the poi t of view
that it may ever be repayable. ô this regard, it is argued i some circles that it may be i the i terest
of both le ders a d borrowers to forgive the debt of these ñDgs. Eco omists such as Jeffery sachs have
argued that the partial forgive ess could allow developi g eco omies that are heavily i debted atio s to
use their debt servici g mo ies to build capacity to fi a ce i vestme t a d to i crease future levels of
output. he problem here is that where do we strike the bala ce as the creditors would always wa t less
debt forgive ess a d the debtor atio s would always wa t more debt forgive ess.


 *#- '## 26 #)&-$.!$('!(

Guya a is o e of the most heavily i debted developi g cou tries. ô particular the issue of the level of
atio al debt has bee o e of the most pressi g for the prese t gover me t. ô 1999 through effects of
the Paris glub a d the eavily ô debted Poor gou tries ( ôPg) i itiative Guya a was able to successfully
egotiate up to $256 i debt forgive ess.
Approximately 50% of the Guya ese Natio al Debt is owed to the i ter atio al multilateral developme t
ba ks (ôM a d World Ba k), a d about 20% to its gARôgOM cou terpart ri idad a d obago.
Guya aƞs debt burde has seriously hampered the developme t of the eco omy to the exte t that a high
debt burde to foreig creditors has mea t limited availability of foreig excha ge a d reduced capacity
to import ecessary raw materials, spare parts, a d euipme t, thereby further reduci g productio . he
i crease i global fuel costs also co tributed to the cou try's decli e i productio a d growi g trade
deficit. he decli e of productio has i creased u employme t. Although o reliable statistics exist,
combi ed u employme t a d u deremployme t are estimated at about 30%.
c
 j
 

he cost of servici g the atio al debt is represe ted by i terest payme ts to the holders of the atio al
debt. garibbea eco omies are amo gst some of the most i debted eco omies i the world. Natio al
debt to GDP ratios i excess of 50% are typically co sidered high a d so i accorda ce with the data i
able 4.9 overleaf either by total atio al debt or the proportio held exter ally have high debt ratios.

ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccc
25
http://e .wikipedia.org/wiki/Eco omyofGuya a

c 131
 #.-/< .!##@
otal atio al debt as Exter al debt as a % of GDP,
gou try a % of GDP, 2004 2004
A tigua a d Barbuda 99 64
Barbados 46 10
Bahamas 86 24
Belize 102 74
Domi ica 115 73
Gre ada 129 77
Guya a 166 137
Jamaica 139 58
St Kitts 179 82
St ñucia 70 43
St Vi ce t 79 54
 45 13

he debt service ratio is calculated as the ratio of i terest payme ts as a proportio of key the exports of
goods a d services a d the curre t reve ue receipts of gover me t.

#.-/08 !(!#!##(%!#,%'((!()' 
&#(&%.(!#!40<<8C2880
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
A tigua 19.90 19.86 17.47 8.82 9.72 8.91 11.92 11.81 11.77 9.16 11.97 .a
Bahamas .a .a .a 12.80 12.26 12.81 13.58 12.80 .a .a .a .a
Barbados 13.92 16.51 16.38 14.29 15.42 16.28 16.28 13.84 14.17 13.95 13.04 14.92
Domi ica 5.61 6.23 7.77 9.97 9.81 10.76 10.18 8.77 9.23 9.78 19.56 .a
Gre ada 9.53 12.27 10.89 10.22 9.65 8.75 6.69 9.40 6.43 9.16 8.14 .a
Guya a 78.24 73.39 64.14 45.12 51.56 29.3 24.61 30.35 27.92 27.94 26.2 .a
Jamaica 35.16 33.76 33.92 32.39 37.54 33.37 46.63 39.41 49.37 51.44 45.99 49.05
St Kitts 12.55 14.59 10.33 10.53 9.84 9.29 12.83 11.05 10.43 12.68 16.75 .a
St ñucia 3.27 2.76 3.06 3.06 2.92 3.36 4.32 5.40 4.69 5.59 5.52 .a
St Vi ce t 4.07 3.31 3.93 4.21 4.43 6.10 5.49 5.44 5.38 7.87 9.01 .a
Suri ame .a .a 12.97 11.91 6.12 1.92 2.09 .a .a .a .a .a
ri idad 17.53 15.97 20.24 21.52 20.98 18.65 15.73 18.52 18.13 19.87 20.77 16.67
Source: Eco omist ô tellige ce U it; gou try Reports (various years).

or small states, i terest payme ts o debt ca have a serious impact o the growth pote tial of their
eco omy. ô terms of i terest payme ts as a perce t of curre t reve ues, the average value of this ratio
for the e tire garicom body was 19.9% with a ra ge of 3.27% i St. ñucia to 78.24% i Guya a i 1990.
By 2000, the average value of this variable across all garicom member states would have i creased to
16.7% with a ra ge from 5.52% i St. ñucia to 45.9% i Jamaica. Betwee 1990 a d 2000, i terest
payme ts as a perce t of curre t reve ues i creased i all the member states for which co siste t data
is available except for A tigua a d Barbuda, Barbados, Gre ada a d Guya a. Both Domi ica a d
Jamaica realized a i crease i the share of i terest payme ts as a proportio of curre t reve ues by
more tha te perce tage poi ts.

As a perce tage of the exports of goods a d services, the debt service ratio i creased betwee 1997 a d
2004 for most of the listed gARôgOM eco omies.

c 132
 #.-/00 .!()&%##@!+*(!,$#$()&% 
gou try 1997 2004
A tigua a d
Barbuda 2.7 9.4
Barbados 5.2 3.4
Bahamas 5.6 5.5
Belize 9 50.9
Domi ica 6.7 11.4
Gre ada 6 11.3
Guya a 10.5 7.7
Jamaica 15.3 20.4
St Kitts 4.7 22
St ñucia 3.5 7.8
St Vi ce t 3.5 11.5
 15.4 4.6

#.-/02 -#!&4%'((&%#'#-@ 
Guya a Jamaica Suri ame ri idad a d obago
1995 12.2 19.9 235.6 5.2
1996 7.1 26.4
0.7 3.4
1997 3.6 9.7 7.1 3.6
1998 4.6 8.6 19.0 5.6
1999 7.5 6.0 98.9 3.4
2000 6.1 8.2 59.4 3.6
2001 2.6 7.0 38.6 5.5
2002 5.3 7.1 15.5 4.1
2003 6.0 10.3 23.0 3.8
2004 4.7 13.6 10.1 3.7
2005 6.9 15.3 9.9 6.9
2006 6.6 8.6 11.3 8.3

c



Ë  j

c


Àc Barteri g i volved the excha ge of goods for other goods.

Àc here are esse tially two types of mo ey, toke mo ey a d commodity mo ey.

Àc he heory of ñiquidity Prefere ce shows that the dema d for mo ey is determi ed by the
ra sactio ary motive (m), Precauctio ary motive (Pm) a d the speculative motive (Sm). hese
three motives ca be combi ed to give a si gle dema d curve by addi g o to the dema d for
active bala ces (m + Pm), which is ot i flue ced by the rate of i terest, to Sm, which is
i flue ced by the rate of i terest.

Àc he mo ey supply refers to the qua tity of curre cy i circulatio i a eco omy at a particular
time. he mo ey supply also i cludes dema d deposits.

c 133
Àc Mo etary policy refers to the deliberate actio s of the mo etary i stitutio s to ma ipulate
mo etary i strume ts to achieve macroeco omic objectives.

Àc Some of the mo etary i strume ts i clude the i terest rate, the reserve requireme t, the
discou t rate a d ope market operatio s.

Àc he mai target variables of Mo etary Policy are the rate of i terest a d the Ms.

Àc he mo ey multiplier is simply a umber which i dicates the amou t by which the mo ey supply
would i crease if commercial ba ksƞ reserves or deposits i crease by $1. he mo ey multiplier is
calculated as:

Àc Mo ey multiplier = 1/ Reserve requireme t.

Àc ô its simplest format, the Qua tity heory of Mo ey ca be explored through the equatio of
excha ge. he equatio of excha ge ca be prese ted as:

VM = P

Where;
M: mo ey supply;
P: price level;
: total umber of tra sactio s;
V: velocity of circulatio of mo ey.

Àc iscal Policy i volves the deliberate i terve tio by gover me t to ma age gover me t
expe diture a d gover me t i come to achieve particular eco omic a d social outcomes. he
i strume ts of fiscal policy are taxatio (t) a d gover me t expe diture (G).

Àc Public expe diture refers to the expe diture by gover me t which is fed from taxatio reve ues
or from gover me t borrowi g. Gover me t expe diture ca take two (2) pri cipal forms,
curre t a d capital a d may be u dertake by the ce tral gover me t, local gover me t a d/or
by atio al i dustries.

Àc iscal policy ca be used to ma ipulate aggregate dema d.

Àc Budgets ca either be i surplus, deficit or i bala ce. A Budget Deficit occurs whe Gover me t
Expe diture (GE) > Gover me t Reve ue (GR). A budgetary surplus occurs whe GE < GR.

Àc he Natio al Debt refers to the debt of the ge tral Gover me t.

Àc he cost of servici g the atio al debt is represe ted by i terest payme ts to the holders of the
atio al debt.











c 134
  
  j 



1.c ô E gla d, atio al i come is $600b, the margi al prope sity to tax is 0.20, the multiplier is 4
a d the budget deficit is $30b. By how much would gover me t spe di g have to i crease for
atio al i come to i crease to $650b ?

(a)c less tha $8b.

(b)c betwee $8b a d $16b.
(c)c betwee $16b a d $24b.
(d)c more tha $24b.

2.c Mo ies dema ded for tra sactio ary purposes are primarily used as a

(a)c store of value

(b)c u it of accou t
(c)c medium of excha ge
(d)c sta dard of deferred payme t

3.c ô a small eco omy, there are o ly three ba ks. ôf the ge tral ba k imposes a reserve
requireme t of 10%, by how much will total deposits i crease i each ba k receives $1 millio i
additio al deposits.

(a)c $3 millio
(b)c $10 millio
(c)c $27 millio
(d)c $50 millio

4.c What is the omi al i terest rate if i flatio is 6% a d the real i terest rate is 5%?

(a)c 5%
(b)c 1%
(c)c 6%
(d)c 11%

5.c rictio al u employme t may be defi ed as u employme t that arises

(a)c because of co flicts o the job

(b)c whe people are betwee jobs
(c)c whe i dustries co tract
(d)c due to u co trolled immigratio

6.c Which of the followi g fiscal tools ca be used to i crease aggregate dema d?

(a)c ô crease taxes o profits

(b)c ô crease value added tax.
(c)c ômpose import quotas.
(d)c ô crease social security payme ts.

c 135
7.c ôf Stephe $12000 per year a d pays $1000 i i come tax, Da iel ear s $20,000 per year a d
pays $2,500 i i come tax a d Jayelle ear s $25,000 per year a d pays $5,500 i i come tax,
what ki d of tax system exists?

(a)c U fair
(b)c Progressive
(c)c Regressive
(d)c Proportio al


Ë   j 
c

1. B 2. g 3. g 4. D 5. B 6. D

7. B




Ë
jj   ( !! 
t: (  flt) T 
,  t,

l , 
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Usi g examples a d illustratio s show how discretio ary fiscal policy a d automatic stabilizers work  ( !! 
t: (  flt) T 
,  t,

l , 
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duri g periods of recessio or i flatio i a eco omy.
(25 marks)

c 136