Chapter Five

Macroeconomic Policy

Lecture By:
Kamal Regmi
KDBC Business School

Monetary Policy:
The policies issued by the central bank of the
country to achieve specific economic activities
through change in money supply and rate of
interest are called as monetary policy.
Monetary policy helps in the achievement of
objectives such as optimum level of output and
employment, high economic growth rate, price
stability etc.
It includes all monetary decisions and measures
and such non-monetary decisions and measures
as have monetary effects.

 K.P.Kent, The management of the expansion and

contraction of the volume of money in circulation for the
explicit purpose of attaining a specific objective such as
full employment.
Shapiro, Monetary policy is the exercise of the central
banks control over the money supply as an instrument
for achieving the objectives of economic policy.
Central bank of a country is the traditional agent which
formulates and operates monetary policy in a country.
Monetary policy was considered as the best policy before
1930s great depression.
A sound monetary policy is a prerequisite of a successful
and comprehensive program of a development planning.
Monetary policy is only a means to and end, not an end in
itself.

Instruments of Monetary
policy:
Instruments of monetary policy can
be classified into the following two
types:
1. Quantitative Controls:
a) Bank Rate Policy:
b) Open Market Operations:
c) Cash Reserve Ratio:
d) Statutory liquidity Ratio: etc.

2. Selective Credit Controls:

a) Regulation of consumers Credit
b)Regulation of margin requirements
c) Credit Rationing
d)Direct Action
e) Moral Sausion
f) Publicity etc.

Types of Monetary Policy:

1. Restrictive/Contractionary
Monetary Policy:
2. Expansionary Monetary Policy:

Objectives of Monetary
Policy:
1. Full Employment
2. Price Stability
3. Neutrality of Money
4. Exchange Rate Stability
5. Balance of Payments Equilibrium
6. Achievement of High economic
Growth Rate
7. Overall Economic Stability

Goals/Targets of Monetary
Policy:
Short Run Goals
Creation of employment opportunities
Control of Inflation
Liquidity Management

Long Run Goals

Achievement of High economic growth
rate
Overall economic stability
Adjustment between policies and acts.

Limitations of Monetary
Policy:
Monetary Policy is only the means to
an end, not an end in itself.
Only an indirect impact on Aggregate
demand/output of the economy.
It shows long term effect on
economy.
Not suitable for cyclical stabilization.
Institutional Limitations

Fiscal Policy
Origin of fiscal policy:
Until 1930s great depression, fiscal policy was
taken as a policy that affected public treasury.
In modern time, fiscal policy is taken as the
government financial policies designed to
benefit the economy.
It benefits the economy by diverting resources
from low priority uses to the high priority uses.
Classical economists did not give any
importance to the fiscal policy.

The reasons for the origin of

fiscal policy:
1. Ineffectiveness of Monetary policy to
solve 1930s great depression.
2. Development of new economics by
J.M.Keynes.
3. Increase in the importance of
government expenditure and taxes.

Meaning of fiscal policy:

The term fiscal was originated from Greek
word fisc which means basket and
treasury in Italian language.
Fiscal policy is the use of governments
taxing, borrowing and spending powers to
maintain full employment without inflation.
Philip E. Taylor, Public finance is concerned with
the operation of the fisc, or public treasury. Hence,
to the degree that it is a science, it is the fiscal
science, its policies are fiscal policies, and its
problems are fiscal problems.

Contd.

Arthur Smithies, Fiscal policy is a policy under which

the government uses its expenditure and revenue
programs to produce desirable effects and avoid
undesirable effects on national income, production
and employment.
Musgrave, Fiscal policy is concerned with those

aspects of economic policy which arise in the

operations of public budget.
In conclusion, fiscal policy is the government policy
related to public revenue, public expenditure and
public debt used to achieve predetermined
objectives.

Instruments of fiscal
policy:
There are mainly four instruments or constituents of
the fiscal policy, which are:
1. Budget:
. Budget is an estimation of income and expenditure for
upcoming fiscal year.
. It explains the actual revenue and expenditure of
previous year, revised estimation of current year and
estimation for next year.
. There are three types of Budget:
1) Surplus Budget (TR >TE)
2)Deficit Budget (TR<TE)
3) Balanced Budget (TR = TE)

Contd.
2. Public expenditure:

1.
2.

It refers to the expenses made by public authorities

including central and local governments during one
year.
Public expenditure is most effective instrument to
fight against unemployment.
It will help to increase effective demand through
multiplier.
It can be classified into the following two categories:
Current Expenditure
Capital expenditure/Development expenditure.

Contd.
3. Public Revenue:
The income of the government which is obtained
through various sources such as taxes, grants, fees
and borrowing etc. are called as public revenue.
There are two sources of public revenue:
a)
b)

Tax revenue :
Non-tax revenue:

. Tax revenue includes income received from

direct and indirect taxes.
. Non-tax revenue includes income received form
other sources than tax such as fees, fines and
penalties, gifts, profits etc.

Contd
4. Public debt:
. The amount of loan taken by the government from
internal and external sources is called as public
debt.
. If public revenue cant meet all the public
expenditure the government needs public debt.
. There are two sources of public debt:
a)
b)

Internal sources:
External sources:

. The main objectives of govt. borrowing are:

to meet budgetary deficit, to finance war, to finance
development activities, to fight against depression etc.

Methods of fiscal policy:

There are three types of fiscal policy:
1. Built in Flexibility (automatic stabilization) policy:
. Under this policy, fiscal instruments are linked to
GNP. Increase and decrease in rate of tax and
expenditure are automatically adjusted with fall and
rise of GNP.
. During deflation NI will decrease, public expenditure
will increase and creates deficit budget, which
controls deflation.
. During inflation NI will increase, public expenditure
will decrease and creates surplus budget, which
controls inflation.

Contd.
2. Discretionary fiscal policy:
. Under this policy, the government makes
deliberate changes in a) level and pattern of
taxation b)size and pattern of its expenditure
c) size and composition of public debt:
. Change in taxation and expenditure policy are:
1.
2.
3.
4.

Changing tax with expenditure constant

Changing expenditure with tax constant
Variation
in
both
expenditure
and
taxes
simultaneously.
Change in composition and size of public debt.

Contd
3. Compensatory Fiscal Policy:
. It is a deliberate budgetary action
taken by the government to
compensate for the deficiency in or
excess of aggregate demand.
. Government uses deficit budgetary
policy or surplus budgetary policy to
control deflation or inflation.

Objectives of fiscal policy:

The problems of developing countries are different
from developed countries .
Therefore, the objectives of fiscal policy are also
different.
The main objectives of fiscal policy in developing
countries are:
1.
2.
3.
4.
5.
6.

Mobilization of resources
Capital formation
Minimize the inequalities of income and wealth:
Increase employment opportunities
Counteract inflation
Correct disequilibrium in BOP etc.

Counter Cyclical Fiscal

Policy:
Fiscal Policy is the main Instrument of
economic stabilization.
The economic problems such as
recession as well as depression of
Business Cycle can be solved only
through the effective fiscal policy.
Fiscal Policy not only helps to solve
the problem of depression but also
helps to control unwanted high
growth rate.

What Is Countercyclical Fiscal Policy?

Countercyclical fiscal policy goes against the

current norm in the economy. For example,
in a slow economy, a countercyclical action
would be meant to help encourage an
upswing. It is a government effort which is
implemented through taxes and various
kinds of policies. This type of policy can be
administered for isolated situations or as an
ongoing means of controlling the effect of
business on the economy.

Contd
Countercyclical fiscal policy can also address isolated issues in
the economy. It can be used to attempt to prevent imbalances
that can cause problems, such as when inflation outpaces
unemployment. The goal is to maintain a certain output, which
is affected by job growth, inflation, and the general health of the
A common kind of ongoing countercyclical policy is progressive
taxation. This is a system in which the percentage of taxes on
income increases with the rise of the economy. An increase in
taxes tends to decrease demand, which helps to ensure that the
rise in prosperity will not be too dramatic. This policy can be
applied to an entire population or to people at a certain income
level.
There are some who believe that countercyclical fiscal policy
tends to risk the stability of an economy. These people are wary
of excessive government intervention in the economy. They feel
that the cycle of supply and demand provides adequate controls
for a thriving economy.