Policy¶
| Monetary Policy | Fiscal Policy | |
|---|---|---|
| Short-Run objectives | Interest rates Exchange rate Money supply Aggregate Demand | |
| Long-Run objectives | Price level Inflation | Equilibrium Growth |
| Instruments | Repo rates Trade of financial assets | Government spending Taxation Subsidies |
| Authority | Managed by central banks | Managed by government (Congress/Parliament) |
| Nature | Indirect (effect on G&S market via Financial Market) | Direct (direct effects on G&S market) |
| Changes Implementation Lag | Quicker | Slower |
| Changes Impact Lag | Quicker | Slower |
| Inflation Control | Directly targets inflation | Indirectly influences inflation through spending |
| Economic Impact | Affects borrowing costs directly | Affects aggregate demand through fiscal measures |
Money Supply¶
However, this may not always be true
- Interest Rate \(\not \propto\) Repo Rate Commericial banks may not follow the same as central bank, if they have high liquidity (lots of hot cash)
- Inflation \(\not \propto \frac{1}{\text{Interest Rate}}\) People may not always spend more just because of higher money supply caused by lower interest rates
Budget Deficit¶
Scenario where Govt Expenditure > Revenue. This happens a lot in developing countries, as they are trying to develop as rapidly as possible.
High budget deficit leads to high inflation - When the govt spends a lot of money in development, then the demand for investment and labor will increase - Developing countries always try to spend more than their revenue, because they're trying to develop as quickly as possible
Monetization of budget deficit¶
When the govt prints money/borrows from banks, instead of selling assets
This leads to inflation as there is more money in the system
Money¶
Exchange Rate
| Absolute exchange rate | Real exchange rate | |
|---|---|---|
| Meaning | Ratio of nominal value of 2 currencies | Rate at which one commodity is exchanged for another |
| Comment | Also called as terms of trade Ratio of the goods/services you can buy with 2 currencies |
Pegging¶
the absolute exchange rate is fixed against another currency
isn’t natural it is due to govt intervention
for eg, in UAE Dirham, the Central Bank of UAE
- buys dollars when the value of dollars reduces
- in order to create a fake shortage
- and hence increase value
- sells dollars when the value of dollars decreases
Demand for Money¶
Tradeoff - Hold more money: ease of transactions, but opportunity cost of missing return - Hold more bonds: higher returns, but low liquidity
How much of your wealth you hold in form of money and bonds depends on - price level of transactions - absolute income - interest rate
Equilibrium Interest Rate¶
In reality, \(M_d\) is very volatile - Seasonality - Holidays - Events
| Nominal Income | Interest Rates | \(\implies\) | Money Supply | Interest Rates | |
|---|---|---|---|---|---|
| Constant | Constant | Constant | Constant |  | |
| Constant | Decrease | Increase |  | ||
| Increase | Constant | Increase |  |
Money supply changed through trade of bonds - Central bank buying bonds - Decreases bond supply, increases price of bonds, decreases the interest rate - Increased money supply, decrease money demand, decrease interest rate