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Institute for Integrated Learning in Management IILM Graduate School of Management GREATER NOIDA


Prof. Rajkishan Nair


CONTENT Introduction Effect of fiscal and monetary policy Graphs Implications Effect in business Conclusion Bibliography

Monetary policy A major factor that can affect the direction of a nations economy is its monetary policy, which determines the amount of money flowing through the economy. Set by the Federal Reserve in the United States, monetary policy influences economic activity by controlling the countrys money supply and credit. The Federal Reserve is able to control monetary policy by altering rates of interest and changing the amount of money banks must have in their reserves. The Federal Reserve act of 1913 officially gave the Federal Reserve the power over the countrys monetary policy. Since then, the monetary policy has increased tremendously in importance. The goals of monetary policy, stabilizes prices and wages, which in turn leads to an increase in jobs and long-term economic growth. U.S. monetary policy plays a significant role not just in the economy as a whole, but in specific decisions consumers make, such as buying house and cars, starting and expanding businesses and deciding to invest money. Monetary Policy in the IS-LM model In the IS-LM model the only exogenous variable related to monetary policy is the level of money supply. So we consider a monetary policy as a change in the money supply. Y* = h Bk +(1-c)h A+ b M

bk + (1-c)h P

As increase in money supply (everything else constant) will increase the equilibrium level of output and will decrease the equilibrium interest rate. An increase in M will shift the LM curve (M does not appear in the IS curve) down, by an amount given by the change in M. Consider an increase in the supply of money M, other factors remaining unchanged. This pushes the LM1 curve out to LM2 in fig. In the new equilibrium at E2, income Y IS HIGHER THAN INTEREST RTE R IS LOWER the effect of a decrease in money supply contradiction or tight monetary policy is raise to r and reduce Y. when money supply expands the increase in Y is brought about by a raise in I induce by the fall in R the higher Is G (the interest elasticity of investment) the larger will be the boost to I following drop in R. Thus the effectiveness of expansionary monetary action where is positively with G. Recall that a high G implies a Is curve.

LM1 r E1 E2 LM2




Fig.1.1(a) less effective monetary action r LM1 LM2

E1 E2




Fig.1.1(b) More effective monetary action

The effect of monetary policy. Monetary policy is the regulation of a countrys money supply by the central bank of a country or region. In the United States, the central bank is the federal reserve board. Monetary policy tools are used to help control the economy. The primary tools used by a central bank are changes to the prime interest rate, changes to the amount of money in circulation and changes in the reserve requirements for banks. The effects of monetary policy are: Control inflation

One of the primary impacts of monetary policy is on inflation. The goal of monetary policy is to control inflation, or the value of currency, through changes in monetary policy tools. When inflation rises, the central bank typically raise interest rates. High inflation makes the cost of goods higher. Central banks want to keep inflation low to keep the prices of goods stable relative to the value of the currency. Interest Rates

Monetary policy directly impacts interest rates. The central bank raises or lowers the prime rate, or interest rate the central bank loans money to other banks, as a tool to impact the economy. These actions have a trickle don effect on the interest rates charged on loans, credit cards and any other financial vehicle that is tied to the prime rate.

Business cycles

Business is cyclic in nature and goes through periods of expansion and contraction. Monetary policy attempts to minimize the speed and severity of the expansions and contractions to maintain steady growth or decrease a negative contraction. The goal is to keep an economy on a slow, but steady growth pattern to prevent recessions during periods of contraction.


Monetary policy impacts the amount of money spent in an economy. When a central bank decrease interest rates, more money is typically spent in an economy. This increase in spending can equate to better overall health for an economy. Likewise, when interest rates are increased, spending declines, this could curtail inflation.


Employment levels relate to the health of an economy. When inflation is low and an economy is stable or in an expansionary phase, employment levels are higher than when inflation is high and an economy is in a contraction phase. Changes in monetary policy that maintain economic stability and minimize inflation, tend to keep unemployment low.

Fiscal policyGovernment spending policies that influence macroeconomic conditions. These policies affect tax rates, interest rates and government spending, in an effort to control economy. Fiscal policy is based on the theories of british economist john maynard Keynes, which state theta increasing o decreasing revenue (taxes) and expenditure (spending) levels influences inflation, employment and the flow of money through the economic system. Fiscal policy is often used in combination with monetary policy, which in the united states is set by the federal reserve, to influence the direction of the economy and meet economic goals.The two main tools of fiscal policy are taxes and spending.

Taxes influence the economy by determining how much money the government has to spend in certain areas and how much money individuals have to spend. For example, if the government is trying to spur spending among consumers ,it can decrease taxes. A cut in taxes provides families with extra money, which the government hopes they will turn around and spend on other goods and services, thus spurring the economy as a whole.

Spending is used as a tool for fiscal policy to drive government money to certain sectors that need an economic boost. Whoever receives those dollars will have extra money to spend and as with taxes, the government hopes that money will be spent on the other goods and services.

R r2 E1 r3



IS1 O Fig 2 Fiscal expansion Y1 Y2


Fiscal policy involves in G and T. Suppose the government steps up its spending (G) on goods and services, keeping T unchanged. In fig 1,IS1 shifts to IS2. Compared to the old equilibrium, both Y and R are higher in the new equilibrium, E2. Expansionary fiscal action stimulates output and employment. The rate of interest goes up after the rise in G for the following reason. As Y goes up, the transaction demand for money also rises. With money supply unchanged, this rise in demand will cause r to go up. Another way of looking at it is: people will have to sell bonds to get the extra money needed to meet the higher transaction demand. This causes bond price to decline, which is the same as a rise in r. At the new equilibrium r must rise sufficiently to keep money demand unchanged even though income is higher. Fiscal policy in the IS-LM model First, we write the IS-LM model using specific function forms. In particular, we focus on linear functions. Consider the following functions: Consumption function: : C = (C0 + c Y T) Where c0>0 is a constant and 0<c<1 is the marginal propensity to consume. Y is real income and T is the tax level, so(Y-T) is the disposable income. Investment function: I = I0 br Where IO>0 is a constant and b>0 measures the responsiveness of investments to the interest rate. Government expenditure is exogenous and equal to G. Tax level is exogenous and equal to T (you may assume that the tax level depends on income as we have done in one of the problem sets, however, nothing substantial will change in the analysis). The equilibrium in the goods market is: Y = C + I + G

Using the functions defined above we have: Y = C0 + c(Y T) + I0 br + G Solving for Y: Y = 1 [C0 + I0 +G cT br]1) 1c Equation 1) is our IS curve. However, the IS curve as we plotted so far should be written as r as a function of Y. Therefore, we can rewrite the IS curve as: r = 1 [C0 + I0 + G ct- br] 1) b equations 1) and 2) are obviously the same thing written in a different way. Effect of fiscal policy: Politicians talk about fiscal policy as if it were a business strategy for the country. But government is nothing like a business. The state doesnt earn anything. Instead, it confiscates its money from people in the form of tax. Its subject to none of the constraints and competition a normal business has to contend with. All fiscal policy means is how the government taxes us and how it spends the money. However, like any person or business, governments borrow and spend for two principal reasons either to produce or to consume. The most obvious form of government consumption is when the state transfers money to people in the form of pensions and benefits. Spending on health and education can also consume money, especially when it fails to deliver improvements. The bottom line is that borrowings to fund this kind of expenditure wont pay for it. When the cash is spent, its gone and can only be repaid with higher taxes. Public investment

Alternatively, when government spends money productively it invests in things like roads, railways energy generation and communication networks. Investment in capital infrastructure like this is commonly associated with higher economic growth and output. It can help to facilitate trade and promote economic activity in the private sector, where a nations wealth is created. In other words, borrowing to produce can pay for itself.

Effect of fiscal policy

Action on Taxes

Action on Governme nt Spending

Effect on Federal budget Towards deficit Towards surplus Towards deficit

Effect on the National debt

1.National employment rate rises to 12% 2. Inflation is strong at a rate of 14% per year. 3. Surveys show consumers are losing confidence in the economy, retail sales are weak and business inventories are increasing rapidly. 4. Business sales and investment are expanding rapidly, and economists think strong inflation lies ahead.

Towards surplus

Implications of fiscal and monetary policy to business:Because monetary and fiscal policies affect business directly and indirectly, it is important for business owners to understand and monitor changes in government policies. Fiscal and monetary policies are tools used by the government to stabilize the ebb and flow of the economy. In a 2012 survey by the national federation of independent business, business owners revealed that two of their main concerns were the economy and fiscal polices.

Expansionary Fiscal Policy

Expansionary fiscal policies are laws passed by the legislative and executive branches to increase government spending or lower taxes, often intending to relieve the economy from a recession. When taxes decrease for individuals, the government is hoping to boost consumerism to help businesses and the overall economy. Government spending contributes to an increase in the nation's growth rate, or gross domestic product. Less restrictive legislation on business operations contributes to increased cost savings. Legislation passed to fund job growth, stimulus packages, and

business grants aids business growth because of a resulting increase in consumer spending and business investment. Contracting fiscal policy

Contracting fiscal policies are enacted by congress and the president to increase government income while the economy is doing well and to prevent an economic bubble by stabilizing the peak of a booming economy. When taxes are increased, people have less money to spend on consumer goods. When government spending is reduced, programs and jobs are cut. The unemployed will seek jobs from businesses. Sales will decline because of unemployment and higher taxes on consumers. Corporations will also experience less government sales for military equipment and other government goods. Increasing monetary policy

Expansionary monetary policy is another government tool to boost the economy through lower interest rates and a larger money supply. The Federal Reserve can directly decrease interest rates or purchase U.S. bonds from the Treasury to increase the money supply. As the money supply rises, the government accumulates more money without increasing taxes. As interest rates decrease, businesses and individuals can take advantage of cheaper loans and credit rates to help pay for expensive items. Inflation would raise the price of goods, but the overall effect would be a boost in consumer activity from business investment, government projects, and individual purchases. Decreasing monetary policy

Monetary policy contractions are used to prevent an economic bubble. The Federal Reserve raises the interest rate to control the rate of money being lent, sells U.S. bonds for Federal Reserve notes and decreases the overall money supply. This will reduce inflation but will cut spending. As the bank's ability to lend money declines, businesses and people will find it harder to get a loan. People will make less major purchases and spend less using credit cards. Government and business investment will also decline.

Fiscal and monetary policy effected by the industries:A) Airlines industry As per the news of 11th September 2001 the airlines industrys fiscal and monetary policies have been deeply affected by the terrorist attacks. Although the deep-seeded tragedy occurred several years ago, the effect on the airlines industry has been astounding. Immediately following the tragedy demand decreased, the base-ticket prices increased, along with added taxes. The workforce was hit with lay offs nationwide in the airline, and the travel industry as a whole was affected. As a result many people being afraid to fly and the rise of ticket prices a steep decline in demand caused some airlines to go into


bankruptcy. Immediately following the September 11th tragedy, the demand for airline tickets dropped and airlines were forced to make immediate cutbacks. Passengers were the first to notice the increase of the fares. Some travelers who could avoid traveling did so out of fear of another attack or just because of added fees. The base-ticket price increased, but there was an added tax called September 11th Security Fee. "The funds raised through this September 11 Security Fee will be used to implement new aviation security measures to help achieve this important goal."(Mineta, 2001) Even though passengers understood the logic of increasing security measures, the increase in fare still affected the demand. This policy made the demand drop even more, and as a result the base-price of tickets increased.
The September 11th tragedy and implemented policies affected the employment rate dramatically. Unfortunately, many employees in the industry were laid because the demand was lower. Many airlines implemented a hiring freeze; this was also seen in other sectors of the travel industry. Airlines are actively hiring again, and layoffs have ceased since the demand has increased since the tragedy occurred. Some airlines such as United and Delta went through bankrupt; instead sacrifices were made by employees, retirees, and passengers. The airline industry is highly competitive, but it is an unstable industry. Many airlines have gone bankrupt over the years such as Texas Air, PanAm, TWA, and so many more (USA Today ,2005) have been acquired by other airlines. The fiscal and monetary policies are largely affected by the September 11th terrorist attacks. The employment rate in the airline industry immediately decreased, and all hiring processes were suspended due reduction of revenue. The base-ticket price increased due to the decrease in demand for airline tickets, the terrorist attacks created a scare, and the Department of Transportation and Department of Homeland Security decided increased security was necessary, the solution was to add a special tax called September 11 fee to the price of airline tickets. The effects of deregulation and competition have continued to have a positive impact on the airline industry; however the impact of the terrorists attack overwhelmed the industry and many airlines went bankrupt.

B) Oil industry According to a paper entitled world crude oil markets: monetary policy and the 2004-05 oil shock by economists Hossein Askari and noureddine krichene, published on the GW centre for the study of Globalizations website, monetary policy that resulted in record low interest led to a spike in oil demand, resulting in a jump in world oil prices and rising oil industry profits in 2004-05. Expert insight

According to the federal reserve bank of Dallas, monetary policy cannot directly affect energy. However, monetary policy can respond to significant rises in oil prices. Potential

Because of oils importance in driving world economic activity, high prices could affect economic output and lead to recessions. High oil prices also raise production costs and could cause inflation.



Contractionary monetary policy reduces the money supply and could lower oil prices by reducing demand for oil. Expansionary monetary policy raises money supplies and could cause oil demand to control rising, sending oil prices and industry profits higher.

Fiscal consolidation or budget deficit reduction leads to a decrease output and interest rate. In India, the blame for inflation is often laid squarely at the door of budgeting deficit of the central government and deficit reduction is strongly recommended for containing inflationary pressure. The major policy conclusion of monetarism is that stability in money supply is crucial for stability in the economic system. And stability in money supply is crucial for stability in the economic system of M. The best possible things that monetary authorities can do is to announce a fixed rate of growth of M. The best possible thing that the monetary authorities can do is to announce a fixed rate of growth of the money stock and stick to that irrespective of short run fluctuations in prices or output.

www.businessnewsdaily.com www.ehow.com www.debtbombshell.com www.yourbusiness.azcentral.com www.google.com principles of macroeconomic by Soumyen sikdar