Sunday, March 24, 2013

Destabilized economy and corrective measures

Fiscal Policy

When the economy does not function properly under the influence of unemployment, depression or inflation, the government tries to make certain changes in its expenditure policy to bring in the desired changes, and to eliminate the forces that are destabilizing the economy.

There are two basic measures that a government can undertake to stabilize the economy.

1. Government Expenditure

Increase in government expenditure acts as an investment. It gets added to the private investment that is prevailing in the economy. Thus, more government expenditure generates more employment and income, and takes the economy to a new equilibrium position.

2. Taxation

Government Expenditure expands the economy, whereas taxation contracts the economy. More taxation reduces the disposable income of individuals. This reduces their capacity to spend on consumer goods. A rise in taxes lowers the demand curve of the economy. This reduces income and employment. This is necessary during periods of inflation, when prices are moving upwards.

A reduction in taxes will give more income in the hands of consumers. Demand will increase, and new investment and income will be generated. This is necessary during periods of depression. Cut in taxes helps the economy to recover from a depressed state.

Monetary policy is aimed to control the supply of money in an economy. The central bank, which acts as the agent for the government, determines and controls the money supply according to the need of the economy.
Monetary policy is a tool or a process through which a government, central bank, or monetary authority of a country controls
(a) the supply of money,
(b) availability of money, and
(c) cost of money or rate of interest to attain certain sets of objectives to promote the growth and stability of the economy.

Cash reserve Ratio (CRR) is the amount of money or funds that the banks have to keep with the central monetary authority, mainly the central bank of the country.  If the central bank decides to increase the CRR, commercial banks are left with lesser money in hand.  The central banking authority uses the CRR to pull out excess money from the economy or put in more money into the economy.

Commercial banks are always required to maintain with the central monetary authority an average cash balance, the amount of which shall not be less than a certain percentage (say 4-5%) of their total demand and time Liabilities.

Repo(ssession) rate or discount rate is the rate at which the central bank of a country lends money to commercial banks. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the central bank. A reduction in the repo(ssession) rate helps banks to get money at a cheaper rate and vice versa. 

Reverse Repo(ssession) rate is the rate is at which the central monetary authority of a country borrows money from commercial banks, or the rate at which the central monetary authority pays to commercial banks for keeping surplus funds with it (above CRR-determined amount).

An increase in reverse repo. rate can prompt banks to deposit more funds with the central bank to earn higher returns on idle cash. It is also a tool, which can be used by the central bank to pull out excess money from the banking system or the country's economy as a whole.
Repo(ssession) rate, reverse repo(ssession) rate and Cash Reserve Ratio are all determined by the central monetary authority of a country.

When the growth rate of an economy slows down abnormally, it is an indication there is possible dearth of liquid capital. Along with this there may be a great decrease in optimism among investors. This affects the supply side of the economy due to lower and lower rates of production of goods and services. As a resultant effect inflation sets in. Too much money starts chasing too few goods causing a spiraling price rise. Dearth or scarcity of capital may be caused by sinking of capital in assets, which are absolutely non-performing, like gold and silver, or are non-performing in relation to the current economic scenario. Less optimism increases the dampening effect. An acute imbalance of excess government expenditure over government income, including foreign trade (balance of payments) deficits (imports exceeding exports) destabilizes the economy further and pushes it towards possible stagflation, which is stagnation (abnormally slow growth rate) and inflation (price rise) combined.

But the peculiar aspect of this whole depressing economic affair might have been initially caused by an excess demand for goods and services created in one or more sectors of the economy, causing excess income in the hands of people working in those sectors. This excess income, mainly due to over-caution, gets invested and consequently sunk in relatively secured non-performing assets, causing a drain out of effective, production-oriented capital from the economy.

Under such circumstances, an effective combination of monetary (short term measure) and fiscal policy (long term measure) has to be adopted by the government to gear up the economic growth rate and bring down the rate of price rise.

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