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.

Synthesis of Monetary and Income Analysis - Part I

IS-LM Analysis - Commodity Market and Money Market Equilibrium

Macro Economics deals with the fundamental problems, which are concerned with determination of gross domestic output, income and employment, price level, and growth of national income. In the short-run determination of income, employment and price level are the primary concerns. Government policies, necessary to control these variables, are required to be ascertained, and put into use at the right time to accelerate or retard the economy.

Keynesian analysis is known as Income Analysis. The Monetary Analysis was done by classical economists. But this is actually a sysnthesis of Keynesian economics.

Economists Hicks and Hansen designed a model, which is popularly known as the Hicks-Hansen IS-LM Analysis. Assumptions of this analysis are as follows.

1. An economy consists of four types of markets, namely commodity market, money market, securities market and labour market.
2. There are enough resources available to produce the required quantity of goods and services, in accordance with the demand.
3. Any change in demand is reflected in a change in output.
4. Aggregate demand or expenditure consists of consumption expenditure, investment expenditure and government expenditure.
5. Aggregate supply consists of consumption goods and savings. To this we add tax collected (T), which is the income of the government.

I) Income Analysis - This is done in the commodity market. II) Monetary analysis - This is done in the money market.

Commodity market equilibrium condition
1. Consumption Function
'a' is the minimum level of consumption even at zero income. The income identity is Y = C + S (income = consumption + savings)
C = a + b*Y
Or, C = a + (ΔC / ΔY)*(Y)
Y = disposable income







2. Savings Function

s = ΔS / ΔY
3. Investment Function

Investment (I) = f(r), where 'r' is the rate of interest. Investment is inversely related to the rate of interest, as rate of interest is the cost of borrowing investment money.
This shows the equilibrium condition in the commodity market. The commodity market is said to be in equilibrium when the economy spends as much as it earns, or when income is equal to expenditure. That means when the supply side Y = the demand side E.
Y = E Or, C + S = C + I
C cancels out from both the sides of the equation, leaving S and I on either side, which are equal. That is, S = I (savings = investment)

Money Market Equilibrium condition

Demand function for money or Money-Demand function is Md = KPY + L(r)
where Md = demand for money
P = Price Level
Y = money income (gross national product)
PY = National Income or the money value of the goods and services produced. It is the real income.
K = proportion of money that is held for transactions purpose and precautionary purpose.
Transaction demand and precautionary demand depend upon the level of income. If the income increases, the demand for money also increases. Any increase or decrease in the rate of interest is unable to influence these two demands for money. Only speculative demand for money is influenced by the rate of interest.

"L" = Speculative demand for money or Liquidity Preference (that is, preference to keep liquid cash). 'L' is a function of the rate of interest. That is, L = f(r)
Suppose an individual is initially at point A. He is holding OMo amount of money, when the rate of interest is Oro. Money holding means the sacrifice of the current rate of interest. If the rate of interest goes up, an individual reduces his money holding, in order to earn the high rate of interest. Therefore, the rate of interest is called the opportunity cost of holding money, i.e. loss of the opportunity to earn interest at the current rate. Higher the rate of interest, higher is the opportunity cost of holding money, and consequently lower is the demand for money. People will then want to maintain their wealth in the form of bonds and securities.

Money Supply curve
Ms = C + D
C = currency in circulation in the form of notes and coins.
D = deposit or bank money
Money supply, Ms, remains fixed in the short-run, as it is controlled by the Central Bank, the central monetary authority. Equilibrium condition in the money market is established when Md = Ms (demand for money = supply of money).

Part I - of IV | Part II - Derivation of the IS Curve

Money - An Economic Overview

Evolution of Money: The fundamental aim of man is to satisfy his economic wants. In earlier days man produced whatever was needed by him. But in course of time, economic wants started to increase. So to satisfy all his economic wants, man started to exchange the goods. In earlier days the system that was followed for exchange is known as the Barter System. Under this system there was direct exchange of goods for goods. But man started to face many difficulties under this system. So to overcome these difficulties man introduced money.

First precious metals were used as money. Then, in course of time, a small quantity of a metal, with a with a stamp or mark put on it to indicate value, was introduced to serve the purpose of money. This process is called coinage. Now a days paper money, duly sanctioned by law, with appropriate signs and symbols, is used used universally as the medium of exchange. For small transactions, however, coins are still used.

Legal Tender Money: Legal tender money means money, the tender or payment of which constitutes, by law, the sufficient discharge of a debt.

The fundamental difference between money and other commodities is that money is generally acceptable in payment for goods, services, debts and compensations, while other commodities are not. People want other commodities for the commodity's sake - to consume, enjoy or otherwise utilize them, but money is wanted not for its own sake but because it has purchasing power over other goods.

The real significance of money is that it is a claim, which can be used by its owner to buy everything. As because general acceptability is the fundamental characteristic of money, we can define money as anything which is generally accepted by people in exchange for commodities or services, or in payment of debts or compensations.

Mr. Paul Samuelson: "Money is an artificial social convention."

Definition: Money is something, which serves as a medium of exchange. It is accepted unquestionably by everyone in exchange for goods and services. Different economists have defined money in different ways. According to Mr. Francis Walker "money is what money does."

We can define money as anything, which is accepted by the people

1. as medium of exchange,
2. as a measurement of value,
3. as a store of value,
4. as a standard of deferred value, and
5. as a transfer of value.

From this above definition follows the functions of money.

1. Medium of Exchange: Money promotes or facilitates exchange of goods and services. Our whole economic system depends entirely upon money, without which all modern forms of consumption, production, distribution and exchange will cease to exist.

2. Measurement of Value: Money assigns a value or price to any commodity or service. Every commodity or service can be weighed in terms of money. So it serves as a measuring instrument for value.

3. Store of Value: Money is the best form in which one can store his wealth. It has a universal usefulness at any given time, which makes it the best form as a store of value.

4. Standard of Deferred Value: Money serves as standard for deferred payments, that is payments, which are to be made in future.

5. Transfer of Value: Since any economic commodity or service can be weighed in terms of money, for any kind of value transfer it acts as the best medium.

Demand for money or reasons for holding money: J, M. Keynes forwarded three primary reasons or motives for holding money.

1. Transactions motive: Every man requires a certain amount of money to meet his daily expenditure. From this, the transaction demand for money arises.
2. Precautionary motive: People normally hold more money than what is required for his transactions purpose. He keeps some extra money in hand to meet the unforeseen circumstances, or any kind of emergency situation. This gives birth to the precautionary demand for money.
3. Speculative motive: Money, when invested, brings income in the form of interest. If someone decides to hold money he will be foregoing the interest that it would have yielded, if invested. Thus holding money means preferring liquidity, as money is the most liquid form of asset. When there is an expectation that interest will rise in the future, people purchase securities to earn higher interest income in the future. Interest is the reward for parting with liquidity. Thus individuals or institutions, who have sufficient money left after satisfying the first two demands, may also need some money for speculative purpose.

In the short run, transactions demand and precautionary demand are more or less fixed. Only under a situation of rising prices and consequent inflation, these two demands may increase in the short run. Otherwise in the short run, it is the speculatory demand for money, which determines the overall demand for money.

Supply of Money: The supply of money basically means the quantity of money in circulation. In simple terms, the total amount of cash held by individuals and institutions in the form of notes and coins, together with the total value of deposits held in bank accounts of commercial banks, together with bills and bank notes constitute the supply of money. Some writers prefer to use the term money in a narrow sense to mean only legal tender money. Others include deposits, but only such deposits as are withdrawable by cheques, thus excluding non-chequeable deposits. The measures that are taken to control the total supply of money in an economy are compositely called the Monetary Policy.

Value of money: Meaning: Value of money means the purchasing power of money. It means that goods and services can be purchased with money. When more goods and services can be purchased with money, the value of money is said to be more, and vice versa.

Determination of the value of money: There are two theories given by the economists for the determination of the value of money. The two theories are

1) Quantity Theory of Money
2) Income Theory of Money