Fiscal and Monetary

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Institute for Integrated Learning in Management

IILM Graduate School of Management

GREATER NOIDA

PROJECT OF FISCAL AND MONETARY POLICY ON BUSINESS

SUBMITTED TO: SUBMITTED BY:

Prof. Rajkishan Nair PUNAM PANDEY

FT-FS-11-335



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CONTENT

Introduction

Effect of fiscal and monetary policy

Graphs

Implications

Effect in business

Conclusion

Bibliography



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Introduction

Monetary policy

A major factor that can affect the direction of a nation’s 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 country’s 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 country’s

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 A + b M

Bk +(1-c)h 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.



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LM1

r LM2

E1

E2

IS

O Y1 Y2 Y

Fig.1.1(a) less effective monetary action

r LM1 LM2

E1

E2

IS

O Y1 Y2 Y

Fig.1.1(b) More effective monetary action



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The effect of monetary policy.

Monetary policy is the regulation of a country’s 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.

Spending

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.



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Employment

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 policy-

Government 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.



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R E2 LM

r2

E1 M D

r3

IS1 IS2

O Y1 Y2 Y

Fig 2 Fiscal expansion

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



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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)

1 – c

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 doesn’t earn anything. Instead, it confiscates its money from people in

the form of tax. It’s 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 won’t pay for it. When the cash is spent, it’s 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.



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Effect of fiscal policy Action on

Taxes

Action on

Governme

nt

Spending

Effect on

Federal

budget

Effect on

the

National

debt

1.National employment rate rises to 12% Towards

deficit

2. Inflation is strong at a rate of 14% per

year.

Towards

surplus

3. Surveys show consumers are losing

confidence in the economy, retail sales are

weak and business inventories are

increasing rapidly.

Towards

deficit

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



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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 governmentincome 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 industry’s 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



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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 logicof 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

Globalization’s 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 oil’s 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.

http://voices.yahoo.com/topic/15541/september_11.html

http://voices.yahoo.com/topic/15541/september_11.html



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Consideration

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.

Conclusion

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.

Bibliography

www.businessnewsdaily.com

www.ehow.com

www.debtbombshell.com

www.yourbusiness.azcentral.com

www.google.com

principles of macroeconomic by Soumyen sikdar

http://www.businessnewsdaily.com/


http://www.ehow.com/


http://www.debtbombshell.com/


http://www.yourbusiness.azcentral.com/


http://www.google.com/







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Fiscal and Monetary