Chapter 4

Fiscal Policy:

Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy.

Working and Explanation:

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when between 2-3%), increases employment and maintains a healthy value of money. Fiscal policy is very important to the economy. For example, in 2012 many worried that the fiscal cliff, a simultaneous increase in tax rates and cuts in government spending set to occur in January 2013, would send the U.S. economy back to recession. The U.S. Congress avoided this problem by passing the American Taxpayer Relief Act of 2012 on Jan. 1, 2013.

Objectives of Fiscal Policy –1. To achieve desirable price level:The stability of general prices is necessary for economic stability. The maintenance of a desirable price level has good effects on production, employment and national income. Fiscal policy should be used to remove; fluctuations in price level so that ideal level is maintained.2. To Achieve desirable consumption level:A desirable consumption level is important for political, social and economic consideration. C onsumption can be affected by expenditure and tax policies of the government. Fiscal policy should be used to increase welfare of the economy through consumption level.3. To Achieve desirable employment level:The efficient employment level is most important in determining the living standard of the people. It is necessary for political stability and for maximization of production. Fiscal policy should achieve this level.4. To achieve desirable income distribution:

The distribution of income determines the type of economic activities the amount of savings. In this way, it is related to prices, consumption and employment. Income distribution should be equal to the most possible degree. Fiscal policy can achieve equality in distribution of income.5. Increase in capital formation:In under-developed countries deficiency of capital is the main reason for under-development. Large amounts are required for industry and economic development. Fiscal policy can divert resources and increase capital.6. Degree of inflation:In under-developed countries, a degree of inflation is required for economic development. After a limit, inflationary be used to get rid of this situation. 

Tools of fiscal policy: 1.     Automatic Stabilizers – Structural features of government spending and

taxation that smooth fluctuations in disposable income, and hence consumption, over the business cycle.

 -         Federal Income Tax 2.     Discretionary Fiscal Policy – The deliberate manipulation of government

purchases, taxation, and transfers in order to promote macroeconomic goals such as full employment, price stability, and economic growth.

 -         Changes in Government Purchases II.               Discretionary Fiscal Policy  A.   Changes in Government Purchases Example:  Real GDP = G * (1/1-MPC) B.   Changes in Net Taxes Decrease in net taxes  increases disposable income  consumption increases  increases real GDP demanded.

Increase in net taxes  decreases disposable income  consumption decreases decreases real GDP demanded.Example: Simple tax multiplier- The ratio of a change in equilibrium real GDP demanded to the initial change in autonomous net taxes that brought it about; the numerical value of the simple tax multiplier is -MPC/1-MPC.   Real GDP = NT * (-MPC/1-MPC)  Notes:1.     Increase in government spending, increases equilibrium real GDP demanded.

(simple government purchase multiplier >0)2.     Increase in net taxes, decreases equilibrium real GDP demanded. (simple tax

multiplier <0)

Autonomy of state bank of Pakistan:

A large section of the state bank's duties were widened when the State Bank of Pakistan Act 1956 was introduced. It required the state bank to "regulate the monetary and credit system of Pakistan and to foster its growth in the best national interest with a view to securing monetary stability and fuller utilisation of the country’s productive resources". In February 1994, the State Bank was given full autonomy, during the financial sector reforms.On January 21, 1997, this autonomy was further strengthened when the government issued three Amendment Ordinances (which were approved by the Parliament in May 1997). Those included were the State Bank of Pakistan Act, 1956, Banking Companies Ordinance, 1962 and Banks Nationalisation Act, 1974. These changes gave full and exclusive authority to the State Bank to regulate the banking sector, to conduct an independent monetary policy and to set limit on government borrowings from the State Bank of Pakistan. The amendments to the Banks Nationalisation Act brought the end of the Pakistan Banking Council (an institution established to look after the affairs of NCBs) and allowed the jobs of the council to be appointed to the Chief Executives, Boards of the Nationalised Commercial Banks (NCBs) and Development Finance Institutions (DFIs). The State Bank having a role in their appointment and removal. The amendments also increased the autonomy and accountability of the chief executives, the Boards of Directors of banks and DFIs.

Role of State bank:

1 Banker to the Government: 

As banker to the government, SBP:

    a. Receives deposits (taxes, fees, fines, etc.) on behalf of the  federal government.

     b. Disburses payments (tax refunds, interest, etc.) on behalf of the federal government.

     c. Manages the national debt—buys, sells, and cashes    government securities and pay interest/profit on  them.

     d. Lends money to the federal government as needed.

 2.  Banker to Banks:  As banker to the scheduled banks, SBP:

     a. Holds deposits made by them as a part of their required reserves—5% at this time.   

     b. Lends them funds as a “lender of the last resort” to meet their pressing needs by discounting their bills of exchange and other

3.  Acts as a Clearing House:

Provides facilities, physical and/or electronic, to scheduled banks to clear cheques and other claims drawn against each other—deposited by their customers for collection--by adding up what they owe or owed them and transfer funds from their accounts at SBP.

4.Supervisor of Banks and other Financial Institutions:

One of the fundamental responsibilities of the State Bank is regulation and supervision of   the financial system to ensure its soundness and stability as well as to protect the   interests of depositors. The banking activities are now being monitored through a system of ‘off-site’ surveillance and ‘on-site’ inspection and supervision. Off-site surveillance is  conducted through regular checking of various returns regularly received from the different banks. On other hand, on-site

inspection is undertaken by the  State Bank in the premises of the concerned banks when required.

To broaden financial markets as also to diversify the sources of credit, a number of non-bank financial institutions were allowed to increase substantially. The State Bank has also been charged with the responsibilities of regulating and supervising of such institutions.

5. Issuer of Paper Currency:

State Bank has the sole authority to issue paper notes.  It has the prime responsibility  to  control its supply in order to ensure a stable price of money, i.e., its value  or  purchasing power.  Its notes, however, are not convertible into gold or silver.

6. Exchange Rate Management and Balance of Payment:

The Bank is responsible to keep the exchange rate of the rupee at an appropriate level  and prevent it from wide fluctuations in order to maintain competitiveness of our exports and maintain stability in the foreign exchange market.  As the custodian of country’s external reserves, it is responsible for management of the foreign exchange reserves.

7. Developmental Role of SBP:

     The Bank’s participation in the development process has been widened in the form of rehabilitation of banking system, development of new financial institutions and debt instruments in order to promote financial intermediation, establishment of Development Financial Institutions, directing the use of credit according to selected development priorities, providing subsidized credit, and development of the capital market.

8. Non-traditional Role: The non-traditional or promotional functions, performed by the State Bank include development of financial framework, institutionalization of savings and investment, provision of training facilities to bankers, and provision of credit to priority sectors. The State Bank also has been playing an active part in the process of  Islamization of the banking system

 9. To Formulate and Implement the Monetary Policy: The Bank is also in charge of conducting monetary policy which means changing the supply of money in the economy.  The tools of the monetary policy are:

a.     Changing the monetary base: This directly changes the total amount of money circulating in the economy. The State Bank can use open market operations to change the monetary base. The Bank would buy/sell bonds in exchange for hard currency. When the central bank sells government bonds it receives hard currency in payment, thus reducing the money supply. It buys government bonds and pays hard cash to the sellers, thus, increasing the money supply.

b.     Changing the reserve requirements:  Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with SBP. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the SBP changes the availability of loanable funds. This acts as a change in the money supply.

c.     Changing the discount rate:  Banks borrow money from the State Bank by cashing or discounting credit instruments, such as bills of exchange.  By raising the discount rate SBP discourages banks to borrow money.  If and when the goal is to increase the money supply, the Bank lowers its discount rate to encourage borrowing by the banks and, thus, helps increasing the money supply. 

Also by calling in existing loans or extending new loans, the monetary authority can   directly change the size of the money supply.

Money Laundering:

Money laundering is the processing of criminal proceeds (including but not limited to drug trafficking) to disguise their illegal origin or the ownership or control of the assets, or promoting an illegal activity with illicit or legal source funds. 

Money laundering systems generally have three basic elements- placement, layering and integration. In the placement stage of money laundering, the launderer introduces his illegal profits into the financial system. This can be done by breaking up large amounts of cash into smaller sums that are then deposited into a bank account, or by purchasing a series of monetary instruments (money orders, checks, etc.). After the money has entered the financial system, the second, or layering, stage takes place, where the launderer moves the funds from one account to another at various banks around the world to distance them from the original source. The funds might also be channeled through the purchase and sales of investment instruments or the transfers may be disguised as payments for goods or services. The launderer then moves into to the third stage, integration, in which the funds re-enter the legitimate economy. Afterwards, the launderer might choose to invest the funds into real estate, luxury assets, or business ventures.

Control of Money laundering:

The fight against money laundering and the funding of terrorism affects all involved in the eGambling industry. Licensees must comply with the various laws and regulations that have been adopted in the fight against money laundering and the funding of terrorism. Customers will need to appreciate that it may mean a lengthierand potentially more detailed registration process before they can begin to use the services of the eGambling licensee, coupled with occasions when they may have to provide further information about themselves. Some aspects of this should already be familiar to customers from their experience of dealing with the wider banking and financial services sector.The entire process requires that there be vigilance on the part of all concerned. It is no longer acceptable to turn a blind eye and hope for the best.The nature of the eGambling sector is such that small weaknesses, if exploited, could pose great risks by virtue of the sums of money involved, the speed of transactions, and the levels of turnover.