UNIT-4.pdf

UNIT-4 Money Money is the commonly accepted medium of exchange. Money place a significant role in modern economic life of Human beings. Money occupies a unique place in an economic system. The society needs money for a variety of transactions undertaken...

UNIT-4 Money Money is the commonly accepted medium of exchange. Money place a significant role in modern economic life of Human beings. Money occupies a unique place in an economic system. The society needs money for a variety of transactions undertaken by the people and the government in the daily life. Now-a- days we cannot imagine a society without a role for money. Definition Robertson defined money as “anything which is widely accepted in payment for goods or in discharge of other kinds of Business obligations.” Evolution of money The term "money' was derived from the name of Goddess Juno Moneta of Rome. Prior to the introduction of money, the barter system was in vogue. In that system one commodity was exchanged for another commodity. That system was beset with several difficulties. Money was coined in order to overcome the difficulties of the barter system. In the initial stage animal was used as money Gradually metallic money replaced it. In the third stage coins came into use. That was followed by paper money. The latest is the credit money. Thus money has undergone different stages in the process of evolution. Difficulties of the Barter system: Money was introduced so as to remove the difficulties of the barter system which may be enumerated as follows Lack of coincidence of wants Under the barter system, the buyer must be willing to accept the commodity which the seller is willing to offer in exchange The wants of both the buyer and the seller must coincide. This is called double coincidence of wants Suppose the seller has a goat and he is willing to exchange it for rice. Then the buyer must have ice and he must be willing to exchange rice for goat. If there is no such coincidence direct exchange between the buyer and the seller is not possible. This caused exchange very difficult as more and more new commodities were being produced and the consumption patterns changed over a period of time. Lack of store of value In a barter system, it was very difficult to store wealth in form of goods, as most of the goods were of perishable nature and required huge space and heavy transportation costs. Money makes it easy to store wealth in the most convenient, secure, and economical way to meet contingencies and unpredictable emergencies. Lack of divisibility of commodities Depending upon its quantity and value, it may become necessary to divide a commodity into small units and exchange one or more units for other commodity but all commodities are not divisible. This is particularly true in the case of animals. In such a case a Sheppard will not be able to buy his needs as he possesses only sheep to exchange for other commodities Lack of common measure of value 1 Under the barter system, there was no common measure of value. To make exchange possible, it was necessary to determine the value of every commodity in terms of every other commodity Difficulty in making deferred payments Under barter system future payment for present transaction was not possible, because future exchange involved some difficulties. For example, suppose it was agreed to sell specific quantity of rice in exchange for a goat on a future date keeping in view the present value of the goat. But the value of goat may decrease or increase by that date. Sometimes the quality of the commodity to be given in payment may undergo change. Because of these problems, agreement on the terms of deferred payment was found to be difficult. Types of money 1. Commodity money and representative money a) Commodity money includes metallic coins whose face value and intrinsic value is the same. b) Representative money includes coins and paper money whose intrinsic value is less than their face value 2. Legal tender money and optional money a) Legal tender money. Legal tender money is the money which should be accepted as per law by everyone in payment for commodities. Ex 5paise, 10paise, 25paise and 1rupee, 2 rupees, 5 rupees, 50rupees. b) Optional money is non-legal tender. Nobody is bound by law to accept such money. However, the public may generally accept it optionally. Eg., cheques. One may refuse to accept cheques towards payment of bills, but in actual practice they are accepted at the option of sellers. Bills of exchange and hundis are other forms of optional money 3.Metallic money and paper money Money is divided into metallic and paper money on the basis of the material used to make it. a) Metallic money is made up of metals such as silver, nickel, steel etc. All coins are metallic money b) Paper money is money printed on paper. Currency notes are paper money 4.Standard money and token money a) Standard money is the money whose face value and intrinsic value are the same. The government adopts some precious as the standard. Previously governments all over the world accepted. gold standard to print their currency. Under gold standard, the banks give gold in exchange for the unit of currency as per the face value. It is convertible. Indian rupee is not standard money. b) Token money is the money or unit of currency whose face value is higher than the intrinsic value It is not convertible. It facilitates transactions and accepted by the public as medium of exchange. 5.Credit money This is also called bank money. This refers to the bank deposits that are repayable on demand and which can be transferred from one individual to the other through cheques. Supply of money Money supply is a stock concept. There may be increase or decrease in the money stock over a period of time. The changes in the money supply influence the economic activity in the economy in a number 2 of ways. Money supply determines the rate of interest, and credit availability, investment, the levels of output, national income and employment. It affects the general price level. components of money supply Money supply includes all money in the economy. The components of money supply may vary from country to country. Broadly speaking, money supply composes of the following: 1) Currency issued by the central bank In any country the central bank issues currency. Currency consists of paper notes and coins. In India Reserve Bank of India, which is the central bank of the country, issues notes in the denominations of 2000, 500, 100, 50, 20, 10, 5 and 2 rupees. The one rupee note and coins are issued by the finance department of the Government of India. Coins are the metallic money. It is also issued in different denominations to facilitate day-to-day monetary transactions by the public. Coins are produced in the mints maintained by the Government of India in different places. Currency notes are printed in the security presses of the Government of India 2) Demand deposits created by commercial banks Bank deposits are a prominent component of money supply Commercial banks create credit from the primary deposits of money received from the public. Credit is created in the form of deposits. In developed countries they constitute nearly 80% of money supply. Monetary aggregates: In India money supply is measured in terms of the following monetary aggregates: M1= Currency + demand deposits + other deposits M2= M1+ time liability portion of savings deposits with Banks + Certificates of Deposits issued by banks + term deposits maturing within one year M3= M2+ term deposits over one-year maturity +call/term borrowings of banks These monetary aggregates will be discussed in greater detail in higher courses of study. It is sufficient at this stage to remember the terms i.e. M1, M2 and M3 as monetary measures or monetary aggregates. Demand for Money Demand for money refers to the total amount o f money that individuals, businesses, and governments are willing to hold in cash or in easily accessible forms such as checking and savings accounts within a specific period. Types of Demand for Money Demand for money is varied, reflecting various economic requirements and conditions. Transactional Demand: Transactional demand for money emerges from everyday economic activities. Individuals and businesses require funds for routine transactions: buying groceries, paying bills, or conducting business deals. The higher the economic activity, the greater the transactional demand. It directly correlates with the level of trade and commerce in an economy. Precautionary Demand: 3 Precautionary demand arises due to uncertainty. People hold money aside, like a financial safety net, for unexpected events such as medical emergencies or sudden job loss. The amount kept for precautionary reasons varies based on individual circumstances and economic stability, providing a cushion against unforeseen financial challenges. Speculative Demand: Speculative demand for money is driven by investment foresight. Investors, anticipating future changes in asset prices or interest rates, may choose to hold onto cash temporarily. For instance, if there’s an expectation of falling stock prices, investors might defer investments, preferring the flexibility of liquid assets. Speculative demand is closely linked with market perceptions and financial speculation. Functions of Money The functions of money can be divided into two categories, i.e., Primary Functions and Secondary Functions. The Primary Functions are the main or basic functions of money; whereas, the Secondary Functions are the subsidiary or derivative functions of money. Primary Functions: Medium of Exchange Money acts as a mode of exchanging goods. It has solved the main problem of barter system of double coincidence of wants. Money also provides a freedom of choice purchasing a good. E.g. A Fruit seller can sell goods to his customer and in return can demand money for his fruits. Customer can use the money to buy another goods from different seller. Measure of Value Money helps in determining the specific value of goods and services. calculating the exchange rates between two goods. Money serves a “measure” or “unit” by which, we can measure the value of goods and services, also compare their pricess. E.g. In India, Rupees is the unit of account, in America, it is Dollar, etc. Secondary Functions Store of Value Money acts as an asset that sustains value over a period of time. It is the most liquid asset. It is like a store of wealth for future use. E.g., A person can save his salary and spent it later according to his needs at different times. Transfer of Value Today, cost of transporting money from one place to another is very less. (Compared to the time when barter system was in use) With improved technology in banking system, interstate and international trades are increasing. E.g., NEFT and RTGS are facilities offered by RBI. They help transfer money using internet from one bank account to another. Standard of Deferred Payments Deferred payments refer to payments made on loans, salaries, pensions, insurance premium, interests, and rents. Money acts as a ‘standard’ for making future payments. 4 E.g., A person paying his EMIs on his home loan. Money Creation or Credit Creation The banking structure is entirely based on the creation of credit. In simple words, credit means getting the power to purchase anything now and promise to pay it later in the future; the bank charges interest in case of non-fulfillment of the desired amount. Based on these credits, the bank uses a part or a fraction of its customer deposits to offer loans or lend money on credit to other individuals and businesses. Money creation or credit creation is one of the most important activities of commercial banks. Because of credit creation, banks are able to create credit, which is in excess of the initial deposits. Banks use the deposits held with them for giving loans. However, they cannot use the whole deposits for lending. It is legally compulsory for the banks to maintain a certain minimum fraction of their deposits as reserves. This fraction is called Legal Reserve Ration (LRR), which is fixed by the central bank. Some basic terms used in Credit Creation or money creation Primary Deposits: A deposit is considered a primary deposit when the bank accepts cash from its customer and deposits it under his name into his account. These deposits convert the currency money into deposit money. Secondary or Derivative Deposits: A deposit is considered a secondary or derivative deposit when the bank grants loans to the borrower. Instead of giving cash, the amount is deposited under the borrower’s name into his account. Excess Reserves: Every financial institution or bank is required to hold a certain amount of money as a reserve to ensure proper liquidity. However, when the cash held by the bank is above the reserve requirements set by the authority, it is said to be an excess reserve. Credit Multiplier: Credit Multiplier refers to the ratio of change in secondary deposits due to the change in primary deposits. Money Multiplier or credit Multiplier Money Multiplier can be stated as the phenomenon in which the creation of money is done in the form of credit creations in the economy. In other words, a money multiplier can be described as the influence a central bank plays over the money supply by modifying the required reserve rates. Money Multiplier or Credit Multiplier measures the amount of money that the banks are able to create in the form of deposits with every unit of money it keeps as reserves. The Money Multiplier plays a great role in the banking system of the economy as every time the government needs to kick-start the economy, the multiplier helps decide what proportion of stimulation should be applied and in what manner. Formula The money multiplier is expressed as: 5 Where ‘r’ is the Reserve Ratio or the Cash Reserve Ratio, and it can be described as the minimum ratio required to be maintained by commercial banks. Integrating money and capital markets Money Market The money market refers to the platform for short-term borrowing and lending of funds, typically for a period of up to one year. It is a part of the financial market where financial instruments such as Treasury bills, commercial papers, certificates of deposit, and repurchase agreements are traded. The money market provides liquidity to investors and helps in the efficient allocation of funds among the various sectors of the economy. It is an important segment of the financial system as it provides short-term funding for banks, corporations, and governments. Features of Money Market Short-term instruments: Most of the financial instruments on the money market have an end date of less than one year. This makes it easy for buyers to get short-term loans without being locked into long-term contracts. High liquidity: High liquidity is one of the most important things about the money market. On the money market, it's easy to turn financial assets into cash, so investors can get their money quickly when they need it. Low risk: The money market is thought to be a relatively low-risk way to spend because most of the financial instruments that are traded there come from creditworthy sources like governments, banks, and corporations. A regulated market: Central banks, financial regulators, and other government groups keep an eye on the money market. These agencies make sure that the market works in a fair and clear way and take steps to stop scams from happening. Interest rates that are competitive: The interest rates on the money market are set by how much money is on the market and how much people want to borrow. This lets people who need money get it at a reasonable interest rate and gives investors a good return on their money. A variety of financial instruments: The money market has a lot of different financial instruments, such as Treasury bills, commercial papers, certificates of deposit, and buyback agreements. This gives investors the freedom to choose the investment instrument that best fits their wants and willingness to take on risk. Functions of Money Market  Makes short-term borrowing and lending easier  Keeps the financial system running smoothly  Sets short-term interest rates  It sets a standard for other financial instruments  Helps control risk  Helps with monetary policy 6 Commodity Market The commodity market is a financial market where people buy and sell commodities like agro products, metals, energy, and other raw materials. Producers and consumers of commodities use commodity markets to control price risk and figure out prices. To put it more simply, it is a place where people can buy and sell goods. The physical market and the derivatives market are the two kinds of commodity markets. In the physical market, real goods are traded. In the derivatives market, contracts are traded that show a deal to buy or sell a specific good at a certain time in the future. Features of Commodity Markets Standardization: Commodities traded in the market are standardized. This means that the quality, quantity, and delivery date of the commodity are predetermined and specified in the contract. Standardization enables buyers and sellers to trade in a transparent and efficient manner. Price discovery: Commodity markets facilitate price discovery, which is the process of determining the market value of a commodity. The price of a commodity is determined by the forces of supply and demand in the market. Price discovery helps producers and consumers of commodities to determine the fair value of the commodity. Low transaction costs: Commodity markets have low transaction costs compared to other financial markets. This is because commodities are physical assets that do not require complex financial instruments for trading. As a result, transaction costs such as brokerage fees and commissions are relatively low. Leverage: Commodity markets provide leverage to traders. This means that traders can buy or sell a larger quantity of commodities with a smaller amount of capital. Leverage allows traders to amplify their gains or losses. Volatility: Commodity markets are volatile. The prices of commodities are influenced by a variety of factors such as weather conditions, geopolitical events, and supply and demand dynamics. As a result, commodity prices can fluctuate rapidly and unpredictably. Hedging: Commodity markets provide a mechanism for hedging against price risk. Producers and consumers of commodities can use futures contracts to lock in a price for the commodity and protect themselves against price fluctuations in the physical market. Speculation: Commodity markets also attract speculators who seek to profit from price changes in the market. Speculators are traders who do not have an underlying interest in the physical commodity but trade futures contracts for profit. Functions of Commodity Markets  Price discovery 7   Risk management  Price stabilization  Liquidity  Investment  Market information IS-LM Model The economic theories suggested by economist John Maynard Keynes in the 1930s can be described and explained through the IS-LM model. In 1936 when Keynes published their magnum opus, “The General Theory of Employment, Interest, and Money”, economist John Hicks constructed the IS-LM model in 1937. IS-LM Model is a macroeconomic tool that shows the interaction between interest rates and production within the money market. This model highlights the main ideas of Keynesian economic theory and its full form is Investment-Savings and Liquidity Preference-Money Supply. In addition, it represents the equilibrium that emerges between real production and interest rates. Geeky Takeaways:  The IS-LM model is derived from “Investment Savings” (IS) and “Liquidity Preference-Money Supply” (LM).  The model explains the impact of changes in market preferences on the levels of market interest rates and GDP that are in equilibrium.  The IS-LM model is also known as the Hicks-Hansen Model.  It offers insights into the complicated aspects of the economy. Components of IS-LM Model The IS-LM model includes components such as monetary and fiscal policy, liquidity preference, and the balance between investment and saving: Monetary Policy: This involves the central bank’s management of the money supply and interest rates to achieve macroeconomic goals. It plays a pivotal role in influencing economic stability and controlling inflation. Fiscal Policy: This encompasses government decisions on spending and taxation, directly impacting aggregate demand. It serves as a potent tool for policymakers to navigate economic conditions and stimulate growth. Liquidity Preference: Reflects individuals’ inclination to hold cash rather than invest it. This psychological aspect influences economic decisions and plays a role in shaping monetary policy. Investment-Saving Balance: This represents the intricate relationship between savings and investment, a critical factor in understanding the impact of economic policies on investment decisions and overall economic growth. IS Curve and LM Curve The IS-LM Model comprises the IS Curve and LM Curve: IS Curve: 8 The IS Curve outlines the correlation between real interest rates and output levels. It shows the impact of investment and government spending changes on AD (Aggregate Demand) and Economic Equilibrium. The shift in the IS curve directly impacts the equilibrium output level which can provide valuable insights to policymakers in fiscal policy changes. Figure 1 shows the IS curve graphically. The goods market is shown on the left side and the IS curve is shown on the right side. The real GDP is shown on the X-axis and the real interest rate is shown on the Y-axis. This curve shows the equilibrium in the goods market at different real interest rate levels. A particular level of economic output is associated with each equilibrium. The real interest rate is in equilibrium when the saving and investment curves are the same. This can be better understood with an example. Suppose the real interest rate is 5%, and the output in the economy is 8000 units. Now, the output increases from 8,000 units to 10,000 units in an economy. The increased output increases the savings resulting in a shift from S1 to S2. This increase in savings leads to a decrease in the real interest rates. The new equilibrium shifts from point A to B, with higher output and lower interest rates. Due to this negative relationship between output and real interest rate, the IS curve is downward sloping. LM Curve: The LM curve shows the connection between central bank-induced interest rate adjustments and the equilibrium between nominal and real money supplies. When RBI changes interest rates and money supply, it can directly impact the position of the LM curve, influencing real income, output, and overall economic activity. LM curve can help policymakers maintain monetary equilibrium and promote sustainable economic growth. Figure 2 shows the LM curve graphically. The assets market is shown on the left and the LM curve on the right. The real GDP is shown on the X-axis and the real interest rate is shown on the Y-axis. This curve shows the asset market equilibrium at different real interest rate levels. When the demand for money intersects with its supply, the asset market is in equilibrium. This can be better understood with an example. Let’s suppose the real interest rate is 5%, the output in the economy is 8,000 units, and the money supply is ₹2,000 (which is also the money that a person wants to hold). Now, the output increases from 8,000 to 10,000 units in an economy. The increased output can increase the income level, which increases the spending and ultimately increases the demand for cash. This shifts the demand curve from left to right. The quantity of money increases from 2,000 to 2,200 but the supply is fixed at 2,000 which ultimately leads to a shortage of money in the economy. This increases the interest rate from 5% to 6%. Thus, there is a new equilibrium at 10,000 units and a 9 6% interest rate. Due to this positive relationship between the increase in output and real interest rate, the LM curve is upward-sloping. Difference between IS Curves and LM Curves in the IS-LM Model Basis IS Curve LM Curve It shows combinations It shows of National combinations of Income (Y) and Interest Rates and Representation Interest Rates (r), Income (Y) where where total spending money supply equals equals money demand. total production. It is based on the It is based on investment-savings liquidity preference- relationship which money supply which shows how changes Derivation shows how changes in interest rates can in income can influence planned influence the demand investment and for money. national income. The IS model slopes The LM model slopes downward because of upward because of a a negative positive relationship Behaviour relationship between between income and interest rates and the demand for planned investment. money. Monetary and Fiscal Policies in IS-LM Curve Model 10 1. Fiscal Policy in the IS-LM Model a. Expansionary Fiscal Policy: In the IS-LM framework, an upsurge in government spending or a tax reduction prompts a rightward shift in the IS curve. This shift elevates national income and interest rates, signifying heightened aggregate demand due to increased government expenditure. The impact extends to both income and interest rates, influencing economic equilibrium. b. Contractionary Fiscal Policy: Conversely, a decrease in government spending or a tax increase shifts the IS curve leftward, resulting in diminished national income and interest rates. This leftward shift indicates a reduction in aggregate demand owing to decreased government spending, affecting both income and interest rates within the IS-LM model. 2. Monetary Policy in the IS-LM Model a. Expansionary Monetary Policy: Within the IS-LM model, an expansionary monetary policy involves increasing the money supply, leading to a downward shift in the LM curve. This shift brings about lower interest rates and potentially an augmented national income. The policy aims to invigorate economic activity by reducing borrowing costs and fostering investment. b. Contractionary Monetary Policy: On the contrary, a contractionary monetary policy involves decreasing the money supply, causing an upward shift in the LM curve. This shift results in higher interest rates and potentially decreased national income. The policy aims to mitigate inflation by elevating borrowing costs and diminishing investment within the IS-LM framework. Criticisms of IS-LM Model 1. Static Nature: The IS-LM model’s primary limitation lies in its static nature, emphasizing short-term analysis while overlooking time lags in policy implementation. This inherent characteristic restricts its effectiveness in capturing the dynamic and evolving nature of economic processes over time. It may struggle to provide insights into the consequences of delayed policy responses. 2. Unrealistic Assumptions: A noteworthy drawback stems from the model’s reliance on unrealistic assumptions, such as a closed economy, fixed money supply, and static investments. This departure from the complexities of the real world undermines its applicability, as economic systems are inherently open and subject to dynamic changes. These assumptions may oversimplify the intricate interactions within a globalized economic environment. 3. Limited Policy Tools: The IS-LM model’s explanatory power is hampered by its inability to provide a nuanced understanding of tax or spending policies. The model lacks specificity in detailing the intricacies of policy tools, limiting its practical application in real-world economic scenarios. Its oversights may hinder policymakers from seeking comprehensive guidance on intricate fiscal measures. 4. Ignorance of Inflation: 11 Early versions of the model face criticism for neglecting the consideration of inflation. By assuming rigid prices in the short run, the IS-LM model overlooks a critical aspect of economic dynamics, hindering its accuracy in forecasting and analysis. Ignoring inflation dynamics may result in an incomplete understanding of economic phenomena. 5. Simplistic View of Financial Markets: The model’s portrayal of financial markets is criticized for its simplistic nature, disregarding the intricate realities of multiple financial instruments and varying time horizons. This oversimplification hampers the model’s ability to capture the complexities inherent in real-world financial systems comprehensively. The model may struggle to represent the diverse array of financial instruments and their impacts on market dynamics. 6. Conflict with Modern Monetary Policy: A fundamental misalignment arises in the IS-LM model’s focus on controlling the money supply, a concept that clashes with contemporary monetary policy practices. In modern economic frameworks, interest rates have emerged as the primary target of monetary policy, highlighting the model’s divergence from current policy strategies. This misalignment poses challenges for policymakers relying on interest rate mechanisms for economic stabilization. 7. Insufficient Explanation of International Trade: Another notable limitation is the model’s inadequate consideration of international trade and exchange rates, critical components in the global economic landscape. These elements are necessary for the model’s relevance in understanding and predicting the complexities of interconnected economies. Its limitations in addressing global economic interactions may limit its usefulness in a highly interconnected world. Monetary Policy Monetary policy is an economic policy that manages the size and growth rate of the money supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation and unemployment. These policies are implemented through different tools, including the adjustment of the interest rates, purchase or sale of government securities, and changing the amount of cash circulating in the economy. The central bank or a similar regulatory organization is responsible for formulating these policies. Objectives of Monetary Policy Inflation Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue. Unemployment Monetary policies can influence the level of unemployment in the economy. For example, an expansionary monetary policy generally decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market. Currency exchange rates Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign currencies. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts. 12 Tools of Monetary Policy Interest rate adjustment A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. Change reserve requirements Central banks usually set up the minimum amount of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients, and thus, money supply decreases. Open market operations The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy. Fiscal Policy The fiscal policy serves as a guide used by the government for determining the amount to support the country's economy as well as the revenue that must be earned to ensure that the economy runs efficiently. It has become increasingly important recently in order to achieve rapid economic growth in India as well as throughout the world. One of the main objectives of the Indian government's fiscal policy is to attain speedy economic growth. To manage the economy of the country, the monetary policy and the fiscal policy are two important pillars. Objectives of Fiscal Policy  Fiscal policy aids in maintaining the growth of the economy in order to achieve economic objectives.  Another goal of the fiscal policy is increasing employment to help the economy recover from a period of low economic activity.  It maintains the country’s price level by controlling the rates during inflation.  The fiscal policy imposes direct taxes on those with higher incomes and subsidises the consumption goods of low-income families.  It subsidises food, fuel, and other necessities and levies indirect taxes on luxury goods such as imported cars and cosmetics, thereby, promoting social equality. Types of Fiscal Policy Expansionary Fiscal Policy The decisions that the governments have taken to raise their monetary contributions to the country's economy are included in an expansionary fiscal policy. This policy is responsible for generating a huge number of goods and services. It also increases employment opportunities and boosts personal and governmental profits. Contractionary Fiscal Policy This type of fiscal policy is used when the economy is booming. However, rapid growth in the country’s economy can pose a risk. In this case, the government takes steps to stop the on-going economic boom. This additionally contributes to controlling both inflation and economic growth. 13 Neutral Fiscal Policy The government uses a neutral fiscal policy when the economy of the country is balanced. It indicates that things are progressing well given the economic highs and lows. A neutral fiscal policy includes government expenditure that is financed by taxes imposed on individuals, companies, or various sectors of the economy. It does not influence the condition of the country's economy. Difference between Fiscal Policy and Monetary Policy Business cycle and stabilization The business cycle refers to the fluctuations in economic activity that occur over time, typically characterized by periods of expansion, peak, contraction, and trough. During an expansion, economic output, employment, and incomes are rising. This phase is often associated with increased consumer spending, business investment, and overall optimism. Peaks mark the highest point of economic activity before a downturn. Contraction follows the peak, characterized by declining economic indicators such as GDP, employment, and consumer spending. This phase often leads to a recession if the downturn is severe and prolonged. Finally, a trough is reached, representing the lowest point of the cycle where economic activity bottoms out. Stabilization policies aim to moderate the extremes of the business cycle and promote economic stability. Governments and central banks implement various monetary and fiscal policies to achieve this goal. Monetary policy involves actions by the central bank to control the money supply, interest rates, and credit availability to influence spending and investment. Fiscal policy, on the other hand, involves government spending and taxation to manage aggregate demand and stabilize the economy. During an economic downturn, policymakers may implement expansionary policies to stimulate demand and boost economic activity. This could involve cutting interest rates, increasing government spending, or reducing taxes to encourage consumption and investment. Conversely, during periods of high inflation or overheating, policymakers may pursue contractionary policies to cool down the economy and prevent excessive price increases. Stabilization policies are crucial for promoting sustainable economic growth, minimizing unemployment, and maintaining price stability. However, implementing these policies effectively 14 requires careful analysis of economic conditions, as well as coordination between monetary and fiscal authorities. Additionally, the effectiveness of stabilization policies can vary depending on factors such as the flexibility of the economy, external shocks, and the credibility of policymakers. The classical paradigm In macroeconomics, the classical paradigm refers to a school of economic thought that emerged primarily in the 18th and 19th centuries. It emphasizes the idea of self-regulating markets and long- term equilibrium in the economy. Key features of the classical paradigm in macroeconomics include: Say's Law: This principle, often associated with Jean-Baptiste Say, suggests that supply creates its own demand. In other words, the act of producing goods and services generates income, which in turn creates the demand for those goods and services. Therefore, according to Say's Law, gluts or shortages in the economy are only temporary and will be resolved by market forces. Market Flexibility: Classical economists believe in the flexibility of markets to adjust to changes in supply and demand without the need for government intervention. Prices, wages, and interest rates are seen as flexible and capable of adjusting to ensure equilibrium in the long run. Neutral Money: Classical economists often adhere to the concept of monetary neutrality, which posits that changes in the money supply only affect nominal variables (such as prices and wages) in the economy, not real variables (such as output and employment) in the long run. This implies that changes in the money supply do not have long-term effects on the real economy. Laissez-faire Policy: The classical paradigm generally advocates for minimal government intervention in the economy. Governments should focus on protecting property rights, enforcing contracts, and maintaining a stable monetary environment, but should otherwise refrain from interfering with market transactions. Long-Run Equilibrium: Classical economists believe that in the long run, the economy will naturally gravitate towards full employment of resources and potential output. Any short-term fluctuations in output or employment are viewed as temporary and will be corrected by market mechanisms over time. While the classical paradigm has been influential in shaping economic thought, it has also been subject to criticism and revision over time, particularly in response to the challenges posed by recessions, depressions, and other economic phenomena that classical theory struggles to explain. Keynesian economics, for example, emerged in response to perceived shortcomings of the classical paradigm, particularly its inability to adequately address issues such as unemployment and aggregate demand shortfall. Price and Wage Rigidities Price and wage rigidities refer to situations where prices and wages do not adjust easily or quickly in response to changes in supply and demand conditions in the economy. These rigidities can lead to inefficiencies and contribute to economic downturns or fluctuations. Here's a breakdown: Price Rigidities: 15 Price rigidities occur when prices in markets do not adjust freely to changes in supply and demand. This can happen due to various reasons such as: Menu Costs: The costs associated with changing prices, such as printing new menus or updating price tags, may discourage businesses from adjusting prices frequently. Long-term Contracts: Prices may be set in long-term contracts or agreements, making it difficult to adjust them in the short term. Social or Legal Constraints: Some prices may be regulated by government policies or social norms, preventing them from adjusting freely. Coordination Issues: In markets with many firms, coordinating price changes can be challenging, leading to sticky prices. Wage Rigidities: Wage rigidities refer to situations where wages do not adjust quickly or fully in response to changes in labor market conditions. This can occur due to: Labor Contracts: Wages may be set in long-term labor contracts, making it difficult for firms to adjust them in response to short-term changes in demand. Minimum Wage Laws: Minimum wage laws may prevent firms from lowering wages below a certain level, even if market conditions warrant it. Worker Resistance: Workers may resist wage cuts due to concerns about fairness or morale, leading to sticky wages. Insider-Outsider Effects: Existing workers (insiders) may resist wage reductions to protect their own interests, potentially leading to unemployment among new entrants or outsiders. Price and wage rigidities can have significant implications for macroeconomic stability. During economic downturns, rigidities can prevent prices and wages from adjusting downward quickly, leading to unemployment and inefficient resource allocation. Similarly, during economic booms, rigidities can prevent prices and wages from rising rapidly enough to match increases in demand, leading to inflationary pressures. Understanding the causes and implications of price and wage rigidities is crucial for policymakers seeking to implement effective economic policies, particularly during times of economic uncertainty or crisis. Efforts to reduce rigidities, such as through structural reforms or targeted policy interventions, can help promote a more flexible and resilient economy. voluntary and involuntary unemployment 16 Voluntary and involuntary unemployment are two key concepts in economics that describe different reasons individuals may be out of work: Voluntary Unemployment: This occurs when individuals choose not to work at the current wage rate and under the prevailing conditions in the labor market. There are several reasons why someone might be voluntarily unemployed: Job Search: Individuals may be voluntarily unemployed while they search for a job that matches their skills, preferences, or desired working conditions. They may be waiting for a better job offer or taking time off between jobs. Education or Training: Some individuals may voluntarily leave the labor force to pursue education or training opportunities to improve their skills and future employment prospects. Retirement: People who have reached retirement age and choose not to work are considered voluntarily unemployed. Discouraged Workers: In some cases, individuals may become discouraged by their job search efforts and temporarily withdraw from the labor force, leading to voluntary unemployment. Involuntary Unemployment: This occurs when individuals are willing and able to work at the prevailing wage rate but are unable to find employment due to factors beyond their control. Involuntary unemployment is typically caused by deficiencies in the labor market or broader economic conditions: Cyclical Unemployment: Involuntary unemployment often rises during economic downturns or recessions when overall demand for goods and services decreases, leading firms to reduce production and lay off workers. Structural Unemployment: In some cases, there may be a mismatch between the skills and qualifications of job seekers and the available job openings. This structural mismatch can lead to long-term unemployment even when there are job vacancies. Frictional Unemployment: This type of involuntary unemployment occurs due to the time it takes for individuals to find a suitable job after entering or re-entering the labor force, or after changing jobs. Seasonal Unemployment: In industries or regions where employment is highly dependent on seasonal factors (e.g., agriculture, tourism), workers may experience involuntary unemployment during off-peak seasons. Policymakers often focus on addressing involuntary unemployment through measures such as fiscal and monetary policy to stimulate economic activity, job training programs to address structural unemployment, and labor market reforms to reduce frictions in the job search process. Understanding 17  the distinctions between voluntary and involuntary unemployment is essential for designing effective policies to address labor market challenges and promote full employment. Central Bank The central bank is an autonomous, powerful, government-controlled bank tasked with regulating the banking industry, addressing currency concerns, and advising the government on economic policy. Its primary aim is to stabilize the currency and economy while limiting inflation. A central bank is an independent, non-political financial agency that supervises monetary policy. It is responsible for maintaining cash and foreign currency reserves, thus stimulating the nation’s economic growth and controlling inflation. Each country has its central bank to manage its financial and banking issues. These banks perform the following operations:  Maintaining monetary policy by regulating the money supply and interest rates  Providing financial stability to the government and commercial institutions  Safeguarding and managing the nation’s gold, foreign currency, and government bonds  Overseeing the functioning of the banking sector and balancing the nation’s banking system  Handling financial transactions; locally via clearing houses and globally via networks such as SWIFT  Issuing new currency and coins inside a nation  Providing financial advice to the government Examples Let us look at the following central bank examples to understand the concept better: Example 1 Let us take the example of the US central bank, the Federal Reserve (Fed). However, its ability to dominate the economy is not limited to the United States since the dollar is the most powerful currency in the world. Fed ensures overall financial health by regulating monetary policy, assuring solid financial institutions, securing monetary transactions, and operating as a settlement system. Example 2 In recent news, a story by Economic Times emphasized the trend of global central banks to increase interest rates. In their efforts to control inflation, banks like the US Federal Reserve, the Reserve Bank of Australia, and the Bank of England, have made it highly likely for their countries to go into recession due to recent rate increases. In 2021, central banks emphasized that inflation was merely “temporary” as prices rose due to supply chain inefficiencies after lockdowns imposed amid the COVID-19 pandemic. However, global inflation continued and increased due to Russia’s invasion of Ukraine. As a result, oil and food prices skyrocketed, forcing economists to reduce their global growth forecasts for 2022. Central bank and government The central bank and the government are two key institutions in a country's economic system. The central bank is responsible for managing monetary policy, regulating banks, and controlling the money supply. On the other hand, the government sets fiscal policy, which involves decisions about taxation, spending, and borrowing. While they often work closely together, they also maintain some degree of independence to fulfill their respective roles effectively. 18 Central banks and governments play crucial roles in managing a country's economy, but they have distinct functions and responsibilities. Central Bank: Monetary Policy: Central banks control monetary policy, which involves managing interest rates, money supply, and credit conditions to achieve specific economic goals, such as controlling inflation, stabilizing currency value, and promoting economic growth. Currency Issuance: Central banks are typically responsible for issuing and regulating a country's currency. Banking Regulation: They supervise and regulate commercial banks and financial institutions to maintain stability in the financial system. Foreign Exchange Reserves: Central banks manage a nation's foreign exchange reserves, which are used to stabilize the currency's value and intervene in the foreign exchange market if necessary. Government: Fiscal Policy: Governments control fiscal policy, which involves taxation and government spending to influence economic activity. They use fiscal policy to achieve goals such as promoting economic growth, reducing unemployment, and ensuring social welfare. Legislation and Regulation: Governments create laws and regulations governing various sectors of the economy, including labor, trade, environment, and consumer protection. Public Goods and Services: Governments provide public goods and services, such as infrastructure, education, healthcare, and defense, which contribute to the overall well-being of society. Income Redistribution: Governments often engage in income redistribution through welfare programs, social security, and progressive taxation to reduce inequality and alleviate poverty. 19