Fiscal And Monetary Policy: How They Influence Economic Development?

Watsala Shakya

The power of every economy in the world (excluding some exceptions) is vested in their respective governments and the market. The government plays an important part in shaping an economy, and the tools a government uses to direct its economy are fiscal and monetary policies. The fiscal policy and monetary policy stimulate the economy to the position it should be in. If the economy is leaning towards a downturn these tools are used to revive the health of the economy.

Monetary Policy

Monetary policy is the guide in managing the money supply in an economy. The central bank of a country is responsible for preparing it. The central bank usually dictates the interest rates as well in the monetary policy. Interest rates play vital roles in controlling the circulation of money in the economy, or in other words, it controls the money supply. In Nepal, Nepal Rastra Bank (NRB) is responsible for managing the circulation of money. For this NRB and other central banks all over the world stimulate the economy to expand it by lowering interest rates. When interest rates are lowered, borrowing becomes cheaper, this encourages more and more people to borrow and increase consumption, which means the more people spend, the more money circulates the economy, and hence money supply increases. This is one of the scenarios in an economy when monetary policy is used to stimulate the economy. Other times, if the economy is expanding too fast, central banks restrict the circulation of money in the economy. For this, the monetary policy increases interest rates. Interest rates are mostly raised at times when inflation rises swiftly, by doing so the supply of money is controlled as the cost of borrowing becomes expensive, and as a result demand for money and liquidity reduces to a great extent. A country also employs monetary policy when its economy falls into a recessionary period. During this time expansionary monetary policy is employed, in this case, interest rates are reduced and reserve limits are more lenient. At times of recession, bonds are issued by countries so that new money is formed.

How Monetary Policy Influences Economic Development?

1) Adjustments to Demand and Supply of Money

Economic development results in an increase in demand for money as, economic growth and a decline in subsistence sectors significantly increase the demand for currency transactions. In addition, the increase in per capita income and population growth in the development process has also increased the demand for money. The ever-increasing demand for money requires the monetary authority to increase the money supply at the rate of increase in real income so that the price does not fall due to the increase in national income. The decline in price levels has a negative impact on economic growth and triggers a vicious spiral in prices and production. This will slow growth and lead to inflation.

2) Price Stability

A stable price level and the exchange rate are vital for economic growth in an economy. Inflation is an inevitable phenomenon that takes place in an economy, it does not particularly indicate weakness in economic health, but high rates of inflation usually do. The price increases have a negative impact on the propensity to save and directly impact investments into speculative and non-productive investments, such as real estate, jewelry, gold, warehouses, etc. Therefore, the monetary authority must constantly monitor price movements. Thereby regulating the supply and direction of money and credit, thereby controlling price increases. Also, inflationary price increases lead to frequent currency devaluations. Exchange rate fluctuations will have a negative impact on international trade, which will help a country’s development. This may hinder economic growth, for this, the monetary authorities use monetary policies to prevent such incidents.

3) Credit Control

The banking system of weaker economies like Nepal is not yet fully developed. Due to this, the monetary authorities must intervene when the possibility of credit problems arises, to provide sufficient guarantees and rediscount options to induce banks to provide medium and long-term credit for production purposes. When borrowing rates become too cheap, the supply of money in the economy will be high which may lead to inflation. Commercial banks mainly provide short-term loans to entrepreneurs and businessmen and are unwilling to provide medium and long-term loans to meet the financial needs of industry and production.  Selective control of loans is also needed to influence the investment and production structure and to distinguish the cost and availability of credit in different sectors and industries.

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Fiscal Policy

Fiscal policies are guidelines that regulate the spending of the government. It guides the government on how revenue from taxation and other sources should be spent. In fiscal policies, tax rates are vital mediums to stimulate the economy. The government will reduce tax rates and increase spending in an attempt to stimulate the economy. If the government senses the economy to be slow or to not have enough activities, it will boost its spending, which is also known as stimulus spending. However, if there is not sufficient tax revenue to fund stimulus spending, the government will resort to public borrowing, or will even issue bonds and securities, also referred to as deficit financing. On the other hand, for a contradictory situation, when an economy needs to cool off, the government will raise taxes and reduce spending, and hence it encourages economic growth.

How Fiscal Policy Influences Economic Development?

1) Mobilization of Resources

The main goal of fiscal policy in less developed countries is to mobilize resources from the public and private sectors. Usually, the savings rate, national income, and per capita income are very low. The speed of investment and capital accumulation, in turn, has accelerated the pace of economic development.

Private investment has the beneficial effects of increasing investment and reducing tangible consumption. Investment in non-productive channels can help limit inflation in the economy. The problem of foreign investment could be solved by increasing savings rates and increasing the marginal propensity to save through public finances, taxes, and compulsory loans. Progressive tax rates, high import taxes on luxury goods, and bans on the production of luxury goods and luxury goods are further measures that can help mobilize resources. Expenses, real estate, etc. can make a huge contribution to the fair distribution of wealth and resources.

2) Encourage Investments

In underdeveloped countries, fiscal policies encourage investment in socially and economically accepted production channels, which means that investors can promote economic development and avoid waste and unproductive investment. Ultimately, the goal of fiscal policy should be to invest in general social and economic expenditures such as transportation, communications, technical training, education, health, and soil protection, which tend to increase productivity and expand markets for foreign trade. At the same time, Non-productive investment is restricted and directed to productive and social needs channels.

3) Employment Opportunities

The populations of the least developed countries are growing very fast, for this, the fiscal policies of these countries aim to generate high expenditures that help expand employment opportunities. Underdeveloped countries usually suffer from unemployment, usually cyclical unemployment and disguised unemployment. Cyclical unemployment in underdeveloped countries occurs as these countries mainly export raw materials. If the demand for these raw materials declines due to the economic downturn, underdeveloped countries will also have to deal with unemployment in major industries. To eliminate this type of unemployment, the government can increase government spending, but this is unlikely to have many positive effects. When government spending increases, people can spend on imports or conspicuous consumption. On the other hand, disguised unemployment in underdeveloped countries exists in the agricultural sector, which means that more people are engaged in production activities, rather than eliminating the number of people really needed for this type of unemployment. Therefore, it is necessary to improve the level of education. The main goal of fiscal policy in less developed countries should be to maximize capital accumulation without inflation.

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