Monetary Fiscal Policy at NSPP by Muqeem

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Monetry and Fiscal Policy by Muqeem ul Islam


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PowerPoint Presentation:

Monetray & Fiscal Policies with emphasis on Inflation Muqeem ul Islam Additional Directing Staff, NIM National School of Public Policy

Policy Making Process ?:

Policy Making Process ?

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Vision Policy formulation process Policies/ Intervention Tools Programmes Projects Use of Humanity’s Knowledge base Alternative Schools of thoughts Analysis Research/Technical Analysis Cost Benefit Analysis Expert Opinion Technocrats’ views Choices between alternate options Consensus making process Policy formulation process Wisdom Information / Data Knowledge Theories Analytical Framework

Inflation by design or by accident?:

Inflation by design or by accident?

Impact of Inflation:

Impact of Inflation

Measuring Inflation:

Measuring Inflation Price Indices The Consumer Price Index (CPI) Quarterly changes in the price of a ‘basket’ of goods and services (eight broad headings) Group weightings Only metropolitan households, wage and salary earners GDP deflator (IPDI)= Nominal GDP/Real GDP × 100

Economic Gain of Inflation to the Government:

Economic Gain of Inflation to the Government Real wages in the Govt sector goes down Real interest payment on domestic debt reduces Real value of Domestic debt reduces Revenue of the Government increases as prices go up.

Causes and Cures of Hyperinflation:

Causes and Cures of Hyperinflation Hyperinflation is generally caused by a combination of large budget deficits, excessive growth in monetary and credit aggregates, purchase of Treasury securities by the government, and an outflow of foreign capital. During periods of hyperinflation, real growth generally declines and often turns negative. Inflation can be stopped almost immediately with the imposition of a new regime, a return to a balanced budget, and renewed investor confidence. It does not take years to wind down a hyperinflationary spiral.

Macroeconomic Policies:

Macroeconomic Policies Demand Management Policies Exchange rate Adjustment Policies Demand Switching Policies

Monetary Policy:

Monetary Policy Attempts to influence the level of economic activity (the amount of buying and selling in the economy) through changes to the amount of money in circulation and the price of money – short-term interest rates. Interest rates the key area of Monetary Policy

Monetary Policy:

Monetary Policy Basis of Monetary Policy is that there is a long run relationship between the amount of money and inflation Demand for Money – the amount people wish to hold as cash as opposed to other assets The Supply of Money – the amount of money in circulation in the economy

Money and Its Uses:

Money and Its Uses M1 Sum of currency outstanding and balances held in checking accounts M2 All the assets in M1 plus some additional assets that are usable in making payments but at greater cost or inconvenience than currency or checks

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Currency and coin (CC): Rs. 982 billions .. (Actual wealth) Demand Deposits and Saving Deposits in all banks (D)= Rs.3706 Billions Other Deposits with SBP = Rs. 4.2 billions Resident For. Cur Accounts (RFC)= Rs. 263 Billions M2 (Broad Definition) (CC+D+RFC) = Rs. 4689 Billions (perceived wealth) Ratio (CC and M2) = 0.21 Money Supply = M2 Actual wealth & Actual Wealth As on January 24, 2009 Source : SBP, Monthly Report, Feb 209

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Irving Fischer Equation….economic law M V=P Q M=Money Supply…perceived quantity of money in the economy V= Velocity of Money P=Price level(inflation) Q= GDP, Production, Quantity of goods & Services available for consumption Money Supply = m B ..m = money multiplier B= base money …actual money…number of notes in the economy Sources of money supply expansion Govt deficit financing….State bank direct financing of credit Bank Credit to private sector…FDI, Foreign Loan….

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STATE BANK MONETARY POLICY TOOLS: Required Reserve Ratio: –which determines the volume of demand deposits that can be supported by a given level of reserves. Discount Policy (Primary Credit Policy): -which encourages (or discourages) borrowing from the SBP to meet the reserve requirement, thus increasing (or decreasing) . Open Market Operations: –Reserves can be increased (or decreased) directly by the SBP’s buying (or selling) Treasuring bills.

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Objective Targets and Instruments of Monetary Policy

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Open Market Operations “Open Market Operations” is a term that refers to the Fed’s buying Treasury bills from commercial banks as a means of directly increasing the level of reserves. Treasury bills in the portfolio of a commercial bank represent “funds lent out.” That is, when the bank bought the Treasury bill (i.e., the IOU) from the Treasury, it lent funds to the Treasury. When the Fed buys the Treasury bill from the bank, it replaces “funds lent out” with Reserves, which enables the bank to engage in further lending.

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Open Market Operation: Interest Rate Channel Expansionary Monetary Policy Short run: Central bank reduces the repo rate Commercial banks and financial institutions find it profitable to sell bonds to the central bank Central bank raises their reserves Commercial banks have more money to lend Firms and households find it cheaper to borrow They borrow and create more deposits Demand for goods and services rises Money supply expands Long run: Prices will eventually rise following higher demand Real money supply (M/P) shrinks Interest rises back to natural position

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Open Market Operation: Interest Rate Channel Contractionary Monetary Policy Short run: Central bank raises the repo rate Commercial banks and financial institutions find it profitable to buy bonds from the central bank Central bank sell bonds and reduces reserves of the financial institutions Commercial banks have less money to lend Firms and households find it expensive to borrow They pay back loans and close deposits accounts Demand for goods and services falls Money supply contracts Long run: Prices will eventually fall Real money supply increases Interest rises back to natural position

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Budget 2007-08 (Billion Rs.) Budget 2007-08 Revised Budget 07-08 Variations A. Total Revenue 1475.9 1512.7 +36.8 - Tax Revenue 1095.5 1056.5 -39.0 - Non-Tax Revenue 380.4 456.2 +75.8 B. Total Expenditure 1874.6 2250.5 +375.9 - Current Expenditure 1378.1 1837.5 +459.4 - Interest Payments 374.6 503.2 +128.6 - Grants 37.8 87.0 +49.2 - Subsidies 100.4 378.3 +277.9 - WAPDA 52.9 113.0 +60.1 - Oil 15.0 175.0 +160.0 - Wheat 0 40.0 +40.0 - R & D Textile 0 19.0 +19.0 - TCP 8.7 7.5 -1.2 - Development Expenditure 496.5 413.0 -83.5 - Budget Deficit (A – B) -398.7 -737.8 339.1 As % of GDP 4.0 7.0 3.0

Fiscal Policy:

Fiscal Policy

Fiscal Policy:

Fiscal Policy Influencing the level of economic activity though manipulation of government income and expenditure Associated with Keynesian Demand Management Policies Now seen in wider terms:

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Use of Fiscal Policy: Two Policies : Expansionary Policies and Contractionary Policies are used to control output Injections and withdrawals helps or takes away from the circular flow Governments effects aggregate demand and aggregate supply Government purchases have immediate effect on aggregate demand while tax cuts are less immediate Automatic Stabilizers: Discretionary policies are intentional government intervention in the economy Automatic stabilizers are built-in measures that lessen the effects of the business cycle Examples are taxation and transfer payment programs

Summary of Fiscal Policy:

Summary of Fiscal Policy Expansionary fiscal policy Problem : unemployment and deflation Remedy : induce an expansion in aggregate demand (AD) by pursuing a budget deficit Government action - Increase G - Decrease T , or - A combination of both Contractionary fiscal policy Problem : demand-pull inflation Remedy : induce a contraction in the AD by pursuing a budget surplus Government action - Increase T - Decrease G , or - A combination of both

Benefits of Fiscal Policy:

Benefits of Fiscal Policy Two benefits as a stabilization tool: its regional focus, and the direct impact it has on spending Regional Focus : Parts of Canada may be more affected than others by the business cycle Discretionary fiscal policy can focus on particular regions where, for example, unemployment rates are the highest or inflation is at its worst Automatic stabilizers have the greatest effect in regions that need them the most Impact on Spending : Fiscal policy has a more straightforward impact when altering government purchases than monetary policy, since the government itself initiates the change

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Increase in budget deficit Higher real interest rates Inflow of financial capital from abroad Decline in private investment Appreciation of the dollar Decline in net exports Crowding-Out in an Open Economy An increase in government borrowing to finance an enlarged budget deficit places upward pressure on real interest rates. This retards private investment and Aggregate Demand . In an open economy, high interest rates attract foreign capital. As foreigners buy more dollars to buy U.S. bonds and other financial assets, the dollar appreciates. The appreciation of the dollar causes net exports to fall. Thus, the larger deficits and higher interest rates trigger reductions in both private investment and net exports, which limit the expansionary impact of a budget deficit.

Tax/GDP Ratio: An International Comparison :

Tax/GDP Ratio: An International Comparison Countries 2005 Countries 2005 Bangladesh (470) 8.7 Thailand (2750) 16.4 India (720) 14.1 Malaysia (4960) 16.1 Pakistan (690) 10.5 Philippines (1300) 12.6 Sri Lanka (1160) 16.5 Sweden (41,060) 50.4 Mexico (7310) 19.0 Turkey (4710) 31.3 Egypt (1250) 14.1 Australia (32,220) 31.2 Korea (15,830) 24.6 U.K. (37,600) 36.0

Tax/GDP Ratios in Pakistan:

Tax/GDP Ratios in Pakistan FY Total Revenue Tax Revenue Federal Taxes * FBR Revenue Sur-charges Provincial Taxes 1999-00 13.4 10.6 10.1 9.1 1.0 0.5 2000-01 13.2 10.6 10.1 9.3 0.7 0.5 2001-02 14.0 10.8 10.3 9.1 1.2 0.4 2002-03 14.8 11.4 10.9 9.4 1.4 0.4 2003-04 14.1 10.8 10.4 9.2 1.1 0.5 2004-05 13.9 10.2 9.5 9.1 0.4 0.6 2005-06 14.3 10.7 10.1 9.4 0.7 0.6 2006-07 13.6 10.8 10.1 9.7 0.3 0.7 * Also includes minor collection on account of Foreign Travel Tax

Drawbacks of Fiscal Policy:

Drawbacks of Fiscal Policy Delays : Recognition Lag – the amount of time it takes policy-makers to realize that a policy is needed Decision Lag – the amount of time needed to formulate and implement an appropriate policy Impact Lag – the amount of time between a policy’s implementation and its having an effect on the economy Political Visibility : Voters are likely to respond more favourably to increases in government purchases and cuts in taxes Public Debt : Public Debt - the total amount owed by the federal government as a result of its past borrowing Public Debt Charges – are the amounts paid out each year by the federal government to cover the interest charges on its public debt

US subprime credit crisis – how US reached there?:

US subprime credit crisis – how US reached there? Problems in fulfilling subprime mortgage obligations Low interest rates Property bubble Deterioration of financing standards Sluggish regulation Excessive financing – search for yield Spreading risks via securitization where the original risk can not be seen Burst of property bubble Tightening credit conditions Economic Environment Reaction of financial institutions Financial innovation Lack of transparency

US subprime crisis and its spreading in the global financial system:

US subprime crisis and its spreading in the global financial system Losses of financial intermediaries and investors Financing possibilities have narrowed Increase in counter-party risk, losses of confidence Cost of financing has increased Reassessing risks, and risk-taking (banks, funds, investors) Problems in fulfilling subprime mortgage obligations Impact on financial markets and real economy

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Fiscal Policies for Revival Economic Policy Prescriptions for Economic Revival of Pakistan


Problems Budget and current account deficits and inflation are already in crisis mode A slow down in capital inflows triggered a balance of payments crisis . The economy is in crisis

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Time to remove fiscal biases against manufacturing and introduce biases against competing non-commodity producing sectors and activities. Needed Tax measures to: reduce costs to manufacturing sector raise costs to competing non-commodity producing sectors.

1. Sales Tax on manufactured goods: :

1. Sales Tax on manufactured goods: * Industry: rising cost of manufacturing inputs * Indirect taxation. * Reduce sales tax rate from 15% to 12.5% (to 7.5% eventually) on manufactured items *Raise profitability from manufacturing *Reduce revenues in short term, but medium term rise in revenues *Not a ‘trade protective’ measure

2. Sales tax on retail trade and services::

2. Sales tax on retail trade and services: Retail trade and services are competing activities to commodity sectors Attempts to generate ST revenues from retail trade and services sectors unsuccessful

Sales Tax on Retail trade and Services (Contd):

Sales Tax on Retail trade and Services (Contd) Levy sales tax on the basis of the square foot area of the business premises at a rate that is a % of property tax rate of premises and vary, as well, by sector. Businesses located in high-priced premises and businesses in high value products, e.g., jewelry, will pay ST at higher rates. Revenue receipts substantial. Reduce profitability vis-à-vis manufacturing.

3. Import Duty rate: :

3. Import Duty rate: Average import duty rate below WTO Domestic industry losing market share within country. 5-%age point increase in import duty for all consumer items. Curb import growth rate Reduce profitability vis-à-vis manufacturing

4. Import restriction: :

4. Import restriction: Place inessential consumer items on negative list. Help domestic industry regain/retain market share within the country.

5. Cost of imports: :

5. Cost of imports: Under-invoicing imports impediment to domestic industry. Introduce ‘Right of First Purchase’ Customs places Invoices of all arriving goods consignments on website Entitle any party within 3-5 working days to purchase consignment by paying, say, a minimum 25% premium. Raise import cost Reduce profitability vis-à-vis manufacturing

6. Capital Gains Tax: :

6. Capital Gains Tax: Capital markets profits super-large – and exempt from taxation. Trading in same scrips of small number of cos. rather than expansion of base. Stock markets not served as source of resource mobilization. Capital market major competing activity to manufacturing.

6. Capital Gains Tax: (Contd) :

6. Capital Gains Tax: (Contd) Remove CVT Levy Capital Gains Tax at, say, 5% Exempt shares held for at least six months. Exempt dividends from income tax. Will discourage speculative trading Encourage the long-term (genuine) investors Raise revenues for the exchequer. Reduce profitability vis-à-vis manufacturing

7. Land prices: :

7. Land prices: Land prices now single largest item in fixed capital cost. Profitability from real estate exceeds that from manufacturing activity. Land price inflation is due to speculation, facilitated by flawed institutional factors. Land is a finite commodity and increase in land prices does not imply wealth creation.

7. Land prices: (Contd) :

7. Land prices: (Contd) Land speculation has been facilitated by: (1)   absence of computerized land records, leading to cornering of plots by speculators (2)   under-valuation of land, leading to revenue loss for government.

7. Land prices: (Contd) :

7. Land prices: (Contd) Consideration may be given to (1)   computerize land records (2)   introduce the concept of ‘Right of First Purchase’ to enable any party to purchase the property for sale at a premium of, say 15% Curb speculative trading in land Bring down land prices Reduce profitability vis-à-vis manufacturing

8. Wealth Tax on luxury housing: :

8. Wealth Tax on luxury housing: Luxury housing competes with commodity producing sectors for investment funds. Given pervasive tendency to fail/under-report income, accumulation of wealth from unaccounted income. Tax the obvious and measurable taxable base – urban residential land.

8. Wealth Tax on luxury housing: (Contd) :

8. Wealth Tax on luxury housing: (Contd) Fixed rate per sq. feet on all urban plots > (400) If rate is a mere Rs. 1 per square foot/month, tax burden on a 1000 square yard plot is Rs. 108,000/year – less than half monthly household expenditure bill or less than 5% of total annual exp. for households in upper 10% income bracket. Aggregate revenue gain for the government Raise relative profitability in manufacturing.

9. Windfall Gains Tax: :

9. Windfall Gains Tax: Sectors of the economy (lately, oil, banking) that accrue windfall gains on account of exogenous factors. Impose a Windfall Gains Tax. Reduce profitability vis-à-vis manufacturing

10. Gas pricing: :

10. Gas pricing: Natural gas prices: Domestic users are subsidized Tab is placed on industry. A reversal is in order. Correct the relative price distortion in favour of industry

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