Monetary Policy and Public Finance

CONTENTS

Chapter One
MONEY
1.0.Introduction
1.1. Functions of Money
1.2. Defects of barter economy
1.3. Qualities of good money
1.4. Advantages of Monetary economy
1.5. Historical evolution of money
1.6. The effects of Macroeconomic Policies on IS-LM curves

Chapter Two
THE THEORY OF DEMAND FOR MONEY
2.0. The quantity theory of money
2.1.Restatement of the Quantity theory of money
2.2. Keynesian theory of demand for money
2.3. The Baumol Tobin Model of Demand for Money

Chapter Three
Money Supply
3.0. Definition of money supply
3.1.Determinants of Money Supply
3.2.Commercial Banks and the Credit Creation process

Chapter Four
MONEY AND INFLATION
4.0. Definition
4.1. Causes of Inflation in Uganda
4.2. Policies to curb Inflation in Uganda

Chapter Five
CENTRAL BANKING AND MONETARY POLICY
5.0. Introduction
5.1. Functions of the Central Bank
5.2. Monetary Policy

Chapter Six
INTERNATIONAL FINANCIAL INSITITUTIONS
6.0. Introduction
6.1. International Monetary Fund (IMF)
6.2. Grievances of the third World
6.3. Suggestions of the World
6.4. The IMF Sphere of influence
6.5. The World Bank
6.6. Capital flows in LDCs
6.7. Determinants of capital flows in LDCs
6.8. Public debt
6.9. Debt Relief

Chapter Seven
PUBLIC REVENUE
7.1. Taxation
7.2. Characteristics of a good tax system
7.3. Direct taxes
7.4. Indirect taxes
7.5. Tax Incidence
7.6. Tax Buoyancy and Tax elasticity
7.7. Public Finance Management

Chapter Eight
MARKET FAILURE AND PUBLIC GOODS
8.0. Introduction
8.1. Monopoly
8.2. Public goods
8.3. Costly Information
8.4. Non – Existence of the Market
8.5. Externalities
8.6. Possible Remedies to Externality

Chapter Nine
DETERMINANTS OF REVENUE
9.1. Statistical Determinants
9.2. Institutional (Social determinants)
9.3. Tax Policy Determinants

Chapter Ten
GOVERNMENT BUDGET
10.0. Introduction
10.1. Types of budgets
10.2. The role of a budget
10.3. Financing a deficit budget

Questions

References

Dedication.

Fred and Margret Kururagire.

Chapter One

1.0.Introduction

There has been a link between financial development and real growth of economies. Financial development together with growth in banking stimulates entreprenuer action and this transfers resources from the traditional sector to modern sector.

This paper is divided into two sections; Section A- Monetary Economics that covers the following topics; Money in the macro economy, Demand for money, Supply for money, Money and Inflation, Central banking and Monetary policy, International Financial Institutions and Policy, Monetary market and the Hansen Hickisian IS-LM curve analysis. Section (B) covers; Public revenue, Tax Burden, Incidence of Taxes, Classification and Choices of Taxes, Public Debt, Public expenditure and Public Budget.

Course Objectives:

The main objective of the course is to equip learners with analytical skills in understanding the basic concepts of monetary economics in the context of developing countries. It enables students acquire sufficient knowledge of monetary theory and the working of financial institutions that help in carrying out monetary and other macroeconomic policy analysis. The course also equips learners with issues relating to taxation and public expenditure

MONEY.

Money is anything commonly acceptable as an instrument of debt settlement and as an instrument of exchange. Most importantly is legal tender and often takes the form of paper notes or token money. It includes cash (coins and notes ) and deposits in financial institutions. Brown, (1985: 137) asserts that money is a device invented by human beings to facilitate the basic functions production, consumption and exchange.

Narrow money. Refers to currency in circulation which entails notes and coins plus demand deposits. According to Maunder ( 1996 : 313), narrow money entails notes and coins, banks’ operational balances, sight deposits and retail deposits.

M = C+ D

Whereas broad money refers to currency in circulation plus deposits which include fixed deposit account and other financial assets. For Maunder, broader money incorporates money market instruments, time deposits, and foreign currency bank deposits.

1.1 Functions of money.

Unit of account. Money serves as a unit of account. It is used as a unit of value for carrying out calculations and accounting procedure so as to effect business transactions.

Standard measure of value to allow easy economic transaction. According to D.J.Brown, (1985:138), emphasizes facilitating the price system as a vital function of money. The relative prices of goods and services are determined through the intermediary of money. It usually reflects the quality and quantity of goods and services bought in the market.

Money is used as a standard for deferred payments so that it enables to effect transactions for payments to be done at some future date.

Money acts as a store of value and wealth. This entails money saved in the bank or money that is used to acquire a financial asset. For money to act as a store of value there should be stable prices so that the value of money is not eroded away.

Medium of exchange. It facilitates business transactions through space and time. Alternative to this function would be the barter trade.

Barter trade in the economy refers to the physical exchange of goods for goods. The condition for exchange in this market is usually the double coincidence of wants.

1.2. Defects of barter economy.

a).It is not easy to establish the double coincidence of wants which will satisfy both trading partners.
b). There is a restricted number of transactions that can take place at the same time.
c). There is lack of divisibility of some of the commodities or services.
d). It is difficult to stock commodities for future exchange due to the fact that some may be perishable or bulky to store.
e). The use value or exchange value of the commodities cannot easily be ascertained under the barter trade arrangement.

4- Store of Wealth.

Some commodities cannot perform this function because they are perishable or others are valueless. For reasons of solvency at all times, businessmen hold part of their assets in form of money to be used for any urgent business transaction and any other monetary obligation. Nevertheless the value of money in the long run tends to change because of the time value of money because of inflation.

Standard for deferred payments.

Money facilitates payment of debt and transactions at a future debt. D.J Brown ( 1985: 138) notes that ni monetary exchange the recipient of money has confidence in it and is willing to accept it, whereas another good in exchange may not be accepted. This situation results into double coincidence of wants.

1.3.Qualities of good money.

Money should be portable and easy to carry and this makes it easy to be transmitted from one person to another and across distant markets.

Divisibility. Should be divisible into smaller units without any loss of value. This makes market transactions more convenient.

Homogeneity. It must be homogenous i.e a unit of shilling should be worth another unit at all times, in all places within a geographical area where it is legal tender.

Recognizable. Genuine money should be easy to recognize.

Acceptability of value. Money is acceptable because a specific value has been conferred in it. Without this value no money could be used as a medium of exchange. Good money should maintain this value. However in a world of inflation it is quite difficult to maintain the value.

1.4 Advantages of monetary economy.

The existence of a credit market is made possible in a monetary economy. In a credit market the surplus spending units come into contact with the deficit spending units.

A monetary economy facilitates the extension of markets in time and space even to international level.

It makes it possible for the price system to operate and this makes it easy to ascertain market demand for the factors of production and thus leading to improved resource allocation. Anitra, N.(2011: 1), asserts that money is the measure of the exchange value and determines production decisions for production and growth.

1.5.Historical Evolution of money.

Barter system. Was the earliest form of exchange where there was a direct exchange of goods and services.

There was use of use of high value goods that were being used as a medium of exchange such as salt, tobacco, and cereals and these were used to determine the value of other goods. Though these commodities were used because of their real value, they lacked a standard measure, some were perishable, while others were bulky.

Use of durable commodities such as silver, gold and other materials. Though these commodities were scarce, they never acted a good medium of exchange since they lacked a standard measure.

Use of rare metals such as gold and silver which were adopted because of their scarcity and durability.This was followed by minting coins made out of these metals. This is called commodity money.

Paper money. It all started with people depositing their gold with the Gold smith. The Gold smith acted as bankers who would issue out the receipts for the gold that was being kept. The receipts were later accepted to settle debts and obligations. It is these receipts that were later standardized into paper money that was fully backed by gold. This was later improved and nations abandoned the gold standard. They started printing money that was not fully backed by gold which is known as the fiduciary issue.

Fiat money. This type of money is not backed by reserves of another commodity and is issued on the directive of the government authorities irrespective of the economic activity.

1.6. The Effects of Macro Economic Policies on IS-LM curves.

The IL- SM model.

The IS/LM model denotes the Investment-savings/Liquidity prefence -Money Supply. It is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market.

The LS curve is the curve that relates the levels of aggregate demand and interest rates consistent with the equilibrium in the goods market holding other factors constant.

The rise in the interest rates normally negatively affects the aggregate demand through its effects on both consumption and investment.

The IS curve is defined by the equation

Qd = C+ I + G

Which implies that,

Y= C[Y-T(Y)] + I(r) + G + N X(Y),

where Y represents income,

C[ Y-T(Y)], shows consumer spending. It is an increasing function of disposable income (income, Y, minus taxes, T(Y), which themselves depend positively on income),

I(r) shows investment. It is a decreasing function of the real interest rate,

G shows government spending, The level of (government spending), G, is presumed to be exogenous.

NX(Y) shows net exports (exports minus imports). It is a decreasing function of income (decreasing because imports are an increasing function of income).

The LM Curve.

This is a locus showing various combinations of aggregate demand and interest rates consistent with the money market equilibrium. i.e the LM curve shows the combinations of interest rates and levels of real income for which money market is in equilibrium. In the money market equilibrium the supply of real cash balances must be equal to the demand for these real balances.

Each point on the LM curve reflects a particular equilibrium situation in the money market equilibrium diagram, based on a particular level of income.

illustration not visible in this excerpt

The intersection of the IS and LM curves is the "general equilibrium" where there is simultaneous equilibrium in both markets. Therefore the intersection of the IS and LM curves shows the values of aggregate demand and interest rate so that the goods and the money market are in equilibrium. These curves are drawn for a given price level and for given levels of policy instruments e.g government spending, taxes and money supply.

Expansionary Monetary policy. (An increase in government spending).

A rise in government spending increases the aggregate demand and this shifts the IS curve to the right.

Lm

illustration not visible in this excerpt

Point B cannot be the new equilibrium because there is excess demand for real dd balances which means that the money market is not in equilibrium. With the rising output there must be a corresponding increase in interest rate and with the equilibrium point B the households would have insufficient money holdings.

A rise in government spending leads to an increase in interest rate which tries to reduce investment and consumption. This dampening effect on investment and consumption due to a rise in interest rate brought about by increase in government spending is called crowding out effect.

Lm

Ii Lm

Ii

IoIs1

Iso

QdoQd1 Qd1

Contractionary fiscal policy.

Spending and increase in taxation shifts the IS curve towards the left (origin).

LmLm1

Io

IiIs0

Is1

Qd Qd1Qd0Qd

If the LM curve is more elastic, the fiscal policy is to reduce aggregate demand.

The extent to which a policy will affect aggregate demand will depend on elasticities of IS and LM curves. With more elastic LM curve expansionary fiscal policy lead to a fall in aggregate demand from Qdo to Qd1.

Comparing a fall from Qdo to Qd1 when the LMcurve is more inelastic.

Effects of contractionary monetary policy.

Reduction in money supply. Monetary policy affects the LM curve to the left.Lm1

Interest Rate I Lm0

Ii

Io Is1

Is0

Qd1 Qd0 Qd

The extent to which the policy affects the aggregate demand depends on the elasticity of IS and LM curves. Contractionary monetary policy will be more effective if the IS curve more elastic and is usually attained at lower interest compared to when the IS curve is inelastic.

An increase in money supply shifts the LM curve to the right. It leads to an increase in aggregate demand for real balances.

Interest

Rate LM0

Iio LM1

I1 Is1

I0 Iso

Qd0 Qd Qd

Chapter Two

THE THEORY OF DEMAND FOR MONEY.

2.0.The Quantity theory of money (classical).

Fischer’s concept emphasized the transaction velocity circulation of money which means the rate money changes hands.

According to him in every transaction, there is always a buyer and seller hence in the aggregate economy the value of sales must be equal to the value of receipts. The value of sales must be equal to the number of transactions multiplied by the average price at which these transactions take place.

Value of sales = PT, where;

P = Average Price level.

T = Level of transactions in an economy.

However the value of purchases must be equal to the amount of money in circulation in the economy times the average number of times it changes hands over the same period.

Value of purchases = MV

Where;

M = total money supply in the economy.

V = velocity of circulation.

MV = PT Fischer’s equation.

In the traditional Quantity theory of money, the velocity of circulation and the level of transactions are always assumed to be constant

Thus MV = PT.

In this assumption we come out with the proposition that the equilibrium price level is determined by and is directly proportional to the money supply.

If the economy is to be in equilibrium, then money supply must be equal to money demand. MS= MD

MV = PT

MV= PT

M = PT/V, M = PT/V.

M= k P

Modified Quantity theory of Money.

MV + M1V1 =PT

Where, MV refers to the proportion of transactions that occur using cash.

M1V1 refers to the proportion of transactions that take place without using cash, by either credit cards or Cheques etc.

M1 refers to the total deposits subject to transfer in either Cheques or credit cards.

V1 is the average velocity of circulation of these deposits.

In most LDCS most transactions take place by use of cash because of the poorly developed financial sectors. Thus M1V1 is not very relevant to a country like Uganda.

MV = PT.

According to the monetarists, velocity of circulation cannot be constant; is usually affected by the interest rates, rate of inflation or expected inflation, efficiency of payment mechanism, efficiency in the withdrawal system of banks etc.

2.1.Restatement of the Quantity theory of Money.

According to Friedman, the level of output and employment in an economy can be affected by the changes in the money supply. The monetarists recognize the fact that the velocity of money is not constant and is affected by a number of factors.

He postipulated that it is fairly predictable both in the Long run and short run, therefore it requires to carefully study the features that determine the variables in the Fischers equation MV = PT.

They identify the interest rate as a major factor that affects the velocity of money in an economy. They argue that for a rise in the rate of interest increases the opportunity cost of holding money rather than on high yielding assets. Investing in high yielding assets raises the level of investment activity in the economy hence leading to an increase in output and employment.

Other factors.

High inflation causes high nominal interest rates and it erodes the purchasing power of money and hence leads to both individual and business to hold as little money as possible.

Inefficiency of the payment mechanism in the money market includes how quick the cheques are cleared in the banking system. Use of credit cards and other methods of transferring money and the frequency with which pay cheques are received help to increase efficiency.

2.2. Keynesian Theory of Demand for Money.

According to Keynes individuals will demand for money for 3 major reasons;

Transactions motive.

Precautionary motive.

Speculative motive.

Transaction motive.

People demand for money to meet their day – to- day requirements and this depends on the level of income of a particular individual or business and also depends on the prices in the economy.

Precautionary Motive.

People will demand for money to meet the unforeseen expenditure and this will also depend on the level of income and on the prices.

Speculative motive.

Keynes major focus is on the speculative motive of demand for money. The Keynesian theory is based on the preposition that money is a financial asset in a portfolio that consists either money or bonds.

Wealth portfolio. This is the ability of an individual to keep his wealth in different forms e.g either in form of cash, in form of bonds or other financial assets or in form of fixed assets.

According to Keynes, the choice between holding money or bonds is determined or influenced by the rate of interest.

If bonds bear a positive rate of interest, there is only one alternative of holding wealth i.e. investing it in a bonds market. It is also assumed here that the rate of return on money is always zero.

Keynesian speculative demand theory regards investors as holding their wealth in that asset that yields the highest rate of return. Therefore if the rate of return on bonds is positive, and given rate of return on money is zero, investors would prefer to hold bonds instead of money.

Find out the relationship between the rate of return on bonds and return on bonds.

Analysis of speculative demand for money.

Rate of

Interest

Money supply

r2

Liquidity trap.

r1 Md

M2 M1 Quantity of Money.

At the rate of interest r2, money ss is greater than money dd and an investor with excess money balances will seek to hold bonds and therefore the price of bonds will rise. Note that the interest rates will fall as the demand for money rises until an equilibrium position r1 is reached.

It is therefore important to note that there is an inverse relationship between the interest rates and the price of bonds.

At the level, rl, the interest rate is very low and the demand for money becomes perfectly elastic. This is known as the liquidity trap. The interest rate cannot fall further since everyone wants to hold money in the expectation that there will be the eventual rise of interest rates and a consequential fall in the bond prices.

At the point of liquidity trap any further increase in money supply will have no effect in interest rate and changes in price level will also have no effect on investment and income. It is therefore argued that the Keynesian liquidity trap shows the limitation of the monetary policy in rectifying an economic recession.

2.3. The Baumol- Tobin Model.

At any given time, a household holds some of its wealth in the form of money in order to make purchases at a future date. If it keeps little of its wealth in form of money, it will have to convert the other wealth into money e.g. selling bonds whenever it wants to make a purchase.

The household must bear a cost such as a brokerage fee each time it sells an interest bearing asset to get the money needed to make a purchase. A household therefore faces a trade off by holding a lot of wealth in form of money. The household loses interest it would have earned by holding an interest bearing asset instead.

At the same time a household lowers the transaction cost of converting say bonds into money each time it wants to make a purchase. Thus the household must balance the opportunity cost of holding money (the interest foregone) against the transaction cost of frequently converting other assets into money.

Such a problem is likely to be of a firm that must decide what levels of inventory to keep. With a large stock of inventories the firm always has inputs readily available for production or sale. But at the same time inventories are costly since they do not add interest for the firm and the firm incurs other costs such as storage and insurance. Thus the firm must balance the convenience of holding large inventories against the cost of holding them.

The main particular assumptions.

Assume the household earns an income Y whose nominal value is given by PQ.

Assume that these earnings are automatically deposited at the beginning of each period on an interest bearing account in a bank.

Assume that the household consumption expenditure represents a constant flow during a month the sum adds up to PQ at the end of the month.

There is a fixed cost (Pb ) each time money is withdrawn from the savings account, where b represents the real cost of withdrawing the money and Pb is therefore the nominal cost. This cost includes time, expense of going to the bank or the inconvenience involved. If the household held other interest bearing assets his cost would include the brokerage fee (from brokers).

Assume the household goes to the bank three times in a month or in a given period of time withdrawing an amount of money equivalent to M*

The household withdraws M* from the bank and follows a constant flow of consumption.

M*

01/32/31Time

The smooth flow of withdraws and consumptions continue until the amount of money in the bank is exhausted, and it depends on the number of times the household goes to the bank to withdraw. In this case the household withdraws M* 3 times in a given period of time.

The number of times the household goes to the bank is PQ/M*

The amount of money that the household keeps = Area of a triangle= 1/2bh

e.g Md = ½×1/4×M* ×4

Md = M*/2.

Money demand is the average amount of money held by the household during the month.

Chapter Three.

MONEY SUPPLY.

3.0.Definition of money supply.

Money supply refers to the amount of money available for the public at a given period of time

This comprises of the total amount of money available in the public for spending at a particular point in time. It includes currency notes, coins and demand deposits with banks. Cash balances held by the government, the central bank and commercial banks are excluded from money supply.

3.1.Determinants of money supply.

Determinants of money supply include the following:

The nature of the monetary policy adopted by the respective government. This may be restrictive or expansionary monetary policy.

The amount of goods and services produced within the country.

The rate of interest on deposits and loans.

The nature of the Balance of Payments of a country. This may be a deficit or surplus.

Government borrowing from the central bank.

Printing of money by the central bank to finance specific on spot programs, financing the war etc.

The size of capital inflows and outflows.

Capital inflows through tourism that allows entry of foreign exchange. When the earnings from the exports exceed the expenditure on imports, the surplus foreign exchange increases money supply with the domestic economy.

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