Question

1. (a) (3 Marks) "A counter-cyclical fiscal policy has crowding out effects”. Explain with economic reasoning and appropriate diagram(s). (b) (3 Marks) Define open market operations, and explain how executing them can be used as a tool for the conduct of monetary policy. (c) (4 Marks) Use diagram to explain why do fiscal and monetary policies are ineffective in combating stagflation. How a stagflation be cured?

Answer 1

a) When government conducts an expansionary fiscal policy (i.e. increases in government spending or decreases in tax rate, it may run afoul of the crowding outeffect. Expansionary fiscal policy means an increase in the budget deficit. The government is spending more money than it has in income.

A larger budget deficit will increase demand for financial capital. The supply of funds in financial markets is the sum of private saving, government saving, and net investment by foreigners into domestic financial markets. If private saving and net foreign investment remain the same, then less financial capital will be available for private investment in physical capital.

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b) An open market operation is an activity by a central bank to give liquidity in its currency to a bank or a group of banks. Open market operations is a tool that the RBI uses to smoothen liquidity conditions through the year and regulate money supply in the economy.

Open market operations is the sale and purchase of government securities and treasury bills by RBI or the central bank of the country.

The most commonly used tool of monetary policy in the U.S. is open market operations. Open market operations take place when the central bank sells or buys U.S. Treasury securities in order to influence the quantity of bank reserves and the level of interest rates. When the Fed conducts open market operations, it targets the federal funds rate, since that interest rate reflects credit conditions in financial markets very well.

c)  

Stagflation is an economic condition combining slow growth and relatively-high unemployment with rising prices, or inflation. The standard macroeconomic remedies for inflation or unemployment are considered ineffective against stagflation. For this reason, there is no universal agreement on the best way to stop stagflation.

The policy difficulty stems from the fact that the normal response to the components of stagflation—recession and inflation—are diametrically opposed. Governments and central banks respond to recessions through expansionary monetary and fiscal policy, yet inflation is normally fought through contractionary monetary and fiscal policy.

The main reason why monetary and fiscal policies are largely ineffective against stagflation is that these tools were built on the assumption that concurrent rising inflation and unemployment was impossible.

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