FISCAL AND MONETARY POLICY

Fiscal and monetary policies are a tool for controlling macroeconomic variables in an economy. These are discussed in this post. 

FISCAL POLICY

Definition of Fiscal Policy:

Fiscal policy is raising of government revenue and spending of government funds.

Meaning of Fiscal Year

Fiscal year simply means govt revenue and expenditure for the period of 12 months. So, 2017 fiscal year would mean govt revenue & expenditure for year 2017

Fiscal Policy Instruments in Nigeria

(a) Govt gets its revenue through:

i.        taxation

ii.       borrowing

iii.      sale of crude oil and other mineral resources

(b) Govt incurs expenditure on:

i.        payment of wages and salaries

ii.       purchase of goods and services

Hint: In many countries, govt revenue (i.e. public fund) comes largely from tax. So when govt pay wages & salaries; purchase goods & services, it is common to say “This is taxpayer money at work”. But in Nigeria, govt revenue comes more from crude oil than tax. This explains why govt revenue falls when price of crude oil drops in the international market.    

 A Brief Discussion of Fiscal Policy Instruments

Fiscal instruments that generate revenue to govt are:

1.       Tax: This is a compulsory levy by the govt on income, property, production, exchange and consumption of goods and services as well as fine for offences.

2.       Borrowing: This refers to both short-term borrowing (treasury bills) and long-term borrowing (govt bond)

3.       Sale of Crude oil and other mineral resources

Going by the law in Nigeria, mineral resources (liquid and solid minerals) like petroleum, gold, etc. belong to the govt. So, whenever these mineral resources are sold, revenue accrues to the govt.      

Using Fiscal Policy to Check Inflation

If inflation is caused by high quantity of money in circulation, and the Government uses fiscal policy measure: Govt. has to reduce the quantity of money in circulation by:

(i)  increasing taxes: with increased taxes, more money is paid as tax to govt, thereby withdrawing more money from circulation.  

(ii) budgeting surplus:

Budget surplus means government spends less than it collected from tax revenue. For example, govt collected ₦4 trillion as tax revenue but spent ₦3 trillion. By withdrawing ₦4tn from the economy and injecting ₦3tn into the economy, the quantity of money in circulation has reduced by N1tn. This is same as increasing govt tax revenue and reducing government expenditure. 

Note: If taxation is used to reduce quantity of money in circulation, to curb inflation, then govt spending should NOT be used to inject back the same quantity of money, hence the need to spend less than amount generated from revenue – budget surplus.       

BUDGET DEFICIT AND BUDGET SURPLUS Explained

Budget deficit and budget surplus are fiscal policy instruments. These are explained next.

Budget Deficit:

This is when govt budgets to spend more than it collects as revenue.

For example, if govt raises a revenue of say, ₦500 billion from many sources except borrowing, but budgets an expenditure of ₦700 billion, then it is budget deficit.  How does the govt finance the deficit? By borrowing! So, govt finances deficit budget by borrowing.     

As a fiscal policy instrument, the essence of deficit budget is to inject more money into the economy by spending more from the borrowing.

Budget Surplus:

This is when govt budgets to spend less than it collects as revenue.

For example, if govt raises a revenue of say, ₦600 billion, especially through tax, but budgets an expenditure of ₦400 billion, then it is budget surplus. Meaning part of revenue raised by the govt is left unspent. 

As a fiscal policy instrument, the essence of surplus budget is to withdraw more money from circulation than the govt injects into it. This is done to reduce volume of money in circulation in the economy – to correct inflation.   

MONETARY POLICY

Definition of Monetary Policy:

Monetary policy is all the measures taken by the government to control money supply.

It is the Central Bank that performs the monetary policy on behalf of the government. So we may define monetary policy as the measures taken by the Central Bank, on behalf of the govt, to control money supply.

Meaning of Money Supply

Money supply  is the total stock of money available for use in an economy.

Monetary Policy Instruments

i.        fixing bank rate (also known as discount rate)

ii.       printing and issuing currency notes/coins

iii.      buying and selling govt securities (treasury bills and govt bond) in the money market and capital market respectively.

iv.      fixing cash reserve ratio

v.       managing foreign reserve and foreign exchange (i.e. reserve of foreign currencies with the Central Bank and the rate other currencies exchange to the Naira)   

Difference between Fiscal Policy and Monetary Policy

An instrument like treasury bill can be seen as both monetary policy and fiscal policy. Here is how to distinguish it:

if the intention of govt is to raise revenue, then it is fiscal policy; but if it is to control money supply, then it is monetary policy.  

Objective of monetary policy

(i)      To maintain price stability:

The supply of money in the economy affects prices of goods/services. When too much money is in circulation, prices of goods/services increase (i.e. inflation results). But if the opposite happens the result is deflation.

(ii)      Financial system stability:

This has to do with absence of financial crisis.      

(iii)     To encourage Economic growth:

Price and financial system stability are pursued so that there would be economic growth. 

Discussing Monetary Policy Instruments

1.       Bank Rate

Bank rate refers to the rate of interest charged by the Central Bank for lending funds (money) to commercial banks. Bank rate determines the rate of interest commercial banks charge when they in turn lend money to their customers. Low bank rate encourages borrowing; high bank rate discourages borrowing. So, with low bank rate individuals, businesses and even govt would borrow more. And with more borrowing, comes more spending, making the supply of money in the economy to increase.  

How Bank Rate affects Granting of Credit (Loan) by Commercial Banks

When commercial banks grant loan they charge interest. Now commercial banks only charge interest that is above the bank rate. So, high bank rate would mean that commercial banks will charge high interest for lending to their customers. With high interest rate the willingness to borrow reduces. So, with high interest rate, the ability of commercial banks to create credit (money) reduces and the supply of money in the economy reduces as well .

Note: 
i. The bank rate is commonly called monetary policy rate (MPR) or discount rate. As of June 2017, the MPR was put at 14% by the Central Bank of Nigeria (CBN). This meant that no Nigerian commercial bank would lend money at 14% or less.  

ii. So bank rate is cost of bank credit (loan). It is also referred to as cost of borrowing.     

2.       Open Market Operations (OMO)

Open market operation (OMO) refers to the buying and selling of government securities by the Central Bank in the open market in order to increase or reduce the supply of money in the banking system or economy.   

How Buying and Selling of Govt Securities affect Volume of Money in the Economy

Recall that when you sell something, you get money. So when the government sells securities using the Central Bank, the govt gets money from individuals and business organizations that buy the securities. And when the govt buys the securities, it pays money to individuals and business organizations.

So, the volume of money in circulation in the economy REDUCES when the govt sells securities, because it gets money from individuals and business organizations and keeps it in the Central Bank. But when the govt buys the securities, it INCREASES the volume of money in circulation in the economy, because money is paid back to individuals and business organizations that had earlier invested in the govt treasury bill. 

Note:

(i). Securities simply means financial assets and liabilities. When the govt sells securities it incurs financial liabilities, because it collects monies from the buyers and issues a paper (document) as evidence of the borrowing. On the part of the buyers, they hold financial assets (that they will get back the money they lent to the govt). The paper (document) issued to them by the govt is also their evidence. When the govt ‘buys back’ the same securities, they pay back the money and retrieve the paper (document) issued.    

(ii) Open market simply means a market that is free to all buyers and sellers. So, regarding govt securities, open market means market that any body can buy and sell govt securities.         

3.       Cash Reserve Ratio (or Cash Ratio or Bank Reserve Ratio)

Cash ratio or cash reserve ratio is the percentage of customers’ deposits that commercial banks are required to hold as cash reserve, as directed by the Central Bank.

Example, if the deposit of a customer with a commercial bank is ₦200,000 and the cash ratio (cash reserve ratio or bank reserve ratio) is 10%, then the bank would keep ₦20,000 and lend out ₦180,000. The cash reserve is usually kept in the bank itself or with the Central Bank. It is the minimum cash reserve that the CBN requires commercial banks to set aside for every deposit received from customers.  

Here is another example: if the cash reserve requirement is 30%, and a customer makes a deposit of ₦90,000, the commercial bank can lend out ₦63,000 to borrowers but keep ₦27,000 as cash reserve.

Note:

1. Credit creation by commercial banks is also termed money creation. This is achieved through lending by commercial banks to borrowers (For detailed explanation, see my later post on ‘Money & Banking’).   

2. Borrowers can be individuals, businesses or even govt.      

How Cash Reserve Ratio affects Volume of Money in the Economy

If the Central Bank desires to increase the money supply in the economy, it will reduce the cash reserve ratio, so that commercial banks would have more money to lend, inject into the economy.  And if it desires to decrease the money supply in the economy, the Central Bank will raise the cash reserve ratio, and commercial banks would have less money to lend.  

4.       Special Deposits

Special deposits are additional cash reserves other than the minimum cash reserve ratio which the Central Bank orders the commercial banks to lodge with the Central Bank.

If the minimum cash reserve ratio is 30% and additional 5% is required by the Central Bank as special deposit, it means if a customer deposits ₦200,000 with a commercial bank, the commercial bank will lodge ₦60,000 as minimum cash reserve ratio and additional ₦10,000 as special deposits.    

Note:
Cash Reserve Ratio and Special Deposits determine availability of credit, and by that determines money creation.         

  
5.       Printing and Issuing of Currency Notes

The Central Bank issues currency notes. The quantity or amount currency notes issued depends on the volume of production of goods and services. If the Central Bank issues too many currency notes, it results in inflation, because too much money would be chasing few goods and services.

(Note: I did not say ‘currency notes and coins’, because in Nigeria, coins are no longer in circulation)

6.       Managing Foreign Exchange

The Central Bank works to ensures that the value of the Nigerian Naira (NGN) remains stable or appreciates against other currencies, so that the Nigerian financial system would remain stable. Foreign exchange is the exchange of one currency for another.

Explanatory Note: Why the Central Bank Keeps Foreign Currency 

Yes, if you buy goods/services in Nigeria, you pay with the Naira. But certainly not if you buy from the UK, US, China, Japan, Germany, etc.

To buy from these countries you should have their currencies. Here in Nigeria, how do you get these foreign currencies to travel with and pay for your imports from these countries?

Surely, from the Central Bank of Nigeria (CBN). The CBN has a reserve of the foreign currencies. This is what we refer to as Foreign Reserve. So, just go and exchange your Naira equivalent with the amount of the foreign currency you want. The CBN uses the commercial banks and Bureau de Change to do this exchange of the Naira for other currencies (foreign exchange), because individuals do not transaction business with the Central Bank.

Note that the Naira currency unit exchangeable for a unit of foreign currency is referred to exchange rate, or foreign exchange rate.

  

Uses of Monetary Policy Instruments

(a)      Issuing of currency notes:

(i)    Used to tackle deflation: deflation is persistent fall in general price level. If the deflation is caused by inadequate money supply, few amount of money would be chasing high volume of goods/services, resulting in price fall. To tackle deflation, the CBN will issue more currency notes.

(ii)   To encourage economic growth – production of more goods/services. Money is used to finance production. If govt wants more production of goods/services, it can inject more currency notes in the economy.    

(iii)  Production of more goods/services can result in the creation of more employment 

(b)     Bank rate:

(i)      Bank rate determines borrowing and lending of money. This in turn decides the quantity of money in circulation – the supply of money. The economy will have more money if more money is borrowed and spent.

(ii)   To encourage economic growth – production of more goods/services. Money can be borrowed to finance the production of more goods/services. Therefore bank rate may be used to influence increase in economic activities.

(iii)  Production of more goods/services can result in the creation of more employment. Therefore bank rate may be used to influence increase in economic activities, thereby creating more employment.

 (c)      Open Market Operations (OMO):

(i)    Used to raise revenue for government spending on goods/services: When govt sells securities such as treasury bills, etc it raises money to meet its financial obligations.

(ii)    Used to tackle inflation: Inflation is persistent rise in general price level. If the inflation is caused by excess money supply, too much amount of money would be chasing few goods/services, resulting in price rise. To tackle inflation, the CBN will sell govt securities on behalf of the government, to reduce the money supply.

 (d)     Cash Reserve Ratio: Cash reserve ratio affects amount of money available to commercial banks to grant credit, which of course, affects money supply. When loan is taken and the money spent, it increases the supply of money. To reduce the ability of commercial banks to grant more, so that the supply of money would not increase, the CBN would increase the Cash Reserve Ratio.   

(e)      Foreign Exchange Rate:

(i)      used to increase export of goods/services.  When govt wants to increase exports, it may devalue its countries currency so that locally made goods would become cheap to other countries, making them buy the goods.   

Note

i. Currency devaluation is when the govt fixes the exchange rate such that more unit of the country’s currency is exchange for one unit of a foreign currency. 

ii.  Why all the talk about the United States Dollar (USD) exchange rate with the Naira? Because in international trade, the USD is the mostly widely use currency. 

Using Monetary Policy to Check Inflation

(a)  If inflation is caused by high quantity of money in circulation: the monetary policy measure will be:

(i)   increase the bank rate to discourage borrowing. Quantity of money in circulation that came from borrowing will reduce.

(ii)  sell more govt securities through open market operation (OMO) to reduce money in circulation

(iii) increase cash reserve ratio to reduce amount available to commercial banks to grant credit and create money.  

Monetary policy measures aimed at reducing money supply is termed contractionary monetary policy. And monetary policy measures aimed at increasing money supply is termed expansionary monetary policy. 

Contractionary monetary policy

Contractionary money policy is implemented by:

- increasing the bank rate i.e. the cost of credit.

- increasing the cash reserve ratio and/or special deposit, so that less money would be available for lending.  

Contractionary monetary policy would reduce money available for investments.

Expansionary monetary policy

Expansionary money policy is implemented by:

- decreasing the bank rate i.e. the cost of credit.

- decreasing the cash reserve ratio and/or special deposit, so that more money would be available for lending.

Expansionary monetary policy would boosts investments, thereby increasing output and by extension employment.