1. Impacts of Fiscal and
Monetary Policies on
Macroeconomic Variables
of Sri Lanka
Double the per capita income by 2016
UWU/SCT/11/0044
2/22/2013
Fiscal and monetary policies produce different effects on macroeconomic variables of srilankan
economy. It is discussed the about the impacts of those policies and which policies are favorable to
double the per capita income of Sri Lanka by the year2016
2. Circular Flow of Four Sector Economy
A circular flow model of the macro economy containing four sectors(business,
household, government and foreign)and three markets(product, factor and
financial) that illustrates the continuous movement of the payments for goods
and services between producers and consumers, with particular emphasis on
exports and imports.
3. During past several years Sri Lanka was able to maintain a strong growth. Though
growth dropped to3.5% in 2009 during final military campaign now It is has
obtained a growth rate of 8.3% dramatically. Agricultural land in conflict affected
areas could once again be cultivated; double shifts in manufacturing became
possible as workers no longer had to worry about security restrictions, services
related to tourism also picked up as tourist arrival increased after the war. Further
under the vision “miracle of Asia” Srilankan government has the goal of doubling
the per capita income by the year 2016.
4. Fiscal and monetary policies produce different effects on
macroeconomic variables of Sri Lankan economy. The government plans to
double the per capita income by 2016 can be helped by those policies.Sevarel
ways of obtaining that goal can be explained through the following graphs.
Aggregate demand
Aggregate supply
p2
p1
GDP1 GDP2
Figure 1: By increasing the aggregate demand GDP can be doubled, when this is
done price levels go up.
Aggregate demand Aggregate supply
P1
P2
GDP1 GDP2
5. Figure 2: By increasing the aggregate supply GDP can be doubled. When the
expected goal is achieved through increasing aggregate supply price level also
goes down in this method. Therefore this method is better comparing to the
increasing the aggregate demand.
Aggregate demand Aggregate supply
p1
GDP1 GDP2
Figure 3: Through this method a same price level can be maintained by changing
both. (Increasing aggregate supply and increasing aggregate demand)
GDP=C+I+G+(X-M)
On the left side is GDP the value of all final goods and services produced in
economy. On the right side are the sources of aggregate spending or demand-
private consumption(C),private investment(I),purchases of goods and services by
the government affect economic activity(GDP) controlling G directly and
influencing C,I and (X-M) indirectly, through changes in taxes,transfers,and
spending.
6. How Does Fiscal Policy Impacts on
Macroeconomic Variables of the Country
The economy can be impacted through two major types of economic policy.
The first type is called fiscal policy. Mainly it is focused on taxation law and
government spending. The most immediate effect of fiscal policy is to change the
aggregate demand for goods and services. If the government increases its
purchases but keeps taxes constant, it increases demand directly. Second if the
government cuts taxes or increase transfer payments, households’ disposable
income rises, and they will spend more on consumption. The rise in consumption
will in turn raise the aggregate demand.
By changing tax laws, the government can effectively modify the amount
of disposable income available to its tax payers. For example if taxes were to
increase, consumers would have less disposable income and in turn would have
less money to spend on goods and services. This difference in disposable income
would go to the government instead of going to consumers, who would pass the
money onto companies or the government could choose to increase government
spending by directly purchasing goods and services from private companies. It
would increase the flow of money through the economy and would eventually
increase the disposable income available to customers. Simply when the houses
are having more money because of less taxation that money is spent in local
market, to import or to save. Through this money is received to investors and
when they also have to pay less taxes money can be spent more on economy.
This is a better way since supply and demand both are influenced by a tax cut.
When the government is maintained a deficit budget, it can have a
positive macroeconomic effects in the long run if it is used to increase the stock of
national assets. For example, spending on the transport infrastructure improves
the supply capacity of the economy. And increased investment in health and
education can bring positive effects on productivity and employment.
7. When the government is maintained a surplus budget the amount of
collected taxes are higher and it stabilize the economy.
On the other hand a fiscal expansion affects the output level in the long
run because it affects the country’s saving rate. The country’s total saving is
composed of two parts: private saving (by individuals and corporations) and
government saving. When the spending is increased or taxes are lowered it
decreases the government saving. Lower saving means, that the country will
either invest less in new plants and equipment or increase the amount that it
borrows from abroad. Lower invest will lead to a lower capital stock and total
reduction in a country’s ability to produce output in the future. Increased
indebtedness to foreigner’s means that a higher fraction of a country’s output will
have to be sent abroad in the future rather than being consumed at home.
Thereby monetary policy is far more agile than fiscal policy.
8. How Does Monetary Policy Impacts on
Macroeconomic Variables of the Country
The second way the government can impact the economy is through
monetary policy. Monetary policy is instigated by the central bank of a Sri Lanka
to control the supply of money within the economy. By impacting the effective
cost of money, the central bank can affect the amount of money that is spent by
consumers and business.
Central bank influences the economy by influencing the money supply
through adjustments to interest rates, bank reserve requirements, and the
purchase and sale of government securities and foreign exchange. A monetary
policy decision that cuts interest rate, for example, lowers the cost of borrowing,
resulting in higher investment activity and the purchase of consumer durables
(cars, TV ...Etc.)Banks may also prompt to ease lending policy, with the
expectation of economic activity will strengthen. In turn this enables business and
households to spend more money to economy. When a low interest rate is
maintained stocks become more attractive to buy, raising households’ financial
assets. This may also contribute to higher consumer spending, and makes
companies’ investment projects more attractive. Low interest rates also tend to
cause currency to depreciate because the demand for domestic goods rises when
imported goods become more expensive. The combination of these factors raises
output and employment as well as investment and consumer spending.
