Question

1. Discuss the effects of fiscal and monetary policy on inflation. Illustrate with good examples

2. You have AED 1000 as a cash money and AED 500 in traveler's checks. Also, you have AED 1000 in checking account at Dubai Islamic Bank. At the same bank you put AED 5000 in savings account. Based on this information illustrate how you can change your M1 and M2.

Answer 1

Ans 1: Tightening monetary policy is used to control the inflation which implies the reduction in the availability of credit and increase in its cost.For example:

1. The central bank sells the government securities to commercial banks and public through open market operations thereby reducing the liquid funds with general public which will shrink the money supply in the economy. The reduction in money supply which help control the inflation.

2.The increase in the repo rate will reduce the availability of credit and thus will result in reduces demand for investment goods. The reduction in investment demand help reducing the inflationary pressures.

3.One of important ways to controlling inflation is the raising the CRR which will have direct impact on contraction of money supply in economy.

The fiscal policies which are used to control Inflation are:

1.Reducing the government expenditure

2. Increasing the taxes.The increase in the taxes which help create the budget surplus which will cause the aggregate demand to shift down and will ease the pressure on the prices.

Ans 2: M1= currency with public + Demand(checkable) deposit with banking system + traveler's check

M2= M1 + saving deposits + certificates of deposits+ other time posits

M2 can altered by any changes in the components of M1 and M2 while M1 will be altered if there is change in cash money with people, checkable deposits or change in the traveler's check .