Question

Q1: Assume the position of finance secretary of Pakistan and devise a monitory policy to manage its
economy in such difficult times of global crisis. COVID’19 pandemic has widely spread across Pakistan
and the government is having crucial time in reviving its economy. This situation has further increased
the significance of your job role. Compare and contrast the utility of following types and tools of implementing the monetary policy
 Contractionary Monetary Policy
 Expansionary Monetary Policy

Open Market Operations
 Discount Rates
 Reserve Requirement

As finance secretary, you are expected to opt for the best type and tool for devising a monetary policy of
Pakistan.

Justify your answer.?

Answer 1

There are broadly two main types of economic policies that economists use to achieve macro economic goals: Fiscal policy and Monetary policy.
Fiscal Policy is more focussed on taxation and spending related decisions of the Government, whereas, Monetary Policy deals with money supply in the economy and is usually undertaken by the Central Bank of The Country.

Monetary Policy impacts the supply of money available in the economy as well as interest rates and this in turn keeps a check on inflation, increases or decreases economic activity, growth and liquidity. Braodly speaking, Monetary Policy can either be expansionary in nature or contractionary in nature.

Compare the utility of types of monetary policy and tools to implement them

Expansionary Policy
It can be understood that the objective of this policy is to EXPAND economic activity or increase demand, be it consumer spending or investment by businesses. This approach is usually followed when the market is dull, in a recessionary state where unemployment exists and the flow of money in the economy is less. Here, various monetary policy tools are used to increase liquidity or pump money into the system so that people spend more and investment picks up. Always understand that one person's spending genertates income for others.
By reducing interest rates for example, it is easier for businesses and consumers to take loans which can be channelised into various investment projects or consumer spending. This can revive economic activity by increasing aggregate demand.

Contractionary Policy
This works in reverse gear, ie. to CONTRACT or reduce economic activity. When aggregate demand in the economy is more than the aggregate supply of goods and services, it results in rising prices or inflation and cost of living/doing business increases. This is a situation where business have to cut production and consumers have to hold their spending and the only way to do this is to arrest or reduce the flow of money in the economy. Using the tool of interest rates, the Central Bank may increase interest rates making it unfavourable to take credit. Various tools will be adopted (as we will see later) to suck liquidity from the economy.

Now, there are a few major tools used to execute any of the above two policies:

Open Market Operations
This is a tool where, The Central Bank will purchase short term Govt. bonds from commercial banks and the money that the banks receive will be loaned to the genral public and businesses at low interest rates (based on interest rate target set by Central Bank). This pushes money into the economy and increases spending. The opposite takes place in the case of a contractionary policy, where the central bank would sell short term bonds to the banking system thereby pulling some money away. Banks will have lesser money to provide as credit in the economy.

Discount Rates
The Central Bank loans to commercial banks in the country. It is known as lender of last resort. The interest rate the Central Bank charges for providing loans to various banks is known as discount rate and can be altered depending on what type of monetary policy the Govt. wants to apply. In case of expansionary policy, the discount rate will be lowered and collateral requirements will be eased. Banks in turn will have to space to borrow money from Central Bank and increase credit loans to public thereby increasing money supply.
For a contractionary policy, discount rates will be increased and conditions tightened. At the far end, banks will reduce loans to market participants.

Reserve Requirement
When commercial banks take deposits of people, a percentage of these deposits should be kept as a reserve, to be paid back to people when there are sudden withdrawals. The Central Bank advises what the reserve level should be. By decreasing the reserve requirement, banks are left with more cash to provide as loans or invest in assets. This is encouraged while opting for an expansionary policy. In the case of contractionary policy, reserve requirement will be increased, locking funds that could otherwise have been used in the economy.

Choose and justify the best type of policy to follow during the pandemic and tool to implement the same.

In times of the Covid-19 pandemic, economic activity is very dull. Unemployment rates are increasing as people are let off their jobs. Businesses are struggling to survive due to meagre demand and incomes have fallen. There is a need to revive demand and increase the supply of money in the economy. As a Finance Secretary, it is advisable to follow an expansionary policy approach for its various utilities as explained above. Reducing interest/discount rates would be the most obvious measure so that more credit can be channeled in to the economy. Businesses have to get money to invest and continue production whereas consumers need money to make purchases. Practically however, you cannot choose only one tool of monetary policy. You also have to take the aid of OMO (purchasing bonds from the market leaving more money in their hands) and reduce reserve requirements so that banks can lend money.

This would be the right theoritical answer but in reality this cannot be a sure shot solution. Even if you inject money into the economy, many businesses that need a personal interaction will take a hit. Since people are at home, their spending will be restricted to essentials and some other online shopping goods and services. Travel, tourism, restaurants, airlines and such industries will see very less demand. A combination of various policies have to be taken to override the pandemic and revive the economy.