Evaluation It effects people in different ways.

. The effect of higher interest rates does not affect each consumer equally. Those consumers with large mortgages (often first time buyers in the 20s and 30s) will be disproportionately affected by rising interest rates. For example, reducing inflation may require interest rates to rise to a level that cause real hardship to those with large mortgages. This makes monetary policy less effective as a macro economic tool. Time lags. The effect of rising interest rates can often take up to 18 months to have an effect. For exampl,e if you have an investment project 50% completed, you are likely to finish it off. However, the higher interest rates may discourage starting a new project in the next year. It depends upon other variables in the economy. At times, a rise in interest rates may have less impact on reducing the growth of consumer spending. For example, if house prices continue to rise very quickly, people may feel that there is a real incentive to keep spending despite the rise in interest rates. Real Interest Rate. It is worth bearing in mind that what is important is the real interest rate. The real interest rate is nominal interest rates minus inflation. Thus if interest rates rose from 5% to 6% but inflation rose from 2% to 5.5 %. This actually represents a cut in real interest rates from 3% (5-2) to 0.5% (6-5.5) Thus in this circumstance the rise in nominal interest rates actually represents expansionary monetary policy.

Limitations of Monetary Policy

Some limitations of monetary policy include: Liquidity Trap - When a cut in interest rates fail to stimulate economic activity. e.g. because of low confidence. Difficult to control many objectives with one tool - interest rates. For example, a rise in oil prices causes cost push inflation and lower growth. The Bank could increase interest rates to reduce inflation, but, it would cause economic growth to fall as well. Changing interest rates has an effect on the exchange rate Interest rates may affect some parts of the economy more than others. e.g. higher interest rates increase the disposable income of people with savings. But, could cause homeowners to be unable to afford their mortgages.

The objectives of the government are: 1. low inflation CPI=2% 2. Strong economic growth, but, not inflationary growth. Increasing long run trend rate of growth 3. reduce unemployment

4. avoid large deficit on current account balance of payments In the UK, Monetary policy has been given to the Bank of England. Therefore, the Bank of England has independence in setting interest rates. The government only set the inflation target of 2% inflation. If the MPC predict inflation will rise above the inflation target then they will increase interest rates. Higher interest rates reduce demand and prevent the economy expanding too fast. If economic growth is sluggish, then interest rates can be cut, lower interest rates boost economic growth and help to reduce inflation. Fiscal policy is not used so much in modern economies, but, in theory can be used to prevent recessions or prevent inflation. If inflation is a problem the government can increase tax rates and cut spending. These will reduce Aggregate demand, and therefore, reduce inflationary pressure. In a recession, the government can increase AD, by increasing government spending and cutting taxes. Lower taxes increase disposable income. This helps increase economic growth and reduce unemployment. Evaluation of Monetary Policy in controlling inflation

MONETARY POLICY Monetary policy is the oldest policy for the economic stability. It is a policy which is adopted by the central bank of the country to control the supply of money: We can say that all those methods which are adopted by central bank, of the country to control the supply of money are called the monetary policy. In simple words, monetary policy means monetary management. In the words of Harry G. Johnson, "It is a policy of central bank to control the supply of money with the aim of achieving macroeconomic stability". Tools Of Monetary Policy They are classified into 1. Quantitative Methods 2. Qualitative Methods 1. Quantitative Methods: They consists of those methods which Physically affect the amount of credit creation in the economy. They are as: 1) Changes in Bank Rate Policy or Rediscount Rate: The rate at which the central bank of the country gives loans to commercial banks is known as Bank Rate or re-discount rate, In Pakistan; State Bank charges 10% as bank rate. By changing such rate of interest, the central bank can influence the supply of money in the

country. To control inflation the central bank increases the rate of interest. The commercial banks will also increase their rate of interest. Accordingly, the loans will decrease, investment, output and prices will fall. In this way, inflation will be controlled. Now, we assume that the country is facing deflation. To remove deflation central bank will decrease the bank rate, the commercial banks will also decrease the rate of inl91'Cst. In this way, people will get more loans. Investment production, employment and Prices will start rising up. Accordingly, deflation will be controlled. Limitations: But the success of the bank rate policy depends upon

The fact that how flexible is the economic system. How rapidly, there will be the effect of bank rate on other variables of the economy, like prices, wages, Interest and output, etc. Commercial banks should abide by the instructions of the central bank. If the central bank brings changes in the rate of interest, the commercial banks should also change the rate of interest. If commercial banks already have excess reserves then commercial banks will not depend upon central bank. It this way, they will not care for changes in the rate of interest from central bank. If economic activity is flourishing or economy is having boom, then the business class will be prepared to pay even higher rate of interest and inflation will not to be controlled.

2) Open Market Operation .. This is the second instrument of the monetary policy. Under this technique, the central bank sells or purchases 'government securities. If the central bank finds that commercial banks are providing excessive loans which are creating inflation. To remove the inflation, the central bank sells the government securities. The commercial banks will purchase these securities to earn interest against such securities. In this way, the resources of commercial banks will go down. They will advance less loans. Accordingly, the inflation will be controlled. If there is deflation in the economy. To control the deflation, the central bank purchases the government securities. Then the monetary base of the commercial banks will increase their loaning power will increase. As a result, investment will increase, income and prices will go up. Limitations The problem is that, in most of the countries the money market is not organized where the securities could be sold or bought. The funds which are collected through sale of government securities should not be spent on unproductive fields. 3) Changes in Reserve Requirements Each commercial bank has to keep a certain proportion of its deposits in the form of reserves just to meet the demands of the depositors. As in the case of Pakistan, each commercial bank has to keep 30% of its deposits to meet the needs of its depositors. The central bank can influence this reserve rate. If the central bank realizes that the commercial banks are advancing excessive loans, it will increase the reserve requirements. Accordingly, commercial banks could advance less loans. On the other hand, in deflation, if the central bank reduces the reserve requirements, the commercial banks will be able to advance' more loans. Hence, deflation could be removed. 4) Changes in Reserve Capital Each commercial bank has to keep a certain ratio of its deposit with central bank. In case of Pakistan, each commercial bank has to keep 5% of its deposit in the central bank. By changing the reserve capital, a central bank can control the supply of money by commercial banks.

When there is inflation in the economy. To remove this inflation, the central bank will increase the reserve ratio. As a result, lending of commercial banks will fall. As a result the supply of money will decrease. On the other hand, if central bank decreases the 'reserve ratio, the commercial banks will be having more funds to advance. Accordingly, the deflation could be controlled. 5) Changes in Marginal Requirements Commercial banks do not give loans against leaves, rather they ask for pledges to make. How much a person will have to pledge is settled by the central bank. This is given the name of marginal requirement. The central bank can bring changes in the marginal requirements. If there is inflation in the economy, the marginal requirements will increase. In this way, people will get less loans. As a result, supply of money will decrease. During deflation the marginal requirements are decreased. Hence people will get more loans from the commercial banks. As a result supply of money will go up and deflation will be controlled. 6) Credit Ceiling/Rationing of Credit The central bank can issue directions that loans will be given to commercial banks upto a certain limit. As a result, the commercial banks-will be careful in advancing loans to the people. But this is a very strict method, hardly adopted by the central bank. Moreover, if the commercial banks are having other sources to borrow, they will not bother for this policy. 2) Qualitative Methods

Moral Suasion: It is concerned with just as a moral request by central bank to commercial banks that loans should not be given for unproductive fields which create inflation. Loans should not be given for speculative purposes and hoarding. But such like requests could be effective in the developed countries. Consumers Credit Control: This instrument is applied during inflation. If the central bank wants to control the supply of money, it will issue directions to commercial banks that loans should not be advanced for consumption purposes or for consumer durables because they create inflation. Direct Action: The instrument of direct action is concerned with the policy of central bank against commercial banks. It can refuse to give loans to commercial banks. The central bank will not advance loan to commercial banks for the sectors which create inflation. Moreover, if commercial banks do not follow the instructions of the central bank, It will refuse to lend commercial banks Publicity: The central bank of the country is the overall in charge of economic stability of the country. Its aim is to protect the economy from inflation and deflation. For this purpose, it analyses the whole economy. It keeps an eye over the activities of the commercial banks. If the commercial banks are found advancing loans which create inflation, their activities will be unhealthy for whole economy. The central bank can black list such banks. Thus to avoid such bad reputation in' future, they will be careful in advancing loans.

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Central bankers around the world have similar tools at their disposal.

The qualitative tools in a central bank or a Treasury Department's monetary policy are those that affect bank lending through any means other than the expansion or constriction of the money supply itself. These may include, for example, the direct rationing of credit, changes in the marginal requirements of loans, moral suasion and publicity.

Rationing Credit
1. The central bank of a country typically functions as a lender of last resort. It can use
this aspect of its operations to control the money supply. It could simply refuse to lend any more money to certain banks or impose a ceiling on how much it will lend per bank per fiscal quarter.

In the words of T.R. Jain and O.P. Khanna in their book "Macroeconomics," this "is relatively an old method of control of money supply," that has been used recently by central banks.

Margin Requirements
2. Banks or other financial institutions routinely lend money to customers to buy securities. The "margin" is the portion of a security that the regulated institution's loan is not allowed to cover. In other words, if a bank were allowed to loan up to $80 to a customer eager to buy $100 of stock, the margin would be $20. By increasing or decreasing the margin requirement, the authorities can effectively tighten the money supply.

Moral Suasion
3. The central bank of a country typically exercises regulatory authority over all or part
of the banking industry, issuing licenses or operating permits in that capacity. This gives it leverage, as Clifford Gomez wrote in "Financial Markets, Institutions, and Financial Services" (2008) to persuade banks "not to make excessive use of Central

Bank's credit facilities and also not to use the accommodation already obtained" to fuel non-essential or speculative activities by its customers.

Other Tools
4. Publicity can also be a tool for a central bank. If public opinion sees speculation or
excessive borrowing as a bad thing, there will likely be less of it, and the central bankers can seek to influence public opinion.

Still other tools may be available, depending on the particular social andlegal context in which a central bank operates.

Contrast
5. Such qualitative methods of the control of the money supply are generally contrasted
with "quantitative" tools such as the purchase of bonds in the open market or changes in the reserve ratio.

When a central bank purchases bonds, it increases the bank account of the seller--often a bond dealer---by the amount of money equal to the price of those bonds, and thus by fiat increases the amount of money in the system. When it sells bonds, it does the reverse, with the effect of contracting the money supply.

The reserve ratio is the percentage of a commercial bank's money it is required to keep in its vaults as ready cash (to protect against bank runs, for example). The central bank can increase the money supply by lowering the reserve requirement and can decrease it by increasing that requirement.

Which Is Better Fiscal or Monetary Policy?

By Russell Huebsch, eHow Contributor updated: September 23, 2010

1.

The U.S. uses fiscal and monetary policy.

Monetary Policy Less Political

2. The U.S. tends to manage the economy through monetary policy--which changes the amount of money in the economy through means such as changing interest rates-because it reduces the politics of economics, according to EconomicsHelp.org. Fiscal policy, which involves direct investment in the economy, such as changing tax rates, often means making unpopular decisions, like cutting spending.

Fiscal Policy Better for GDP

3. Fiscal policy allows the government to directly affect the gross domestic output of the
country, according to the Library of Economics and Liberty. The federal government can try to stabilize business cycles by adjusting demand and prices with fiscal policy. In a recession, monetary policy changes alone may not jump start the economy.

Bottom Line
4. In the end, the government must use fiscal and monetary policy to enable a growing economy, but monetary policies are generally preferred because they are less political. Fiscal policy sometimes caters to a politician's voting block, such as tax cuts for only a certain income bracket.
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The Differences Between Monetary & Fiscal Policy

By Shane Hall, eHow Contributor

Governments try to manage their nations' economies through their control of fiscal and monetary policy. Fiscal policy relates to government taxation and spending, while monetary policy affects a nation's money supply and interest rates. Fiscal and monetary policies both have short- and long-term effects of which governments should be mindful.

Function
1. Fiscal policy includes the government's range of taxation and expenditure options by which it can affect the course of a nation's economy. Governments may, for example, attempt to stimulate a sluggish economy through a combination of fiscal policy tools such as tax cuts and spending increases. The legislative and executive branches of

government control fiscal policy. Monetary policy refers to the range of policy instruments by which a government tries to manage the nation's money supply. Monetary policy's goals include protecting the purchasing power of money by acting to control inflation. Central banks, such as the Federal Reserve in the United States or the Bank of Canada, have control over monetary policy. Both types of policy try to impact key economic variables such as unemployment, inflation and economic growth.

Fiscal Policy
2. Governments often use fiscal policy tools in times of a weak economy. In times of an
economic recession or depression, government policymakers hope that fiscal policy will provide a short-term economic stimulus that leads to long-term growth. During the Great Depression of the 1930s, for example, President Franklin Roosevelt's New Deal used a variety of new government spending initiatives to stimulate the economy and put people to work on public infrastructure projects. In 1981, President Ronald Reagan cut income tax rates to allow people to keep more of the money they earn, giving them greater freedom to spend and invest.

Effects of Fiscal Policy

3. Government spending, along with consumer spending and investment by firms, is an element in determining a nation's gross domestic product, or GDP. The GDP is a key measure of overall economic activity. Many economists contend that government fiscal policy has a multiplier effect. As government increases spending or reduces the amount of taxes people pay, it increases the overall demand for goods and services in the economy. For example, if the government boosts spending on military aircraft, it creates more work for defense contractors, which hire more workers to meet the government's production demands. Workers and defense firms make more money, which they spend on other goods and services. The firms with which they spend must then hire more workers and produce more output. This illustrates the multiplier effect.

Warning
4. Economists warn, however, that fiscal policy has a downside. Higher government spending often leads to higher interest rates, which reduces investment and overall demand for goods and services by making it more expensive to borrow money. Economists call this phenomenon the "crowding out" effect.

Monetary Policy
5. Monetary policy instruments include the buying and selling of government bonds (known as open market operations), changing the proportion of reserves that banks are required to hold against deposits and changing the interest rates that central banks charge member banks for loans. All monetary policy instruments can expand or contract the money supply. All monetary policy tools strive to protect the value of money and prevent inflation.

Effects of Monetary Policy

6. Expansionary monetary policy, such as buying government bonds from the
public, reducing banks' reserve requirements or cutting key interest rates expand the money supply by putting more money into circulation or increasing the percentage of deposits that banks are able to lend. Central banks such as the Federal Reserve will use expansionary monetary policy in times when the economy is in a recession. For example, in 2001 after the September 11 terrorist attacks, the Federal Reserve repeatedly cut interest rates in an attempt to boost economic activity. Contractionary monetary policy, such as selling government bonds to the public, raising reserve requirements or boosting interest rates, reduces the money supply by taking money out of circulation and reducing lending by banks. Central banks use contractionary measures, such as raising interest rates, to counter inflationary pressures.

Considerations
7. Central bank policymakers make monetary policy decisions based on current economic conditions and forecasts of the future. However, predicting future economic conditions is a difficult task, as variables beyond the control of central banks can cause sudden changes.
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Effectiveness of Monetary & Fiscal Policy

By Shane Hall, eHow Contributor

Monetary and fiscal policies affect the circulation of dollars throughout the economy.

Governments influence the course of a nation's economy through fiscal policy, which refers to government spending and taxation, and monetary policy, which involves regulation of a nation's monetary system. Both types of policy have differing economic effects.

Function
1. Monetary policy promotes price stability, and sustainable rates of employment and growth. Governments often use fiscal policy to stimulate the economy during a recession.

Effects
2. Fiscal policy often has a multiplier effect. Increased government spending on defense, for example, creates more work for defense contractors and their employees, who in turn spend their incomes on other goods and services.

Expert Insight
3. A study of monetary policy by the Federal Reserve Bank of St. Louis found that countries that set annual inflation targets often achieve price stability.

Benefits
4. Fiscal policy can compensate for lower consumer and business spending during a
recession. Monetary policy can reduce inflationary pressures in a growing economy, or encourage more investment during a recession.

Considerations
5. Higher government spending through fiscal policy may lead to a "crowding out effect," in which interest rates increase, reducing investment and making borrowing more costly.

Time Frame
6. The St. Louis study found that monetary policy actions, such as interest rate changes, may take up to 18 months to be felt throughout the economy.
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