ECONOMIC TOOLS : FISCAL

AND MONETARY POLICIES

CHAPTER 10
MONETARY AND FISCAL POLICIES
– are tools that we can utilize to help
resolve economic problems
Fiscal Policy
The government has a very important role
to play in the nation’s economic performance. It is
responsible to “promote maximum employment, production,
and purchasing power”.

State of Nation Address (SONA)

The President is mandated to issue a report each year

explaining how he/she will achieve or what he/she has done to
achieve these goals.
 

Fiscal Policy

Is the use of government revenue collection (taxes or 

tax cuts) and expenditure (spending) to influence a
country's economy.
• Main tools available to the President and the Congress
to achieve good economic performance .
• Involves changes in government spending and in taxes.
Fiscal Policy
• Main tools available to the President and the Congress
to achieve good economic performance .
• Involves changes in government spending and in taxes.

Budget deficit or budget surplus

- difference between government spending and tax
revenues determines the amount
Two Types of FISCAL POLICY

1. Discretionary Fiscal Policy

2. Automatic Fiscal Policy
DISCRETIONARY FISCAL POLICY
- refers to deliberate choice on the part of
the government agencies

Marginal Propensity to Consume (MPC)

Is a metric that quantifies induced consumption, the
concept that the increase in personal consumer
spending (consumption) occurs with an increase in 
disposable income (income after taxes and transfers).
Assume that the government purchases are
deliberately increased by
P 100,000.00. Assume that if there is a P100
addition to income, people will spend an
additional P80 and save an additional P20.

We say that the marginal propensity to

consume is 0.8 (change in consumer spending
divided by change income – P80 divided by
P100).
Assume that the government spent the additional
P100,000 buying computers form Samsung . This
gave Samsung P100,000 of additional income. That
additional income went to the company ‘s workers,
owners, and suppliers. What did they do with their
additional P100,000 income?

With a marginal propensity to consume of 0.8, they

would increase their additional income was saved.
The workers, owners, and suppliers of Samsung
spent an additional P80,000 buying goods at Bench
This provided an additional P80,000 of income for the workers, owners, and
suppliers of Bench. What did these people do with this additional income?
The answer is that they spent P64,000 of it (0.8 times P80,000) and saved
the other P16,000. The workers, owners, and suppliers of Sears spent
P64,000 of additional income buying food at Jollibee. This gave the workers,
owners, and suppliers of Vons an additional P64,000 of income.

Let us summarize +1000 Purchases by the Government

+ 80,000 consumption by Samsung
+64,000 consumption by Bench
+51,200 consumption by Jollibee

= +500,000 increase in Equilibrium Real GDP

We know the multiplier is 5 because there is a formula to calculate it.

Multiplier = 1
1 – Marginal Propensity to Consume
(Take the marginal prosperity to consume, subtract it from 1, and then
divide the result into 1. So take 0.8, subtract it from 1, and the result is
0.2. Take 0.2 and divide it into 1 and the result is 5). There is no
substitute to deal with this formula except to remember it.

Now let us examine a second discretionary fiscal policy – reducing taxes.

Assume that the taxes are reduced by the same P100,000. those who
receive that tax reduction will now have P10,000 more in disposable
income. What will they do with this P100,000?

With a marginal propensity to consume of 0.8, they would increase their

consumption by P80,000 (.8 times P100,000). They would save the other
P20,000 of their additional disposable income. Assume they spent the
additional P80,000 buying goods at Bench. This provided an additional
P80,000 of income for the workers, owners, and suppliers of Bench. What
did these people do with additional income?
The answer is that they spent P64,000 of it (0.8 times P64,000) and saved the
other P16,000. From this point on, the story is the same as it was for
government purchases.

Let us summarize + 800 consumption by Those Receiving the Tax Reduction

+ 640 Consumption by Bench

+ 512 Consumption by Jollibee

What does this total? Compare it to the numbers for government purchases.
You can see that all of the numbers are the same except for the fine P100,000.
Therefore the sum must be P400,00 (P100,000 less than for government
purchases). Therefore, we have a different multiplier. We call it the tax
multiplier.

Tax multiplier is a number that multiplies a change in taxes in

order to calculate the change in Real GDP.
In this case the tax multiplier is equal to 4, that is (P100,000
time s 4 = P400,000).

Change in Taxes x Tax Multiplier =

Generated by an Adobe application Change in Real GDP

(P100,000 (4) = (P400,000)

To calculate the tax multiplier, there is a new formula. As with

the government purchases multiplier, it is best to just
remember it. The denominator is the same as before but the
numerator is different.

Tax Multiplier = Marginal Propensity to Consume

1 – Marginal Propensity to Consume
(Take the marginal propensity to consume,
subtract it from 1, and then divide it into the
marginal propensity to consume. Since the
marginal propensity to consume is equal to
0.8, then calculation becomes
Tax Multiplier = 0.8 / 1.(0.8)
= 0.8 / 0.2
=4
• Historically in most nations such as the Philippines and the United
States, discretionary fiscal policy has not played much of a role in
achieving good economic performance.
• The Kennedy tax cut in 1964 of the United States may be the
only example of a successful discretionary fiscal policy.
• Time lags – problem come from

The fiscal policy during the time of President Marcos was primary focused
on indirect tax collection and on government spending on economic
services and infrastructure development.
• The tax system during his administration was generally regressive as it
relied a great deal on indirect taxes.
• When President Aquino assumed her office, she inherited
a large fiscal deficit heightened by the low tax effort due
to a weak tax system of the previous administration.
• Six to nine months – the process of changing tax laws or
of changing discretionary government spending time
• IN PHILIPPINES, OUR KNOWLEDGE IS LACKING AND OUR
INSTITUTIONS ARE NOT APPROPRIATE FOR US TO UTILIZE
DISCRETIONARY FISCAL POLICY IN A TIMELY MANNER.
• THEREFORE , IT HAS BEEN FORTUNATE THAT WE HAVE
AUTOMATIC FISCAL POLICY.
Automatic Fiscal Policy
Generally since the end of World War II, the recessions experienced in the
United States have not been as severe as those that had existed before 1940.

Certainty nothing like the Great Depression has occurred. Part of the reason for
this fortunate occurrence has been the existence of the “automatic stabilizers”.
Remember that we want the actual Real GDP to be equal to the Potential Real
GDP.

SOMETHING IS STABILIZING IF IT INCREASES ACTUAL REAL GDP, when it is too

low (that is, when there is recessionary gap and actual Real GDP is below the
Potential Real GDP) and decreases actual Real GDP when it is too high (that is,
when there is inflationary gap and actual Real GDP is above the Potential Real
GDP).

AUTOMATIC STABILIZER – something that does this without the need for
government action
Entitlements
- certain types of governments spending act as automatic
stabilizers
- in entitlement program, the government does not specify an
amount it will spend, instead the government specifies who is
entitled to certain benefits and how much that person is entitled
to.

Three examples of entitlements that are automatic stabilizers are:

1. Unemployment benefits
2. Welfare spending
3. Social Security spending

INCOME TAXES also act as an automatic stabilizer. IN FACT, TAXES

ARE THE LARGEST AUTOMATIC STABILIZER.
MONETARY POLICY

Barter – people would have to trade

goods for goods

money – whatever people will accept

as a medium of exchange
There are certain characteristics that a good needs to be a good
medium of exchange.
1. The good needs to be durable.
2. The food needs to be high in value in relation to its weight.
3. The good needs to be scarce.
4. It is acceptable

COMMODITY MONEY – the value of the coin as a money was equal

to its value as a commodity
Flat money or token money – this means that the metal in the coin
is worth less than the value of the coin
Two Other Functions that money serves:

1. Money is a store of value – this means that

money is one way of holding wealth

2. Money acts as a unit of account – this means that

money is a unit of
measurement of value
The money supply in the Philippines today
The commission came up with four definitions of
money that we use today:
→ M-1 → M-3
→ M-2 → M-4 →L
L – stands for Liquidity
- it includes everything that is considered liquid
AN ASSET IS CONSIDERED “LIQUID” if it can be
easily converted into money without a risk of loss
The Bangko Sentral ng Pilipinas
- central bank of the Philippines

central bank – central monetary authority which

provides monetary policy directions that
covers the areas of money, credit, and
banking

- also supervises the operations of banks and

regulates the activities of non bank financial
institutions and intermediaries
The Role of the Banko Sentral ng Pilipinas
The BSP focuses o three main areas or pillars to carry out its
objectives:
1. Price Stability. This refers to the condition of low and
stable inflation rate.
2. Financial Stability. The BSP makes sure that financial
institutions follow the prudential rules and regulations.
3. Efficient Payment and Settlement Systems. The BSP
guarantees that the settlements of financial
transactions of the general public are safe, timely, and
accurate.
Expansionary Monetary Policy is focused on expanding, or
increasing, the money supply in an economy.
Contractionary Monetary Policy is focused on decreasing
the money supply in the economy.

MONETARY POLICY TOOLS

The BSP uses the following monetary policy tools or instruments
in order to influence the desired level of liquidity in the economy:
1. BSP’s Policy Interest Rates
-These policy interest rates are used by the BSP when it
lends or borrows to or from banks with government
securities as collateral.
2. Reserve Requirement – it refers to the mandatory
proportion of the deposits and deposit substitute
liabilities of the banks that they hold as reserves
3. Special Deposits Accounts Facility – this facility allows
banks and trust entities of BSP supervised financial
institutions to have fixed term deposits with the BSP
4. Rediscount Rate – this is the interest rate that BSP
uses when it lends’ money to a financial institution
5. Open Market Operations – it involves the outright sale
or purchase of government securities by the BSP