MONETARY AND FISCAL

POLICY

Introduction
This unit introduces two major economic
policies - Monetary and Fiscal Policy - used by
countries to influence economic outcomes at
a macro scale. This unit begins with the
theories from two different schools of thought
(Classicals and Keynesians), which brought
into existence both policies. The Classicals
believe that the government should not
intervene in the workings of the economy,
while the Keynesians believe in government
intervention.

Fiscal Policy and Monetary

Policy

Fiscal policy The taxing and spending tools

that the government can use to influence
the macroeconomy. Specifically: tax rate,
government spending and transfer
payments. Using these tools the
government attempts to Influence the AD.
Aggregate demand Total spending on
goods and services made in the Economy
i.e. AD = C+I+G+X-M
Monetary Policy The tools that central
Bank uses to influence the money market
by expanding and contracting the money
supply which in turn affects the interest rate
which in turn affects AD ( i.e. the goods
market and out put ( income Y)

Monetary Policy
Monetary Policy (MP) is the responsibility of the
Central Bank of PNG (BPNG). BPNG is the monetary
authority on behalf of government. Prior to 1994, the
objectives of MP were to control inflation (price
stability) and maintain equilibrium in BOP. The
current MP objective is primarily achieving and
maintaining price stability (Central Banking Act
2000). MP involves regulating level of aggregate
demand and aggregate supply so as to maintain
price and exchange rate stability. This is achieve
through changes in money supply. Money supply
influences prices (inflation) and interest rates (cost
of borrowing, profitability of income, propensity to
save and invest and capital flows.

PNG defines its money supply

Money Supply Components, 2004

K
mill
ion

Notes and Coins in circulation

Demand deposits

1795.1

Narrow Money Supply (M1) (1+2)

2214.7

Savings Deposits

429.1

Term Deposits

954.0

Other items (net)

1477.2

Broad Money Supply (M3*) (3+4+5+6)

5075.0

Deposits of Commodity Funds with BPNG

Total Money Supply (M3) (7+8)

419.6

5075.0

Monetary Policy
In economics M1 is defined as the money
supply (demand deposits form a large part of
it). Central Bank targets demand deposit
components. Demand deposits also include
loans. Loans create deposits. Commercial
banks have the power to create deposits
through lending. The creation of an
oversupply of money will cause inflation.
Therefore the central bank exercises control
and control oversupply of money and bank
credit.

Monetary Policy Instruments

The BPNG has at its disposal a number
of MP instruments.
1. Minimum Liquid Assets Ratio (MLAR)
and Cash Reserve Requirement (CRR)
2. Open Market Operations (OMO)
3. Discount Rate / Kina Facility Rate
(KFR)
4. Moral Suasion or Persuasion

1. Minimum Liquid Assets Ratio MLAR)

and Cash Reserve Requirement (CRR)
Commercial banks are required by law
to keep a certain percentage of assets
in cash or liquid assets. For example,
in the December quarter of 2004, the
MLAR was 25% and the CRR was 3%.
Then when a bank receives a K100
deposit, it will:
Keep K25 required reserves, and
Lend K75 excess reserves

1. Minimum Liquid Assets Ratio MLAR)

and Cash Reserve Requirement (CRR)
If the CRR is 3%, then the bank will
keep K0.75 in the form of cash (i.e.,
K25 x 0.03). The commercial banks
power to create money is dependent
on the MLAR. The credit creation
multiplier can be derived as follows:

1
1
k
4; where d MLAR
d 0.25

1. Minimum Liquid Assets Ratio MLAR)

and Cash Reserve Requirement (CRR)
A higher MLAR
banks power to
create money lower (i.e., d=0.25, k=4).
A lower MLAR
banks power to
create money higher (i.e., d=0.2, k=5).
If there is Inflation in the economy, the
appropriate policy would be to raise the
MLAR. Unemployment is a result of low
investment levels thus the appropriate
policy would be to lower the MLAR.

2. Open Market Operations

OMO)
In the OMO, Treasury bills and government
inscribed stocks are bought and sold by Central
Bank to the public. Prior to 2004, the minimum
purchase amount on treasury bills was K10,
000. This rose to K1 million in December 2004.
When there is inflation and therefore excess
credit in circulation, BPNG will sell treasury bills,
and government bonds to commercial banks,
other financial institutions and the public
thereby withdrawing money from circulation.
Money supply will fall and therefore prices are
stabilized (inflation is controlled).

2. Open Market Operations

OMO)
Unemployment in the economy may be
attributed to low investment spending. To
stimulate investment BPNG will buy Treasury
bills and government bonds from commercial
banks, other financial institutions and the
public thereby increasing the money supply,
allowing for increased credit creation. Interest
rates will fall as a result. This will encourage
investment borrowing, promote investment,
resulting in higher GDP and improved
employment situation.

3. Discount Rate / Kina Facility

Rate
KFR)
The KFR is the rate that BPNG charges on loans
to commercial banks. The BPNG reduced the
KFR by 7 percentage points from 14% in
December 2003 to 7% in December 2004. The
BPNG utilizes the KFR as its key instrument in
signaling its monetary policy stance. It can be
noted that between 2003 and 2004, the bank
pursued a tight monetary policy stance.

In the face of inflation and excess liquidity the

central bank will raise the KFR to restrict credit
supply. In the case of unemployment, the KFR
will be reduced to encourage commercial bank
lending. Commercial banks respond to a lower
KFR but charging correspondingly lower
interest rates on lending and deposits. Lower
lending rates encourage investment borrowing.

4. Moral Persuasion

The Central Bank tries to persuade member

banks to act responsibly when there is inflation
or unemployment in the economy. It also try to
influence the direction of lending towards
genuine productive purposes.

In third world countries including PNG, the

success of MP is limited by the following factors:
1. the degree of monetisation is low
2. banking habits have not fully developed
there is too much usage of cash and debit
cards and not cheques, and
3. money markets are largely underdeveloped

4. Moral Suasion or
Persuasion
PNG has come a long way since independence.
Electronic banking (automated teller machines ATMs)
with the use of debit cards have been introduced
recently in PNG. PNG also has its own stock exchange
market and the easing of exchange controls will
attract portfolio investment by foreigners in PNG.
In summary, the effectiveness of MP will also
depends on the investment climate and
opportunities, the responsiveness of speculative
investment to higher interest rates, inflation and
unemployment, the cost structure of the economy,
quality of manpower, law and order, political stability
etc. MP can not be pursued in isolation but part of a
policy package.

Fiscal Policy

1.
2.
3.
4.

The objectives of fiscal policy are the same as

monetary policy. The enforcing authorities are
the Department of Finance (DF), Department of
Treasury (DT) and the Internal Revenue
Commission (IRC). Fiscal policy involves revenue
raising (IRC) and spending (DF and DT) by
government.
The following are instruments of fiscal policy:
taxation
government expenditure
borrowing
buying and selling (of goods)

1. Taxation
This is the primary source of revenue for the
government. There are basically 2 types of
taxes:
1. direct taxes (taxes on incomes)
e.g., wages and salaries tax and company
tax.
2. indirect taxes (taxes on goods and services)
e.g., sales tax, excise tax, import tariffs
- Excise taxes (levied at product or
manufacturing stage)
- Sales tax imposed at the stage of
distribution or sales

1. Taxation
Differences between the two types of taxes are
illustrated in Table below.
Direct taxes

Indirect taxes

Imposed on persons

Imposed on goods and services

Paid as you earn

Paid as you spend

Paid and borne by same

individual

Tax payer is the seller, the

bearer is the buyer

Progressive (capacity to pay)

Regressive, same amount of tax

May be proportional or
regressive (e.g., council tax)

1. Taxation
The following criteria must be present to allow
taxation to take place:
1. Efficient and cost-effective: Cost of
collection must be low. Direct taxes qualify.
2. Certainty: Must know in advance the tax
amount. With direct taxes, the degree of
certainty of X amount of taxes is very high than
indirect taxes.
3. Equity: Taxes should be levied according to
peoples ability to pay. Direct taxes meet this
criteria.
4. Convenience: taxes should be collected from
the people when it is most convenient for them
to pay. Direct taxes qualify.
Prior to the introduction of the goods and
services tax (GST), PNG had a very narrow tax

2. Government Expenditure

There is correlation between the role

of government and its spending
pattern. Government expenditure is
spending associated with the
following government roles:
1.
2.
3.
4.

maintain law and order (police),

provide external security (defence force),
maintain system of judiciary, and
Provision of public goods and services
(such as education, health, utilities,
infrastructure) etc.

2. Government Expenditure
However, too often in LDCs, governments tend
to venture into the domain of the private
sector.
Public enterprises are run on commercial basis.
Examples of this in PNG are Ramu Sugar and
Air Niugini and business arms of provincial
governments.
Public enterprises have generally not done
well (e.g., PNG Power, Telikom etc) and most
have failed. Free market or some form of
privatization is now advocated in many
developing countries including PNG.

3. Borrowing and
Lending
Often borrowing takes place whenever there
is a gap between Revenue and Expenditure.
The government can borrow internally and or
externally.
Internal borrowing has a crowding-out effect.
If the government borrows from commercial
banks for instance, then less loanable funds
will be available to private investors or firms
who might want to borrow money to expand
their businesses or establish new entities.
For most LDCs lending is mostly internal,
e.g., the Rural Development Bank in PNG.
The debt problem in PNG appears to be rising.

4.Buying and Selling by

Government

The objective of Commodity Stabilisation

Funds and Buffer Stocks is to stabilise price
and incomes of producers. This is how a
buffer stock operates. If the demand for
coffee on the world market falls to D2, the
government will buy AB tons from the
growers and maintain P and store it. If
demand increases to D3, the government
will sell BC tons (which is equal to AB). Refer
to Figure below. In the case of stabilization
funds, the government imposes a levy on
growers during boom periods (higher prices,
D3 and P3 in the Figure below) and pays a
bounty during the lean periods (depressed
prices, D2 and P2). See Figure below.

4.Buying and Selling by

Government
S2

S1

P3

P
D3
P2
D1
D2
A

Qty