Except for a few exceptions, the power of every economy in the world is vested in its respective governments and the market. The government plays an important role in shaping an economy, and fiscal and monetary policies are tools that governments use to direct their economies. Fiscal and monetary policies both stimulate the economy to its proper position. If the economy is on the verge of a downturn, these tools are used to resurrect its health.
Monetary policy is the guide for managing an economy’s money supply. It is the responsibility of a country’s central bank to prepare it. In monetary policy, the central bank usually dictates interest rates as well. Interest rates play critical roles in controlling the circulation of money in the economy, or the money supply. The Nepal Rastra Bank (NRB) is in charge of managing money circulation in Nepal. For this NRB and other central banks around the world, lowering interest rates stimulates the economy and allows it to grow. When interest rates are reduced, borrowing becomes more affordable, which encourages more people to borrow and increase consumption, which means that the more people spend, the more money circulates in the economy, and thus the money supply expands. This is one of the economic scenarios in which monetary policy is used to stimulate the economy. If the economy is growing too quickly, central banks may restrict the circulation of money in the economy. The monetary policy raises interest rates to accomplish this. Interest rates are typically raised when inflation is rapidly rising; by doing so, the supply of money is controlled as the cost of borrowing rises, and as a result, demand for money and liquidity falls significantly. When a country’s economy enters a recession, it also employs monetary policy. During this period, expansionary monetary policy is used, which means that interest rates are reduced and reserve limits are relaxed. In times of recession, countries issue bonds to create new money.
How Monetary Policy Influences Economic Development?
1) Adjustments to Demand and Supply of Money
Economic development increases the demand for money because economic growth and a decline in subsistence sectors increase the demand for currency transactions. Furthermore, rising per capita income and population growth have increased the demand for money during the development process. The ever-increasing demand for money necessitates the monetary authority increasing the money supply at the rate of increase in real income, so that prices do not fall as national income rises. A drop in price levels has a negative impact on economic growth and sets off a downward spiral in prices and production. This will cause growth to slow and inflation to rise.
2) Price Stability
A stable price level and exchange rate are critical for economic growth. Inflation is an unavoidable phenomenon that occurs in an economy; it does not necessarily indicate a weakening of the economy’s health, but high rates of inflation usually do. Price increases reduce the propensity to save and have a direct impact on investments in speculative and non-productive assets such as real estate, jewelry, gold, warehouses, and so on. As a result, the monetary authority must keep a close eye on price movements. As a result, the supply and direction of money and credit are regulated, and price increases are controlled. Furthermore, inflationary price increases result in frequent currency depreciation. Changes in exchange rates will have a negative impact on international trade, which will aid a country’s development. This may impede economic growth; therefore, monetary authorities use monetary policies to prevent such occurrences.
3) Credit Control
The banking systems of less developed economies, such as Nepal, are still underdeveloped. As a result, when the possibility of credit problems arises, the monetary authorities must intervene to provide sufficient guarantees and rediscount options to induce banks to provide medium and long-term credit for production purposes. When borrowing rates become too low, the supply of money in the economy increases, potentially leading to inflation. Commercial banks primarily make short-term loans to entrepreneurs and business owners and are hesitant to make medium- and long-term loans to meet the financial needs of industry and production. Selective loan control is also required to influence the investment and production structure, as well as to differentiate the cost and availability of credit in various sectors and industries.
Fiscal policies are guidelines that govern the government’s spending. It advises the government on how to spend revenue from taxation and other sources. Tax rates are critical mediums for stimulating the economy in fiscal policies. In order to stimulate the economy, the government will lower tax rates and increase spending. If the government perceives that the economy is slowing or that there aren’t enough activities, it will increase its spending, also known as stimulus spending. However, if sufficient tax revenue is not available to fund stimulus spending, the government will resort to public borrowing or even the issuance of bonds and securities, a practice known as deficit financing. In a contradictory situation, when an economy needs to cool off, the government will raise taxes and cut spending, thereby encouraging economic growth.
How Fiscal Policy Influences Economic Development?
1) Mobilization of Resources
In less developed countries, the primary goal of fiscal policy is to mobilize resources from both the public and private sectors. Savings rates, national income, and per capita income are typically very low. In turn, the rate of investment and capital accumulation has accelerated the rate of economic development.
Private investment has the dual benefit of increasing investment while decreasing tangible consumption. Investment in non-productive channels can help to keep the economy’s inflationary pressures at bay. Foreign investment could be reduced by increasing savings rates and the marginal propensity to save through public finances, taxes, and mandatory loans. Other measures that can help mobilize resources include progressive tax rates, high import taxes on luxury goods, and bans on the production of luxury goods and luxury goods. Expenses, real estate, and so on can all make a significant contribution to the equitable distribution of wealth and resources.
2) Encourage Investments
Fiscal policies in developing countries encourage investment in socially and economically acceptable production channels, allowing investors to promote economic development while avoiding waste and unproductive investment. Finally, fiscal policy should invest in general social and economic expenditures such as transportation, communications, technical training, education, health, and soil protection, which tend to increase productivity and expand foreign trade markets. Simultaneously, non-productive investment is limited and directed toward productive and social needs channels.
3) Employment Opportunities
Because the populations of the least developed countries are rapidly growing, these countries’ fiscal policies aim to generate high expenditures that help expand employment opportunities. Unemployment is common in developing countries, with cyclical and disguised unemployment being the most common. Because these countries primarily export raw materials, underdeveloped countries experience cyclical unemployment. If demand for these raw materials falls as a result of the economic downturn, developing countries will be forced to deal with job losses in key industries. The government can increase government spending to eliminate this type of unemployment, but this is unlikely to have many positive effects. When government spending rises, people have more money to spend on imports or conspicuous consumption. On the other hand, disguised unemployment exists in underdeveloped countries, which means that more people are engaged in production activities rather than eliminating the number of people who are truly needed for this type of unemployment. As a result, it is necessary to raise the educational level. In less developed countries, the primary goal of fiscal policy should be to maximize capital accumulation while avoiding inflation.