This week, everyone has been talking about a meeting between President Gotabaya Rajapaksa and senior officials at the Central Bank of Sri Lanka, where the president openly lashed out at the Central Bank’s inaction against the current economic crisis. In a blog post I wrote about a month ago, I talked about some of the Economics of “Reemerging from the COVID-19 Recession,”
and explained that governments and central banks should be ready to hit the accelerator when the pandemic settles down. Now that the spread of COVID-19 has been controlled, and economic activity is recovering, this is exactly what the President is asking for. So this week, I thought it would be useful to explain what hitting the accelerator actually means and how it can be done using Monetary and Fiscal policy.
Why hit the accelerator?
As I’ve explained in past blog posts, the movement restrictions aimed at curtailing the spread of COVID-19 caused a demand-deficient recession in Sri Lanka. This means that there was a decline in Aggregate Demand – the total demand for a nation’s goods and services from households, firms, government and foreigners. In normal circumstances, governments and central banks would immediately hit the accelerator and implement expansionary demand side policies in order to restore Aggregate Demand and minimize decreases in output and employment. However, this time around, we had to wait till the pandemic itself was under control before implementing expansionary demand side policies because we didn’t want to increase economic activity and risk the spread of the disease.
Now that the economy is slowly returning to normalcy, the idea is to use expansionary demand side policies and in turn accelerate the restoration of Aggregate Demand, output and employment. Monetary and Fiscal policy are the two main forms of demand-side policy that can be used to do so.
Hitting the Accelerator with Monetary Policy
Monetary Policy is the policy adopted by Central Banks in order to increase or decrease aggregate demand by adjusting the money supply in a nation. In this case, hitting the accelerator would require expansionary monetary policy that increases the money supply or the amount of money in circulation in the economy. Once the money supply increases, interest rates or the price of borrowing decrease and as a result aggregate demand will increase because lower interest rates will incentivize increased investment and consumption by firms and households. When it comes to actually implementing expansionary monetary policy and increasing the money supply, there are three key tools available to the Central Bank.
1. Adjusting the Required Reserve Ratio
The required reserve ratio specifies the fraction of deposits that commercial banks have to hold in reserves without loaning out to anyone else. For example, if the Required Reserve Ratio is 10%, then a bank with deposits of 1000LKR can only loan out 900LKR; 100LKR would have to remain in their reserves. Therefore, reducing the required reserve ratio leads to an increase in the money supply because a higher proportion of every rupee saved in commercial banks can be reinjected back into the economy as loans. This is why the Central Bank reduced the Required Reserve Ratio from 4% to 2% after the meeting with the president this week.
2. Adjusting the Discount Rate
The discount rate is the interest rate at which central banks lend money to commercial banks. Commercial banks rarely borrow from the central bank because the discount rate is usually set slightly above the federal funds rate or the interest rate at which commercial banks borrow from each other. However, the discount rate functions as an important signalling tool. When the discount rate is decreased, commercial banks will increase their lending activity because they can borrow money for a cheaper rate from the central bank if need be. This increase in lending activity leads to an expansion in the money supply that will in turn increase aggregate demand.
3. Engaging in Open Market Operations
Hitting the Accelerator with Fiscal Policy
Fiscal policy on the other hand relates to how the government adjusts its budget in order to alter aggregate demand in an economy. Just like with monetary policy, expansionary fiscal policy will hit the accelerator and cause an increase in aggregate demand. Expansionary fiscal policy can be achieved through decreased taxation or increased government spending.
1. Decreasing taxation
A decrease in taxation leads to an increase in the disposable income available to firms and household. This in turn leads to an increase in consumption and investment that will increase aggregate demand. However, as a consequence the government risks sinking further into debt because taxation is the primary form of government income.
2. Increasing Government Spending
An increase in government spending leads to increased levels of aggregate demand because government spending is a component of aggregate demand. Regardless of the way in which the government chooses to spend its money, be it via an increase in welfare payments or infrastructure development, increased spending will lead to increased aggregate demand. However, I discussed ways in which government spending can be increased to maximize the long term benefits in my post about reemerging from this recession
Although I haven’t spent much time evaluating any of these policies or suggested an approach best suited to the current situation, I hope this rudimentary explanation of the mechanics behind hitting the accelerator with fiscal and monetary policy helps you better understand the policy decisions that the treasury department and central bank will be making in the coming weeks and months.
Let me know if you have any questions or concerns.
Have a great week!