Macroeconomics: Monetary and Fiscal Policies

Explain the concept of the “Balance of Payments” (BoP), and how it relates to the foreign exchange (“forex”) market under

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  • a floating rate and
  • a so-called “fixed” exchange rate.

How does the latter regime cause problems for the Chinese economy?

The balance of payment indicates all the transactions of a given country with the rest of the world. The country transacts using domestic and foreign currencies as a medium of exchange for imports and the export of goods and services.

The type of exchange system in a given economy will therefore affect the transactions of that country with the rest of the world. The exchange rate system used determines the value of a domestic currency in relation to other major currencies used in international trade. As Shahbaz, Awan, and Ahmad (2011) indicate, there is a strong relationship between exchange rate and balance of payment (p.69). Depreciation or appreciation of the domestic currency will rise or lower imports and exports of a given economy and therefore affect the country’s balance of payment.

In a fixed exchange rate system, the government, through the central bank, fixes the rate of exchange in relation to one of the major currencies or a combination of several currencies. The government maintains the fixed rate of exchange using its currency reserve. The government achieves this through selling or buying domestic or foreign currencies when necessary. The central bank balances the demand and supply of the foreign currency reserve to maintain a fixed exchange rate. The balance of payment may be in surplus or deficit. This depends on the quantity of both domestic and foreign currency that the government holds through the central bank.

A deficit in the balance of payment occurs when the government sells the foreign currency in the reserve and buys the domestic currency while a surplus occurs when the government purchases the foreign currency and sells the domestic currency. The official reserve account of the transaction is the account that contains all the transaction records of the central bank. If there are increments to this account over a given time, then it connotes that the central bank runs nimiety balance payment.

A decrease, on the other hand, indicates that the government operates a deficit balance of payment. A country running a deficit in the balance of payment has its demand for imports higher than the exports; therefore, the foreign currency has higher demand than the domestic currency.. The vice versa is also true which may require the government to intervene to restore the balance.

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In a system of floating exchange rates, the forces of the foreign exchange market determine the rate of exchange. The demand and supply of domestic and foreign currencies determine the rate of exchange. Given the ever-changing foreign reserves from time to time, the official reserve transaction might indicate surplus or deficit depending on the change of the reserve. The government, through the central bank, can step in and change the exchange rate in any direction using its currency reserves in this floating exchange system.

However, direct control may not be possible like in the case of a fixed exchange rate system. The Chinese government uses a fixed exchange rate in which it fixes its currency, Yuan, using the US dollar to control its foreign transactions. This system has turned out to be problematic to the Chinese government since the currency cannot operate in an open exchange market as the other currencies. The aim of the government is to create an illusion of the country’s economic growth where its currency does not change like other currencies in the world. This may limit the ability of the country to trade with other countries thus threatening its economic stability.

The condition forces the government to either sell its excess currency at a price lower than the market price or keep it in their reserves. Both options have some negative effects on their balance of payment. The Chinese policymakers overlook the seemingly compelling observation that, in the face of globalization, no country can assume ‘autonomy’ in terms of trade. International trade deals are the rule of the day and China is not exempted from such market forces.

Explain the original nature and function of the International Monetary Fund (IMF), and how this mission was sabotaged in the early 1970s. What role has the IMF subsequently assumed in the world economy — i.e. what is the typical problem that it treats — and how well has it performed this revised function

The signing of an agreement in 1945 by 29 countries in New Hampshire, US, resulted in the formation of the IMF. However, the organization started its operations in March 1947. Today IMF has a membership of 182 countries from all the regions in the world. IMF aimed to enhance cooperation in the international monetary affairs, to facilitate growth and expansion of international trade, and enhance stability in the foreign exchange.

It also aimed at establishing a multilateral system of payment, availing resources to its members who may have difficulties in their balance of payment, and ensuring a stable international balance of payment. Alongside the formation of IMF was the UN’s special agency, the World Bank. The role of the two bodies was to stabilize the global monetary affairs and promote the expansion of world trade. A country has to be a member of both bodies. IMF’s specific role was monitoring the exchange rate and balance of payment while the mandate of the World Bank was to finance the member states that experienced some financial challenges.

. 1970 saw the sabotage of the IMF mission as it became a lending institution rather than a body of ensuring stability in international monetary affairs. Economists attribute the change to the oil crisis at that period, which forced the member states to borrow large amounts of funds. The flow of funds changed globally as OPEC countries accumulated a lot of money in their reserves while industrialized economies went through a period of increased inflationary resulting from increased oil prices. Because of these crises, many countries, especially developing countries, run a deficit in their balance of payment due to import reduction and increased interest rates.

The IMF created an Oil Facility in response to this crisis in 1974 to assist many countries that were experiencing financial challenges. These financial challenges forced many countries to borrow funds from IMF and private banks, which kept the petrodollars. Since then, the bank has continued to monitor international monetary affairs with changing its approaches as problems in the international monetary systems become more complicated.

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For instance, in the 1980s the problem of debt crises arose with many countries defaulting to pay their debt. The IMF had to come up with programs for a long and medium adjustment that gave conditions to borrowers before accessing the funds (Dreher, 2009, p.233). The conditions required that all the countries intending to borrow these funds were to come up with convincing programs of how they are going to expend the funds for economic growth, especially in developing countries. The IMF also came up with guidelines for debt reduction in 1989 to help address the problem of debt crises in the developing economies.

Over the years, the IMF has faced many economic challenges that have affected its operation. The oil shock of the 1970s, the fall of the USSR and the end of communism, and the emergence of African independent states are some of the challenges the body has faced in history. The IMF is currently facing challenges that are more complex. Global financial crises experienced in the past few years and complexities of the international capital market are some of the sophisticated challenges facing the body today (Bird & Rowlands, 2010, p.131). Despite these difficulties, the body has tried to provide technical and financial assistance to many countries.

Explain the basic engine of growth —i.e. the investment = savings equation of the circular flow model — and how this leads to

  • the “Harrod-Domar’ model in which a country’s savings rate and so-called “capital-output” ratio determines its rate of growth, which may or may not match its population growth rate; and
  • how this inconsistency is eliminated in the standard neo-classical (“Solow”) model.

What is the essential difference between current economic growth in “developed” vs. “developing” countries?

Investment is the engine of economic development in any economy. Indeed, there is no economy that can grow without investment. Saving is the main determinant of investment. A number of equations, as illustrated below, describe the relationship between investment and saving. GDP represents the aggregate income of a given household;

GDP = C + S +T, where C is consumption, S is saving and T represent tax By Equating aggregate output and income;

C + I + G + NX = C + S + T

Then rearranging the equation we have:

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I = S – (G – T) – NX

From these equations, the investment is a function of saving. These equations show that savings in any economy determine investment. Thus, an increase in savings increases investment and hence the economic growth of an economy.

The investment equation shown above relates to a theory that Harrod and Domar developed in 1948in the Harrod Domar model. The model aimed at addressing the instability in the developing economies where the demand side of the economy always exceeds the supply side. According to this model, the savings and the ‘capital-output’ determine the growth of the economy. This is model can be illustrated using the equation shown below.


Where g represents the national income growth rate, s is the ratio of saving to income and c is the ratio of marginal capital-output.

The equation implies that for constant c, the rate of growth is proportional to the savings in the economy. Since s depend on the income, low income will translate to low saving and investment and hence low economic growth. This means that developing economies need to promote their investment for them to experience economic growth. Government planning in the economy ensure increased savings and investment and hence economic growth can enhance this promotion of investment.

However, the Harrod Domar model is based on the assumption of a special production function in which forced savings stimulated economic growth (Hagemann, 2009, p.67). The model, therefore, became inconsistent, and more advanced theories developed. One of those advanced models is the slow model, which corrected inconsistency in the Harrod Domar model by separating the process of economic growth with technical progress and increased inputs. According to this model, later capital was better than former capital since the latter was technologically improved. In conclusion, the difference between economic growth in developed and developing economies depends on the utilization of factors of production.

Returning to the present situation of the U.S. economy, discuss the differing views of the “Classical” vs. “Interventionist” schools of thought regarding monetary and fiscal policy — particularly government deficits and accumulated debt — in light of our discussions about the long-run importance of maintaining our rate of income growth into the future in comparison to the need for short-run stabilization (most notably, “full employment”).

The recent global recession has brought back the debate between the classical and interventionist schools of thought in the US particularly on the role of government in reversing the economic downturn. According to Hart (2010), the two schools failed and it is them to blame for their ineffective predictions (p.205). The two schools of thought differ in their views on how the government is supposed to use both monetary and fiscal policy to restore the economy of a country.

Classical theorists, influenced by the founders of classical theory such as Adam Smith and David Ricardo, argue that market forces should determine what goods and services the economy should produce without the intervention of the government, an open system that underscores capitalism at its best. If anything, people should decide their fate by either working hard and acquire as much as they can, or do nothing if not little to survive. On the other hand, Interventionists claim that economic stability and growth are not achievable without the intervention of the invisible hand of the government in the economy. In other words, plausible economic stability hinges on a central body, which in this case happens to be the government.

Government deficit occurs when expenditures of the government exceed its revenue. The budget deficit represents the difference between tax revenues and the expenditures of the government. To finance this deficit, the government usually borrows funds from other sources through the issue of bonds.

The accumulated issued bonds and their interest forms the national debt of a country, the accumulated debt. The expansion of fiscal policy increases the government deficit while the contraction of fiscal policy decreases the government deficit. Since the 2008 recession, the expenditures of the US government have been increasing creating more and more government deficits. Government borrowing, which has led to the accumulated debt over the years, has catered for this deficit.

According to the classical view, contraction and expansion of fiscal policies are not necessary for the economy since there are other market mechanisms that stimulate the economy. Market mechanisms such as adjustable wages and prices can freely balance the economy even without the intervention of the government. This school of thought claims that government should always operate with a balanced budget where its revenue and expenditures are equal. This will ensure that the government operates within its limit without borrowing funds to finance its activities. This automatically eliminates the problem of accumulated debt.

On the other hand, interventionists postulate that government intervention is inevitable due to the market challenges of a free market economy. The government uses contraction and expansionary fiscal and monetary policies to stimulate growth in the economy. The government should not wait for wages and prices to adjust automatically especially during the time of economic turndown but instead use fiscal and monetary policies to bring back stability in the economy. Compared to fiscal and monetary policies, interventionists argue that the market mechanisms take a longer time to restore the economic order of a country.

The two schools of thought completely disagree on the actions that the government should take to move out of recession and stabilize the economy. The classical view holds that the government should not concentrate on short-term policies to stabilize the economy but should let market mechanisms restore the economy on a long-term basis. On the other hand, interventionists believe that government has the long-term ability to stabilize the economy through fiscal and monetary policies. Nevertheless, the two schools of thought have failed to cushion America against recession and a better strategy is paramount to stabilize the economy even in the face of recession.


Bird, G., & Rowlands, D. (2010). The IMF and the Challenges it faces. World Economics journal, 11(4), 131-156.

Dreher, A. (2009). IMF conditionality: theory and evidence. Public Choice journal, 141(2), 233-267.

Hagemann, H. (2009). Solow’s 1956 Contribution in the Context of the HarrodDomar Model. History of Political Economy, 41, 67-87.

Hart, N. (2010). Macroeconomic theory and the global economic recession. International Journal of Business Research, 10(2), 205-214.

Shahbaz, M., Awan, R., & Ahmad, K. (2011). The exchange value of the Pakistan rupee & Pakistan trade balance: an Ardl bounds testing approach. Journal of Developing Areas, 44(2), 69-93.

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StudyCorgi. "Macroeconomics: Monetary and Fiscal Policies." January 26, 2021.


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