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Why is Control of Budget Deficits Argued to be Central to the Control of the Money Supply in LDC's? Is this a Strong Argument?

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Introduction

WHY IS CONTROL OF BUDGET DEFICITS ARGUED TO BE CENTRAL TO THE CONTROL OF THE MONEY SUPPLY IN LDC'S? IS THIS A STRONG ARGUMENT? A budget deficit is the excess of government expenditure over government taxation and any other receipts, in any one fiscal year. The operation of a budget deficit is a useful tool of fiscal policy to enable government to influence the level of aggregate demand and employment in the economy. J.M Keynes advocated this policy in the 1930's to offset the depression that occurred at the time. Prior to this, it was often thought that the government should operate a balanced budget policy, allowing the economy to respond in its own way without government intervention. Keynes argued that government should intervene by deliberately imbalancing its budget in order to inject additional aggregate demand into a depressed economy and vice versa. The money supply is the amount of money in circulation in an economy. Money supply can be specified in a variety of ways, and the total value of money in circulation depends on which definition of the money supply is adopted. 'Narrow' definitions of the money supply include only assets possessing ready liquidity, such as notes and coins. 'Broad' definitions include other assets, which are less liquid but still important in strengthening spending, for example, building society deposits must be withdrawn before they are converted into notes and coins. ...read more.

Middle

In the revenue tax collections the share of excise duty has come down from 43% in 1991 to 37% in 1996 and that of customs collections has come down from 36% to 32%, while the share of direct taxes has gone up from 18% in 1991 to 29% in 1996. The 'Broad' money supply has increased in first quarter of 1997 mainly due to 20% increase in RBI credit to the government to finance the budget deficits which in turn increases the money reserves. In the interim credit policy announced by RBI the cash reserve ratio was reduced by 1% to 12%. This along with easing of the tight liquidity situation, led to fall in money rates. As a result of this, RBI credit to the commercial sector fell by 24%. Though year on year 'Broad' money (M3) growth has been 16%, the growth since 31st March'96 has been only 3.5%. Where, reserve money has increased by 7.7%, since 31st March 1996. We expect the 'Broad' money to further rise and thus put a downward pressure on interest rates. 1) The budget has largely been anti-inflationary by reducing customs and excise duties across various raw materials and items of daily usage like detergent, toothpaste etc. 2) The budget recognised the need for infrastructure development to facilitate economic growth and have several provisions to encourage investment in infrastructure. ...read more.

Conclusion

The decrease in the money stock would offset the rise in velocity associated with deficit-induced increase in the interest rate. The deficit would then have no effect on nominal national income. Consequently, neither real output nor the price level would increase, even in the short-run. To maintain price stability in the long run, the rate of growth of the money stock and nominal income would have to be adjusted to allow for any slowdown in the growth of real output. Theoretically, the appropriate monetary policy could insulate the price level from the impact of the federal deficit. We see that the effects that the budget deficit has on the money supply are fairly vital and therefore may even be considered as 'central to the control of the money'. As for the strength of this argument, I believe that from the above examples, the importance of the budget deficit to the control of the money supply is fairly evident. APPENDIX 1 INITIALS DEFINITION Narrow' Money Money held predominantly for spending Bank notes and coins in circulation M0 Currency plus banks' till money & operational balances at Bank Of England M1 M0 plus UK private sector sight Bank deposits M2 M1 plus UK private sector Deposits in banks & building Societies 'Broad' Money Money held for spending &/or as a store of value M3 (formerly sterling M3) M1 plus UK private sector time Bank deposits & UK public sector sterling deposits M4 M3 plus net building society Deposits M5 (formerly private sector liquidity) M4 plus UK private sector Holdings of money market Instruments (e.g. ...read more.

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