Thursday, July 2, 2009

Pakistan Economy Performance-The daily times

WASHINGTON: In a meeting with Adviser on Finance Shaukat Tareen on Saturday, top International Monetary Fund (IMF) and European leaders commended Pakistan’s economic achievements made in a short span of time. Tareen, who is leading a high-level Pakistani delegation to the annual World Bank-IMF spring gathering, held productive meetings with IMF Managing Director Dominique Strauss Kahn, Deputy Managing Director Murilo Portugal and the ministers from Germany, Britain, France, Turkey, Sri Lanka and Afghanistan. Kahn, Portugal and UK’s Secretary of State for International Development Douglas Alexander commended Pakistan’s achievements made through its homegrown programme of economic reforms.German Minister for Economic Cooperation and Development Wieczorek-Zeul appreciated the courageous measures taken by Pakistan to correct the macroeconomic imbalances. She reaffirmed Germany’s commitment to support the country in overcoming its economic challenges and offered a debt swap for the HIV AIDS and Malaria Global Fund. In a meeting with Turkish Minister of Economy Mehmet Simsek, the two countries agreed to increase the mutual trade volume as well as investment in the business sector. He held constructive meetings with his counterparts from Afghanistan and Sri Lanka. Tareen reiterated that Pakistan would continue its support for the development and stability of Afghanistan. He proposed to set up groups to work on different areas for strengthening bilateral relations. Tareen also suggested availing international assistance for the regional integration projects. Pakistan and Afghanistan agreed to work closely on trade related issues including tariffs and unofficial trade.The financial adviser briefed his interlocutors about the current economic challenges and the blowback effect of the war on terrorism being faced by Pakistan. Islamabad, he said, was focusing on agriculture, manufacturing, infrastructure and poverty reduction for achieving a higher growth rate and a better standard of living for the people. Tareen highlighted that mobilising domestic resources was the key challenge and efforts had to be made to increase revenues to bridge the savings-investment gap and reduce Pakistan’s reliance on external borrowing. app

Pakistan-Economic Sustainability Part-4


Industrial and export growth and diversification. Manufacturing sector has been growing
at 8.4% and its share rose from 14.7% in FY00 to 19.1% by FY07. To realize its growth targets,
industrial sector’s share in GDP has to rise to 30% and must be export led. The corner stone of
industrial growth and diversification strategy is to set in place programs to:
• Move up the value added chain in all key industries by developing capacities, skills and attracting
strategic partnerships and technology;
• Exploitation of mineral and other strategic resources of the economy;
• Modernization, enhancement and design innovation in the textile industry. Scale enhancement
could be achieved through foreign investment and joint venture/merger and acquisition. This would
enable the textile industry, currently accounting for one-fourth of Pakistan’s output and 69% of
exports, to withstand aggressive regional competition; and
• Developing backward and forward linkages of large scale industry with small and medium industry
that will help in improving productivity and competitiveness.
20. Export growth has been quite impressive, more than doubling to $18 billion over FY01-07.
Export Plan for 2006-20131 envisages a rise in export/GDP ratio from around 13% to 15% to generate
almost $40-45 billion of export revenues. The principal thrust of this strategy will be to promote export
diversification to reduce industry and exports vulnerability to textile sector. Substantial exploration is
underway to exploit Pakistan’s potential to promote:
• Agriculture exports efforts are underway to promote growth of minor crops and noncrop sector
particularly dairy sector where Pakistan is now the world’s fifth largest producer. Aside from
developing innovative guidelines for credit flows to the sector, efforts are underway to improve
agriculture marketing, grading and quality; establishment of agriculture export processing
zones with public-private partnership; encouragement of livestock development through cross
breeding, artificial insemination and embryo transfer technology. Also, there is scope for
expanding inland fish farms and developing in public: private partnership fish harbors etc.
• Pakistan, being the fourth largest cotton producer in the world after China, India and US, has
strong raw material and experience-edge in textiles. To augment capacities, industry invested
$5.5 billion over the FY99-FY05. There is further scope for a three to fourfold increase in
spindle and looms capacity and to diversify product (knitwear, bed ware and ready-made
garments) and market base and improve quality and design.
• In view of the relocation of industry and changing production and subcontracting
networks/hubs and alliances as newly industrialized economies move out of labor intensive
industries, Pakistan has an opportunity to serve as an alternate production center for
electronic, electrical, and engineering industry.
• Pakistan has made some inroads into the medium and high-end technology products such as
electronic goods and this area could be explored further.
1 Government of Pakistan, Planning Commission: Export Plan –Pakistan Inc. 2007.
6
• Mineral is another sector where Pakistan has large potential given its copper, high quality
granite and marble and gem reserves.
• Finally, information technology (IT) and other services sectors which constitute 55% of GDP
have a role to play in enhancing exports and can be nurtured by promoting venture capital
and private equity funds and enhancing the skill base of population in this area.
21. Infrastructure. To enhance the competitiveness of Pakistan’s industry and exports, it is
however critical to bridge infrastructure gaps. The Government has developed a broad based strategy
and short, medium and long term plan for energy sector. Pakistan has good domestic reserves of oil,
gas and other fuels and hydro potential. The investment requirements and opportunities arising from
a well designed and integrated energy security plan that offers an Asian Energy Corridor are
enormous. Potential within this corridor exists for mega projects that involve development, sharing
and trading of energy resources between the largest producers of oil and gas in the Central Asian
Republic and Middle East to the deficit countries including China, India and Pakistan.
22. To ensure energy security and sustainability, Pakistan’s energy plan recognizes the growth in
domestic demand for energy that has to be catered by exploitation and development of balanced
energy mix with maximum reliance on indigenous and environment-friendly resources, besides
tapping the regional resources. Recognizing this, Pakistan plans to
(i) Optimize energy mix between hydel: thermal from existing levels of 28:72 to 39:61 in the years
ahead by exploiting all key sites with substantial hydel generation potential – this program will
help in fuel substitution and energy efficiency resulting in savings of oil imports;
(ii) Enhance exploration and development of gas reserves. Gas supplies are to be supplemented
by exploiting cross border energy transaction through Iran-Pakistan-India pipeline,
Turkmenistan and Qatar-Pakistan pipelines and import possibility of LNG;
(iii) Unleash coal potential given the large measured reserves estimated to 3,300 million tons with
substantially large inferred reserves. Major deposits are in Sindh province in Thar though
other pockets also are showing promising signs; and
(iv) Exploit renewable energy resources.
23. Investment requirements for key infrastructure programs were estimated to be in the range of
$39 billion for 2005-2010. Over the long term, investment requirements will be staggering as, by some
estimates, the aggregate power generation requirements alone will be around 143,310 MW during
2005-2030. Since 1994, generation has been largely in private sector and WAPDA – the largest utility
company of Pakistan – has been unbundled by spinning off the regional distribution companies which
are to be privatized. Given fiscal constraints, Pakistan has scope for limited public investments so
bulk of the new development projects is to be available for private investment. The Private Power
Infrastructure Board has floated 45 projects of 12 GW in pipeline, involving cost of close to $11 billion.
24. Independent Power Producers (IPP) are generating 6005 MW, with remaining 13,083 MW MW
generated by WAPDA and KESC. IPP have made significant progress (excluding Hubco outside
Power Sector Policy framework) though 66% of the total capital requirements were met from official
debt sources. Drawing from the lesson learnt of past power sector policy, the 2002 Power Sector
Policy set prices based on cost structure of the project as determined by the regulator. Pricing policy
allow pass through of items such as the fuel price, interest rate and exchange rate.
7
25. Pakistan needs $1 billion per year for new dams and related infrastructure, and $5 billion per
year for transport infrastructure etc. In road sector, the Medium Term Development Program includes
plans to improve 14000 km of existing road and construct 7000 km of new road. Pakistan has
managed to promote public-private partnership for a highway project on BOT basis for Lahore-
Faisalabad 4 lane divided express way on 25 year concession agreement. The National Trade
Corridor is one of the strategic integrated projects that aims to develop trade route from ports in south
of Pakistan to northwest towards Afghanistan and Central Asian Republics and will carry 500 million
tons of freight up the north-south route and another 50 million tons of international freight. Aside from
expansion of two ports in Karachi city, commissioning of Gawadar port, awarded to Port of Singapore
for management and operation. Located at the mouth of the Persian Gulf and outside the Straits of
Hormuz, this port will serve as a regional hub for energy transportation.
26. The Government has now developed a policy and legal framework for the Public Private
Partnership (PPP) which will be supported by the Infrastructure Project Financing Facility (financed by
the Government and Multilateral Development Banks). A Project Development Fund will help identify,
prepare and procure PPP projects to support economically viable projects, mobilize private capital
resources and float the corporate and infrastructure bonds. To support delivery of basic services,
public funding will complement and replace user fee to the extent feasible to facilitate viability gap
funding along with a supportive risk management framework.
27. Improving Productivity. Pakistan is structuring a number of initiatives to allow for
enhancement in total factor productivity growth which has been key driver of East Asian economic
growth. Besides encouraging higher enrollment accompanied by improvement in standards in each
of the education tier, investments are being made to (i) enhance vocational and technical education
which thus far only caters for requirements of one percent of 15-23 years age cohort; (ii) open six
foreign sponsored Universities to augment supply and quality of higher education in the country; and
(iii) enhance SME and industry entrepreneurial skills. Supplementary efforts are underway to
develop strong integrated linkages between technology and R&D needs of industrial sector and
science and technical education.
28. Conclusion. Pakistan has great potential, both in terms of its natural and human resource,
and has developed fairly good forward looking development agenda and plans. A major
breakthrough in industrial and export diversification depends, among others, critically on
reinvigorating agriculture sector and ensuring adequate availability of infrastructure to meet the
growing economic requirements. Given huge domestic demand and high returns in virtually every
sector, there has been a strong interest in Pakistan’s economy as illustrated by the strong foreign
investment that has come from both GCC and West. The region given its diversity and richness of
resources – with Gulf countries accounting for large proportion of world’s oil and gas proven reserves
and now holding sizeable world foreign exchange reserves – along with Pakistan’s large agriculture
and growing industrial base, domestic market, skilled labor force which, if effectively, exploited offers
opportunities for deepening collaboration and cooperation for mutual advantage. The new
Government given its strong political backing has the opportunity to restore macroeconomic stability
disrupted in last couple of years which should help restore investor confidence and allow country to
attract non-debt creating flows critical for development of industry and infrastructure sectors and to

Pakistan-Economic Sustainability Part-3


Recapitalization and restructuring/privatization and induction of professional management,
banking sector has been the most dynamic sector. Liberal entry requirements and huge market
potential given the current low financial penetration ratio have encouraged entry of global players.
Foreign investors are allowed to hold up to 49% of the foreign equity in the banking sector, while
banks with global Tier-1 capital is US$ 5 billion or more or institutions from the regional cooperation
organizations (ECO) can hold up to 100% foreign equity in a banking institution in Pakistan.
Companies acquired have to over the years be incorporated as wholly owned subsidiary or opening a
branch in Pakistan. Even in those cases where foreign equity up to 49% is permissible, a higher
percentage of foreign equity ownership is allowed by SBP on a case-to-case basis depending on the
strength of the incoming institution.
14. Companies have further benefited from access to private credit which grew at an average rate
of 25.5% for FY03-07. This growth has been supported by structural changes in banking sector which
is largely private sector run. Over the last five years, profitability of banking sector has surged
reaching $1.70 billion in 2007, return on equity growing to 20.0% by Sept 07 and net NPLs ratio
reducing to 2.3%. Capital market has benefited from the growth in stock market capitalization from
$7.51 billion to $65.9 billion by the end-2007 and rise in P/E ratios have attracted foreign portfolio
investment.
15. To promote competition and efficiency corporate tax rate has been lowered and trade has
been liberalized. Average tariffs are 7.6% and tariffs on import of plant, machinery & equipment for
industrial sector has been reduced to 5% and for agriculture sector to zero percent while 50% Initial
Depreciation Allowance is allowed. Nontariff barriers have been removed. Pakistan has Free Trade
Agreements with the People’s Republic of China, Sri Lanka, Malaysia, Iran and Mauritius; negotiations
are underway with Singapore and the Gulf Cooperation Council to be concluded in 2008, and
preferential trade arrangements are also underway with Afghanistan, Bosnia, Bangladesh, Canada,
Russian Federation, Serbia, Syria, Switzerland, Laos, Thailand, Indonesia etc.
16. Future prospects for economic sustainability depends on building momentum of
structural reforms – I will however dwell on the most strategic elements here.
17. Agriculture and food self sufficiency. With global commodity prices on the rise and
alternate uses of corn and other products as bio-fuels in vogue, enhancement of crop productivity and
area under cultivation will be critical for stabilizing food prices and curbing recourse to imports that
have induced fresh external vulnerabilities. Given also the country’s rich and diverse landscape,
Pakistan has good potential to serve the GCC and Middle East at large and exploit export potential of
its agro-based sector. Renewed efforts will need to be launched by the Government to improve yields
of major crops by intensifying research and extension, application of right type of seed and other
inputs and mechanization.
18. Comparative advantage in agriculture gives an edge in the development of agro-based
industry, value-addition chains and processing and packaging of products and offer huge potential for
growth and investment. Besides increasing value-addition, the Government has promoted private
sector involvement; except for setting procurement price for wheat – to maintain strategic reserves –
market-based pricing mechanism prevails for all agriculture produce. Efforts are underway for
transmission of pricing signals to farmers (e.g. through introduction of a commodity futures
market), development of crop insurance (particularly to encourage the raising of new cash crops
such as oilseeds) and improvement in transportation and storage infrastructure. The proximity
to the rich Middle East states, which are widely dependent on import of vegetable products, provides
a strong market for agriculture-based products. The ancillary requirements to boost agricultural
products exports also require massive investment in mass storage and transportation activities.

Pakistan-Economic Sustainability Part-2


Restore macroeconomic stability; despite the disruption caused by 2007 events.
Economic growth of Pakistan has benefited from macroeconomic stability. Containing macroeconomic
imbalances helped generate (i) external current account surpluses in two of the preceding five fiscal
years while (ii) fiscal deficit was below 4% in three of the five preceding fiscal years supported by
surplus or zero primary balances (reflecting an effort to balance current revenues with current
expenditures).
10. Pakistan however now faces renewed economic vulnerabilities. Among others, compulsion to
subsidize food, oil products and power & gas tariffs by preventing full pass through of international
price hikes and to raise public investment to address infrastructural and skills gaps, essential to
maintain growth path, have together disrupted progress in fiscal containment. Corrective policy
actions, taken in the last few weeks, including rise in petroleum products, electricity and gas prices
and cuts in development expenditures will at best ease marginally fiscal strains.
11. Notwithstanding, the growing aggregate demand pressures in face of rising per capita income,
six-fold increase in remittance, set to reach $6.5 billion for FY08, and exceptional rise in private credit,
high import growth of petroleum products and capital, intermediate and raw material goods have
compounded these vulnerabilities. Underlying demand pressure and threefold increase in import oil bill
coupled with slow down in export growth has also widened external current account deficit.
12. Keeping strong vigilance on the economy, the central bank took a lead in containing the
aggregate demand pressures. Incrementally, monetary policy was tightened through three rounds of
raising the SBP policy rate (by 300bp) since April 2005 to 10.5%, raising the reserve ratio, and
improving liquidity management through open market operations. Monetary policy in Pakistan has
3
benefited from the independence and strong accountability of the central bank as well as from the
central bank’s conscious efforts to ensure transparency in public communications of monetary policy
stance and perspective on the economy. Monetary policy has managed to keep inflationary pressures
in check by managing to lower core inflation; slippages in inflation target were inevitable given the
uptrend in the global commodity prices as well as structural complexities and inefficiencies of
wholesale and retail markets.
13. Global and domestic cyclical events will undoubtedly pose frequent challenges for small and
open economies, like Pakistan. Recognizing this, the new Government will need to strengthen the
Medium-Term Macroeconomic Stabilization Program and front load it, while accelerating the
implementation of structural reforms to realign deficits to sustainable levels. Keeping this in
perspective, the Government’s broader economy strategy for the next few years will need to include:
i. Increasing domestic resource mobilization to raise revenue/GDP ratio by at least 5 percentage
points of GDP. This is possible given the scope for enlargement of tax base: the existing tax
regime collects almost 68% of taxes from manufacturing and corporate sector, while agriculture
and services sectors (aside from banks) are exempt and segments of economy are outside tax
net;
ii. Nation-wide campaign to raise saving levels through continued efforts to raising awareness and
deepening financial markets;
iii. Restricting large proportion of new resource mobilization for public investment, while prioritizing
the recurrent expenditures through a major overhauling of the Government machinery;
iv. Restoring the momentum of privatization of state-owned enterprises, which has been one of the
most successful in Asia. The Government has sold off cumulatively almost $7 billion of assets
over FY00-FY08 and there are around 61 state entities in the pipeline;
v. Providing more autonomy to public sector organizations, with effective leadership and
management, to improve their operational and financial efficiencies accompanied by a program
to strengthen their balance sheets which should allow them to graduate from budgetary
allocations to seeking funding from the market; and
vi. Raising private investment/GDP from 23% to at least 28% which involves significant tapping
additional resources both from domestic and international financial markets.
12. Although this is an ambitious macroeconomic framework, but launching and adhering to it is
attainable and critical. To position itself, Pakistan plans to further enhance its policy framework and
tap its economic potential by mobilizing additional foreign capital that is likely to be attracted as the
country offers lucrative investment opportunities across all sectors.
13. Deepening of liberal incentive and investment regime will help economic sustainability.
Broad based deregulation and liberalization of investment and pricing regime, Pakistan attracted
cumulatively $13.5 billion investment across all strategic sectors. This has been facilitated by easing
entry of domestic private sector and foreign equity with flexibility to fully own businesses. Long
standing liberal and partial capital account convertibility allows individuals, firms or companies to freely
undertake all international transactions through the interbank market. Aside from allowing 100%
foreign equity, there are no bars on repatriation of capital, profits, royalty etc. Exchange rate stability
has been supported by prudent exchange rate management.

Pakistan—Economic Sustainability

Pakistan has withstood series of endogenous events, including political uncertainty as a lead
up to election, and the unprecedented exogenous shocks that have ranged from financial markets
turmoil to climbing global commodity prices. On domestic political front, with elections now over the
country is well on its way to a smooth transition gearing for a fully democratic system. Leading parties’
efforts to cement a coalition augurs well for confidence building; smooth functioning of legislature and
their inbuilt accountability, while ensuring representation of public voice in steering the formulation and
implementation of the future economic agenda. Ruling and opposition parties will need to rise above
personal agenda to ensure sustainability of democracy.
2. After a period of benign global economic environment, world economic outlook since August
2007 has been adversely impacted by subprime mortgage meltdown and its ripple effects on financial
markets. Advanced countries are facing slowdown in economic activity. To mitigate the ensuing
recessionary pressures, easing of monetary policy by the United States are to compound the already
high inflationary pressures emerging from the exceptional rise in the global commodity prices, in
particular of products such as oil, gold and wheat.
3. Thus far Pakistan, like other Asian economies, remained immune to these shocks. Economic
and financial markets remained calm in Pakistan as they had limited exposure to the US subprime
market and other related products. With financial market turmoil deepening, the slowdown in
economic growth and consequent reduced demand of advanced countries triggered greater
uncertainty and induced vulnerabilities in international equity markets. These developments have
begun to cast shadow, impacting emerging economies equity markets softening their growth
prospects, albeit they remain set to grow strongly and .
4. Pakistan, like other emerging markets, faces a key question regarding sustainability of its
economic achievements. Abstracting from political debates, there is widespread confidence that
Pakistan has achieved a significant economic turnaround. While short terms challenges and stresses
have magnified, I propose to provide perspectives that the turnaround achieved is sustainable
provided it is urgently backed by a well designed macroeconomic stabilization package and deeper
structural reforms. In my presentation I make the case that Pakistan has strong economic growth
potential given the country’s inherent dynamics. Second, restoring macroeconomic sustainability,
despite disruption in FY08 trends, has to be on top of economic agenda and is feasible given scope
for domestic resource mobilization and improved debt management. Third, there is need to deepen
investment incentives and climate have to improve
5. Finally, Pakistan has to build momentum to diversify agriculture, industry as well as export
base, and develop infrastructure. Implementation of this agenda will augur well for country’s long term
economic growth prospects while offering wide range of investment opportunities that make Pakistan
an attractive destination.
6. Economic performance and potential: Pakistan’s’ average economic growth rate was 6.3%
for fiscal years (FY) FY03-07: during these 5 years economic growth was above 7% in two years and
2
9% in FY04-05 confirming rise in trend growth rate and capturing well the real economic potential. In
productive sectors growth has been broad-based but accompanied by underlying structural shifts.
Services sector has been the most buoyant and constitute over 53% of the overall GDP, with
agricultural sector’s share declining from 25.9% in FY00 to 20.9% in FY07 and industrial sector’s
contribution rising from 23% to 27% over this period.
7. Rising domestic consumption demand has been the main driver of growth; accompanying rise,
albeit somewhat slow, in investment rate. After averaging around 18.6% over the FY03-06, investment
rate grew to 23% in FY07 -- reflecting a 4.4% percentage point growth in investment/GDP ratio in one
year. This was expected to be boosted further by significant growth in public investment in FY08,
though given fiscal exigencies a part of this may not be realized.
8. Pakistan’s rich and large landscape offers a sizeable domestic market that is likely to double,
reaching a population base of 230 million by 2030. Being at the crossroads of South Asia, Central
Asia and West Asia with close proximity, both by air and sea, to the Gulf region makes Pakistan a
promising regional hub and market for nurturing intra and inter-regional trade and investment.
Recognizing these considerations, Multinational Corporations several years back set up businesses
here. As confidence in Pakistan’s economy grew, there has been a significant growth in foreign
capital inflows, cumulatively estimated to be around $13.5 billion (including global deposit receipts
flows) over the last five years. The telecom sector, the major recipient of foreign investment close to
$4.6 billion, is under private ownership and management; among other achievement the number of
mobile subscribers is now over 80 million. Similarly, close to half of banking assets are now under
foreign ownership as close to $2.7 billion foreign equity was injected in the sector and oil and gas
sector has attracted $1.4 billion. Pakistan is now a well tested destination for foreigners. Corporate
and banking companies’ returns have been high and investors, be domestic or foreign, are being well
compensated for whatever risk premium they attach to Pakistan.
9. Restore macroeconomic stability; despite the disruption caused by 2007 events.

Economic and Social Problems Created by Unemployment

Summary:
Unemployment, using Australia as an example, causes social and economic problems, such as lost productivity, lost output and income opportunity, loss of human capital, and lost self-esteem and dignity of workers.
Unemployment is the percentage of people in the labour force without work but actively seeking employment. Australia's rate of unemployment is around 23 year lows measuring at 5.7% in April, 2004 but structural, long-term and underemployment have risen.
Unemployment's fundamental economic cost is the opportunity cost of lost output and income. Real GDP will be lower (as it's below full employment) reducing national income, productivity along with living standards. High unemployment means there is an excess supply of jobs so employers find labour more easily and are less likely to increase wages to attract workers.
Unemployment causes a loss of human capital as the unemployed don't contribute skills and experience to the workforce. The depreciation in unemployed human capital and increased duration of unemployment escalates this rate of unemployment. Securing a job is more difficult the

Limitations of the unemployment definition

The unemployment rate may be different from the impact of the economy on people. The unemployment figures indicate how many are not working for pay but seeking employment for pay. It is only indirectly connected with the number of people who are actually not working at all or working without pay. Therefore, critics believe that current methods of measuring unemployment are inaccurate in terms of the impact of unemployment on people as these methods do not take into account the 1.5% of the available working population incarcerated in U.S. prisons (who may or may not be working while incarcerated), those who have lost their jobs and have become discouraged over time from actively looking for work, those who are self-employed or wish to become self-employed, such as tradesmen or building contractors or IT consultants, those who have retired before the official retirement age but would still like to work (involuntary early retirees), those on disability pensions who, while not possessing full health, still wish to work in occupations suitable for their medical conditions, those who work for payment for as little as one hour per week but would like to work full-time. These people are "involuntary part-time" workers, those who are underemployed, e.g., a computer programmer who is working in a retail store until he can find a permanent job, involuntary stay-at-home mothers who would prefer to work, and graduate and Professional school students who were unable to find worthwhile jobs after they graduated with their Bachelor's degrees.
On the other hand, the measures of employment and unemployment may be "too high". In some countries, the availability of unemployment benefits can inflate statistics since they give an incentive to register as unemployed. People who do not really seek work may choose to declare themselves unemployed so as to get benefits; people with undeclared paid occupations may try to get unemployment benefits in addition to the money they earn from their work. Conversely, the absence of any tangible benefit for registering as unemployed discourages people from registering.
However, in countries such as the United States, Canada, Mexico, Australia, Japan and the European Union, unemployment is measured using a sample survey (akin to a Gallup poll). According to the BLS, a number of Eastern European nations have instituted labor force surveys as well. The sample survey has its own problems because the total number of workers in the economy is calculated based on a sample rather than a census.
It is possible to be neither employed nor unemployed by ILO definitions, i.e., to be outside of the "labor force." These are people who have no job and are not looking for one. Many of these are going to school or are retired. Family responsibilities keep others out of the labor force. Still others have a physical or mental disability which prevents them from participating in labor force activities.
Typically, employment and the labor force include only work done for monetary gain. Hence, a homemaker is neither part of the labor force nor unemployed. Nor are full-time students nor prisoners considered to be part of the labor force or unemployment. The latter can be important. In 1999, economists Lawrence F. Katz and Alan B. Krueger estimated that increased incarceration lowered measured unemployment in the United States by 0.17% between 1985 and the late 1990s. In particular, as of 2005, roughly 0.7% of the US population is incarcerated (1.5% of the available working population).
Children, the elderly, and some individuals with disabilities are typically not counted as part of the labor force in and are correspondingly not included in the unemployment statistics. However, some elderly and many disabled individuals are active in the labor market.
In the early stages of an economic boom, unemployment often rises. This is because people join the labor market (give up studying, start a job hunt, etc.) because of the improving job market, but until they have actually found a position they are counted as unemployed. Similarly, during a recession, the increase in the unemployment rate is moderated by people leaving the labor force or being otherwise discounted from the labor force, such as with the self-employed.
For the fourth quarter of 2004, according to OECD, (source Employment Outlook 2005 ISBN 92-64-01045-9), normalized unemployment for men aged 25 to 54 was 4.6% in the USA and 7.4% in France. At the same time and for the same population the employment rate (number of workers divided by population) was 86.3% in the U.S. and 86.7% in France.
This example shows that the unemployment rate is 60% higher in France than in the USA, yet more people in this demographic are working in France than in the USA, which is counterintuitive if it is expected that the unemployment rate reflects the health of the labor market.
Due to these deficiencies, many labor market economists prefer to look at a range of economic statistics such as labor market participation rate, the percentage of people aged between 15 and 64 who are currently employed or searching for employment, the total number of full-time jobs in an economy, the number of people seeking work as a raw number and not a percentage, and the total number of person-hours worked in a month compared to the total number of person-hours people would like to work. In particular the NBER does not use the unemployment rate but prefer various employment rates to date recessions.

Solutions of unemployment

Societies try a number of different measures to get as many people as possible into work. However, attempts to reduce the level of unemployment beyond the Natural rate of unemployment generally fail, resulting only in less output and more inflation[citation needed].

[edit] Demand side
According to classical economic theory, markets reach equilibrium where supply equals demand; everyone who wants to sell at the market price can. Those who do not want to sell at this price do not; in the labour market this is classical unemployment. Increases in the demand for labour will move the economy along the demand curve, increasing wages and employment. The demand for labour in an economy is derived from the demand for goods and services. As such, if the demand for goods and services in the economy increases, the demand for labour will increase, increasing employment and wages. Monetary policy and fiscal policy can both be used to increase short-term growth in the economy, increasing the demand for labour and decreasing unemployment.

[edit] Supply side
However, the labour market is not efficient: it doesn't clear. Minimum wages and union activity keep wages from falling, which means too many people want to sell their labour at the going price but cannot. Supply-side policies can solve this by making the labour market more flexible. These include removing the minimum wage and reducing the power of unions. Other supply side policies include education to make workers more attractive to employers.
Supply side reforms also increase long-term growth. This increased supply of goods and services requires more workers, increasing employment. It is argued that supply side policies, which include cutting taxes on businesses and reducing regulation, create jobs and reduce unemployment.

[edit] Tax-related
One structural solution to unemployment proposed was a graduated retail tax, or "jobs levy", to firms where labor is more expensive than capital. This method will shift tax burden to capital intensive firms and away from labor intensive firms. In theory this will make firms shift operations to a more politically desired balance between labor intensive and capital intensive production. The excess tax revenue from the jobs levy would finance labor intensive public projects.[11] However, by raising the value of labour artificially above capital, this would discourage capital investment, the source of economic growth. With less growth, long-run employment would fall.

Types of unemployment

Though there have been several definitions of voluntary and involuntary unemployment in the economics literature, a simple distinction is often applied. Voluntary unemployment is attributed to the individual's decisions, whereas involuntary unemployment exists because of the socio-economic environment (including the market structure, government intervention, and the level of aggregate demand) in which individuals operate. In these terms, much or most of frictional unemployment is voluntary, since it reflects individual search behavior. On the other hand, cyclical unemployment, structural unemployment, and classical unemployment, are largely involuntary in nature. However, the existence of structural unemployment may reflect choices made by the unemployed in the past, while classical unemployment may result from the legislative and economic choices made by labor unions and/or political parties. So in practice, the distinction between voluntary and involuntary unemployment is hard to draw. The clearest cases of involuntary unemployment are those where there are fewer job vacancies than unemployed workers even when wages are allowed to adjust, so that even if all vacancies were to be filled, there would be unemployed workers. This is the case of cyclical unemployment, for which macroeconomic forces lead to microeconomic unemployment. See also: unemployment types

[edit] Frictional unemployment
Frictional unemployment occurs when a worker moves from one job to another. While he searches for a job he is experiencing frictional unemployment. This applies for fresh graduates looking for employment as well. This is a productive part of the economy, increasing both the worker's long term welfare and economic efficiency, and is also a type of voluntary unemployment. It is a result of imperfect information in the labor market, because if job seekers knew that they would be employed for a particular job vacancy, almost no time would be lost in getting a new job, eliminating this form of unemployment.
Frictional unemployment is always present in an economy, so the level of involuntary unemployment is properly the unemployment rate minus the rate of frictional unemployment, which means that increases or deceases in unemployment are normally under-represented in the simple statistics.[3]

[edit] Classical unemployment
Classical or real-wage unemployment occurs when real wages for a job are set above the market-clearing level. Libertarian economists like F.A. Hayek argued that unemployment increases the more the government intervenes into the economy to try to improve the conditions of those with jobs. For example, minimum wages raise the cost of labourers with few skills to above the market equilibrium, resulting in people who wish to work at the going rate but cannot as wage enforced is greater than their value as workers becoming unemployed.[4][5] They believed that laws restricting layoffs made businesses less likely to hire in the first place, as hiring becomes more risky, leaving many young people unemployed and unable to find work.[5] Some, such as Murray Rothbard,[6] suggest that even social taboos can prevent wages from falling to the market clearing level.

[edit] Cyclical or Keynesian unemployment
Cyclical or Keynesian unemployment, also known as demand deficient unemployment, occurs when there is not enough aggregate demand in the economy. This is caused by a business cycle recession, and wages not falling to meet the equilibrium level.

[edit] Structural unemployment
Structural unemployment is caused by a mismatch between jobs offered by employers and potential workers. This may pertain to geographical location, skills, and many other factors. If such a mismatch exists, frictional unemployment is likely to be more significant as well. For example, in the late 1990s there was a tech bubble, creating demand for computer specialists. In 2000-2001 this bubble collapsed. A housing bubble soon formed, creating demand for real estate workers, and many computer workers had to retrain to find employment.
André Gorz believes that structural unemployment could be permanent in modern society, as the microchip revolution and the explosion in computer science and robotising of work even in less developed industrialized countries increase productivity.
Nobel Prize winning economist, Paul Krugman has attacked this view, arguing that "One problem capitalism does not suffer from ... is being too productive for its own good."[7].

Productivity gains in steel may reduce the number of jobs in steel, but they create jobs elsewhere (if only by lowering the price of steel, and therefore releasing money to be spent on other things); advanced countries may lose garment industry jobs to developing-country exports, but they gain other jobs producing the goods that those countries buy with their new export income. To observe that productivity growth in a particular industry reduces employment in that same industry tells us nothing about whether productivity growth in the economy as a whole reduces employment in the economy as a whole.[8]


[edit] Seasonal unemployment
Seasonal unemployment results from the fluctuations in demands for labour in certain industries because of the seasonal nature of production.In such industries there is a seasonal pattern in the demand for labor. During the period when the industry is at its peak there is a high degree of seasonal employment, but during the off-peak period there is a high seasonal unemployment.
Seasonal unemployment occurs when an occupation is not in demand at certain seasons.

[edit] Okun's Law
Okun's law states that for every 3% GDP falls relative to potential GDP, unemployment rises 1% (of the total workforce). When the economy operates at productive capacity, it will experience the natural rate of unemployment. [9]
U= ^u-h[100(y/yn)-100]

[edit] Involuntary unemployment
Say's law declares that, in time, "markets clear" in an unfettered, unregulated laissez-faire economy: every seller will find a buyer at some strike price, and every buyer will find a seller at some strike price. Sellers and buyers may refuse the strike price but this personal decision is voluntary, which causes the selling or buying to leave the economic model. This theory relies heavily on the absence of government regulation and assumes a developed economy without sabotage where labor strikes, as opposed to strike (mutually agreed upon) prices, are illegal.[citation needed]
Keynes tried to demonstrate in The General Theory of Employment, Interest and Money that Say's law did not work in the real world of the 1930s Depression because of oversaving and private investor timidity, and that in consequence people could be thrown out of work involuntarily without being able to find acceptable new jobs.
This conflict of the neoclassical and Keynesian theories has had strong influence on government policy. The tendency for government is to curtail and eliminate unemployment through increases in benefits and government jobs, and to encourage the job-seeker to both consider new careers and relocation to another city.
Involuntary unemployment does not exist in agrarian societies nor is it formally recognized to exist in underdeveloped but urban societies such as the mega-cities of Africa and of India/Pakistan, given that, in such societies, the suddenly unemployed person must meet his survival needs, by getting a new job quickly at any strike price, entrepreneurship, or joining the invisible economy of the hustler.[10]
From the narrative standpoint, involuntary unemployment is discussed in the stories by Ehrenreich, the narrative sociology of Bourdieu, and novels of social suffering such as John Steinbeck's Of Mice and Men.

Unemployment an Economic Problem

Unemployment occurs when a person is available to work and seeking work but currently without work.[1] The prevalence of unemployment is usually measured using the unemployment rate, which is defined as the percentage of those in the labor force who are unemployed. The unemployment rate is also used in economic studies and economic indices such as the United States' Conference Board's Index of Leading Indicators as a measure of the state of the macroeconomics.
Most economic schools of thought agree that the cause of involuntary unemployment is that wages are above the market clearing rate. However, there are disagreements as to why this would be the case: the economists argue that in a downturn, wages stay high because they are naturally 'sticky', whilst others argue that minimum wages and union activity keep them high. Keynesian economics emphasizes unemployment resulting from insufficient effective demand for goods and services in the economy (cyclical unemployment). Others point to structural problems, inefficiencies, inherent in labour markets (structural unemployment). Classical or neoclassical economics tends to reject these explanations, and focuses more on rigidities imposed on the labor market from the outside, such as minimum wage laws, taxes, and other regulations that may discourage the hiring of workers (classical unemployment). Yet others see unemployment as largely due to voluntary choices by the unemployed (frictional unemployment). Alternatively, some blame unemployment on Globalisation. There is also disagreement on how exactly to measure unemployment. Different countries experience different levels of unemployment; traditionally, the USA experiences lower unemployment levels than countries in the European Union,[2] although there is variant there, with countries like the UK and Denmark outperforming Italy and France and it also changes over time (e.g. the Great depression) throughout economic cycles.

Fiscal policy imperatives

Tuesday, June 09, 2009Dr Ashfaque H KhanAfter successfully reducing macroeconomic imbalances in the current fiscal year, the government appears to have lost patience and decided to pursue an aggressive expansionary fiscal policy in the 2009-10 fiscal year. The National Economic Council (NEC) has already approved the highest-ever Public Sector Development Programme (PSDP) amounting to Rs621 billion for the next fiscal year – up from the revised estimates of Rs363 billion for 2008-09, thus representing a hefty increase of over 71 percent. With massive increase in the PSDP, the budget deficit is likely to be in the range of 5.0 to 5.3 percent of the GDP in the next fiscal year. In rupee term, the budget deficit is expected to be in the range of Rs740-780 billion. It is important to point out that in the current fiscal year the government pursued tight fiscal and monetary policies with a view to reducing macroeconomic imbalances. Such a policy stance was necessary to address the challenges of high budget and current- account deficits. These policies have paid handsome dividend as the fiscal deficit is likely to decline to 4.3 percent of the GDP from 7.4 percent last year and account deficit to around 5.0 percent of the GDP from as high as 8.4 percent. Inflationary pressure has also eased somewhat. These have been the major achievements of the current fiscal year for which the government must be commended. As we move towards the new fiscal year, the government appears to have lost patience and decided to undertake an expansionary fiscal policy. This is not the right time to pursue an expansionary policy because the underlying weaknesses in some key macro aggregates such as fiscal and current-account deficits and inflation still persist. The government should not be complacent about the successes and must avoid taking the expansionary route. This is the message of the SBP's third quarterly report as well.It is well-known that high budget deficit is the "mother of economic problems" as it gives birth to a variety of economic issues. A budget deficit in the range of Rs740 to 780 billion will be construed in the market as the government's becoming a desperate borrower, and as such the market will exploit it. If the bulk of this deficit is financed from external sources it will lead to the accumulation of the external debt and when multiplied by the exchange rate it will add to the public debt which is already growing at a rapid pace. It appears that the government is banking on the pledged sources of external financing to bridge revenue –expenditure gap. Banking on uncertain external inflows to undertake expansionary fiscal policy is a highly risky job. Any shortfall in external financing will have to be met through domestic borrowing. Borrowing from domestic sources (banking and non-banking) to such a large extent will put tremendous pressures on the interest rate, which will prevent the State Bank from even thinking of easing the monetary policy. As such, the high interest rate environment will continue to persist with investment and growth stagnating. If we assume that external sources of financing are fairly certain (on the basis of which the government is increasing expenditure in 2009-10), it will give rise to another type of risk. What will happen if these magnitudes of external resources are not available in the future? Can any government cut down development or other components of spending if external resources are not available in this magnitude going forward? These are valid questions and must be taken into account before enlargement of the base of each component of expenditure. It is presumed that the government has decided to pursue an expansionary fiscal policy to revive economic growth, create employment opportunities and reduce poverty. Is this a viable policy in the face of a current-account deficit of over five percent of GDP? Should we pursue an expansionary fiscal policy in the midst of rising oil prices? Crude prices have already reached a seven-month high at $68 a barrel and the Goldman Sachs has recently predicted the price to touch $85 per barrel by the end of December. An expansionary fiscal policy will increase aggregate demand, which will translate into higher imports, including higher imports of oil. With rising oil prices it will further widen the current-account deficit and will surely enhance macroeconomic imbalances. The purpose of reviving economic activity, creating job opportunities and reducing poverty will certainly be frustrated by the rise in macroeconomic imbalances. It will simply contribute to the widening of the already high current-account deficit and will give rise to macroeconomic instability which will be inimical to economic growth. It will certainly raise the country's debt burden, and most of the budgetary resources will be consumed by interest payments alone. Within the past two years (2007-08 and 2008-09), the interest payment has surged from Rs336 billion to Rs676 billion -- an increase of 101 percent. The interest payment is projected to rise to over Rs750 billion in 2009-10, which will consume 53 percent of the projected FBR's tax revenue. The government should have continued with tight fiscal and monetary policies for one more year. It could have consolidated the gains in 2009-10 before embarking on an expansionary fiscal policy route. Enough resources would have been available for spending in the remaining three budgets of this government. The government appears to have become impatient and the IMF has also forgotten its own lesson of a sound fiscal position, which vital for achieving macroeconomic stability and increasingly recognised as being critical for sustained economic growth and poverty reduction.

Fiscal Policy Comprehensively

In an earlier article, monetary policy was identified as one of the tools that a national government uses to influence its domestic economy. The second tool available to government (and one that is used by all levels of government) is fiscal policy. The term fiscal policy refers to the expenditure a government undertakes to provide goods and services and to the way in which the government finances these expenditures.
There are two methods of financing: taxation and borrowing. Taxation takes many forms in the developed countries including taxation of personal and corporate income, so-called value added taxation and the collection of royalties or taxes on specific sets of goods. The debt burden assumed by the government is itself an important policy variable and one that has implications for the conduct of monetary policy. Governments in democratic societies act on many different, occasionally conflicting objectives. They may want to smooth out the nation's income in order to minimize the pejorative effects of the business cycle or they may want to take steps designed to increase the national income. They may also want to take steps intended to achieve specific social objectives deemed to be appropriate by the political or legal process.
LEVELS OF GOVERNMENT
In a democratic system, there are two ways to organize a government: a unitary system and a federal system.
Canada is an excellent example of a federal system of government in which there is one central or federal government and there are ten provincial governments. Underneath the provincial governments, there is a patchwork of local government.The United Kingdom is an example of a unitary system in which there is effectively one central government with no provincial governments. There are, of course, local governments.
In a federal system, both the federal and provincial governments conduct fiscal policy. The Constitution delineates areas of responsibility for the two levels of government and the Supreme Court interprets the actions of the different levels of government in light of the Constitution and other legal precedent to enforce the policy distinctions between the two levels of government. For example, in Canada, national defence is a wholly federal responsibility while education is a completely provincial domain.
However, different levels of government can find ways of participating in areas outside of their purview. In the past, the federal government has given funds to the provinces targeting their spending on education in the form of grants to subsidize university education.
In Canada, one can access the federal government budget online (http://www.fin.gc.ca/budget97/facte/fiscfte.html). From the 1997 budget, we can see the following:
* Federal program spending was budgeted to be C$103.5 Billion or roughly 12% of Canadian Annual Gross Domestic product. Program spending includes all expenditures on federal areas of responsibility including national defence, external affairs, the RCMP, fisheries subsidization, regulation, the administration of the tax regime, etc. Program spending also includes transfers made to the provincial governments.
* The operating balance is the difference between program spending and budgetary revenues (i.e. taxation, royalties, customs tariffs). For 1998-1999, this was estimated to be a surplus of roughly 5% of Canadian Annual GDP. A surplus refers to an excess of revenues over outlays.
* The federal government was still in overall deficit because of interest payments on the stock of outstanding debt. Every year that the federal government has run an overall deficit, they have added to the mountain of debt payable by the people of Canada. In 1997, the total government deficit was forecast to be C$17 Billion.
The provincial governments also have their financial results and forecasts accessible over the Internet.
EXPENDITURES AND TAXATION
There are two types of expenditures: money spent on the delivery of goods and services and the transfer of funds to other levels of government.
All of the money that the government spends has a stimulative effect on the economy. The government is large enough that it can spend during periods of economic contraction thereby helping to prop up the economy and consumer confidence. This school of thought in which the government plays an activist role in stimulating the economy in times of recession and in easing their spending in times of success is called the Keynesian School, after the economist John Keynes. Keynes, a legendary speculator, formulated his theories during the Great Depression as governments in Europe and North America struggled to revive economies troubled by a pullback in the provision of private credit and the negative effects of beggar-thy-neighbour competitive currency devaluations.
The problem with this school of thought is that when it is applied, it is politically very appealing to be spending money during a downturn and helping people when they need help. It is also politically very attractive to be spending money and helping people during a boom time.
It is also very appealing to try and redistribute goods to one group from other groups in the society. This is a very common objective of fiscal policy. Politicians in Western democracies often try to redistribute resources to people living in poverty from people living in comparative wealth. In Canada, one of the most controversial fiscal policy decisions of the post-war era was the Trudeau government's move during the oil crisis of 1978 to force Alberta to sell its oil and gas to Central Canadians at prices that were far below the price that Alberta could have received by selling those resources on the open international market. This constituted a real transfer of money from the people of Alberta to the people of Ontario and Quebec. People in the West are still bitter about that policy twenty years after the fact.
The types of goods that governments typically provide are called public goods. A good or a service is said to be a public good if it is characterized by an externality. This is best demonstrated by an example.
If I buy a chocolate bar, my consumption of that chocolate bar is excludable. If I choose to do so, I can eat the whole thing myself. If I eat the chocolate bar without sharing it, nobody else gets any benefit from it.
Consider now the case where I hire a security service to patrol my street. Not only is my house safer but so are the other houses on that street. However, in this case, I am the only one paying for the service from which everyone else derives a benefit. The other people living on my street are said to be "free-riding" on my provision of the security service. There is nothing that I can do to inhibit them from obtaining this benefit, short of cutting out the service altogether.
If everyone on my street were to chip in for what would be the "optimal" level of security service, there would be inevitably some people who would not contribute anything and there would be others who would not contribute their fair share. Relying on the group to privately provide this public good would mean that too little of it would be supplied.
Traditionally, governments have stepped in to the role of providing these public goods in order to get around the "free-riding" problem. They are deemed to be able to ascertain the optimal amount of the public good to be supplied and to be able to collect the funds to fund it.
Naturally, this is a value-driven exercise. One has to determine how the government should judge what is "optimal" and what is the individual's "fair share." In a democracy, these kinds of normative questions are answered by the people's vote.
In practice, expenditures are driven by all kinds of considerations.
Some people talk about "pork barrel" politics, a situation in which politicians reward their friends and constituents at the expense of people outside of their group. It is not difficult to imagine the local Member of Parliament arguing in favour of the maintenance of his local Armed Forces base and the removal of another base in someone else's riding.
There are other politicians and bureaucrats who have a set of ideological objectives to fulfill. They may want to make the taxation system more progressive, for example. This means taxing people with higher incomes at higher rates and, possibly, not taxing people in the lower income brackets at all.
The construction of the taxation system is very difficult. Another set of objectives may be to distort production as little as possible. That is, in designing the tax code, we may want to develop a set of rules that do not change the relative prices of goods and services (and therefore the decisions investors must make about where to invest and in what industry, etc.).
BORROWING
A government that wants to provide a great deal of goods and services to its people while not having the immediate tax revenue to fund that expenditure can turn to the capital markets to borrow the necessary money. They do this primarily by issuing securities, either Treasury Bills or Treasury Bonds. All levels of government will borrow money at some point. These securities are obligations compelling the government to repay the borrowed amount at maturity and also to pay interest in the form of coupons at specific points in time.
Borrowing has a number of effects.
If a country borrows too much money, it has to pay a great deal of interest every year in order to service that debt. This represents money that could have been used to pay for program spending instead. By borrowing money, the government has placed a greater emphasis on spending in the present than in the future. It has discounted the value of future expenditure.
Depending on how much money the citizens of that country or that province save out of their own incomes, the borrowing government must sell its obligations to foreigners. By doing so, the government makes itself vulnerable to the shifting and often volatile sentiment of the international capital markets. If they have a sufficiently large external debt in relation to their GDP (as an indicator of their current and future capacity to repay), speculators might attack their currency or their country's bond markets forcing interest rates higher and causing the value of their economy to degrade in international terms.
Indeed, an excessive debt policy can lead to a vicious cycle of speculative attacks, followed by higher interest rates and higher interest payments that can cause an economic slowdown. Just when a stimulative policy is required to help the economy struggle back to its normal growth trajectory, the government finds itself crippled by high interest rates and poor liquidity. Nobody else will lend the government money with which it can stimulate the economy under anything but the most onerous terms.
This vicious cycle is one that has plagued economies of the Third World, and particularly Brazil, for years.
On the other hand, it may be prudent to borrow during economic downturns in order to stimulate the economy with the intention of repaying those funds (and thereby dampening the economy) in times of economic growth.
The conduct of fiscal policy is very complicated in its effects on the economy, its reliance on external factors and the value-driven objectives that characterize much of the redistribution of resources and other fiscal policy choices.

Economic effects of fiscal policy

Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. Keynesian economics suggests that adjusting government spending and tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies due to its size and prestige and stimulate trade. In theory, these deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.
During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.
Some classical and neoclassical economists argue that fiscal policy can have no stimulus effect; this is known as the Treasury View, and categorically rejected by Keynesian economics. The Treasury View refers to the theoretical positions of classical economists in the British Treasury who opposed Keynes call for fiscal stimulus in the 1930s. The same general argument has been repeated by neoclassical economists up to the present day. From their point of view, when government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD), contrary to the objective of a budget deficit. This concept is called crowding out.
Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing demand while labor supply remains fixed, leading to inflation.

Methods of funding

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits.

This expenditure can be funded in a number of different ways:

Taxation
Seignorage, the benefit from printing money
Borrowing money from the population, resulting in a fiscal deficit.
Consumption of fiscal reserves.
Sale of assets (e.g., land).

[edit] Funding the deficit
A fiscal deficit is often funded by issuing bonds, like treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors.


[edit] Consuming the surplus
A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. When income from taxation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring a deficit.

Fiscal Policy in Economy

In economics, fiscal policy is the use of government spending and revenue collection to influence the economy.[1]
Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:
Aggregate demand and the level of economic activity;
The pattern of resource allocation;
The distribution of income.
Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:
A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.
A contractionary fiscal policy (G < title="Surplus" href="http://en.wikipedia.org/wiki/Surplus">surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.

Monetary Policy in Modern Economy

Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the supply and availablity of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank", the Bank of Canada and the Federal Reserve Bank in the United States.

Central banks have not always existed. In early economies, governments would supply currency by minting precious metals with their stamp. No matter what the creditworthiness of the government, the worth of the currency depended on the value of its underlying precious metal. A coin was worth its gold or silver content, as it could always be melted down to this. A country's worth and economic clout was largely to its holdings of gold and silver in the national treasury. Monarchs, despots and even democrats tried to skirt this inviolate law by filing down their coinage or mixing in other substances to make more coins out of the same amount of gold or silver. They were inevitably found out by the traders, money lenders and others who depended on the worth of that currency. This the reason that movies show pirates and thieves biting Spanish dubloons to ascertain the value of their booty and loot.
The advent of paper money during the industrial revolution meant that it wasn't too difficult for a country to alter its amount of money in circulation. Instead of gold, all that was needed to produce more banknotes was paper, ink and a printing press. Because of the skepticism of all concerned, paper money was backed by a "promise to pay" upon demand. A holder of a "pound sterling" note of the United Kingdom could actually demand his pound of silver! When gold became the de facto backing of the world's currency a "gold standard" was developed where nations kept sufficient gold to back their "promises to pay" in their national treasuries. The problem with this standard was that a nation's economic health depended on its holdings of gold. When the treasury was bare, the currency was worthless.
In the 1800s, even commercial banks in Canada and the United States issued their own banknotes, backed by their promises to pay in gold. Since they could lend more than they had to hold in reserves to meet their depositers demands, they actually could create money. This inevitably led to "runs" on banks when they could not meet their depositers demands and were bankrupt. The same happened to smaller countries. Even the United States Treasury had to be rescued by JP Morgan several times during this period. In the late 1800s and early 1900s, countries legislated their exclusive monopoly to issue currency and banknotes. This was in response to "financial panics" and bank insolvencies. This meant that all currency was issued and controlled by the national governments, although they still maintained gold reserves to support their currencies. Commercial banks still could create money by lending more than their depositors had placed with the bank, but they no longer had the right to issue banknotes.
Modern Monetary Policy
Modern central banking dates back to the aftermath of great depression of the 1930s. Governments, led by the economic thinking of the great John Maynard Keynes, realized that collapsing money supply and credit availability greatly contributed to the savagery of this depression. This realization that money supply affected economic activity led to active government attempts to influence money supply through "monetary policy". At this time, nations created central banks to establish "monetary authority". This meant that rather than accepting whatever happened to money supply, they would actively try to influence the amount of money available. This would influence credit creation and the overall level of economic activity.
Modern monetary policy does not involve gold to a great extent. In 1968, the United States rescinded its promise to pay in gold and effectively removed itself from the "gold standard". Since then, it has been the job of the Federal Reserve to control the amount of money and credit in the U.S. economy. I doing this, it wants to maintain the purchasing power of the U.S. dollar and its comparative worth to other currencies. This might sound easy, but it is a complex task in an information age where huge amounts of money travels in electronic signals in microseconds around the world.
The Effectiveness of Monetary Policy
Economists debate the relevant measures of money supply. "Narrow" money supply or M1 is currency in circulation and the currency in easily accessed chequing and savings accounts. "Broader" money supply measures such as M2 and M3 include term deposits and even money market mutual funds. Economists debate the finer points of the implementation and effectiveness of monetary policy but one thing is obvious. At the extremes, monetary policy is a potent force. In countries such as the Russian Republic, Poland or Brazil where the printing presses run full tilt to pay for government operations, money supply is expanding rapidly and the currency becomes rapidly worthless compared to goods and services it can buy. Very high levels of inflation or "hyperinflation" is the result. With 30-40% monthly inflation rates, citizens buy hard goods as soon as they receive payment in the currency and those on fixed income have their investments rendered worthless.
At the other extreme, restrictive monetary policy has shown its effectiveness with considerable force. Germany, which experienced hyperinflation during the Weimar Republic and never forgot, has maintained a very stable monetary regime and resulting low levels of inflation. When Chairman Paul Volcker of the U.S. Federal Reserve applied the monetary brakes during the high inflation 1980s, the result was an economic downturn and a large drop in inflation. The Bank of Canada, headed by John Crow, targeted 0-3% inflation in the early 1990s and curtailed economic activity to such an extent that Canada actually experienced negative inflation rates in several months for the first time since the 1930s.
Without much debate, the effectiveness of monetary policy, its timing and its eventual impacts on the economy are not obvious. That central banks attempt influence the economy through monetary is a given. In any event, insights into monetary policy are very important to the investor. The availability of money and credit are key considerations in the pricing of an investment.
Operations of a Modern Central Bank
The Central Bank attempts to achieve economic stability by varying the quantity of money in circulation, the cost and availability of credit, and the composition of a country's national debt. The Central Bank has three instruments available to it in order to implement monetary policy:
Open market operations
Reserve requirements
The 'Discount Window'
Open market operations are just that, the buying or selling of Government bonds by the Central Bank in the open market. If the Central Bank were to buy bonds, the effect would be to expand the money supply and hence lower interest rates, the opposite is true if bonds are sold. This is the most widely used instrument in the day to day control of the money supply due to its ease of use, and the relatively smooth interaction it has with the economy as a whole.
Reserve requirements are a percentage of commercial banks', and other depository institutions', demand deposit liabilities (i.e. chequing accounts) that must be kept on deposit at the Central Bank as a requirement of Banking Regulations. Though seldom used, this percentage may be changed by the Central Bank at any time, thereby affecting the money supply and credit conditions. If the reserve requirement percentage is increased, this would reduce the money supply by requiring a larger percentage of the banks, and depository institutions, demand deposits to be held by the Central Bank, thus taking them out of supply. As a result, an increase in reserve requirements would increase interest rates, as less currency is available to borrowers. This type of action is only performed occasionally as it affects money supply in a major way. Altering reserve requirements is not merely a short-term corrective measure, but a long-term shift in the money supply.
Lastly, the Discount Window is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), there by affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over.
By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates ,and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole.

Monetary Policy (Gold and silver)

When gold and silver are used as money, the money supply can grow only if the supply of these metals is increased by mining. This rate of increase will accelerate during periods of gold rushes and discoveries, such as when Columbus discovered the new world and brought back gold and silver to Spain, or when gold was discovered in California in 1848. This causes inflation, as the value of gold goes down. However, if the rate of gold mining cannot keep up with the growth of the economy, gold becomes relatively more valuable, and prices (denominated in gold) will drop, causing deflation. Deflation was the more typical situation for over a century when gold and paper money backed by gold were used as money in the 18th and 19th centuries.
Modern day monetary systems are based on fiat money and are no longer tied to the value of gold. The control of the amount of money in the economy is known as monetary policy. Monetary policy is the process by which a government, central bank, or monetary authority manages the money supply to achieve specific goals. Usually the goal of monetary policy is to accommodate economic growth in an environment of stable prices. For example, it is clearly stated in the Federal Reserve Act that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”[25]
A failed monetary policy can have significant detrimental effects on an economy and the society that depends on it. These include hyperinflation, stagflation, recession, high unemployment, shortages of imported goods, inability to export goods, and even total monetary collapse and the adoption of a much less efficient barter economy. This happened in Russia, for instance, after the fall of the Soviet Union.
Governments and central banks have taken both regulatory and free market approaches to monetary policy. Some of the tools used to control the money supply include:
changing the interest rate at which the government loans or borrows money
currency purchases or sales
increasing or lowering government borrowing
increasing or lowering government spending
manipulation of exchange rates
raising or lowering bank reserve requirements
regulation or prohibition of private currencies
taxation or tax breaks on imports or exports of capital into a country
In the US, the Federal Reserve is responsible for controlling the money supply, while in the Euro area the respective institution is the European Central Bank. Other central banks with significant impact on global finances are the Bank of Japan, People's Bank of China and the Bank of England.
For many years much of monetary policy was influenced by an economic theory known as monetarism. Monetarism is an economic theory which argues that management of the money supply should be the primary means of regulating economic activity. The stability of the demand for money prior to the 1980s was a key finding of Milton Friedman and Anna Schwartz[26] supported by the work of David Laidler,[27] and many others. The nature of the demand for money changed during the 1980s owing to technical, institutional, and legal factors and the influence of monetarism has since decreased.

Functions of Money

Money is generally considered to have the following functions, which are summed up in a rhyme found in older economics textbooks: "Money is a matter of functions four, a medium, a measure, a standard, a store." That is, money functions as a medium of exchange, a unit of account, a Standard of deferred payment, and a store of value. However, most modern textbooks now list only three functions, that of medium of exchange, unit of account, and store of value.
There have been many historical disputes regarding the combination of money's functions, some arguing that they need more separation and that a single unit is insufficient to deal with them all. One of these arguments is that the role of money as a medium of exchange is in conflict with its role as a store of value: its role as a store of value requires holding it without spending, whereas its role as a medium of exchange requires it to circulate.Others argue that storing of value is just deferral of the exchange, but does not diminish the fact that money is a medium of exchange that can be transported both across space and time. The term 'financial capital' is a more general and inclusive term for all liquid instruments, whether or not they are a uniformly recognized tender.

Medium of exchange
Main article: Medium of exchange
When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the 'double coincidence of wants' problem.

Unit of account
Main article: Unit of account
A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a "measure" or "standard" of relative worth and deferred payment, a unit of account is a necessary prerequisite for the formulation of commercial agreements that involve debt. To function as a 'unit of account', whatever is being used as money must be:
Divisible into smaller units without loss of value; precious metals can be coined from bars, or melted down into bars again.
Fungible: that is, one unit or piece must be perceived as equivalent to any other, which is why diamonds, works of art or real estate are not suitable as money.
A specific weight, or measure, or size to be verifiably countable. For instance, coins are often made with ridges around the edges, so that any removal of material from the coin (lowering its commodity value) will be easy to detect.

Store of value
Main article: Store of value
To act as a store of value, a commodity, a form of money, or financial capital must be able to be reliably saved, stored, and retrieved — and be predictably useful when it is so retrieved. Fiat currency like paper or electronic money no longer backed by gold in most countries is not considered by some economists to be a store of value.

Money Supply
Main article: Money supply
In economics, money is a broad term that refers to any financial instrument that can fulfill the functions of money (detailed above). These financial instruments together are collectively referred to as the money supply of an economy. Since the money supply consists of various financial instruments (usually currency, demand deposits and various other types of deposits), the amount of money in an economy is measured by adding together these financial instruments creating a monetary aggregate. Modern monetary theory distinguishes among different types of monetary aggregates, using a categorization system that focuses on the liquidity of the financial instrument used as money.

Market liquidity
Main article: Market liquidity
Market liquidity describes how easily an item can be traded for another item, or into the common currency within an economy. Money is the most liquid asset because it is universally recognised and accepted as the common currency. In this way, money gives consumers the freedom to trade goods and services easily without having to barter.
Liquid financial instruments are easily tradable and have low transaction costs. There should be no (or minimal) spread between the prices to buy and sell the instrument being used as money.

Measures of money
The money supply is the amount of financial instruments within a specific economy available for purchasing goods or services. The money supply is usually measured as three escalating categories M1, M2 and M3. The categories grow in size with M1 being currency (coins and bills) and checking account deposits. M2 is currency, checking account deposits and savings account deposits, and M3 is M2 plus time deposits. M1 includes only the most liquid financial instruments, and M3 relatively illiquid instruments.
Another measure of money, M0, is also used, although unlike the other measures, it does not represent actual purchasing power by firms and households in the economy. M0 is base money, or the amount of money actually issued by the central bank of a country. It is measured as currency plus deposits of banks and other institutions at the central bank. M0 is also the only money that can satisfy the reserve requirements of commercial banks.

Types of money
Currently, most modern monetary systems are based on fiat money. However, for most of history, almost all money was commodity money, such as gold and silver coins. As economies developed, commodity money was eventually replaced by representative money, such as the gold standard, as traders found the physical transportation of gold and silver burdensome. Fiat currencies gradually took over in the last hundred years, especially since the breakup of the Bretton Woods system in the early 1970s.

Commodity money
Main article: Commodity money
Commodity money value comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity.[18] Examples of commodities that have been used as mediums of exchange include gold, silver, copper, rice, salt, peppercorns, large stones, decorated belts, shells, alcohol, cigarettes, cannabis, candy, barley, etc. These items were sometimes used in a metric of perceived value in conjunction to one another, in various commodity valuation or Price System economies. Use of commodity money is similar to barter, but a commodity money provides a simple and automatic unit of account for the commodity which is being used as money.

Representative money
Main article: Representative money
Representative money is money that consists of token coins, other physical tokens such as certificates, and even non-physical "digital certificates" (authenticated digital transactions) that can be reliably exchanged for a fixed quantity of a commodity such as gold, silver or potentially water, oil or food. Representative money thus stands in direct and fixed relation to the commodity which backs it, while not itself being composed of that commodity.
The gold standard, based on paper notes that are normally freely convertible into fixed quantities of gold, is the most common form of representative money. It was adopted by most of the industrialized countries during the 18th and 19th centuries.

Fiat money

Banknotes from all around the world donated by visitors to the British Museum, London.
Main article: Fiat money
Fiat money or fiat currency is money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold). Instead, it has value only by government order (fiat). Usually, the government declares the fiat currency (typically notes and coins from a central bank, such as the Federal Reserve System in the U.S.) to be legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts, public and private.
Fiat money may be symbolic of a commodity (e.g. the UK Pound sterling), but it does not carry a guarantee that it can be traded directly for fixed quantities of anything, other than the same government's money. Fiat monies usually trade against each other in an international market, and can change value, as with other goods. Thus the number of U.S. dollars or Japanese yen which are equivalent to each other, or to a gram of gold, are all market decisions which change from moment to moment. An exception to this is when a government implements a fixed exchange rate, and locks the value of its currency versus the currency of another (usually larger) trading partner. For example, the Belize dollar trades in fixed proportion (at 2:1) to the U.S. dollar.
Fiat money, if physically represented in the form of currency (paper or coins) can be accidentally damaged or destroyed. However, fiat money has an advantage over representative or commodity money, in that the same laws that created the money can also define rules for its replacement in case of damage or destruction. For example, the U.S. government will replace mutilated Federal Reserve notes (U.S. fiat money) if at least half of the physical note can be reconstructed, or if it can be otherwise proven to have been destroyed. By contrast, commodity money which has been lost or destroyed cannot be recovered.

Credit money
Main article: Credit money
Credit money is any claim against a physical or legal person that can be used for the purchase of goods and services. Credit money differs from commodity and fiat money in two ways: It is not payable on demand (although in the case of fiat money, "demand payment" is a purely symbolic act since all that can be demanded is other types of fiat currency) and there is some element of risk that the real value upon fulfillment of the claim will not be equal to real value expected at the time of purchase.
This risk comes about in two ways and affects both buyer and seller. First it is a claim and the claimant may default (not pay). High levels of default have destructive supply side effects. If manufacturers and service providers do not receive payment for the goods they produce, they will not have the resources to buy the labor and materials needed to produce new goods and services. This reduces supply, increases prices and raises unemployment, possibly triggering a period of stagflation. In extreme cases, widespread defaults can cause a lack of confidence in lending institutions and lead to economic depression. For example, abuse of credit arrangements is considered one of the significant causes of the Great Depression of the 1930s.
The second source of risk is time. Credit money is a promise of future payment. If the interest rate on the claim fails to compensate for the combined impact of the inflation (or deflation) rate and the time value of money, the seller will receive less real value than anticipated. If the interest rate on the claim overcompensates, the buyer will pay more than expected. The process of fractional-reserve banking has a cumulative effect of money creation by banks.