Impact and importance of Taxation on Savings

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Why is Savings an Important Policy Issue?

In his Economics of Tax Policy lecture note, Antonie Bozio (2009) highlighted why savings is an important policy issue as follows:-

Savings are crucial for growth - since capital accumulation is one of the determinants of investment, saving rate is therefore crucial for growth in the long run;

With increased life-expectancy, savings are crucial for retirement provisions [1] .

Distribution of wealth is highly unequal. Wealth is current and past savings and taxing capital income is sometimes viewed as fairer.

Recent trends make taxation of savings a political issue. Such trends include recent increase in wealth inequalities and dramatic fall in saving rates in the United States and other developed countries.

Determinants of Savings

For the purpose of this assignment, some theories underlying savings behaviour of individual are considered as follows:-

The Life-Cycle Model

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The life cycle model is based on the assumptions that the primary motive for saving or dissaving is their consumption over their lifetime, of which retirement savings is the major example. The simple life cycle model assumes that individuals' utility depends on only their own consumption and their time horizon is their own lifetime.

Postulated by Ando and Modigliani suggests that consumption spending will be smooth in the face of an erratic stream of income. Like Friedman's Permanent Income Hypothesis (PIH), Modigliani and Ando assumed that households strive to maximize their utility of future consumption. The marked difference between the two theories concerns the length of the planning period. For Friedman, this period is infinite, meaning that people save not only for themselves but also for their descendants but in the Modigliani-Ando version, the planning period is finite: people save only for themselves. From the postulate of utility maximization it follows that consumption is evenly distributed over time and this, in turn, implies that the individual during his active period, builds up a stock of wealth which he consumes during his old age. [2] 

In extended life cycle models, an induced change in labour supply is an important factor. Labour supply changes depending on the traditional income and substitution effects [3] . Assuming that the income effect dominates, then individuals will increase their demand for leisure and retire earlier, leading them to increase their savings rate during their -now shorter- working life anticipation of a longer retirement [4] .

The net displacement effect will be less than 100 per cent and could be zero, depending on the size of this and other offsetting factors (Richard Kohl and Paul O'Brien, 1998).

Precautionary Motive

Precautionary motives for saving in the face of uncertain death, extraordinary health expenditure or income disruptions [5] . The presence of precautionary motives for savings will modify displacement effects by affecting the degree of substitutability between 'Pay As You Go' (PAYG) pensions and other savings instruments (Richard Kohl and Paul O'Brien, 1998).

Bequest Motive

The bequest model assumes that individuals have a multi-generational time horizon and that they maximise not only their own utility but those of parents and children, giving rise to bequest motives. In this model, the introduction of PAYG pension systems, or of changes in their generosity, implies no displacement of private savings, whether or not there is a change in expected net pension wealth (Richard Kohl, et al, 1998).

Theories of bequest motives fall into several distinct categories. One school of thought holds that bequests result from uncertainty concerning length of life coupled with restrictions on the availability of annuity insurance contracts (Davies, 1981). A second maintains that individuals care directly about the amount of wealth bequeathed to their heirs (Blinder, 1974 and Andreoni, 1989). A third is predicated on the assumption that individuals have altruistic preferences, in the sense that they care directly about the utility or consumption of their heirs (Barro, 1974 and Becker, 1974). A fourth depicts bequests as payments associated with transactions within families (Bernhein, Shleifer and Summer, 1985).

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A number of studies have examined the empirical validity of these various alternatives. Collectively, the evidence points to a mixture of motives. Several authors have investigated the hypothesis that bequests are intentional, rather than accidental (Bernheim, Shleifer and Summer, 1985, Hurd, 1987, 1989). Bernheim and Bagwell (1988) argue that the altruism model leads inevitably to stronger, empirically untenable conclusions. Specific implications of exchange motives have also been examined and according to Menchik (1980) and Wilhelm (1996), all available theories have difficulty accounting for the robust empirical finding that more than two-third of United States testators divide their estates exactly equally among their heirs [6] .

The Implication of bequest motives for tax policy depends critically on the type of motive that one assumes. For instance, the taxation of bequests and the inhertance is clearly non-distortionary if intergenerational transfers are accidental, but may have substantial efficiency costs if individuals have other motives. Different assumptions therefore lead to different implications concerning the desirability of including the consumption tax base, or inheritances in the wage tax base (Bernheim, 1999).

The interest elasticity of saving is also sensitive to one's assumptions about the nature of bequest motives. Standartd formulation of the altruistic motive imply that the long-run interest elasticity of saving is much higher than in the absence of a bequest motive (Summers, 1981, Evans, 1983, Lord and Rangazas, 1992); indeed, the long-run partial equilibrium interest elasticity of saving is infinite. In constrast, several studies have found that the interest elasticity of saving declines when one introduces accidental bequests (Engen, 1994) or preferences for bequest that are defined over the amount of wealth bequeathed rather than over heirs' consumption or utility (Evans, 1983, Starrett, 1988, Fullerton and Rogers, 1993). These are not general results, but depend on the form of the utility function, and on the manner in which one recalibrates other parameters of the model when bequests motives are introduced [7] .

Alternative Models of Savings Behaviour

Self Control

Self control refers to the ability to follow through on intertemporal plans that require an individual to forego short-term gratification. While the life cycle hypothesis implicitly assumes tha self-control is perfect, a large body of psychological research suggests that self-control lies at the heart of many intertemporal decision-making problems (Ainslie, 1975, 1982, 1984; Furnham and Lewis, 1986).

One can formalise problems of self-control in a number of different ways. Thaler and Shefrin (1981) propose a model in which an individual decision-maker consists of two distinct 'selves' - a farsighted patient 'planner' and a shortsighted, impatient 'doer'. The planner can keep the door in check only by expending costly effort ('willpower'). Laibson (1994) analyses a class of models in which problems with self-control arise directly from time-incinsistent preferences [8] .

In contrast to the life cycle hypothesis, Laibson's formulation of the intertemporal planning problem assumes that an individual becomes less willing to defer gratification from perid 't' to some period 's>t' once period t actually arrives. As a result, the individual is typically unwilling to follow through on an optimal intertemporal plan.

Existing models of self-control have at least one serious drawback; their solution are significantly more complex than those of standard life cycle problems. For example, the application of Laibson's framework reqiures one to solve for the equilibrium of a dynamic game played between an individual's current 'self' and all of his or her future incarnations. Thus, in solving the problems of self control, these frameworks accentuate the problems associated with cognitive limitations.

Bounded Rationality

Rational behaviour in economics mean that individuals maximise some target function under the constraints they face (e.g. their utility function) in pursuit of their self-interest. This is reflected in the theory of expected utility (Savare, 1954). Bounded rationality is the theory that there is only so much information that humans can be aware of. Therefore, when making decision they base them on a limited choice.

They are rational given limited choice and awareness of alternatives but they rarely maximize total utility because people don't want to take time to fully consider all options. It is concerned with the ways in which the actual decision-making prices influence decisions [9] .

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Formal models of bounded rationality proceed in one of several different directions (Conlisk, 1996). Some impose structure on beliefs, for instance, by assuming a bias toward excessive optimism, a penchant for noticing salient or reassuring information, a tendency to forget information in the absence of rehearsl or corroboration, or a proclivity to update beliefs in a simplistic manner, for example, through adaptive expectations. Others impose restrictions on decisions, limiting behaviour to simple rules of thumb, such as a fixed fraction of income [10] .

Hyperbolic Discounting

In economic models, future benefits are discounted against the present constant rate. Human decision makers apply much higher rates in t he short term than the long term. For example, someone may prefer to receive £100 now over £200 next year. However, they may also prefer £200 in three years time over £100 in two years. This is termed 'hyperbolic discounting' (Ainsle, 1975), and has been demonstrated emprically in a range of studies on people (and animals) - (Ainslie, 2001).

Hyperbolic discounting relates to issues with self control and procrastination - people will consume more inthe short term than is in their long term (or even tomorrow morning) interests, and will put of sacrifices such as exercising or saving money. Extreme forms of hyprbolic discounting are linked to addiction (Madden, et al, 1997).

Other Policies That Can Influence Savings

Other policies that can influence savings include debt and monetary policy through interest rates that affect savings rate and public debt that tend to crowd out private debt; Social insurance by way of pension provisions can reduce the amount of necessary savings while unemployment or health insurance tend to reduce the amount of uncertainty. In relation to financial markets, imperfect capital markets might lead to borrowing constraints and individuals might be compelled to save to avoid these constraints.

Modelling Savings & Taxation

The Life Cycle Model

The debate within the literature between the life-cycle supporters and the alternative models as well as the issue of whether individuals are rational and time consistent or irrational, myopic e.t.c, all have huge implications for fiscal policy formulation and implementation. The idea of life-cycle savings and borrowing are necessary tools to smooth consumption. Individuals have to make intertemporal choices more now or in the future period.

It is the same model as the consumption of different goods, or between leisure and consumption, but here is a trade-off between consumption, but here it is a trade-off between consumption now and consumption later. This model originated from the work of Modigliani and Brumberg (1954) and shares features from the Permanent Income Hypothesis of Friedman (1975). A change in interest rate changes the relative price of consumption from one period to the next.

Two contradicting effects of an increase in taxes on savings:-

1. Substitution Effects - The price of second period consumption is increased; this leads to an increase in consumption in period 1; and therefore to a decrease in savings.

2. Income Effect - The total income is reduced; this leads to an increase in savings.

The total effect (income and substitution effects) depends on the curvature of the indifference curve:-

If the indifference curves are L-shaped (the elasticity of substitution is zero), the income effect will dominate.

If the indifference curves are straight line (the elasticity of substitution is infinitely high), the substitution effect will dominate.

The Elasticity of Intertemporal Substitution

The elasticity of intertemporal substitution (EIS) is the formal measure of the responsiveness of consumption to changes in the relative price of consumption in different preiods - the larger is the EIS, the larger will be the shift in consumption from one period to another following a charge in theg relative price of consumption in those two periods.

For a very small EIS, consumption will be almost unaffected by such relative price changes.

Using the Euler equations, it is possible to express the change in consumption as a function of the EIS and the interest rate. It is the base of empirical estimation of the EIS, Although there is no concensus on this elasticity, the traditional view suggests that EIS is very low when it is close to zero and more recent research findings indicates that EIS ranging between 0.5 and 1.0 is not too low.

The measure of the EIS has implications for policy conclusions as with very low EIS, tax incentives for savings shouldn't have much effects while with high EIS, taxes matter a lot for savings rate. It is always very difficult to identify these effects precisely because, interest rate is usually the same for everyone.

The Two-Period Life-Cycle Model is based on the following assumptions:-

Two periods, with consumption C1 and C2;

Stylised life with work and retirement; In period 1, the individual earns income, Y.

He can save S, and earn r interest on these savings

The intertemporal budget constraint is given by :- Y=C1+ C2[1/(1+r)]

1/(1+r) is the price of consumption in the second period

Lower interest rate means a higher price of consumption in the second period.

If the government increases taxes on savings t, the net return of savings is reduced to [1+r(1+t)]

The intertemporal budget constraint shifts as a result.

Figure 1 - Taxation & the Intertemporal Consumption Decision

Consumption while working in Period 1, Cw

Savings, S

Cw1

Budget Constraint, BC2

Budget Constraint, BC1

Indifference Curve, IC1

B

A

Cr2

Cr1

S*(1-t)

Slope=-[1+r*(1-t)]

Slope=-(1+r)

Y*(1+r)

Consumption while retired in Period 2, Cr1

Y*[1+r(1-t)]

S

TAXATION AND THE INTERTEMPORAL CONSUMPTION DECISION

Before taxes are introduced, individuals lose -(1+r) worth of consumptionin period two (Cr) for every dollar of consumption in period one (Cw). On the basis of this budget constraint (BC1), individuals will choose to do some amount of savings, S, in the first period, and consume S*(1+r) in the second period. When taxes rise, the budget constraints pivots inward to BC2. Individuals lose only -(1+r(1+t)) worth of consumption in period one. This may raise or lower savings depending on which is more powerful, the substitution or the income effects.

Figure 2 - Intertemporal Substitution Versus Income Effect

Consumption while working in Period 1, Cw

Savings, S

Cw1

Budget Constraint, BC2

Budget Constraint, BC1

Indifference Curve, IC1

B

A

Cr2

Cr1

Slope=-[1+r*(1-t)]

Slope=-(1+r)

Y*(1+r)

Consumption while retired in Period 2, Cr1

Y*[1+r(1-t)]

S

S2

S2*[1+r(1-t)]

Cw2

IC2

Panel A = Substitution Effect is Larger

S*(1-t)

INTERTEMPORAL SUBSTITUTION VERSUS INCOME EFFECT - (I)

If the substitution effect is larger than the income effect (Panel (a)), individuals will move from Point A to Point B, consuming more in the first period (Cw2) and thus saving less (S2). A a result, their consumption in period two (Cr2) falls by a lot.

Figure 3 - Intertemporal Substitution Versus Income Effect

Consumption while working in Period 1, Cw

Savings, S

Cw1

Budget Constraint, BC2

Budget Constraint, BC1

Indifference Curve, IC1

C

A

Cr2

Cr1

Slope=-[1+r*(1-t)]

Slope=-(1+r)

Y*(1+r)

Consumption while retired in Period 2, Cr1

Y*[1+r(1-t)]

S

S3

S3*[1+r(1-t)]

Cw3

IC2

Panel A = Income Effect is Larger

S*(1-t)

INTERTEMPORAL SUBSTITUTION VERSUS INCOME EFFECT - (II)

If the income effect is larger (Panel (b)), individuals will move from Point A to Point C comsuming less in the first period (Cw3) and thus saving more (S3). The consumption in period two still falls, but not by as much.

Figure 4 - Tax Subsidies & Intertemporal Consumption Trade-off

Consumption while working in Period 1, Cw

Savings, S

Cw4

Budget Constraint, BC2

Budget Constraint, BC3

Indifference Curve, IC1

B

A

Cr2

Cr3

Slope=-[1+r*(1-t)]

Slope=-(1+r)

Y*(1+r)

Consumption while retired in Period 2, Cr1

Y*[1+r(1-t)]

S4

S2

S2*[1+r(1-t)]

Cw2

IC2

Panel A = Substitution Effect is Larger

C

S2*[1+r1-t)]

Cw3

S3

Cr4

TAX SUBSIDIES & THE INTERTEMPORAL CONSUMPTION TRADE-OFF

Individuals initially face a budget constraint BC2 with a loss of -(1+r(1-t)). When retirement savings is tax-subsidezed, the budget constraint moves to BC3, with a higher slope -(1+r(1-t*p)). This leads to a substitution effect toward more savings, and on income effect toward less savings. If the substitution effect is larger, the first period consumption will fall from Cw2 to Cw3, and savings will fall from S2 to S4.

Figure 5 - IRAs & The Intertemporal Consumption Decision

B

A

Cr

-Y*[1+r(1-pt)]

Slope=-[1+r*(1-t)]

Y*[(1+r(1-t)]

Y

BC3

CW2

CW

$3,000

D

E

IRAs AND THE INTERTEMPORAL CONSUMPTION DECISION

The availability if IRAs raise the return to savings less than $3,000 from -(1+r(1-t)) to -(1+r(1-tp)), where p is the net tax preference from using an IRA.Once savings is above $3,000 (period one consumption less than Cw2), the IRA simply increases period two income and the retun to each dollar of savings returns to -(1+r(1-t)).

Figure 6 - Low Versus High Savers (I)

Cw1

F

S1=$1000

Panel A = Low Saver

B

A

BC1

Cr

Cw3

-Y*[1+r(1-pt)]

Slope=-[1+r*(1-t)]

Y*[(1+r(1-t)]

Y

S2=$1500

BC2

CW2

CW

S3=$500

C

D

E

LOW SAVER VERSUS HIGH SAVERS - (1)

In Panel (a), Mr Samuel saves little before the IRA is introduced (Point A), consuming Cw1 and saving only $1,000. For Mr. Samuel, the effect of the IRA on savings is ambiguous. If substitution effect dominates, he will move from point A to point B (with savings rising); If income effect dominates, he will move from Point A to Point C (with savings falling)

Figure 7 - Low Versus High Savers (II)

Cw1

F

S1=$5000

Panel B = High Savers

B

A

BC1

Cr

-Y*[1+r(1-pt)]

Slope=-[1+r*(1-t)]

Y*[(1+r(1-t)]

Y

S2=$4000

BC2

CW2

CW

D

E

LOW SAVER VERSUS HIGH SAVERS - (2)

In Panel (B), Miss Esther was a high saver before the IRA was introduced, consuming Cw1 and saving $5,000 (Point A). For Miss Esther, the introduction of the IRA does not change the price of first period consumption, but it does have an income effect, causingn her period one comsumption to rise to Cw2 and her savings to fall to S2, $4000.

THE RELATIONSHIP BETWEEN FISCAL AND MONETARY POLICY

Monetary Policy Defined

Monetary policy is the branch of economic policy which attempts to achieve the broad objects of policy relating to stability of employment and prices, economic growth, and balance in external payment through control of monetary system and by operating on such monetary magnitudes as the supply of money, the level and structure of interest rate and other conditions affecting the availability of credit.

Instruments of Monetary Policy- These are the means through which Central Banks enforce monetary policy notably reserve requirements, discount rate of official interest rate, and open market operations. Reserve Requirements - this refers to the amount of asset in money terms that banks are required to hold against their deposits. It varies from country to country and it can be altered at the instance of the Central Bank from time to time [11] . Discount Rate/Official Interest Rate - This could be taken to mean the rate at which Central Bank lend money to its clients such as discount houses and banks having deficit position in their balance with the Central Bank through the performance of lender of last resort role [12] . Open Market Operations - This involves buying and selling of securities (usually government bonds) on the open market by the Central Bank in order to achieve some desired monetary policy goals most especially to influence the cash reserves of banks. [13] 

Monetary policy transmission Mechanism refers to the route through which a monetary policy adjustment is passed to the real sector via open market operation, rediscounting or cash reserve changes.

Fiscal Policy are measures employed by governments to stabilize the economy, specifically by adjusting the levels and allocations of taxes and government expenditures. When the economy is sluggish, the government may cut taxes, leaving taxpayers with extra cash to spend and thereby increasing levels of consumption. An increase in public-works spending may likewise pump cash into the economy, having an expansionary effect. Conversely, a decrease in government spending or an increase in taxes tends to cause the economy to contract.

Fiscal policy is often used in tandem with monetary policy. Until the 1930s, fiscal policy aimed at maintaining a balanced budget; since then it has been used "countercyclically," as recommended by John Maynard Keynes, to offset the cycle of expansion and contraction in the economy. Fiscal policy is more effective at stimulating a flagging economy than at cooling an inflationary one, partly because spending cuts and tax increases are unpopular and partly because of the work of economic stabilizers.

The Effects of Monetary and Fiscal Policies

While the monetary policy has the following effects - direct effect whereby excess money would cause aggregate demand to rise, because an increase in the money supply at any given price level would cause the purchase of more output of real goods and services; the indirect effect in which when there is excess money some people would deposit it in banks. The recipient banks would have higher reserves than necessary and would lower interest rates to induce people to borrow. The increased loans would create a rise in aggregate demand.

Fiscal Policy effects are manifested through the following actions - a change in government purchases or a tax cut increases aggregate expenditure directly and increases aggregate demand with a multiplier; a change in real GDP changes the demand for money, which changes the interest rate; and a change in the interest rate changes investment and other interest-sensitive components of aggregate expenditure, which counteract the effects of the initial increase in aggregate expenditure-a crowding-out effect.

There were some extremely powerful theoretical models of the short-run effects of monetary and fiscal policy, developed in the early 1960s by Robert Mundell and Marcus Fleming (Mundell 1961, 1962, 1963; Fleming 1962). The sharpest prediction of the early models occurred under the assumption of perfect substitutability between domestic and foreign assets and a fixed domestic price level. In a flexible exchange rate regime, only monetary policy (and not fiscal policy) would affect the level of output - (internal balance). Expansionary fiscal policy would, however, lead to a sizeable deterioration of the current account of the balance of payments. Conversely, in a fixed exchange rate regime, only fiscal (and not monetary policy) would affect the level of output, while monetary policy would affect the balance of payments through its implications for changes in official reserves (David Dodge, 2002).

Fiscal and Monetary Policies' Goal Conflicts

Fiscal Policy has three main goals which are to provide public goods and services, to redistribute income, and to stabilize aggregate demand which can be conflicting. Also, monetary policy has three main goals, viz:- price level stability, real GDP stability, and stability of the financial system. There is less conflict among these goals than among those of fiscal policy. Attempts to accomplish all these goals at the same time often lead to the problem of policy trilemma

'Policy trilemma is the idea that of the three policy objectives of fixed exchange rate, open capital markets, and autonomous monetary policy, only two can be mutually consistent and hence,tenable as stable features of the policy regime.'

David Dodge, (2002) states that whether one is thinking about monetary policy or fiscal policy, there are two important results when medium-to-long term objectives are established and achieved. First, a sustainable situation is created over time. Policy instruments are forced to adjust to surprises - particularly permanent surprises - because there is a longer run anchor. Second, in choosing long-term objectives, appropriate consideration is given to the type of policy framework that will raise living standard over longer run. The longer run should be more than the result of a series of ad hoc short-run decisions aimed at economic fine-tuning.

Extreme Conditions and Fiscal - Monetary Policy Interaction

At one extreme, monetary policy is all-powerful and fiscal policy is completely ineffective. This extreme occurs if the quantity of money demanded is independent of the interest rate. At another extreme, monetary policy is completely ineffective and fiscal policy is all-powerful. This extreme occurs if there is one interest rate at which people are willing to hold any quantity of money, a situation called a liquidity trap. Reality is that empirical evidence suggests that neither extreme holds in real economies.

The fiscal policy impacts both directly and indirectly on a number of monetary transmission channels, and thereby has implications for the implementations of monetary policy. The principal channels by which fiscal policy affects monetary policy are summarized below:-

-Domestic Demand - when households and businesses base their expenditure decision on short term or medium term time horizons (as opposed to very long term or cross-generational time horizons), then changes in government revenue and expenditure policies are likely to have direct effects on nominal domestic demand. This arises because, with short time horizons, household and business spending patterns are likely to be relatively closely related to current incomes and to current taxation liabilities. Therefore, when fiscal decisions reduce current disposable incomes, for example, households will tend to respond by reducing their spending to some degree.

Where economic agents have longer term or, at the extreme, lifetime or cross-generational time horizons, fiscal policy is likely to have less effect on domestic demand. In these circumstances, households and businesses may tend to discount transitory changes in fiscal policies, or changes that are viewed as potentially unsustainalbe over time. With long time horizons, households may anticipate corresponding, offsetting shifts in fiscal policy over future years. As current fiscal policies will thus be expected to have little effect on incomes and taxes over the longer time horizon relevant to the consumer in this case, fiscal policy is likely to exert significantly less influence on short term spending behaviour. - (Andrea Doughty, 1991)

Fiscal policy may also affect domestic demand indirectly via its influence on interest rates. Where policies to reduce a fiscal deficit, for example, are reflected in lower interest in lower interest rates than would otherwise have occurred, such interest rate effects are likely to have a positive influence on domestic confidence and activity.

Through both the direct and indirect channels, fiscal policy is likely to influence aggregate demand conditions within the economy. Demand conditions in turn tend to influence wage and price-setting behaviour and thus the stance of fiscal policy can affect inflation and inflationary expectations. The first round impact of fiscal consolidation, for example, is likely to reduce aggregate demand and through this channel ultimately to exert pressure on profit margins. Flow-on effects to the labour market may also act to dampen wage pressures.

Interest rate effects on demand, on the other hand, acts in the opposite direction to the direct fiscal influence. Thus the overall longer term impact of fiscal consolidation on domestic demand is ambiguous.

-Interest Rates - Movements in interest rates arising from changes to fiscal policy may have several aspects discussed below:-

The impact of fiscal policy on domestic demand may alter the demand for funds in the economy and thereby affect interest rates.

Longer term considerations related to the sustainability and overall stability of the fiscal/monetary policy mix- may lead to changes in the risk premium related to government policy built into interest rates. Fiscal policy sustainability in this context may be defined as the ability of government to continue to pursue a set of budgetary policies over the medium term without the need to increase taxes, decrease spending, have recourse to monetization of the deficit, or to structure or even repudiate debt. [14] 

Fiscal policies that are viewed as unsustainable over time may impact on expectations of future monetary policy, increasing the perceived likelihood that the situation will arise in the future where the growing cost of servicing a rising public debt forces or encourages the government monetize its deficits, than to fund them in financial markets. Thus unsustainable fiscal settings are likely to reduce the credibility of a government commitment to direct monetary policy towards price stability. In turn, this reduction in credibility will raise longer-term inflation expectations, and so increase the costs of pursuing an anti-inflationary monetary policy. - (Sargent, T. S. and Wallace, N. 1981)

-Capital market effects - related to government funding requirements may lead to changes in interest rates in response to changes in fiscal policy changes. An increase in the demand for funds by government may lead to a rise in domestic interest rates if domestic and foreign debts are not perfect substitutes. Such a rise in interest rates increases the cost of capital to firms, raising the rate of return required on potential new investment projects to break-even, and thus potentially 'crowd out' some private sector investment spending.

-Direct Inflation Effects - Changes in the settings of indirect tax rates, tariff levels, government user charges and other fiscal instruments can have a direct impact on measured inflation. Although technically a change in the price level, the experience of recent years suggests that adjustments to these administratively-determined 'prices' may have more than a transitory effect on inflation through their influence on inflation expectations.

Fiscal consolidation achieved via increases in government user charges and other indirect forms of taxation that are perceived to contribute to the inflation process may thus lead to a rise inflationary expectations. Via this route, fiscal consolidation may be transmitted into higher wages and interest rates. While the resultant change in nominal interest rates will affect domestic demand and, ultimately, through that channel, depress inflation, the rise in inflation expectation may put upward pressure on wages and potentially, on prices for final goods. However, the degree of upward impact on inflation, and thuis the implication for monetary policy,will depend on the degree of capacity utilisation and the stage of the business cycle.

Timing and Flexibility - Fiscal policy is political in nature and as such concerns about elections as well as long debates are often required. Fiscal policy is inflexible and incapable of the rapid-fire response that is often called for to keep aggregate demand growing smoothly. On the other hand, monetary policy effects are long and drawn out, but actions can be taken quickly.

Conclusion

While monetary and fiscal policies are both mutually desirable in managing the economy of any nation, they both have different time and a mix of economic conditions ideal for their applications. Discretionary fiscal policy might be better for deep recessions and monetary policy might be better for normal fluctuations. There are a couple of strands in the theoretical literature on the interaction between fiscal and monetary policy, which essentially assert that fiscal policy will eventually dominate in determining long-run monetary policy [15] . Both these strands, however, require that the fiscal authorities will either eventually require the monetary authorities to monetize the debt or convince the financial markets that, ultimately, the fiscal authority will have the upper hand.

These appear to be extreme assumptions because they depend on the view that fiscal authorities are unconcerned with any inflationary consequence of their actions and ignore the many legal and institutional separations that exist between fiscal and monetary authorities. Nonetheless, market concerns about the potential for fiscal dominance can potentially have significant effects in financial markets, particularly on longer term bond rates.

It is important to note that the supporting role that the credibility of monetary policy plays in this process.

Policy coordination and co-operation between fiscal and monetary policies are of paramount importance. Coordination came through the joint agreement on inflation targets. With clear agreement on the medium-term policy objectives and an understanding of the policy framework, there is no need for coordination on the setting of interest rates or fiscal policy instruments. The economic literature on policy coordination tends to be about situations where the fiscal and monetary authorities have one or more of the following :- very different view of economic welfare, inconsistent policy objectives, policy that is totally discretionary, or a tendency to get involved in game-like behaviour with one another.

Given the policy framework, when the government changes fiscal policy, it needs to think of how these changes will affect inflation and, consequently, interest rates. Similarly, the Bank needs to consider how changes in fiscal policy will affect demand and inflation, and thus its settling of interest rates. Therefore, it is to the mutual benefit of both parties to cooperate in the sharing of information and analysis as they set their policies.

For example, it is important for the Bank to recognize that government policies can affect the production potential of the economy through their effect on sustainable labour utilization rated and the level of productivity. The Bank needs to consider this information when making its policy decisions.

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Nature and Extent of Plagiarism (please highlight or underline plagiarised text):

What, if known, is the source of plagiarism? (e.g. peer plagiarism, single or multiple texts, websites)

What proportion of the submission is plagiarised?

%

Any other comments?

What mark should be awarded?

%

Name of 1st marker:

Date (dd/mm/yyyy)

PART 2 - TO BE COMPLETED BY SECOND MARKER

Comments (please indicate agreement or disagreement with the first markers assessment and recommended action):

Name of 2nd Marker

Date (dd/mm/yyyy)

PART 3 - TO BE COMPLETED BY DEPUTY HEAD OF SCHOOL

Recommendation (following, where appropriate, a student interview and consultation with the Director of Postgraduate Studies and the Director of Undergraduate Studies)

Resubmission Permitted?

Yes/No

Mark Awarded

%

Name of Deputy Head of School

Date (dd/mm/yyyy)

School of Management

Second Marker Feedback Form

Student Name:

Programme

Date of Enrolment

Module

Is resubmission automatically permitted?

Yes/No [16] 

Your assignment has been subject to a system of second marking. Unfortunately the markers have concluded that your assignment has not met a satisfactory standard.

You should follow the advice offered on the AGC form and consider the information below.

REASON(S) FOR THE FAIL GRADE

ACTION TO TAKE

You have not adequately answered the question set.

You need to check carefully that you have understood the question set. Please discuss your interpretation of the question with a Tutor on Blackboard and use the support materials on writing assignments found on Blackboard.

You have not adequately explained what you have done.

Please discuss the expectations of the assignment with the Tutor on Blackboard.

Your answer is too descriptive - it lacks sufficient analysis to address the question set.

Please refer to the support material on Blackboard. Please discuss your plans for the resubmission with a Tutor on Blackboard.

Your answer is too brief or exceeds the word limit set for this assignment.

Please keep to the word count stipulated in the assignment question. For advice on developing an essay please see your Programme Handbook and Blackboard.

You do not make sufficient use of the concepts and theories that are relevant to addressing the assignment question.

Please discuss any plans for a resubmission with a Tutor on Blackboard.

You have made use of literature/study materials without fully acknowledging the sources.*

Please read the guidance in your programme handbook on referencing. There is further information on how to avoid plagiarism on Blackboard.

You have simply reproduced the information contained in the module and other readings. You must use this material to answer the question in your own words.*

Please read the guidance in your programme handbook on referencing. There is further information on how to avoid plagiarism on Blackboard.

Your answer is too similar to that of another student.*

Please read the guidance in your programme handbook on referencing. There is further information on how to avoid plagiarism on Blackboard.

Other: Please specify:

Items marked with an * are serious academic offences and amount to plagiarism or cheating. Please see your Programme handbook about the regulations governing plagiarism.

Second Marker:

Date: