Macroeconomic Implications of China\'s Fiscal

Macroeconomic Implications of China's Fiscal Policy

The China Central Bank's new policy will reduce commercial bank reserves, thereby reducing their ability to lend and ultimately reducing the supply of money in the economy.

Theoretically, a bank which holds deposits and uses those deposits to lend out money should always keep enough money in reserve to cover all of its liabilities as a borrower, the total amount of money that has been deposited with the bank that is subject to withdrawal at any time. Naturally, the bank should hold a 100% ratio of reserves to liabilities to ensure that it can cover all of its liabilities in the event that they become due at the same time.

However, most commercial banks know that, in normal times, it is very unlikely that all of the people with money deposited at a bank will withdraw their money at the same time. Thus, they often keep only a fraction of their deposits in reserve, which frees up money for the bank to lend out. This practice is called fractional-reserve-banking.

Despite the instability that fractional-reserve banking creates, most governments now allow commercial banks to keep fractional reserves because it creates more money in the economy. More money in the economy increases liquidity, which promotes increased economic exchange. Some central banks will even loan money to fractional-reserve banks when they are in danger of defaulting. In return, many central banks will require commercial banks to hold a certain fraction of its total deposits with the central bank.

Ordering commercial banks to hold more deposits with the central bank increases the commercial bank's reserves relative to its total deposits. It will also increase interest income earned by commercial bank's on deposits to the central bank. However, it reduces the commercial bank's free capital, the amount of money it has on hand to lend out.

Increased deposits with the central bank will increase the total liabilities of the bank, as it must be able to return the deposits to the commercial banks should any of those banks require it. Increased deposits will also increase the amount of interest that the central bank must pay to the commercial banks.

Gross Domestic Product is the most important measure of a nation's economic performance. GDP is the measure of the nation's total expenditures, the amount spent by households in the market for goods and services. It is also the measure of the nation's total income, all of the wages, rent, and profit paid by firms in the market.

GDP is composed of four different types of spending. There is consumption, investment, government purchases, and net exports. Net exports is calculated by the amount of exports minus the amount of imports.

Because the capacity of banks to lend money is diminished, it will be harder for firms to borrow the money required for business ventures, which reduces the total amount of investment. The decrease in investment could affect have an effect on consumption levels because it leads to less wages to workers, less rent paid to landlords, and less profits to business-owners. This will also have an effect on net exports, as it will reduce firms' ability to import foreign machinery and reduce consumers' ability to buy foreign goods for consumption, thereby reducing the value of imports, which will result in an increase in net exports.

Macroeconomic equilibrium is when aggregate demand, quantity of goods and services that households, firms, and the government want to buy, is equal to aggregate supply, the quantity of goods and services that firms produce. The reduction in the money supply will cause aggregate demand to fall. However, aggregate supply always responds, eventually, to demand so aggregate supply will fall as well, until there is a state of equilibrium again.

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Increasing the amount of deposits that commercial banks must hold with the central bank will diminish the money multiplier, which is the amount of money a bank can create with each dollar of reserves. The money multiplier is determined by the reserve ratio. The higher the reserve ratio, the less money the bank will have to lend out, diminishing the money multiplier. Requiring the commercial banks to increase deposits will increase the reserve ratio by.5%, thereby diminishing the money multiplier by .5.

The spending multiplier, which is the measure of additional spending in the economy generated as a result of the initial spending, will be reduced because of the reduction in consumption caused by less wages, rent, and profits paid by firms. The investment multiplier, the measure of additional investment in the economy generated as a result of the initial investment, will be reduced because of the reduction in investment caused by less lending to firms for business ventures.

The Marginal Propensity to Save, the increase in the desire to save as a result of increased income, will decrease as a result of China's policy because it will slow inflation, making money more valuable in consumption than in saving. A lower MPS increases the money multiplier effect by putting a larger portion of each created dollar back into the economy instead of sitting in a bank account. The Marginal Propensity to Consume, the increase in the desire to consume as a result of increased income, will increase as a result of China's policy for the same reasons that MPS decreased.

The Average Propensity to Consume, the actual proportion of income which is spent on consumption, would typically increase as money becomes more valuable in consumption but may not increase here because the base for the money multiplier has been reduced by the government policy. The Average Propensity to Save, the actual proportion of income which is saved, would typically decrease as money becomes more valuable but may increase her as a result of higher interest rates.