Monetary & Fiscal Policy

Economic Stabilization • Economic stabilization is a major target of all govt. • Modern Economies perform a variety of functions to

ensure high level of socio economic welfare • Development of various sectors of economy,

improving std of living, maintaining high level of employment & income etc. are prime objectives of modern govt

• Stabilizing economy at high level of output & employment is most important concern of govt & is known as Economic Stabilization

• Macro Economic Policy guides govt in attaining economic stability

Economic Stabilization • Objectives of macro economic policy – Attain full employment & ensure high level of

output – Maintain Price Stability – Accelerating rate of economic growth

• Instruments of Macro Economic Policy – Monetary Policy – Fiscal Policy

Monetary Policy • It is concerned with money supply, credit creation in the

market & rate of interest • Formulated & implemented by Central Bank i.e. RBI • By controlling money supply & credit creation, stability

can be ensured in an economy • At present, combination of monetary & fiscal policy is

used to achieve objectives of macro economic policy • The objectives differ from country to country & from time

to time• It depends upon the stage of development & economic

situation in the economy during a particular time

Objectives of Monetary Policy• Monetary Policy & Economic Growth – High N.I. – Capital Formation should be high –

providing capital to investors at the right time at reasonable rates – During Inflation Dear Money Policy – Deflation Cheap Money Policy

• Monetary Policy & Price Stability – Controlling fluctuations in price – should take care

that growth is not affected

Objectives of Monetary Policy• Monetary Policy & Full Employment – Productive resources are fully employed – high level

of output & income – increase in std of living

• Monetary Policy & Exchange Rate Stability – Till 1970’s it was emphasized by monetary policy –

considered imp for int trade & control movement of capital - at present it is secondary & many nations prefer flexible exchange rate so that adjustments can be made as per requirements

Instruments of Monetary Policy

• Quantitative Instruments – Also known as General Credit Control – Helps to control the quantity of credit

• Qualitative Instruments – Controls the direction of credit

Quantitative Instruments

• Bank Rate – Rate @ which central bank discounts the

securities of commercial banks – It influences the cost of credit – During inflation central bank increases the

bank rate thereby, making credit costlier & during deflation it is decreased

Quantitative Instruments

• Open Market Operations – Refers to buying & selling of govt securities by central

bank – During inflation there is too much money in the market,

bank will sell securities to commercial banks thereby reducing their cash reserves & reducing their credit formation

– During De4flation it buys securities from commercial banks to increase their cash reserve & thereby increasing their credit creation capacity

Quantitative Instruments• Cash Reserve Ration (CRR) – Commercial banks have to keep a % of their deposits with

central bank to ensure liquidity & solvency of the bank – During Inflation, the CRR is increased to reduce their capital &

during deflation it is reduced

• Statutory Liquidity Ratio (SLR)– Refers to ratio of liquid assets to net demand liabilities and time

liabilities– Time liabilities are liabilities which the banks are liable to pay

after a certain period of time. E.g. A 1 year fixed deposit– Demand liabilities are liabilities which the banks are liable to pay

on being demanded by the customer. E.g. A savings account

Quantitative Instruments

• Repo Rate – Refers to repurchase option – securities are sold by the seller to

the investor with an agreement to repurchase at a predetermined rate & date i.e. Rate at which central bank gives loans to commercial banks against their securities

– During inflation, repo rate is increased & deflation it is reduced

• Reverse Repo – Rate at which central bank borrows from commercial banks – Repo helps to inject liquidity into the market, reverse repo helps

to absorb it from market

Qualitative Instruments• Also known as selective credit control • Used to control the flow of credit to

particular sector of economy i.e. the direction is controlled

• It is used as complementary to quantitative credit control technique to discourage flow of credit to unproductive sectors

Qualitative Instruments• During inflation, central bank takes below

steps – Increase Bank Rate – Sell Securities – Increase Cash Reserve Ratio – Rises the margin requirements – Control credit for unproductive purpose or

sectors

Fiscal Policy • Fiscal policy is formulated & implemented to

achieve pre-determined objectives • It is concerned with Public Revenue,

Expenditure & Debt • Govt can influence production, distribution,

consumption & resource allocation through it • Through Fiscal Policy economic growth &

development can be accelerated

Fiscal Policy - Objectives• Optimum Utilization of Resources • Increase demand & thereby achieve full

employment & maintain it • Ensure Price Stability • Equality in distribution of income &

wealth

Instruments of Fiscal Policy• Taxation – Govt imposes direct & indirect taxes – It is levied on the principle to pay i.e. rich people pay

more tax than the poor people – Through taxation, govt can influence production,

consumption, distribution & allocation of resources – Tax incentives are given to produce mass consumption

goods, certain prod have low tax rates where as harmful products have high taxes

– Various regions have various tax rates

Instruments of Fiscal Policy• Public Expenditure – Govt incurs various types of expenditures viz admin expenses,

defence, development of agriculture, transport, communication, subsidy, interest payment etc.

– It needs to be productive in nature to have +ve effect on economy – E.g. Spending on education, health, social security like old age

pension, unemployment allowances, provide subsidy to essential products etc.

– It can reduce inequality in distribution of income etc. – If it is unproductive then economy will have adverse effect like

inflation, shortage of products, inappropriate allocation of resources etc.

– Effect of public expenditure depends upon the way it is incurred

Instruments of Fiscal Policy• Public Debt – When the expenditure of govt exceeds its revenue it can resort

to public debt – It can also be helpful to finance a war or meet unexpected

expenditure like natural calamity etc.– Useful to control inflation – Funds borrowed should be utilized for productive purposes like

development of infrastructure, industrial sector, etc. So that these debts can become self financing i.e. the projects start yielding money & can repay for themselves

– Thus economic growth can be accelerated through public debt

Instruments of Fiscal Policy• Deficit Financing – Used when govt expanses are higher than its

income – Refers to borrowing of funds from central bank– Securities are issued by govt against which

currency notes are provided by central bank – Deficit financing leads to more money supply

leading to increase in demand for goods & services – if no proper supply it will lead to inflation

Fiscal Policy During Inflation & Deflation

• To control inflation generally govt adopts a surplus budget policy • It either increases the taxes or govt expenditure if reduced or both are

implemented at same time • Policy adopted is called as contractionary fiscal policy • Taxation is used by govt to control price rise i.e. rich people are taxed

more than poor people • Govt can increase direct tax like income tax or wealth tax thereby

reducing their disposable income leading to less demand of goods & services & hence price can be stabilized

• Public expenditure can also be used to control inflation i.e. by reducing unproductive expenses like war, admin expenses etc.

• It is not easy to reduce expenses but govt should make an effort to do so.

Questions 1. Explain Economic Stabilization and

objectives of Macro Economic Policy 2. Explain Monetary Policy & its

objectives 3. Throw light on Instruments of

Monetary Policy 4. Discuss Fiscal Policy and its

instruments