MONETARY POLICY

INTRODUCTION:
Monetary policy involves the regulation of the money supply and of interest rates
by a central bank. Monetary Policy is the policy of RBI (under guidance of Central
Govt.) which regulates flow of money in the market. This has a direct bearing on
inflation, as by reducing the money flow, inflation can be controlled. Monetary
policy is one the two ways the government can impact the economy. Monetary
Policy involves changes in the base rate of interest to influence the rate of growth
of aggregate demand, the money supply and ultimately price inflation.
Monetarist economists believe that monetary policy is a more powerful weapon
than fiscal policy in controlling inflation. Monetary policy also involves changes in
the value of the exchange rate since fluctuations in the currency also impact on
macroeconomic activity (incomes, output and prices) Changes in short term
interest rates affect the spending and savings behaviour of households and
businesses over time and therefore feed through the circular flow of income and
spending. The transmission mechanism of monetary policy works with variable
time lags depending on the interest elasticity of demand for different goods and
services – e.g. the demand for interest-sensitive consumer goods and services
bought on credit or the demand for capital investment from private sector
businesses. Because of the time lags involved in setting an appropriate level of
short-term interest rates, the Bank of England sets nominal interest rates on the
basis of hitting the inflation target over a two year forecasting horizon. In the
United States, monetary policy is determined by the Federal Reserve Board. The
goals of the Federal Reserve Board (the Fed) are to encourage economic growth,
control inflation, reduce unemployment to acceptable levels and stabilize the
exchange rate between the U.S. dollar and foreign currencies in the foreign
exchange marketplace.
In a modern welfare state, macroeconomic policy (monetary policy) has come to
play a vital role as a policy instruments. It aims at brining about the desired
changes in income and employment in the economy. In order to attain the objective
of maintaining price stability, providing full employment, rapid economic growth,
maintaining exchange rates, the government adopts suitable macroeconomic
policies. Monetary policy in an underdeveloped country is regarded as an
important instruments for stimulating the process of economic development by
ensuring sufficient credit policy, controlling inflation and maintaining the
equilibrium of the balance of payment. I also provide essential credit supply to
meet the requirements of industry, trade and population in a rapidly growing
economy.

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MEANING:
Monetary policy is defined as the policy of regulating money supply according to
the requirement of the money. It is the policy of monetary authority or the central
bank of the country to influence the availability, cost and use of money and credit
through the monetary techniques to attain specific objectives. Monetary Policy is
the policy of RBI (under guidance of Central Govt.) which regulates flow of
money in the market. This has a direct bearing on inflation, as by reducing the
money flow, inflation can be controlled.

DEFINITIONS:
According to G.K. Shaw, “By monetary policy we mean a conscious action
undertaken by the monetary authority to change the quality, availability or cost
“rate of interest of money”.
Monetary policy is thus the policy of the central bank regarding the availability of
money and cost of money to achieve the various macro economic objectives such
as stabilization, and economic growth.

INSTRUMENTS OF MONETRAY POLICY:

The instruments of monetary policy are the tools with the help of which the
monetary authority achieves the objective of monetary policy. These instruments
are used to affect the money supplier the credit creation or credit contraction at the
level of commercial banks.
By credit creation we mean the power of commercials banks to increase derivative
or secondary deposit on the basis of primary deposits either through the process of
making loans or investment in securities. The central controls credit with the help
of the following instruments of monetary policy. The different instruments of
monetary policy:
A. Quantitative or General Instruments: With the help these instruments
the amount of credit money is controlled. It includes the following three
instruments.

1. Bank rate policy: The bank rate is the minimum lending rate of the central
bank at which it rediscounts first class bills of exchange and government
securities held by the commercial banks. When the central bank finds that
inflationary pressures have started emerging within the economy, it raises
the bank rate. Borrowing from the central bank becomes costly and
commercial banks borrow less from it. The commercial bank, in turn, raises

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 their landing rates to the business community and borrowers borrow less
from the commercial banks. There is contraction of credit and prices are
checked from rising further. On the contrary, when prices are depressed, the
central bank lowers the bank rate. It is cheap to borrow from the central bank
on the part of commercial banks. The latter also lower their lending rates.
Businessmen are encouraged to borrow more. Investment is encouraged.
Output, employment, income and demand start rising and the downward
movement of prices is checked.

2. Open market operations: Open market operations refer to sale and

purchase of securities in the money market by the central bank. When prices
are rising and there is need to control them, the central bank sells securities.
The reserves of commercial banks are reduced and they are not in a position
to lend more to the business community. Further investment is discouraged
and the rise in price is checked. On the other hand, when recessionary forces
start in the economy, the central bank buys securities. The reserves of
commercial banks are raised. They lend more investment, output,
employment, income and demand rise, and fall in price is checked.

3. Changing the Reserve Ratios: The weapon was suggested by Keynes in

his treatise on money and the USA was the first to adopt it is a monetary
device. Every bank is required by law to keep a certain percentage of its total
deposits in the form of a reserves fund in its vaults and also a certain
percentage with the central bank when prices are rising, the central bank
raises the reserve ratio. Banks are required to keep more with the central
bank their reserves are reduced and they lend less. The volume of
investment, output and employment are adversely affected. In the opposite
case, when the remove ratio is lowered the reserves of commercial banks are
raised they lend more and the economic activity is favorably affected.

B. Qualitative or selective instrument: Qualitative or selective instrument

are used to influence a specific types of credit for particular purposes. These
tools are as under:
4. Moral persuasion or advice: The central bank gives advice to other
bank, on moral grounds, about the credit control and therefore the objectives
and needs of the money supply and by pollutions and analysis the statistics
about the economic situation of country, the central bank tells than about he
dangerous consequences of the credit expansion so that it may seek the
cooperation of the commercial bank in coping with the situation of economic

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 emergency. The central bank gives advice no only to central credit but also
the objective of the credit

5. Rationing of credit: The maximum limit of taking loans from the central
bank is increase for those commercial bank which co-operate with the
central bank in controlling the credit and the central bank loans to such bank
at a higher bank rate. In this way, during emergency, with the help of central
bank the liquidity of these banks falls in danger. So these bank are
compelled to control the expansion of the credit .this methods of credit
control became very popular after the world war-1.this methods of rationing
has been very much in use Russia and Germany and his used know-a-days
by almost all the country.

6. Direct action: When some commercial banks do not cooperate whit the
central bank in controlling the credit then the central bank has to take some
direct action against such banks. The direct action can be in so many forms.
Sometimes the central bank refuses to give loans or discounting the bills of
exchange of the commercials banks and sometimes the central bank starts
imposing some extra fines other than the rates of discounting (or bank rate)
on the commercial banks. Due to this the reputation of the commercial banks
and also their business are affected badly in the market.

7. Changes in the margin requirement: The banks give loan by

mortgaging some stock with them. This loan is not equal to the stock
mortgaged but is less than that. The central banks gives order as to how
much should be the margin requirements i.e., what percentage of the total
stock mortgaged should be given in the form of the loans. Higher margin
requirement means the loan should be much less than the value of the stock.
When the credit id to be controlled the central bank decrease the amount of
loans gives against the securities or it increase the margin requirements. This
method can be successful used in controlling the loans taken for the purpose
of hording for speculation.

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OBJECTIVES OF MONETARY POLICY:
Following are the principal objectives of monetary policy:
1. Price stability: one of the policy objectives of monetary policy is to stabilize
the price level. Both economic and laymen favour this policy because fluctuations
in price bring uncertainty and instability to the economic. Rising and falling prices
are both bad because they bring unnecessary loss to some and undue advantage to
others. Again, they are associated with business cycle. So a policy of price stability
keeps the value of money stable, eliminates cyclical fluctuations, brings economic
stability, helps in reducing inequalities of income and wealth, secures social justice
and promotes welfare.
Price stability can be maintained by following a counter cyclical monetary policy
i.e. liberal or cheap monetary policy during recession or deflation and dear or tight
monetary policy during boom or inflation.

2. External Economic Stability: External economic stability means exchange

rate stability. The exchange rate stability is needed for three reasons:
a) With instability in exchange rate the people lose their confidence in the home
currency.
b) The foreign investment gets discouraged with instability in exchange rate.
c) The exports are badly affected due to unstable exchange rate.
The monetary policy helps in stabilizing the exchange rate in the following ways:
i. For external economic stability i.e. for stability in the exchange rate the
internal economic stability is much needed. We have studied in detail in
already that how monetary policy helps in maintaining internal stability
of the country.
ii. The balance of payments must be kept favourable for exchange rate
stability. For this purpose the qualitative instruments of monetary policy
are quite help full.

3. Full employment: with the publication of Keynes ‘general theory of

employment’ Interest and money (1936)’full employment become the ideal goal of
monetary policy. Keynes emphasized the role of monetary policy in promoting full
employment of human and natural resources in the country. He advocated cheap
money policy, i.e. expansion of currency and credit and reduction in rate of
interest, to achieve the goal of full employment. Full employments of labour and
full utilization of other productive resources are important from the point of view
of maximizing economic welfare in the country.
Monetary policy can help the economy to achieve full employment. According to
Keynes, unemployment is mainly due to deficiency of investment and the level full

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employment can be achieved by increasing investment and making it equal to the
saving a he full employment level.
The main task of monetary policy is to expend money supply and reduce rate of
interest to that optimum level which raises the investment demand and equates it
with full employment saving.
The monetary policy aiming at increasing investment and ultimately achieving full
employment is commonly called cheap money policy. Cheap money policy
stimulates investment by expanding money supply reducing the interest rate.

4. Monetary policy for economic development: Economic development is the

major objective of monetary policy in the underdeveloped countries. After
Second World War many Asian, African and Latin American countries got
political independence and India was also one of them. At that time all these
countries were very poor and were facing many economic problems. The question
was how the per capita income of these countries could be increased and how the
different economic problems could be solved. This is known as the problem of
economic development. Monetary policy is quite helpful in achieving this
objective of economic development.
i. With monetary policy the price-rise can be checked and due to which the
savings and investment get encouraged in the country.
ii. Under the monetary policy, the central bank of the country expends financial
institutions in the country which help in mobilization of savings.
iii. Monetary policy helps in stabilizing the exchange rate of the country due to
which the domestic and foreign investment increases.
iv. With the help of different instrument of monetary policy, appropriate rate of
interest can be maintained in the country due to which the investment in the
economy could be increased.

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LIMITATIONS OF MONETARY POLICY:
The monetary policy deals with the problem of determining the optimal
quantity of money or the optimal rate of growth of the money stock. Monetary
policy infact, faces several problems which reduce its scope and effectiveness.
Numerous limitations of monetary policy are discussed as bellow:

1. Conflicting goals: It is difficult to define money stock because the ultimate

goals or objectives of monetary policy may be in conflict. For example, the
central bank reduces the growth rate of money supply to stablilise the price
level. But this lower rate of growth of money supply may increase
unemployment rate and reduce the rate of economic growth. Similarly, a
faster rate of growth of the money supply may reduce unemployment and
increase the rate of economic growth, but on the other hand, may create
disequilibrium in the balance of payment or generate intolerably high rate
of inflation.

2. Limitations during deflation: It is argued b many economists that

monetary policy has a little scope during deflation. It fails to pull the
economy out of the depths depression. It id argued that during deflation,
marginal efficiency o capital is very low because of falling prices. Investors
are completely discouraged, pessimistic and nervous. Through the various
monetary policy techniques, commercial banks may be encouraged to
create more and more credit for promoting investment in the economy. But
this will be successful only if the investors come forward for taking loans
from commercial banks for he purpose of investment. Investors cannot be
compelled to take loans and make investment. It is said, “You can take a
horse to the water but you cannot make it drink.”
As a result, the various instruments of help of cheap money policy fail to
pick up investment in the economy and do not prove much useful for
controlling inflation.

3. Limitations during inflation: During inflation marginal efficiency of

capital is very high and because of rise in prices, income output and
employment. Investors are highly optimistic. Rise in the rate of interest
through various monetary instruments fail to check the new investment.
However, the effectiveness of monetary policy during inflation is much
greater than during deflation. It is because of the following reasons:
a) It is easier to raise interest rates than to lower them.
b) Rate of interest can be raised as high as monetary authorities wish
but reverse is not possible, because of liquidity trap.
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 c) Open market operations, changes in cash reserve ratio, changes in
margin requirements are more effective to check inflation than to
check depression.

4. Lags in monetary policy: The effectiveness of monetary policy in

achieving is objectives depends upon time lag between the need for taking
action and recognition of the need for taking action and between the need
for taking action and the actual action taken. The firs lag i.e., time lag
between the need for taking action and recognition of the need for taking
action, is called as recognition lag. Recognition lag implies the time to
recognize that the economy has changed in such a way as is require change
in the existing policy. The second lag, i.e., lag between the need for taking
action and actual action taken, is called as action lag. Action lag means
that once the need for change in policy is recognized, sometimes elapses
before suitable change in policy is made. The sum total of recognition
lag and action lag is called as inside lag.
The effects of changes in monetary policy are not instantaneous. Changes
in policy require some time to work and effect the economic system. This
time lag between the actual action taken and effects of action taken is called
as outside lag.

5. Change in the velocity of money: The various instruments of monetary

policy prove effective only if velocity of money remains constant. Any
change in velocity of money makes them ineffective in achieving the
objectives of stabilization.
During deflation, the various attempts of he central bank to increase money
supply in the economy fail to make much effect on the level of prices and
output, if with increase in money supply, the various of money falls.
Similarly, during inflation, the various efforts of the central bank to check
money supply in the economy fail to make much effect on prices if with
check on money supply the velocity of money increase. What is important
is no merely ‘M’ but ‘M.V.’, where ‘M’ stands for money supply and ‘V’
stands for velocity of money.

6. Near-money assets: Some assets like treasury bills, bonds, shares, gold
ect. Are not money exactly, but these are as liquid as money since these can
be easily converted into money. These asses are called as near money
assets. The central bank of the country has little control over these assets. It
limits the scope of monetary policy in achieving is various objectives.

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7. Non-banking financial institutions: Besides banks, in any economy there
are man other financial institutions like; post offices, private finance
companies, insurance companies, trusts etc. central banks of he country has
limited control over these non banking financial institutions. These
financial institutions have grown very rapidly in the post war years. Some o
these non-banking financial institutions have grown so big that these can
affect money supply in an economy. It limits the applicability of monetary
policy.

8. Attitude of banks: The success of monetary policy also depends upon

attitude of commercial banks. During inflation, central bank of the country
may be interests in controlling credit in the economy, but the commercial
banks may not follow this policy because their objectives are to earn
profits. During deflation central banks may be interested in increasing
credit in the economy but, the commercial banks may hesitate credit
creation because of low rate of interest.

9. Limitations in under-development countries: In under development

and developing countries, the monetary policy has limited applicability. It
is because of the following reasons:
a) These countries have unorganized money market.
b) These countries have large non-monetised sector.
c) In these countries, there is a huge amount of black money which is
beyond the control of central bank.
d) These countries have less developed banking sector.
e) People are illiterate and do not have banking habits.
f) People prefer non-banking financial institutions and private money
lenders.

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SOME MONETARY POLICY TERMS:
1. Bank Rate: Bank rate is the minimum rate at which the central bank
provides loans to the commercial banks. It is also called the discount rate.
This is the rate at which RBI lends money to other banks (or financial
institutions.
The bank rate signals the central bank’s long-term outlook on interest rates.
If the bank rate moves up, long-term interest rates also tend to move up, and
vice-versa.
Banks make a profit by borrowing at a lower rate and lending the same
funds at a higher rate of interest. If the RBI hikes the bank rate (this is
currently 6 per cent), the interest that a bank pays for borrowing money
(banks borrow money either from each other or from the RBI) increases. It,
in turn, hikes its own lending rates to ensure it continues to make a profit.
Usually, an increase in bank rate results in commercial banks increasing
their lending rates. Changes in bank rate affect credit creation by banks
through altering the cost of credit.

1. Cash Reserve Ratio: All commercial banks are required to keep a certain
amount of its deposits in cash with RBI. This percentage is called the cash
reserve ratio. Cash Reserve Ratio is a bank regulation that sets the minimum
reserves each bank must hold to customer deposits and notes. These reserves
are designed to satisfy withdrawal demands, and would normally be in the
form of fiat currency stored in a bank vault (vault cash), or with a central
bank.
The reserve ratio is sometimes used as a tool in monetary policy, influencing
the country’s economy, borrowing, and interest rates. Western central banks
rarely alter the reserve requirements because it would cause immediate
liquidity problems for banks with low excess reserves; they prefer to use
open market operations to implement their monetary policy. The People’s
Bank of China does use changes in reserve requirements as an inflation-
fighting tool, and raised the reserve requirement nine times in 2007. As of
2006 the required reserve ratio in the United States was 10% on transaction
deposits (component of money supply “M1″), and zero on time deposits and
all other deposits. An institution that holds reserves in excess of the required
amount is said to hold excess reserves. Cash reserve Ratio (CRR) in India is
the amount of funds that the banks have to keep with RBI. If RBI decides to
increase the percent of this, the available amount with the banks comes
down. RBI is using this method (increase of CRR rate), to drain out the
excessive money from the banks. The current CRR requirement is 8 per
cent.
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2. Inflation: Inflation refers to a persistent rise in prices. Simply put, it is a
situation of too much money and too few goods. Thus, due to scarcity of
goods and the presence of many buyers, the prices are pushed up.
The converse of inflation, that is, deflation, is the persistent falling of prices.
RBI can reduce the supply of money or increase interest rates to reduce
inflation.

3. Money Supply (M3): This refers to the total volume of money circulating
in the economy, and conventionally comprises currency with the public and
demand deposits (current account + savings account) with the public.
The RBI has adopted four concepts of measuring money supply. The first
one is M1, which equals the sum of currency with the public, demand
deposits with the public and other deposits with the public. Simply put M1
includes all coins and notes in circulation, and personal current accounts.
The second, M2, is a measure of money, supply, including M1, plus
personal deposit accounts - plus government deposits and deposits in
currencies other than rupee.
The third concept M3 or the broad money concept, as it is also known, is
quite popular. M3 includes net time deposits (fixed deposits), savings
deposits with post office saving banks and all the components of M1.

4. Statutory Liquidity Ratio: Banks in India are required to maintain 25 per

cent of their demand and time liabilities in government securities and certain
approved securities.
These are collectively known as SLR securities. Besides the CRR, banks are
required to invest a portion of their deposits in government securities as a
part of their statutory liquidity ratio (SLR) requirements. What SLR does is
again restrict the bank’s leverage in pumping more money into the economy.
The buying and selling of these securities laid the foundations of the 1992
Harshad Mehta scam.

5. Repo: Repo rate is the rate at which banks borrow funds from the RBI to
meet the gap between the demand they are facing for money (loans) and how
much they have on hand to lend. If the RBI wants to make it more expensive
for the banks to borrow money, it increases the repo rate; similarly, if it
wants to make it cheaper for banks to borrow money, it reduces the repo rate
A repurchase agreement or ready forward deal is a secured short-term
(usually 15 days) loan by one bank to another against government securities.

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 Legally, the borrower sells the securities to the lending bank for cash, with
the stipulation that at the end of the borrowing term, it will buy back the
securities at a slightly higher price, the difference in price representing the
interest.

6. Open Market Operations: An important instrument of credit control, the

Reserve Bank of India purchases and sells securities in open market
operations.
In times of inflation, RBI sells securities to mop up the excess money in the
market. Similarly, to increase the supply of money, RBI purchases securities

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 FISCALPOLICY

INTRODUCTION:
Fiscal policy relates to public expenditure, taxation dept and state’s budget and
finance. This policy is being used in both developed and under-developed nations
to realize different objectives. Mainly, in developed countries, it relates to the
achievement of economic stability and in under-developed countries it concerns
with the acceleration of rate of economic development.
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

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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.

DEFINITION:
According to prof. Musgrave, “Fiscal policy is concerned with those aspects of
economic policy which arise in the operation of the public budget.”
Thus, Fiscal policy is the policy of any government regarding its expenditure,
taxation, borrowing and budget to achieve the various macro-economic objectives.

INSTRUMENS OF FISCAL POLICY:

Following are the main instruments of fiscal policy:
1. Public expenditure: Public expenditure means expenditure incurred by
government. It generates sufficient influence on aggregate demand and
development activities of country .this expenditure can be two types :
a) Expenditure incurred by the government to get goods and services. It
directly influence aggregate demand.
b) Public expenditure incurred on passions, scholarships, educational and
medical facilities to people etc. this expenditure is known as transfer
payment. It also raises aggregate demand.

2. Taxation: Modern states are welfare-oriented states and they have to use
money to achieve this end. Tax is the main source to acquire money.
Aggregate demand can also be influenced by taxes. Government collects
money by imposing different taxes to finance public expenditure and to
manage various development activities. Mainly .taxes can be classified
into two groups –1.direct taxes and 2.indirect taxes. Direct taxes reduce
the income of the people and a part of their income goes into the
government treasury. On the other hand, Indirect taxes lead to rise in
price of goods. Both direct and indirect taxes lead to the reduction in
aggregate demand.

3. Public dept: The third instrument of fiscal policy is public dept.public

dept means dept taken by the government from people or from the
government of others countries. The government has to take the help of
public dept if public expenditure exceeds public revenue. Public dept is
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 arranged from two sources-1.internal and 2.external sources. It means
that dept can be two types, first, internal dept, which the government
acquires from the people within the country and second external or
foreign dept. public dept affects aggregate demand in many ways. If
private expenditure does not fall with public dept, there cannot be fall in
demand of private sector, the government can spend the money collected
with the help of public dept and can increase aggregate demand. On the
other hand, if demand of private sector falls due to public dept than
nothing can be said about the influence of public dept on demand.

4. Deficit financing: A heavy public expenditure has to be incurred for the

economic development. This amount can be collected only through the
public dept, taxation etc .So deficit financing has to be introduced.
Deficit financing means to finance the deficit in the government budget.
When there emerges a deficit due to excess of public expenditure over
public revenue. this deficit is met with either by borrowing from the
central bank or by issuing new notes. Deficit financing can be used to
meet government expenditure. It increases aggregate demand. Deficit
financing is being used wildly, but excess of it can lead to the emergence
of rise in price.

OBJECTIVES OF FISCAL POLICY:

Different economists have given different objectives of fiscal policy. The main
objectives of fiscal policy are as follows:
1) Economic stabilization: The foremost objective of the fiscal policy is to
maintain the stability in the economy by elimating the cyclical fluctuations.
Compensatory fiscal actions check the up-and –down swings in the business to
counteract fluctuations. Strict steps are taken to control both inflation and
deflation by suitable budgetary action over the period of cycle.

2) Economic growth: The second important objective to fiscal policy id to

maintain a continuous upward trend in economic activity. Total outlay is
increase in depression but is not allowed to decrease correspondingly in boom
through fiscal measures.

3) Optimum allocation of economic resources: It means that the fiscal policy

should be so framed as to increase the efficiency of productive resources like

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 man, money, materials etc. It also means that the government should spend on
those public works which give the maximum employment and are the
beneficial of society.

4) Equitable distribution of income and wealth: Fiscal policy should be so

designed as to bring about an equality of incomes between different groups by
transferring wealth from rich to poor. It means that the differences in payments
to the factors of production should be reduced to the minimum.
5) Break the vicious circle of poverty: Another objective of fiscal policy is to
break the vicious circle of poverty so that rapid development of both
agriculture and industry can become possible.

6) Provide full employment: Full employment means the availability of job for
everyone who is fit to work and wants a job at the prevailing wage rates. Fiscal
policy is considered as an effective instrument for reducing unemployment and
securing full employment.

7) Acceleration of rate of capital formation: One more objective of fiscal

policy is to maximize the rate of saving, investment and capitals formation, to
break down economic stagnation and thus to lead the country to the path of
rapid economic progress.

8) To restrict monopolies and check the concentration of economic power in

fewer hands only.

9) To establish balance in foreign trade.

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

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 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 < T) occurs when net government
spending is reduced either through higher taxation revenue or reduced
government spending or a combination of the two. This would lead to a
lower budget deficit or a larger 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.

LIMITATIONS OF FISCAL POLICY:

1) Limitation during deflation: It cannot be defined that fiscal policy is more
defective than monetary policy in controlling deflation. But, it suffers from several
limitations during deflation which are as follow:
1) It is feared that government investment may replace private investment and
may fail to raise the level of total investment in the economy.
2) Reduction in tax rates may fail to induce new replace private investment
because of vary low M.E.C.
3) Reduction in tax rate may fail to boost consumption; because of continuous
fall in prices people may go on postponing consumption.
4) Public borrowing may cause dept trap for the government.
5) Continuous financing may cause inflation in the economy which is equally a
dangerous problem.
6) Unproductive spending may prove harmful in the long-run.

2) Limitation during inflation: Critics have many doubts regarding the

effectiveness of fiscal policy during inflation. Fiscal policy has following
limitations in inflation:
i. It may be difficult to reduce Government expenditure because it will affect
public welfare.
ii. People may resist new taxes and hike rates because they are already
suffering because of rising prices.
iii. Various measures to encourage savings may prove futile; because of
continuous rise in prices, people may prefer consumption to savings.
iv. It ma be difficult to stop the going government projects.
v. It is very difficult to adjust government expenditure immediately and
effectively according to changing economic conditions.
vi. Control of demand may put economy into depression which is equally a
serious economic problem.
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3) Limitations in U.D.Cs: In under-development countries, fiscal policy suffers
from several limitations for achieving the objective of rapid economic
development.
i. Government taxation effects only small segments of the people
ii. Adequate statistics are not available.
iii. People are illiterate.
iv. Large part of economy is non-monetised and is not affected b fiscal
measures.
v. Taxation system is not flexible and cannot be changed quickly.
vi. There is a large scale corruption and tax evasion.
vii. There is a large scale black-marketing operations.

4) Lack of adequate forecasting: For the success of fiscal policy, it is a must

that deflation and inflation are properly forecasted. In reality it is very difficult. It
limits the scope of fiscal policy.

5) Size of fiscal measures and their timings: The effectiveness of fiscal policy
depends upon the proper size and time of fiscal measures. A change in national
income depends upon a change in public revenue or expenditure. How much public
expenditure and how much public revenue will be there, are the questions, difficult
to predict by the fiscal apparatus. It is also difficult to know proper timing of fiscal
measures.

6) Change in the balance of payments: another limitation o fiscal policy is a

change in balance of payments. The influence of increase in government
expenditure becomes insignificant if imports increase and exports decrease with it.
It means, exports reduce income and it reduces the expansionary influence of
public expenditure. Similarly, if people spend a part of this income an import in
place of home produced goods, there is a fall in the multiplier effect of public
expenditure.

7) Nature of People’s Efforts: the effectiveness of fiscal policy depends upon

people’s efforts. There can be an increase in national income according to
expectations only if changes in public expenditure and taxes do not adversely
affect the will to work of the people. But the increasing income of the people
adopted to check inflationary pressures becomes effectless when people work and
thus earn more than before to meet the loss due to imposition of taxes on them.

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8) Burden of public dept: Among fiscal measures, public dept is one measure.
Government takes public dept to reduce unemployment and bad effects of
depression. There are many problems regarding public dept. It returning and its
interest is a big problem. Consequently, there emerges dept burden on government.

9) Problem relating to deficit financing: deficit financing is an instrument of

fiscal policy adopted by various governments in various nations to be accelerate
the rate of economic development. Dr. V.K.R.V. Rao is of the view that deficit
financing can be used upto a limit for the development of a country. After this
limit, it influence the economic the adversely.

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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.

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How is the Monetary Policy different from the Fiscal Policy?
Two important tools of macroeconomic policy are Monetary Policy and Fiscal
Policy.
The Monetary Policy regulates the supply of money and the cost and availability of
credit in the economy. It deals with both the lending and borrowing rates of interest
for commercial banks.
The Monetary Policy aims to maintain price stability, full employment and
economic growth.
The Reserve Bank of India is responsible for formulating and implementing
Monetary Policy. It can increase or decrease the supply of currency as well as
interest rate, carry out open market operations, control credit and vary the reserve
requirements.
The Monetary Policy is different from Fiscal Policy as the former brings about a
change in the economy by changing money supply and interest rate, whereas fiscal
policy is a broader tool with the government.
The Fiscal Policy can be used to overcome recession and control inflation. It may
be defined as a deliberate change in government revenue and expenditure to
influence the level of national output and prices.
For instance, at the time of recession the government can increase expenditures or
cut taxes in order to generate demand.
On the other hand, the government can reduce its expenditures or raise taxes
during inflationary times. Fiscal policy aims at changing aggregate demand by
suitable changes in government spending and taxes.
The annual Union Budget showcases the government's Fiscal Policy.

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