ECONOMICS ASSIGNMENT

MONETARY & FISCAL POLICY

PRESENTED BY:

DR. SHYAMSUNDER CHITTA

SUBMITTED BY:

ARUN KANADE

17021141050

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 INDEX

Sr. No. Content Pg. No.

Monetary Policy
1. Definition 3
2. Objectives 3
3. Types of Monetary Policy 5
4. History 6
5. Instruments Used 8
6. Key Indicators 10
Fiscal Policy
7. Definition 12
8. Objectives 12
9. Types of Fiscal Policy 15
10. History 16
11. Instruments Used 17
12. Advantages 19
13. Shortcomings 21
14. Recent Fiscal Policy Reforms 22

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 Monetary Policy

Definition:

Monetary policy is the process by which the monetary authority of a country, like the central
bank or currency board, controls the supply of money, often targeting an inflation rate or interest
rate to ensure price stability and general trust in the currency. Goals of a monetary policy are
usually to contribute to economic growth and stability, to lower unemployment, and to maintain
predictable exchange rates with other currencies.

Objectives:

Monetary Policy of India is formulated and executed by Reserve Bank of India to achieve
specific objectives. It refers to that policy by which central bank of the country controls

(i) the supply of money

(ii) (ii) cost of money or the rate of interest, with a view to achieve particular objectives.

Following are the main objectives of monetary policy:

i. To Regulate Money Supply in the Economy: Money supply includes both money in
circulation and credit creation by banks. Monetary policy is farmed to regulate the
money supply in the economy by credit expansion or credit contraction. By credit
expansion (giving more loans), the money supply can be expanded. By credit
contraction (giving less loans) money supply can be decreased.

Monetary policy aimed at expanding and contracting money supply according to the
needs of the economy.

ii. To Attain Price Stability: Another major objective of monetary policy in India is to
maintain price stability in the country. It implies Control over inflation. Price level, is
affected by money supply.

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iii. To promote Economic Growth: An important objective of monetary policy is to
make available necessary supply of money and credit for the economic growth of the
country. Those sectors which are quite significant for the economic growth are
provided with adequate availability of credit.
iv. To Promote saving and Investment: By regulating the rate of interest and checking
inflation, monetary policy promotes saving and investment. Higher rates of interest
promote saving and investment.

v. To Control Business Cycles: Boom and depression are the main phases of business
cycle. Monetary policy puts a check on boom and depression. In period of boom,
credit is contracted, so as to reduce money supply and thus check inflation. In period
of depression, credit is expanded, so as to increase money supply and thus promote
aggregate demand in the economy.

vi. To Promote Exports and Substitute Imports: By providing concessional loans to

export oriented and import substitution units, monetary policy encourages such
industries and thus help to improve the position of balance of payments.

vii. To Manage Aggregate Demand: Monetary authority tries to keep the aggregate
demand in balance with aggregate supply of goods and services. If aggregate demand
is to be increased than credit is expanded and the interest rate is lowered down.

viii. To Ensure more Credit for Priority Sector: Monetary policy aims at providing
more funds to priority sector by lowering interest rates for these sectors. Priority
sector includes agriculture, small- scale industry, weaker sections of society, etc.

ix. To Promote Employment: By providing concessional loans to productive sectors,

small and medium entrepreneurs and special loan schemes for unemployed youth,
monetary policy promotes employment.

x. To Develop Infrastructure: Monetary policy aims at developing infrastructure. It

provides concessional funds for developing infrastructure.

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 Types of Monetary Policy:

(i) Expansionary Monetary Policy: The expansionary monetary policy is adopted

when the economy is in a recession, and the unemployment is the problem. The
expansion policy is undertaken with an aim to increase the aggregate demand by
cutting the interest rates and increasing the supply of money in the economy. The
money supply can be increased by buying the government bonds, lowering the
interest rates and the reserve ratio.
(ii) Contractionary Monetary Policy: The Contractionary Monetary policy is applied
when the inflation is a problem and economy needs to be slow down by curtailing the
supply of money. The inflation is characterized by increased money supply and
increased consumer spending. Thus, the Contractionary policy is adopted with an aim
to decrease the money supply and the spendings in the economy. This is primarily
done by increasing the interest rates so that the borrowing becomes expensive.

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History

Monetary policy is associated with interest rates and availability of credit. Instruments of
monetary policy have included short-term interest rates and bank reserves through the monetary
base. For many centuries there were only two forms of monetary policy: (i) Decisions about
coinage (ii) Decisions to print paper money to create credit. Interest rates, while now thought of
as part of monetary authority, were not generally coordinated with the other forms of monetary
policy during this time. With the advent of larger trading networks came the ability to set the
price between gold and silver, and the price of the local currency to foreign currencies. Paper
money called "jiaozi" originated from promissory notes in 7th century China. Jiaozi did not
replace metallic currency, and were used alongside the copper coins. The successive Yuan
Dynasty was the first government to use paper currency as the predominant circulating medium.
With the creation of the Bank of England in 1694, which acquired the responsibility to print
notes and back them with gold, the idea of monetary policy as independent of executive action
began to be established. The goal of monetary policy was to maintain the value of the coinage,
print notes which would trade at par to specie, and prevent coins from leaving circulation. The
maintenance of a gold standard required almost monthly adjustments of interest rates. The gold
standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type
of commodity price level targeting. Nowadays this type of monetary policy is no longer used by
any country.

During the period 1870–1920, the industrialized nations set up central banking systems, with one
of the last being the Federal Reserve in 1913. By this point the role of the central bank as the
"lender of last resort" was understood. Monetary decisions today take into account a wider range
of factors, such as:

 Short-term interest rates;

 Long-term interest rates;
 Velocity of money through the economy;
 Exchange rates;
 Credit quality;
 Bonds and equities (corporate ownership and debt);

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 Government versus private sector spending/savings;
 International capital flows of money on large scales;
 Financial derivatives such as options, swaps, futures contracts, etc.

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Instruments Used

A. Quantitative Instruments: The Quantitative Instruments are also known as the General
Tools of monetary policy. These tools are related to the Quantity or Volume of the
money. They are designed to regulate or control the total volume of bank credit in the
economy. The general tool of credit control comprises of following instruments.

1. Bank Rate Policy: The Bank Rate Policy (BRP) is a very important technique
used in the monetary policy for influencing the volume or the quantity of the
credit in a country. The bank rate refers to rate at which the central bank (i.e RBI)
rediscounts bills and prepares of commercial banks or provides advance to
commercial banks against approved securities. If the RBI increases the bank rate
than it reduce the volume of commercial banks borrowing from the RBI. It deters
banks from further credit expansion as it becomes a more costly affair. Even with
increased bank rate the actual interest rates for a short term lending go up
checking the credit expansion. On the other hand, if the RBI reduces the bank
rate, borrowing for commercial banks will be easy and cheaper. This will boost
the credit creation. Thus any change in the bank rate is normally associated with
the resulting changes in the lending rate and in the market rate of interest.

2. Open Market Operation: The open market operation refers to the purchase
and/or sale of short term and long term securities by the RBI in the open market.
The OMO is used to wipe out shortage of money in the money market, to
influence the term and structure of the interest rate and to stabilize the market for
government securities, etc. Under OMO there is continuous buying and selling of
securities taking place leading to changes in the availability of credit in an
economy.

B. Variation in the Reserve Ratios: The Commercial Banks have to keep a certain
proportion of their total assets in the form of Cash Reserves. Some part of these cash
reserves are their total assets in the form of cash. Apart of these cash reserves are also to
be kept with the RBI for the purpose of maintaining liquidity and controlling credit in an

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 economy. These reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory
Liquidity Ratio (SLR). The CRR refers to some percentage of commercial bank's net
demand and time liabilities which commercial banks have to maintain with the central
bank and SLR refers to some percent of reserves to be maintained in the form of gold or
foreign securities. In India the CRR by law remains in between 3-15 percent while the
SLR remains in between 25-40 percent of bank reserves.

C. Qualitative Instruments: The Qualitative Instruments are also known as the Selective
Tools of monetary policy. These tools are not directed towards the quality of credit or the
use of the credit. They are used for discriminating between different uses of credit. This
method can have influence over the lender and borrower of the credit. The Selective
Tools of credit control comprises of following instruments.

1. Fixing Margin Requirements: The margin refers to the "proportion of the loan
amount which is not financed by the bank". A change in a margin implies a change in
the loan size. This method is used to encourage credit supply for the needy sector and
discourage it for other non-necessary sectors. This can be done by increasing margin
for the non-necessary sectors and by reducing it for other needy sectors

2. Consumer Credit Regulation: Under this method, consumer credit supply is

regulated through hire-purchase and installment sale of consumer goods. Under this
method the down payment, installment amount, loan duration, etc is fixed in advance.

3. Publicity: This is yet another method of selective credit control. Through it Central
Bank (RBI) publishes various reports stating what is good and what is bad in the
system. This published information can help commercial banks to direct credit supply
in the desired sectors.

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Key indicators of monetary policy

1. Open Market Operations: An open market operation is an instrument of monetary

policy which involves buying or selling of government securities from or to the
public and banks. The RBI sells government securities to contract the flow of credit
and buys government securities to increase credit flow.

2. Cash Reserve Ratio: Cash Reserve Ratio is a certain percentage of bank deposits
which banks are required to keep with RBI in the form of reserves or balances
.Higher the CRR with the RBI lower will be the liquidity in the system and vice-
versa.RBI is empowered to vary CRR between 15 percent and 3 percent.

3. Statutory Liquidity Ratio: Every financial institution has to maintain a certain

quantity of liquid assets with themselves at any point of time of their total time and
demand liabilities. These assets can be cash, precious metals, approved securities like
bonds etc.

4. Bank Rate Policy: Bank rate is the rate of interest charged by the RBI for providing
funds or loans to the banking system. Increase in Bank Rate increases the cost of
borrowing by commercial banks which results into the reduction in credit volume to
the banks and hence declines the supply of money. Increase in the bank rate is the
symbol of tightening of RBI monetary policy.

5. Credit Ceiling: In this operation RBI issues prior information or direction that loans
to the commercial banks will be given up to a certain limit. In this case commercial
bank will be tight in advancing loans to the public. They will allocate loans to limited
sectors.
6. Credit Authorization Scheme: Credit Authorization Scheme was introduced in
November, 1965 when P C Bhattacharya was the chairman of RBI. Under this
instrument of credit regulation RBI as per the guideline authorizes the banks to
advance loans to desired sectors.

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 7. Moral Suasion: Moral Suasion is just as a request by the RBI to the commercial
banks to take so and so action and measures in so and so trend of the economy. RBI
may request commercial banks not to give loans for unproductive purpose which does
not add to economic growth but increases inflation.
8. Repo Rate and Reverse Repo Rate: Repo rate is the rate at which RBI lends to
commercial banks generally against government securities. Reverse Repo rate is the
rate at which RBI borrows money from the commercial banks

Changes in Key Indicators in last 5 years

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 FISCAL POLICY

Definition:

The fiscal policy is concerned with the raising of government revenue and incurring of
government expenditure. To generate revenue and to incur expenditure, the government frames a
policy called budgetary policy or fiscal policy. So, the fiscal policy is concerned with
government expenditure and government revenue.

Objectives:

1. Development by Effective Mobilization of Recourses: The principal objective

of fiscal policy is to ensure rapid economic growth and development. This
objective of economic growth and development can be achieved by Mobilization
of Financial Resources.

The financial resources can be mobilized by:

a. Taxation: Through effective fiscal policies, the government aims to mobilize

resources by way of direct taxes as well as indirect taxes because most important
source of resource mobilization in India is taxation.

b. Public Savings: The resources can be mobilized through public savings by

reducing government expenditure and increasing surpluses of public sector
enterprises.

c. Private Savings: Through effective fiscal measures such as tax benefits, the
government can raise resources from private sector and households. Resources
can be mobilized through government borrowings by ways of treasury bills, issue
of government bonds, etc., loans from domestic and foreign parties and by deficit
financing.

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 2. Efficient allocation of Financial Resources: The central and state
governments have tried to make efficient allocation of financial resources. These
resources are allocated for Development Activities which includes expenditure on
railways, infrastructure, etc. While Non-development Activities includes
expenditure on defence, interest payments, subsidies, etc.

3. Reduction in inequalities of Income & Wealth: Fiscal policy aims at achieving

equity or social justice by reducing income inequalities among different sections
of the society. The direct taxes such as income tax are charged more on the rich
people as compared to lower income groups. Indirect taxes are also more in the
case of semi-luxury and luxury items, which are mostly consumed by the upper
middle class and the upper class.

4. Price Stability & Control of Inflation: One of the main objective of fiscal
policy is to control inflation and stabilize price. Therefore, the government always
aims to control the inflation by reducing fiscal deficits, introducing tax savings
schemes, Productive use of financial resources, etc.

5. Employment Generation: The government is making every possible effort to

increase employment in the country through effective fiscal measure. Investment
in infrastructure has resulted in direct and indirect employment. Lower taxes and
duties on small-scale industrial (SSI) units encourage more investment and
consequently generates more employment. Various rural employment
programmes have been undertaken by the Government of India to solve problems
in rural areas. Similarly, self-employment scheme is taken to provide employment
to technically qualified persons in the urban areas.

6. Balanced Regional Development: Another main objective of the fiscal policy is

to bring about a balanced regional development. There are various incentives
from the government for setting up projects in backward areas such as Cash
subsidy, Concession in taxes and duties in the form of tax holidays, Finance at
concessional interest rates, etc.

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7. Capital Formation: The objective of fiscal policy in India is also to increase the
rate of capital formation so as to accelerate the rate of economic growth. An
underdeveloped country is trapped in vicious (danger) circle of poverty mainly on
account of capital deficiency.

8. Increasing National Income: The fiscal policy aims to increase the national
income of a country. This is because fiscal policy facilitates the capital formation.
This results in economic growth, which in turn increases the GDP, per capita
income and national income of the country.

9. Development of Infrastructure: Government has placed emphasis on the

infrastructure development for the purpose of achieving economic growth. The
fiscal policy measure such as taxation generates revenue to the government.

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Types of Fiscal Policy:

There are two main types of fiscal policy: expansionary and contractionary.

1. Expansionary fiscal policy: Designed to stimulate the economy, is most often used
during a recession, times of high unemployment or other low periods of the business
cycle. It entails the government spending more money, lowering taxes, or both. The goal
is to put more money in the hands of consumers so they spend more and stimulate the
economy.

2. Contractionary fiscal policy: It is used to slow down economic growth, such as when
inflation is growing too rapidly. The opposite of expansionary fiscal policy,
contractionary fiscal policy raises taxes and cuts spending.

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History

The initial years of India’s planned development strategy were characterized by a conservative
fiscal policy whereby deficits were kept under control. The tax system was geared to transfer
resources from the private sector to fund the large public sector driven industrialization process
and also cover social welfare schemes.

In the 1980s some attempts were made to reform particular sectors. But the public debt increased,
as did the fiscal deficit. India’s balance of payments crisis of 1991 led to economic liberalization..
The fiscal deficit was brought under control. When the deficit and debt situation again threatened
to go out of control in the early 2000s, fiscal discipline legalizations were instituted. The deficit
was brought under control and by 2007-08 a benign macro-fiscal situation with high growth and
moderate inflation prevailed. During the global financial crisis fiscal policy responded with
counter-cyclical measures including tax cuts and increases in expenditures. In the future, the focus
would probably be on bringing in new tax reforms and better targeting of social expenditures.

Recent developments indicate that policymakers have come to accept strict budgetary constraints,
while attempting to maximize resources for developmental activities. The Planning Commission
abundantly reveals this in its preparatory reports for the 12th Five Year Plan (2012-17). The
approach paper to the plan while projecting the center’s fiscal resources assiduously envisages an
average fiscal deficit of 3.25 percent of GDP for the entire plan period with the fiscal deficit
projected to come down from 4.1 percent in 2012-13 to 3.5 percent in 2013-14.It is then expected
to remain at 3 percent of GDP for the next three financial years. The gross budgetary support for
the plan is kept realistic. It is projected to increase from 4.92 percent of GDP in 2011-12 to 5.75
percent by the end of the 12th Plan. Similarly, revenue targets are projected at conservative levels.
Net tax revenue for the center is expected to increase from 7.4 percent of GDP in 2011-12 to 8.91
percent in 2016-17.

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Instruments Used

Some of the major instruments of fiscal policy are as follows:

A. Budget: The budget of a nation is a useful instrument to assess the fluctuations in an

economy.
Different budgetary principles have been formulated by the economists, prominently
known as:
1. Annual Balanced Budget:
The classical economists propounded the principle of annually balanced budget. They defended
it with force till the deep rooted crisis of 1930’s.

2. Cyclically Balanced Budget:

The cyclical balanced budget is termed as the ‘Swedish budget’. Such a budget implies
budgetary surpluses in prosperous period and employing the surplus revenue receipts for the
retirement of public debt. During the period of recession, deficit budgets are prepared in such a
manner that the budget surpluses during the earlier period of inflation are balanced with deficits.

3. Fully Managed Compensatory Budget:

This policy implies a deliberate adjustment in taxes, expenditures, revenues and public
borrowings with the motto of achieving full employment without inflation. It assigns only a
secondary role to the budgetary balance. It lays down the emphasis on maintenance of full
employment and stability in the price level.

B. Taxation: Taxation is a powerful instrument of fiscal policy in the hands of public authorities
which greatly affect the changes in disposable income, consumption and investment. An anti-
depression tax policy increases disposable income of the individual, promotes consumption and
investment. Obviously, there will be more funds with the people for consumption and investment
purposes at the time of tax reduction.

C.Anti-Inflationary Tax Policy: An anti-inflationary tax policy, on the contrary, must be

directed to plug the inflationary gap. During inflation, fiscal authorities should not retain the

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existing tax structure but also evolve such measures (new taxes) to wipe off the excessive
purchasing power and consumer demand. To this end, expenditure tax and excise duty can be
raised.
D. Public Expenditure: The active participation of the government in economic activity has
brought public spending to the front line among the fiscal tools. The appropriate variation in
public expenditure can have more direct effect upon the level of economic activity than even
taxes. The increased public spending will have a multiple effect upon income, output and
employment exactly in the same way as increased investment has its effect on them.

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Advantages of Fiscal Policy of India:
The following are some of the important merits or advantages of fiscal policy of Government of
India:
1. Capital Formation: Fiscal policy of the country has been playing an important role in raising
the rate of capital formation in the country both in its public and private sectors. The gross
domestic capital formation as per cent of GDP in India has increased from 10.2 per cent in 1950-
51 to 22.9 per cent in 1980-81 and then to 24.8 per cent in 1997-98. Therefore, it has created a
favorable impact on the public and private sector investment of the country.
2. Mobilization of Resources: Fiscal policy of the country has been helping to mobilize
considerable amount of resources through taxation, public debt etc. for financing its various
developmental projects. The extent of internal resources mobilization for financing plan has
increased considerably from 70 per cent in 1965-66 to around 90 per cent in 1997-98.
3. Incentives to Savings: The fiscal policy of the country has been providing various incentives
to raise the savings rate both in household and corporate sector through various budgetary policy
changes, viz., tax exemption, tax concession etc. Accordingly, the saving rate has increased from
a mere 10.4 per cent in 1950-51 to 23.1 per cent in 1997-98.
4. Inducement to Private Sector: Private sector of the country has been getting necessary
inducement from the fiscal policy of the country to expand its activities. Tax concessions, tax
exemptions, subsidies etc. incorporated in the budgets have been providing adequate incentives
to the private sector units engaged in industry, infrastructure and export sector of the country.
5. Reduction of Inequality: Fiscal policy of the country has been making constant endeavor to
reduce the inequality in the distribution of income and wealth. Progressive taxes on income and
wealth tax exemption, subsidies, grant etc. are making a consolidated effort to reduce such
inequality. Moreover, the fiscal policy is also trying to reduce the regional disparities through its
various budgetary policies.
6. Export Promotion: The Fiscal policy of the government has been making constant endeavor
to promote export through its various budgetary policy in the form of concessions, subsidies etc.
As a result, the growth rate of export has increased from a mere 4.6 per cent in 1960-61 to 10.4
per cent in 1996-97.
7. Alleviation of Poverty and Unemployment: Another important merit of Indian fiscal policy
is that it is making constant effort to alleviate poverty and unemployment problem through its

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various poverty eradication and employment generation programmes, like, IRDP, JRY, PMRY,
SJSRY, EAS etc.

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Shortcomings of Fiscal Policy of India:
The following are the main shortcomings of the fiscal policy of the country:

1. Instability: Fiscal policy of the country has failed to attain stability on various fronts.
Growing volume of deficit financing has created the problem of inflationary rise in price level.
Disequilibrium in its balance of payments has also affected the external stability of the country.

2. Defective Tax Structure: Fiscal policy has also failed to provide a suitable tax structure for
the country. Tax structure has failed to raise the productivity of direct taxes and the country has
been relying much on indirect taxes. Therefore, the tax structure has become burdensome to the
poor.

3. Inflation: Fiscal policy of the country has failed to contain the inflationary rise in price level.
Increasing volume of public expenditure on non-developmental heads and deficit financing has
resulted in demand-pull inflation. Higher rate of indirect taxation has also resulted in cost-push
inflation. Moreover, the direct taxes has failed to check the growth of black money which is
again aggravating the inflationary spiral in the level of prices.

4. Negative Return of the Public Sector: The negative return on capital invested in the public
sector units has become a serious problem for the Government of India. In-spite of having a huge
total investment to the extent of Rs. 2,04,054 crore in 1998 on PSUs the return on investment has
remained mostly negative. In order to maintain those PSUs, the Government has to keep huge
amount of budgetary provisions, thereby creating a huge drainage of scarce resources of the
country.

5. Growing Inequality: Fiscal policy of the country has failed to contain the growing inequality
in the distribution of income and wealth throughout the country. Growing trend of tax evasion
has made the tax machinery ineffective for the purpose. Growing reliance on indirect taxes has
made the tax structure regressive.

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Recent Fiscal Policy Reforms:
In the meantime, the Government of India has introduced various fiscal policy reforms which
constitute the main basis of the stabilization policy of the country.
The following are some of the important measures of fiscal policy reforms adopted by the
Government of India in recent years:

1. Reduction of Rates of Direct Taxes: The peak rate of income tax was reduced to 30 per cent
in 1997-98 budget. This has resulted an increase in the share of direct taxes in total revenue of
the country from 19 per cent in 1990-91 to around 30 per cent in 1996-97.
2. Simplification of Tax Procedure: In recent years as per the recommendation of Raja
Chelliah or Taxation Reform Committee, several steps have been taken to simplify the tax
procedure in the successive budgets. The 2003-04 budget introduced filing of return through e-
mail.
3. Reforms in Indirect Taxes: These include introduction of ad-velorem rates, MODVAT
scheme etc.
4. Fall in the Volume of Government Expenditure: Several measures were undertaken
recently by the government. Accordingly, total expenditure of the government under various
heads has been reduced. As a result, total public expenditure as per cent of GDP has declined
from 19.7 per cent of GDP in 1990-91 to 16.4 per cent in 1996-97.
5. Reduction in the Volume of Subsidies: Central Government has been making huge payments
in the form of subsidies, i.e., food subsidies, fertilizer subsidies, export subsidies etc. Steps have
been taken to reduce these subsidies phase-wise.
6. Reduction in Fiscal Deficit: The Central Government has been trying seriously to contain the
fiscal deficit in its annual budget. Accordingly, it has reduced the extent of fiscal deficit from 7.7
per cent of GDP in 1990-91 to 5.1 per cent in 1998-99. But fiscal stabilization necessitates
containing the fiscal deficit at least to 3 per cent of GDP.
7. Reduction in Public Debt: Recently, the Central Government has been trying to reduce the
burden of public debt. Accordingly, the external debt as per cent of GDP which was 5.4 per cent
in 1990-91 gradually declined to 3.2 per cent in 1998-99 (BE). The internal debt as per cent of
GDP has declined from 48.6 per cent in 1990-91 to 49.8 per cent in 1998-99. Similarly, the total

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outstanding loan or liabilities as per cent of GDP has also declined from 54.0 per cent to 49.1 per
cent during the same period.
8. Disinvestment in Public Sector: Another important fiscal policy reforms introduced by the
Government of India is to disinvest the shares of the public sector enterprises. The government
has disinvested as part of its stake in 39 selected PSUs since the disinvestment process began in
1992. Till 2002-03, it has raised around Rs. 29,440 crore through disinvestment of share of
PSUs. In the meantime, the government has constituted a Disinvestment Commission to advise it
on how to go about disinvesting the shares of PSUs. A separate Ministry of Disinvestment has
also been formed.

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