Monetary and Fiscal Policy(Final)

8/22/2019 Monetary and Fiscal Policy(Final)

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What is monetary policy Monetary policy is atool used by the central bank to managemoney supply in the economy in order toachieve a desirable growth . The central bankcontrols the money supply by increasing anddecreasing the cost of money, the rate ofinterest.


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In a Narrow Sense: Monetary Policy meansmonetary matters and decisions of a countrywhich aim at controlling the volume ofmoney, influencing the level of interest rates,

public spending, use of money and credit etc.

In Broader Sense: It includes all thosemonetary and non monetary measures and

decisions which influence the cost and supplyof money.


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This policy statement, traditionallyannounced twice a year, through which theReserve Bank of India seeks to ensure pricestability for the economy.These factors include - money supply,

interest rates and the inflation. In bankingand economic terms money supply is referredto as M3 - which indicates the level (stock) oflegal currency in the economy.

Besides, the RBI also announces norms forthe banking and financial sector and theinstitutions which are governed by it.


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1. Expansionary - Under an expansionarypolicy, policy makers increase the moneysupply in the system by lowering interestrates. This is done mainly to boost economic

growth and decrease level of unemployment.


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2. Contractionary -In contractionary policy,the cost of money is made dearer byincreasing the rate of interest, which in turnhelps in reducing the money supply in the

system and combat inflation. Thus, whileexpansionary policy is followed to boost theeconomic growth, a contractionary policy isadopted to deal with an overheated economysituation.


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Economic growth -increase capital formation Exchange stability -stability of balance of

payment Full employment -increase production

Price stability - to eradicate inflation anddeflation.

Credit control -increase and decrease interestrates

Reduction in economic inequalities -distribution of income and wealth.


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1. Bank Rate of Interest 2. Cash Reserve Ratio

3. Statutory Liquidity Ratio

4. Open market Operations 5. Margin Requirements

6. Deficit Financing

7. Issue of New Currency


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Bank Rate of Interest It is the interest ratewhich is fixed by the RBI to control thelending capacity of Commercial banks .During Inflation , RBI increases the bank rate

of interest due to which borrowing power ofcommercial banks reduces which therebyreduces the supply of money or credit in theeconomy .When Money supply Reduces itreduces the purchasing power and therebycurtailing Consumption and lowering Prices.


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Cash Reserve Ratio CRR, or cash reserve ratio,refers to a portion of deposits (as cash) whichbanks have to keep/maintain with the RBI.During Inflation RBI increases the CRR due to

which commercial banks have to keep agreater portion of their deposits with the RBI .This serves two purposes. It ensures that aportion of bank deposits is totally risk-freeand secondly it enables that RBI controlliquidity in the system, and thereby, inflation.


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Statutory Liquidity Ratio Banks are required tokeep a given proportion of its deposits ascash with itself.it is called liquidity ratio

Banks are required to invest a portion of theirdeposits in government securities as a part oftheir statutory liquidity ratio (SLR)requirements . If SLR increases the lendingcapacity of commercial banks decreasesthereby regulating the supply of money in theeconomy.


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It refers to the buying and selling of Govt.securities in the open market . Duringinflation RBI sells securities in the openmarket which leads to transfer of money to

RBI.Thus money supply is controlled in theeconomy.


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During Inflation RBI fixes a high rate ofmargin on the securities kept by the publicfor loans .If the margin increases thecommercial banks will give less amount of

credit on the securities kept by the publicthereby controlling inflation.


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Deficit Financing It means printing of newcurrency notes by Reserve Bank of India .Ifmore new notes are printed it will increasethe supply of money thereby increasing

demand and prices. Thus during Inflation, RBIwill stop printing new currency notes therebycontrolling inflation.


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During Inflation the RBI will issue newcurrency notes replacing many old notes.

This will reduce the supply of money in theeconomy.


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A) Instruments B) IntermediateVariables or

operating targets(Because they come inbetween targets and

instruments)

C) Objectives of

MonetaryPolicy

i) Quantitative

instruments

CRR, SLR, OMO Bank Rate

Repos and Reverse

Repos

ii) Qualitative

instruments

Margin requirements

Consumer credit

regulation

Rationing of creditiii) Moral Suasion

Quantity of money,

Interest rates

Investments,

Bank credit,

Exchange rate etc.

Indicative variables (a

sub-set of intermediate

variables):

Forex reserves,

Stock indices, etc.

Price stability

Growth,

Exchange rate

stability

Financial stability,

Full employment etc.


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Fiscal policy is used by the governments toinfluence the level of aggregate demand inthe economy, in an effort to achieveeconomic objectives of price stability, full

employment and economic growth.


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Fiscal policy is thedeliberatemanipulation ofgovernment

purchases, transferpayments, taxes, andborrowing in order toinfluencemacroeconomicvariables such as

employment, the pricelevel, and the level ofGDP


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Net taxes are taxes paid by firms andhouseholds to the government minus transferpayments made to households by thegovernment.

Disposable, or after-tax, income (Yd ) equalstotal income minus taxes.

Y Y Td


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Adding Net Taxes (T) and Government

Purchases (G) to the Circular Flow of Income

When government enters the picture, theaggregate income identity gets cut intothree pieces:

Y Y Td

Y C Sd

Y T C S

Y C S T And aggregate expenditure (AE) equals:

AE C I G


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A governments budget deficit is thedifference between what it spends (G) andwhat it collects in taxes (T) in a given

period:Budget def G Ticit

IfG exceeds T, the government must

borrow from the public to finance thedeficit. It does so by selling Treasury

bonds and bills. In this case, a part of

household saving (S) goes to the

government.


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Removal of unemployment -increases govt.expenditure and reduces taxes.

Maintenance of economic development-increase the rate of capital formation

Maintenance of price stability- reduceaggregate demand by reducing expenditureand increasing direct and indirect taxes.

Reduction in economic inequality- moretaxes on rich


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1. Govt. Expenditure policy

2. Taxation policy

3. Deficit financing 4.Rationing

5. Public Debt policy

6. Pump priming-increase in investment of

private sector through govt.


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1. Increase in Imports of Raw materials2. Decrease in Exports

3. Increase in Productivity

4.

Provision of Subsidies


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1.Decrease in public expenditure

2. Increase in public debts

3. Increases in taxes 4. Surplus budget policy-expenditure is less

than its revenue


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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 ratesof interest for commercial banks. The Monetary Policyaims to maintain price stability, full employment andeconomic growth. The Monetary Policy is differentfrom Fiscal Policy as the former brings about achange in the economy by changing money supplyand interest rate, whereas fiscal policy is a broadertool with the government. The Fiscal Policy can be

used to overcome recession and control inflation. Itmay be defined as a deliberate change in governmentrevenue and expenditure to influence the level ofnational output and prices.

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Monetary and Fiscal Policy(Final)

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