Fiscal and Monetary Policies

Lesson 1: Monetary Policy

Concept and Objectives:

Monetary policy refers to the process by which a nation's central bank (like the Reserve Bank of India)

controls the money supply, interest rates, and availability of credit in the economy. The main macroeconomic

goals are to ensure price stability (control inflation), achieve full employment, promote economic growth, and

stabilize the currency.

Active vs. Passive Monetary Policy:

- Active monetary policy is based on discretionary changes where the central bank adjusts interest rates and

liquidity conditions based on real-time economic indicators. This approach is flexible and can address

economic shocks, like a sudden recession or inflation spike. However, it carries the risk of misjudgment or

time lags in policy effects.

- Passive monetary policy follows set rules or guidelines with limited flexibility. It is based on maintaining

long-term stability and predictability. Examples include monetary growth targeting or fixed interest rate

policies. This method enhances credibility but may not react well to unforeseen economic developments.

Rule-based vs. Discretionary Policy:

- Rule-based policy involves systematic guidelines. The Taylor Rule, for example, sets the interest rate based

on inflation and output gaps, reducing political influence and increasing transparency.

- Discretionary policy allows central banks to act as needed, especially during economic crises. However, it

risks inconsistency and may be influenced by political cycles or short-term goals.

Time Inconsistency Problem:

This refers to the tendency of policymakers to deviate from planned policies due to short-term pressures,
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undermining long-term credibility. For instance, promising low inflation but later printing more money to

stimulate the economy. Solutions include:

- Inflation Targeting: A transparent goal (e.g., 4% inflation) to anchor expectations.

- Forward Guidance: Communicating future policy intentions to shape market behavior.

Policy Tools:

1. Repo Rate: Rate at which RBI lends to commercial banks; lowering it makes borrowing cheaper.

2. Reverse Repo Rate: Rate at which RBI borrows from banks; used to absorb liquidity.

3. Liquidity Adjustment Facility (LAF): Framework for short-term liquidity management.

4. Marginal Standing Facility (MSF): Overnight borrowing for banks beyond LAF.

5. Bank Rate: Long-term lending rate by RBI; less commonly used.

6. Cash Reserve Ratio (CRR): Percentage of deposits banks must keep with RBI.

7. Statutory Liquidity Ratio (SLR): Percentage of deposits in government-approved securities.

8. Open Market Operations (OMO): Buying/selling government bonds to manage liquidity.

9. Market Stabilization Scheme (MSS): Special bonds to absorb excess liquidity.

Money Market Equilibrium and LM Curve:

Equilibrium occurs when the demand for real money balances (dependent on income and interest rate)

equals supply (controlled by central bank). The LM (Liquidity-Money) curve slopes upward because higher

income increases money demand, raising interest rates if money supply is fixed.

Lesson 2: IS-PC-MR Model

Purpose:

The IS-PC-MR framework is a modern macroeconomic model that incorporates:

- IS Curve: Goods market equilibrium (Investment = Saving)

- PC (Phillips Curve): Inflation dynamics from labor markets

- MR (Monetary Rule): Central bank behavior

IS Curve:

Shows inverse relationship between interest rate and output. When interest rates fall, investment increases,

boosting aggregate demand. Determinants include:

- Consumption: Based on disposable income and interest rates.

- Investment: Inversely related to interest rates.

- Government Spending: Fiscal stimulus.

- Net Exports: Affected by exchange rates and global demand.

Phillips Curve (PC):

Represents short-run trade-off between inflation and unemployment. When output/employment is high,

inflation rises due to wage pressures. The curve can shift due to:

- Expectations of inflation.

- Supply shocks (e.g., oil prices).

- Labor market policies.

MR Curve (Monetary Rule):

Derived from central bank's objective to minimize a loss function comprising deviations in inflation and output

from targets. The curve shows combinations where monetary policy maintains optimal trade-off. A typical MR

curve is downward sloping because to reduce inflation, the central bank must slow output.

Application:
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Central banks adjust interest rates (monetary policy) in response to:

- Inflation Shocks: Supply-side disturbances like oil shocks shift the PC upward. The central bank may raise

interest rates, reducing demand and inflation.

- Demand Shocks: Fiscal or private sector demand changes shift IS. The central bank moderates output

fluctuations via interest rate adjustments.

Temporary vs. Permanent Demand Shocks:

- Temporary shocks cause short-run deviations. IS returns to original level, requiring short-term monetary

response.

- Permanent shocks shift IS permanently, needing new equilibrium through sustained monetary policy (e.g.,

permanent tax cuts).

Lesson 3: Fiscal Policy and Government Debt

Definition:

Fiscal policy involves government decisions on taxation, spending, and borrowing to influence the economy.

It plays a key role in macroeconomic stabilization, income redistribution, and public investment.

Objectives:

- Stabilize economic cycles by managing demand.

- Promote inclusive growth and employment.

- Support infrastructure and development.

- Ensure fair income distribution through progressive taxes and subsidies.

Types of Fiscal Policy:

1. Discretionary Fiscal Policy:

- Active changes in government spending or taxes.

- Example: Increased infrastructure spending during a recession.

2. Non-Discretionary (Automatic Stabilizers):

- Built-in mechanisms that counteract economic fluctuations.

- Example: Progressive income taxes and unemployment benefits.

Government Budget Constraint:

Governments must finance their spending through:

- Tax Revenue.

- Borrowing (via bonds and securities).

- Printing money (less common due to inflation risks).

Crowding Out Effect:

Occurs when government borrowing increases interest rates, reducing private sector investment. Particularly

relevant in full-employment economies. It can dampen the effectiveness of fiscal expansion.

Government Debt:

Governments issue debt instruments such as:

- Treasury Bills (short-term), Government Bonds (long-term), State Development Loans (SDLs),

Inflation-Indexed Bonds, Zero Coupon Bonds, and Foreign Currency Bonds.

Implications and Management of Public Debt:

- High debt burdens future taxpayers and limits fiscal room.

- Can destabilize investor confidence and raise borrowing costs.

- Strategies include debt restructuring, extending maturities, fiscal rules (like FRBM in India), and maintaining

a sustainable debt-to-GDP ratio.

Ricardian Equivalence:

A theoretical proposition that consumers are forward-looking and save more when the government borrows,

expecting future tax hikes. Therefore, fiscal deficits have no net effect on aggregate demand. Criticized for

assuming rational behavior, perfect foresight, and capital markets.