MONETARY POLICY

&
FISCAL POLICY
 What is Monetary Policy
• Monetary policy stands between monetary theory and
monetary practice
• A policy employing the central bank’s control of the supply of
money as an instrument for achieving the objectives of general
economic policy
• Since the common objectives of economic policy are
– Attainment of full employment, price stability, balance of payments
equilibrium and rapid economic growth
• Monetary policy would be concerned with these objectives with
certain given priorities fixed by the monetary authorities and
the government of the country
• Effectiveness of monetary policy depends upon the degree to
which it succeeds in achieving these objectives.
 Monetary Policy - Objectives
• To control the supply of money as an
instrument of achieving the objectives of
general economic policy
• Strives at minimizing the disadvantage of
increasing money supply and to maximizing
the benefits of resulting from the existence
and operation of the monetary system
 Monetary Policy – Objectives cont.
• Regime of Price Stability:
• Stable prices are preferred to avoid the evil affects of inflation
or deflation.
• Stable prices generally ensure a stable rate of exchange.
• If a country wants to avoid too much inflation in prices, it may
design its monetary policy in such a manner that the prices
remain almost stable
• It means supply of money is maintained in the economic
system in a manner which just meets the needs of the system
• It is not so easy to accomplish because monetary policy does
not depend solely on the Central Bank alone
• There are commercial banks and a vast unorganized money
market which also have a great influence on the economic
system
 Monetary Policy – Objectives cont.
• Regime of Gradual rise in Prices:
• Stable prices are considered desirable from a purely
distribution angle,.
• Rising prices, although at a lower rate, may be found
desirable from point of view of production
• A mild increase in prices stimulates investment
employment and output.
• If the basic aim of the economy is to improve the
level of investment, employment and output,
monetary policy would be geared towards this end
• This would allow supply of money to increase in such
a manner that prices rise in a gradual manner
 Monetary Policy – Objectives cont.
• Regime of fall in Prices:
• If an economy is suffering from a very high rate of inflation, the monetary
policy of the government will aim at tightening the economy by putting a
strong restraint on the supply of money.
• It will pursue a dear money policy so as to control inflation in the
economy.
• The only snag in pursuing such a policy is that it might ultimately lead to
slowing down of employment and may thus sow the seeds of depression
• Attainment of full employment:
• By maintaining the rate of savings and investment at a level which would
ensure full employment. This is dependent on the behavior of banking
system, as a whole and in general on economic climate which could inspire
investment
• Economic Growth: By encouraging investment in productive
activities and discouraging it in less useful activities. All the policies
monetary, fiscal and economic are to be pursued in an integrated manner
to achieve common goal of rapid economic development.
 Monetary Control Measures
• Central Bank uses two types of measures;
– Quantitative or general measures
– Qualitative or selective measures
• Quantitative measures: (To change total volume of credit in the economy)
• Bank Rate Policy: Bank rate is the rate at which the Central Bank
discounts the bills of commercial banks. When Central bank wishes to
control credit and inflation in the economy, it raises the Bank Rate.
Increased bank rate increases the cost of borrowings of the commercial
banks who in turn charge a higher rate of interest. This means the price of
credit will increase. This in turn will lead to a cumulative downward
movement in the economy.
• On the other hand, if the Central Bank wishes to boost production and
investment activities in the economy, it will decrease the Bank Rate.
Decreasing the Bank Rate will have a reserve effect.
 Monetary Control Measures (Quantitative)
• Open Market Operations: This implies deliberate
direct sales and purchases of securities and bills in
the market by the Central Bank on its own initiative
to control the volume of credit.
• When Central Bank sells securities in the open
market, other things being equal, the cash reserves
of the commercial banks decrease to the extent that
they purchase these securities.
• The credit-creating base of commercial banks is
reduced and hence credit contracts.
• Open market purchases of securities by the Central
Bank lead to an expansion of credit.
 Monetary Control Measures (Quantitative)
• Variable Reserve Requirements: Central Bank uses
the method of variable reserve requirements to
control credit. These are two types of reserves which
commercial banks are generally required to maintain
– Cash Reserve Ratio: Refers to that portion of total deposits
which a commercial bank has to keep with the Central
Bank in the form of cash reserves
– Statutory Liquidity Ratio: Refers to that portion of total
deposits which a commercial bank has to keep with itself
in the form of liquid assets.
• By changing these ratios, Central Bank controls credit in the economy
 Monetary Control Measures (Qualitative)
• Qualitative – regulating credit for specific purposes
• Securing loan regulation by fixation of margin
requirements
• Consumer Credit regulation
• Issue of Directives (oral or written statements,
appeals or warnings)
• Rationing of Credit
• Moral Sausion (Persuasion and request made by
Central Bank)
• Direct Action (action against erring commercial
banks)
 FISCAL POLICY
• Fiscal policy is an important instrument to stabilize the
economy – to overcome recession and control inflation in the
economy
• Fiscal policy of two types
– Discretionary – Deliberate change in the Govt expenditure
and taxes to influence the level of national output and
prices
– Non-discretionary – Automatic stabilizer with built in tax
or expenditure mechanism that automatically increases
aggregate demand when recession and reduces aggregate
demand when there is inflation without deliberate govt
actions.
FISCAL METHODS to cure RECESSION
• Two methods to get the economy out of
recession:
– Increase in Govt. Expenditure
– Reduction Taxes
 Recession – Increase in Govt Exp
• Govt can increase expenditure by starting public works, like
building roads, dams, ports, telecommuniction links, irrigation
works, electrification of new areas etc
• Direct effect: Increase in incomes of those who sell materials
and supply for these projects.
• Indirect effect: In the form of multiplier effect. Those who get
more incomes spend them further on consumer goods and
the relative mpc impact. (Keynes recognized this effect)
• Demand for money increases, which may raise interest rates.
This should not happen if recession has to be controlled.
Therefore, money supply need to be increased to contain the
interest rates.
 Recession – Reduction of Taxes
• Reduction in taxes increases the disposable
income of society and consumption picks up
• For example, a reduction of Rs.200 crores in
taxes will lead to Rs.150 crores in
consumption, assuming mpc = 0.75 or ¾
• The multiplier effect as seen for increase in
Govt expenditure will not be there in case of
reduction taxes.
 Budget Deficit
Budget deficit (G – R)
Total Revenue and Capital Expenditure
Revenue Receipts and Non-debt capital receipts
Market Borrowing and Foreign Assistance
Monetisation of Deficit
 GOVT DEBT
• Govt borrowing is anti-inflationary measure
• Govt borrowing has two forms:
– Market loans
– Small savings
• Borrowing is the quickest form of raising funds
 DEFICIT FINANCING

• Refers to created money