ECONOMICS ASSIGNMENT

MONETARY POLICY
FISCAL POLICY

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MONETARY POLICY

Monetary policy is the macroeconomic policy laid down by the central bank.

Its aimed at managing the quantity of money in order to meet the

requirements of different sectors of the economy and to increase the pace of

economic growth or in other words, it is how the central banks manage the

liquidity to create economic growth.

Liquidity here refers to the money supply in the country. Money supply is the

entire stock of currency and other liquid instruments circulating in a country's

economy as of a particular time. It includes cash, checks and money

market mutual funds, loans, bonds and mortgages.

In India monetary policy is maintained by the RBI.

Broadly, there are two types of monetary policy:

o Expansionary monetary policy

o Contractionary monetary policy

Expansionary monetary policy increases the money supply in order to lower

unemployment, boost private-sector borrowing and consumer spending,

and stimulate economic growth.

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Contractionary monetary policy slows the rate of growth in the money supply

or outright decreases the money supply in order to control inflation; while

sometimes necessary, contractionary monetary policy can slow economic

growth, increase unemployment and depress borrowing and spending by

consumers and businesses.

OBJECTIVES OF MONETARY POLICY

o To Regulate Money Supply in the Economy

Money supply includes both money in circulation and credit creation by

banks. The main aim of the monetary policy of the Reserve Bank was to

control the money supply in such a manner as to expand it to meet the needs

of economic growth and at the same time contract it to curb inflation. In other

words monetary policy aimed at expanding and contracting money supply

according to the needs of the economy.

o To Attain Price Stability:

Another major objective of monetary policy is to maintain price stability in the

country, i.e. Control over inflation. Price level, is affected by money supply.

Monetary policy regulates money supply to maintain price stability.

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 o To promote Economic Growth:

The policies make sure that adequate cash and credit is available whenever

necessary for the economic growth of the country.

o 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.

o To Control Business Cycles:

Business cycle consists of phases of boom and depression. Monetary policies

controls the phases to keep the economy stable. 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.

o 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.

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 o 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

then the money supply is expanded and the interest rate is lowered down.

Because of low interest rate, more people take loan to buy goods and services

and hence aggregate demand increases and vice-verse.

o To Promote Employment:

By providing concessional loans to productive sectors, small and medium

entrepreneurs, special loan schemes for unemployed youth, monetary policy

promotes employment.

o To Regulate and Expand Banking:

RBI regulates the banking system of the economy. RBI has expanded banking

to all parts of the country. Through monetary policy, RBI issues directives to

different banks for setting up rural branches for promoting agricultural credit.

Besides it, government has also set up cooperative banks and regional rural

banks. All this has expanded banking in all parts of the country.

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INSTRUMENTS OF MONETARY POLICY

There are two instruments of monetary policy:-

- Quantitative instruments

- Qualitative instruments.

QUANTITATIVE INSTRUMENTS

o Bank rate

It is the rate at which the central bank is prepared to give credit to the

commercial banks. Increase in bank rate increases the interest rates the banks

further offer, and thus demand for credit gets reduced. On the other hand

decrease in bank rate lowers the rate of interest and credit becomes cheap,

and demand for credit expands.

o Open market operations

It refers to purchase and sale of securities in the open market by the central

bank.

A Government security is a tradable instrument issued by the Central

Government or the State Governments. It acknowledges the Governments

debt obligation.

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Some of these securities are:

o Treasury Bills (T-bills)

Treasury bills or T-bills, which are money market instruments,

are short term debt instruments issued by the Government of

India and are presently issued in three tenors, namely, 91 day,

182 day and 364 day. Treasury bills are zero coupon securities

and pay no interest. They are issued at a discount and

redeemed at the face value at maturity.

o Cash Management Bills (CMBs)

Government of India, in consultation with the Reserve Bank

of India, has decided to issue a new short-term instrument,

known as Cash Management Bills (CMBs), to meet the

temporary mismatches in the cash flow of the Government.

The CMBs have the generic character of T-bills but are

issued for maturities less than 91 days. Like T-bills, they are

also issued at a discount and redeemed at face value at

maturity.

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 o Dated Government Securities

Dated Government securities are long term securities and

carry a fixed or floating interest rate which is paid on the

face value, payable at fixed time periods (usually half-

yearly).

By selling the securities, central bank takes cash out of circulation and thus

reduces the money supply in the economy. By buying securities the reverse

happens, fresh cash is introduced in circulation and thus money supply

increases in the economy.

o Change in minimum reserve ratio and liquidity ratio

Minimum reserve ratio refers to the minimum percentage of the banks total

deposit which it is required to be keep with the central bank. This amount is

also known as the cash reserve ratio (CRR).

Every bank is required to maintain a fixed percentage of its assets in the form

of cash or any other liquid asset. This percentage is also known as the liquidity

ratio(SLR).

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The central bank increases the ratios, when the money supply has to be

reduced and it reduces the ratios when money supply in the economy has to

be increased.

QUALITATIVE INSTRUMENTS

o Change in margin requirements of loans

The margin requirements of loans refers to the difference between the

current value of the security offered for loans and the value of loans granted.

As the margin increases the demand for loan decrease thus money supply

reduces.

o Rationing of credit

Rationing of credit refers to fixation of credit quotas for different business

activities. Rationing of credit is used when credit flow is to be checked

particularly for speculative activities in the economy.

The central bank fixes quotas for different business activities. The commercial

bank cannot exceed the quotas limits while granting loans.

o Direct action

The central bank may initiate direct action against the banks in case they do

not comply with its directions and orders.

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 o Moral pressure

Sometimes the central bank directs the commercial banks to follow the rules

framed by it to control the credit. And if they deviate from the orders they are

morally pressured into complying.

EXAMPLE:

MONETARY POLICY IN CASE OF DEFICIENT DEMAND

Deficient demand is the scenario where demand in the economy is less and
supply is more. So it means that people are not demanding the amount of
goods that are being produced, investments and growth is also low in this
scenario. In such case to improve the economy the money supply has to be
increased. This can be done in the following ways:

1. Reduction in bank rate: If the bank rate is reduced, then it will easier to
borrow money and thus, more money will be borrowed which will be further
invested.

2. Purchase of securities in open market: The central bank buys securities in

the open market to inject the additional purchasing power in the economy.
Thus, stimulating spending and encouraging investments and growth.

3. Decrease in cash reserve ratio: The cash reserve ratio(CRR) is reduced to

make more funds available for borrowing in the form of loans etc. Thus, more
money is injected in the economy and used towards growth.

4. Decrease in liquidity ratio: The liquidity ratio(SLR) is lowered to make

more money available for lending and thus encouraging borrowing and
investments.

5. Reduction in margin requirement of loans: If the loan margins are reduced

then value of loan received increases and thus more money circulates in the
economy.

6. Credit rationing is lifted: Commercial banks are advised to be liberal in

lending money to public, to encourage the borrowings.

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FISCAL POLICY

Fiscal policy means using taxes and government expenditure to monitor and

stabilize growth.It is the sister strategy to monetary policy through which a

central bank influences a nation's money supply.

Fiscal policy is based on the theories of British economist John Maynard

Keynes. Also known as Keynesian economics, this theory basically states that

governments can influence macroeconomic productivity levels by increasing

or decreasing tax levels and its spending levels.

Types of fiscal policy :

o Expansionary fiscal policy

o Contractionary fiscal policy

The first, and most widely-used, is expansionary.

It's most critical at the recession phase of the business cycle, as people are

looking out for a relief from the dip in economy.

The government either spends more or cuts taxes, or does both if it can.

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Thus, injecting money into the economy and increasing the money in hands of

the people. People spend and invest more and that jump starts demand, which

keeps businesses running and adds jobs.

There are ongoing debates about which works better tax cuts or increased

spending.

- Advocates of supply-side economics prefer tax cuts as it frees up businesses

to hire more workers to pursue business ventures.

- Advocates of demand-side economics prefer increased spending as the

money goes into the pockets of consumers, who go right out and buy the

things businesses produce.

Expansionary fiscal policy is usually impossible for state and local

government. That's because they are mandated to keep a balanced budget.

But the central government has no such restrictions and can use expansionary

policy whenever needed.

The second type, contractionary fiscal policy.

Its used mainly to stamp out inflation.

The government will either increase taxes and, or spending is cut. Increasing

the taxes will lead to lower disposable income with the consumers and thus,

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demand will reduce leading to fall in prices and bringing inflation under

control.

INSTRUMENTS OF FISCAL POLICY

o Taxation

That includes income tax, capital gains from investments tax, property tax,

sales tax or just about anything else.

There are broadly two types:

- Direct tax: tax cut at source , example income tax.

- Indirect tax: all other taxes cut for various other activities , example

sales tax , service tax, VAT etc.

Taxes provide the major revenue source that funds the government.

The downside of taxes is that whatever or whoever the tax is levied on has

less income to spend on themselves.That makes taxes unpopular.

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Thus, when the government wants to reduce the money supply in the

economy it increases the tax rate so that people have less cash in hand and the

spending of people reduces.

On the other hand, tax reduction leads to higher disposable income and thus

increases the spending and money supply in the economy.

o Government spending

It includes providing subsidies, transfer payments including welfare

programs, public works projects and government salaries.

If the government increases its spending, then the money supply in the

economy increases. Whoever receives the funds has more money to spend

and that increases demand in the economy and leads to economic growth.

On the other hand, if the government reduces its spending, then the money

supply reduces in the economy and spending falls.

Government spends money on a wide variety of things, from the military and

police to services like education and healthcare, as well as transfer

payments such as welfare benefits.

This expenditure can be funded in a number of different ways:

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 Tax Tax the main source of government income and its expenditure is

taken out from it.

Seigniorage - The benefit from printing money

Borrowing money - Public debt or borrowing refers to the government

borrowing from the public.

Consumption of fiscal reserves - A fiscal surplus is often saved for future

use, and may be invested in either local currency or any financial

instrument that may be traded later once resources are needed. Another

possibility is that the government might decide to increase its own

spending say, by building more highways. The idea is that the additional

government spending creates jobs and lowers the unemployment rate.

Sale of fixed assets (e.g., land)

But there have been debates on if fiscal policy is actually beneficial for the

country. One one hand excessive printing of money leads to inflation on the

other if the government borrows too much from abroad it leads to a debt

crisis, also if it draws down on its foreign exchange reserves, a balance of

payments crisis may arise, and excessive domestic borrowing by the

government may lead to higher real interest rates and the domestic private

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sector being unable to access funds resulting in the crowding out of private

investment.

Sometimes a combination of these can occur. In any case, the impact of a large

deficit on long run growth and economic well-being is negative.

Therefore, there is broad agreement that it is not prudent for a government to

run an unduly large deficit.

However, in case of developing countries, where the need for infrastructure

and social investments may be substantial, it sometimes argued that running

surpluses at the cost of long-term growth might also not be wise.

HISTORY OF POLICIES

o The Reserve Bank of India (RBI) is India's central banking institution,

which controls the monetary policy of the Indian rupee.

o It commenced its operations on 1 April 1935 during the British Rule

in accordance with the provisions of the Reserve Bank of India Act,

1934.

o The first Governor of the central bank was Sir Osborne Smith,
appointed by the British. He was succeeded by another Britisher
and Indian Civil Services officer, Sir James Braid Taylor in 1937,
after which C D Deshmukh took over.

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o In 1969, the Indira Gandhi-headed government nationalized 14

major commercial banks. Upon Gandhi's return to India in 1980, a

further 6 banks were nationalized.

o The regulation of the economy and especially the financial sector was

reinforced by the Government of India in the 1970s and 1980s.

o The central bank became the central player and increased its policies

a lot for a lot of tasks like interests, reserve ratio and visible deposits.

o These measures aimed at better economic development and had a

huge effect on the company policy of the institutes. The banks lent

money in selected sectors, like agri-business and small trade

companies.

o Since 1950, India has followed a system of five- year plans for

ensuring long-term economic objectives.

o This process is steered by the Planning Commission for which there

is no specific provision in the Constitution. The main fiscal impact of

the planning process is the division of expenditures into plan and

non-plan components. The plan components relate to items dealing

with long-term socio- economic goals as determined by the ongoing

plan process. They often relate to specific schemes and projects.

Furthermore, they are usually routed through central ministries to

state governments for achieving certain desired objectives. These

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 funds are generally in addition to the assignment of central taxes as

determined by the Finance Commissions.

o While these institutional arrangements initially appeared adequate

for driving the development agenda, the sharp deterioration of the

fiscal situation in the 1980s resulted in the balance of payments crisis

of 1991.

o The national economy contracted in July 1991 as the Indian rupee

was devalued.

o The currency lost 18% relative to the US dollar, and the government

decided to restructure the financial sector by a temporal reduced

reserve ratio as well as the statutory liquidity ratio.

o New guidelines were published in 1993 to establish a private

banking sector. This was a turning point for India.

o Following economic liberalisation in 1991, when the fiscal deficit and

debt situation again seemed to head towards unsustainable levels

around 2000, a new fiscal discipline framework was instituted.

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o At the central level this framework was initiated in 2003 when the

Parliament passed the Fiscal Responsibility and Budget Management

Act (FRBMA).

o The central bank deregulated bank interests and some sectors of the

financial market like the trust and property markets.

o The Constitution provides for the formation of a Finance Commission

(FC) every five years. Based on the report of the FC the central taxes

are devolved to the state governments. The Constitution also

provides that for every financial year, the government shall place

before the legislature a statement of its proposed taxing and

spending provisions for legislative debate and approval. This is

referred to as the Budget. The central and the state governments

each have their own budgets.

o The global financial crisis that erupted around September 2008 saw

Indian fiscal policy being tested to its limits. The policymakers had to

grapple with the impact of the crisis that was affecting the Indian

economy through three channels; contagion risks to the financial

sector; the negative impact on exports; and the effect on exchange

rates. Somewhat serendipitously, the government already had an

expansionary fiscal stance in view of a rural farm loan waiver

scheme, the expansion of social security schemes under the National

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 Rural Employment Guarantee Act (NREGA) and the implementation

of revised salaries and compensations for the central public servants

as per the recommendations of the Sixth Pay Commission.

o The following graph shows the Deficits of the Central Government as

percentage of GDP (1990-91 to 2009-10)

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CHANGES IN MONETARY AND FISCAL INSTRUMENTS

Monetary Policy Changes

o Bank interest rate: The following graph shows the changes of the bank

rate from 2008-2017. The Reserve Bank of India lowered its

benchmark interest rate by 25bps to 6 percent on August 2nd 2017.

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o Open market operation: The Reserve Bank in its latest monetary

policy signalled it was moving to easier money policies. It hinted at

keeping domestic liquidity in neutral rather than deficit mode.

The central bank is expected to aggressively deploy open market

operations (OMO) to release money into the market.

o Cash reserve ratio (CRR): The following graph shows the CRR over

10 years. The ratio has fallen over the years from 15 to 4, showing

that the government has been on an expansionary path.

CRR 1992-2012
16

14

12

10

0
10/8/95
10/8/92
10/8/93
10/8/94

10/8/96
10/8/97
10/8/98
10/8/99
10/8/00
10/8/01
10/8/02
10/8/03
10/8/04
10/8/05
10/8/06
10/8/07
10/8/08
10/8/09
10/8/10
10/8/11
10/8/12

o Statutory liquidity ratio (SLR): The following graph shows the SLR

from 1949- 2011. The ratio has increased and then fallen again to

approximately the same amount.

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 SLR 1949- 2011
45
40
35
30
25
20
15
10
5
0

7/1/86
3/1/49
11/1/51
7/1/54
3/1/57
11/1/59
7/1/62
3/1/65
11/1/67
7/1/70
3/1/73
11/1/75
7/1/78
3/1/81
11/1/83

3/1/89
11/1/91
7/1/94
3/1/97
11/1/99
7/1/02
3/1/05
11/1/07
7/1/10
Fiscal Policy Changes

o Tax rate: The following shows the changes in income tax over the

decade.

Income Tax Rates for Assessment Year 1992-93

Income Slab (Rs.) => Tax Rate
0 22,000 => 0%
22,001 30,000 => 20%
30,001 50,000 => 30%
50,001 1,00,000 => 40%
1,00,001 and above => 50%
Surcharge: 12% Surcharge if taxable income exceeds Rs. 75,000

Income Tax Rates for Assessment Year 2002-03

Income Slab (Rs.) => Tax Rate
0 50,000 => 0%
50,001 60,000 => 10%
60,001 1,50,000 => 20%
1,50,001 and above => 30%
Surcharge: 2% for the gross income exceeding Rs. 60,000.

Income Tax Rates for Assessment Year 2012-13

Senior citizen (above 60) :Taxable Income Slab (Rs.) => Tax %
0 2,50,000 => 0%
2,50,001 5,00,000 => 10%
5,00,001 8,00,000 => 20%
8,00,000 and above => 30%

Females below 60: Taxable Income Slab (Rs.) => Tax %

0 1,90,000 => 0%

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 1,90,001 5,00,000 => 10%
5,00,001 8,00,000 => 20%
8,00,000 and above => 30%

All other males: Taxable Income Slab (Rs.) => Tax %

0 1,80,000 => 0%
1,80,001 5,00,000 => 10%
5,00,001 8,00,000 => 20%
8,00,000 and above => 30%
Surcharge: No Surcharge
Education Cess @ 2% and Secondary & Higher Education
Cess @ 1% on Tax Payable

This shows us that tax rates have increased over the years, specially for

the middle income group and high income group. Some relief has been

achieved by the low income people.

o Government spending: the following graph shows the indian

government spending for the last 5 years. As we can spending has

increased over the years.

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MAJOR THRUST AREAS OF THE POLICIES

o The First Five-year Plan(1951-1956) was launched in 1951 which

mainly focused in development of the primary sector. The First

Five-Year Plan was based on the HarrodDomar model with few

modifications.

The total planned budget of Rs.2069 crore(2378 crore later) was

allocated to seven broad

areas: irrigation and energy (27.2%), agriculture and community

development(17.4%), transport and communications (24%),indu

stry (8.4%), social services (16.64%), land rehabilitation (4.1%),

and for other sectors and services (2.5%)

o The Second Plan(1956-1961) was particularly in the development

of the public sector and "rapid Industrialisation". The plan

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 followed the Mahalanobis model, an economic

development model developed by the Indian statistician Prasanta

Chandra Mahalanobis in 1953.

The plan attempted to determine the optimal allocation of

investment between productive sectors in order to maximise

long-run economic growth.

It used the prevalent state of art techniques of operations

research and optimization as well as the novel applications of

statistical models developed at the Indian Statistical Institute.

The plan assumed a closed economy in which the main trading

activity would be centred on importing capital goods.

o The Ninth Five-Year Plan(1997-2002) came after 50 years of

Indian Independence. Atal Bihari Vajpayee was the Prime Minister

of India during the Ninth Five-Year Plan.

The Ninth Five-Year Plan tried primarily to use the latent and

unexplored economic potential of the country to promote

economic and social growth. It offered strong support to the social

spheres of the country in an effort to achieve the complete

elimination of poverty.

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 The Ninth Five-Year Plan also saw joint efforts from the public

and the private sectors in ensuring economic development of the

country. In addition, the Ninth Five-Year Plan saw contributions

towards development from the general public as well as

governmental agencies in both the rural and urban areas of the

country.

The Ninth Five-Year Plan focused on the relationship between the

rapid economic growth and the quality of life for the people of the

country.

The prime focus of this plan was to increase growth in the country

with an emphasis on social justice and equity. It placed

considerable importance on combining growth oriented policies

with the mission of achieving the desired objective of improving

policies which would work towards the improvement of the poor

in the country. It also aimed at correcting the historical

inequalities which were still prevalent in the society.

o The eleventh five-year plan(2007-2012) focused on the following:

Rapid and inclusive growth. (poverty reduction), Emphasis on

social sector and delivery of service therein, Empowerment

through education and skill development, Reduction of gender

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 inequality, Environmental sustainability, To increase the growth

rate in agriculture, industry and services to 4%, 10% and 9%

respectively, Reduce total fertility rate to 2.1, Provide clean

drinking water for all by 2009, Increase agriculture growth to 4%.

o The Twelfth Five-Year Plan(2012-2017) of the Government of

India has been decided to achieve a growth rate of 8.2% but the

National Development Council (NDC) on 27 December 2012

approved a growth rate of 8% for the Twelfth Five-Year Plan.

The plan aims towards the betterment of the infrastructural

projects of the nation avoiding all types of bottlenecks. The

document presented by the planning commission is aimed to

attract private investments of up to US$1 trillion in the

infrastructural growth in the 12th five-year plan, which will also

ensure a reduction in the subsidy burden of the government to 1.5

percent from 2 percent of the GDP (gross domestic product).

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 References:

1. https://tradingeconomics.com/india/interest-rate

2. http://profit.ndtv.com/news/economy/article-the-history-of-

changes-to-reverse-repo-rate-crr-slr-327497

3. https://cleartax.in/s/income-tax-slabs

4. www.wikipedia.com

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