8/31/2020 Monetary and

Fiscal policy
1st Assignment

Faridullah Hamdard
ID: N19521022
Question 1: Explain and define Monetary Policy?
Answer:
Monetary policy talks of the monetary system of a country and related to the measures and
decisions of a monetary nature. The monetary system is in fact used to influence the economic
and social conditions. Monetary policy can be broadly defined as the deliberate effort of the
central bank to influence the economic activity by making changes in the money supply, in the
availability of credit or in the interest rates in order to achieve the set objectives.
Monetary policy is the process by which the government, central bank or monetary authority
manages the supply of money, or trading in foreign exchange markets. it is the exercise of the
central bank’s control over conditions governing the quantity of money or money supply.
It is an instrument for achieving the objective of general economic policy as set out by the
national economic goals i.e. economic growth, full employment and price stability by
influencing the level of aggregate demand and there by the level of money income.
Monetary policy is usually defined as the central bank’s policy pertaining to the control of the
availability, cost and use of money and credit with the help of monetary measures in order to
achieve specific goals.
According to Harry G. Johnson, Monetary policy is a “Policy employing the central bank’s
control of the supply of money as an instrument for achieving the objectives of general economic
policy.”
According G. Hart defines monetary policy as a policy “Which influences the public’s stock of
money substitutes or the public’s demand for such assets, or both. That is, policy which
influences the public’s liquidity position.” From both these definitions, it is clear that a monetary
policy is related to the availability and cost of money supply in the economy in order to attain
certain broad objectives. The central bank of a nation keeps control on the supply of money to
attain the objectives of its monetary policy.
In the words of R.P. Kant, "Monetary Policy is the management of the expansion and
contraction of the volume of the money in circulation for the explicit purpose of attaining a
specific objective of full employment.
Milton Fried man has made the difference between the credit policy and monetary policy. The
credit policy means the objects of the motions of the monetary authorities on the rates of interest,
terms of lending etc. while monetary policy means the effects of the motions for monetary
authorities on stock of money.
monetary policy is an economic policy of the government In monetary field and the central bank
of a country uses monetary policy in order to influence the quantity of money directly or
indirectly with the help of general instruments of bank rate, open market operations, variable
reserve ratio and selective instruments such as margin requirement, moral suasion, minimum
interest rate etc. to achieve certain objectives set by state.
Question 2: Explain and define Fiscal policy?

Answer:

Fiscal policy is the use of government spending and taxation to influence the economy.
Governments use fiscal policy to influence the level of aggregate demand in the economy in an
effort to achieve the economic objectives of price stability, full employment, and economic
growth.
in simple terms, is an estimate of taxation and government spending that impacts the economy.
the key objectives of fiscal policy are economic stability, price stability, full employment,
optimum allocation of resources, accelerating the rate of economic development, encouraging
investment, and capital formation and growth.
if a government wants to stimulate growth in the economy, it will increase spending for goods
and services. This will increase demand for goods and services. Since demand goes up,
production must go up. If production goes up, companies may need to hire more people. People
that were once unemployed may now have jobs and money to spend on goods and services. This
will further increase the demand and require more production and, hopefully, the cycle of growth
will continue. Barry may even get more business as people have more money to spend on
products at his store. Consequently, government spending tends to speed up economic growth.
If the government thinks the economy is overheating - or growing too fast - the government may
decrease spending. A decrease in government spending will decrease overall demand in the
economy. Businesses will slow production, which means profits will decline, resulting in less
hiring and business investments.
The other side of fiscal policy is taxes. Decreasing taxes tends to stimulate economic growth. If
taxes go down, consumer /people will have more money in his pocket. They'll either spend it or
save it. If they spend it, they will increase demand and businesses have to produce more. This
means they may have to hire more people. These people will then have more money to save or
spend. On the other hand, if consumer saves the money, they'll put it in his bank. The bank will
loan the money he deposited, and borrowers will spend it.

There are two key tools of the fiscal policy:

Taxation: 
Funds in the form of direct and indirect taxes, capital gains from investment, etc, help the
government function. Taxes affect the consumer's income and changes in consumption lead to
changes in real gross domestic product (GDP).
 
Government spending:
It includes welfare programs, government salaries, subsidies, infrastructure, etc. Government
spending has the power to raise or lower real GDP, hence it is included as a fiscal policy tool.
 
There are three main types of fiscal policy:
1. Neutral:
This type of policy is usually undertaken when an economy is in equilibrium. In this
instance, government spending is fully funded by tax revenue, which has a neutral effect
on the level of economic activity.

2. Expansionary:
This type of policy is usually undertaken during recessions to increase the level of
economic activity. In this instance, the government spends more money than it collects in
taxes.

3. Contractionary:
This type of policy is undertaken to pay down government debt and to cap inflation. In this
case, government spending is lower than tax revenue.
 
Fiscal policy is a crucial part of the economic framework, it plays a key role in elevating the rate
of capital formation, both in the public and private sectors.
 
The fiscal policy helps mobilize resources for financing projects. The central theme of fiscal
policy includes development activities like expenditure on railways, infrastructure, etc. Non-
development activities include spending on subsidies, salaries, pensions, etc. It gives incentives
to the private sector to expand its activities. 
A prudent fiscal policy stabilizes price and helps control inflation. Fiscal policy planning gives
the larger chunk of funds for regional development so as to achieve a balanced regional
development. It aims to reduce the deficit in the balance of payment.
 
Difference between monetary policy and fiscal policy
 Monetary policy is concerned with the management of interest rates and the total supply
of money in circulation. It is generally carried out by the RBI.
 Fiscal policy, on the other hand, estimates taxation and government spending. It should
ideally be in line with the monetary policy, but since it is created by lawmakers, people's
interest often takes precedence over growth.

Question 3: Explain major reforms in Banking, Capital market and insurance

Sector post 1991 in India?
Answer:
Reforms in Capital Markets: Recommendations of the Narasimham Committee were initiated
in order to reform capital markets, aimed at removing direct government control and replacing it
with a regulatory framework based on transparency and disclosure supervised by an independent
regulator. The Securities & Exchange Board of India (SEBI) which was set up in 1988 was given
statutory recognition in 1992 on the basis of recommendations of the Narasimham Committee.
SEBI has been mandated to create an environment which would facilitate mobilization of
adequate resources through the securities market and its efficient allocation.

Banking sector reforms:

First Narasimhan Committee Report – 1991

1.    Lowering SLR and CRR

 The high SLR and CRR reduced the profits of the banks. The SLR had been reduced
from 38.5% in 1991 to 25% in 1997. This has left more funds with banks for allocation to
agriculture, industry, trade etc.
 The Cash Reserve Ratio (CRR) is the cash ratio of banks total deposits to be maintained
with RBI. The CRR had been brought down from 15% in 1991 to 4.1% in June 2003. The
purpose is to release the funds locked up with RBI.

2.    Prudential Norms: –

 Prudential norms have been started by RBI in order to impart professionalism in

commercial banks. The purpose of prudential norms includes proper disclosure of
income, classification of assets and provision for Bad debts so as to ensure that the books
of commercial banks reflect the accurate and correct picture of financial position.
 Prudential norms required banks to make 100% provision for all Non-performing Assets
(NPAs). Funding for this purpose was placed at Rs. 10,000 crores phased over 2 years.

3.    Capital Adequacy Norms (CAN): Capital Adequacy ratio is the ratio of minimum capital to
risk asset ratio. In April 1992 RBI fixed CAN at 8%. By March 1996, all public sector banks had
attained the ratio of 8%. It was also attained by foreign banks.

4.    Deregulation of Interest Rates

 The Narasimhan Committee advocated that interest rates should be allowed to be

determined by market forces. Since 1992, interest rates have become much simpler and
freer.
 Scheduled Commercial banks have now the freedom to set interest rates on their deposits
subject to minimum floor rates and maximum ceiling rates.
 The interest rate on domestic term deposits has been decontrolled.
 The prime lending rate of SBI and other banks on general advances of over Rs. 2 lakhs
has been reduced.
 The rate of Interest on bank loans above Rs. 2 lakhs has been fully decontrolled.
 The interest rates on deposits and advances of all Co-operative banks have been
deregulated subject to a minimum lending rate of 13%.
 5.    Recovery of Debts: The Government of India passed the “Recovery of debts due to Banks
and Financial Institutions Act 1993” in order to facilitate and speed up the recovery of debts due
to banks and financial institutions. Six Special Recovery Tribunals have been set up. An
Appellate Tribunal has also been set up in Mumbai.

6.    Competition from New Private Sector Banks

 Banking is open to the private sector.

 New private sector banks have already started functioning. These new private sector
banks are allowed to raise capital contribution from foreign institutional investors up to
20% and from NRIs up to 40%. This has led to increased competition.

7.    Access to Capital Market: The Banking Companies (Acquisition and Transfer of

Undertakings) Act was amended to enable the banks to raise capital through public issues. This
is subject to the provision that the holding of Central Government would not fall below 51% of
paid-up-capital. SBI has already raised a substantial amount of funds through equity and bonds.

8.Freedom of Operation: Scheduled Commercial Banks are given freedom to open new branches
and upgrade extension counters, after attaining capital adequacy ratio and prudential accounting
norms. The banks are also permitted to close non-viable branches other than in rural areas.

9.  Local Area Banks (LABs): In 1996, RBI issued guidelines for setting up of Local Area
Banks, and it gave Its approval for setting up of 7 LABs in private sector. LABs will help in
mobilizing rural savings and in channeling them into investment in local areas.

10.  Supervision of Commercial Banks: The RBI has set up a Board of financial Supervision
with an advisory Council to strengthen the supervision of banks and financial institutions. In
1993, RBI established a new department known as Department of Supervision as an independent
unit for supervision of commercial banks.

Narasimham Committee Report II – 1998

In 1998 the government appointed yet another committee under the chairmanship of Mr
Narsimham. It is better known as the Banking Sector Committee. It was told to review the
banking reform progress and design a program for further strengthening the financial system of
India. The committee focused on various areas such as capital adequacy, bank mergers, bank
legislation, etc.
It submitted its report to the Government in April 1998 with the following recommendations.

1. Strengthening Banks in India: The committee considered the stronger banking system in
the context of the Current Account Convertibility ‘CAC’. It thought that Indian banks must be
capable of handling problems regarding domestic liquidity and exchange rate management in the
light of CAC. Thus, it recommended the merger of strong banks which will have ‘multiplier
effect’ on the industry.
2. Narrow Banking: Those days many public sector banks were facing a problem of the
Non-performing assets (NPAs). Some of them had NPAs were as high as 20 percent of their
assets. Thus for successful rehabilitation of these banks, it recommended ‘Narrow Banking
 Concept’ where weak banks will be allowed to place their funds only in the short term and risk-
free assets.
3. Capital Adequacy Ratio: In order to improve the inherent strength of the Indian banking
system the committee recommended that the Government should raise the prescribed capital
adequacy norms. This will further improve their absorption capacity also. Currently, the capital
adequacy ratio for Indian banks is at 9 percent.
4. Bank ownership: As it had earlier mentioned the freedom for banks in its working and
bank autonomy, it felt that the government control over the banks in the form of management
and ownership and bank autonomy does not go hand in hand and thus it recommended a review
of functions of boards and enabled them to adopt professional corporate strategy.
5. Review of banking laws: The committee considered that there was an urgent need for
reviewing and amending main laws governing Indian Banking Industry like RBI Act, Banking
Regulation Act, State Bank of India Act, Bank Nationalization Act, etc. This up gradation will
bring them in line with the present needs of the banking sector in India.

Apart from these major recommendations, the committee has also recommended faster
computerization, technology up gradation, training of staff, depoliticizing of banks,
professionalism in banking, reviewing bank recruitment, etc.

Insurance Sector Reforms:

Insurance Sector Reforms In 1993, Malhotra Committee headed by former Finance Secretary &
RBI Governor R.N. Malhotra. Objective - to create more efficient & competitive financial
system.
Key recommendations of the reform;
1 Structure: a government stake 50% in insurance companies.
2 Competition: Private Companies with a minimum paid up capital of Rs.1bn should be allowed
to enter the sector. No Company should deal in both life and general insurance through a single
entity. Foreign companies may be allowed to enter the industry in collaboration with the
domestic companies.
Regulatory Body: The insurance act should be changed. An insurance regulatory body should be
set up. Controller of insurance-a part of the Finance Ministry – should be made independent.
Investments: Mandatory Investments of LIC Life Fund in government securities to be reduced
from 75% to 50%. GIC and its subsidiaries are not to hold more than 5% in any company.
Customer Service: LIC should pay interest on delay on payment beyond 30 days. Insurance
companies must be encouraged to set up unit link pension plans