Unit 3: Monetary and Fiscal Policy

❖ Monetary Policy and its objectives –

❖ CRR and SLR-
❖ Money Supply-
❖ Instruments of money supply-
❖ RBI’s Monetary Policy Measures-
❖ Fiscal Policy and its Objectives-
❖ Techniques of Fiscal Policy-
1
❖ Impact of Monetary and Fiscal Policy on business
environment-
❖ Central and States Budget-
❖ Finances of the central and state budgets.
 Monetary Policy and Its Objectives
2  Monetary policy is a central bank’s actions and
communications that manage the money supply.
 Central banks use monetary policy to prevent inflation,
reduce unemployment, and promote moderate long-term
interest rates.
 Monetary Policy is a mechanism rough which the supply
of and demand of money in an economy is regulted.
 The objective of monetary policy is to achieve a desired
expansion of the economy by facilitating the availability
of money supply needed for the process.
 This needs to be done in such a way that it imposes no
undue inflationary pressures on the economy.
 The two objectives of ensuring the required money supply
for economic development and checking inflation are, to
an extent, mutually conflicting in their nature.
 Monetary Policy and Its Objectives
3
 In India, monetary policy of the Reserve Bank of India is 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.
 Monetary policy can be expansionary and contractionary in
nature.
 Increasing money supply and reducing interest rates indicate an
expansionary policy. The reverse of this is a contractionary
monetary policy.
 For instance, liquidity is important for an economy to spur
growth.
 To maintain liquidity, the RBI is dependent on the monetary
policy.
 By purchasing bonds through open market operations, the RBI
introduces money in the system and reduces the interest rate.
 Objectives of Monetary Policy
4

 CRR and SLR
5  Cash Reserve Ratio (CRR): Every commercial bank is
obligated to maintain CRR, which is a specified percentage
of their net demand and time liabilities.
 CRR refers to the portion of total deposits of
a commercial bank which it has to keep with the RBI as cash
reserves.
 SLR stands for Statutory Liquidity Ratio. It refers to that
portion of total deposits which a commercial bank has to
keep with itself in the form of cash reserves.
 Increasing or decreasing the SLR, like the CRR, either
decreases or increases the availability of funds with the
banks to advance credit thereby complementing the objective
of the central bank to influence the volume of money supply
in the economy.
 CRR and SLR - Differences
6

.
Parameter CRR SLR
Meaning It is a percentage of It is a proportion of liquid
money that a bank has assets per a percentage of
to keep with the RBI. time and demand
liabilities.
Form Maintained in the Maintained in the form of
form of cash. cash, gold and
government-approved
securities.
Uses Regulates the flow of Ensures the solvency of
money in the banks.
economy.
Reserved Reserved with the RBI Reserved with commercial
With banks.
National Regulates the liquidity Maintains the credit
Impact of cash in the country. growth of the country.
 Instruments of Money Supply
7
 Instruments of Money Supply
8  Various instruments of monetary policy that the RBI has at its disposal are:
 1] Open Market Operations: Open Market Operations is when the RBI involves
itself directly and buys or sells short-term securities in the open market. This
is a direct and effective way to increase or decrease the supply of money in
the market. It also has a direct effect on the ongoing rate of interest in the
market.
 2] Bank Rate: A bank rate is essentially the rate at which the RBI lends money
to commercial banks without any security or collateral. It is also the standard
rate at which the RBI will buy or discount bills of exchange and other such
commercial instruments.
 3] Variable Reserve Requirement: There are two components to this instrument of
monetary policy, namely – The Cash Reserve Ratio (CLR) and the Statutory
Liquidity Ratio (SLR).
 4] Liquidity Adjustment Facility: TheLiquidity Adjustment Facility (LAF)
controls the flow of money through repo rates and reverse repo rates. The
repo rate is actually the rate at which commercial banks and other institutes
obtain short-term loans from the Central Bank. And the reverse repo rate is
the rate at which the RBI parks its funds with the commercial banks for short
time periods. So the RBI constantly changes these rates to control the flow of
money in the market according to the economic situations.
 Instruments of Money Supply
9  Various instruments of monetary policy that the RBI has at
its disposal are:
 5] Moral Suasion: This is an informal method of
monetary control. The RBI is the Central Bank of the
country and thus enjoys a supervisory position in the
banking system. If there is a need it can urge the banks to
exercise credit control at times to maintain the balance of
funds in the market. This method is actually quite
effective since banks tend to follow the policies set by the
RBI.
 6]Margin requirements – The RBI prescribes a certain
margin against collateral, which in turn impacts the
borrowing habit of customers. When the margin
requirements are raised by the RBI, customers will be able
to borrow less.
 7] Selective credit control – Controlling credit by not
lending to selective industries or speculative businesses.
 Fiscal Policy and its Objectives
10
 Fiscal policy is the policy relating to government revenues from taxes
and expenditure on various projects.
 It is an estimate of taxation and government spending that impacts the
economy.
 In India, the Union finance minister formulates the fiscal policy.
 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 programmes,
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.
 Fiscal Policy and its Objectives
11
 Fiscal Policy Objectives
 Some of 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.
 What is the importance of fiscal policy?
 Fiscal policy plays a key role in elevating the rate of capital
formation, both in the public and private sectors.
 The fiscal policy helps mobilise resources for financing projects. The
central theme of fiscal policy includes development activities like
expenditure on railways, infrastructure, etc. It gives incentives to the
private sector to expand its activities.
 Fiscal policy aims to minimise income and wealth inequalities.
 A prudent fiscal policy stabilises 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.
 Types of Fiscal Policy
12
 There are two types of fiscal policy, they are:
 Expansionary Fiscal Policy: The policy in which the government
minimises taxes and increase public spending.
 Contractionary Fiscal Policy: The policy in which the government
increases taxes and reduce public expenditure.
 AD = Aggregate Demand

 Difference between Monetary and Fiscal Policies
13

 Techniques of Fiscal Policy
14
 Four important techniques of fiscal policy of India, i.e.,
 (1) Taxation Policy,
 (2) Public Expenditure Policy,
 (3) Public Debt Policy, and
 (4) Deficit Financing Policy.
 1. Policy of Taxation of Government of India
 One of the important sources of revenue of the Government of India is
the tax revenue. Both the direct and indirect taxes are being levied by
the Government of India. Direct taxes are progressive by nature and
most of indirect taxes are regressive in nature. Taxation plays an
important role in mobilizing resources for plan.
 Techniques of Fiscal Policy
15
 2. Public Expenditure Policy of Government of India:
 Public expenditure is playing an important role in the economic
development of a country like India. With the increase in
responsibilities of the government and with the increasing
participation of government in economic activities of the country, the
volume of public expenditure in a highly populated country like India
is increasing at a galloping rate.
 3. Policy of Deficit Financing of Government of India:
 The deficit financing in India indicates taking loan by the government
(for financing its developmental plans) from the Reserve Bank of
India in the form of issuing fresh dose of currency. Considering the
low level of income, low rate of savings and capital formation, the
government is taking recourse to deficit financing in increasing
proportion. Deficit financing is a kind of forced savings.
 Techniques of Fiscal Policy
16
 4. Public Debt Policy of the Government of India:
 As the taxation has got its limit in a poor country like India due to
poor taxable capacity of the people, thus the government is taking
recourse to public debt for financing its developmental expenditure. In
the post-independence period, the Central Government has been
raising a good amount of public debt regularly in order to mobilize a
huge amount of resources for meeting its developmental expenditure.
Total public debt of the Central Government includes internal debt
and external debt.
 Impact of Monetary and Fiscal Policy on Business Environment

17
 Fiscal policy affects aggregate demand through changes in
government spending and taxation. Those factors influence
employment and household income, which then impact consumer
spending and investment.
 Monetary policy impacts the money supply in an economy, which
influences interest rates and the inflation rate. It also impacts business
expansion, net exports, employment, the cost of debt, and the relative
cost of consumption versus saving—all of which directly or indirectly
impact aggregate demand.
 Aggregate Demand (D) = C+I+G+(X−M) where:
 C = Consumer spending on goods and services;
 I = Investment spending on business capital goods;
 G = Government spending on public goods and services
 X = Exports;
 M = Imports​
 Impact of Monetary and Fiscal Policy on Business Environment

18
 Fiscal policy determines government spending and tax rates.
Expansionary fiscal policy (during the times of recessions), increases
government spending in areas such as infrastructure, education, and
unemployment benefits.
 Contractionary fiscal policy can be used to reduce government
spending or to correct out-of-control growth fueled by rapid inflation
and asset bubbles.
 Central and States Budget

19
 A government budget is a statement of the expected expenditure of the
government and the sources of financing these expenditures during a
financial year.
 A government budget has been defined as a statement showing
estimated receipts and expenditure of the government during a fiscal
year beginning on April 1 and ending on March 31 of the subsequent
year.
 It is the government that takes decisions about proposed activities at
all levels and requires funds to execute them.
 The funds are allocated through the instrument of budget, which is
passed by legislature, parliament, civic bodies, etc.
 A budget has the power to steer the economy in a direction provided
by the government.
 It is the most significant economic policy tool to translate the
government’s policies into executive action in areas that it needs to
function.
 Central and States Budget

20
 According to Article 112 of the Indian Constitution, the Union Budget
of a year is referred to as the Annual Financial Statement (AFS).
 The Budget Division of the Department of Economic Affairs in the
Finance Ministry is the nodal body responsible for preparing the
Budget.
 A budget provides information about the:

➢ plans, programmes, projects, schemes, and activities pertaining to the

current year and proposals for the ensuing year;

➢ sources of finance;

➢ receipts and expenditure for the previous year; and

➢ economic and accounting data relating to the performance of various

agencies of the government.
 Finances of the Central and State Budgets

21
 Meaning of Union (Central) Budget of India:
 According to Constitution of India, there is three-tier system of
government, namely –
 Central (or Union) government.
 State government and
 Local government (like Municipal Corporation, Municipal
Committee, Zila Parishad, etc.).
 Accordingly, these governments prepare their own respective budgets
(called Union Budget, State Budget and Municipal Budget) containing
estimates of expected revenue and proposed expenditure.
 Finances of the Central and State Budgets

22
 Components of the Union (Central) Budget of India:
 The budget is divided into two parts:
 (i) Revenue Budget and
 (ii) Capital Budget.
 The Revenue Budget comprises revenue receipts and expenditure
met from these revenues. The revenue receipts include both tax
revenue (like income tax, excise duty) and non-tax revenue (like
interest receipts, profits).
 Capital Budget consists of capital receipts {like borrowing,
disinvestment) and long period capital expenditure (creation of assets,
investment).
 Capital receipts are receipts of the government which create
liabilities or reduce financial assets, e.g., market borrowing, recovery
of loan, etc. Capital expenditure is the expenditure of the government
which either creates assets or reduces liability. Capital budget is an
account of assets and liabilities of the government which takes into
consideration changes in capital.
 Finance Commission

23
 Under the Constitution of India, a Finance Commission is to be
constituted every fifth year or at such earlier time as the President
considers necessary to make recommendations to the President as to:
➢ The distribution between the Union and States of the net proceeds of
taxes which are to be or may be divided between the States of the
respective shares of such proceeds;
➢ The principles which should govern the grants-in-aid of the revenues
of the State in need of such assistance out of the Consolidated Fund
of India; and
➢ Any other matters referred to the Commission by the President in the
interest of sound finance.
 The recommendation of the Commission, together with an
explanatory memorandum as to the action taken thereon, are laid
before each House of Parliament. The government accepted the
recommendations of the Fourteenth Finance Commission (FFC)
covering the period April 1, 2015 to March 31, 2020.
 Finances of the Central and State Budgets

24
 Components of the Union (Central) Budget of India:
 Finances of the Central and State Budgets

25
 Components of the Union (Central) Budget of India:
 Finances of the Central and State Budgets

26
 Components of the Union (Central) Budget of India:
 Finances of the Central and State Budgets

27
 Components of the Union (Central) Budget of India:
 Finances of the Central and State Budgets

28
 Components of the Union (Central) Budget of India:

 Union Budget – 2021-2022 - Highlight &Analysis

29  Expenditure: The government proposes to spend Rs 34,83,236 crore in

2021-22. As per the revised estimates, the government spent Rs 34,50,305
crore in 2020-21, 13% higher than the budget estimate.
 Receipts: The receipts (other than borrowings) are expected to be Rs
19,76,424 crore in 2021-22, which is 23% higher than the revised estimates of
2020-21. In 2020-21, revised estimates for receipts were 29% lower than
budget estimates. Given the impact due to COVID-19, it is useful to see the
growth from 2019-20, an annual increase of 6%.
 GDP growth: Nominal GDP is expected to grow at of 14.4% (i.e., real
growth plus inflation) in 2021-22.
 Deficits: Revenue deficit is targeted at 5.1% of GDP in 2021-22, which is
lower than the revised estimate of 7.5% in 2020-21 (3.3% in 2019-20). Fiscal
deficit is targeted at 6.8% of GDP in 2021-22, down from the revised estimate
of 9.5% in 2020-21 (4.6% in 2019-20). The government aims to steadily
reduce fiscal deficit to 4.5% of GDP by 2025-26.
 Ministry allocations: Among the top 13 ministries with the highest
allocations, the highest annual increase over 2019-20 is observed in the
Ministry of Jal Shakti (64%), followed by the Ministry of Consumer Affairs,
Food and Public Distribution (48%) and the Ministry of Communications
 State Budgets

30
 Much like the Union Budget, State budgets, too, are typically
associated with the State Finance Minister presenting the Budget in
the State Assembly/Vidhaan Sabha.
 State Governments have a number of sources to raise money:
 States’ share of Central Taxes
 The part of the tax collection that the Central Government shares with
State Governments is known as the States’ Share in Central Taxes.
 States’ Own Tax Revenue
➢ Goods and Services Tax (GST):
➢ State Excise Duty:
➢ Sales tax and VAT:
➢ Stamps and Registration Duty:
➢ Vehicle Registration Tax:
➢ Entertainment Tax:
 State Budgets

31
 States’ Non-Tax Revenue: The most important are:
 Lease/sale of natural resources: Lease of minerals is major source.
 Economic services: Examples of certain services provided by the
government for which it charges the user, are - irrigation, health, education,
forestry and wildlife, etc.
 Sale of lotteries
 Interest receipts – On the loans provided by the state governments to certain
entities like public sector undertakings (PSUs), local bodies, etc.
 Borrowings
 As with the Union budget, when the expenditure of a State Government
exceeds the receipts, it borrows money to bridge the gap. This borrowed
money, however, needs to be repaid with interest.
 State Budgets

32
 States’ Non-Tax Revenue: The most important are:
 Lease/sale of natural resources: Lease of minerals is major source.
 Economic services: Examples of certain services provided by the
government for which it charges the user, are - irrigation, health, education,
forestry and wildlife, etc.
 Sale of lotteries
 Interest receipts – On the loans provided by the state governments to certain
entities like public sector undertakings (PSUs), local bodies, etc.
 Borrowings
 As with the Union budget, when the expenditure of a State Government
exceeds the receipts, it borrows money to bridge the gap. This borrowed
money, however, needs to be repaid with interest.
 Kerala Receipts Budget, 2020-21

33
 Example: Components of Kerala’s Receipts Budget 2020-21

34
 Example: Components of Kerala’s Receipts Budget 2020-21
 The Constitution of India mentions the areas/items for which State
35
Governments are responsible, either fully or jointly, with the
Union Government.
 Example: Components of Kerala’s Revenue Expenditure Budget
 .
36
37