Unit- 4

MONETARY AND FISCAL POLICY

What you will learn?
✔Meaning and objectives of monetary policy
✔Tools of monetary policy
✔Use of monetary policy during depression and inflation
✔Monetary policy mismanagement and policy of quantitative easing
✔Role of fiscal policy, equity and price stability crowding out
✔Fiscal policy and fiscal deficit in India- The implications
✔Measures of fiscal consolidation, fiscal policy crowding out
✔Policy mix of fiscal and monetary policy
Insight into monetary policy
It is the policy instrument taken by RBI for ensuring growth and price
stability in the economy. The major purpose of monetary policy is to affect the
stock of money in the economy which in turn will affect the aggregate demand
in the economy.
Monetary policy is concerned with the measures taken to regulate the
supply of money, the cost and availability of credit in the economy. The major
objective of any monetary policy includes:
✔To ensure economic stability at full employment or potential level of output
✔To achieve price stability by controlling inflation and deflation
✔To promote and encourage economic growth in the country
✔To achieve exchange rate stability
✔At recession expansionary monetary policy or easy money policy should be
taken to increase the flow of money in the economy
✔At inflation, contractionary monetary policy or tight money policy should be
adopted to decrease the flow of money in the economy to curtail excessive
spending.
✔Hence the monetary policy plays an important role at the time of recession
and inflation
✔Monetary policy is used to influence the availability of credit in the economy
which in turn will affect the recession and inflation in the economy.
✔Excessive credit will result in inflationary pressure whereas low credit will
result in recession.
 Monetary policy
instruments

Qualitative or selective
Quantitative or general

Selective credit control

Bank rate and repo Open market measures
operation Changing CRR
rate
Bank rate:
⮚This is the rate at which RBI lends money to the commercial banks
⮚If the bank rate is increased the banks will also increase their lending rates
which will result in contraction of money supply in the economy
⮚If bank reduces the interest rate, banks will also decrease interest rate which
will expand monetary supply at the times of recession or depression.
⮚This is a long term interest rate
Repo rate and reverse repo rate
⮚This is a measure of Liquidity Adjustment Facility (LAF) in which RBI provides
short term loans to commercial banks for a period of 1-14 days.
⮚This is the rate at which RBI lends to commercial banks overnight to meet their
short term liquidity crisis
⮚RBI buys securities from banks and provide loans to the bank
⮚The banks can also keep their surplus funds with the RBI. The rate hence paid by
the RBI is called as reverse repo rate
⮚Repo and reverse repo operations are useful tools of short run liquidity
management by RBI in which RBI determines the interest rate
⮚High repo rate means high interest rate charged by the banks which results in
contraction of money supply during inflation.
⮚Low repo rate means low interest rate charged by banks for expansion of money
supply.
Limitations of bank rate and repo rate
⮚The changes in rates by RBI must get reflected in commercial bank also. But
this won't happen always.
⮚The change is useless unless the change happens from the business man or the
common public. If changes in interest rate does not bring any significant
changes in the borrowing patterns of the economy, it does not have any
relevance.
⮚The maxim of any monetary policy itself is “ Take care of the legal tender
money and the credit will take care of itself”.
Open market operations:
✔This act as a corrective mechanism when the market or bank does not
respond to the changes in the bank or repo rate
✔In open market operations the RBI sells or purchases its government securities
in the open market to regulate money supply in the market
✔The purchaser can be the public, a bank or group of banks
✔During inflation to contract money supply RBI will sell the securities
✔During depression, to increase the money supply RBI will buy the securities
from the bank
Limitations of open market operations:
✔At higher rates of hoarding the desired results of open market operations will
not happen
✔Even the cash reserves of the bank my get affected, it won't change the
interest rate
✔If more cash is there with the bank, the open market operation will not yield
any desired results
✔There should be broad and active market for short term and long term
government securities and such markets exists only for developed countries
and not in developing economies.
Changes in cash reserve ratio
• This represents the amount bank has to keep as a reserve in RBI from the
deposits received.
• If RBI increases CRR, this will reduce the credit in the society which will results
in contraction of money supply during inflation
• If RBI decrease CRR, this will increase the credit in society which will result in
expansion of money supply during depression.
• This policy measure will work well only if there is no excess reserves with the
banks.
 Quick recap
Reserved Bank of India Commercial banks Effect in Economy/society
Increases bank rate Increases interest rate Contraction of money supply

Decrease bank rate Decrease interest rate Expansion of money supply

Increase in repo rate Increase in interest rate contraction of money supply

Decrease in repo rate Decrease in interest rate Expansion of money supply
Open market operation- buy Increase in cash flow Expansion of money supply

Open market operation - Sell Decrease in cash flow Contraction of money supply

Increase in CRR Decrease in cash balance Contraction of money supply

Decrease in CRR Increase in cash balance Expansion of money supply

Increase in SLR Decrease in cash balance Contraction of money supply

Decrease in SLR Increase in cash balance Expansion of money supply

Selective credit control
✔This is meant to regulate credit for general or specific purpose
✔Distribution or allocation of credit between various uses
✔Measures are taken to stimulate the flow of credit for the development of
priority sectors
How it is done?
❖Changes in minimum margin of lending by banks against the stock of specific
goods
❖The fixation of maximum limit or ceiling on advances to individual borrowers
❖Prohibition of excess loans and benefits to sensitive commodities
Types of monetary policy
➔ Expansionary monetary policy (Easy money policy)
● This is a policy measure to cure recession or depression
● Under this policy,the RBI takes necessary steps to increase money supply in
the market.
● RBI adopts those steps which increases the liquid resources with the banks
which will increase the money supply and availability of credit in the
economy.
● RBI purchases security through open market operations
● Lower the bank rate or discount rate
● Lower the cash reserve ratio
● Lower the statutory liquidity requirement
2. Contractionary monetary policy or tight money policy
❖ This policy measure is taken to control the inflation in the economy
❖ The central bank will sell the government securities to the banks and general
public through open market operations.
❖ The bank rate or discount rate will be raised
❖ An increase in repo rate also will reduce the inflation rate
❖ The most best anti-inflationary measure is CRR. Rise in CRR and rise in SLR
will result in contractionary money supply.
❖ The RBI can also used qualitative credit control measure to contract the
money supply in the economy.
 Comparison
Expansionary monetary policy
Issue: Recession and unemployment
Measures:
● Central bank buys securities
● Reduce CRR
● Lowers bank rate
What happens?
Money supply increases
Interest rate falls
Investment increases
Aggregate output increases
Tight monetary policy
Issue: Inflation
Measures:
● Sells securities
● Increase CRR
● Raises bank rate
What happens?
Money supply decreases
Interest rate rises
Investment expenditure declines
AD declines
Price or inflation falls
Monetary mismanagement
1. Variable time lag:
It takes huge time for an economic policy to start yielding results.
Approximately an economic policy needs 8-12 months to make its desired
results. The policy taken at one time will become detrimental in the other
time.
2. Interest rate as wrong target variable:
Interest rate should not always be considered as a target variable while fixing
the monetary policy. The long term oriented economic growth should be
considered in a wider spectrum.
The policy of quantitative easing
● This policy is adopted when any form of monetary policy is not working in
the economy
● This is considered as a deliberate policy of the federal reserve and is also
called as non-conventional monetary policy
● When the monetary policy is unable to revive the economy the RBI will
produce more new money and will use this money for the purchase of more
government bond and corporate bond.
● When the RBI purchases more of the securities it will instil more money with
the commercial banks which will lend it to the general public
● But when the policy of quantitative easing is suddenly withdrawn it will
cause more damage to the economy and will destabilize the entire system.
Introduction to fiscal policy
❖ It refers to the policy relating to taxation, expenditure and borrowing by the
government
❖ It is essential to curb inflation, depression and promote equitable growth.
Objectives:
● To mobilize resources for economic growth , especially for public sector
● To promote economic growth for private sector by providing incentives to
save and invest
● To restrain inflationary forces in the economy
● To ensure equitable distribution of income and wealth so that fruits of
economic growth are fairly distributed
● This policy is also called as demand management policy as the major
intention is to affect the AD
Types of fiscal policy

Fiscal Policy

Discretionary Fiscal Non-discretionary

policy fiscal policy

Increase in govt.
Reduction of taxes Automatic Stabilizer/
expenditure
built in system
How is fiscal policy used to curb recession?
There are two fiscal methods to get economy out of recession
• Increase in government expenditure
• Reduction of taxes
How can the increase in expenditure impact the economy?
● Starting more public investment - This has both direct and indirect impact on
the economy. Direct impact caused by the increase in national income and
indirect impact is caused due to the functioning of multiplier effect.
How far the government should expand their expenditure?
• The decision on the volume of govt. Expenditure depends on the marginal
propensity to consume and the working of multiplier in the economy.
How the increase in government expenditure is financed?
● It cannot be done by increasing the taxes
● Proper discretionary policy will result in budget deficit on;ly
● Borrowing
● Creating new money
● Each of the alternative have its own consequences in the long run
Can the fiscal policy work alone to influence the economy?
The fiscal policy is effective only if the interest rate remains constant with
the increase in government expenditure. But as output has to be increased in
response to increase in aggregate demand, the demand for transactionary
money will increase. This increased demand may pull inflation which actually
set off the desired results of expansionary fiscal policy. Therefore an
expansionary fiscal policy must be accompanied by expansionary monetary
policy to obtain the desired results.
Reduction in taxes
• People will have more disposable income with them
• This budget deficit can also be financed through borrowing or creation of
new money.
• This method is the most sorted method by the people of the country as they
have more autonomy over their income.

Which fiscal policy is good? Increase in expenditure or reduction in taxes?

Which method can be used under full employment and potential levels of
output?
 ● The criteria depends upon the role of public sector. If economist think public
sector is doing good, they will increase the govt. Expenditure or else they will
prefer reduced tax rate.
● It also depends on the chances between expenditure multiplier and and tax
multiplier. It should be noted that tax multiplier will be always lower than the
expenditure multiplier.
Expenditure multiplier= 1/1-MPC
Tax multiplier= MPC/1-MPC
Suppose govt. Expenditure is 100 crore. Assume MPC= 0.75,
Then expenditure multiplier= 1/1.0.75= 4
Ie, if the government expenditure is increased by 100 crores, national income will
increase by 400 crore.
Tax multiplier= 0.75/0.25= 3
Ie, if the tax collection is reduced by 100 crores, national income will increase by
300 crores only.
● Effect of tax reduction has less impact on national income due to multiplier
effect.
● Rate of tax cut should be more than the rate of increase in government
expenditure
● However the decision should not be taken solely on the basis of multiplier
effect
● Tax reduction is mostly welcomed by the people as it gives more autonomy
in their decision making.
Fiscal policy to control inflation
❖ Inflation happens when the aggregate demand is too high than the
maximum capacity of the economy . Also, it happens when the monetary
supply in the economy is very high.
❖ The fiscal policy to curb inflation is also called as anti-cyclical fiscal policies
How it is done?
● Decrease in government spending- will reduce the AD which will bring down
the inflation
● Increase in taxes- this will result in less disposable income
● These measures will lead to budget surplus if the existing budget is a
balanced budget or can be used to reduce the existing huge budget deficit.
● The desired results of anti- inflationary policy depends on how efficiently a
budget surplus can be disposed.
● How can a budget surplus be disposed? Retiring Vs. impounding of debt
Non-discretionary fiscal policy- Automatic stabilizers
❖ The tax structure and expenditure pattern is so designed that the taxes and govt
spending vary automatically in appropriate direction with changes in national income
❖ No deliberate action from the government is needed
❖ It automatically raises the aggregate demand during recession and decreases the
aggregate demand during inflationary period
❖ Due to the presence of automatic stabilizers, the recession and inflationary effect will
not be more intense
How it is done?
● Personal income taxes
● Corporate taxes
● Transfer payment
● Corporate dividend policy
Crowding out and effectiveness of fiscal policy
• Crowding in denotes increase in private investment
• Crowding out denotes drastic decrease in private investment
• The concept of crowding out was formed as a critics to the Keynes idea about
the fiscal policy
• Keynes critics believed that increase in government spending or reduction in
tax rate increases the interest rate in the economy
• At a higher rate of interest the private investment will go down in the
economy.
• So, actually an expansionary fiscal policy will crowd out the private
investment which will affects the economy in a negative manner.
• The magnitude of crowding out depends on the elasticity of investment
demand.
• Higher the magnitude of crowding out lower will be the effectiveness of the
fiscal policy
Policy mix in action
Monetary policy and the economy
Act as a policy to stimulate savings
Act as a policy for investment- cost of credit,
credit availability, credit rationing
Fiscal policy and the economy
Mobilizing resources for economic growth
Promote economic growth in public sector
Restrain inflationary forces and ensure price
stability
Ensure equitable distribution of wealth