Chapter 26

Role of Monetary & Fiscal Policies- Economic Development

Structure:

26.1 Introduction

26.2 Definition of Economic Development

26.3 Definition of Monetary policy

26.3.1 Objectives of Monetary policy

26.3.2 Role of Monetary policy in economic development

26.3.3 Limitations of Monetary policy

26.4 Fiscal policy and its Meaning

26.4.1 Objectives of fiscal policy

26.4.2 Role of Fiscal policy in economic development

26.4.3 Limitations of Fiscal policy

26.5 Summary

26.6 Check your Progress

26.7 Key Concepts

26.8 Self-Assessment Questions

26.9 Answers to check your progress

26.10 Suggested Readings

Objectives:
After studying this lesson, you will be able to understand

 Meaning of Monetary policy

 Categories of Monetary policy

 Definition of fiscal policy

 Constituents of fiscal policy

 Difference between Growth and Development

 The importance of monetary and fiscal policies in economic development

26.1 Introduction:

In this lesson, you learn about the meaning of Economic Development and also Monetary
and Fiscal policies. Further, we learn the constituents of monetary and fiscal polices and
importance of both the policies in attaining overall economic development in an
economy. In General either monetary or fiscal policy is used to attain economic
development of an undeveloped economies, because these economies are lagging behind
due to several reasons and there exists either inflationary or deflationary conditions which
destabilize the system, Therefore, there is a need of application of both the above stated
policies not only to stabilize the economy but also to achieve overall economic
development.

Since Economic Depression, all most all economies compelled to think about the
problems of economic development and interest shown by the states in the problems of
undeveloped economies development. Economics of development is now considered as
an important branch of economic theory. The study of economic development related to
the causes of underdevelopment and its removal. Therefore, it is pertinent to examine the
role of monetary and fiscal policies in economic development. Subsequent sections job is
to concentrate on the terms of economic development, monetary and fiscal polices. And
the role of these policies.

26.2.1. Definitions of Economic Development:

Economists have defined the term economic development in different ways. In general
economic development implies not only a particular sector development but also the
development of all sectors in an economy. Now let us look into the definitions given by
the following economists;

An Eminent development economist Mr. Gerald Mier has explained that “ Economic
development is a process, whereby the real per capita income of country increases over a
long period of time. Bernard Okun and RW Richardson explained economic development
in terms of material welfare. The definition runs as “ Economic development may be
defined as a sustained secular improvement in well being, which may be considered to be
reflected in an increasing flow of goods and services” Williamson and Buttrick have
defined” Economic development refers to the process, whereby the people of country or
region come to utilize the resources available to bring about a sustained increase in per
capita production of goods and services” Kindle berger CP defined” Economic
development implies both more output and changes in the technical and institutional
arrangement by which it is produced”

The definitions reviewed above reveal that development has been interpreted in terms of
national output. Many objections crop up on above definitions, therefore, emphasis has
shifted for measuring economic development later towards the “Redistribution criterion”.
Of late, Amartya Sen. puts “Economic growth cannot be sensibly treated as an end itself.
Development has to be more concerned with enhancing the lives we lead and the
freedoms we enjoy”

Development must, therefore, be conceived of as a multidimensional process involving

major changes in social structures, popular attitudes and national institutions as well as
the acceleration of economic growth, the reduction in inequality and the eradication of
absolute poverty”

Each section of society and every sector of economy are influenced by economic
development. Therefore, it is must to study the role of overall economic policy in general
and monetary policy and fiscal policy in particular. So let us look into the details of both
the policies and their role in economic development.

26.2 Meaning of Monetary policy:

Having discussed the concept of economic development , now let us define the monetary
policy and describe its objectives. In General, monetary policy means the policy of credit
control and the deliberate management of money supply. As there are different versions
on meaning of economic development, here on monetary policy also various definitions
drawn by different economists. Paul Eizing defines monetary policy as” The attitude of
the political authority towards the monetary system of the community under its control”.
KP Kent has defined “ The Management of the expansion and contraction of the volume
of money in circulation for the explicit purpose of attaining a specific objective, such as
full employment” CK Johri states “ Monetary policy comprises those decisions of
Government and the Reserve Bank of India which affect the volume and composition of
money supply, the size and distribution of credit the level and structure of interest rates
and the effects of these variables upon the factors determining output and prices” GK
Shaw ‘ By Monetary policy we means any conscious action undertaken by the monetary
authorities to change the quantity availability or cost of money”

We have various definitions, some of them are narrow and some are broad definitions of
monetary policy. CK Johri and GK Shaw given broad definitions. In recent years, the use
of monetary policy in its broad sense is getting popular, as it is more useful and practical.

26.3.1: Aims of Monetary Policy:

The objectives of monetary policy have been varying from time to time depending upon
the nature of problems facing the countries and the general economic policy pursued by
them. The main objectives are: (a) Exchange Stability (b) Price Stability (c) Neutrality of
Money (d) Full-Employment (e) Economic Growth (f) Balance of Payments equilibrium.
Some times these objectives are mutually incompatible and the monetary authority has to
make a choice on the basis of priorities. For instance, the objective of maintaining
exchange rate stability may come in conflict with the objective of maintaining internal
price stability; Similarly attainment of full employment may not go hand in hand with
price stability and an accelerated rate of economic growth may but always be possible
with stable exchange rates. Therefore, Radcliff Committee suggested the criterion of
‘orderly life of the society’; it implies that priorities have to be decided keeping in view
the economic situation and social circumstances of country. In this connection
Duesenbery says “faced with a set of conflicting objectives, whose achievement is
influenced by a variety of factors, the problem of monetary management is one of
continuous a adaptation’.

26.3.2 : Role of Monetary Policy in Economic Development:

The role of monetary policy in economic development may be discussed under the
following lines of approach:

 Appropriate Adjustment between Demand for and Supply of money

 Price Stability
 Credit Control
 Creation and Expansion of Financial Institutions
 Suitable Interest Rate Structure
 Debt Management

Monetary policy can play a vital role in the economic development of underdeveloped
countries by minimizing fluctuations in prices and general economic activity by
achieving an appropriate balance between the demand for money and supply of money.
Because, economic development result in increase in more demand for money and it
makes imperative for the monetary authority to increase the money supply but either
more or less money supply than the requirement result in fluctuations in an economy.
Therefore, the gist of the argument is that a proper control upon the supply of money will
prevent economic fluctuations and pave the way for rapid development of
underdeveloped economies.

In the process of economic development, it is unavoidable an increase in prices.

Therefore it is imperative for the monetary authority for maintenance of stability in the
domestic level of prices and exchange rates. The inflationary trend in price negatively
affects the savings and diverts investment into unproductive channels. It is the duty to
have a vigil by the monetary authority not only to regulate but also should keep constant
check on the direction of money flow in turn to control price rise. The same inflationary

trend will also adversely affect international trade and the foreign exchange earnings
which otherwise could help in the development of the country. Thus, monetary policy
should adopt such policy, which will check inflation and frequent devaluation of the
currency.

Monetary authority should also employ quantitative and qualitative credit control tools
for the control of inflation, correction of adverse balance of payments and help the
process of economic development. Not only that, with these instruments, it can influence
and shape the character and pattern of investment and production, in particular selective
credit control, unlike quantitative credit control, makes a discrimination between essential
and non-essential uses of bank credit and help the funds to flow into desirable and uses
without affecting the economy as a whole. This will quicken the pace of economic
development.

The process of economic development can speed up by establishing more and more
financial institutions by developing financial system. These institutions are in less
number in underdeveloped economies, therefore, it is difficult to mobilize the savings
from the public effectively for economic development and consequently economic
growth rate is very low. Monetary authority to extend the sphere of the monetary sector
with the expansion of co-operative banking sector to meet the credit needs of ruralites
and cut the tentacles of non-magnetized sector in rural areas.

There are two subcomponents of monetary policy: cheap and dear money policy. Cheap
money policy in other words availability of funds at lower rates of interest to stimulates
investment both public and private. Thus, a policy of low interest rates serves as an
incentive to investment for economic development. But there is a harm if these funds are
diverted for hoarding and stockpiling and for other speculative purposes, thus monetary
authority should be checked through selective credit controls and thereby directing
investment into desirable channels. In contrary to low rates of interest policy, there are
economists who suggest a policy of high interest rates to control inflationary conditions.
Further they stated that it would stimulate savings and thus increase the supply of invests
able resources; it would secure the allocation of scarce resources into most productive
uses. Therefore, keeping in view the conditions in an economy, countries should be more
pragmatic in their approach and must evolve differentiated interest rate policy, which
ensure rapid pace of economic development.

To attain rapid progress in economic development, the monetary policy should aim at
efficient management of public debt, which implies proper timing of the issuing of
government bonds, stabilizing heir prices and minimizing he burden of debt. Because it
is unavoidable to borrow on a large scale to implement the programs of economic
development in undeveloped economies, hence as stated above, responsibility of
managing public debt effectively and efficiently so as to serve the requirements of
economic growth lies with the monetary authority.

26.3.3 Limitations of Monetary Policy:

The following factors may be limited the effectiveness of monetary policy. They are:

o Existence of Vast Non-Magnetized Sector

o Prevalence of Indigenous bankers
o Weapons of Credit Control have limited application as people mostly rely on
Currency in circulation
o Lack of Banking habits among public
o Undeveloped Security and Bill market
o Unsound Practices of Banking sector
o Accumulation of Black money by tax-evasion

In spite of these limitations, there is no denying the fact that monetary policy can be used
with advantage to economic growth by ‘influencing the supply and uses of credit,
combating inflation and maintaining the balance of payments equilibrium’. However, no
single policy can achieve the desired goal, hence monetary policy must be supplemented
by fiscal policy, which influence economic activity.

26.4 Fiscal policy and its Meaning

Fiscal Policy is one more important component of overall economic policy. Monetary
policy deals with the changes in demand for and supply of money where as fiscal policy
is concerned with non-monetary instruments. Fiscal policy, by employing its instruments,
secures the economic stabilization in developed economies and economic growth in
underdeveloped countries. Its instruments broadly consists of (i) taxes (ii) Public
Borrowing (iii) Public Expenditure.

The importance of fiscal policy as an instrument of economic development was first

envisaged by Keynes in his General Theory wherein he showed that the total national
income was an index of economic activity and brought out the relation between economic
activity and total spending. The direct and indirect effects of fiscal policy on aggregate
spending in the community were clearly established and as a result the budgetary policy
of the government as a weapon of economic control and development came into
prominence. But the Keynesian analysis of fiscal policy is, applicable to the advanced
and industrialized countries and it has little relevance to underdeveloped countries.
Let now look at definitions given by different economists. According to Arthur Smithies,
fiscal policy means “ a policy under which the government uses its expenditure and
revenue programs to produce desirable effects and to avoid undesirable effects on the
national income, production and employment” GK Shaw has defined fiscal policy in
these words, “We define fiscal policy to encompass any decision to change the level,
composition or timing of government expenditure or to vary the burden, structure or
frequency of the tax payment”. A skilful management of fiscal policy instruments can go
long way in maintaining economic stability and ensuring higher rates of economic
growth.

26.4.1 Objectives of fiscal policy

Objectives of fiscal policy are as follows (i) Securing the most efficient and rational
allocation of economic resources (ii) Accelerating the rate of capital formation (iii)
Controlling inflation (iv) Securing equitable distribution of income and wealth (v)
Attaining and maintaining full employment

As like in monetary policy objectives, fiscal policy objectives also mutually consistent
but some times there are conflicts between them. Therefore, policy must decide its course
of action in the light of the requirements of the situation prevailing in the country at the
time.

26.4.2 Role of Fiscal policy in economic development

K K Kurihara regards fiscal policy as a “desiderate for underdeveloped countries lacking

in private initiative, private voluntary saving and private innovation”. He discusses the
fiscal policy of government as an additional saver, an investor and an income
redistributor. He observes as par as underdeveloped economy is concerned, budgetary
surplus is the relevant position to be achieved and maintained. As an additional investor,
government can increase the productive capacity of the economy and secure an
accelerated rate of economic growth by changing the pattern of investment and laying
emphasis on capacity creating rather than on income-generating aspects. As an innovator,
the government should spend on research and experimentation and stimulate innovations
and new techniques of production. As an income redistributor and for that fiscal measures
can go a long way in reducing economic inequalities. In the words of Nurkse, fiscal
policy assumes a new significance in he face of the problem of capital formation in
underdeveloped countries”

The fiscal policy should be construed as to secure full employment conditions and
economic growth at rapid rate. The integration of the government budgets with the
nation’s economy budgets can go a long way for the attainment of the objectives of rapid
economic development and creation of full employment opportunities.
We now proceed to discuss the role of fiscal policy instruments role in economic
development.

Taxation :Of the important sources of public revenue taxation is the most important.
Through taxation, governments are collecting from 10- 30 percent levels to the national
income in developed countries. Shortage of financial resources is the main obstacle in the
way of economic development of the underdeveloped countries. There are certain forces
operating in these countries, which increase consumption and reduce savings. The first
among them is the population pressure. Besides, the high incomes groups spend much of
their incomes on conspicuous consumption and their propensity to consume is further
reinforced by the ‘demonstration effect’ Still worse, a large part of the meager savings is
dissipated in unproductive channels like real estate, hoarding, gold, jewellery,
speculation, etc the taxation measures can be employed effectively to divert savings of
the people into productive channels. In this connection, Report of the Taxation Enquiry
Commission, Govt of India, observes, “A tax system which on the whole, promotes
capital formation in its two aspects of saving and investment fulfills an essential
desideratum.

Public Borrowing: There is a limit to which taxation can be resorted for resource
mobilization. If the taxes are excessive, they will adversely affect people’s desire and
ability to work, save and invest. This will obviously retard the paced of economic
development. To avoid such a situation, public borrowing may cover the gap in resources
required. It will not adversely affect people’s desire to work, save and invest as lending is
voluntary n the lenders not only get back the amount lent but also earn interest on it.
Further, public borrowing may add to the incentives of the people to save and invest more
as he lure of earning more interest on lending is there. Public borrowing has its own
limitations. The general masses are poor and their propensity to consume is high and
hence they have no lending capacity. The rich generally do not like to lend to the
government but instead divert their investive resources into speculative channels as they
can earn more from there. Absence of organized money and capital markets are some of
the other obstacles in the way of public borrowing program. However, government has
to do efforts to compulsory borrowing for economic development. But it may be noted
that no democratic government can rely on forced loans except for a short period and for
certain specified projects. Ultimately, it is the voluntary lending by the people that
matters and the government must be prepared to increase its domestic borrowing when
the incomes and savings of the people increase as a result of economic and make public
borrowing and important tool of resource mobilization.

Public Expenditure:

Public expenditure is one of the important weapons in the hands of the state to secure
economic development of underdeveloped economies. Initially for economic
development, infrastructure facilities have to be provided. For which, government
initiation is essential condition. Therefore, government has to spent huge amount on its
development to pave the way to private entrepreneur to start key industries and also agro-
based industries. Thus, a carefully and wisely planned public expenditure by creating
social and economic overheads can go a long way in creating necessary environment for
growth. But public expenditure can achieve its wider objective of development only if it
conforms to certain well-defined principles of public expenditure. Further, care should be
taken that public expenditure does not adversely affect people’s desire to work, save and
invest and for that people should not be provided with direct money help but with goods
and services in the form of free education, free medical facilities.

Thus, the fiscal policy can affect the rate of economic development in a variety of ways
such as by increasing the rate of saving and investment, affecting the allocation of
resources, controlling inflation, promoting economic stability, securing equitable
distribution of income and wealth and creating full employment policy in advance
countries.
26.4.3 Limitations of Fiscal Policy:

The effectiveness of fiscal policy will depend on the extent and depth of measures
adopted and their right timing.
Public spending on a large scale during depression poses the problem of finding out
adequate sources of revenue. For instance, reliance placed on taxation to finance public
investment during depression is not advisable. Thus, effectiveness of fiscal policy during
depression is limited and conditioned by the availability of finance.

Political and administrative delays have adverse effect in efficiency of fiscal measures.

To cure unemployment through raising the aggregate demand in an economy, which

suffers from disguised unemployment, cannot yield desired results.

A vigorous pursuit of fiscal measures for removing unemployment may lead to balance
of payments difficulties.

In recent years, economists have suggested control of private investment, in addition to

fiscal and monetary measures, with a view to secure economic stabilization. This shows
that fiscal policy alone cannot secure economic stabilization and full employment, though
it is the most potent weapon to achieve the same.

26.5 Summary:

Monetary or fiscal policies are important weapons in the hands of the government to
secure rapid economic development. Monetary policy is nothing but the management of
money supply for the purpose of attaining a set of objectives. Similarly, the means and
instruments employed by the state to influence the general level of economic activity
constitute the core of fiscal policy. However, it may be mentioned that the nature of
economic problems facing the underdeveloped and developed economies is so complex
that no single policy by itself can achieve the desired goal. Hence, one policy must be
supplemented by other policy and other major policies of the government, which
influence economic activity.
26.6 Check your Progress

State whether following statements are True or False

1. Monetary policy means the conscious management of money supply

2. The fluctuating exchange rates adversely affect internal trade and the foreign
exchange earnings.
3. one of the instruments of monetary policy is public expenditure
4. Taxation is an instrument of fiscal policy

26.7 Key Concepts:

Demand for money : It refers to the wish to keep some amount in liquidity form.
According to Keynes, demand for money is for transactions, precautionary and
speculative purposes.

Supply of Money : It implies that the quantity of money available in an economy.

Monetary authority of an economy have power to maintain the money supply.

Cheap money policy : It is the part of overall monetary policy. To achieve one of
monetary policy objectives, it can reduce the supply of money from circulation. It is
known as cheap money policy

Dear money policy : It is also the part of overall monetary policy. To achieve one of
monetary policy objectives, it can increase in the supply of money from circulation. It is
known as Dear money policy

Exchange Stability : It is one of the monetary policy objectives. There will be two types
of exchange rates. Fixed and flexible exchange rates. To have smooth trade among the
countries exchange stability is essential condition.
Price Stability : It is also one of the monetary policy objectives. Neither inflation nor
deflation are not viable, therefore, monetary authority tries to achieve stability in prices.

Speculative motive: money will be demanded by the public for different motives.
Among them it is one. If money demanded for the purpose of speculation, we called it as
speculative motive.

Money Market : Finance is required for the development of economy. One is short term
finance and another one is long term finance. Money market objective is to provide short
term finance.

Capital Market: It is part of financial system. Long term finance is available via capital
market for the development of an economy

External borrowing : Finance can be borrowed from two sources, they are: Internal and
external borrowing. If finance is availed through external sources such as foreign
economies, international financial institutions is known as external borrowing.

Internal borrowing : Finance can be borrowed from two sources, they are: Internal and
external borrowing. If finance is availed through internal sources such as household
savings, Public sector and Private sector is known as internal borrowing.

26.8 Self-Assessment Questions

Essay Questions:
1. Explain the objectives of Monetary Policy in a developing economy?
2. Examine the effectiveness of monetary policy in India?
3. Explain the limitations of monetary policy in its working?
4. What is the important instrument of fiscal policy?
5. Examine the role of fiscal policy in under developed economies?
Short Questions:

1. What is meant by cheap money policy?

2. What is the instrument of monetary policy?
3. Write note on lags of monetary policy?
4. Write the different categories of taxation?
5. Internal debt vs. external debt- elaborate

26.9 Answers to check your progress

1. True 2. True 3. False 4 True

26.8 Suggested Readings

1. Ghatak, Subata: Monetary Economics in Developing Countries
2. Meier, Gerald M., Leading Issues in Economic Development
3. Gupta. SP Monetary Planning in India
4. Chellaiah RJ Fiscal Policy in Underdeveloped countries
5. Tyagi BP Public Finance
6. Taneja & Myer Economics of Development & Planning