TERM 1- Credits 3 (Core)

Prof Madhu & Prof Rajasulochana

TAPMI, Manipal
Session 12

Fiscal Policy
Government spending and taxes

Budget-Policy Statement
Revenue Account

items of recurring nature

Capital Account

items that have implications

on creating/reducing assets

Revenue Budget
Revenue Receipts

Taxes - income taxes, corporate

taxes, customs, VAT, excise
duties etc
Non-tax revenues earnings
from PSUs and departmental
undertakings like railways, P&T
and interests on loans advanced.

Revenue Expenditure
Plan Expenditure
Expenditure related to central 5-year
plans
Grants to states and UT
Non-Plan Expenditure
Civil administration
Salaries and Pensions
Subsidies
Defence revenue expenditure
Interest on public debt

Revenue receipts do not have any debt obligations, while revenue

expenditure do not create any productive assets!

Capital Budget
Capital Receipts
Non-debt
Loan Recovery
creating
PSU Disinvestment
receipts
Borrowing
-from market(public)
-from RBI
-from banks and FIs through sale of TBs
-from foreign govts and international
agencies

Capital Expenditure

Planned Expenditure
Expenditure related to Central Plan
Central assistance for State and UT
plans
Non-Plan Expenditure
Expenditure on General, Social and
Economic Services
Loan repayment

Capital Expenditure involve acquisition of land , building, machinery and

equipment's - building productive capacity of the economy.

FRBM Act 2003

FRBM (Fiscal Responsibility and Budgetary Management) Act 2003
provides rules for the fiscal responsibility of the Central Government.
The objectives of the Act are:
- To reduce fiscal deficit
- To adopt prudent debt management
- To generate revenue surplus

FRBM Act 2003 (Contd)

3 policy statements are mandated by the FRBM Act
1. The Medium Term Fiscal Policy Statement sets a three-year rolling
target for specific fiscal indicators.
2. The Fiscal Policy Strategy Statement sets the priorities of the Govt in
the fiscal area.
3. The Macroeconomic Framework Statement assesses the prospects of
the economy with respect to the GDP growth rate, fiscal balance of the
Central Government and external balance.

Concepts of Budget Deficit

Revenue Deficit = Revenue Expenditure- Revenue Receipts
Fiscal Deficit = Total expenditure (Revenue Receipts + non-debt creating capital Receipts)
Fiscal Deficit = Budget Deficit
+ Net Borrowing at home
+ Borrowing from RBI
+Borrowing from Abroad
Primary Deficit = Fiscal Deficit- Interest Payments
Monetized Deficit = net RBI credit to the Government

Monetary Policy
Interest rates and money supply

Monetary Policy
Policy made by the central bank (It is RBI in Indian context).
To control money supply in the economy
RBI implements monetary policy using two tools:
1. Quantitative tools
2. Qualitative tools

Monetary policy tools: Quantitative vs. Qualitative

Quantitative Tools

Qualitative tools

1. Reserve Ratios (SLR and CRR)

2. Open Market Operation (OMO)
3. Policy Rate Repo, Reverse Repo,
Bank rate

1.
2.
3.
4.
5.

Margin Requirements
Consumer credit regulation
Moral Suasion
Rationing of Credit
Direct Action

Monetary Aggregates

Credit creation within the banking system

Creation of credit means that the commercial banks by taking in
deposits and making loans expand the money supply.
Credit creation is the multiple expansion of banks demand deposits.

Numerical illustration of credit creation

Let us assume that there are more than one banks in
the country. It is further assume that the required
reserve ratio is 20%.
Some body deposits INR 1000 in bank A. For simplicity
sake, we will show new changes in assets and liabilities
only.
The balance sheet of bank A now appears as under.

Bank A Balance Sheet

Assets

Liabilities

Cash received = INR 1000

Demand Deposits = INR 1000

We assume now that Mr. X approaches the bank A for a

loan. The bank set aside 20% or INR 200 as required
reserve and the balance of INR 800 is loaned out to Mr. X
The Balance sheet of Bank A after giving loan would
appear as under.

Bank A Balance Sheet

Assets

Liabilities

Cash received = INR 200

Loan to Mr. X =
800
Total
= INR 1000

Demand Deposits = INR 1000

_________
Total
= INR 1000

Now We assume that the borrower Mr. X makes a

payment of INR 800 by check to Mr. Y to pay his debt.
Mr. Y has account in Bank B and he deposits this
amount in his account.
The Bank B receives INR 800 as deposits and its
balance sheet now appear as under.

Bank B Balance Sheet

Assets

Liabilities

Cash received = INR 160

Loan to Mr. N =
640
Total
= INR 800

Demand Deposits = INR 800

_________
Total
= INR 800

Now We assume that the borrower Mr. N makes a

payment of INR 640 by check to Mr. M to pay his debt.
Mr. M has account in Bank C and he deposits this
amount in his account.
The Balance Sheet of bank C increases by INR 640.The
Bank C also keep 20% as required reserve ( INR 128)
and give excess reserve of INR 512 as loan to Mr. Z.

 The increase is five fold, the reciprocal of the reserve

requirement which is shown in the table below.

Example of credit creation by banking system

Banks

Primary Deposits

Cash reserve at 20%

Credit Creation

A
B
C
D
E
F
G
H
.
.
N

1000
800
640
512
409
327
262
209

200
160
128
102
81
65
54
41

800
640
512
409
327
262
209
167

TOTAL

5000

1000

4000

Money Multiplier Formula

CREDIT CREATION FORMULA
K= 1/r
K= Deposit multiplier
r= ratio of cash reserve to deposit

Contraction of credit
Just as deposits create loans and loans create deposits, similarly
the withdrawal of deposits contracts credit.
For example, If cash reserve ratio is 20%, the initial reduction of
INR 1000 in bank A, will lead to a reduction of deposits of INR
800 in bank B, Of INR 640 in bank C and so on.
If this process of credit contraction is continued, the total
deposits in the banking system is reduced by INR 5000.

Expansionary Fiscal Policy

Increase in government
expenditures crowds out
investment spending through
rise in interest rates.

Income increases to Y0 instead

of Y

Crowding out phenomenon is associated with expansionary FP.

Expansionary Monetary Policy

At the initial equilibrium, E, the
increase in money supply creates an
excess supply of money.
People tend to demand more bonds
till yields decrease at point E1
Decline in interest rate increases AD
and output expands till final position
is reached at Y.

Extreme case of Liquidity Trap associated with option 2

Liquidity trap occurs when the
LM curve is horizontal
changes in the quantity of
money do not shift it.
Monetary policy has no impact
on either the interest rate or
the level of income
monetary policy is ineffective.

Lags in Policy
Inside Lag is the amount of time it takes for a government or
a central bank to respond to a shock in the economy. It is the
delay in implementation of a fiscal policy or monetary policy.
Outside Lag once a policy is implemented, its effects are
spread over a period of time.
Reaction uncertainties intended and unintended outcomes
associated with policy implementation.