ECONOMICS FOR MANAGERS

MONETARY AND FISCAL POLICY

By
Y.G. RAHUL REDDY
17021141118
What is monetary policy?
As the name suggests it is policy formulated by monetary authority i.e. central bank
which happens to be RBI in case of India.It deals with monetary i.e money matters i.e.
affects money supply in the economy.
Eg. CRR, SLR, OMO, REPO etc
What is fiscal policy then?
It is formulated by finance ministry i.e. government. It deals with fiscal matters i.e.
matters related to government revenues and expenditure.
Revenue matters- tax policies, non tax matters such as divestment, raising of loans,
service charge etc
Expenditure matters subsidies, salaries, pensions, money spent on creation of capital
assets such as roads, bridges etc.
Monetary policy and fiscal policy together deal with inflation.

Tools available with RBI:

MONETARY POLICY:
Quantitative tools or general tools- they affect money supply in entire economy-
housing, automobile, manufacturing, agriculture- everything.
Reserve ratio- Banks have to set aside certain percentage of reserves as cash or
RBI approved assets.

They are of two types

1. Cash Reserve Ratio (CRR) as the name suggests, banks have to keep this
proportion as cash with the RBI. Bank cannot lend it to anyone. Bank earns
no interest rate or profit on this.Bank cannot lend it to anyone.
2. Statutory Liquidity Ratio (SLR)- As the name indicates banks have to set
aside this much money into liquid assets such as gold or RBI approved
securities mostly government securities. Banks earn interest on securities but
as yield on govt securities is much lower banks earn that much less interest.
This reserve requirement is calculated on banks net demand (current and savings
account) and time liabilities (Fixed deposits) which is roughly equivalent to total bank
deposits.
At present CRR is 4% and SLR is 21.50% . But what if RBI tomorrow raised CRR or
SLR, what would be its impact.

Consider this-

Consider interest rate as price for a commodity called money/ cash and apply
demand supply principle of less commodity, higher prices i.e less money, higher
interest rates
Less money with the banks # demand for money same # apply demand supply
principle # interest rate will rise # costlier for you and I to borrow money to buy car #
demand for car down # apply demand supply principle # cost of car will come down
Similarly business will borrow less # less expansion of business activity # wages will
come down # less money with people # less demand for goods # prices wall

Net effect is that interest rate rises and prices fall.

What is dear money policy or contractionary monetary policy?

Money becomes costlier when interest rate rises and when RBI makes money to
become costlier or dearer, it is said to be following dear money policy. As money
supply decreases in the economy, i.e. contraction in money supply, it is also known
as contractionary monetary policy.

What are the negative effects of dear money policy?

Businesses postpone expansion due to high cost of credit and investment comes
down in the economy which drags down growth rates and hurts employment. Thats
the reason why corporates and government always clamour for policies which lead
to interest rate cuts such as reduction in CRR, SLR. Investment is thus negatively
correlated with higher interest rates.

2. Open market operations (OMO) As the name indicates this refers to operations
conducted by the RBI in open market i.e. RBI does not directly ask banks to do
anything. In this policy, RBI buys and sells government securities in the open market
to control money supply.
We talked about government security in SLR as well, what is this government
security?
Govt security is a type of debt instrument on which govt pays regular interest. As
chances of default on govt securities is practically zero, they are also called gilt-
edges securities.
What happens when RBI sells government securities?

Consider the below table:

You can clearly observe that amount available for lending has come down i.e. money
supply has contracted.

money going from the banks to the RBI # less money with the banks # dear money #
higher interest rates # costlier for us to borrow to buy cars # less demand for cars #
prices decrease

In effect, govt securities increases with banks when RBI sells govt securities.

Doesnt this look eerily similar to phenomenon when RBI raises SLR, only difference
being then banks were forced to raise their holding of securities. This way RBI suck
out liquidity from the market.
Opposite happens when RBI buy securities, it then injects liquidity in the market.
So basically to control inflation, RBI will sell securities and suck out liquidity from the
market.
OMOs are used more to control temporary mismatches in liquidity due to foreign
capital flow, a policy known as sterilization.

Lets understand sterilization

Consider this-

When foreign investors invest in Indian economy, they buy rupees and sell dollars.
RBI absorbs dollars and issues rupees. Net effect is that rupee supply or liquidity is
increased in the economy. Higher liquidity or money supply chasing similar amount
of goods will lead to inflation. RBI has to suck out excess liquidity from the market
i.e. sterilize economy from capital flows.

What RBI would do

Undertake OMOs and sell government securities.

Note that I didnt mention RBI would bring money supply to 1000 as with FDI,
productive capacity would rise and to that extent goods worth say 1020 may be
manufactured in INDIA and in that scenario to keep inflation stable, RBI needs to sell
securities worth 20rs only. What would be the actual growth is essentially a data
dependent judgement call.
When investors bring back their money, they will sell rupees and buy dollars. RBI will
absorb rupees resulting in less liquidity in the market. To adjust this RBI will buy govt
securities and inject liquidity in the market.
RBI uses another instrument to keep the liquidity intact, it is known as Market
Stabilization Scheme (MSS).

3.Policy rates

Bank rate When banks borrow long term funds from RBI. Theyve to pay this much
interest rate to RBI.
At present bank rate is 7.75%. Bank rate is not the main tool to control money supply
these days. Nowadays, RBI uses LAF ( liquidity adjustment facility) Repo rate as the
main tool, to control money supply.

Whats the use of Bank rate then?

Penal rates are linked with Bank rate. For example, If a bank doesnt maintain CRR,
SLR as per the prescribed limit, penalty is prescribed as per bank rate.

Its clear if RBI raises bank rate, costlier for banks to borrow from RBI # interest rate
rises # repeat same story # costlier for you and I to borrow money to buy car #
demand for car down # apply demand supply principle # cost of car will come down
Liquidity Adjustment Facility (LAF):

Its evident from the name that RBI uses such instruments to adjust liquidity and
money supply.

#1. REPO rate REpurcahse OBligation

Rate at which banks buy from RBI on a short term basis.

What do they have to repurchase?

Banks have to put govt. securities as collateral and buy those securities back at the
end of prescribed period, generally overnight
Banks can not use securities from SLR as collateral
On the Urjit Patel Committees recommendation that the RBI stop fixing the repo
rate in its quarterly reviews, and instead move to rate-setting on an ongoing basis,
RBI started auctioning 7 day and 14 days term repo. In term repo, rate is market
determined unlike overnight repo where RBI decides rate. Also RBI has restricted
access to overnight repo to .25% on NDTL.

Clearly if RBI raises repo # costlier for banks to borrow # interest rate rises # repeat
same story # costlier for you and I to borrow money to buy car # demand for car
down # apply demand supply principle # cost of car will come down

#2. Reverse Repo as the name suggests is reverse of repo i.e. rate RBI pays to
banks to park excess funds into RBI.

Reverse repo is linked to repo with,

Reverse repo = repo 1

#3. Marginal Standing facility

Penal rate at which banks can borrow money from the central bank over and above
what is available to them through the rep window.

It is penal rate, hence REPO + 1

Reverse Repo + 1 = REPO; REPO + 1 = MSF

Under MSF banks can use up to 1% of securities from SLR.

Lets recap all this. To control inflation RBI will follow dear or contractionary
monetary policy to reduce money supply in the economy. It will increase reserve
ratios (CRR,SLR), sell government securities under OMOs or raise various rates
such as REPO, MSF, Bank rates etc.
But we see in India, even when RBI decreases rates banks dont pass on the
benefits to consumers and when banks raise interest rates when RBI raises rates,
inflation does not come down. This suggest monetary policy is highly ineffective in
India.

Monetary Policy Transmission Conundrum

Why banks dont pass on the benefits of rate cut to consumers?

RBI cut repo rate by 125bp last year but banks decreased lending rate only by 60bp.

1. RBI is not the main or even prominent money supplier for banks but Retail
savers are so RBI rate cuts do not affect cost of funds much for the banks
2. Deposits rates are mostly fixed and can not be reduced, only subsequent
deposit rates can be reduced. i.e. If i have deposited 100 rs in FD for 5 years,
banks will have to pay me 8% interest for next 5 years no matter whether RBI
cuts rates or not
3. Small saving instruments such as PPF, Post office accounts have high
administered interest rates. If banks cut deposit rates below those rates,
customers will shift to those instruments and banks will lose out on funds
4. Banks as we all know are under stress. Keeping lending rates high increases
their profit margins
5. No well developed corporate bond market in India. Corporate have no choice
but to come to banks to borrow
Government and RBIs response to improve monetary transmission:

1. Government has decided to reduce interest rates on small saving accounts.

Permanent solution would be to link small savings rates to bank rate
2. RBI has asked banks to shift methodology of calculation of base rate to
marginal cost of funds from average cost of funds at present<marginal cost is
the cost of every extra unit of fund> <What is base rate? How will shift to
marginal cost of funding promote transparency in base rate calculation and
help consumers? Answer in the comments>
But why is RBI unable to control inflation even when banks immediately raise
lending rates?

1. Supply side issues not under RBI control- bottlenecks in agri marketing, high
prices of crude oil, failure of monsoon etc.
2. Higher government fiscal deficit
 3. Non-Monetized economy: in rural areas, many transactions are still of barter
nature
4. Lack of financial inclusion. Since most people are not in the banking net. They
rely on Shroffs and moneylenders. Obviously moneylenders wont listen to
RBI
5. Black money and cash economy
We have talked about quantitative tools so far but RBI also has some qualitative
tools in its kitty which are not important for exams. So in brief

What are the qualitative tools?

They are Selective tools- can affect money supply in a specific sector of economy
unlike general quantitative tools which affect money supply in the whole economy.

Margin Requirements- RBI can prescribe margin against collateral. For

instance, lend only 70 rs for 100 rs value gold, margin requirement being
30%. Obviously if RBI raises margin requirement, customers will be able to
borrow less.
Moral suasion RBI persuade banks to park money in govt securities instead
of certain sectors.
Selective credit control Don loan to theses industries or to speculative
businesses
Issue of autonomy of RBI:
By now we have understood that govt and corporate are more interested in low
interest rates which support investment and growth while primary task of RBI is to
control inflation, keeping prices stable and thus protecting purchasing power of
money. This is not to say that govt and corporate do not want low inflation, they do
but their primary focus lie elsewhere. It is in this context that autonomy of RBI to
decide on monetary policy matters becomes so important.
At present sole authority vests with RBI governor who is advised by a technical
expert committee whose advice is not binding. Government intends to replace it with
a monetary policy committee (recommended by FSLRC and Urjit Patel committee
and followed in many countries) with members both from within and outside RBI.
Two important questions arise-

Composition of such a committee- for autonomy it is important to have either RBI

members majority or equal numbers from both sides with governor exercising a
casting vote (just like speaker does in LokSabha). Having outside majority does
seem to impinge on autonomy of RBI.
Veto of governor If governor is given veto power, it changes nothing. Even now,
theres a committee but its deliberations are only academic. If governor cant
convince his own committee of desirability of policy stance he advocates, he would
seem to be on a weaker wicket.
Ideal committee would be one with RBI majority or equal members with casting vote
with the governor without any veto. This along with explicit inflation target would give
enough autonomy to go along with accountability.
FISCAL POLICY:

fiscal policy is the use of government revenue collection (mainly taxes but also non
tax revenues such as divestment, loans) and expenditure (spending) to influence the
economy.

Fiscal policy thus contains essentially two components-

Revenue Collection- (primarily taxation)- Govt collect taxes which are of two types

1. Direct tax -A direct tax is generally a tax paid directly to the government by the
person on whom it is imposed. Eg-. Income tax<your income, you pay tax>,
corporation tax<Corporate profits, they directly pay tax>, wealth tax<your wealth, you
directly pay tax>, capital gains tax<value of your asset increases, you pay tax>,
securities transaction tax<you trade, you pay>

2. Indirect tax-An indirect tax is indirectly paid by consumers. Govt taxes goods and
services # manufacturer/ seller/ service provider pay the taxes # he increases the
prices to recover taxes # indirectly consumers end up paying taxes. In effect, tax is
shifted from one taxpayer to another, by way of an increase in the price of the goods
and services. Eg. Excise duty<union tax on manufacturing>, custom duty<union tax
on imports and exports>, service tax<union tax on services>, sales tax or VAT<state
level tax on sale of goods, thats why price of petrol is different in all the states>, central
sales tax<tax levied by union but given to states on interstate movement of goods>

Q. What Is Minimum Alternative Tax (MAT)? Is it a direct or indirect tax? What is the
rationale for imposing it?

Indirect tax is generally considered regressive in nature as tax remains the same no
matter how much you earn. So, for instance, if tax on diesel is 20%, a poor farmer
would have to pay the same tax to run his tube-well as Ambani has to pay to drive his
Audi. On the other hand, in direct taxes, less you earn, less you have ti pay<Brackets
in income tax>.
Of course, governments try to make indirect tax structure a bit less regressive by taxing
luxury products more. For instance, taxes on SUVs are higher than taxes of small cars.
Also, govt by way of higher taxes try to shift consumption away from some product
such as cigarette, tobacco etc.<sin tax>.
Source-differencebtw.com
What would happen if govt increased taxes?

When government increases taxes, it basically leaves less money in the hands of
people # less money # less consumer demand # apply demand supply principle # less
demand for goods # prices fall # corporate will delay investment # job loss # slowdown
in the economy.

As we saw when RBI raises rates or sucks out liquidity through open market sales of
government securities, it tightens money supply and reduces demand resulting in
prices fall. It is said to be following dear or contractionary monetary policy.

Similarly when government raises taxes, it reduces consumption demand and it is

known as contractionary fiscal policy. On the other hand when government slashes
rates to stimulate consumption to kick start the economy, it is known as expansionary
fiscal policy.
Expenditure (spending) - Government spend money which also provides demand to
the economy. If government decides to spend more by borrowing, it increases
aggregate demand and it is known as expansionary fiscal policy.

Basically contractionary policy- increase taxes, slash spending is followed when

inflation is high to bring down demand and thus cool down prices and expansionary
policies to pump prime the economy by creating the demand through decreased taxes
and higher spending.
Estimates of spending and taxation are presented in budget which also mentions
various deficits like fiscal deficit, revenue deficit, effective revenue deficit. Want to
know more about them, click here
Plan v/s non plan expenditure

Plan expenditure expenditure on schemes and projects covered by the five-year

Plans (road construction, railway line construction etc.)

Non-plan expenditure: Ongoing expenditure by the government not covered by the

Plans <routine expenditure to run the govt>. Eg. Interest payment, Subsidies, salaries,
pension, defense expenditure etc.

Please note that both plan and non plan expenditure includes revenue and capital
expenditure. Its not that the plan expenditure is equivalent to capital expenditure while
non plan is revenue expenditure. To know the difference b/w revenue and capital
expenditure.
Budget is an important part of fiscal policy as revenue and expenditure statements are
presented during the budget. Lets understand in brief, where all the revenue comes
from and where all the money goes.

Source-PIB
We can clearly see, among non debt creating receipts (not borrowings), maximum
earning is from corporate tax followed by income tax.

facts on revenue and expenditure:

 direct taxes> Indirect taxes
Corporate tax>Income tax>Excise>Service tax>custom
Non plan expenditure> Plan expenditure (more than double)
Interest payment>>subsidies and defense <subsidies and defense are almost
equal. Every year including this year defense is budget higher amount but
eventually, subsidies turn out to be higher during revised estimates
Food subsidies>> Fertilizer subsidies >> Fuel subsidies
When government reduces its fiscal deficit, it is known as fiscal consolidation.

Clearly it can be achieved in two ways, reduce spending or increase taxes or

combination of two. Here we discuss one component of spending known as subsidy
in some detail. Everyday we read about subsidy rationalization, cutting or increasing
subsidies and passionate arguments on both sides.

What is subsidy?

What is subsidy?

In a laymans term, it can be understood as converse of a tax in that using taxation

government takes money from consumers while subsidy in effect transfer money from
government to consumers.

For instance, taxes on grain would increase their market price from say 10 rs a kg to
12 rs a kg, in effect taking 2 rs from you for every kg of grain you buy. On the other
hand subsidy under PDS would reduce price of grain from 10 rs to say 2rs in effect
transferring 8 rs to your pocket. In this way, they are converse of indirect taxes.

When government directly transfers money in your bank account without any condition
i.e. unconditional direct benefit transfer, subsidy becomes converse of direct taxes.

In India government (central and state) subsidize a lot of things from food to fertilizer
to kerosene and LPG etc. Tax concessions can also be considered as implicit subsidy.
Subsidies increase government spending and thus puts pressure on government
finances.

So whats the rationale for subsidy?

Like indirect taxes, subsidies can alter relative prices and budget constraints and
thereby affect decisions concerning production, consumption and allocation of
resources.

So purpose of subsidies is two fold-

Increasing consumption of items government considers important such as health,

education, nutritious food etc or renewable energy in modern times.
Redistributive effect i.e. to provide minimum level of protection to the poor <welfare
function, tax the rich, distribute in poor>
For objective one to be fulfilled government should subsidize merit goods.

What are merit goods

A good which would be under-consumed (and under-produced) in the free market
economy

But why are they under-consumed?

They are associated with positive externality i.e. they also benefit public but since
consumers and producers will take account of only private benefits, they are likely to
consume less than desired. For instance, consider education, not only a person is
educated and earns more <private benefit> but more productive individual would also
benefit society in the form of higher taxes <societal benefit>

For objective two (redistribution) to be achieved, subsidies should be well targeted i.e.
reach the poor with minimal leakages. This requires proper targeting without which
there would be inclusion errors (rich getting subsidy and exclusion errors (poor not
getting subsidy). Exclusion errors are the worst since they direct affect the poor
<kerosene meant for poor not reaching him, how will she light her house>

Subsidy rationalisation is this process of better targeting to weed out unintended

beneficiaries as well as phasing out subsidies on non merit goods.
So, what are the adverse consequences of bad subsidies (non merit, not well
targeted)?

Fiscal effects directly increase fiscal deficit and thus total government debt
<10% of total govt spending is for subsidies> <While golden rule of borrowing
is, borrow to invest >
Allocative effects result in inefficient resource allocation <producers will
produce more of subsidized good even when not required>
perverse distributional effects endowing greater benefits on the better off
people <subsidized diesel being used to run SUVs>
Shortages and black marketing <subsidized urea being diverted to non
agricultural uses, scarcity leading to black marketing harms the poorest farmers
the most>
Tendency to self-perpetuate. They create vested interests and acquire political
hues.
For instance, High MSP for wheat and rice and subsidized water and electricity
illustrates all such effects, an example of bad bad subsidy.

Perverse distributional effects better off farmers of Punjab and Haryana

getting benefited<no procurement from eastern belt, poor farmers of Bihar,
Jharkhand not getting benefits>
Fiscal effects finances of central as well as state govt getting stretched,
discoms in debt <high deficit # high debt # high interest cost # high deficit =
vicious circle>
Allocative effects pulses and oilseeds are not grown resulting in shortages
<procurment only of grains, no incentive to produce pulses>
environmental effect water table going down, soil getting salty and arid
Health effect Groundwater pollution due to high fertilizer use, burning of husks
resulting in air pollution
How subsidies distort the market (in a comical way) is best understood by Railway
subsidies <Example from last years economic survey>

Govt subsidizes passenger fares resulting in losses. Railways cannot generate

sufficient internal resources to finance capacity expansion investments;Result-
Trains always run late, very slow services, whole economy becomes
unproductive
Of course the passenger fare is cross subsidized by high freight tariffs . It results
in diversion of freight traffic to road transport which is costlier. Result- not only
financial and efficiency costs but also acute costs associated with emissions,
traffic congestion, and road traffic accident (RTA) <And we all know passengers
on two wheeler or those walking die the most in the RTA i.e. poorer segments
of society>
High freight cost raises the cost of manufactured goods that all households,
including the poor, consume. <subsidized passenger fare but costly goods, no
 one knows who gains who losses but these distortions decreases the overall
efficiency and thus whole economy suffers.>
Whats the solution?

End perverse subsidies while investing in state capacity to deliver basic goods and
merit goods such as health, education, skills etc. Incentivize research and
development, environment friendly technologies etc. Borrow only to invest. Adhere to
FRBM targets of zero revenue deficit.

Direct Benefit Transfer (DBT) using JAM number trinity, read the economic
survey chapter here
JanDhan i.e. Bank accounts, Adhar i.e biometric identification and mobile i.e.
mobile banking
It will result in direct transfer of money to bank account of beneficiaries and cut
down leakages as intermediaries are removed.
Biometric authentication will remove ghost accounts i.e same person getting
subsidy twice from two different names.
Mobile banking will give access to bank accounts for easy deposit and
withdrawal
But problem of identification of beneficiaries still remains and it requires better and
more robust data collection, publishing names of beneficiaries at gram panchayat level
for people to raise objections, jan sunwai (public hearing), social audits and such
transparency mechanisms
Pitfalls of DBT

1. Where transfers are unconditional, people may just spend money on desi liquor
<objective of changing consumption pattern defeated>. For instance, if govt
transferred 6000 rs to every pregnant women its possible that money will go in
the bank account of husband and instead of better nutrition for pregnant lady,
he will buy desi liquor.
solution- transfer money in the hand of oldest woman and provide her information so
that she can take informed decision in the best interest of family

2. Conditional transfers might give rise to its own kind of corruption. For instance if
money is transferred for check up by a nurse, she might demand bribe for certifying
you indeed showed up for check up.
3. Private market may not exists for people to buy goods and services from the market.
For instance, if PDS shops are closed, where would people buy ration from?
4. Banking infrastructure poor <as we saw in the JAM article, last mile banking access
is jamming the JAM>
5. Real value of subsidy amount will be eroded with inflation. solution- link subsidy with
CPI inflation. But generally food inflation higher than CPI, then what?
6. There is concern that biometric fingerprinting may not work for rural manual
labourers.

Government should rationalize subsidies so they are targeted better and use money
thus made available to invest in physical and social infrastructure.In this way by
rationalizing subsidies government can bring down fiscal deficit and overall debt level.
Bringing fiscal deficit under control, reduces aggregate demand, this cooling down
prices.