MONETARY & FISCAL

POLICY
MONETARY POLICY
Refers to measures designed to influence the cost and
availability of money for the purpose of influencing the
working of the economy.
TWO BROAD VIEWS:
Broad sense:
all measures undertaken by
government to affect expenditure or
use of money by the public.
May include non-monetary measures
taken by the government, for e.g.
wages and price controls, budgetary
operations, etc., which indirectly
influence the monetary situation in
the economy.

Narrow sense:
refers to the regulation of the supply of money
(currency and bank deposits) through discretionary
actions of the central banking authorities.

INSTRUMENTS OF
MONETARY POLICY
Quantitative Credit Control:
they are so called because they control the quantity
of money, e.g., bank rate, open market operations,
changes in reserve requirements.

Qualitative Controls:
they are employed to limit the amount
of money available for certain
specific purposes even though
plenty of money may be available
for other purposes, i.e. they control
the quantity as well as direction of
money flow; consumer credit control,
margin requirements, moral suasion,
etc.

QUANTITATIVE
CONTROLS
BANK RATE OR DISCOUNT RATE
It is the rate of interest the central bank charges
its member banks.
By changing the discount rates, the central bank
controls the level of bank reserves and the
money supply.
Method: Discount rate affects bank interest rates.

OPEN MARKET OPERATIONS
Buying and selling of government bonds or
securities by the Central Bank.
Increase Money supply =>
central bank purchases securities from open
market.
Decrease Money supply =>
central Bank sells securities.

VARIABLE RESERVE RATIO
Cash Reserve Ratio: the amount of cash reserves the
Banks have to maintain with the Central Bank

Banks create credit on the basis of their cash reserves.
The greater the excess reserves, the greater the credit
created.

ER = LR RR
Where LR = legal reserves = banks vault cash (coins and
currency) + deposit in central bank
And RR = required reserves = fraction of deposits that
banks must hold as reserve




HOW IT WORKS
If a Banks balance sheet shows vault cash = Rs.
100,000
Deposit in central Bank = Rs.200,000
LR = Rs. 300,000
If reserve requirement r = 10%
RR = rD= 0.1 x Rs.1,000,000 = Rs.100,000
ER = 300,000 100,000 = 200,000


Banking system can expand money supply by
deposit expansion multiplier (1/r) times the ER =
(1/0.1) x 200,000 = Rs. 2,000,000.
QUALITATIVE
CONTROLS
MARGIN REQUIREMENTS
Margin: Difference between loan value and
market value of securities.
By prescribing the Margin requirement the
Central Bank sets the limit to the amount of loan
extendable against the securities offered as
collateral.


CONSUMER CREDIT
This method helps to regulate the terms and
conditions for the purchase of durable consumer
goods.
Changing minimum down payment.
Changing maturity period of consumer credit.
Changing cost of consumer credit (i)
DIRECTIVES OF CENTRAL
BANK
May be in the form of written orders,
appeals or directives from the Central
Bank to Commercial Banks.
To control lending policies.
To divert credit from less to more
urgent/productive uses.
To prohibit lending for certain purposes.
To fix maximum limits of credit for certain
purposes.
RATIONING OF CREDIT
Fixes the limit upon its re-discounting facility for a
particular bank
Fixes a quota for every affiliated bank for
financial accommodation from the Central Bank.
OTHER METHODS
Moral Suasion: involves advice, request
and persuasion with the commercial banks
to co-operate with the Central Bank.
Publicity: Central Bank gives wide publicity
to what is good/bad in the credit system
of the country.
Direct Action: use of coercive measures
against those Banks who do not comply
with instructions of the Central Bank.
MONETARY POLICY
DURING INFLATION
INFLATION CHARACTERISTICS
High MEC => rising P, O, Y, E
General wave of optimism
Business activity expands rapidly
More cash is released by banks making additions to
consumers income and outlay.
AIMS OF THE MONETARY POLICY
Slow down the rate of expansion of money => affect
the velocity of circulation of money
Reduce volume of liquid assets
Reduce consumption & investment by means of higher
interest rates.

MEASURES
Interest rates can be raised as high as monetary
authorities wish
Open market operations curtail liquidity of bank
and non-bank groups
Margin requirements and consumer credit
controls can also be tightened.
MONETARY POLICY
DURING DEPRESSION
DEPRESSION - FEATURES
Low MEC => falling prices, incomes, output &
employment
Low interest rates
High liquidity preference.
MONETARY POLICY
OBJECTIVES
To offset decline in velocity of money
To satisfy demand for precautionary &
speculative motive
To strengthen the cash position of banks &
non-bank groups
Stimulate lending for investment &
consumption purpose
Bring down structure of interest rates to
encourage investment.

CHEAP MONEY POLICY
Bring down the interest rate
Increases aggregate demand
Using excessive savings for development
Stimulating confidence in security market
DRAWBACKS
Interest rates are already low and cannot be
depressed further
Injections of cash & other liquid securities
absorbed by firms, banks & individuals to
enhance their liquidity position; in changing from
risky & illiquid assets to less risky & more liquid
assets
FISCAL POLICY
The purposeful manipulation of
public expenditure and taxes is
referred to as Fiscal Policy.
Changes in government expenditure and taxation
designed to influence the pattern and level of activity.

Harvey & Johnson
We define Fiscal Policy to include any design to
change price level, composition or timing of
government expenditure or to vary the burden,
structure or frequency of the tax payment.

G.K. Shaw
J.M. KEYNES
Monetary policy went into disrepute in late
1920. Upto 1920s classical economists were
concerned with monetary policy alone to
attain the goals of macroeconomic policy.
Fiscal policy was discovered by Keynes in
1930s => most powerful instrument for affecting
the volume of aggregate effective demand or
desired expenditure and thus the level of
national income, employment and price level.
Applied his fiscal policy prescription in the
context of the great depression of 1930s.
His fiscal policy was concerned with short run
economic stability and tackling cyclical
fluctuations.

Changes in taxes and expenditure that aim at
the short-run objectives of full employment and
stability in prices are called fiscal policy.
OBJECTIVES
Optimum allocation of economic resources
Equitable distribution of income and wealth
Maintain price stability
Promotion and maintenance of full employment
INSTRUMENTS OF FISCAL POLICY
Taxes
Expenditure
Public debt
Budget
TAXATION
Fiscal policy, especially tax policy, can be used
to enhance growth, by encouraging the efficient
use of any given amount of scarce resources.
PUBLIC EXPENDITURE
Public expenditure embraces all the
public sector spending including that of
central governments, state governments,
local authorities and public corporations.
The pattern of public expenditure is
influenced by interest groups and by
economic, political, demographic,
sociological and technological factors.
In addition, international demonstration
effect induces developing countries like
India to follow spending patterns of
advanced countries.
FISCAL POLICY DURING
INFLATION & DEFLATION
During Inflation: Aims at controlling excessive
aggregate spending.

During Depression: aims at making up deficiency in
effective demand; and avoiding unemployment.
Contra Cyclical Budgetary Policy =>
manipulation and managing the budget
to iron out cyclical fluctuations.
Unbalanced Budget during depression
implies deficit spending by increasing
government outlays (expansionary),
while during inflation implies surplus
budget by curtailing government
expenditures (deflationary).
Taxation => determine the size of disposable
income => reduces the inflationary gap, given
the supply of goods & services.
Public Debt => refers to public borrowing and
repayment.
Public Works => stabilizing expenditures of the
pump priming & compensatory nature.

Built-in Stabilizers:
both taxes and transfer payments may vary with
changes in income levels.
Stabilizer counteracts fluctuations in economics
activities
Built-in come into play automatically when
income level changes
LIMITATIONS
Effectiveness depends upon the size and timing
of the measure adopted.
Political and administrative delays
Success depends upon redistribution of income
and a chain of economic and psychological
reactions of the people.