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 – RRWhere LR = legal reserves = banks vault cash (coins and

currency) + deposit in central bankAnd RR = required reserves = fraction of deposits that

banks must hold as reserve

How it works

If a Bank’s 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.