Business CycleMonetary and Fiscal Policy

Business cycle is also called Trade Cycle. The business is never steady. There are always ups& downs in economic activity. This cyclical movement both upwards and downwards are commonly called Trade Cycle. This is a wave like move in regular manner in business cycle

Definition.Keynes: Trade Cycle is composed of periods of good trade characterized by rising price and low unemployment percentage altering with periods of bad trade characterized by falling price and high unemployment percentage.

To put it in simple words:-Business Cycle is a fluctuation of the economy characterized by periods of prosperity followed by periods of depression.

Business cycle

FOUR PHASES OF BUSINESS CYCLE 1. Prosperity Phase: Expansion or Boom or Upswing of economy.

2. Recession Phase: From Prosperity to Recession (upper turning point).

3. Depression Phase: Contraction or Downswing of economy.

4. Recovery Phase: From Depression to Prosperity (lower turning Point).

Prosperity PhaseWhen there is an expansion of output, income, employment, prices and profits, there is also a rise in the standard of living. This period is termed as Prosperity phase.

The features of prosperity are :-•High level of output and trade.•High level of income and employment.•Rising interest rates.•Inflation.•Large expansion of bank credit.•Overall business optimism.•A high level of MEC (Marginal efficiency of capital) and investment.Due to full employment of resources, the level of production is Maximum and there is a rise in GNP (Gross National Product). Due to a high level of economic activity, it causes a rise in prices and profits. There is an upswing in the economic activity and economy reaches its Peak. This is also called as a Boom Period.

Recession Phase

The turning point from prosperity to depression is termed as Recession Phase.

During a recession period, the economic activities slow down. When demand starts falling, the overproduction and future investment plans are also given up.

There is a steady decline in the output, income, employment, prices and profits. The businessmen lose confidence and become pessimistic (Negative). It reduces investment. The banks and the people try to get greater liquidity, so credit also contracts. Expansion of business stops, stock market falls. Orders are cancelled and people start losing their jobs. The increase in unemployment causes a sharp decline in income and aggregate demand. Generally, recession lasts for a short period.

Depression Phase

When there is a continuous decrease of output, income, employment, prices and profits, there is a fall in the standard of living and depression sets in.The features of depression are :-•Fall in volume of output and trade.•Fall in income and rise in unemployment.•Decline in consumption and demand.•Fall in interest rate.•Deflation.•Contraction of bank credit.•Overall business pessimism.•Fall in MEC (Marginal efficiency of capital) and investment.In depression, there is under-utilization of resources and fall in GNP (Gross National Product). The aggregate economic activity is at the lowest, causing a decline in prices and profits until the economy reaches its Trough (low point).

Recovery Phase

The turning point from depression to expansion is termed as Recovery or Revival Phase.

During the period of revival or recovery, there are expansions and rise in economic activities. When demand starts rising, production increases and this causes an increase in investment.

There is a steady rise in output, income, employment, prices and profits.

The businessmen gain confidence and become optimistic (Positive). This increases investments. The stimulation of investment brings about the revival or recovery of the economy. The banks expand credit, business expansion takes place and stock markets are activated.

There is an increase in employment, production, income and aggregate demand, prices and profits start rising, and business expands. Revival slowly emerges into prosperity, and the business cycle is repeated.

Thus we see that, during the expansionary or prosperity phase, there is inflation and during the contraction or depression phase, there is a deflation.

Monetarism has several key tenets:

•Control of the money supply is the key to setting business expectations and fighting inflation's effects.•Market expectations about inflation influence forward interest rates.•Inflation always lags behind the effect of changes in production.•Fiscal policy adjustments do not have an immediate effect on the economy. Market forces are more efficient in making determinations.•A natural unemployment rate exists; trying to lower the unemployment rate below that rate causes inflation.

Policies: Monetary and Fiscal

Monetary Policy –Meaning….

Credit control policy or Monetary policy defined as;-

"that branch of economic policy which is concerned with the regulation of the availability or supply, the costs and the directions of credit."

OBJECTIVES or GOALS

The objectives of credit control/monetary policy have been different at different times in different countries according to the economic situations and problems faced by them.

In the modern times economic development with monetary stability is accepted as the most important goal of credit control.

The main objective of this credit-control function is to save economy from inflation and deflation and to stabilize the economy and prices.  METHODS OF CREDIT CONTROLCredit control is one of the most important responsibility of a central bank. Central bank of a country can control credit by following two methods.

(1)Qualitative controls(2)Quantitative controls

QUANTITATIVE CONTROLSQuantitative controls are used to expand or contract the total quantity (overall size) of credit.

These controls are of the following kinds:

1. Bank rate policy2. Open market operations 3. Variable reserve ratios (Direct instruments like: CRR, SLR)4. Liquidity ratio (Indirect Instruments like: repo and reverse Repo)

Bank Rate (or Discount Rate) PolicyBank rate is the rate at which central bank rediscounts bill of exchange or provides credit to commercial banks. For controlling credit, central bank may increase or decrease bank rate. When bank rate is raised, other bank's interest rates on advances also move up. When bank rate is decreased, other banks' interest rates on advances also go down. Borrowing from banks is discouraged or encouraged and, as a result, the rate of monetary expansion decreases or increases.

Open Market OperationBuying and selling of government securities by the central bank with a view to influencing money supply is called open market operations. When the central bank sells securities the buyers make payment for these to the central bank through commercial banks. A portion of commercial banks' cash flows to the central bank. As a result, the lending and financing power of banks decreases which leads to reduction in the rate of credit expansion. The purchase of securities by the central bank has the reverse effects.

Variable Reserve Ratios

The amount of money which the banks are legally required to keep with the central bank is termed legal cash reserve ratio or requirement. It is a certain percentage of deposits. If the cash reserve ratio is raised, say from 5% to 7% of total deposits, the lending and financing power of banks will contract accordingly. This will cause fall in the rate of money expansion. A decrease in ratio has an opposite effect.

Direct Instruments

Cash reserve ratio (CRR) The money supply in the economy is influenced by CRR. It is the ratio of a bank’s time and demand liabilities to be kept in

reserve with the RBI. The RBI is authorized to vary the CRR between 3% and 15%.

Statutory liquidity ratio (SLR): Under SLR, banks have to invest a certain percentage of its time and

demand liabilities in govt. approved securities. The reduction in SLR enhances the liquidity of commercial banks.

Indirect Instruments Liquidity adjustment facility (LAF) is a monetary policy tool which allows

banks to borrow money through repurchase agreements. LAF is used to aid banks in adjusting the day to day mismatches in liquidity.

LAF consists of repo and reverse repo operations.

Repo or repurchase option is a collaterised lending i.e. banks borrow money from Reserve bank of India to meet short term needs by selling securities to RBI with an agreement to repurchase the same at predetermined rate and date. The rate charged by RBI for this transaction is called the repo rate.

Repo operations therefore inject liquidity into the system. Reverse repo operation is when RBI borrows money from banks by lending securities.

Reverse Repo Rate: The rate at which RBI borrows from commercial banks.

The interest rate paid by RBI is in this case is called the reverse repo rate.

Reverse repo operation therefore absorbs the liquidity in the system. The collateral used for repo and reverse repo operations comprise of Government of India securities. Oil bonds have been also suggested to be included as collateral for Liquidity adjustment facility

SELECTIVE/ QUALITATIVE MEASURES

• The RBI directs commercial banks to meet their social obligations through selective/ qualitative measures.

• These measures control the distribution and direction of credit to various sectors of the economy.

CEILING ON CREDIT MARGIN REQUIREMENTS DISCRIMINATORY RATES OF INTEREST

1. Absence of developed money markets. In underdeveloped countries, central bank control over bank credit is rendered very difficult by the absence of well-developed money markets.2. Existence of non-monetized sector. In less developed countries there exists a large non-monetized and rural subsistence sector. Thus a big section of the community is quite unaffected by monetary policy.3. Large-scale deficit financing. A large-scale deficit financing by the government may make the central bank powerless in controlling the amount of credit and inflationary pressures. Thus, unless it is prevented, the credit control measures will have little value.4. Cooperation of banks. It is very difficult for a central bank to control credit if commercial banks do not extend their full cooperation.5. Conflicting objectives. The greatest difficulty in the way of the central bank in controlling credit is the simultaneous achievement of conflicting objectives. For example controlling inflation and increasing employment opportunities are conflicting objects.

Problems caused by Inflation

• High and persistent inflation imposes significant socio-economic costs.

• High inflation distorts economic incentives by diverting resources away from productive investment to speculative activities.

• Inflation reduces households saving as they try to maintain the real value of their consumption.

• If domestic inflation remains persistently higher than those of the trading partners, it affects external competitiveness through appreciation of the real exchange rate.

• The Reserve Bank’s current assessment suggests that the threshold level of inflation for India is in the range of 4–6 per cent.

How does monetary policy affect inflation and other problems?

raisesdecreases

FISCAL POLICY

Meaning

• Fiscal policy deals with the taxation and expenditure decisions of the government. These include, tax policy, expenditure policy, investment or disinvestment strategies and debt or surplus management.

- Kaushik Basu ( Former Chief Economic Adviser )

OBJECTIVES OF FISCAL POLICY

• Increase in capital formation.

• Degree of Growth.

• To achieve desirable price level.

• To achieve desirable consumption level.

• To achieve desirable employment level.

• To achieve desirable income distribution.

Direct Tax

• Individual Income Tax & Corporate Tax.

• Wealth Tax

Indirect Tax

• Central excise (a tax on manufactured goods)

• VAT • service tax • customs duty • Educational cess

The Expenditure budget includes four main revenue expenditures

Fiscal Deficit• Fiscal Deficit = Total Expenditure (that is Revenue

Expenditure + Capital Expenditure) – (Revenue Receipts + Recoveries of Loans + Other Capital Receipts)

• Currently the deficit is4% (2014-15) reduced from 5.3 % of GDP

Which is More Effective Monetary or Fiscal Policy?In recent decades, monetary policy has become more popular because:•Monetary policy is set by the Central Bank, and therefore reduces political influence (e.g. politicians may cut interest rates in desire to have a booming economy before a general election)•Fiscal Policy can have more supply side effects on the wider economy. E.g. to reduce inflation – higher tax and lower spending would not be popular and the government may be reluctant to purse this. Also lower spending could lead to reduced public services and the higher income tax could create disincentives to work.•Monetarists argue expansionary fiscal policy (larger budget deficit) is likely to cause crowding out – higher government spending reduces private sector spending, and higher government borrowing pushes up interest rates. •Expansionary fiscal policy (e.g. more government spending) may lead to special interest groups pushing for spending which isn’t really helpful and then proves difficult to reduce when recession is over.•Monetary policy is quicker to implement. Interest rates can be set every month. A decision to increase government spending may take time to decide where to spend the money.

However, the recent recession shows that Monetary Policy too can have many limitations.•Targeting inflation is too narrow. This meant Central banks ignored an unsustainable boom in housing market and bank lending.•Liquidity Trap. In a recession, cutting interest rates may prove insufficient to boost demand because banks don’t want to lend and consumers are too nervous to spend. Interest rates were cut from 5% to 0.5% in March 2009, but this didn’t solve recession in UK.•Government spending directly creates demand in the economy and can provide a kick-start to get the economy out of recession. Thus in a deep recession, relying on monetary policy alone, may be insufficient to restore equilibrium in the economy.•In a liquidity trap, expansionary fiscal policy will not cause crowding out because the government is making use of surplus saving to inject demand into the economy.•In a deep recession, expansionary fiscal policy may be important for confidence – if monetary policy has proved to be a failure.

Supply of Money

Money supply at a particular moment of time is

the stock of money held by the public.

It refers to the total currency notes, coins and

demand deposits with the banks held by the

public

There are two views of money supply such as

1. Traditional View

2. Modern View

Traditional View

According to the traditional view, money supply is composed

of

Currency money and Legal tender money, i. e., coins and

currency notes

Bank money, i. e. ,demand deposits with commercial bank

Modern View

According to the this view, the phenomenon of money supply

refers to the whole spectrum of liquidity in the asset portfolio of the

individual.

Thus money supply is wider concept which include

Coins

Currency notes

Demand deposits with banks

Time deposits with the banks

Financial assets, such as deposits with the non-banking financial

intermediaries like the post-office savings bank

Money Supply in India

Monetary authority of a country, by adopting a

proper monetary policy, tend to regulate money

supply in order to influence economic activity.

Formulation and successful implementation of

monetary policy requires an appropriate definition

of money supply.

Till 1976, the Reserve Bank of India(RBI) used to adopt only

the narrow measure of money supply defined as the sum of

currency and demand deposits both held by the public.

From April, 1977, the RBI has adopted four alternative

definitions of money supply.

M1= C+DD+OD

Where C= currency, DD=demand deposits, OT= other deposits

of RBI which includes demand deposits of quasi-government

institution like IDBI, foreign central bank, IMF and World Bank

M2= M1+Saving deposits with post office saving bank

M3= M1+Net time deposits of bank

M4= M3+total deposits with the post office saving

organization

M1 is known as Narrow Money

M3 is known as Broad Money/High powered Money