“Fiscal policy and Monetary policy”

Presented by

Payal Mehta

Roll no.22

Under guidance of
Prof. Oberoi
 Fiscal Policy

Fisc-> State Treasury

Fiscal Policy-> use of government finances

In economics, fiscal policy is the use of government expenditure and revenue

collection to influence the economy. Fiscal policy can be contrasted with the other main
type ofmacroeconomic policy, monetary policy, which attempts to stabilize the economy
by controlling interest rates and themoney supply. The two main instruments of fiscal
policy are government expenditure and taxation. Changes in the level and composition
of taxation and government spending can impact on the following variables in the
economy:

 Aggregate demand and the level of economic activity;

 The pattern of resource allocation;
 The distribution of income.

Fiscal policy refers to the use of the government budget to influence the first of these:
economic activity.
Objectives

→ To achieve macroeconomic goals

→ Relating to any typical problem

Stances of fiscal policy
The three possible stances of fiscal policy are neutral, expansionary and contractionary.
The simplest definitions of these stances are as follows:

 A neutral stance of fiscal policy implies a balanced economy. This results in a

large tax revenue. Government spending is fully funded by tax revenue and overall
the budget outcome has a neutral effect on the level of economic activity.

 An expansionary stance of fiscal policy involves government spending exceeding

tax revenue.

 A contractionary fiscal policy occurs when government spending is lower than tax
revenue.

However, these definitions can be misleading because, even with no changes in

spending or tax laws at all, cyclical fluctuations of the economy cause cyclical
fluctuations of tax revenues and of some types of government spending, altering the
deficit situation; these are not considered to be policy changes. Therefore, for purposes
of the above definitions, "government spending" and "tax revenue" are normally
replaced by "cyclically adjusted government spending" and "cyclically adjusted tax
revenue". Thus, for example, a government budget that is balanced over the course of
the business cycle is considered to represent a neutral fiscal policy stance.

Macroeconomic Goals
• Economic Growth

• Employment

• Stabilization

• Economic equality

• Price Stability
BUDGET
“A budget is a detailed plan of operations for some specific future
period”

Components of budget

 Revenue receipts

 Capital receipts

 Revenue expenditure

 Capital expenditure

Methods of funding
Governments spend money on a wide variety of things, from the military and police to
services like education and healthcare, as well as transfer payments such as welfare
benefits. This expenditure can be funded in a number of different ways:

 Taxation
 Seigniorage the benefit from printing money
 Borrowing money from the population or from abroad
 Consumption of fiscal reserves.
 Sale of fixed assets (e.g., land).

All of these except taxation are forms of deficit financing.

Borrowing
A fiscal deficit is often funded by issuing bonds, like treasury bills or consols and gilt-
edged securities. These pay interest, either for a fixed period or indefinitely. If the
interest and capital repayments are too large, a nation may default on its debts, usually
to foreign creditors.
Consuming prior surpluses
A fiscal surplus is often saved for future use, and may be invested in local (same
currency) financial instruments, until needed. When income from taxation or other
sources falls, as during an economic slump, reserves allow spending to continue at the
same rate, without incurring additional debt.
Government Borrowings, Lending and Investments
 The gross borrowings: Rs 2,40,167 crore
 The net borrowings : Rs 1,68,710
 An Overdraft (OD) for 24 days daily average of OD was Rs.11,233 crore.
 Government has set up National Investment fund

Policy Evaluation
 Fiscal consolidation during the FRBM act.
 2007-08:fiscal deficit was 2.7%.
 Increase in fiscal deficit due to global meltdown (10.3% of GDP).
 Government steps helped reduce inflation(7.8%).

India still growing at the rate of 6.7%(08-09

Government Expenditure

 Government spending on the purchase of goods & services.

 Payment of wages and salaries of government servants

 Public investment

 Transfer payments
Economic effects of fiscal policy
Governments use fiscal policy to influence the level of aggregate demand in the
economy, in an effort to achieve economic objectives of price stability, full employment,
and economic growth. Keynesian economics suggests that increasing government
spending and decreasing tax rates are the best ways to stimulate aggregate demand.
This can be used in times of recession or low economic activity as an essential tool for
building the framework for strong economic growth and working towards full
employment. In theory, the resulting deficits would be paid for by an expanded economy
during the boom that would follow; this was the reasoning behind the New Deal.

Governments can use a budget surplus to do two things: to slow the pace of strong
economic growth, and to stabilize prices when inflation is too high. Keynesian theory
posits that removing spending from the economy will reduce levels of aggregate
demand and contract the economy, thus stabilizing prices.

Economists debate the effectiveness of fiscal stimulus. The argument mostly centers
on crowding out, a phenomena where government borrowing leads to higher interest
rates that offset the stimulative impact of spending. When the government runs a
budget deficit, funds will need to come from public borrowing (the issue of government
bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit
with the issuing of government bonds, interest rates can increase across the market,
because government borrowing creates higher demand for credit in the financial
markets. This causes a lower aggregate demand for goods and services, contrary to the
objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding
out while Keynesians argue that fiscal policy can still be effective especially in a liquidity
trap where, they argue, crowding out is minimal.

Some classical and neoclassical economists argue that crowding out completely
negates any fiscal stimulus; this is known as the Treasury View[citation needed], which
Keynesian economics rejects. The Treasury View refers to the theoretical positions of
classical economists in the British Treasury, who opposed Keynes' call in the 1930s for
fiscal stimulus. The same general argument has been repeated by some neoclassical
economists up to the present.

In the classical view, the expansionary fiscal policy also decreases net exports, which
has a mitigating effect on national output and income. When government borrowing
increases interest rates it attracts foreign capital from foreign investors. This is because,
all other things being equal, the bonds issued from a country executing expansionary
fiscal policy now offer a higher rate of return. In other words, companies wanting to
finance projects must compete with their government for capital so they offer higher
rates of return. To purchase bonds originating from a certain country, foreign investors
must obtain that country's currency. Therefore, when foreign capital flows into the
country undergoing fiscal expansion, demand for that country's currency increases. The
increased demand causes that country's currency to appreciate. Once the currency
appreciates, goods originating from that country now cost more to foreigners than they
did before and foreign goods now cost less than they did before. Consequently, exports
decrease and imports increase.

Other possible problems with fiscal stimulus include the time lag between the
implementation of the policy and detectable effects in the economy, and inflationary
effects driven by increased demand. In theory, fiscal stimulus does not cause inflation
when it uses resources that would have otherwise been idle. For instance, if a fiscal
stimulus employs a worker who otherwise would have been unemployed, there is no
inflationary effect; however, if the stimulus employs a worker who otherwise would have
had a job, the stimulus is increasing labor demand while labor supply remains fixed,
leading to wage inflation and therefore price inflation.
 Tax Slabs(09-10)
Table : New Proposed Tax Slabs

Individu Tax Rate Existing Income Slab (Rs) Proposed In

als

Nil Up to Rs 1,60,000* Up to Rs 1,60

10% 1,60,001 – 3,00,000 1,60,001-10,0

20% 3,00,001 – 5,00,000 10,00,001-25

30% Over 5,00,000 Over 25,00,00

* Minimum slab changes to Rs 1.9 lakhs for women and Rs 2.4 lakhs for s

 The Tax system has been modernized considerably.

 Eliminating exemptions and loopholes for both direct and indirect taxes
would level the playing field, reduce distortions and make the
system simpler for both tax payers and the administration.
 Public debt

 Internal borrowings

1. Borrowings from the public by means of treasury bills and govt. bonds

2. Borrowings from the central bank (monetized deficit financing)

 External borrowings

1. Foreign investments

2. International organizations like World Bank & IMF

3. Market borrowings

Budgetary Surplus & Deficit

 Early 1980s:net of depreciation consistently negative.

 Late 1980s:large deficit averaging about 8% of GDP

 Post liberalization: Fiscal deficit decreased.

 LPG effect was till 1996-1997

 2001:Fiscal deficit increased to 10% of GDP.

Fiscal Policy Overview (2009-10)

 Budget 2008-09 presented in the backdrop of impressive growth.

 Fiscal deficit 2009-10 estimated at 2.5 per cent of GDP

 After presentation of budget Indian economy was hit by global crisis.

 Fiscal policy shifted from fuelling growth to containing inflation, which

had reached 12.9 per cent in August, 2008.

 Stimulus package of Rs .1,50,320 crore was provided

 Tax Policy

 Customs:

1. Sharp reduction was effected in the import duty rates of various food
items.

2. Import duties on crude petroleum was reduced to nil and on petrol and
diesel to 2.5% (earlier 7.5%).

 Excise:

Reduction of 4 %points in the ad valorem rates of excise duty on

non-petroleum items.

 Service tax:

1. Service Tax continued at 10%.

2. Tax base widened.

Monetary Policy
Monetary policy is the process by which the monetary authority of a country controls
the supply of money, often targeting a rate of interest to attain a set of objectives
oriented towards the growth and stability of the economy.[1] These goals usually include
relatively stable prices and lowunemployment. Monetary theory provides insight into
how to craft optimal monetary policy.

Monetary policy is referred to as either being expansionary, or a contractionary, where

an expansionary policy increases the total supply of money in the economy rapidly, and
a contractionary policy decreases the total money supply, or increases it slowly.
Expansionary policy is traditionally used to combat unemployment in a recession by
lowering interest rates, while contractionary policy involves raising interest rates to
combat inflation. Monetary policy is contrasted with fiscal policy, which refers to
government borrowing, spending and taxation.
The part of the economic policy which regulates the level of money in the
economy in order to achieve certain objectives.

In INDIA,RBI controls the monetary policy. It is announced twice a year,

through which RBI,regulate the price stability for the economy.

1.Slack season April-September

policy

2.Busy season October-March

policy

Monetary policy rests on the relationship between the rates of interest in an economy,
that is, the price at which money can be borrowed, and the total supply of money.
Monetary policy uses a variety of tools to control one or both of these, to influence
outcomes like economic growth, inflation, exchange rates with other currencies
and unemployment. Where currency is under a monopoly of issuance, or where there is
a regulated system of issuing currency through banks which are tied to a central bank,
the monetary authority has the ability to alter the money supply and thus influence the
interest rate (to achieve policy goals). The beginning of monetary policy as such comes
from the late 19th century, where it was used to maintain the gold standard.

A policy is referred to as contractionary if it reduces the size of the money supply or

increases it only slowly, or if it raises the interest rate. An expansionary policy increases
the size of the money supply more rapidly, or decreases the interest rate. Furthermore,
monetary policies are described as follows: accommodative, if the interest rate set by
the central monetary authority is intended to create economic growth; neutral, if it is
intended neither to create growth nor combat inflation; or tight if intended to reduce
inflation.

There are several monetary policy tools available to achieve these ends: increasing
interest rates by fiat; reducing the monetary base; and increasing reserve requirements.
All have the effect of contracting the money supply; and, if reversed, expand the money
supply. Since the 1970s, monetary policy has generally been formed separately
from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that
most nations would form the two policies separately.

Within almost all modern nations, special institutions (such as the Federal Reserve
System in the United States, the Bank of England, the European Central Bank,
the People's Bank of China, and theBank of Japan) exist which have the task of
executing the monetary policy and often independently of the executive. In general,
these institutions are called central banks and often have other responsibilities such as
supervising the smooth operation of the financial system.

The primary tool of monetary policy is open market operations. This entails managing
the quantity of money in circulation through the buying and selling of various financial
instruments, such as treasury bills, company bonds, or foreign currencies. All of these
purchases or sales result in more or less base currency entering or leaving market
circulation.

Usually, the short term goal of open market operations is to achieve a specific short
term interest rate target. In other instances, monetary policy might instead entail the
targeting of a specific exchange rate relative to some foreign currency or else relative to
gold. For example, in the case of the USA the Federal Reserve targets the federal funds
rate, the rate at which member banks lend to one another overnight; however,
the monetary policy of China is to target the exchange rate between the
Chineserenminbi and a basket of foreign currencies.

The other primary means of conducting monetary policy include: (i) Discount
window lending (lender of last resort); (ii) Fractional deposit lending (changes in the
reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve
specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the
market).
Trends in central banking
Accordingly, the management of the exchange rate will influence domestic monetary
conditions. To maintain its monetary policy target, the central bank will have to sterilize
or offset its foreign exchange operations. For example, if a central bank buys foreign
exchange (to counteract appreciation of the exchange rate), base money will increase.
Therefore, to sterilize that increase, the central bank must also sell government debt to
contract the monetary base by an equal amount. It follows that turbulent activity in
foreign exchange markets can cause a central bank

to lose control of domestic monetary policy when it is also managing the exchange rate.

In the 1980s, many economists[who?] began to believe that making a nation's central bank
independent of the rest of executive government is the best way to ensure an optimal
monetary policy, and those central banks which did not have independence began to
gain it. This is to avoid overt manipulation of the tools of monetary policies to effect
political goals, such as re-electing the current government. Independence typically
means that the members of the committee which conducts monetary policy have long,
fixed terms. Obviously, this is a The central bank influences interest rates by expanding
or contracting the monetary base, which consists of currency in circulation and banks'
reserves on deposit at the central bank. The primary way that the central bank can
affect the monetary base is by open market operations or sales and purchases of
second hand government debt, or by changing the reserve requirements. If the central
bank wishes to lower interest rates, it purchases government debt, thereby increasing
the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it
can lower the interest rate on discounts or overdrafts (loans to banks secured by
suitable collateral, specified by the central bank). If the interest rate on such
transactions is sufficiently low, commercial banks can borrow from the central bank to
meet reserve requirements and use the additional liquidity to expand their balance
sheets, increasing the credit available to the economy. Lowering reserve requirements
has a similar effect, freeing up funds for banks to increase loans or buy other profitable
assets.

A central bank can only operate a truly independent monetary policy when
the exchange rate is floating.If the exchange rate is pegged or managed in any way, the
central bank will have to purchase or sell foreign exchange. These transactions in
foreign exchange will have an effect on the monetary base analogous to open market
purchases and sales of government debt; if the central bank buys foreign exchange, the
monetary base expands, and vice versa. But even in the case of a purefloating
exchange rate, central banks and monetary authorities can at best "lean against the
wind" in a world where capital is mobile.

somewhat limited independence.

In the 1990s, central banks began adopting formal, public inflation targets with the goal
of making the outcomes, if not the process, of monetary policy more transparent. In
other words, a central bank may have an inflation target of 2% for a given year, and if
inflation turns out to be 5%, then the central bank will typically have to submit an
explanation.

The Bank of England exemplifies both these trends. It became independent of

government through the Bank of England Act 1998 and adopted an inflation target of
2.5% RPI (now 2% of CPI).

The debate rages on about whether monetary policy can smooth business cycles or not.
A central conjecture of Keynesian economics is that the central bank can
stimulate aggregate demand in the short run, because a significant number of prices in
the economy are fixed in the short run and firms will produce as many goods and
services as are demanded (in the long run, however, money is neutral, as in
the neoclassical model). There is also the Austrian school of economics, which
includesFriedrich von Hayek and Ludwig von Mises's arguments,[13] but most
economists fall into either the Keynesian or neoclassical camps on this issue.
 Central Banks
 India Reserve Bank of India.

 U.S.A. Federal Reserve bank.

 U.K. Bank of England.

 Pakistan Bank of Pakistan.

Establishment of RBI
 Established in April 1935 with a share capital of Rs. 5 crores.

 Nationalized in the year 1949.

 Initially established in Calcutta but permanently moved to Mumbai in

1937.

Governor of RBI : D. Subbarao

Objectives of monetary policy

 Maximum feasible output.

 High rate of growth.

 Growth in employment & income

 Price stability.

 Stability of Forex & national currency

 Inflation Control

 Greater equality in the distribution of income and wealth.

 Healthy balance in balance of payments(BOP).

Types of control

Quantitative control Tools

Open market operations:
 The open market operations is sale and purchase of government
securities and Treasury Bills by the central bank of the country.

 When the central bank decides to pump money into circulation, it buys
back the government securities, bills and bonds.

 When it decides to reduce money in circulation it sells the government

bonds and securities.

 The central bank carries out its open market operations through the
commercial banks.

OMO’s

Repo rate:

 A repurchase agreement or ready forward deal is a secured short-term

(usually 15 days) loan by one bank to another against government
securities.

 Legally, the borrower sells the securities to the lending bank for cash,
with the stipulation that at the end of the borrowing term, it will buy
back the securities at a slightly higher price, the difference in price
representing the interest.

 Reverse repo rate is the rate that RBI offers the banks for parking
their funds with it. Reverse repo operations suck out liquidity from the
system.
 Bank Rate Policy

Bank rate is the minimum rate at which the central bank provides
loans to the commercial banks. It is also called the discount rate.

 Dear money policy:

Bank rate inc interest rate inc borrowing will be less

profitable results contraction of credit.

 Near money policy:

Bank rate dec interest rate low borrowing will be more

profitable results expansion of credit.
Trends of Bank Rate

In 1940’s BR was at low 3% and remained unchanged till

1953.In 1953 RBI adopted policy controlled expansion BR
raised to 3.5%.It reached at max. level in 1991 to 12%.
Presently it is 6 %

Reserve Requirements Changes:

 The central bank of a country is empowered to determine within
statutory limits, the cash reserve requirements of the commercial
banks.

 Statutory liquid ratio:

Bank has to keep portion of total deposits with

itself in liquid assets.

 Cash reserve ratio:

The percentage of bank’s deposits which they

must keep as cash with RBI.
 SLR Trend

• It was 25% in 1949 after that it increased continuously 32%(1972)--- 35%

(1981)---36%(1984)--- 38%(1988).
• From 1997 it is constant at 25%

CRR Trend
• In beginning it was 5% of demand deposit & 2% of time deposits.

• Reached max. in 1991,92 after 1993 it followed Narsimham report &

decreased.

• But from dec.06 it raised 7 times, 250bp to cool credit growth &
supply.

• Currently, it is 5 %
 Qualitative Control Tools:
o Selective credit control

o They are distinguishable from quantitative tools by the fact that they
are directed towards particular uses of credit and merely to total
volume outstanding.

Important selective control measures are:

• Rationing of credit.

• Changes in margin requirements.

• Moral suasion.

Credit Rationing
 When there is a shortage of institutional credit available for the
business sector, the large and financially strong sectors or industries
tend to capture the lion’s share in the total institutional credit.

 As a result the priority sectors and essential industries are of necessary

funds.

Below two measures are generally adopted:

 Imposition of upper limits on the credit available to large industries and

firms
 Charging a higher or progressive interest rate on the bank loans
beyond a certain limit.

Change in Lending Margins

 The banks provide loans only up to a certain percentage of the value of
the mortgaged property.

 The gap between the value of the mortgaged property and amount
advanced is called Lending Margin.

 The central bank is empowered to increase the lending margin with a

view to decrease the bank credit.

EXPANSIONARY MONETARY POLICY

Problem: Recession and unemployment

Measures: (1) Central bank buys securities

 through open market operation

(2) It reduces cash reserves ratio

(3) It lowers the bank rate

Money supply increases

Investment increases

Aggregate demand increases

Aggregate output increases by a

multiple of the increase in investment

CONTRACTIONARY MONETARY POLICY
Problem: Inflation

Measures: (1) Central bank sells securities

through open market operation

(2) It raises cash reserve ratio

and statutory liquidity

(3) It raises bank rate

(4) It raises maximum margin against

holding of stocks of goods

Money supply decreases

Interest rate raises

Investment expenditure declines

Aggregate demand declines

Price level falls

 Recommendation of Narshimham Committee
Nov.1991
• SLR should not be used for directed investment in PSUs. It should be
lower down to minimum limit of 25%

• CRR should be lower than the present rate. As an instrument it should

be used less & Govt. should depend upon OMOs.

• Selective credit control should be slowly phased out

 Prime lending rate of commercial bank should be independent of RBI

control
 Monetary Policy of India - Overview
The Monetary Policy aims to maintain price stability, full employment
and economic growth.

Emphasis on these objectives have been changing time to time

depending on prevailing circumstances.

For explanation of monetary policy, the whole period has been divided
into 4 sub periods:

a) Monetary policy of controlled expansion (1951 to 1972)

b) Monetary Policy during Pre Reform period (1972 to 1991)

c) Monetary Policy in the Post-Reforms (1991 to 1996)

d) Easing of Monetary policy since Nov 1996

Monetary policy of controlled expansion (1951

to 1972)
To regulate the expansion of money supply and bank credit to promote
growth.

To restrict the excessive supply of credit to the private sector so as to

control inflationary pressures.

Following steps were taken:

1. Changes in Bank Rate from 3% in 1951 to 6% in 1965 and it remained

the same till 1971.

2. Changes in SLR from 20% in 1956 to 28% in 1971.

3. Select Credit Control: In order to reduce the credit or bank loans

against essential commodities, margin was increased.

Monetary Policy during Pre Reform period

(1972 to 1991)
Also known as the Tight Monetary policy: Price situation worsened
during 1972 to 1974.
 Following Monetary Policy was adopted in 70’s and 80’s which were
mainly concerned with the task neutralizing the impact of fiscal deficit
and inflationary pressure.

1) Changes in CRR to the maximum limit of 25%

2) Changes in SLR also to the maximum limit of 38.5%

Monetary Policy in the Post-Reforms – 1991 to

1996
The year 1991-1992 saw a fundamental change in the institutional
framework It had twin objectives which were Price stability and
economic growth.

1) Continuing the same maximum CRR and SLR of 25% and 38.5%,
mopped up bank deposits to the extent of 63.5%

2) In order to ensure profitability of banks, Monetary Reforms

Committee headed by late Prof. S Chakravarty, recommended raising
of interest rate on Government Securities which activated Open Market
Operations (OMO).

3) Bank rate was raised from 10% in Apr 1991 to 12% in Oct 1991 to
control the inflationary pressures.

Easing of Monetary policy since Nov 1996:

In 1996-97, the rate of inflation sharply declined. In the later half 1996-
97, industrial recession gripped the Indian economy. To encourage the
economic growth and to tackle the recessionary trend, the RBI eased
its monetary policy.

1. Introduction of Repo rate. Repo rate increased from 3% in 1998 to

6.5% in 2005. This instrument was consistently used in the monitory
policy as a result of rapid industrial growth during 2005-06.

2. Reverse Repo rate –Through RRR, the RBI mops up liquidity from the
banking system. The Repo rate was cut from 3.50% to 3.25%.

3. Flow of credit to Agriculture – The flow of credit to agriculture has

increased from 34,013 (9.2% of overall credit) in 2008 to 52,742 (13%
in overall credit) in 2009 – (Rs. in crore).
4. Reduction in Cash Reserve Ratio – The CRR which was at 15% until
1995 gradually reduced to 5% in 2005. The CRR remained unchanged
in the current monetary policy.

5. Lowering Bank rate – The Bank rate was gradually reduced from 12%
in 1997 to 6% in 2003.

RBI In Recession
 CRR cut to 5%

 Repo rate cut to 5.5%

 Reverse Repo rate cut to 4%

 Short-term lending and borrowing rates cut

 Slashed tax rates

 Injection of Money

 Opening up new borrowing channels for banks

 Government hikes its spending

Review of 2009/10 Monetary Policy

 GDP growth at 7.9% for Q2 2009 which was predicted to be 6.3

 WPI-currently at 4.78%. Food Inflation touched 19% because of easy

monetary policies & decreasing agricultural production

 Bank Rate has been retained unchanged at 6.0 per cent

 Repo Rate has been retained unchanged at 4.75 per cent

 Reverse Repo Rate has been retained unchanged at 3.25 per cent

 CRR- 5 per cent & SLR to 25 per cent of their NDTL

 Planning to tighten liquidity scenario from January