Public Systems & Policy

Course Contents

The invisible hand and market failures

Welfare economics principles

Income distribution issues

Public good, externalities and political economy

Cost-benefit analysis

Health, education, public distribution, environment

Institutions and policy making

Taxes and incentives, social security issues

Coverage

Overview

Public Finance Management

Government Expenditures • Government operations• Income distribution

Financing of Government Expenditures

• Taxes• Debt• Public finance through state enterprise

Coverage (Contd.)

E- Governance

• Definition• Scope• Objective• Advantages• Strategies

Coverage (Contd.)

Public Policy

• Theoretical aspects of public policy• Implementation in India and in other countries and

effects thereof.

CONCEPTS , TOPICS• BUDGET, FISCAL DEFICIT, FISCAL CLIFF• IS-LM- KEYNESIAN MODEL • E-GOVERNANCE• CROWDING OUT EFFECT• PUBLIC PRIVATE PARTNERSHIPS (PPP)• INDUSTRIAL POLICY• FISCAL POLICY• MONETARY POLICY• PUBLIC POLICIES & ECO REFORMS – INDIA, CHINA, US• SECTORAL POLICIES- INDIA-TRANSPORT & ENERGY

OverviewPublic Policy:

• With the rejection of the exclusive regulatory stand after the 1990s in favour of a developmental role of the state, the study of public policy has become a significant discipline in recent times.

• Theoretical aspects of public policy, its meaning, significance and models for public policy analysis.

• Emphasis on theory and conceptual premises alongside contextual analysis of public policy

• Analyse its implementation in India, the United States and in a globalized world.

• As the state has proved itself to be a catalyst of development, the impact of the policy changes on areas such as public life, rural development, anti-poverty programmes and decentralized planning is to be analysed.

Overview

Public Finance is the study of the role of the government in the economy.

• efficient allocation of resources • distribution of income • macroeconomic stabilization

The purview of public finance is considered to be governmental effects on:

Overview

The proper role of government provides a starting for the analysis of public finance.

In theory, under certain circumstances, private markets will allocate goods and services among individuals efficiently.

Market failure occurs when private markets do not allocate goods or services efficiently. The existence of market failure provides an efficiency-based rationale for collective or governmental provision of goods and services.

Overview

Public sector programs should be designed to maximize social benefits minus costs (cost-benefit analysis), and then revenues needed to pay for those expenditures should be raised through a taxation system that creates the fewest efficiency losses.

Government can pay for spending by borrowing although borrowing is a method of distributing tax burdens through time rather than a replacement for taxes.

A deficit is the difference between government spending and revenues. The accumulation of deficits over time is the total public debt

Overview

Deficit finance allows governments to smooth tax burdens over time, and gives governments an important fiscal policy tool. Deficits can also narrow the options of successor governments.

Public finance is closely connected to issues of income distribution and social equity. Governments can reallocate income through transfer payments or by designing tax systems that treat high-income and low-income households differently.

Overview

Public policy doctrine concerns the body of principles that strengthen the operation of legal systems in each state. This addresses the social, moral and economic values that tie a society together: values that vary in different cultures and change over time.

Overview

The fundamental principle in the operation of a legal system is that ignorantia juris non excusat (ignorance of the law is no excuse).

Strengthening most social, moral and religious systems is the policy of sanctity of life.

Similarly, in many branches of law, the Doctrine of Evasion prevents persons from evading the application of obligations and liabilities already attaching to them.

Public Finance Management

Essential components of a Public Financial

Management system:

•Resource Generation: Collection of sufficient resources from the economy in an appropriate manner along with allocating (Resource allocation)

•Expenditure Management: Use of these resources efficiently

•Resource Utilization: Effectively constitute good financial management

Government Expenditures

Economists classify government expenditures

into three main types:

•Government purchases of goods and services for current use are classed as government consumption.

•Government purchases of goods and services intended to create future benefits- such as infrastructure investment or research spending are classed as government investment.

•Government expenditures that are not purchases of goods and services, and instead just represent transfers of money- such as social security payments are called transfer payments

Government Expenditures

Government Operations

•Government operations are those activities involved in the running of a state or a functional equivalent of a state for the purpose of producing value for the citizens.

•Government operations have the power to make, and the authority to enforce rules and laws within a civil, corporate, religious, academic, or other organization or group.

•In its broadest sense, "to govern" means to rule over or supervise, whether over a state, a set group of people, or a collection of people

Government Expenditures

Income Distribution

•Some forms of government expenditure are specifically intended to transfer income from some groups to others.

•Other forms of government expenditure which represent purchases of goods and services also have an effect of changing the income distribution

Financing of Government Expenditures

Government expenditures are financed in the

following ways:

•Government Revenue: •Taxes•Non-tax revenue

•Government borrowing•Printing of Money•Privatization

Financing of Government Expenditures

Taxes•Taxation is the central part of modern public finance. •The main objective of taxation is raising revenue to meet its

ever-growing expenditure on administration and social services .

•It is used as an instrument of attaining certain social objectives i.e. as a means of redistribution of wealth and thereby reducing inequalities.

•It is used to reduce the inequalities of income and wealth.•Taxation is also needed to draw away money that would

otherwise go into consumption and cause inflation to rise

Financing of Government Expenditures - Taxes

• Corporate income tax on corporations (incorporated entities)• Wealth tax• Personal income tax (may be levied on individuals, families such as the Hindu Joint

Family in India, unincorporated associations, etc.)• Gift tax

Direct Tax (which is proportional) , e.g.

• Stamp duty, levied on documents• Excise tax (tax levied on production)• Sales tax (tax on business transactions, especially the sale of goods and services) • Value added tax (VAT) is a type of sales tax• Services taxes on specific services• Duties (taxes on importation, levied at customs)• Road tax; Vehicle excise duty (UK), Registration Fee (USA), Regco (Australia),

Vehicle Licensing Fee (Brazil) etc.

Indirect tax (which is differential in nature):

Financing of Government Expenditures

Debt•Governments, like any other legal

entity, can take loans, issue bonds and make financial investments.

•Government/Public/National debt is money (or credit) owed by any level of government (central/municipal or local government)

Financing of Government Expenditures

Debt•Government debt can be categorized as internal debt,

owed to lenders within the country, and external debt, owed to foreign lenders.

•Governments usually borrow by issuing securities such as government bonds and bills.

•Less creditworthy countries sometimes borrow directly from commercial banks or international institutions such as the International Monetary Fund or the World Bank

Financing of Government Expenditures

Debt•Most government budgets are calculated on a cash basis,

meaning that revenues are recognized when collected and outlays are recognized when paid.

•Some consider all government liabilities, including future pension payments and payments for goods and services the government has contracted for but not yet paid, as government debt. This approach is called accrual accounting, meaning obligations are recognized when they are acquired, or accrued, rather than when they are paid

Financing of Government Expenditures

Seigniorage•Is the net revenue derived from the issuing

of currency. It arises from the difference between the face value of a coin or bank note and the cost of producing, distributing and eventually retiring it from circulation.

•Is an important source of revenue for some national banks, although it provides a very small proportion of revenue for advanced industrial countries

Financing of Government Expenditures

Public Finance

through State Enterprise

•Public finance in centrally planned economies has differed in fundamental ways from that in market economies.

•Some state-owned enterprises generated profits that helped finance government activities.

•In market-oriented economies with substantial state enterprise, (Venezuela), the state-run oil company PSDVA provides revenue for the government to fund its operations and programs that would otherwise be profit for private owners

Public Finance through State

Enterprise

•In various mixed economies, the revenue generated by state-run or state-owned enterprises are used for various state endeavours. Various market socialist systems or proposals utilize revenue generated by state-run enterprises to fund social dividends, eliminating the need for taxation altogether

Financing of Government Expenditures

• The general government sector of a nation includes all non-private sector institutions, organisations and activities. The general government sector, by convention, includes all the public corporations that are not able to cover at least 50% of their costs by sales, and, therefore, are considered non-market producers.

Measuring Govt. Economic Operations (Contd.)

Measuring Govt. Economic Operations (Contd.)

Measuring Govt. Economic Operations (Contd.)

• The general government sector has three sub-sectors:• "Central government" consists of all administrative departments of

the state and other central agencies whose responsibilities cover the whole economic territory of a country, except for the administration of social security funds.

• "State government" is defined as the separate institutional units that exercise some government functions below those units at central government level and above those units at local government level, excluding the administration of social security funds.

• "Local government" consists of all types of public administration whose responsibility covers only a local part of the economic territory, apart from local agencies of social security funds.

Measuring Govt. Economic Operations

Financial Accounting of Governments: • Governments produce a full set of financial

statements including the statement of government operations (akin to the income statement), the balance sheet, and a cash flow statement.

Measuring Govt. Economic Operations (Contd.)

• The government’s balance sheet presents the level of the debt, i.e., the government’s liabilities. Hence it provides data to help estimate the resources a government can potentially access to repay its debt.

• The memorandum items of the balance sheet provide additional information on the debt including its maturity and whether it is owed to domestic or external residents.

• The balance sheet also presents a disaggregated classification of financial and non-financial assets.

Measuring Govt. Economic Operations (Contd.)

• The statement of operations (“income statement”) contains the revenue and expense accounts of the government.

• The revenue accounts are divided into subaccounts, including the different types of taxes, social contributions, dividends from the public sector, and royalties from natural resources.

• Finally, the interest expense account is one of the necessary inputs to estimate the cost of servicing the debt.

Measuring Govt. Economic Operations

• Health is a critical contributor to the success of social policies that enable the attainment of national goals of social and economic development.

• Attaining those goals depends on effective health policies.

• Addressing health policy issues, which shape the health system, poses problems because social needs are multidimensional, adverse effects can be cumulative, resources are finite, and, frequently, solutions lie outside the health sector.

Public Policies, Health Systems and Services (Contd.)

• Health policies are important because they directly or indirectly affect all aspects of daily life, actions, behaviours, and decisions.

Public Policies, Health Systems and Services (Contd.)

• Most of the literature on the policy process focuses on how policy is made.

• There is a part concerned with the relationship between policy and what actually happens in the process of delivery.

The Public Policy –Action Relationship

• By the time a policy is being rolled out, those at the centre are already focusing on the next problem or policy innovation and staff may have moved on to an entirely different policy area. Yet, clearly, implementation is crucial to the success of any policy.

• This unit is not concerned with technical questions about policy instruments and levers, but with a deeper question: how does change happen as a result of new policies? The aim is to explore the relationship between policy and action

The Public Policy –Action Relationship

Models of ImplementationPolicy delivery seems to be growing in importance. - for example, the Blair governments in the UK were, from the

outset, preoccupied with ‘delivery, delivery, delivery’ as ministers and prime minister grew increasingly frustrated with what was often viewed as the intransigence of public service professionals.

- The constant cycle of change, in which new policies and initiatives were introduced in rapid succession, producing what critics described as ‘policy overload’ or ‘initiativitis’, can be understood in part as a result of prime ministerial and ministerial frustration. This also produced an explosion of new regulatory mechanisms

The Public Policy –Action Relationship

• Definition• Scope• Objective• Advantages• Strategies

E- Governance

Definition:

• The term E-government is misleading, as it implies an electronic substitute for the physical government. Electronic substitution of a government is not possible as Government is a unit of people coming together to administer a country.

• A Government is a group of people responsible for the administration and control of a Country/State. It involves people like the Heads of States, Ministers, Government Employees, etc. It also involves public participation. So electronic substitution for a Government is not possible.

E- Governance

Definition:• Electronic Governance means using Information and Communications

Technology (ICT) to transform functioning of the Government/ to run or carry on the business of the Government of a Country.

It differs from E-Government as Governance is wider than Governance. E-governance may refer to governance of a Country, or the governance of an institution and also governance of a Household by a housewife.

• E-Governance in the popular parlance refers only to the governing of a Country/State using ICT

E- Governance

Definition:• E-Governance therefore means the application of ICT to

transform the efficiency, effectiveness, transparency and accountability of exchange of information and transaction:

• between Governments,• between Government agencies,• between Government and Citizens• between Government and businesses.

E-governance also aims to empower people through giving them access to information.

E- Governance

Scope:• Governance is all about flow of information between

the Government and Citizens, Government and Businesses and Government and Government. E-Governance also covers all these relationships as follows:

• A. Government to Citizen (G2C)B. Citizen to Government (C2G)C. Government to Government (G2G)D. Government to Business (G2B)

E- Governance

Scope:A. Government to Citizen (G2C):

In modern times, Government deals with many aspects of the life of a citizen. The relation of a citizen with the Government starts with the birth and ends with the death of the citizen.

E- Governance

Scope:• Government to Citizen (G2C):• The G2C relation will include the services provided by the

Government to the Citizens. These services include the public utility services i.e. Telecommunication, Transportation, Post, Medical facilities, Electricity, Education and also some of the democratic services relating to the citizenship such as Certification, Registration, Licensing, Taxation, Passports, ID Cards etc.

• Therefore E-Governance in G2C relationship will involve facilitation of the services flowing from Government towards Citizens with the use of Information and Communications Technology (ICT).

E- Governance

Scope:Government to Citizen (G2C):• Therefore E-Governance in G2C relationship will involve facilitation

of the services flowing from Government towards Citizens with the use of Information and Communications Technology (ICT).

• E-Citizenship• E-Registration• E-Transportation• E-Health• E-Help• E-Taxation

E- Governance

Scope:Government to Citizen (G2C):• E-Citizenship: • Includes the implementation of ICT for facilitation of Government Services relating to

citizenship of an individual. It involves online transactions relating to issue and renewal of documents like Ration Cards, Passports, Election Cards, Identity Cards, etc. It will require the Government to create a virtual identity of every citizen so as to enable them to access the Government services online. For the same, Government would need to create a Citizen Database which is a huge task.

• E-Registration: • E-Registration will cover the online registration of various contracts. An individual enters

into several contracts during his life. Many of these contracts and transactions require registration for giving it legality and enforceability. Such registration may also be made ICT enabled. E-registration will help to reduce a significant amount of paperwork.

E- Governance

Scope:Government to Citizen (G2C):

• E-Transportation:• E-Transportation services would include ICT enablement of services of

Government relating to Transport by Road, Rail, Water or Air. This may involve online –

• booking and cancellation of tickets,• status of vehicles, railways, boats and flights,• issue and renewal of Driving Licences,• registration and renewal of vehicles, • transfer of vehicles,• payment of the fees of licences,• payment of fees and taxes for vehicle registration.

E- Governance

Scope:Government to Citizen (G2C):

• E-Health: E-Health services would be ICT enablement of the health services of the Government. Under this interconnection of all hospitals may take place. A patient database may be created. A local pharmacy database may also be created. All this can be done.

• E-Education - E-Education would cover the implementation of ICT in imparting of education and conducting of Courses. Distant as will as classroom education will be facilitated with the use of ICT. Use of internet can reduce the communication time required in Distance education; Internet may also help in conducting online classes.

E- Governance

Scope:Government to Citizen (G2C):• E-Help:

E-Help refers to facilitation of disaster and crisis management using ICT. It includes the use of technologies like internet, SMS, etc. for the purpose of reducing the response time of the Government agencies to the disasters. NGOs help Government in providing help in situations of disasters. Online information relating to disasters, warnings and calls for help can help the Government and the NGOs coordinate their work and facilitate and speed up the rescue work.

• E-Taxation - E-Taxation will facilitate the taxing process by implementing ICT in the taxing process. Online tax due alerts and online payment of taxes would help transact faster.

E- Governance

Scope:Citizen to Government (C2G):• Citizen to Government relationship will include the communication of citizens

with the Government arising in the Democratic process like voting, campaigning, feedback, etc.

• E-Democracy - The true concept of Democracy includes the participation of the citizens in the democratic and governing process. Today due to the increased population the active participation of the citizens in governing process is not possible. The ICT can help enable the true democratic process including voting, public opinion, feedback and Government accountability.

• E-Feedback includes the use of ICT for the purpose of giving feedback to the Government. Lobbying is pursuing the Government to take a certain decision. Use of ICT can enable online feedback to the Government, online debates as to the Government services.

E- Governance

Scope:Government to Government (G2G):

• G2G relationship would include the relationships between Central and State Government and also the relationship between two or more Government departments.

• E-administration - E-administration would include the implementation of ICT in the functioning of the Government, internally and externally. Implementation of ICT can reduce the communication time between the Government Departments and Governments. It can substantially reduce paperwork if properly used. E-administration will also bring morality and transparency to the administration of Government Departments.

E- Governance

Scope:Government to Government (G2G):• E-police - The concept of E-police is little different from Cyber-Police. Cyber

Police require technology experts to curb the electronic/cyber crimes. E-police refers to the use of ICT for the purpose of facilitating the work of the Police department in investigation and administration. The concept of E-police includes databases of Police Officers, their performances, Criminal databases – wanted as well as in custody, the trends in crimes and much more. ICT can help reduce the response time of the Police department and also reduce cost by reducing paperwork.

• 3. E-courts - The concept of E-Court will include the ICT enablement of the judicial process. Technology may help distant hearing, online summons and warrants and online publication of Judgments and Decrees.

E- Governance

Scope:Government to Business (G2B):• E-Taxation : Corporate sector pays many taxes, duties and dues to the Government.

Payment of these taxes and duties will be made easier by E-Taxation. Online taxing and online payment of taxes can help reduce cost and time required for physical submission of taxes. ICT can also help crosscheck the frauds and deficiencies in payment, further bringing accuracy and revenue to the Government.

• E-Licencing : Companies have to acquire various licences from the Government, similarly the companies have to acquire various registrations. ICT enablement of the licensing and registration can reduce time and cost.

• E-Tendering : E-Tendering will include the facilities of online tendering and procurement. It will online alerts as to new opportunities of business with the Government and also online submission of tenders and online allotment of work. It will reduce time and cost involved in the physical tendering system.

E- Governance

Objectives:• The object of E-Governance is to provide a SMARRT Government. The Acronym SMART refers to Simple,

Moral, Accountable, Responsive, Responsible and Transparent Government.

S - The use of ICT brings simplicity in governance through electronic documentation, online submission, online service delivery, etc.

M - It brings Morality to governance as immoralities like bribing, red-tapism, etc. are eliminated.

A - It makes the Government accountable as all the data and information of Government is available online for consideration of every citizen, the NGOs and the media.

• R - Due to reduced paperwork and increased communication speeds and decreased communication time, the Government agencies become responsive.

• R - Technology can help convert an irresponsible Government Responsible. Increased access to information makes more informed citizens. And these empowered citizens make a responsible Government.

• T - With increased morality, online availability of information and reduced red-tapism the process of governance becomes transparent leaving no room for the Government to conceal any information from the citizens.

• These objects of E-Governance are achievable with the use of ICT and therefore the concept is very alluring and desirable.

E- Governance

Objectives/Aims of E Governance : • To build an informed society: An informed society is an empowered

society. Only informed people can make a Government responsible. So providing access to all to every piece of information of the Government and of public importance is one of the basic objective of E-Governance.

• To increase Government and Citizen interaction: In the physical world, the Government and Citizens hardly interact. The amount of feedback from and to the citizens is very negligible. E-Governance to aims at build a feedback framework, to get feedback from the people and make the Government aware of people's problems.

E- Governance

Objectives/Aims of E Governance : • To encourage citizen participation - True democracy requires participation of each

individual citizen. Increased population has led to representative democracy, which is not democracy in the true sense. E-governance aims to restore democracy to its true meaning by improving citizen participation in the Governing process, by improving the feedback, access to information and overall participation of the citizens in the decision making.

• To bring transparency in the governing process - E-governance carries an objective to make the Governing process transparent by making all the Government data and information available to the people for access. It is to make people know the decisions, and policies of the Government.

E- Governance

Objectives/Aims of E Governance : • To make the Government accountable: Government is responsible and answerable for every act

decision taken by it. E-Governance aims and will help make the Government more accountable than now by bringing transparency's and making the citizens more informed.

• To reduce the cost of Governance - E-Governance also aims to reduce cost of governance by cutting down on expenditure on physical delivery of information and services. It aims to do this by cutting down on stationary, which amounts to the most of the government's expenditure. It also does away with the physical communication thereby reducing the time required for communication while reducing cost.

• To reduce the reaction time of the Government – Normally due to red-tapism and other reasons, the Government takes long to reply to people's queries and problems. E-Governance aims to reduce the reaction time of the Government to the people's queries and problems,.

E- Governance

Advantages:• Speed: Technology makes communication speedier.

Internet, Phones, Cell Phones have reduced the time taken in normal communication.

• Cost Reduction: Most of the Government expenditure is appropriated towards the cost of stationary. Paper-based communication needs lots of stationary, printers, computers, etc. which calls for continuous heavy expenditure. Internet and Phones makes communication cheaper saving valuable money for the Government.

E- Governance

Advantages:• Transparency: Use of ICT makes governing profess transparent. All the

information of the Government would be made available on the internet. The citizens can see the information whenever they want to see. But this is only possible when every piece of information of the Government is uploaded on the internet and is available for the public to peruse. Current governing process leaves many ways to conceal the information from all the people. ICT helps make the information available online eliminating all the possibilities of concealing of information.

• Accountability : Once the governing process is made transparent the Government is automatically made accountable. Accountability is answerability of the Government to the people. It is the answerability for the deeds of the Government. An accountable Government is a responsible Government.

E- Governance

Strategies:• To build technical infrastructure/framework

across India.• To build institutional capacity• To build legal infrastructure• To build judicial infrastructure

E- Governance

Strategies:

• To make all information available online• To popularise E-governance• Centre-State Partnership• To set standards

E- Governance

E-GovernanceExample: • The Central Vigilance Commission (CVC) in India started an initiative to

create a website with the objective of reducing corruption and increasing transparency by sharing a large amount of information related to corruption with citizens. The CVC website communicates directly with the public through messages and speeches to bolster confidence in the institution, informs the public about its efforts in fighting corruption, and makes public

• the names of officers from the elite administrative and revenue services against whom investigations have been ordered or penalties imposed for corruption. Members of the public are highly encouraged (mainly by rewards) to make their complaints and to provide information against a public servant about taking of bribes in order for the commission to undertake the necessary anticorruption actions to eliminate bribery and to increase the transparency of rules, procedures and service delivery.

E-GovernanceExample: • In India, the Gyandoot project is a government-to-citizen intranet project which

offers numerous benefits to the region, to citizens and to the community in general. The goal of the project has been to establish community owned technologically innovative and sustainable information kiosks in a poverty-stricken rural area of Madhya Pradesh. The benefits assured by this intranet system have increased the awareness of ICT importance and have spin off other IT initiatives and programs, such as: the creation of new private ICT

• training institutions; a high level of student enrolment – about 60%; parliament has allocated resources to set up other kiosks in schools and to develop new models for e-education; Indira Gandhi National Open University has opened a study center for undergraduate and postgraduate courses on computer applications; the government has instituted a cash award to motivate ICT projects.

Definition:• An economic concept where increased public sector spending

replaces, or drives down, private sector spending. Crowding out refers to when government must finance its spending with taxes and/or with deficit spending, leaving businesses with less money and effectively "crowding them out." One explanation of why crowding out occurs is government financing of projects with deficit spending through the use of borrowed money. Because the government borrows such large amounts of capital, its activities can increase interest rates. Higher interest rates discourage individuals and businesses from borrowing money, which reduces their spending and investment activities.

Crowding Out Effect

• Thus crowding out effect describes the idea that

large volumes of government borrowing push up the real interest rate, making it difficult or close to impossible for individuals and small companies to obtain loans.

Crowding Out Effect

• For example, the higher taxes required for government to fund social welfare programs leaves less discretionary income for individuals and businesses to make charitable donations. Further, when government funds certain activities there is little incentive for businesses and individuals to spend on those same things. Another example is increased government spending on Medical aid, which has been linked to decreased availability of private health insurance.

Crowding Out Effect

How It Works:• The theory behind the crowding out effect assumes that governmental borrowing uses up a larger

and larger proportion of the total supply of savings available for investment. Because demand for savings increases while supply stays the same, the price of money (the interest rate) goes up.

Crowding out begins to take effect when the interest rate level reaches a point at which only the government can afford to borrow. Unable to compete for loans under such circumstances, individuals and smaller-scale companies are forced (crowded) out of the market.

Why It Matters:• Because crowding out leads to decreases in private sector consumption and, therefore, slows

economic growth, the crowding out effect should be a serious consideration for any government that plans to get an increasing percentage of its funding through the capital markets.

Crowding Out Effect

• Crowding out effect occurs when governments borrow funds from other countries to finance government spending usually through expansionary fiscal policies. This is of concern because the government is overspending i.e. revenue that is collected from taxes and other relevant transactions is less than the amount put forward in the budget and more recently, large stimulus packages (e.g., what America had done in the past few months of 2009).

Crowding Out Effect

• When the government borrows from another country, interest rate in that country goes up because an increase in demand for loans, hence pushing up the prices. Because the interest rate of the central bank subsequently influences the interest rates of commercial or private banks, this would in turn discourage private borrowing. Using the Marginal Efficiency Capital Theory, firms with planned investments will choose to postpone them and consumers who have plans of buying large scale durable goods will do likewise.

Crowding Out Effect

• Increase in government spending crowd outs some private borrowing. Again, the severity of the effect is largely determined by the magnitude of the crowding out effect i.e. if the effect was significant, fiscal policies undertaken by governments would largely become ineffective.

Crowding Out Effect

• Consider another source of crowding out effect through the FOREX markets. The increase in borrowings of foreign funds raises the interest rates of the central bank and commercial banks. Given that most countries adopt a free capital movement policy, the rise in interest rate makes it attractive for investors to save in that country's financial market. This raises the demand for the country's currency causing it to appreciate which would in turn make imports cheaper and exports more expensive relative to the prices of foreign goods. This increases imports and decreases exports causing net exports to decrease - this is actually a decrease in aggregate demand (AD). Hence, the increase in government spending to boost the economy fails to do so as expected as it crowds out an increase in net exports, even causing it to fall further.

Crowding Out Effect

• Thus the crowding out effects of fiscal policy must be minimised in order to maximise its effectiveness. Crowding out effect is one of the adverse effects of Keynesian policies; the other being chronic budget deficits. In fact, many economic analysts are fearing that President Obama's fiscal stimulus plan might cause America to suffer huge budget deficits. The issue at hand still remains largely controversial.

Crowding Out Effect

IS-LM MODEL AND CROWDING OUT EFFECT

Definition of 'IS-LM Model'

• A macroeconomic model that graphically represents two intersecting curves, called the IS and LM curves.

• The investment/saving (IS) curve is a variation of the income-expenditure model incorporating market interest rates (demand for this model), while the liquidity preference/money supply equilibrium (LM) curve represents the amount of money available for investing (supply for this model).

• The model attempts to explain the investing decisions made by investors given the amount of money they have available and the interest rate they will receive. Equilibrium occurs when the amount of money invested equals the amount of money available for investing.

IS-LM MODEL• Since this is a non-dynamic model, there is a fixed relationship

between the nominal interest rate and the real interest rate (the former equals the latter plus the expected inflation rate which is exogenous in the short run); therefore variables such as money demand which actually depend on the nominal interest rate can equivalently be expressed as depending on the real interest rate.

• The point where these schedules intersect represents a short-run equilibrium in the real and monetary sectors (though not necessarily in other sectors, such as labor markets): both the product market and the money market are in equilibrium. This equilibrium yields a unique combination of the interest rate and real GDP.

IS MODEL• The IS curve is defined by the equation:

Y = C(Y-T(Y))+ I(i)+G+(X-M(Y))

• where Y represents income, C represents consumer spending as an increasing function of disposable income (income, Y, minus taxes, T(Y), which themselves depend positively on income), represents investment as a decreasing function of the real interest rate, G represents government spending, and X-M represents net exports (exports minus imports) as a decreasing function of income (decreasing because imports are an increasing function of income). In this equation, the level of G (government spending) is presumed to be exogenous, meaning that it is taken as a given.

IS MODEL

• The IS curve is a locus of points of equilibrium in the "real" (non-financial) economy. Given expectations about returns on fixed investment, every level of the real interest rate (i) will generate a certain level of planned fixed investment and other interest-sensitive spending: lower interest rates encourage higher fixed investment and the like. Income is at the equilibrium level for a given interest rate when the saving that consumers and other economic participants choose to do out of this income equals investment .

• The multiplier effect of an increase in fixed investment resulting from a lower interest rate raises real GDP. This explains the downward slope of the IS curve.

• In summary, this line represents the causation from falling interest rates to rising planned fixed investment (etc.) to rising national income and output.

LM MODEL• For the Liquidity preference and Money supply curve, the independent variable is "income"

and the dependent variable is "the interest rate." The LM curve shows the combinations of interest rates and levels of real income for which the money market is in equilibrium. It is an upward-sloping curve representing the role of finance and money.

• The LM function is the set of equilibrium points between the liquidity preference (or Demand for Money) function and the money supply function (as determined by banks and central banks).

• Each point on the LM curve reflects a particular equilibrium situation in the money market equilibrium diagram, based on a particular level of income. In the money market equilibrium diagram, the liquidity preference function is simply the willingness to hold cash balances instead of securities. For this function, the nominal interest rate (on the vertical axis) is plotted against the quantity of cash balances (or liquidity), on the horizontal. The liquidity preference function is downward sloping. Two basic elements determine the quantity of cash balances demanded (liquidity preference) and therefore the position and slope of the function:

LM MODELDEMAND FOR MONEY:

- willingness to hold cash for everyday transactions and - a precautionary measure (money demand in case of emergencies).

1) Transactions demand for money:Transactions demand is positively related to real GDP (represented by Y, Income). This is simply explained - as GDP increases, so does spending and therefore transactions. As GDP is considered exogenous to the liquidity preference function, changes in GDP shift the curve. For example, an increase in the demand for money for transactions will increase interest rates through the money market, and cause the LM curve to shift to up and to the left.

2) Speculative demand for money: - willingness to hold cash instead of securities as an asset for investment purposes. Speculative demand is inversely related to the interest rate. As the interest rate rises, the opportunity cost of holding cash increases - the incentive will be to move into securities.

LM MODEL• Money supply is determined by the central bank decisions and willingness of commercial banks to loan

money. Though the money supply is related indirectly to interest rates in the very short run, the money supply in effect is perfectly inelastic with respect to nominal interest rates (assuming the central bank chooses to control the money supply rather than focusing directly on the interest rate). Thus the money supply function is represented as a vertical line - money supply is a constant, independent of the interest rate, GDP, and other factors.

• Mathematically, the LM curve is defined by the equation:

Ms/P=Md(i, Y)

where the supply of money is represented as the real amount M/P (as opposed to the nominal amount M), with P representing the price level, and L being the real demand for money, which is some function of the interest rate i and the level Y of real income. The LM curve shows the combinations of interest rates and levels of real income for which money supply equals money demand—that is, for which the money market is in equilibrium.

• For a given level of income, the intersection point between the liquidity preference and money supply functions implies a single point on the LM curve: specifically, the point giving the level of the interest rate which equilibrates the money market at the given level of income.

• An increase in GDP shifts the liquidity preference function rightward and hence raises the interest rate. Thus the LM function is positively sloped.

IS-LM and Crowding Out effect• One hypothesis is that a government's deficit spending ("fiscal policy") has an effect similar to

that of a lower saving rate or increased private fixed investment, increasing the amount of demand for goods at each individual interest rate. An increased deficit by the national government shifts the IS curve to the right. This raises the equilibrium interest rate (from i1 to i2) and national income (from Y1 to Y2), as shown in the graph above. The equilibrium level of national income in the IS-LM diagram is referred to as aggregate demand.

• By the above hypothesis, the graph indicates one of the major criticisms of deficit spending as a way to stimulate the economy: rising interest rates lead to crowding out – i.e., discouragement – of private fixed investment, which in turn may hurt long-term growth of the supply side (potential output).

• Keynesians respond that deficit spending may actually "crowd in" (encourage) private fixed investment via the accelerator effect, which helps long-term growth. Further, if government deficits are spent on productive public investment (e.g., infrastructure or public health) that directly and eventually raises potential output, although not necessarily more (or less) than the lost private investment might have. The extent of any crowding out depends on the shape of the LM curve. A shift in the IS curve along a relatively flat LM curve can increase output substantially with little change in the interest rate. On the other hand, an upward shift in the IS curve along a vertical LM curve will lead to higher interest rates, but no change in output.

IS-LM MODEL

IS-LM and Crowding Out effect• Rightward shifts of the IS curve also result from exogenous increases in investment spending

(i.e., for reasons other than interest rates or income), in consumer spending, and in export spending by people outside the economy being modelled, as well as by exogenous decreases in spending on imports. Thus these too raise both equilibrium income and the equilibrium interest rate. Of course, changes in these variables in the opposite direction shift the IS curve in the opposite direction.

• The IS/LM model also allows for the role of monetary policy. If the money supply is increased, that shifts the LM curve downward and to the right, lowering interest rates and raising equilibrium national income. Further, exogenous decreases in liquidity preference, perhaps due to improved transactions technologies, lead to downward shifts of the LM curve and thus increases in income and decreases in interest rates. Changes in these variables in the opposite direction shift the LM curve in the opposite direction.

• The IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y).

• In economics, crowding out is a phenomenon occurring when expansionary fiscal policy causes interest rates to rise, thereby reducing investment spending. That means increase in government spending 'crowds out' investment spending.

• Changes in fiscal policy shifts the IS curve, the curve which describes equilibrium in the goods market. A Fiscal Expansion shifts IS curve to the right from IS1 to IS2. A fiscal expansion increases equilibrium income from Y1 to Y2 and interest rates from i1 to i2. At unchanged interest rates i1, the higher level of government spending increase the level of Aggregate Demand. This increase in demand must be met by rise in output. At each level of interest rate, equilibrium income must rise by the multiplier times the increase in government spending.

Crowding Out Effect

• If the interest rate stayed constant at i1, the goods market is in equilibrium in that planned spending equals output, but the assets market is no longer in equilibrium. Income has increased, and, therefore, the quantity of money demanded is higher. Because there is an excessive demand for real balances, the interest rate rises. Firms planned spending declines at higher interest rates, thus the aggregate demand falls. Therefore, the equilibrium is at higher interest rates. The adjustment of interest rates and their impact on aggregate demand dampen the expansionary effect of the increased government spending.

Crowding Out Effect

What factors determine how much crowding out takes place?• The extent to which interest rate adjustments dampen the output expansion induced by

increased government spending is determined by:• Income increases more, interest rates increase less, the flatter LM (Liquidity preference—

Money supply) curve.• Income increases less, interest rates increase less, the flatter IS (Investment—Saving)

curve.• Income and interest rates increase more the larger the multiplier, thus, the larger the

horizontal shift in the IS curve.• In each case, the extent of crowding out is greater the more interest rate increases when

government spending rises.

Crowding Out Effect

Two extreme cases:

(I) Liquidity trap

• If the economy is in the liquidity trap, the LM curve is horizontal, an increase in government spending has its full multiplier effect on the equilibrium income. There is no change in the interest associated with the change in government spending, thus no investment spending cut off. Therefore no dampening of the effects of increased government spending on income. If the demand for money is very sensitive to interest rates, so that the LM curve is almost horizontal, fiscal policy changes have a relatively large effect on output, while monetary policy changes have little effect on the equilibrium output. So, if the LM curve is horizontal, monetary policy has no impact on the equilibrium of the economy and the fiscal policy has a maximal effect.

Crowding Out Effect

(II) The Classical Case and crowding out:

• If the LM curve is vertical, then an increase in government spending has no effect on the equilibrium income and only increases the interest rates. If the demand for money is not related to the interest rate, as the vertical LM curve implies, then there is unique level of income at which the money market is in equilibrium.

• Thus, with vertical LM curve, an increase in government spending cannot change the equilibrium income and only raises the equilibrium interest rates. But if government spending is higher and the output is unchanged, there must be an offsetting reduction in private spending. In this case, the increase in interest rates crowds out an amount of private spending equal to increase in government spending. Thus, there is full crowding out if LM is vertical.

Crowding Out Effect

Is Crowding Out Likely?

• The question is how seriously we must take the possibility of crowding out? This is discussed in three points given below:

(I) Consider an economy with given prices, in which the economy operates below full employment. Under such conditions, when fiscal expansion increases demand, firms can increase their output by hiring more workers. But if the economy is at full employment level, crowding out becomes a much more realistic possibility because firms cannot increase their output through additional hiring. In this situation an increase in demand will lead to an increase in price level rather than an increase in output.

Crowding Out Effect

Is Crowding Out Likely?

(II) In an economy with unemployed resources full crowding out will not occur because the LM curve is not vertical. A fiscal expansion will raise interest rates, but income will also rise depending on the slope of the LM curve. Crowding out, if it occurs, is thus a matter of degree.

Crowding Out Effect

Is Crowding Out Likely?

(III)Monetary authorities can accommodate a fiscal expansion by increasing the money supply, thus dampening any rise in interest rates. This monetary accommodation is referred to as "monetizing the deficit", where the central bank prints money to buy bonds issued by the government to pay for its expansionary deficit. In this case, both IS and LM curves shift to right, resulting in increased output at the same interest rate. Thus with an appropriate monetary policy complementing fiscal policy, there need not be any crowding out of private investment.

Crowding Out Effect

BACKGROUND:

• Broadly, during the first 30 years of independence, between 1950 and 1980, the• fiscal deficits of both the central and the state governments were not excessive. • This was a period of revenue surplus in general. However, automatic monetisation of

government deficit by the RBI, which started as an exception during the mid 1950s, became a regular practice thereafter.

• Simultaneously, there was also a distinct shift in the management of the financial• sector with the nationalisation of major commercial banks in 1969 and 1980. These two

developments had a significant bearing on the relationship between the monetary authority (RBI) and the fiscal authority (Government).

• There was a significant deterioration in the fiscal situation in the 1980s, accompanied by large and automatic monetisation of government deficits.

FISCAL POLICY AND ECONOMIC REFORMS IN INDIA

• The process involved issue of ad-hoc Treasury bills.• Since July 1974, the ad-hoc Treasury bills were offered at off-market discount rate of

4.6 percent, which was less than half of the prevailing market rates. • There were two immediate consequences:

- When large government deficits were monetised, there was excess liquidity in the system, which prompted the monetary authorities to increase the cash reserve ratio (CRR) for banks at regular intervals with a view to mop up the excess liquidity. - To facilitate the central government to borrow comfortably, the monetary authority, which is also the debt manager for the government, periodically increased the statutory liquidity ratio (SLR) to be maintained by banks.

• This process went on to an extent that CRR and SLR, together, pre-empted more than 50 percent of banking sector liabilities, for a period.

FISCAL POLICY AND ECONOMIC REFORMS IN INDIA

• The process involved issue of ad-hoc Treasury bills.• Since July 1974, the ad-hoc Treasury bills were offered at off-market discount rate of 4.6 percent, which was less

than half of the prevailing market rates. • There were two immediate consequences:

- When large government deficits were monetised, there was excess liquidity in the system, which prompted the monetary authorities to increase the cash reserve ratio (CRR) for banks at regular intervals with a view to mop up the excess liquidity. - To facilitate the central government to borrow comfortably, the monetary authority, which is also the debt manager for the government, periodically increased the statutory liquidity ratio (SLR) to be maintained by banks.

• This process went on to an extent that CRR and SLR, together, pre-empted more than 50 percent of banking sector liabilities, for a period.

• In other words, more than 50 percent of the resources of the banking sector were preempted• to primarily finance the budget deficits of the governments. Further, the deposit and• lending rates of banks were, for most part, administered. This situation impacted the health• of the banking system and the consequential adjustments during the banking sector• reform process were, naturally, somewhat complex.• The large fiscal deficit and its monetisation had some spill-over effect on the

FISCAL POLICY AND ECONOMIC REFORMS IN INDIA

• In other words, more than 50 percent of the resources of the banking sector were pre-empted• to primarily finance the budget deficits of the governments. • Further, the deposit and lending rates of banks were, for most part, administered. This situation impacted the

health of the banking system and the consequential adjustments during the banking sector reform process were, naturally, somewhat complex.

• The large fiscal deficit and its monetisation had some spill-over effect on the external sector, which reflected in the widening current account deficit in the late 1980s and early 1990s.

• Triggered by the balance of payments crisis in the early 1990s, when our foreign currency assets depleted rapidly to the extent that it could barely finance just two weeks of imports, we started the reform process in 1991-92. A credible macroeconomic structural and stabilisation programme encompassing trade, industry, foreign investment, exchange rate, public finance and financial sector was put in place, which created an environment that was conducive for the expansion of trade and

• investment. • Simultaneously, several reform measures towards the marketisation of government borrowings were initiated.

FISCAL POLICY AND ECONOMIC REFORMS IN INDIA

• RBI entered into the first agreement with the government in 1994 to place a limit on automatic monetisation.

• The First Supplemental Agreement between the RBI and the Government of India was signed in 1994 setting out a system of limits for creation of ad hoc treasury bills during the three-year period ending 1996-97.

• In 1997, RBI signed the second agreement with the government for the same.• In pursuance of this Second Supplemental Agreement between the RBI and the

Government of India on March 6, 1997, the ad hoc Treasury Bills were completely phased out from April 1997, replaced by a scheme of Ways and Means Advances, subject to limits.

• In order to smoothen the transition, the Government of India was allowed to incur also an overdraft, but at an interest rate higher than the rate applicable for Ways and Means Advances (WMA). With effect from April 1, 1999 these overdrafts were allowed only for a maximum of ten working days.

FISCAL POLICY AND ECONOMIC REFORMS IN INDIA

• These features placed the Central Government on par with the State governments which were brought under an ‘Overdraft Regulation Scheme’ since 1985.

• Furthermore, it was agreed that the RBI would trigger fresh floatation of Government securities whenever 75 percent of the WMA limit was reached.

• It was also agreed that the government’s surplus cash balances with the RBI, beyond an agreed level, would be invested by it in government securities.

• While the transition to a full-fledged WMA and overdraft mechanism was gradual, non-disruptive and consensual, the successful implementation of this mechanism made it possible to incorporate some of these practices into a law – the Fiscal Responsibility and Budget Management Act (FRBM Act).

• It is noteworthy that this law also practically prohibited RBI from participating in primary issues of all government securities.

FISCAL POLICY AND ECONOMIC REFORMS IN INDIA

• As a result of the concerted efforts to restore fiscal balance through tax reforms, expenditure management, institutional reforms and financial sector reforms in the first half of the 1990s, there was significant reduction in the magnitude of fiscal deficit and the proportion of debt relative to GDP during the period 1991 to 1997.

• However, during the period 1997 to 2003, there was a reversal in the trend of fiscal consolidation, and the cumulative impact of industrial slowdown, fifth pay commission award, and a lower than expected revenue buoyancy culminated in fiscal deterioration.

• This deterioration in the Indian fiscal position happened at an inopportune time when there was fiscal improvement the world over and India was trying to globalize. It is important to remember that India’s fiscal situation has been significantly divergent from the global fiscal situation and continues to be so even now.

• This is the background we have to keep in view whenever we discuss the pace and the content of economic reforms in India.

• The coming into force of the FRBM Act, 2003 on July 5, 2004, which established a framework for a rule based fiscal consolidation, should be viewed in this background.

FISCAL POLICY AND ECONOMIC REFORMS IN INDIA

• In the period subsequent to 2003, the central government’s fiscal position improved.

• The states’ fiscal positions also improved significantly during this period and their revenue deficits also were close to being virtually eliminated.

FISCAL POLICY AND ECONOMIC REFORMS IN INDIA

• Given the institutional arrangement, the RBI’s primary objective is to maintain monetary stability.

• The fiscal situation is decided and determined by the Government. Once the fiscal situation is decided, it is the Central Bank’s responsibility to ensure that monetary stability is maintained and the government’s borrowing programme is managed with minimum disruptions in terms of stability.

ROLE OF RBI IN FISCAL REFORMS

• With regard to operational issues relating to monetary policy, there is some element of freedom but, in view of the fiscal dominance in the economy, the overriding approach has been harmonization of monetary policy with fiscal policy for ensuring stability. Within this framework, through mutual cooperation, several reform measures have been undertaken by the government and the RBI.

• A few illustrations of the links that exist between fiscal and monetary management: • First, the Statutory Liquidity Ratio (SLR) was gradually reduced to the then• statutory minimum of 25%, effective October 21, 1997. Currently at 23%.• CRR has been reduced gradually, depending on the liquidity conditions, as a first step,

with the objective of ultimately reducing it to the statutory minimum of 3%.• In the meantime, RBI’s commitment to the removal of the statutory prescriptions of• minimum reserve and liquidity requirements was demonstrated by its proposal to the

Government for legislative amendments to remove the minima. • These legislations have since been passed. Now, there is no minimum statutory

stipulation for SLR and CRR.

FISCAL AND MONETARY MANAGEMENT

• The Reserve Bank of India (RBI) Act implicitly prescribed the CRR originally at a minimum of 3 % of any bank’s net demand and time liabilities. This restriction was removed by an amendment in 2006. While the RBI is now free to prescribe this rate, and any CRR above 3% can still be viewed as a monetary tool to contain expansion of money supply by influencing the money multiplier.

• But the way in which the CRR was operated historically made it serve a much wider role. During the 1990s, when there was influx of foreign funds through non-resident Indian (NRI) deposits, a differential CRR was prescribed on such deposits to restrict their inflows.

• In the more recent period after 2004, when there was a huge influx of foreign capital through varied forms of debt and non-debt flows, and the RBI ended up accumulating large forex reserves, the CRR became an optional instrument to sterilise the rupee resources released from such dollar purchases. This was particularly enabled by not paying any interest on CRR balances maintained by banks with the RBI. The other options of sterilisation was through open market operations and the repo operations through the liquidity adjustment window (LAF) which is a cost to the central bank, just as the market stabilisation scheme cost the Government fiscally in terms of interest payments.

FISCAL AND MONETARY MANAGEMENT

• Since 2004, the use of CRR as an instrument of sterilisation and also a monetary tool has gained ground again.

• Since CRR acts as a tax that increases their transaction costs, banks in general would want its role to be restored to being a prudential minimum requirement of not more than 3%.

• Since quantitative easing has become a fashion of central banking across the world, the RBI may well choose to bring the CRR further down gradually to about 3% during the current easing phase, without losing sight of monetary control in the face of inflation remaining high at around 7-8%.

• Like CRR, SLR can also be viewed as a hybrid instrument of a different variety. The SLR, according to some, is not a monetary tool and is only a prudential requirement to serve as a cushion for safety of bank deposits.

• The minimum prescription in this manner was 25% of bank’s demand and time liabilities. But it was also more a way of finding a captive market for government securities, particularly when they were bearing below market interest rates. Not surprisingly, this ratio touched about 38 per cent around 1991.

FISCAL AND MONETARY MANAGEMENT

FISCAL AND MONETARY MANAGEMENT

• Second: An issue that has come to the fore in the recent period pertains to highervolatility in government’s cash balances maintained with the RBI, which impactsthe liquidity conditions in the financial markets.

• Volatility in Government’s cash balances is not unique to the Indian situation and is an issue even in other countries, but in our situation, it has become increasingly prominent now.

• It so happens that, at times, government’s cash balances and the external situationmove in different directions and they create very little net impact on liquidity fromthe perspective of overall monetary management.

• However, there are occasions when they move in the same direction, in which case the volatility in the liquidity conditions is much higher. This is one major current issue in monetary management which could be linked to cash management in the government.

• The link becomes critical for maintaining orderly liquidity conditions in the money market and effectively using short term overnight interest rates for monetary operations.

FISCAL AND MONETARY MANAGEMENT

• Third, the magnitude of the combined fiscal deficit of the centre and the states is close to half of the households’ financial savings, which is the largest component of domestic savings. If fifty percent of households’ financial savings are taken away by the government sector, it has vital implications for ensuring stability in the financial markets because the demand for funds from the non-government productive sectors of the economy has to be met simultaneously.

FISCAL AND MONETARY MANAGEMENT

• Fourth, India is still a bank-dominated system and about 70 percent of our banks (in terms of business) are owned by the government. Thus, we could have a situation when the objective of monetary policy and the objective of broader public policy dealings with banking converge, in which case the monetary policy could be very effective. Sometimes, it could happen that the objective of monetary policy and the objective of broader public policy may not converge, in which case monetary policy may not be that effective. In other words, the effectiveness of the monetary policy depends not only on the actions of the monetary authority, but also on other public policy postures. This certainly complicates monetary management.

FISCAL AND MONETARY MANAGEMENT

• The issue of conflict of interest in public sector banking and government ownership is yet another issue. The issue of conflict of interest in private sector banks arises when the owner of the bank borrows from his own bank. The single largest source of borrowing for the government being the government-owned banks themselves, this conflict is rather apparent.

• Fifth, one of the factors imparting rigidity to the interest rate structure in India is the administered interest rates, particularly on small savings instruments. In this context, administered interest rates fixed by the Government on a number of small saving schemes and provident funds are of special relevance as they have generally offered a rate different from those on corresponding instruments available in the market, in some cases along with tax incentives. The administered interest rates significantly impact the level and allocation of savings. On the lending side also, there are some administrative prescriptions for banks. Depending on how it is calculated, on both the savings and the lending sides, the administered structure of interest rate would apply to about 25 to 40 percent. In this context, it is pertinent to note that the monetary policy mainly operates through interest rates and interest rate signals, and constraints posed by administered interest rates have to be duly recognized while dealing with issues relating to monetary policy transmission mechanisms.

FISCAL AND MONETARY MANAGEMENT

• Sixth, theoretically it is well recognised that monetary policy is generally a more effective counter-cyclical policy instrument than fiscal policy because interest rate changes can be made and reversed quickly.

• However, monetary policy adjustments may take longer than fiscal policy adjustments to affect aggregate demand. It is also recognized that fiscal policy contributes to broader based stabilization through the impact of taxes and government spending on income sensitive (in addition to interest-sensitive) components of aggregate demand.

• When monetary policy is thus constrained in responding to output variations, fiscal policy should normally take a more central role. Thus, effective co-ordination between the fiscal policy and monetary policy is important.

FISCAL AND MONETARY MANAGEMENT

• At a more aggregate level, in the context of our capacity to respond to global developments, if we have a counter-cyclical policy approach, not only the monetary policy but also the fiscal policy should be counter-cyclical. If the fiscal policy continues to be unidirectional, as we have in our case, with persisting deficits, then the fiscal policy is not in a position to produce a reasonable counter-cyclical impact. In these circumstances, the monetary policy has a challenge in designing and implementing appropriate countercyclical policies, that has the added burden of off-setting the impact of the fiscal policy. Well, despite these challenges, the RBI has managed the situation reasonably well and we have the confidence that we would be able to continue to manage. However, it is important to recognize that, at times, unorthodox policies have assured the stability of the Indian financial system despite fiscal stress, which is a desirable outcome rather than achieving ritualistic compliance with pre-set rules.

RBI’s Perspectives on Fiscal Policy• The RBI’s approach to fiscal reforms is that while we agree on the need to eliminate the

revenue deficit, and agree on a nominal limit for fiscal deficit, what is even more important is the mode of financing the fiscal deficit and the use that the resources so raised are put to.

• Exclusive focus on fiscal deficit may tend to reduce the role of the Government, and consequently, it will not be in a position to aid the process of growth, in particular, inclusive growth. Re-prioritisation of expenditure may be achieved through reduction or elimination of subsidies and deployment of resources thus released to the more needy sectors. Higher level of resources may also be available through reduction in tax exemption.

• In the light of financial turbulence across the world in the recent period, the relevance of the fiscal in the management of the macro economy has become even more important.

PUBLIC POLICY IN INDIA

• Public Policy refers to an area of government activity In which broader interests of the people are linked in areas. Like, education health, housing, agriculture, energy, transport, even foreign policy is referred as a public policy.

• Thus any government activity having wider ramifications for the people is considered a Public Policy.

PUBLIC POLICY IN INDIA

• Public Policy refers to an area of government activity In which broader interests of the people are linked in areas. Like, education health, housing, agriculture, energy, transport, even foreign policy is referred as a public policy.

• Thus any government activity having wider ramifications for the people is considered a public policy.

Industrial Policy in India

• Industrialisation in India is considered to be the engine of growth for the rest of the economy.

• The economic environment in India is that of a mixed economy: i.e., co-existence of public and private sectors.

• The present mixed economy has evolved through a series of policy formulations and legislations.

Industrial Policy in India

Goals of Industrial Policy:• Generate situations for maximum utilisation of raw

materials and human capital for industrialisation.• Suggest competitive advantages to investors, including

foreign investors.• Take advantage of govt.’s incentives packages• Offer special attention to areas, like, export oriented

units.• To establish middle and large scale industries in public,

private and joint sectors to create industrial base.

Industrial Policy in India

Industrial Policy Resolution of 1948:• Reflected the concept of a mixed economy –

establishment of industries in both private and public sectors will play a dynamic role.

• Industries were divided into 4 broad categories:– Industries involved in the manufacture of arms,

ammunitions, production and control of atomic energy and the ownership and management of railway transport.

Industrial Policy in India

Industrial Policy Resolution of 1948: (Contd.)– Industries such as, coal, iron and steel, aircraft,

ship building, manufacture of telephones, telegraphs and wireless apparatus.

– Basic industries, like, automobiles, tractors, fetilizers, sugar, paper, cement, cotton.

– Leftover industries which were managed by individual, priate and joint enterprises.

Industrial Policy in IndiaIndustrial Policy Resolution of 1956:

• Industrial Policy Resolution of 1948 brought significant Industrial development during the First 5 Yr Plan.

• Industrial Policy Resolution of 1956 replaced this and aimed at implementation of a socialistic pattern of society.

• Industries were classified into 3 categories: - Schedule A: Exclusively controlled by the State for establishing and developing them (Defence, Heavy Inds, mining, transport and power)- Schedule B: Controlled by both public and private sector ( mixed economy concept), like, mining, aluminium, chemical, fertilizers, machine tools, etc.- Schedule C: Remaining industries under private sector.

• Encouraged establishment of small scale industries.• Discovering modern techniques of production.• Reducing regional inequalities in terms of development.• Improving living and working conditions of workers.• Securing participation of foreign capital so as to increase the pace of industrialisation.

Industrial Policy in India

Industrial Policy Statement of 1977:Provisions of this Policy were: Emphasis on • Small scale industries (Inv upto Rs. 10 lacs), cottage industries,

ancillary inds.( Inv upto Rs. 15 lacs).• Basic industries for development of infrastructure, small scale and

village inds.• Capital goods and high technology industries which meet

requirements of agricultural and small scale inds.• Role of Public sector for encouragement of ancillary, small scale &

cottage inds.• Raising funds for revival of loss making small scale and sick industries.

Industrial Policy in IndiaIndustrial Policy Statement of 1980:

The Policy identified the inefficiencies of the public sector and determined to improve the efficiency of PSUs.

Most important Provisions were:• Limits of investments for small scale industries were re-

defined/raised ; handloom , handicrafts were promoted.• Policy regularised unauthorised excess capacity in private

sector industries with important acts like Monopolies Restriction & Trade Practices (MRTP) Act and the Foreign Exchange Regulations Act (FERA).

Industrial Policy in India

Industrial Policy Statement of 1980 (Contd.):

• The Policy liberalised the licensing capacity for modernisation of industries.

• The Govt de-licensed 23 industries.The companies covered under MRTP and FERA were considered for de-licensing after 1980.

• In 1985, 25 broad groups of industries were de-licensed ( like, industrial machinery, Iron and Steel industry(before liberalisation)).

• Limit for Cos. Under MRTP Act was raised from Rs. 20 Cr to Rs. 100 Cr.

Industrial Policy in India

Industrial Policy 1991:Turning point for the Indian Economy. PM – Mr Narasimha Rao announced the New Economic Policy with the following objectives:

• To release industrial sector from unnecessary policy restrictions.• Introduce liberalisation with a view to integrate the Indian

economy with the world economy.• To remove restrictions on Foreign Direct Investment.• To free domestic entrpreneurs from the restrictions of MRTP

Act.• To revive the sick enterprises under the public sector.

Industrial Policy in India

Industrial Policy 1991 (Contd.):Govt. took up the Policy proposals in the following areas:

• Industrial Licensing Policy• Foreign Investment• Foreign Technology• Public Sector Policy• MRTP Act

Industrial Policy in India

Industrial Policy 1991 (Contd.):Industrial Licensing Policy• Licensing abolished for all categories except for

industries related to security and strategic concerns, social reasons, harmful chemicals and environmentally hazardous.

• In some industries licensing compulsory – like, coal & lignite, petroleum, alchoholic drinks, industrial explosives, cigarettes, etc.

Industrial Policy in India

Industrial Policy 1991 (Contd.):Foreign Investment:• To encourage foreign investment in high

priority sectors, those requiring huge investments and advanced technology, govt accorded approval for FDI upto 51% equity.

• Sanctions were given for forign technology agreements in high priority industries.

Industrial Policy in India

Industrial Policy 1991 (Contd.):Public sector policy:• The loss in public sector enterprises due to low return on

investment has burdened the govt. E.g., under this Policy, the govt decided to strengthen those public enterprises which fall in the reserved areas of operation and high priority areas. Competition was induced in these areas by inviting private sector participation. Sick industries were referred to Board for Industrial and Financial Reconstruction (BIFR) for rehabilitation schemes.

Government policy and reforms in China

China’s consumption story is driving MNCs’strategy: • The Chinese government’s drive to raise incomes

and shift growth towards domestic consumption is likely to have a profound impact on most companies. Among survey respondents, 58% said that this policy is the factor that will have the biggest impact on their China strategy, while 56% said that growth prospects for their industry was the key driver of their China strategy.

Government policy and reforms in China

• The Chinese government is eager to rebalance economic growth drivers away from investment and exports towards consumption, and it is especially keen to raise incomes of the less well-off. It plans to raise minimum wages by at least 13% a year for the five years covered by the government’s 12th Five-Year Plan (FYP) for 2011-15. Market forces are already driving up wages at an even quicker pace in some areas: since 2010, 30 Chinese provinces have raised their minimum wages, by an average of 23%.

Government policy and reforms in China

• In 2010 the minimum wage in Beijing went up by over 45%, thanks largely to the galloping economy and tightening labour supply.

• While companies are in the short term scrambling to find efficiencies to offset rising wages, they are keenly aware of the opportunity the creation of a new consumer class represents. This class will not be limited to the first-tier cities of Beijing and Shanghai, but will emerge all across China and deep into its poorer interior regions.

Government policy and reforms in China

• In addition to wage rises, China’s galloping urbanisation will help push up consumption and reduce the income gap. It will, in turn, further spur economic growth and support consumption by existing city dwellers and new migrants, as well as making it easier to reach more consumers, creating huge potential opportunities for the world’s industrial firms.

• Forecast is that by 2025 around 70% of China’s population will live in cities. Between now and then 170 new mass transit systems and 40bn square metres of floor space will be built. China’s companies are not likely to be able to manage all this on their own.

Government policy and reforms in China

• The housing sector is driving growth in China. At current rates of construction China can build a city the size of Rome in only two weeks. This means China is underpinning demand in global markets for many key commodities. It also means that any downturn will quickly register on Chinese GDP and global commodity markets.

• In the decade leading up to 2010, China built the housing equivalent of roughly two Spains or United Kingdoms, or one Japan. In per capita terms, the average amount of floor space enjoyed by urban Chinese has doubled over the same period.

• So what does the future hold? Is China’s current housing boom sustainable or is it heading for a Dubai-style bust?

Government policy and reforms in China

• Healthcare reform, a key Chinese government initiative, will be vital in unleashing the full potential of the country’s consumption power. With no social safety net, many Chinese households continue to save an inordinate amount of their incomes against medical emergency, or to fund their retirement. Even relatively well-off city dwellers report that they save more than 30% of their annual household income, in part to cover medical emergencies. There is an urgent need to overhaul China’s patchy healthcare system to prepare for the coming upsurge in the elderly population, and also to bring a much-needed boost to the quality of life of many of its citizens.

Government policy and reforms in China

• China’s rapid economic development has not translated automatically into political development with many of its institutions still in need of major reform. In the post – MAO era despite the decentralisation of local government with significant administrative and fiscal authority, China’s government and policy making processes have retained much of the inefficiency and corruption characteristics of the earlier period.

• In OECD (Organisation of Economic Cooperation and Development) countries, for instance it is believed that the authority of policy making should be moved closer to the citizens so that the decisions made are more suited to citizen’s needs.

• The process of reform in China has been one of continuous conflict between the agenda of political elites in central government, and the priorities of local leaders, with local agents often distorting, delaying or ignoring the policies emanating from the central government.

Government policy and reforms in China

• Since the mid-1990s the central government has taken over several important tax bases and substantially increased its tax revenue at the expense of local governments.

• The decentralisation since the early 1980s aimed at motivating local leaders to develop the economy was a coping strategy to deal with the problems caused by centralisation. Centralisation in China since the mid 1990s, in turn was a response to the decentralisation problems such as economy overheat, decline in central government’s capacity over taxation and thriving corruption.

• A usual approach of researching China is to understand the theories and concepts generated from the Western liberal democracies and then apply these theories and concepts to the context of China. Without modification, these theories and concepts are often inapplicable to China.

Government policy and reforms in China

• The Chinese government has continually reformed its government structure and policy making process to spur sustainable development and enhance its legitimacy. The reform of government and policy making in China follows two intertwining trajectories: the first is to refine the technical arrangements of various stages of policy process: the second is more political, entailing power redistribution.

• The global financial crisis has undeniably raised China’s stature in the world. Thanks to its ability to maintain near double-digit annual GDP growth through the tumult of 2008-09, China overtook Japan as the world’s second-largest economy in 2010. Before the global financial crisis erupted, Goldman Sachs had expected China to surpass the US as the world’s biggest economy around 2041.

EXPECTATIONS FROM INDIA’S BUDGET : 2013-14

Background of Balancing the Budget 2013-14:

• Some would say that the main suspense of the Budget session of Parliament is already over. The railway ministry announced its first hike in passenger fares in 12 years in January, while the finance ministry has floated a weather balloon canvassing opinion on whether taxing the rich more would help bridge the fiscal deficit.

EXPECTATIONS FROM INDIA’S BUDGET : 2013-14

• A widening fiscal deficit,• slower growth than previous years (the government has projected GDP growth for fiscal

year 2013-14 at 5%) and • Not enough headroom to spend (even on defence, which is going to face spending cuts

this year) mean that the finance minister has less space than before for any financial pyrotechnics. • This is a particularly problematic situation when presenting the last full budget before a

general election.

The session, therefore, will be packed with: • heavy-duty bills, contentious and political, • increasingly looking like a wish list • that should have been done and dusted over the past two years but which now appears

as governance in hindsight.

EXPECTATIONS FROM INDIA’S BUDGET : 2013-14

High fiscal deficit would trim welfare spending:

• There may not be a major increase in the allocation for social sector in the forthcoming Budget due to the grim fiscal situation.

• In the face of rating downgrade threats, Finance Minister had in October set a fiscal deficit target of 4.8 per cent next fiscal. He had also said he would rein in fiscal deficit at 5.3 per cent this fiscal yr.

The Government's flagship rural employment guarantee programme MGNREGA (Mahatma Gandhi National Rural Employment Guarantee Act)

• needs to be more "flexible" to regional sensitivities, especially in the central India, where the Maoist insurgents are capitalising on the discontent spread by lack of development.

• This is the second time flaws have been found with MGNREGA. Earlier, the programme had been termed as "paying wages for unproductive work" which creates no real assets.

EXPECTATIONS FROM INDIA’S BUDGET : 2013-14

Government may target Rs 40,000 crore from stake sales in FY14:• The government is likely to target Rs 40,000 crore ($7.42 billion) in

proceeds from stake sales in state-run companies in the next fiscal year.

The revenue target from a partial privatisation of state-run companies is higher than the Rs 30,000 crore government is aiming for in the current fiscal year.

With less than two months to go before the year closes, the government has managed to raise 70 percent of the targeted amount, and officials in the government concede that the final figures for this year could fall shy of the target.

EXPECTATIONS FROM INDIA’S BUDGET : 2013-14

Salaried class employees want IT exemption limit raised• Salaried class want Finance Minister to raise the

income tax exemption limit to at least Rs 3 lakh and increase deductions like medical and educational allowances in the Budget.

Over 89 per cent of respondents said the slab of tax free income has not moved up in line with real inflation. The current basic exemption limit of Rs two lakh should be increased to at least Rs three lakh . This will increase the purchasing power of individuals and stimulate demand.

EXPECTATIONS FROM INDIA’S BUDGET : 2013-14

• Barring education, the country's performance on the other human development indicators like health has not been good, even though the economic growth has been strong, he said. He also pointed out a slew of paradoxes like the human development index continuing to be poor in spite of high per capita incomes in states like Gujarat, Punjab and Haryana.

Similarly, richest states like Maharashtra, Andhra and Karnataka, have districts or pockets having the worst human development indicators.

EXPECTATIONS FROM INDIA’S BUDGET : 2013-14

Raising tax exemption cap on interest payments on housing loans

• Consultancy firm PwC today demanded increasing the cap on interest payments (up to Rs 1.5 lakh are eligible for deduction on housing loans should be increased to Rs 3 lakh) and medical expenses for the purpose of tax benefits in the upcoming Budget.

He said the realty sector has been under pressure for quite some time now and the government should incentivise investments into the sector, which will go a long way in helping the economy.

On deductions for medical expenses, which currently stand at Rs 15,000 per annum, an increase to Rs 50,000 is being demanded, more so considering that revision has not happened in the past 14 years, but medical cost has surged manifold since then.

There is also a demand for the government to revisit standard deduction for the next fiscal, which has been called off since 2006.

EXPECTATIONS FROM INDIA’S BUDGET : 2013-14

Tax benefits for M&As (Mergers and Acquisitions) in all sectors sought:• Industry body CII wants the government to extend tax benefits pertaining to

mergers and amalgamations (M&As) to all businesses such as telecom, financial services, entertainment, sports, IT and entertainment.

The move will help industry to reorganise and restructure operations in sync with the rapidity of changes taking place in the business environment as well as to deal with the emergence of new sectors and segments.

Currently, M&A tax benefits are limited to industrial undertakings and select services such as shipping, hotels, aircraft and banking.