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Monetary and Fiscal Policies in India 93

CHAPTER-5

MONETARY AND FISCAL POLICIES IN INDIA

5.1 INTRODUCTION

Economic stability and economic developments are always

intertwined. One of the essential prerequisite for growth of the country

as well as for sustaining it in this era of highly globalised world is

existence of the price stability. Of course, there are chances of occurrence

of fluctuations in the economy. To overcome these fluctuations; we need

monetary and fiscal policies.

The main objectives of the monetary policy are price stability

providing adequate credit to productive sectors and financial stability.

India has always emphasized on price stability and growth with in broad

content of controlling the inflation. The four key channels of monetary

policy transmission are interest rate, credit aggregates, asset prices and

exchange rate channels. ‘Expectation’ has emerged recently as the fifth

channel of the transmission mechanism of monetary policy.

Fiscal policy aims to increase the rate of growth and employment

rate as well. Also, government tries to control fluctuations in aggregate

demand through fiscal policy measures. By definition fiscal policy is

“The government’s attempt to influence the economy by varying its

purchases of goods and services and taxes to smooth the fluctuations in

aggregate expenditure, use of the government budget to achieve

macroeconomic objectives such as full employment, sustained long term

economic growth and price level stability.”


Monetary and fiscal policies in any country are two macroeconomic

stabilization tools. However, these two policies have often been pursued

in different countries in different directions. Monetary policy is often

pursued to achieve the objective of low inflation to stabilize the economy

from output and price shocks. On the other hand, fiscal policy is often

biased towards high growth and employment even at the cost of higher

inflation. For achieving an optional mix of macroeconomic objectives of

growth and price stability, it is necessary that the two policies

complement each other. However, the form of complementarily will

vary according to the stage of development of the country’s financial

markets and institutions.

With increasing independence of central bank in the conduct of

monetary policy from fiscal dominance during the last few decades,

there has been a renewed interest in the issue of monetary and fiscal

policy coordination.

The recent global financial crisis has once again demonstrated the

importance of coordinated response of monetary and fiscal policies.

Sovereign debt problem in many countries in the Euro area, in particular,

has also underlined the need for monetary and fiscal policies coordination.

5.2 MONETARY & FISCAL POLICIES: AN INDIAN

PERSPECTIVE

The Reserve Bank of India was set up in 1935. An active role by

the Reserve Bank of India in terms of regulating the growth in money

and credit became evident only after 1950s. During 1950s monetary

growth was extremely moderate and there was an increasing dependence


on market borrowing and deficit financing. These became pronounced

in the 1970s and thereafter. Current revenues of the central government

exceeded current expenditure so that there was a surplus available to

finance in part the deficit on capital account, a deficit that is normal for

a developing country. This means that the government had to borrow at

home and abroad, not only to finance its investment as would normally

be the case in a developing country, but also its current consumption.

On the eve of the macroeconomic crisis in 1990-91, external debt

had tripled to $69.3 billion, of which around 30 per cent was owed to

private creditors. Thus, debt to private creditors grew five-fold in seven

years. The balance of gross fiscal deficit, after taking into account the

domestic and external borrowings, small saving, and provident funds,

was monetized through the sale of ad hoc treasury bills to the Reserve

Bank. Since the onset of the reforms process, monetary management in

terms of framework and instruments has undergone significant changes,

reflecting broadly the transition of the economy from a regulated to

liberalized and deregulated regime. While the twin objectives of

monetary policy of maintaining price stability and ensuring availability

of adequate credit to productive sectors of the economy to support

growth have remained unchanged; the relative emphasis on either of

these objectives has varied over the year depending on the circumstances.

Reflecting the development of financial markets and the opening up of

the economy, the use of broad money as an intermediate target has been

de-emphasised, but the growth in broad money (M3) continues to be

used as an important indicator of monetary policy. The composition of

reserve money has also changed with net foreign exchange assets

currently accounting for nearly one-half. A multiple indicator approach


was adopted in 1998-99, wherein interest rates or rates of return in

different markets (money, capital and government securities markets)

along with such data as on currency, credit extended by banks and

financial institutions, fiscal position, trade, capital flows, inflation rate,

exchange rate, refinancing and transactions in foreign exchange available

on high frequency basis were juxtaposed with output data for drawing

policy perspectives. Such a shift was gradual and a logical outcome of

measures taken over the reform period since early nineties. (Y.V.

Reddy, 2002).

A Liquidity Adjustment Facility (LAF) has been introduced

during June 2000 to precisely modulate short-term liquidity and signal

short-term interest rates. The LAF, in essence, operates through repo

and reverse repo auctions thereby setting a corridor for the short-term

interest rate consistent with policy objectives. It has emerged as a tool

for liquidity management and signaling of interest rate in the market.

The RBI has also been able to use open market operations effectively to

manage the impact of capital flows in view of the stock of marketable

Government securities at its disposal and development of financial

markets brought about as part of reform.

5.3 MONETARY POLICY IN INDIA

Monetary policy represents one of a number of policies available

to the authorities in the pursuit of macroeconomic objectives, the

objectives usually considered are low inflation, high or full employment,

balance of payments equilibrium and a satisfactory rate of growth of

real income. In a broader context, monetary policy as part of overall

economic policy is basically as set of techniques, the users of which are


located at the central bank and not in the government. This suggests

fundamentally three major aspects of monetary policy in India:

a) The degree of autonomy of the central bank v/s the government,

b) The optimum policy mix between monetary policy and fiscal

policy,

c) The relations between monetary policy and other instruments of

economic policy.

The preference for a high degree of independence for the central

bank is desirable due to the observation that, although economic policy

is framed as a whole by the Government, the objective of monetary

stability is not given a sufficiently important place in the formulation

and implementation of economic policy.

In India, monetary policy has always emphasized the objectives

of price stability and growth. What this, in effect, has meant in practical

policy setting is formulating a balance between the two objectives

depending on the evolving situation but in the broad context of keeping

the inflation rate with in a reasonable bound.

Apart from these two important goals, there has been a conscious

attempt on the part of the Reserve Bank in recent years to maintain

orderly conditions in the foreign exchange market, and to curb

destabilizing and self- fulfilling speculative activities. This has assumed

strategic importance for the sustainability of the external sector in the

face of growing cross- border capital flows in to the economy. With the

increasing order of domestic and international financial integration,

exchange rate expectations do impact on the domestic stance of


monetary policy and hence the significance of inflation. In the

transitional phase, however, given the exchange market imperfections,

the exchange rate objective may occasionally predominate due to

emphasis on the avoidance of undue volatility. In fact, sometimes, as

was the case recently, it could be the most dominant reason for short

term monetary policy adjustments.

In a broader framework, the objectives of monetary policy in

India continue to be price stability and growth. These are pursued, inter

alia, through ensuring credit availability, with stability in the external

value of the rupee as well as overall financial stability. The relative

emphasis on any one of the objectives is governed by the prevailing

circumstances.

In the Indian context, the objective of monetary policy has been to

accelerate economic development in an environment of reasonable price

stability. The monetary authority has to ensure that no legitimate

productive activity is retarded by shortage of finance but at the same

time the funds shall not become excessive to cause inflation. It is in this

sense that the monetary policy adopted by the RBI has come to be

known as that of controlled monetary expansion.

Controlled monetary expansion implies two things: 1) Expansion

in the supply of money, and 2) Restraint on the secondary expansion of

credit.

1) Expansion in the Supply of Money: In a developing economy

money supply has to be expanded sufficiently to match the growth

of real national income. Although it is difficult to say what relation


the rate of increase in money supply should bear to the rate of

growth of national income, more generally the rate of increase in

money supply has to be somewhat higher than the projected rate

of growth of real national income for two reasons:

• As incomes grow the demand for money as one of the

components of savings tends to increase.

• As increase in money supply is also necessitated by the

gradual reduction of the non- monetized sector of the

economy. In India, the rate of increase in money supply has

been far in excess of the rate of growth in real national

income. It has resulted, to a large extent, in the creation of

consistent inflationary pressure in the economy.

2) Restraint on the Secondary Expansion of Credit: Government

budgetary deficit for financing a part of the investment outlays

constitutes an important source of monetary expansion in India. In

the circumstances an important aim of monetary policy is to

restrain the secondary expansion of credit. This indeed poses

difficult problems Since the general tendency in such a situation

is for a marked expansion of credit for the private sector also.

While exercising restraint, care is taken that the legitimate

requirements of production and trade are not affected adversely.

Besides, the bank has to manage the public debt of the government

in such a way as to ensure the raising of public debt at low interest rates,

and at the same time, keeping interest rates attractive enough for

promoting savings in the economy.


The fulfillment of the above twin goals requires:

a) A correct choice of instruments of monetary policy designed to

regulate the flow of credit and

b) An effective credit planning.

RBI is empowered, under its statute, to use the usual instruments

of monetary policy such as the bank rate, open market operations,

variable reserve ratios, selective credit controls and so on. The choice of

instruments of the monetary control that can be used is limited, however,

by various environmental factors like:

• Seasonality in demand for credit,

• Nature of money market,

• Availability of black money and parallel economy,

• The gradual expansion of the monetized sector,

• Inflationary financing of development,

• The existence of non- banking financial intermediaries.

Monetary policy as an instrument of economic policy has certain

advantages. Monetary policy changes, unlike in the case of fiscal policy,

can be made at any time during a year. Monetary policy has been

operated with a view to ensuring a reasonable degree of stability

consistent with the needs of economic development.

The first and most important part of the monetary policy frame work

in a country is the task mandated to the monetary authorities. In a

democracy, this task is typically specified in the central bank act. It is

interesting to note that despite overwhelming changes in the financial

sector in India, the mandate to the monetary authorities in India mentioned

in the Reserve Bank of India act 1934 has remained unchanged.


The preliminaries of the Reserve Bank of India act 1934 set the

mandated tasks as “ to regulate the issue of bank notes and keeping of

reserves with a view to securing monetary stability in India and

generally to operate the currency and credit system of the country to its

advantage.” (Kaushik Bhattacharya, 2003)

A major failure of the monetary policy lies on the price front. The

monetary authorities in India have not been in a position to curb an

inflationary rise in prices: for regulating money supply, the monetary

authority must have a reasonable degree of control over the creation of

reserve money. The degree of independence in regulating reserve money

depends upon institutional arrangements governing the functioning of

the monetary authority. In India, government finances have come under

increasing pressure in recent years. The increasing monetization of the

budget deficit raises important questions on the roles of fiscal and

monetary policy.

5.4 REFORMS IN THE INDIAN MONETARY POLICY

DURING 1990s

The monetary policy of the RBI has undergone massive changes

during the economic reform period. After 1991 the monetary policy is

disassociated from the fiscal policy. Under the reform period an

emphasis was given to the stable macro economic situation and low

inflation policy.

The major changes in the Indian monetary policy during the

decade of 1990s.


1) Reduced Reserve Requirements: During 1990s both the cash

reserve ratio (CRR) and the statutory liquidity ratio (SLR) were

reduced to considerable extent. The CRR was at its highest 15%

plus and additional CRR of 10% was levied , however it is now

reduced by 4%. The SLR is reduced form 38.5% to a minimum of

25%.

2) Increased Micro Finance: In order to strengthen the rural

finance the RBI has focused more on the Self Help Group (SHG).

It comprises small and marginal farmers, agriculture and non

agriculture labour, artisans and rural sections of the society.

However, still only 30% of the target population has been

benefited.

3) Fiscal Monetary Separation: In 1994, the government and the

RBI signed an agreement through which the RBI has stopped

financing the deficit in the government budget. Thus, it has

separated the monetary policy from the fiscal policy.

4) Changed Interest Rate Structure: During the 1990s, the interest

rate structure was changed from its earlier administrated rates to

the market oriented or liberal rate of interest. Interest rate slabs

are now reduced up to 2 and minimum lending rates are

abolished. Similarly, lending rates above Rs. two lakh are freed.

5) Changes in Accordance to the External Reforms: During the

1990, the external sector has undergone major changes. It

comprises lifting various controls on imports, reduced tariffs etc.


The monetary policy has shown the impact of liberal inflow of the

foreign capital and its implications on domestic money supply.

6) Higher Market Orientation for Banking: The banking sector

got more autonomy and operational flexibility. More freedom to

banks for methods of assessing working funds and other

functioning has empowered and assured market orientation.

5.5 INDIAN MONETARY POLICY AFTER 2000s

Structural reforms and financial liberalisation in the 1990s shifted

the financing paradigm for the government and commercial sectors with

increasingly market-determined interest rates and exchange rate. By the

second half of the 1990s, in its liquidity management operations, the

Reserve Bank was able to move away from direct instruments to indirect

market-based instruments. Starting in April 1999, the Reserve Bank

introduced a full-fledged liquidity adjustment facility (LAF). It was

operated through overnight fixed rate repo and reverse repo in November

2004. This process helped to develop interest rate as an instrument of

monetary transmission. This framework was reinforced in May 2011

when the weighted average overnight call money rate was explicitly

recognised as the operating target of monetary policy and the repo rate

was made the only one independently varying policy rate. (Deepak

Mohanty, 2011)

During 2001 to 2007, the RBI has lowered CRR from 8.8% to

4.5% and then raised it to 7.5%. The repo / reverse repo rate had been

reduced 8 times (from 10% to 6%) and then raised 9 times (to 7.75%).

The bank rate was reduced thrice (to 6%) and then kept unchanged. It


has used the three instruments simultaneously only once but has lately

used a combination of the CRR and repo rates. It has also occasionally

used the repo – reverse repo corridor as an instrument.

The overall GDP growth rate decelerated significantly from 6.1%

in 1999-2000 to 4% in 2000-01. The gross value added in agriculture

and allied sectors declined by 0.2% in 2000-01 compared with an

increase of 1.3% in 1999-2000. The saving and investment rates in India

were high as judged by the country's level of economic development.

Gross domestic savings improved marginally from 23.2% of GDP in

1999-2000 to 23.4% of GDP in 2000-2001 as a result of better

performance by household savings and private corporate savings. Gross

domestic investment at current prices declined marginally from 24.3%

of GDP in 1999-2000 to 24% of GDP in 2000-01 mainly due to a fall in

private sector investment. The rates of domestic investment were higher

than the rates of domestic savings in both 1999-2000 and 2000-01. The

reduction of overall growth rate of GDP to 6% in 2000-01 is mainly due

to a decline in the growth rate of service sector from 9.6% in 1999-2000

to 8.3% in the current year. An important measure designed to further

enhance the efficiency of the money market taken in June this year was

related to the transition to a full-fledged Liquidity Adjustment Facility

(LAF) involving injection and absorption of liquidity via variable rate

reverse repo auctions and variable rate repo auctions respectively.

Regulatory powers have been given to RBI under amendment to the

Securities Contracts (Regulation) Act, 1956 to regulate dealings in

Government and money market securities. The decade of reform was

successful in eliciting supply responses as evidenced in the higher


growth of GDP, comfortable foreign exchange reserves, improving short

term debt profile, moderate inflation and buoyant exports.

The Indian economy was passing through a difficult phase caused

by several unfavorable domestic and external developments. Domestic

output and demand conditions were adversely affected by poor

performance in agriculture. The average annual growth rate during the

Ninth Five Year Plan (1997-2002) was estimated at 5.4% which is lower

than the plan target of 6.5%. The Indian economy has been resilient in

the face of several external shocks during this period such as the East

Asian crisis of 1997-98, the oil price increase of 2000-01, and the most

recent world economic slowdown. The overall growth of 5.4% in 2001-

02 is supported by a growth rate of 5.7% in agriculture and allied

sectors, 3.3% in industry and 6.5% in services. There has been

significant deceleration in the growth rate of industry. However, the

performance of the services sector has improved moderately. Recent

years have witnessed strong growth of food credit in response to the

increase in the quantum as well as price of food grains procured in

support of the twin objectives of food security and price support. The

deceleration in the growth of non-food credit to 8.7% cent from 12.1%

during the previous year mirrored the weak demand for commercial

credit owing to economic slowdown, which has been aggravated by the

global downturn in economic activity. India‘s balance of payments

remained reasonably comfortable in both 2000-01 and 2001-02. The

current account deficit as a percentage of GDP declined from 1.1% in

1999-2000 to about 0.5% in 2000-01 due to a dynamic export

performance and sustained buoyancy in invisible receipts.


In 2002,the average annual growth rate of 8%.The RBI reduced

the bank rate by 25 basis points to 6.25% in October 2002. At this level,

the bank rate is the lowest since 1973. The Cash Reserve Ratio (CRR)

was reduced by 50 basis points to 5.0% from June 1, 2002, and further

to 4.75% from the fortnight beginning November 16, 2002. With a

faltering global recovery, private final consumption expenditure has

been the major factor sustaining growth in the Indian economy. The

household sector was once again the best performer, with the increase in

its gross savings exceeding the total increase in gross domestic savings.

The economy appeared in a resilient mode in terms of growth,

inflation, and balance of payments, a combination that offers large scope

for consolidation of the growth momentum with continued

macroeconomic stability. Real Gross Domestic Product (GDP) was

estimated to have grown by 8.2% and it reached at 8.5% in 2003-04.

The robust performance of India and the emerging market economies

contributed to the good performance of the world economy. The growth

recovery in 2003-04 was accompanied by continued maintenance of

relative stability of prices. The RBI had to moderate the impact of these

inflows through open market sale of Government securities and repo

operations through the Liquidity Adjustment Facility. RBI reduced the

Bank Rate from 6.25% to 6.00%.The Cash Reserve Ratio (CRR) was

reduced by 25 basis points to 4.50%.

The performance of the Indian economy in 2004-05 has exceeded

expectations formed at the beginning of the year. The quick monetary

and fiscal measures taken by the Reserve Bank of India (RBI) and

Government, coupled with a slight easing of global petroleum prices,


inflation has been on a declining trend and stood at 5% on February 5,

2005 compared to 6.1%. In 2004-05, Government stepped in to keep

inflation under check by reducing excise and customs duties on

petroleum products and selected items. The RBI hiked the Cash Reserve

Ratio (CRR) in two stages, effective from September 18, 2004, and

October 2, 2004, respectively, and the reverse-repo rate was hiked

effective from October 27, 2004, to check liquidity overhang in the

system.

Growth expectation was at 8.1% in the year, 2005-06. Some

significant dimensions of the dynamic growth during the years are new

industrial resurgence, a pick up in investment, modest inflation in spite

of spiraling global crude prices, rapid growth in exports and imports

with a widening of the current account deficit, laying of some institutional

foundations for faster development of physical infrastructure, progress in

fiscal consolidation and the launching of the National Rural

Employment Guarantee (NREG) Scheme for inclusive growth and

social security. Maintaining price stability continued to be one of the

main objectives of monetary policy. For achieving this, along with the

other objective of providing an enabling environment for higher

investment and growth, the policy variables were recalibrated

appropriately. While the Bank Rate and the Cash Reserve Ratio (CRR)

were kept unchanged during the current year at 6.0% and 5.0%,

respectively, the fixed reverse repo rate under the Liquidity Adjustment

Facility (LAF) of the Reserve Bank of India (RBI) was raised three

times by 25 basis points each, to reach 5.50% on January 24, 2006. With

the given spread of 100 basis points, the repo rate is pegged at 6.50%

since January 24, 2006. RBI‘s policy response was in line with the


cautious approach in many other countries of moving policy interest

rates in a measured way in the face of the threat of inflationary

expectations firming up with high crude oil prices.

Vigorous growth with strong macroeconomic fundamentals has

characterized developments in the Indian economy in 2006-07. Growth

of 9.0% and 9.2% in 2005-06 and 2006-07, respectively, by most

accounts, surpassed expectations. While the up-and down pattern in

agriculture continued with growth estimated at 6.0% and 2.7% in the

two recent years, and services maintained its vigorous growth

performance, there were distinct signs of sustained improvements on the

industrial front. The overall macroeconomic fundamentals are robust,

particularly with tangible progress towards fiscal consolidation and a

strong balance of payments position. In 2006-07, while the share of

agriculture in GDP declined to 18.5%, the share of industry and services

improved to 26.4% and 55.1%, respectively. A notable feature of the

current growth phase is the sharp rise in the rate of investment in the

economy. From mid-September through October, 2006, while RBI had

to provide accommodation to some banks through repo facility, with

reverse repo operations simultaneously, in net terms, RBI absorbed

liquidity from the system. In October 2006, the RBI announced more

measures to stem inflationary expectations and also to contain the credit

off-take at the desired growth rate of 20.0%. Overall, the external

environment remained supportive with the invisible account remaining

strong and stable capital flows seamlessly financing the moderate levels

of current account deficit caused primarily by the rise in international oil

prices.


The economy has moved decisively to a higher growth phase. The

projected economic growth was 8.7% for 2007-08. This represents a

deceleration from the unexpectedly high growth of 9.4% and 9.6%,

respectively. With the economy modernizing, globalizing and growing

rapidly, some degree of cyclical fluctuation is to be expected. This was

taken into account while setting the Eleventh Five Year Plan (2007-08

to 2011-12) growth target of 9%. In a modern economy, the excess of

domestic saving over domestic investment suggests a deflationary

situation in which demand has not kept pace with increased capacity.

Thus the reversal of the saving investment balance should be viewed as

a correction of the domestic supply-demand balance, occurring through

above normal increase in demand during 2005-06 and 2006-07. The

Reserve Bank of India‘s monetary policy stance is to serve the twin

objectives of managing the transition to a higher growth path and

containing inflationary pressures. Short-term liquidity variations were

addressed by RBI through the Liquidity Adjustment Facility during

2006-07.

Despite the slowdown in growth, investment has remained

relatively buoyant, growing at a rate higher than that of GDP. The ratio

of fixed investment to GDP consequently increased to 32.2% of GDP in

2008-09 from 31.6% in 2007-08. This reflects the resilience of Indian

enterprise, in the face of a massive increase in global uncertainty and

risk aversion and freezing of highly developed financial markets. The

global financial meltdown and consequent economic recession in

developed economies have clearly been major factor in India‘s

economic slowdown. Economic growth decelerated in 2008-09 to 6.7%.

The growth of GDP at factor cost (at constant 1999-2000 prices) at 6.7%


in 2008-09 nevertheless represented a deceleration from high growth of

9.0% and 9.7% in 2007-08 and 2006-07 respectively The deceleration of

growth in 2008-09 was spread across all sectors except mining and

quarrying and community, social and personal services. The growth in

agriculture and allied activities decelerated from 4.9% in 2007-08 to

1.6% in 2008- 09. The global crisis also meant that the economy

experienced extreme volatility in terms of fluctuations in stock market

prices, exchange rates and inflation levels during a short duration

necessitating reversal of policy to deal with emergent situations. Before

the onset of the financial crisis, the main concern of the policymakers

was excessive capital inflows, which increased from 3.1% of GDP in

2005-06 to 9.3% in 2007-08. The monetary policy stance during the first

half of 2008-09 was therefore directed at containing the price rise. The

policy stance of the Reserve Bank of India (RBI) in the first half of the

year was oriented towards controlling monetary expansion, in view of

the apparent link between monetary expansion and inflationary

expectations partly due to the perceived liquidity overhang. The

Government also took various fiscal and administrative measures during

the first half of 2008- 09 to rein in inflation. The key policy rates of RBI

thus moved to signal a contractionary monetary stance. The repo rate

was increased by 125 basis points in three tranches from 7.75% at the

beginning of April 2008 to 9.0% with effect from August 30, 2008. The

reverse-repo rate was however left unchanged at 6.0%. The Cash Reserve

Ratio (CRR) was increased by 150 basis points in six tranches from

7.50% at the beginning of April 2008 to 9.0% with effect from August

30, 2008. The RBI responded to the emergent situation by facilitating

monetary expansion through decreases in the CRR, repo and reverse


repo rates, and the Statutory Liquidity Ratio (SLR). The reverse-repo

and repo rates were again reduced by 25 basis points each with effect

from April 21, 2009. SLR was lowered by 100 basis points from 25% of

net demand and time liabilities (NDTL) to 24% with effect from the

fortnight beginning November 8, 2008. The CRR was lowered by 400

basis points in four tranches from 9.0 to 5.0% with effect from January

17, 2009. The credit policy measures by the RBI broadly aimed at

providing adequate liquidity to compensate for the squeeze emanating

from foreign financial markets and improving foreign exchange

liquidity. These measures were supplemented by sector -specific credit

measures for exports, housing, micro and small enterprises and

infrastructure. The monetary measures had a salutatory effect on the

liquidity situation. The overall balance of payments situation remained

resilient in 2008-09 despite signs of strain in the capital and current

accounts, due to the global crisis.

The fiscal year 2009-10 began as a difficult one. There was a

significant slowdown in the growth rate in the second half of 2008-09,

following the financial crisis that began in the industrialized nations in

2007 and spread to the real economy across the world. The growth rate

of the gross domestic product (GDP) in 2008-09 was 6.7%. Financing,

insurance, real estate and business services have retained their growth

momentum at around 10% in 2009-10. The share of industry has

remained the same at about 28%, while that of services has gone up

from 53.2% in 2004-05 to 57.2% in 2009-10. The global economy, led

by the Asian economies especially China and India, has shown signs of

recovery in fiscal 2009-10. While global trade is gradually picking up,

the other indicators of economic activity such as capital flows, assets


and commodity prices are more buoyant. However, there has been

improvement in the balance of payments situation during 2009-10 over

2008-09, reflecting higher net capital inflows and lower trade deficit.

Since the outbreak of the global financial crisis in September 2008, the

RBI has followed an accommodative monetary policy. In the course of

2009-10, this stance was principally geared towards supporting early

recovery of the growth momentum, while facilitating the unprecedented

borrowing requirement of the Government to fund its fiscal deficit. The

fact that the latter was managed well with nearly two-thirds of the

borrowing being completed in the first half of the fiscal year not only

helped in checking undue pressure on interest rates, but also created the

space for the revival of private investment demand in the second half of

the year. The transmission of monetary policy measures continues to be

sluggish and differential in its impact across various segments of the

financial markets. A major concern was regarding the possibility of a

rise in unemployment due to the slowdown of the economy. On the

whole, for the period October 2008 to September 2009, there may have

been a net addition of 1.51 lakh jobs in the different sectors. Under the

NREGA, which is a major rural employment initiative, during the year

2009-10, 4.34 crore households have been provided employment so far.

5.6 EVALUATION OF THE MONETARY POLICY IN INDIA

During the reforms though the monetary policy has achieved

higher success, it is not free from limitations or demerits. It needs to be

evaluated on a proper scale.

1) Failed in Tackling Budgetary Deficit: The higher level of the

budget deficit has made the monetary policy ineffective. The


automatic monetization of the deficit has led to high monetary

expansion.

2) Limited Coverage: The monetary policy covers only commercial

banking system leaving other non- bank institutions untouched. It

limits the effectiveness of the monetary policy in India.

3) Unorganized Money Market: In our country there is a huge size

of the unorganized money market. It does not come under the

control of the RBI. Thus, any tools of the monetary policy does

not affect the unorganized money market making monetary policy

less affective.

4) Predominance of Cash Transaction: In India, still there is huge

dominance of the cash in total money supply. It is one of the main

obstacles in the effective implementation of the monetary policy,

because monetary policy operates on the bank credit rather on

cash.

5) Increase Volatility: As the monetary policy has adopted changes

in accordance to the changes in the external sector in India, it

could lead to a high amount of the volatility.

There are certain drawbacks in the working of the monetary

policy in India. However, during the economic reforms it has got

different dimensions.

5.7 FISCAL POLICY IN INDIA

Fiscal policy has been an important component of government’s

economic policy during recent decades especially after the great

depression of the thirties of the last century. According to Keynes, fiscal

adjustments in any period are in the direction of stimulus or restraint and


these adjustments take place through government purchase of goods and

services, transfer payments and taxes.

In India, the fiscal policy has to perform a significant role.

Among other things, the budgetary policies are expected to achieve the

following objectives:

• To promote and accelerate the growth of productive investment in

the economy both in the public and the private sectors;

• To mobilize the maximum volume of real and financial resources

for the investment plan of the public sector, keeping in view the

expanding demand for real and financial resources of the private

sector, and in this way, to promote the growth of marginal and

average rates of savings in the economy;

• To promote the maintenance of a reasonable measure of economic

stability in keeping with the maximum rate of growth of the

economy;

• To redistribute the growing national output.

There are vast differences in economic conditions, in the cultural,

legal and political environment within which economic policy must

operate and in the state of development of the art of taxation and the

science of government.

5.8 EVALUATION OF INDIA’S FISCAL POLICY

An evaluation of India’s fiscal policy should bring out as to how

far this policy has succeeded in the achievement of the objectives set

before it. The analysis here is confined to the following three objectives:

• To promote saving and capital formation;

• To reduce economic inequalities;


• To bring about domestic stability, specially to curb inflationary

tendencies in the economy.

5.8.1 Fiscal Policy and Savings and Capital Formation

A major objective of fiscal policy has been to promote saving and

capital formation and to mobilize these as instruments of economic

development.

Relationship between taxation and savings is assumed to be direct

and simple. Taxation is believed to reduce the disposable incomes of all

sections of society and thereby reduce their conspicuous consumption,

the resultant tax revenue will increase public sector savings. In

pursuance to this assumption, taxation has been used to mobilize

resources for increasing the domestic savings. In the process of

mobilizing huge sums of additional taxes the tax structure of the country

has also changed. Empirical studies have shown that though additional

taxation had some positive influence on government savings, such

influence was not substantial. This would indicate that the fiscal strategy

which was designed to mobilize additional taxation with a view to

increasing government savings for development purposes had achieved

only partial success. This finding is further supported by the performance

of the public sector in the field of capital formation.

Where as taxation was so designed as to divert increased income

for public sector savings, a major objective laid down for public

expenditure was to increase capital formation in the public sector.

Subsequent studies have shown that this unimpressive performance of

the public sector in capital formation through assets creation has


continued to persist. Three main reasons attributed to this unhealthy

growth have been as follows:

• The economic performance of the public sector as a whole has

been disappointing not only in generating surplus but also in-

service efficiency.

• The attitude of some sections of public sector employees has not

been helpful for achieving the envisaged objectives of the public

sector.

• All the funds invested in the public sector have not gone to

increase capital formation. Consequently, the physical assets

created in the public sector are not of the required standard and

quality. This has been partly reflected in the upward trend in the

capital-output ratio.

The cumulative effect of all these has been that after fifty years of

economic planning the country is starved of resources for public

investment.

5.8.2 Fiscal Policy and Income Inequalities

The most important objective of direct taxes has been to achieve

equity. The effectiveness of these taxes in reducing the inequality of

income and wealth depends upon the progressive structure of the tax

rates. The available evidence shows that only income tax has been

progressive though not significantly, and all other direct taxes have been

mostly proportional. Three reasons explain this situation.

• Though the nominal tax rates have been steeply progressive the

effective tax rates have been made lower owing to exemptions,

rebates and deductions.


• Wherever tax rebates and deductions are available, the complexity

of tax laws and procedures of assessment have been used for tax

avoidance under legal protection.

• Tax -evasion is evident particularly at the higher slabs of income

and wealth as the average marginal effective tax rates become

lower at higher levels of income and wealth.

Similarly, in the case of incidence of indirect taxes, the estimates

made by the Jha committee have shown that these are proportional with

reference to the levels of consumer expenditure. As a rule increase in

productivity has failed to absorb the rise in costs due to taxation and

other related factors. Added to the burden of cost by high prices,

scarcities, harsh living conditions and lack of employment opportunities,

the tax system and changes effected in it from time to time have increased

social discontent and the sense of grievance against public authority.

Administration of the tax system as a whole leaves much to be

desired. Failure to properly administer a tax system threatens the canon

of equity because full payment of taxes is then made only by those

whose elasticity of conscience is such that they cannot do otherwise. It

may further increase the evasion of tax because the large amount of

evasion breaks the morale of the honest tax payers. Also, a poor quality

tax management may collect large proportions from easy- to-tax sector,

thereby further creating intersectoral inequity in the incidence of the tax.

5.8.3 Fiscal Policy and Inflation

A major failure of the fiscal policy has been on the price front-its

inability to arrest inflation. Taxation both direct and indirect, and public


expenditure have fuelled inflationary forces in the country. Public

expenditure adds to the demand-pull inflation, where as taxation,

specially indirect taxes, add to the price rise thought the process of

shifting. It is generally believed that as soon as rates of union excise

duties and sales tax are raised, the prices of these commodities will

automatically rise. This belief is well founded because of the actual

practice of the businessmen where manufacturers, wholesalers and

retailers immediately shift the increased amount of tax in the form of

higher prices of goods.

The other important source of inflation in the budget is deficit

financing. During the earlier plans, deficit financing, as a means of

financing government investment to create productive capacity, was

vehemently defended. This argument was based on the assumption that

all the funds obtained through the mechanism of deficit financing were

invested to create productive capital assets. The development experience

during the last 50 years of planning, however, does not support this

assumption. Several empirical studies have shown the close and direct

association between deficit financing and price level in the country.

In short, the failures of fiscal policy have been too many, almost

on all the major fronts that we have reviewed above. But its single

foremost achievement has been that it has been used effectively as an

instrument to raise huge additional resources required for both

investment and consumption purposes in each of the successive five

year plans.


5.9 CHANGES IN INDIAN FISCAL POLICY AFTER

ECONOMIC CRISIS

At present, the focus around the world, as also in India, has

shifted from managing the crisis to managing the recovery. The key

challenge relates to the feasible fiscal exit strategy that needs to be

designed and implemented. As a response to the current global crisis,

the Indian government has adopted significant discretionary fiscal

stimulus packages to promote investment and sustain aggregate demand.

It is time now to move away from the stimulus packages and

concentrate on long-term policy scenarios to control the fiscal situation

as well as improve GDP growth. The magnitude of fiscal adjustment

needed in the next couple of decades is almost unprecedented, especially

for countries like India with relative high debt.

The key challenge involves balancing between public interventions

and maintaining market confidence in the sustainability of public

finances. This will involve focusing policy attention on removing some

of the structural bottlenecks on raising the potential GDP growth rate.

Essentially, this will imply efforts to improve the investment climate for

both domestic and foreign investors, remove entry barriers to corporate

investment in education and vocational training, improve the delivery of

public goods and services, and expand physical infrastructure capacities,

including a major effort to improve connectivity in the rural regions.

Infrastructure is a key binding constraint on India’s growth and the

government should take up long-term projects to improve infrastructure

facilities. The government also needs to step-up investment in human

capital development through increased spending in areas such as

primary education, primary health, and research and development.


Investment in human capital will help achieve inclusive growth, and

furthermore such expenditures should be considered as part of capital

expenditure rather than as revenue expenditure (which is how they are

categorized now) since they yield a return in the long-term by way of

inter-generational equity and economic growth. These measures will

constitute the package of second-generation structural reforms and will

enable the Indian economy to climb out of the downward cyclical phase

and then extend the upward phase for a longer period than was achieved

in the last cycle. On the revenue side, one way to exit is to increase or

restore excise duties, which were reduced during the economic

slowdown, to previous levels. The consequent revenue gains can be

used to generate employment in public infrastructure projects. However,

given the uncertainty about the robustness of the recovery, completely

reversing the tax cuts would affect the growth prospects. Partial

reversing may help strengthen the revenues of the government without

disrupting the growth prospects. Another possible option is to broaden

the tax base. This will require changes to the tax structure, which is

likely to become more important than before. An important step in this

direction is the expected introduction of the GST in October 2010. GST

is going to replace CENVAT, state VAT, and service tax. Both the

central governments and states have to levy GST concurrently on all

goods and services other than a small list of exemptions. GST will have

a two-rate structure: a standard rate for most goods and a lower rate for

necessities. A combined rate of 12% (8% for states and 4% for the

central government) is seen to be revenue neutral.

The proposed GST will be a comprehensive indirect tax levy on

the manufacture, sale, and consumption of goods as well as services at a


national level. The GST is likely to reduce indirect taxes paid on most of

the goods and services as it would avoid the cascading effect. Product

prices, therefore, can be expected to fall and ensure growth in demand.

In addition, the integration of goods and services taxes will improve tax

collections and thereby help increase economic growth. It will also end

the long-standing differential treatment of the manufacturing and

services sectors. Apart from eliminating cascading effects, double

taxation, and other issues, the introduction of GST will facilitate credit

on uniform terms across the entire supply chain and across all states.

The consensus GST rates may emerge to be 14%. Even this will sharply

bring down the incidence of indirect taxes in the economy and release

new growth impulses.

Another tax reform that is likely to be become effective in near

future is the Direct Tax Code (DTC), which is designed to greatly

simplify the dual tax structure. DTC will achieve this by eliminating

distortions in the tax structure, expanding the tax base, and improving

tax compliance by introducing moderate levels of taxation (Rajiv Kumar

and Alamuru Soumya, 2010).

5.10 AGENDA FOR FUTURE REFORMS

Fiscal reforms have to be an ongoing process. The large gross

fiscal deficit is a cause for concern from the view point of overall macro

economic stability. Continued reduction in the fiscal deficit has to be

our priority with a view to control inflation, to ensure adequate

availability of credit for production and investment and to achieve

external sector viability in the medium term. In the years ahead, our


approach to reducing the overall fiscal deficit will have to stress the

following five themes:

• Reduction and redirection of subsidies,

• Implementing a new approach to a administered prices,

• Further reductions in budgetary allocations to public sector

undertakings,

• Measures to tighten expenditure control, and

• Completion of the tax reform agenda.

5.11 THEMES OF THE ‘NEW FISCAL POLICY’

In the broad framework of the economic liberalisation approach

of the recent years, the major themes of the fiscal policy have been

concretised in India. There is broad agreement on these themes and as

mentioned in (Dhingra, I.C., 2009), they can be summarised as follows:

1) A systematic effort to simplify both the tax structure and the tax

laws,

2) A deliberate shift a regime of reasonable direct tax rates,

combined with better administration and enforcement, to improve

compliance and raise revenues,

3) The fostering of a stable and predictable tax policy environment,

4) Greater recognition and weight given to the resource allocation

and equity consequences of taxation,

5) More reliance on nondiscretionary fiscal and financial instruments

in managing the economy, as compared to ad hoc, discretionary

physical controls,

6) Concerted efforts to improve tax administration and reduce the

scope for arbitrary harassment,


7) Growing appreciations of the links between fiscal and monetary

policy,

8) Fresh initiative to strengthen methods of expenditure control.

5.12 ISSUES AND CHALLENGES IN MONETARY AND FISCAL

POLICIES FORMULATION

The biggest challenge facing the conduct of fiscal and monetary

policy in India is to continue the accelerated growth process while

maintaining price and financial stability. (Rakesh Mohan, 2008)

The conduct of fiscal and monetary policy since the early 1990s

has broadly succeeded in setting the economy on a higher growth path.

Far reaching fiscal reforms have been undertaken during this period,

which are finally bearing fruit through increased revenue mobilisation,

some compression in expenditure, and consequent reduction in the fiscal

deficit, leading to the beginning of some reduction in the debt GDP

ratio. The exercise of fiscal restraint and admirable fiscal and monetary

policy cooperation has enabled the increasing effectiveness of monetary

policy: the cessation of automatic monetisation of the fiscal deficit,

increased importance of market borrowing in financing the deficit,

introduction of the market stabilisation scheme, and the corresponding

measures to deregulate interest rates to enable market discovery, have

all contributed to the strengthening of monetary policy transmission.

The self imposed rule based fiscal correction at both the national

and sub-national levels has to be consolidated and carried forward.

Achievement of the current objectives will still leave the combined

fiscal deficit in India at around 4.8% of GDP and somewhat higher if the


off budget items are also taken into account. By international standards

this is still very high and if this level continues it will be difficult to

make much of a correction to the debt- GDP ratio to bring it down to

desirable levels within the foreseeable future. The government draft on

private sector savings will therefore continue, and hence it will also be

difficult to reduce substantially the various stipulations that mandate

banks and other financial institutions to invest in government securities,

thereby constraining further development in monetary policy and

financial sector framework. The existence of such a high level of fiscal

deficit also contributes to the persistence of an interest rate differential

with the rest of the world which then also constrains progress towards

full capital account convertibility. The sustained interest rate differential

is also connected with the existence of a persistent inflation differential

with the rest of the world.

A key challenge for fiscal and monetary policy in the coming

years is to further reduce inflation expectations toward international

levels. In view of higher inflation rates, higher interest rates, and

exchange rate dynamics reflecting growth prospects and capital account

movements, rather than inflation or interest rate differentials, there is a

need to operate an intermediate regime with a managed floating

exchange rate, and an active management of the capital account so as to

have the necessary discretion and flexibility to operate monetary policy

in order to maintain domestic macroeconomic and financial stability.

In the fiscal policy area, the success achieved in revenue buoyancy

through tax rationalisation and compliance has to be strengthened

further. Large proportions of the self employed remain outside the tax


net, thus continued strengthening and modernisation of tax administration

now needs to be emphasised, relative to further reforms in tax policy in

terms of relative emphasis. This would enable further shifts in tax

revenue toward direct taxes from indirect taxes, thereby aiding greater

economic efficiency. At the state- level also, the move to VAT has

provide very significant tax rationalisation, and emphasis now needs to

be put on its administration: In this sphere, the next step of reform

would, of course, be the proposed move towards a unified “Goods and

Service Tax” regime encompassing the centre and the states. The

foundations of an efficient fiscal regime in India have, therefore, been

achieved.

The second issue on the expenditure side relates to the funding of

public investment, particularly related to infrastructure. As documented,

public investment has been reduced over the past decade or so. Where as

private investment has clearly substituted or complemented public

investment successfully in areas such as telecom, ports and airports,

and partially in roads and power, total investment in infrastructure in

clearly inadequate, and could constrain further acceleration in overall

economic growth. Third, the government is already engaged in

expanding programmes and spending for human development. Funding

for these needs will continue to require enhancement.

The acceleration of economic growth to the next level is therefore

likely to lead to an enhancement of government spending as a proportion

of GDP, Which would be consistent with the experience of other

countries as their per capita incomes increased. This, then is the main

challenge confronting Indian fiscal policy.


Going forward, therefore, there will be a continuous need to adapt

monetary management to the emerging needs of a fast growing and

increasingly open economy. This will necessitate ongoing refinement of

instruments and modes of management, especially as global developments

are expected to have an increasing role in determining the conduct of

monetary and exchange rate policies the India. Consequently, the

expansion of monetary aggregates departs from their traditional

relationship with real GDP growth. The task of monetary management is

then to manage such growth without endangering price or financial

stability.

In the years ahead, the economy will depend increasingly upon

the ability of financial markets to allocate resources efficiently for the

most productive purposes. Further development of financial markets

will also be needed in view of the growing openness and fuller capital

account convertibility. However, the issue remains how long and to

what extent such an exchange rate management strategy would work

given the fact that we are faced with large and continuing capital flows

apart from strengthening current receipts on account of remittances and

software exports. This issue has assumed increased importance over the

last couple of years with increased capital flows arising from the higher

sustained growth performance of the economy and significant

enhancement of international confidence in the Indian economy.

Large capital inflows in recent years, far in excess of the current

account surplus, have, therefore necessitated a certain amount of capital

account management, along with intervention in the form market to curb

volatility in the exchange rate. Management of volatility in financial


markets and implications for the conduct of monetary operations will

continue to need attention. Greater inflows will inevitably exert pressure

on the Reserve Bank's ability to manage the impossible trinity of

independent monetary policy, open capital account and a managed

exchange rate, keeping in view that the impact of exchange rate

fluctuations on the real sector in developing economies is much higher

than in mature economies, particularly in labour intensive low

technology price sensitive goods. India always had a modest current

account deficit though, because of remittances and service exports, the

trade deficit has widened significantly in recent years. These are the

issues that monetary policy will have to continue to deal with while

addressing the impact of capital flows. (Parthasarathi Shome, 2002)

5.13 CAVEATS TO MONETARY AND FISCAL POLICIES

Since 1950-51, India has adopted mixed economy where in

government plays an important role in welfare of people. Hence it

becomes essential to formulate policies with the focus on economic and

social well being of people. While formulating and implementing these

policies, the policy makers come across many challenges. This is true

with monetary and fiscal policy in India as well. Here we discuss some

of the problems posed by gaps in formulation and implementation of

monetary and fiscal policies. (N.T. Neelakanta, 2011)

• There is need for better coordination and cooperation between

both the policies so that Indian economy can attain its objectives

such as price stability and growth. Thus, high level of interface

between both the policies is prerequisite for better performance of

the economy.


• Fiscal sustainability is another big challenge for government.

There is variation in debt / GDP ratio over period of time. As the

interest rate exceeds the output growth rate, the gap between the

two rates increases resulting in higher debt-GDP ratio. This would

require generation of adequate primary surplus equivalent to the

gap between the interest rate and the rate of growth to stabilize

the interest rate but sufficient condition is that the initial debt

stock equals the present discounted value of primary surpluses in

the future.

• There is inflationary bias in monetary policy, therefore there is

existence of a dynamic inconsistency. It can arise from number of

factors such as knowledge of the changing characteristics of the

economy like political pressure and state contingent policy

response but only way is that seigniorage revenue and the

incentives provided to the monetary policy to publicly credible.

• There is a mismatch between announced inflation target and

public's expectations regarding future inflation which should be

corrected.

• Threat from other countries economic fluctuations is also one of

the challenges for Indian economy, because of increase market

integration and globalization in the world. There is a record of

crisis like South East Asian crisis (1997) which had spillover

effect in the world. To protect the domestic economy form such

types of threats there is need of analysing implications of the

policy implementation.


• Threat of deflation is similar to the above caveat but it is totally in

separated. Because threat of deflation comes when monetary

policy revitalise the economy have taken real interest rate in

various countries to levels below their real growth rates,

producing what has been termed as the deflationary. To over-

come this challenge, there should be contingency plans,

emergency liquidity facilities, coordinated monetary and fiscal

intervention, credible and transparent inflation targets are suggest

in literature as part of the strategy to fight the deflation.

• As far as monetary policy is concerned there is need to involve

the constant rebalancing of objectives in terms of the relative

importance assigned to them the selection of instruments and

operating frameworks and a search for improved understanding of

the working of the economy.

• It is crucial to monitor all available information for signs of

overheating with a view of keeping inflation expectations stable

and ensuring that the gains from high growth are consolidated.

Accordingly sensing how close is the economy to its potential

growth is the vital judgement that has to be made to set the timing

and direction of monetary policy.

• An important challenge for the monetary policy authority is to

judge the durability of the recent upsurge in growth. The current

growth momentum is more cyclical than structural, the stance of

monetary policy would need to reflect sensitivity to the

inevitability of a downturn. On the other hand, the judgment that


structural factors predominate would warrant a different policy

stance.

• The monetary policy should give creative solution to problems

which are in non-disruptive manner. It is in this context that

prudential and other measures such as provisioning and risk

weights on bank loans to specific sectors are being used so as to

enhance the sensitivity to risks emanating from these sectors

rather than standard monetary policy responses that address

aggregate demand.

• There should be existence of effective and better tax administration

because when some services are taxed and some are not, there

will always an attempt on the part of service provider to label

their service as belonging to the non-taxable category. More

importantly, the central VAT (CENVAT) only extends in to

manufacturing. Tax credits are not given for services purchased

by manufactures, or manufactures purchased by service producers.

• Inadequate taxation of services has been an important weakness

of the tax system. The share of the services sector in GDP has

grown sharply over time. Here problem of equity arises. Because

most of poor people preferred basic good and rich people prefer

service goods. Therefore, there is need for systematic tax frame

work.

The conduct of the monetary policy in India would continue to

involve the constant rebalancing of objectives in terms of the relative

importance assigned, the selection of instruments and operating frame-


works, and a search for an improved understanding of the working of

the economy and the channels through which the monetary policy

operates over the past few years, the process of monetary policy

formulation has become relatively more expressive, consultative and

participative with external orientation, while the internal work processes

have also been re-engineered. The stance of monetary policy and the

rationale are communicated to the public in a variety of ways.

Documents

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