Chapter 26

Role of Monetary & Fiscal Policies- Economic Development

Structure:

26.1 Introduction

26.2 Definition of Economic Development

26.3 Definition of Monetary policy

26.3.1 Objectives of Monetary policy

26.3.2 Role of Monetary policy in economic development

26.3.3 Limitations of Monetary policy

26.4 Fiscal policy and its Meaning

26.4.1 Objectives of fiscal policy

26.4.2 Role of Fiscal policy in economic development

26.4.3 Limitations of Fiscal policy

26.5 Summary

26.6 Check your Progress

26.7 Key Concepts

26.8 Self-Assessment Questions

26.9 Answers to check your progress

26.10 Suggested Readings

Objectives:

After studying this lesson, you will be able to understand

Meaning of Monetary policy

Categories of Monetary policy

Definition of fiscal policy

Constituents of fiscal policy

Difference between Growth and Development

The importance of monetary and fiscal policies in economic development

26.1 Introduction:

In this lesson, you learn about the meaning of Economic Development and also Monetary

and Fiscal policies. Further, we learn the constituents of monetary and fiscal polices and

importance of both the policies in attaining overall economic development in an

economy. In General either monetary or fiscal policy is used to attain economic

development of an undeveloped economies, because these economies are lagging behind

due to several reasons and there exists either inflationary or deflationary conditions which

destabilize the system, Therefore, there is a need of application of both the above stated

policies not only to stabilize the economy but also to achieve overall economic

development.

Since Economic Depression, all most all economies compelled to think about the

problems of economic development and interest shown by the states in the problems of

undeveloped economies development. Economics of development is now considered as

an important branch of economic theory. The study of economic development related to

the causes of underdevelopment and its removal. Therefore, it is pertinent to examine the

role of monetary and fiscal policies in economic development. Subsequent sections job is

to concentrate on the terms of economic development, monetary and fiscal polices. And

the role of these policies.

26.2.1. Definitions of Economic Development:

Economists have defined the term economic development in different ways. In general

economic development implies not only a particular sector development but also the

development of all sectors in an economy. Now let us look into the definitions given by

the following economists;

An Eminent development economist Mr. Gerald Mier has explained that “ Economic

development is a process, whereby the real per capita income of country increases over a

long period of time. Bernard Okun and RW Richardson explained economic development

in terms of material welfare. The definition runs as “ Economic development may be

defined as a sustained secular improvement in well being, which may be considered to be

reflected in an increasing flow of goods and services” Williamson and Buttrick have

defined” Economic development refers to the process, whereby the people of country or

region come to utilize the resources available to bring about a sustained increase in per

capita production of goods and services” Kindle berger CP defined” Economic

development implies both more output and changes in the technical and institutional

arrangement by which it is produced”

The definitions reviewed above reveal that development has been interpreted in terms of

national output. Many objections crop up on above definitions, therefore, emphasis has

shifted for measuring economic development later towards the “Redistribution criterion”.

Of late, Amartya Sen. puts “Economic growth cannot be sensibly treated as an end itself.

Development has to be more concerned with enhancing the lives we lead and the

freedoms we enjoy”

Development must, therefore, be conceived of as a multidimensional process involving

major changes in social structures, popular attitudes and national institutions as well as

the acceleration of economic growth, the reduction in inequality and the eradication of

absolute poverty”

Each section of society and every sector of economy are influenced by economic

development. Therefore, it is must to study the role of overall economic policy in general

and monetary policy and fiscal policy in particular. So let us look into the details of both

the policies and their role in economic development.

26.2 Meaning of Monetary policy:

Having discussed the concept of economic development , now let us define the monetary

policy and describe its objectives. In General, monetary policy means the policy of credit

control and the deliberate management of money supply. As there are different versions

on meaning of economic development, here on monetary policy also various definitions

drawn by different economists. Paul Eizing defines monetary policy as” The attitude of

the political authority towards the monetary system of the community under its control”.

KP Kent has defined “ The Management of the expansion and contraction of the volume

of money in circulation for the explicit purpose of attaining a specific objective, such as

full employment” CK Johri states “ Monetary policy comprises those decisions of

Government and the Reserve Bank of India which affect the volume and composition of

money supply, the size and distribution of credit the level and structure of interest rates

and the effects of these variables upon the factors determining output and prices” GK

Shaw ‘ By Monetary policy we means any conscious action undertaken by the monetary

authorities to change the quantity availability or cost of money”

We have various definitions, some of them are narrow and some are broad definitions of

monetary policy. CK Johri and GK Shaw given broad definitions. In recent years, the use

of monetary policy in its broad sense is getting popular, as it is more useful and practical.

26.3.1: Aims of Monetary Policy:

The objectives of monetary policy have been varying from time to time depending upon

the nature of problems facing the countries and the general economic policy pursued by

them. The main objectives are: (a) Exchange Stability (b) Price Stability (c) Neutrality of

Money (d) Full-Employment (e) Economic Growth (f) Balance of Payments equilibrium.

Some times these objectives are mutually incompatible and the monetary authority has to

make a choice on the basis of priorities. For instance, the objective of maintaining

exchange rate stability may come in conflict with the objective of maintaining internal

price stability; Similarly attainment of full employment may not go hand in hand with

price stability and an accelerated rate of economic growth may but always be possible

with stable exchange rates. Therefore, Radcliff Committee suggested the criterion of

‘orderly life of the society’; it implies that priorities have to be decided keeping in view

the economic situation and social circumstances of country. In this connection

Duesenbery says “faced with a set of conflicting objectives, whose achievement is

influenced by a variety of factors, the problem of monetary management is one of

continuous a adaptation’.

26.3.2 : Role of Monetary Policy in Economic Development:

The role of monetary policy in economic development may be discussed under the

following lines of approach:

Appropriate Adjustment between Demand for and Supply of money

Price Stability

Credit Control

Creation and Expansion of Financial Institutions

Suitable Interest Rate Structure

Debt Management

Monetary policy can play a vital role in the economic development of underdeveloped

countries by minimizing fluctuations in prices and general economic activity by

achieving an appropriate balance between the demand for money and supply of money.

Because, economic development result in increase in more demand for money and it

makes imperative for the monetary authority to increase the money supply but either

more or less money supply than the requirement result in fluctuations in an economy.

Therefore, the gist of the argument is that a proper control upon the supply of money will

prevent economic fluctuations and pave the way for rapid development of

underdeveloped economies.

In the process of economic development, it is unavoidable an increase in prices.

Therefore it is imperative for the monetary authority for maintenance of stability in the

domestic level of prices and exchange rates. The inflationary trend in price negatively

affects the savings and diverts investment into unproductive channels. It is the duty to

have a vigil by the monetary authority not only to regulate but also should keep constant

check on the direction of money flow in turn to control price rise. The same inflationary

trend will also adversely affect international trade and the foreign exchange earnings

which otherwise could help in the development of the country. Thus, monetary policy

should adopt such policy, which will check inflation and frequent devaluation of the

currency.

Monetary authority should also employ quantitative and qualitative credit control tools

for the control of inflation, correction of adverse balance of payments and help the

process of economic development. Not only that, with these instruments, it can influence

and shape the character and pattern of investment and production, in particular selective

credit control, unlike quantitative credit control, makes a discrimination between essential

and non-essential uses of bank credit and help the funds to flow into desirable and uses

without affecting the economy as a whole. This will quicken the pace of economic

development.

The process of economic development can speed up by establishing more and more

financial institutions by developing financial system. These institutions are in less

number in underdeveloped economies, therefore, it is difficult to mobilize the savings

from the public effectively for economic development and consequently economic

growth rate is very low. Monetary authority to extend the sphere of the monetary sector

with the expansion of co-operative banking sector to meet the credit needs of ruralites

and cut the tentacles of non-magnetized sector in rural areas.

There are two subcomponents of monetary policy: cheap and dear money policy. Cheap

money policy in other words availability of funds at lower rates of interest to stimulates

investment both public and private. Thus, a policy of low interest rates serves as an

incentive to investment for economic development. But there is a harm if these funds are

diverted for hoarding and stockpiling and for other speculative purposes, thus monetary

authority should be checked through selective credit controls and thereby directing

investment into desirable channels. In contrary to low rates of interest policy, there are

economists who suggest a policy of high interest rates to control inflationary conditions.

Further they stated that it would stimulate savings and thus increase the supply of invests

able resources; it would secure the allocation of scarce resources into most productive

uses. Therefore, keeping in view the conditions in an economy, countries should be more

pragmatic in their approach and must evolve differentiated interest rate policy, which

ensure rapid pace of economic development.

To attain rapid progress in economic development, the monetary policy should aim at

efficient management of public debt, which implies proper timing of the issuing of

government bonds, stabilizing heir prices and minimizing he burden of debt. Because it

is unavoidable to borrow on a large scale to implement the programs of economic

development in undeveloped economies, hence as stated above, responsibility of

managing public debt effectively and efficiently so as to serve the requirements of

economic growth lies with the monetary authority.

26.3.3 Limitations of Monetary Policy:

The following factors may be limited the effectiveness of monetary policy. They are:

o Existence of Vast Non-Magnetized Sector

o Prevalence of Indigenous bankers

o Weapons of Credit Control have limited application as people mostly rely on

Currency in circulation

o Lack of Banking habits among public

o Undeveloped Security and Bill market

o Unsound Practices of Banking sector

o Accumulation of Black money by tax-evasion

In spite of these limitations, there is no denying the fact that monetary policy can be used

with advantage to economic growth by ‘influencing the supply and uses of credit,

combating inflation and maintaining the balance of payments equilibrium’. However, no

single policy can achieve the desired goal, hence monetary policy must be supplemented

by fiscal policy, which influence economic activity.

26.4 Fiscal policy and its Meaning

Fiscal Policy is one more important component of overall economic policy. Monetary

policy deals with the changes in demand for and supply of money where as fiscal policy

is concerned with non-monetary instruments. Fiscal policy, by employing its instruments,

secures the economic stabilization in developed economies and economic growth in

underdeveloped countries. Its instruments broadly consists of (i) taxes (ii) Public

Borrowing (iii) Public Expenditure.

The importance of fiscal policy as an instrument of economic development was first

envisaged by Keynes in his General Theory wherein he showed that the total national

income was an index of economic activity and brought out the relation between economic

activity and total spending. The direct and indirect effects of fiscal policy on aggregate

spending in the community were clearly established and as a result the budgetary policy

of the government as a weapon of economic control and development came into

prominence. But the Keynesian analysis of fiscal policy is, applicable to the advanced

and industrialized countries and it has little relevance to underdeveloped countries.

Let now look at definitions given by different economists. According to Arthur Smithies,

fiscal policy means “ a policy under which the government uses its expenditure and

revenue programs to produce desirable effects and to avoid undesirable effects on the

national income, production and employment” GK Shaw has defined fiscal policy in

these words, “We define fiscal policy to encompass any decision to change the level,

composition or timing of government expenditure or to vary the burden, structure or

frequency of the tax payment”. A skilful management of fiscal policy instruments can go

long way in maintaining economic stability and ensuring higher rates of economic

growth.

26.4.1 Objectives of fiscal policy

Objectives of fiscal policy are as follows (i) Securing the most efficient and rational

allocation of economic resources (ii) Accelerating the rate of capital formation (iii)

Controlling inflation (iv) Securing equitable distribution of income and wealth (v)

Attaining and maintaining full employment

As like in monetary policy objectives, fiscal policy objectives also mutually consistent

but some times there are conflicts between them. Therefore, policy must decide its course

of action in the light of the requirements of the situation prevailing in the country at the

time.

26.4.2 Role of Fiscal policy in economic development

K K Kurihara regards fiscal policy as a “desiderate for underdeveloped countries lacking

in private initiative, private voluntary saving and private innovation”. He discusses the

fiscal policy of government as an additional saver, an investor and an income

redistributor. He observes as par as underdeveloped economy is concerned, budgetary

surplus is the relevant position to be achieved and maintained. As an additional investor,

government can increase the productive capacity of the economy and secure an

accelerated rate of economic growth by changing the pattern of investment and laying

emphasis on capacity creating rather than on income-generating aspects. As an innovator,

the government should spend on research and experimentation and stimulate innovations

and new techniques of production. As an income redistributor and for that fiscal measures

can go a long way in reducing economic inequalities. In the words of Nurkse, fiscal

policy assumes a new significance in he face of the problem of capital formation in

underdeveloped countries”

The fiscal policy should be construed as to secure full employment conditions and

economic growth at rapid rate. The integration of the government budgets with the

nation’s economy budgets can go a long way for the attainment of the objectives of rapid

economic development and creation of full employment opportunities.

We now proceed to discuss the role of fiscal policy instruments role in economic

development.

Taxation :Of the important sources of public revenue taxation is the most important.

Through taxation, governments are collecting from 10- 30 percent levels to the national

income in developed countries. Shortage of financial resources is the main obstacle in the

way of economic development of the underdeveloped countries. There are certain forces

operating in these countries, which increase consumption and reduce savings. The first

among them is the population pressure. Besides, the high incomes groups spend much of

their incomes on conspicuous consumption and their propensity to consume is further

reinforced by the ‘demonstration effect’ Still worse, a large part of the meager savings is

dissipated in unproductive channels like real estate, hoarding, gold, jewellery,

speculation, etc the taxation measures can be employed effectively to divert savings of

the people into productive channels. In this connection, Report of the Taxation Enquiry

Commission, Govt of India, observes, “A tax system which on the whole, promotes

capital formation in its two aspects of saving and investment fulfills an essential

desideratum.

Public Borrowing: There is a limit to which taxation can be resorted for resource

mobilization. If the taxes are excessive, they will adversely affect people’s desire and

ability to work, save and invest. This will obviously retard the paced of economic

development. To avoid such a situation, public borrowing may cover the gap in resources

required. It will not adversely affect people’s desire to work, save and invest as lending is

voluntary n the lenders not only get back the amount lent but also earn interest on it.

Further, public borrowing may add to the incentives of the people to save and invest more

as he lure of earning more interest on lending is there. Public borrowing has its own

limitations. The general masses are poor and their propensity to consume is high and

hence they have no lending capacity. The rich generally do not like to lend to the

government but instead divert their investive resources into speculative channels as they

can earn more from there. Absence of organized money and capital markets are some of

the other obstacles in the way of public borrowing program. However, government has

to do efforts to compulsory borrowing for economic development. But it may be noted

that no democratic government can rely on forced loans except for a short period and for

certain specified projects. Ultimately, it is the voluntary lending by the people that

matters and the government must be prepared to increase its domestic borrowing when

the incomes and savings of the people increase as a result of economic and make public

borrowing and important tool of resource mobilization.

Public Expenditure:

Public expenditure is one of the important weapons in the hands of the state to secure

economic development of underdeveloped economies. Initially for economic

development, infrastructure facilities have to be provided. For which, government

initiation is essential condition. Therefore, government has to spent huge amount on its

development to pave the way to private entrepreneur to start key industries and also agro-

based industries. Thus, a carefully and wisely planned public expenditure by creating

social and economic overheads can go a long way in creating necessary environment for

growth. But public expenditure can achieve its wider objective of development only if it

conforms to certain well-defined principles of public expenditure. Further, care should be

taken that public expenditure does not adversely affect people’s desire to work, save and

invest and for that people should not be provided with direct money help but with goods

and services in the form of free education, free medical facilities.

Thus, the fiscal policy can affect the rate of economic development in a variety of ways

such as by increasing the rate of saving and investment, affecting the allocation of

resources, controlling inflation, promoting economic stability, securing equitable

distribution of income and wealth and creating full employment policy in advance

countries.

26.4.3 Limitations of Fiscal Policy:

The effectiveness of fiscal policy will depend on the extent and depth of measures

adopted and their right timing.

Public spending on a large scale during depression poses the problem of finding out

adequate sources of revenue. For instance, reliance placed on taxation to finance public

investment during depression is not advisable. Thus, effectiveness of fiscal policy during

depression is limited and conditioned by the availability of finance.

Political and administrative delays have adverse effect in efficiency of fiscal measures.

To cure unemployment through raising the aggregate demand in an economy, which

suffers from disguised unemployment, cannot yield desired results.

A vigorous pursuit of fiscal measures for removing unemployment may lead to balance

of payments difficulties.

In recent years, economists have suggested control of private investment, in addition to

fiscal and monetary measures, with a view to secure economic stabilization. This shows

that fiscal policy alone cannot secure economic stabilization and full employment, though

it is the most potent weapon to achieve the same.

26.5 Summary:

Monetary or fiscal policies are important weapons in the hands of the government to

secure rapid economic development. Monetary policy is nothing but the management of

money supply for the purpose of attaining a set of objectives. Similarly, the means and

instruments employed by the state to influence the general level of economic activity

constitute the core of fiscal policy. However, it may be mentioned that the nature of

economic problems facing the underdeveloped and developed economies is so complex

that no single policy by itself can achieve the desired goal. Hence, one policy must be

supplemented by other policy and other major policies of the government, which

influence economic activity.

26.6 Check your Progress

State whether following statements are True or False

1. Monetary policy means the conscious management of money supply

2. The fluctuating exchange rates adversely affect internal trade and the foreign

exchange earnings.

3. one of the instruments of monetary policy is public expenditure

4. Taxation is an instrument of fiscal policy

26.7 Key Concepts:

Demand for money : It refers to the wish to keep some amount in liquidity form.

According to Keynes, demand for money is for transactions, precautionary and

speculative purposes.

Supply of Money : It implies that the quantity of money available in an economy.

Monetary authority of an economy have power to maintain the money supply.

Cheap money policy : It is the part of overall monetary policy. To achieve one of

monetary policy objectives, it can reduce the supply of money from circulation. It is

known as cheap money policy

Dear money policy : It is also the part of overall monetary policy. To achieve one of

monetary policy objectives, it can increase in the supply of money from circulation. It is

known as Dear money policy

Exchange Stability : It is one of the monetary policy objectives. There will be two types

of exchange rates. Fixed and flexible exchange rates. To have smooth trade among the

countries exchange stability is essential condition.

Price Stability : It is also one of the monetary policy objectives. Neither inflation nor

deflation are not viable, therefore, monetary authority tries to achieve stability in prices.

Speculative motive: money will be demanded by the public for different motives.

Among them it is one. If money demanded for the purpose of speculation, we called it as

speculative motive.

Money Market : Finance is required for the development of economy. One is short term

finance and another one is long term finance. Money market objective is to provide short

term finance.

Capital Market: It is part of financial system. Long term finance is available via capital

market for the development of an economy

External borrowing : Finance can be borrowed from two sources, they are: Internal and

external borrowing. If finance is availed through external sources such as foreign

economies, international financial institutions is known as external borrowing.

Internal borrowing : Finance can be borrowed from two sources, they are: Internal and

external borrowing. If finance is availed through internal sources such as household

savings, Public sector and Private sector is known as internal borrowing.

26.8 Self-Assessment Questions

Essay Questions:

1. Explain the objectives of Monetary Policy in a developing economy?

2. Examine the effectiveness of monetary policy in India?

3. Explain the limitations of monetary policy in its working?

4. What is the important instrument of fiscal policy?

5. Examine the role of fiscal policy in under developed economies?

Short Questions:

1. What is meant by cheap money policy?

2. What is the instrument of monetary policy?

3. Write note on lags of monetary policy?

4. Write the different categories of taxation?

5. Internal debt vs. external debt- elaborate

26.9 Answers to check your progress

1. True 2. True 3. False 4 True

26.8 Suggested Readings

1. Ghatak, Subata: Monetary Economics in Developing Countries

2. Meier, Gerald M., Leading Issues in Economic Development

3. Gupta. SP Monetary Planning in India

4. Chellaiah RJ Fiscal Policy in Underdeveloped countries

5. Tyagi BP Public Finance

6. Taneja & Myer Economics of Development & Planning