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Monetary policy and Fiscal policy

MBAGalgotias University

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Monetary Policy

• Set of policies by the monetary authority (Central Bank) which regulates the money supply and credit flows in the economy in order to achieve certain macroeconomic goals are called the monetary policy.

• In India, RBI plays the role of central bank and decides the monetary policy.

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Objectives of monetary policy

• Economic growth• Increase in employment• Price stability and inflation control• Exchange rate stability• Balance of payments equilibrium• Reducing income inequality

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Instruments of monetary policy

• All the instruments of the monetary policy can be categorized under two categories

Quantitative measures– Bank rate, Repo rate, Reverse repo rate, CRR, SLR, Open market operations

Qualitative measures – credit rationing, change in margin requirements, moral suasion, direct controls

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Bank rate

• Bank rate is the rate at which RBI lends money to the commercial banks.

• Increase in bank rate is likely to increase all other interest rates and decrease the total money supply. This is a type of contractionary monetary policy.

• Decrease in bank rate is likely to decrease all other interest rates and increase the total money supply. This is a type of expansionary monetary policy.

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Cash reserve ratio (CRR)

• Banks have to keep a certain minimum percentage of their total deposits (demand deposits + time deposits) with the RBI, that minimum percentage is called CRR.

• An increase in CRR will result in less cash available with the banks and it is a contractionary monetary policy.

• A decrease in CRR will result in more cash available with the banks and it is an expansionary monetary policy.

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SLR• SLR stands for Statutory liquidity ratio.• Banks are supposed to maintain a minimum

percentage of their total deposits as a sum of excess reserve (ER), cash balance with other banks (CB) and government securities(GS). That percentage is called SLR.

• SLR = • Increase in SLR is contractionary policy and

decreases in SLR is expansionary policy.

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Repo rate

• Repo means repurchase operations.• The rate at which the RBI lends money to banks

against the government securities with the repurchase agreement in future is called repo rate.

• When the repo rate increases it becomes costly for banks to borrow from RBI and the money supply decreases, it is a type of contractionary monetary policy. The decrease in repo rate will increase the money supply and it is a type of expansionary monetary policy.

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Reverse repo rate• The rate which banks receives when they keep their

extra cash with RBI along with the repurchase agreement of government securities in future is called reverse repo rate.

• Increase in reverse repo rate is going to decrease the money supply and it is a type of contractionary monetary policy.

• Decrease in reverse repo rate is going to increase the money supply and it is a type of expansionary monetary policy.

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Open market operations

• Buying and selling of government securities by the RBI in the open market is called the open market operations.

• When RBI buys government securities the money supply is going to increase and it is a type of expansionary monetary policy.

• When RBI sells government securities the money supply is going to decrease and it is a type of contractionary monetary policy.

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Qualitative measures-1

• It is also called the selective credit controls since these policies are going to affect only certain selected parts.

• Credit rationing is controlling the amount of credit available for certain sectors in order to ensure that all sectors get adequate amount of credit.

• Change in margin requirements is going to affect minimum amount of money that an individual is required to use from his own resources when he borrows money from the bank.

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Qualitative measures-2

• Moral suasion is a method used by RBI like persuading and convincing the banks to undertake certain actions in the economic interests of the country.

• When all methods prove ineffective, RBI can take direct actions by clearly specifying the way in which banks have to operate.

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Fiscal policy

• Fiscal policy is about deciding how the government is going to get the money (taxes, borrowing, printing new money) and where it is going to spend the money keeping in mind certain economic goals.

• Budget of the government shows the fiscal policy for the concerned year in a concise manner.

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Objectives of fiscal policy

• Increasing the economic growth• Increasing employment• Price stability and controlling inflation• Reducing the income inequality• Balanced regional development• Efficient allocation of financial resources

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Sources of government’s income• Taxes – Direct taxes and indirect taxes Direct taxes – Income tax, corporate income tax, wealth tax, estate duty etc. Indirect taxes – Excise, custom duty, sales tax, VAT• Borrowing• Printing new currencies• Profit of the PSUs• Interest received• Disinvestment in PSUs

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Revenue a/c and Capital a/c

• Total budget is divided into two accounts – revenue a/c and capital a/c

• We have revenue receipts and capital receipts sum of both is total receipts.

• Total expenditure is divided into two parts, one is revenue expenditure and the other is capital expenditure.

• Total expenditure is further categorized as plan expenditure and non-plan expenditure.

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Different types of deficits

• Budget deficit = Total expenditure - Total receipts

• Revenue deficit = Revenue expenditure -Revenue receipts

• Fiscal deficit = Total expenditure - Revenue receipts

• Primary deficit = Fiscal deficit - Interest payments

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Discretionary fiscal policy-1

• Deliberate change in the government expenditure and taxes to influence the output, employment and prices is called the discretionary fiscal policy

• Change in taxes, Change in expenditures or change in both taxes and expenditure are discretionary fiscal policy.

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Discretionary fiscal policy-2

• Increase in government expenditure or decrease in taxes or a combination of both are known as expansionary fiscal policy which is going to increase the output.

• Decrease in government expenditure or increase in taxes or a combination of both is known as contractionary fiscal policy which is going to decrease the output.

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Non discretionary fiscal policy

• Under non discretionary fiscal policy government expenditure pattern and tax structure are designed in a way that taxes and government spending vary automatically in appropriate direction with the changes in national income. These are called the automatic stabilizers.

• Progressive income taxes, unemployment benefits etc. are part of non discretionary fiscal policy.