RBI Credit Policy

INTRODUCTION

The Reserve Bank of India as the Central Bank of our country was established on 1 st April,

1935 under the Reserve Bank of India Act, 1934. The Bank was started originally as a

shareholders’ bank and its paid up capital was Rs. 5 crores. The Bank took over the function

of currency issue from the Government of India and the power of credit control from the then

Imperial Bank of India. The Bank was nationalised in the year 1948, soon after

Independence, following a post war trend towards nationalisation of Central Banks all over

the world. Also a centrally administered system had then become necessary to control a

runaway inflation raging in India since 1939, control inflation in the country effectively. And,

as India had to embark upon a programme of economic development and growth, it was

necessary to have a complete control over the activities of banking so that a Central Bank

could be used effectively as an instrument of economic change in the country.

This power of Credit control of RBI as taken from the then Imperial Bank is mainly forming

RBI’s Credit Policy. Through credit policy RBI controls flow of credit in domestic market as

one of its important functions involve control over the volume of credit created by the

commercial banks in order to ensure price stability.

The Reserve Bank of India is largely concerned with organisation of a sound and healthy

commercial banking system, ensuring effective co-ordination and control over credit through

appropriate monetary and credit policies followed from time to time. However, in India the

Reserve Bank of India is also concerned with development of rural banking, promotion of

financial institutions and development of money and capital market in India.

Keeping in view, the functions of RBI of credit control along with the developmental aspects,

the credit policy for a nation is formulated in both quantitative measures and qualitative

measures to control both quantity of credit and quality of work to be formulated by that

credit.

Issue of credit policy for Banking Companies :

The bank formulates credit policies, normally by way of an order, by laying down the bank

rate, lending restrictions, merger restrictions, nature of security to be obtained for credit

extension, defining the scope and eligibility of the private sector for borrowing, determining

the cash reserve ratio and statutory liquidity ratio and any other matter having a bearing on

commercial lending in the first instance, and the economy of the country in the second.

It has been customary for RBI to announce a set of measures of both short-term and structural

nature in the two bi-annual statements on monetary and credit policy normally released in

April and October of each year.

CREDIT POLICY & MONETARY POLICY OF RBI – CONCEPTUAL ANALYSIS

Meaning

Monetary policy comprises implementation of measures that will result either in contraction

or expansion of money supply in the economy and thereby regulate inflation in prices. Banks

being purveyors of credit, they act as change agents by regulating the volume of liquidity for

industries as a measure to control prices of goods and services. As the regulatory authority,

the RBI monitors bank credit through directives altering Cash Reserve and Statutory

Liquidity Ratios for Banks, amending its own lending rate, known as the Bank Rate,

stipulating minimum margins to be retained by banks in their advances and also reviewing

commodities governed by the Selective Credit Control.

The Monetary and Credit Policy is the policy statement, traditionally announced twice a year,

through which the Reserve Bank of India seeks to ensure price stability for the economy. The

Reserve Bank of India enunciates its monetary policy once a year, but announces a mid-

course review six months thereafter.

These factors include - money supply, interest rates and the inflation. In banking and

economic terms money supply is referred to as M3 - which indicates the level (stock) of legal

currency in the economy. Besides, the RBI also announces norms for the banking and

financial sector and the institutions which are governed by it. These would be banks, financial

institutions, non-banking financial institutions, Nidhis and primary dealers (money markets)

and dealers in the foreign exchange (forex) market.1

Historically, the Monetary Policy is announced twice a year - a slack season policy (April-

September) and a busy season policy (October-March) in accordance with agricultural cycles.

These cycles also coincide with the halves of the financial year.

Initially, the Reserve Bank of India announced all its monetary measures twice a year in the

Monetary and Credit Policy. The Monetary Policy has become dynamic in nature as RBI

reserves its right to alter it from time to time, depending on the state of the economy.

1 Salil Panchal, ‘What is RBI’s Monetary Policy’, Morpheus Inc.. Available at: < http://m.rediff.com/money/2002/apr/25tut.htm>.

However, with the share of credit to agriculture coming down and credit towards the industry

being granted whole year around, the RBI since 1998-99 has moved in for just one policy in

April-end. However a review of the policy does take place later in the year.2

Objectives and Efficacy

As an integral component of the overall economic policy of the country, the key objectives of

monetary policy of the Bank are:

Regulation of monetary growth consistent with expected growth in output and a

desirable rate of inflation, and

Ensuring adequate expansion of credit for the purpose of meeting genuine credit

requirements of productive sectors of the economy.

Until the economic reforms were introduced during the nineties, the prevailing system of

administered interest rates was geared towards achieving the twin objectives of allocation of

resources for capital formation and directing credit to preferred sectors, often at

concessionary interest rates. The administered interest rate regime clearly circumscribed the

role of interest rate as an effective instrument of monetary management.

The efficacy of the policy hinges on the identification of the targets by the monetary

authority. Conceptually, such targets are distinguished as intermediate and ultimate. Whereas

inflation rate is an agreeable ultimate target of monetary policy, variables such as different

measures of money supply and/or interest rates could be employed to serve as intermediate

targets. In India, while broad money, or what is referred as M-3, growth has been chosen to

function as intermediate target, the operating target is the level of Bank.

2 Ibid.

The objectives are to maintain price stability and ensure adequate flow of credit to the

productive sectors of the economy.

Stability for the national currency (after looking at prevailing economic conditions), growth

in employment and income are also looked into. The monetary policy affects the real sector

through long and variable periods while the financial markets are also impacted through

short-term implications.

There are four main 'channels' which the RBI looks at:

Quantum channel: money supply and credit (affects real output and price level

through changes in reserves money, money supply and credit aggregates).

Interest rate channel.

Exchange rate channel (linked to the currency).

Asset price.

Monetary Policy is the process by which the monetary authority of a country, generally a

Central Bank controls the Supply of money in the Economy by exercising its control over

interest rates in order to maintain- Growth with Stability Regulation, Supervision &

Development of Financial Stability Promoting Priority Sector Generation of

Employment External Stability Encouraging Saving & Investment Redistribution of

income & wealth Role of Monetary Policy in Combating Inflation www.iosrjournals.org 12 |

Page Regulation of NBFI

OBJECTIVES OF MONETARY POLICY OF INDIA :-

The main objective of monetary policy in India is ‘growth with stability’. Monetary

Management regulates availability, cost and use of money and credit. It also brings

institutional changes in the financial sector of the economy. Following are the main

objectives of monetary policy in India :-

1.    Growth With Stability :-

Traditionally, RBI’s monetary policy was focused on controlling inflation through

contraction of money supply and credit. This resulted in poor growth performance. Thus, RBI

have now adopted the policy of ‘Growth with Stability’. This means sufficient credit will be

available for growing needs of different sectors of economy and at the same time, inflation

will be controlled with in a certain limit.

2.    Regulation, Supervision And Development Of Financial Stability :-

Financial stability means the ability of the economy to absorb shocks and maintain

confidence in financial system. Threats to financial stability can come from internal and

external shocks. Such shocks can destabilize the country’s financial system. Thus, greater

importance is being given to RBI’s role in maintaining confidence in financial system

through proper regulation and controls, without sacrificing the objective of growth.

Therefore, RBI is focusing on regulation, supervision and development of financial system.

3.    Promoting Priority Sector :-

Priority sector includes agriculture, export and small scale enterprises and weaker section of

population. RBI with the help of bank provides timely and adequately credit at affordable

cost of weaker sections and low income groups. RBI, along with NABARD, is focusing on

microfinance through the promotion of Self Help groups and other institutions.

4.    Generation Of Employment :-

Monetary policy helps in employment generation by influencing the rate of investment and

allocation of investment among various economic activities of different labour Intensities.

5.    External Stability :-

With the growth of imports and exports India’s linkages with global economy are getting

stronger. Earlier, RBI controlled foreign exchange market by determining eaxchange rate.

Now, RBI has only indirect control over external stability through the mechanism of

‘managed Flexibility’, where it influences exchange rate by buying and selling foreign

currencies in open market.

6.    Encouraging Savings And Investments :-

RBI by offering attractive interest rates encourage savings in the economy. A high rate of

saving promotes investment. Thus the monetary management by influencing rates of interest

can influence saving mobilization in the country.

7.    Redistribution Of income And Wealth :-

By control of inflation and deployment of credit to weaker sectors of society the monetary

policy may redistribute income and wealth favouring to weaker sections.

8.    Regulation Of NBFIs:-

Non – Banking Financial Institutions (NBFIs), like UTI, IDBI, IFCI plays an important role

in deployment of credit and mobilization of savings. RBI does not have any direct control on

the functioning of such institutions. However it can indirectly affects the policies and

functions of NBFIs through its monetary policy.

The monetary policy of RBI is not merely one of credit restriction, but it has also the duty to

see that legitimate credit requirements are met & at the same time credit is not used for

unproductive & speculative purposes. RBI has various weapons of monetary control & by

using them it hopes to achieve its monetary policy. These are:

A. Quantitative Credit Control Methods In India the legal framework of RBI’s control over

the credit structure has been provided under RBI act 1934 & Banking regulation Act 1949.

Quantitative Credit Control is used to maintain proper quantity of credit or money supply in

market. Some of the important credit control methods are- Bank Rate Policy Open

Market Operations Cash Reserve Ratio Statutory Liquidity Ratio Repo & Reverse

Repo Rate

B. Qualitative Credit Control Methods Under Selective Credit Control Credit is provided to

selected borrowers for selected purposes. These ares- Ceiling on Credit Margin

Requirements Discriminatory Interest Rate(DIR) Directives Direct Action Moral

Suasion

http://rbidocs.rbi.org.in/rdocs/content/PDFs/90017.pdf

Credit Policy or Monetary policy is, by common agreement, the defining function of a central bank. Uniquely for a central bank, the Reserve Bank of India undertook a variety of developmental initiatives in independent India, though monetary policy remained its central preoccupation. The principal structural features of the Bank's economic and financial environment and the resulting diversity in the nature of its responsibilities as a central bank have already been discussed in the introductory chapter. Monetary policy, which is usually understood to represent policies, objectives, and instruments directed towards regulating money supply and the cost and availability of credit in the economy, could not remain unaffected by this inherited context. Therefore the Reserve Bank of India was prone to take a rather wider view of its monetary policy than more traditional central banks, including within its ambit the institutional responsibility for deepening the financial sector of the economy. Thanks to the Bank's own initiatives and the stimulus of the ongoing process of planned development, the institutional context of monetary policy underwent substantial change during our period. At the same time, tensions between the Bank's concern to regulate credit and its wider responsibility to spread and deepen the domestic financial system were often not far in the background. Some of these tensions might be regarded in the light of experience as transient or short-term while others persist to this day, but their impact on the Bank's decision-malung at the time can hardly be overlooked.

As important, the financing of planned development in a poor economy was a source both of challenge and of constraints for the Bank in its role as the monetary policy authority. While the short-term management of seasonal, inflationary, and balance of payments pressures remained an important focus of monetary policy, the overall investment targets proposed in the five-year plans provided the backdrop against which this responsibility had to be discharged. The interactive nature of the relationship between inflationary pressures in the economy and the mobilization of real resources to finance the plan effort gave monetary management a particular salience during these years. In practice, this relationship too translated into a conflict for whose resolution the Bank had much responsibility but little power. On the one hand, inflation had to be controlled in order to promote savings and investment and the plan effort. But on the other, having to step in frequently to cover the budgetary gaps of the central and state governments weakened the Bank's ability to conduct an independent monetary policy. For the Reserve Bank of India therefore, short-term monetary policy meant not merely managing clearly identified variables such as the price level or the exchange rate, but doing so consistent with supporting a given plan effort. Unfortunately but perhaps unavoidably in the circumstances, th~s reconciliation was generally effected at the cost of the private sector's credit requirements. Given the formidable constraints they had to negotiate, the Bank's persistent efforts to balance its diverse responsibilities represent, on closer inspection, an important source of insight for historians as well as for others interested in the broader issues of economic development. Faced with the growing gulf between everyday practice and the canons of orthodox central banking, few contemporary officials recognized they were blazing a trail (whatever may have lain at the end of it), nor were they conscious of the ingenuity they brought to addressing the challenges facing them. In tackling these largely short-term challenges, they did not entirely lose sight of the larger picture. But

the practical necessities of decision-making under multiple constraints often led to the adoption, sometimes against the better judgement of its officers if not always of the Bank, of measures which created bigger problems in the longer term than the more immediate ones they helped to resolve. As the logic of decision-making became endogenized in the form of precedents and institutional evolution, the course was set for departures which however small or partial in the beginning, exercised over a period of time a tangible influence on the overall effectiveness of the Bank's monetary policy.

This part of the volume is organized in three separate but related chapters. The first begins with a broad overview of fiscal developments during the three five-year plan periods covered by this volume and of the Bank's evolving attitude towards deficit financing and its impact upon monetary variables in the economy. From being initially passive about the resource assumptions of five-year plans, the Bank learnt from experience to be more proactive and to urge upon planners the importance of realistic estimates of growth and resource mobilization targets. Concerns such as this led to efforts to formulate a monetary budget for the third five-year plan. Apart from defining the context for monetary policy, deficit financing also raised new questions about currency management and the effectiveness of the Bank's existing tool-kit of monetary policy. In addressing these questions, the Bank endeavoured to augment its powers, as well as adapt the Indian currency and monetary apparatus for the changes and challenges lying ahead. Its efforts in this direction are also discussed in this chapter. The second and third chapters of this section present a largely chronological account of the Bank's monetary and credit policies during the years covered by this volume.

Need for Credit policy

The commercial banks maintain accounts with the Reserve Bank of India and borrow money

when necessary from the Reserve Bank of India. The RBI thus provides credit to commercial

banks and commercial banks in turn provide credit to their clients to promote economic

growth and development. However, credit cannot be extended to an unlimited extent because

it would disturb price stability in the country and therefore, it becomes necessary for the RBI

to control the activities of the commercial banks in the interest of the price stability. The RBI

controls the activities of the commercial banks by virtue of the powers vested in it under the

Banking Regulation Act of 1949 and the Reserve Bank of India Act, 1934.

TOOLS OF RBI’S CREDIT & MONETARY POLICY

The Monetary Policy of RBI is not merely one of credit restriction, but it has also the duty to

see that legitimate credit requirements are met and at the same time credit is not used for

unproductive and speculative purposes RBI has various weapons of monetary control and by

using them, it hopes to achieve its monetary policy.

QUANTITATIVE CREDIT CONTROL METHODS :-

In India, the legal framework of RBI’s control over the credit structure has been provided

Under Reserve Bank of India Act, 1934 and the Banking RegulationAct, 1949. Quantitative

credit controls are used to maintain proper quantity of credit o money supply in market. Some

of the important general credit control methods are:-

1. Bank Rate Policy :-

Bank rate is the rate at which the Central bank lends money to the commercial banks for their

liquidity requirements. Bank rate is also called discount rate. In other words bank rate is the

rate at which the central bank rediscounts eligible papers (like approved securities, bills of

exchange, commercial papers etc) held by commercial banks.

Bank rate is important because it is the pace setter to other market rates of interest. Bank rates

have been changed several times by RBI to control inflation and recession. By 2003, the bank

rate has been reduced to 6% p.a.

2. Open market operations :-

It refers to buying and selling of government securities in open market in order to expand or

contract the amount of money in the banking system.This technique is superior to bank rate

policy. Purchases inject money into the banking system while sale of securities do the

opposite. During last two decades the RBI has been undertaking switch operations. These

involve the purchase of one loan against the sale of another or, vice-versa. This policy aims at

preventing unrestricted increase in liquidity.

3. Cash Reserve Ratio (CRR)

The Gash Reserve Ratio (CRR) is an effective instrument of credit control. Under the RBl

Act of, l934 every commercial bank has to keep certain minimum cash reserves with RBI.

The RBI is empowered to vary the CRR between 3% and 15%. A high CRR reduces the cash

for lending and a low CRR increases the cash for lending. The CRR has been brought down

from 15% in 1991 to 7.5% in May 2001. It further reduced to 5.5% in December 2001. It

stood at 5% on January 2009. In January 2010, RBI increased the CRR from 5% to 5.75%. It

further increased in April 2010 to 6% as inflationary pressures had started building up in the

economy. As of March 2011, CRR is 6%.

4. Statutory Liquidity Ratio (SLR)

Under SLR, the government has imposed an obligation on the banks to maintain a certain

ratio to its total deposits with RBI in the form of liquid assets like cash, gold and other

securities. The RBI has power to fix SLR in the range of 25% and 40% between 1990 and

1992 SLR was as high as 38.5%. Narasimham Committee did not favour maintenance of high

SLR. The SLR was lowered down to 25% from 10 thOctober 1997.It was further reduced to

24% on November 2008. At present it is 25%.

5. Repo And Reverse Repo Rates

In determining interest rate trends, the repo and reverse repo rates are becoming important.

Repo means Sale and Repurchase Agreement. Repo is a swap deal involving the immediate

Sale of Securities and simultaneous purchase of those securities at a future date, at a

predetermined price. Repo rate helps commercial banks to acquire funds from RBI by selling

securities and also agreeing to repurchase at a later date.

Reverse repo rate is the rate that banks get from RBI for parking their short term excess funds

with RBI. Repo and reverse repo operations are used by RBI in its Liquidity Adjustment

Facility. RBI contracts credit by increasing the repo and reverse repo rates and by decreasing

them it expands credit. Repo rate was 6.75% in March 2011 and Reverse repo rate was 5.75%

for the same period. On May 2011 RBI announced Monetary Policy for 2011-12. To reduce

inflation it hiked repo rate to,7.25% and Reverse repo to 6.25%

SELECTIVE OR QUALITATIVE CREDIT CONTROL METHODS :-

Under Selective Credit Control, credit is provided to selected borrowersfor selected purpose,

depending upon the use to which the control try to regulate the quality of credit - the direction

towards the credit flows. The Selective Controls are :-

1. Ceiling On Credit

The Ceiling on level of credit restricts the lending capacity of a bank to grant advances

against certain controlled securities.

2. Margin Requirements

A loan is sanctioned against Collateral Security. Margin means that proportion of the value of

security against which loan is not given. Margin against a particular security is reduced or

increased in order to encourage or to discourage the flow of credit to a particular sector. It

varies from 20% to 80%. For agricultural commodities it is as high as 75%. Higher the

margin lesser will be the loan sanctioned.

3. Discriminatory Interest Rate (DIR)

Through DIR, RBI makes credit flow to certain priority or weaker sectors by charging

concessional rates of interest. RBI issues supplementary instructions regarding granting of

additional credit against sensitive commodities, issue of guarantees, making advances etc. .

4. Directives

The RBI issues directives to banks regarding advances. Directives are regarding the purpose

for which loans may or may not be given.

5. Direct Action

It is too severe and is therefore rarely followed. It may involve refusal by RBI to rediscount

bills or cancellation of license, if the bank has failed to comply with the directives of RBI.

6. Moral Suasion

Under Moral Suasion, RBI issues periodical letters to bank to exercise control over credit in

general or advances against particular commodities. Periodic discussions are held with

authorities of commercial banks in this respect.

EVALUATION OF MONETARY POLICY :-

The RBI aims at one time was controlled expansion. On one hand it was taking steps to expand bank credit. On other hand RBI uses quantitative and qualitative methods to control credit. These two contradictory objectives limited the success of monetary policy. The performance of monetary policy can be seen from its achievements and failures, let us discuss.

ACHIEVEMENTS OR THE POSITIVE ASPECTS OF MONETARY POLICY :-

1. Short Term Liquidity Management :-

RBI has developed various methods to maintain stability in interest rate and exchange rate like LAF, OMO and MSS. RBI has also managed its sterlization operations very well.

2. Financial Stability :-

With the help of controls, regulation and supervision mechanism, RBI has been successful in maintaining financial stability. During the period of global crisis it has also been able to maintain macro economic stability.

3. Financial Inclusion :-

Along with NABARD, RBI has made a great impact in the growth of microfinance. RBI has supported Self Help Group Model and promoted other microfinance institutions.

4. Adaptability:-

In India monetary policy is flexible, as it changes with time. RBI has developed new methods of credit control and shifted from monetary targeting to multiple indicator approach.

5. Increase In Growth:-

To maintain the growth of economy RBI has used its instruments' effectively. At present India has the second highest rate of GDP growth after China. Thus monetary policy has played an important role.

6. Increase In Bank Deposits:-

The increase in bank deposits over the years indicates trust and confidence of people in banking sector. Effective supervision of RBI over banks and financial institutions is largely responsible for trust and confidence of public in banking sector.

7. Competition Among Banks :-

The monetary policy of RBI has resulted in healthy competition among banks in the country. The competition is due to deregulation of interest rates and other measures taken by RBI. Now-a-days due to professionalism banks provide better service to customers.

FAILURES OR THE LIMITATIONS OF MONETARY POLICY

1. Huge Budgetary Deficits :-

RBI makes every possible attempt to control inflation and to balance money supply in the market. However Central Government's huge budgetary deficits have made monetary policy ineffective. Huge budgetary deficits have resulted in excessive monetary growth.

2. Coverage Of Only Commercial Banks :-

Instruments of monetary policy cover only commercial banks so inflationary pressures caused by banking finance can be controlled by RBI, but in India, inflation also results from deficit financing and scarcity of goods on which RBI may not have any control.

3. Problem Of Management Of Banks And Financial Institutions :-

The monetary policy can succeed to control inflation and to bring overall development only when the management of banks and Financial institutions are efficient and dedicated. Many officials of banks and financial institutions are corrupt and inefficient which leads to financial scams in this way overall economy is affected.

4. Unorganised Money Market :-

Presence of unorganised sector of money market is one of the main obstacle in effective working of the monetary policy. As RBI has no power over the unorganised sector of money market, its monetary policy becomes less effective.

5. Less Accountability:-

At present time, the goals of monetary policy in India, are not set out in specific terms and there is insufficient freedom in the use of instruments. In such a setting, accountability tends to be weak as there is lack of clarity in the responsibility of governments and RBI.

6. Black Money :-

There is a growing presence of black money in the economy. Black money falls beyond the purview of banking control of RBI. It means large proposition of total money Supply in a country remains outside the purview of RBI's monetary management.

7. Increase Volatility :-

The integration of domestic and foreign exchange markets could lead to increased volatility in the domestic market as the impact of exogenous factors could be transmitted to domestic market. The widening of foreign exchange market and development of rupee - foreign exchange swap would reduce risks and volatility.

8. Lack Of Transparency :-

According to S. S. Tarapore, the monetary policy formulation, in its present form in India, cannot be continued indefinitely. For a more effective policy, it would be necessary to have greater transparency in the policy formulation and transmission process and the RBI would need to be clearly demarcated.

CONCLUSION :-

Thus, from above we can say that despite several problems RBI has made a good effort for effective implementation of the monetary policy in India.

Monetary policy in India underwent significant changes in the 1990s as the IndianEconomy became increasing open and financial sector reforms were put in place. in the1980s,monetary policy was geared towards controlling the qunatam,cost and directionsOf credit flow in the economy. the quantity variables dominated as the transmissionChannel of monetary policy. Reforms during the 1990s enhanced the sensitivity of priceSignals of price signals from the central bank, making interest rates the increasinglyDominant transmission channel of monetary policy in India.The openness of the economy, as measured by the ratio of merchandise trade(exportsPlus imports) to GDP, rose from about 18% in 1993-94 to about 26% by 2003-04.Including services trade plus invisibles, external transactions as a proportion of GDPRose from 25% to 40% during the same period.Alongwith the increase in trade as aPercentage of GDP, capital inflows have increased even more sharply,foreign currencyAssets of the reserve bank of India(RBI) rose from USD 15.1 billion in the march 1994To over USD 140 billion by march 15,2005.these changes have affected liquidity andMonetary management. monetary policy has responded continuously to changes inDomestics and international macroecomic conditions. In this process, the currentmonetary operating framework has relied more on outright open market operations andDaily repo and reserve repo operations than on the use of direct instruments.overightRate are now gradually emerging as the principal operating target.The Monetary and Credit Policy is the policy statement, traditionally announcedtwice a year, through which the Reserve Bank of India seeks to ensure price stability for the economy. These factors include - money supply, interest rates and the inflation.

Importance of Monetary Policy

The growing importance of monetary policy and the diminishing role played by fiscal

policing economic stabilization efforts may reflect both political and economic realities.

Fighting inflation requires government to take unpopular actions like reducing spendingor raising taxes, while traditional fiscal policy solutions to fighting unemployment tend tobe more popular since they require increasing spending or cutting taxes. Politicalrealities, in short, may favor a bigger role for monetary policy during times of inflation.One other reason suggests why fiscal policy may be more suited to fightingunemployment, while monetary policy may be more effective in fighting inflation. Thereis a limit to how much monetary policy can do to help the economy during a period ofsevere economic decline, such as the States encountered during the 1930s. The monetarypolicy remedy to economic decline is to increase the amount of money in circulation,thereby cutting interest rates. But once interest rates reach zero, the Fed can do no more.The United States has not encountered this situation, which economists call the "liquiditytrap," in recent years, but Japan did during the late 1990s. With its economy stagnant andinterest rates near zero, many economists argued that the Japanese government had toresort to more aggressive fiscal policy, if necessary running up a sizable governmentdeficit to spur renewed spending and economic growth.