2 Monetary & Fiscal Policy

8/13/2019 2 Monetary & Fiscal Policy

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MONETARY AND FISCAL POLICIES

GLOBONOMICS & CONTEMPORARY MACRO ECONOMIC ISSUES

INFINITY BUSINESS SCHOOL

MONETARY POLICY & FISCAL POLICY


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Monetary Policy

Monetary policyis the process by which

the monetary authority of a country

controls the

i. supply of money,

ii. availability of money, and

iii. cost of money or rate of interest

It rests on the relationship between therates of interest, that is, the price at which

money can be borrowed, and the total

supply of money.


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Monetary Policy

It aims to attain a set of objectives

oriented towards the growth and

stability of the economy. The official goals usually include

relatively stable prices and low

unemployment.


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Expansionary Monetary Policy

An expansionary policy increases the total

supply of money in the economy more

rapidly than usual

It decreases the interest rate Therefore consumers save less and opt for

current consumption over future

consumption.

This, in turn, causes demand to strengthen. It is intended to slow down unemployment


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Contractionary Monetary Policy

A contractionary policy expands the money

supply more slowly than usual or even

shrinks it.

It raises the interest rate

Consumers find it more lucrative to save

than spend reducing aggregate demand

It is intended to slow inflation in hopes ofavoiding the resulting distortions and

deterioration of asset values.


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INSTRUMENTS OF MONETARY POLICY

1. Open Market Operations

2. Bank Rate

3. Cash Reserve Ratio

4. Statutory Liquidity Ratio

5. Margin Requirements

6. Deficit Financing

7. Credit Control

8. Moral Suasion

9. Exchange Rate


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Open Market Operations

It refers to the buying and selling of

Govt. securities in the open market.

During inflation, RBI sells securities inthe open market which leads to transfer

of money to the RBI.

Thus money supply is reduced in the

economy thereby reducing aggregatedemand


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Bank Rate

It is the interest rate at which the RBI lends

to the Commercial banks .

During Inflation , RBI increases the bank

rate of interest due to which borrowingpower of commercial banks reduces which

thereby reduces the supply of money or

credit in the economy .

When Money supply reduces, it reducesthe purchasing power and thereby

curtailing Consumption and lowering

Prices.


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Cash Reserve Ratio

CRR, or cash reserve ratio, refers to a

portion of deposits which banks have to

keep/maintain (as cash) with the RBI.

During Inflation RBI increases the CRR dueto which commercial banks have to keep a

greater portion of their deposits with the

RBI

This ensures that a portion of bank depositsis totally risk-free and it enables RBI to

control liquidity in the system, and thereby,

inflation.


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Statutory Liquidity Ratio

Banks are required to invest a certain

portion of their deposits in government

securities as a part of their statutory

liquidity ratio (SLR) requirements .

If SLR increases, the lending capacity of

commercial banks decreases thereby

regulating the supply of money in theeconomy.


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Margin Requirements

During Inflation, RBI fixes a high rate of

margin on the securities kept by the

public for loans .

If the margin increases, the commercial

banks will give less amount of credit on

the securities kept by the public therebycontrolling inflation.


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Deficit Financing

It means printing of new currency notes

by Reserve Bank of India .

This will increase the supply of money

thereby increasing demand and prices.

Thus during Inflation, RBI will stop

printing new currency notes thereby

controlling inflation.


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Credit Control

The Central Bank can direct banks on

the maximum percentage or amount of

loans (credit ceilings) to differenteconomic sectors or activities, interest

rate caps, liquid asset ratio and issue

credit guarantee to preferred loans.

In this way the available saving isallocated and investment is directed in

particular directions.


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Moral Suasion

The Central Bank issues licenses or

operating permit to banks and also

regulates the operation of the banking

system.

It can therefore, persuade banks to follow

certain paths such as credit restraint or

expansion, increased savings mobilization

and promotion of exports through financialsupport, which otherwise they may not do,

on the basis of their risk/return

assessment.


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Exchange Rate

By selling or buying foreign exchange, the

Central Bank ensures that the exchange

rate is at levels that do not affect domestic

money supply in an undesired direction,

through the balance of payments and the

real exchange rate.

The real exchange rate when misalignedaffects the current account balance

because of its impact on external

competitiveness.


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Fiscal Policy

It refers to the Revenue and Expenditure

policy of the Govt.

Through changes in its expenditure and

taxes, the government attempts to increase

or decrease output and income and seeks

to stabilise the ups and downs in the

economy.

In the process, fiscal policy creates a surplus

(when total receipts exceed expenditure) ora budget deficit(when total expenditure

exceed receipts) rather than a balanced

budget (when expenditure equals receipts).


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Macroeconomic Goals

Economic Growth: By creating conditions for

increase in savings & investment

Employment: By encouraging the use of

labour-absorbing technology Stabilization: fight with depressionary trends

and booming (overheating) indications in the

economy

Economic Equality: By reducing the income and

wealth gaps between the rich and poor.

Price stability: employed to contain inflationary

and deflationary tendencies in the economy.


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Instruments of Fiscal Policy

Govt. Expenditure

Taxation

Govt. Borrowing


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Govt Expenditure

The expenditures of the government can

promote economic activity and create jobs.

For example, if the government funds a

project to build a high-speed train acrossthe country, the funds that go into the

project could go toward hiring workers

which could reduce unemployment and

inject money into the economy.

Higher levels of government spending tend

to promote employment and economic

growth.


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Taxation

When the government increases or

decreases taxes, it increases or decreases

the amount of money consumers have to

spend which can have a significant impact

on the direction of the overall economy.

Cutting taxes is a common fiscal policy

measure to encourage economic growth.


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The Crowding-Out Effect

Fiscal policy may not affect the economy asstrongly as predicted by the multiplier.

An increase in government borrowingcauses the interest rate to rise.

A higher interest rate reduces investmentspending.

This reduction in demand that results whena fiscal expansion raises the interest rate is

called the crowding-out effect. The crowding-out effect tends to dampen

the effects of fiscal policy on aggregatedemand.


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Consideration

When the government increases its

purchases by $20 billion, the aggregate

demand for goods and services couldrise by more or less than $20 billion,

depending on whether the multiplier

effect or the crowding-out effect is

larger.


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Govt Borrowing

Method to mobilize savings of the

community for economic development.

Public borrowing becomes necessarybecause taxation alone cannot provide

sufficient funds for economic

development.

Besides, too heavy taxation has anadverse effect on private saving and

investment.

Documents

2 Monetary & Fiscal Policy