13. Economic, Monetary and Fiscal Policies – Business Environment

13

ECONOMIC, MONETARY AND FISCAL POLICIES

The study of economic policy—including monetary and fiscal policies—is of utmost significance to any student of management as they have to relate what is happening around their business in terms of policy perspectives to make appropriate and responsive business decisions. In this chapter, we deal with the objectives of economic policy and study in detail monetary and fiscal policies.

ECONOMIC POLICY

Governments generally accept the view that their key role is to create appropriate public policies that promote economic growth. Experience has proved that healthy economic growth is affected by many factors, thereby requiring continuing efforts by government to manage the macroeconomy. Economic growth is stimulated by government policies that encourage investment (e.g., providing tax exemptions for domestic investments, inviting foreign investors to locate facilities in the country); foster technology development (e.g., patent protection); provide key services (e.g., infrastructure, public health and police protection); and create a capable workforce through education and training. Each year, dozens of laws are proposed by legislators to improve the nation's business climate and promote economic growth.

Poor economic development will aggravate a nation's social problems including high unemployment, pushing people below poverty line and bring in pressures to raise taxes. An expanding economy means job opportunities for trained workers but also higher labour costs for businesses. Satesmen and political leaders favour economic growth because it creates increased national wealth apart from providing employment opportunities and income to the population. Figure 13.1 illustrates the complex nature of how economic policy works through its various constituents.

Every government, irrespective of the economic system it adopts or its political affiliations, pursues an economic policy that reflects the broad objectives it wants to realize for the benefit of its people. Economic policy is often very closely connected to social policy wherein matters such as social security and the improvement of social conditions are concerned. Though there are many objectives depending on the stage and degree of development of the economy and special circumstances in which the country has been placed, five are considered to be the most basic and fundamental. These are: (i) faster economic growth, (ii) reduction in inequalities of income and wealth, (iii) full employment, (iv) price stability, and (v) balance of payments equilibrium. Let us see in the following pages the meaning of these objectives and their implications to the economy.

OBJECTIVES OF ECONOMIC POLICIES

Every nation—be it capitalist, socialist or a mixed economy such as ours—has an economic policy that tries to address the basic problems an economy faces such as what to produce, how much to produce, how to distribute what has been produced and so on. A country's economic policy has certain major objectives discussed below.

  1. To achieve faster economic growth: Every country, be it developed or developing, will attempt to accelerate its economic growth. However, a developing country has a greater need to achieve fast-track growth to eliminate the poverty its people are suffering from. Economic growth refers to the steady process of increasing the productive capacity of the economy, hence, increasing the national income. Economists have been trying to find an answer to the question as to what constitutes the rate of economic growth. The general perception among economists of what makes for economic growth or the desiderata for it are: (a) the rate of growth of labour force; (b) the proportion of national income saved and invested; and (c) the rate of technological improvements effected, including the enhancement of the skillsets of workers and managerial efficiency. Every leader prefers faster economic growth for his country because of the underlying assumption that ceteris paribus, the greater the growth rates of the economy, the greater the material well being of the population. Faster economic growth will also mean more employment and a better standard of living for the people.
  2. To reduce inequalities of income and wealth: Inequality of incomes and wealth, as we have seen on the chapter on national income, arises mainly due to differences in the ownership of property, mostly inherited, and to a lesser degree the result of differences in earned income. Governments all over the world are trying to ensure that inequalities do not widen creating social and political tensions. Inequality of incomes has been reduced much by (i) steeply progressive death duties imposed on inherited wealth, and (ii) steeply progressive income tax from employment and still heavier tax on unearned income. Besides, to blunt the edge of inequalities of income that infuriates the poor, governments adopt a redistributive income policy of “robbing Peter to pay Paul”. Apart from income tax exemption, the poor receive many benefits from public authorities such as subsidized food and essential commodities from the public distribution system, scholarships, quotas and subsidies, old-age pensions and unemployment insurance, and so on.
  3. Full employment: The economy is said to be at full employment when everyone who is prepared to work at the existing level of wages for his type of labour finds employment. There is, at any point of time, a small amount of unemployment since it takes time to switch from one job to another. It is impossible for every job seeker to find a job in a fast-evolving dynamic economy which witnesses changes in demand and supply, the development of more efficient capital, an expanding national income and the creation of new wants. Thus, the full employment level of the GDP can be thought of as measuring full-capacity output—the largest output of which the economy is capable when all resources are employed to their feasible limits.

    Lord Beveridge, the erstwhile Director of the London School of Economics and an authority on unemployment-related issues, laid down three conditions for the maintenance of full employment in a country: (i) The demand should be adequate. If in case, private investment falls short of the quantum necessary to offer full employment, the state should step in with the necessary investment to make up for the deficiency. If necessary, the budget should deliberately be unbalanced to increase the volume of purchasing power in the hands of consumers. (ii) The location of industry must be regulated so that a greater variety of industry can be ensured, especially to those areas where industries are highly localized. (iii) Organized mobility of labour might be necessary so that men could move from declining to expanding industries more easily. (iv) The trade unions must adopt a responsible attitude to the new conditions, if full employment is to be permanently maintained, without causing serious inflation.1

  4. Price stability: Price stability is one of the important objectives of economic policy. Unstable prices such as inflation and deflation are likely to cause several socio-economic problems. If inflation that causes a continuous rise in prices is bad for people as it reduces their purchasing power, deflation is inexpedient. It also reflects certain fundamental weakness of the economy such as loss of production, employment and incomes. Price instability afflicts not only people within the country by adversely affecting trade, but also causes severe problems to importers of the country's products. If prices fluctuate too often and too much, importers will desist from buying goods from these countries; they will try to source products from elsewhere. Thus, price stability is important both for domestic consumers and those who import the country's products for their consumption.
  5. Balance of payments equilibrium: International trade and other financial transactions between countries make it necessary for them to make payments to one another. The balance of payments shows the relationship between one country's total payments to all other countries and its total receipts from them. Balance of payments is a tabulation of the credit and debit transactions of a country with foreign countries and international institutions, drawn up and published in a form similar to the income and expenditure accounts of companies. International trade is akin to barter. Imports must always be paid for by exports. If a country has for a long time an unfavourable balance of payment, it reflects badly on the economic strengths and fundamentals of the country. If a country is unable to export its products to pay for what it imported and consequently faces a continuous unfavourable balance of payments, it will have to either stop further imports or borrow from others to settle the payments or resort to some monetary measures such as deflation, devaluation, exchange depreciation and exchange control.

 

Figure 13.1 Economic Policy

 

Source: A. C. Fernando, Corporate Governance, Principles, Policies and Practices, New Delhi: Pearson Education, 2006.

 

The emphasis on any one of these objectives may change depending on the circumstances. At the same time, the government has to ensure that the one objective is not realized at the cost of others. For instance, if the government of a developing country wants to achieve faster economic growth, it may resort to deficit finance to fund its development projects and the central bank may adopt a cheap money policy to make credit easily available at a low rate of interest. These measures are likely to promote faster economic growth through accelerated investments. However, there is a time lag between the increased money supply through these measures and the increase in production of goods that can absorb excess liquidity in the system. As a result, prices will tend to rise. Thus, it is possible that the realization of one objective through economic policy (in this case faster economic growth through accelerated investment using deficit finance) is likely to jeopardize the other objective of price stability (because of rising prices). Therefore, it is important for the government to ensure that it follows a judicious policy of balancing the objectives.

The objectives of economic policy can be achieved through (i) monetary policy, (ii) fiscal policy, and (iii) physical or commercial policy, as illustrated in Fig. 13.1.

MONETARY POLICY

Monetary policy refers to the policy adopted by the monetary authority of a country with respect to the supply of money, the rate of interest and other matters. In other words, it is the process by which the government, central bank or monetary authority of a country controls (i) the supply of money, (ii) the availability of money, and (iii) the cost of money or the rate of interest in order to attain a set of objectives oriented towards the growth and stability of the economy.2 According to Todaro and Smith, monetary policy refers to the “activities of a central bank designed to influence financial variables such as money supply and interest rates”.3 It can be explained as that component of economic policy that regulates the level of money supply in the economy—with the view to achieving certain desired policy objective such as control of inflation, an improvement in the export earnings, realization of a certain level of employment, or growth in the country's GDP. A more detailed definition of monetary policy is the regulation of the money supply and interest rates by a central bank, such as the Reserve Bank of India with a view to controlling inflation and stabilizing the country's currency. Monetary policy and fiscal policy are the two policy instruments with the help of which the government can influence the functioning of the economy. By impacting the effective cost of money and credit, the central bank can influence the amount of money being spent by consumers and businesses.

Monetary policy is based on the assumption that money in a modern complex economic system, wherein savings and investment are carried out by different groups of people, performs a dynamic function, apart from serving as a medium of exchange. In such a scheme of things, money becomes capable of influencing the size of the national income, the level of employment, the demand for consumers' and producers' goods and, therefore, the volume of both savings and investment. Monetary policy, hence, is used to vary the supply of money and also to effect changes in its liquidity. Viewed in a broader and extended perspective, monetary policy deals with: “(i) the control of financial institutions; (ii) active purchases and sales of paper assets by the monetary authority as a deliberate attempt to affect changes in monetary conditions; and (iii) passive purchases and sales of paper assets resulting from the maintenance of a particular interest structure, the stability of security prices, or meeting other obligations and commitments.”4

Monetary policy is referred to as expansionary when it increases the total supply of money in the economy. It is traditionally used to combat unemployment during recession by lowering interest rates. On the other hand, a contractionary policy decreases the total money supply by raising interest rates to combat inflation. Monetary policies are described as accommodative if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.5 While explaining different contexts of monetary policy, terms such as dear money and cheap money are used. Dear money refers to the period when bank rate and other rates of interest are high so that borrowing is expensive. On the other hand, cheap money refers to a situation where bank rate and other rates are low so that the cost and availability of credit is cheap. Dear money is used to combat inflation while cheap money is used to stimulate recovery of an economy which is recession-set.

Evolution

Monetary policy, which is generally seen as an executive action, has evolved over centuries. Historically, it can be traced to the establishment of the Bank of England in 1694, which as a central bank, was clothed with the powers to issue notes and back them with gold. Along with the Bank of England, the concept of monetary policy as an executive decision of the central bank came to be established. From then on till the twentieth century, monetary policy was concerned with (a) decisions about seigniorage (the power to mint coins) and (b) decisions to print paper money with a view to creating credit. Thereafter, central banks which were established by industrialized countries issued and maintained their currencies based on gold standard, fixed interest rates both for their own borrowers and their fellow bankers who required liquidity.

The period 1870–1920 witnessed creation of more central banks, with one of the last to be established being the Federal Reserve of the United States in 1913. Around this time, economists and bankers understood the impact of interest rates on the entire economy and their links to business cycles. Some empirical studies also demonstrated that central banks' expansionary and contractionary policies were instrumental in causing economic cycles. Thus, these days monetary decisions of central banks take into account a wider range of factors affecting interest rates, exchange rates, credit quality, velocity of money, bonds and equities, savings, capital flows, financial derivatives and the like.

In the 1980s, economists began to canvas for independence of central banks from the pale of executives as the best way to ensure optimal monetary policy and almost all central banks became autonomous and followed an independent policy.

Goals and Objectives

The basic goals of the monetary policy have been identified as maximum feasible output, high rate of growth providing more employment, price stability, greater equity in the distribution of income and wealth and favourable balance of payments. The ideal policy, which the monetary authority should follow, is the policy of long-run neutral money which involves maximum feasible output and price stability in the long run. This monetary policy serves all the policy goals in the best possible manner.

From the above, we can deduce that the following form the objectives of monetary policy: (i) safeguarding the country's gold and forex reserves; (ii) price stability; (iii) foreign exchange stability; (iv) managing cyclical fluctuations and adopting suitable stabilization measures; (v) ensuring full employment; (vi) ensuring balance of payments equilibrium (to the maximum possible extent); and (vii) accelerating economic growth (primarily in developing economies). Of all these objectives, the choice and implementation of a particular one at any given time will depend on the specific economic situation and the issues and problems to be addressed.

Functions

Several economists have attempted to define clearly the functions of monetary policy. Most of them would concur that the functions of the monetary policy would be to ensure: (i) a most suitable interest structure; (ii) a correct balance between the demand and supply of money; (iii) the provision of adequate credit facilities for a growing economy, while preventing undue expansion that may cause inflation, and overseeing the channelling of credit to users as per pre-planned investment decisions; (iv) the establishment, functioning and growth of financial institutions of the economy; and (v) proper management of public debts.

Monetary Versus Fiscal Policy

Monetary and fiscal policies are the two important tools of a country's macroeconomic policy. Though these are complementary policies with one common objective—full employment, the method of each is different. Monetary policy aims to attain full employment by offering credit at an affordable cost. Fiscal policy tries to achieve it through fiscal incentives, subsidies and the like. In an economy characterized by falling prices and unemployment, increased public expenditure and increased taxation leads to a higher demand for goods and services that favourably impacts prices, production and employment. With a view to supporting the fiscal policy of compensatory spending during depression, monetary policy should maintain a low bank rate so as to have a cheap money policy. This will prompt private entrepreneurs to borrow and invest. To that extent, it will help the government reduce its debt burden. The following are the differences between these two policies:

  1. The objective of monetary policy is to maintain price stability, full employment and economic growth. On the other hand, the objective of fiscal policy is to change aggregate demand, to control inflation and overcome recession.
  2. The monetary policy regulates money supply and the cost and availability of credit. It also influences lending and borrowing rates of commercial banks. The fiscal policy, on the other hand, causes a deliberate change in government revenue and expenditure with a view to influencing the price level and the quantum of national output.
  3. Both monetary and fiscal policies are instruments that are available to different arms of the government. Though both are formulated and implemented by the same government, they are done by different departments—monetary policy through the central bank and fiscal policy through the treasury or the ministry of finance.

    In India, it is the responsibility of the Reserve Bank of India (RBI) to formulate and implement the country's monetary policy. It is empowered to increase or decrease the supply of money and credit, alter interest rates, carry out open market operations, control credit and change reserve ratios. The ministry of finance of the central government formulates fiscal policy and overseas its execution. At the time of recession, the government can increase expenditures or cut taxes or resort to both to enhance demand. On the other hand, during periods of inflation, the government can reduce its expenditures or raise taxes.

  4. The monetary policy is the policy statement announced twice a year by the RBI along with an economic overview and future forecasts. The fiscal policy is showcased by the union budget announced on the last day of February every year, preceded by an economic survey.

The Instruments of Monetary Policy

The monetary authority uses various tools to control the supply of money. These are known as instruments of credit control. These instruments can be divided into two categories—quantitative and qualitative credit controls. There are three main methods of quantitative credit control—bank rate policy, open market operation and changes in statutory reserve requirements. These methods are used to control the quantum of credit on the whole. The qualitative methods of credit control are also known as selective credit control methods. These include credit rationing, direct action, changes in margin requirements, moral suasion, etc.

Traditional Credit Control Measures

The following are the traditional credit control measures, also known as quantitative control measures that have been used by central banks all over the world to control the supply of both money and credit:

  1. Bank rate policy: Bank rate policy is the oldest and subtle method of credit control that operates through changes in bank rate made by the central bank. Bank rate is defined as the official minimum rate at which the central bank rediscounts approved bills of exchange. It is the rate at which the central bank is ready to buy or rediscount eligible bills of exchange and other commercial papers. The RBI gives a large proportion of its advances to commercial banks against government securities and as refinance. When the central bank raises the bank rate, the obtaining of fund from the central bank becomes costlier for commercial banks. As a result, other interest rates rise in response and borrowing becomes costlier which may result in contraction of credit. It is through the dear rediscount policy that the central bank restricts credit creation by commercial banks and the money supply in the economy. The reverse happens when the bank rate is lowered during the period of depression. In recent years, its importance has declined because the RBI provides adequate liquidity through reserve repo rates, changes in the credit structure and the use of direct and more effective credit control measures.
  2. Open-market operations: Open-market operation is a primary tool of monetary policy which calls for managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation. The open-market operations refer to the purchase and sale of government securities and other approved securities by the central bank. An open-market sale decreases the money supply and a purchase increases the money supply. The RBI, which is our central bank, transacts both with the public and other banks. During the boom, the RBI sells the government and other approved securities from its portfolio in the open market in order to reduce the aggregate supply of money in the economy. The reverse happens when there is a slump. However, the open-market operations policy has not proved to be a very effective policy of monetary control in India.
  3. Cash reserve requirement: It refers to that portion of banks' total cash reserves which they are statutorily required to hold with the RBI. The remaining portion of the total cash reserves of the banks refers to excess reserves which banks keep themselves to facilitate their normal functioning. An increase in the legal cash reserves ratio decreases the banks' and their optimum credit creating capacity. The reverse is true when the RBI increases the statutory cash reserves ratio.
  4. Statutory liquidity ratio:  Commercial banks in India are required to maintain a particular level of liquidity. The main role of the statutory liquidity ratio is to allocate bank credit between government and commercial sectors. This instrument is also used to control the supply of money. Commercial banks are statutorily required to hold a proportion of their total demand and time liabilities in the form of excess reserves, investment in unencumbered government and other approved securities and current account balances with other banks.

Selective Credit Control Measures

The qualitative or selective credit controls can be easily distinguished from the traditional or quantitative methods of monetary management in as much as they are directed towards particular uses of credit and not merely to total volume outstanding. The selective credit control measures are very popular in developing countries like India. These controls are exercised through official regulations. Section 21 of the Banking Regulation Act 1949 empowers the RBI to issue directives to banks with regard to advances. These directives may be with regard to (a) the purpose for which banks may or may not give advances; (b) the margins to be maintained with regard to secured advances; (c) the maximum amount of advance to any particular borrower; (d) the rate of interest and other terms and conditions for granting advances; and (e) the maximum amount up to which guarantees may be given by the bank. The RBI has made full use of its powers to control speculation and check inflation, especially of some selected commodities that are in common use. For instance, in 1964–65, the RBI announced minimum margins to be kept by commercial banks with regard to their advances against all food grains, oil seeds, vegetable oils, etc.; the objective being to restrain banks from extending excessive loans against these goods which were then in short supply as compared to the demand. From January 1970, RBI had mandated that all nationalized banks need to get its prior approval for investing in debentures and shares of a public limited company exceeding INR 100,000. The central bank also uses many other selective credit controls on nationalized banks in the matter of their credit operations. The RBI uses the following three kinds of selective credit control measures: (a) fixing minimum margins for lending against particular type of securities; (b) imposing a ceiling on the quantum of credit for specific purposes; and (c) charging discriminatory rate of interest on particular types of advances. However, the RBI ensured that credit to export-oriented activities is not adversely affected while credit for purposes of hoarding and speculation is curtailed severely.

Monetary Policy in Developing Countries

The effectiveness of a country's monetary policy assumes the existence of well-developed monetary, banking and financial institutions, the required infrastructure in terms of money and capital market, commercial products and so on. If these facilities are either absent or underdeveloped, the administration of monetary policy may be unsuccessful. Thus, developing countries face problems in establishing an effective operating monetary policy. This is because: (i) they do not have well-developed markets in government debt; (ii) there are difficulties in these countries in forecasting money demand so as to adopt a suitable monetary policy; (iii) the central banks in these countries do not enjoy adequate degree of independence and as such monetary policy takes a backseat while non-monetary policies with social or political goals assume greater importance; (iv) there are many other deficiencies such as lack of development of banking facilities and savings institutions, lack of integration of agricultural and industrial credit, underdeveloped money market and lack of currency reforms; (v) money and capital markets are underdeveloped—“highly unorganized, often externally dependent, and spatially fragmented”6. In India, for instance, there is a dichotomy in money market, with the unorganized sector being a major player and not being under the control of the RBI. These factors seriously limit the ability of the government to control monetary variables; and (vi) there is contradiction in objectives which often make it difficult to decide which objective should be pursued by monetary authorities. For instance, in developing countries including India, compulsions of economic growth require that the price level rises continuously with a view to maintaining the inducement to invest. But then the mild inflationary trends tend to go out of control on occasions and there arises an inflationary spiral causing suffering to the poor and fixed income groups. In such a situation, price stability becomes a casualty of economic growth; and (vii) the negative role played by financial intermediaries such as savings and loan associations, mutual savings banks, development banks, insurance companies and pension funds. The role of these financial intermediaries has been increasing over time which indirectly tends to affect money supply. While the RBI can control money supply created through commercial banks, it has little or no control over what the financial intermediaries do. For instance, if the central bank follows a tight money policy to control inflation by mopping up the excess liquidity in the banking system, financial intermediaries can frustrate its attempt by increasing the velocity of money through attracting idle funds, converting them into active balances as they lend them out for mortgages and higher yielding assets. By doing so, they push up the velocity of money and defeat the very purpose of central bank's contractionary monetary policy; and (viii) there are lags in the monetary policy. It is found that there is a considerable time lag between the time the central bank finds the need for a particular type (expansionary or contractionary) of monetary policy and the time at which the attempted policy can really impact the economy by altering aggregate demand. The problem of managing the lags is crucial for the proper conduct of the monetary policy. For example, “if the monetary authorities prescribe a particular policy for solving the problems of recession in the economy, but due to lag, the policy becomes effective only after a year at a time when the economy has already recovered, the economic situation will worsen as an inappropriate policy is in force.”7

THE INDIAN MONETARY POLICY

The monetary policy of India—a developing economy—has focused on accelerating economic development, while maintaining price and financial stability. RBI has been adopting a monetary policy that aims at controlled monetary expansion whose twin objectives are (a) to ensure that there is no paucity of funds for all legitimate economic activities and (b) the availability of funds is not excessive to cause inflation. This implies that while there is expansion in the supply of money, there is restraint on the secondary expansion of credit.

With regard to the expansion of money supply, it has to expand it to the extent that it more than matches the growth in national income. This is because of two factors: (a) with the growth in incomes, the demand for money to be set aside as savings tends to go up; and (b) with the sizeable growth in the economy, there is a gradual reduction in non-monetized sector that augments money supply. With regard to the restraint on the secondary expansion of credit, financing part of the investment outlay of the government through budgetary deficit causes monetary expansion. In such a situation, there is an imperative need to curtail the secondary expansion of credit, while allowing flow of credit to the manufacturing and trade activities of the private sector. Therefore, an appropriate monetary policy should choose correct instruments to regulate credit and address issues of effective credit planning.

Instruments of the Indian Monetary Policy

Quantitative Credit Control Methods

For properly regulating the cost and quality of credit, the RBI is empowered to use the traditional or quantitative credit control measures such as the bank rate and open market operations. For regulating the use of bank credit, the country's central bank uses the qualitative or selective credit control measures. The selective credit controls are used by the RBI to regulate bank advances mainly against food grains, raw materials such as sugar or groundnut, occasionally against cotton textiles and in recent times against raw jute and jute products. “These measures have been useful in restraining excessive stockpiling of the commodities concerned, though their success is largely due to the fact of their being used in conjunction with measures of general credit control.”8 However, these measures cannot be used in advance of credit expansion, but only after it has been done by banks and thus its success is limited to a great extent.

With regard to quantitative credit controls, the RBI uses the bank rate to buy or rediscount bills of exchange or other commercial papers eligible for purchase under the RBI Act. However, for all practical purposes, the bank rate is considered as the rate at which the central bank offers advances to commercial banks. Under open market operations (OMO), the RBI has been mostly selling government securities to bridge the gap in the budgetary operations. However, the market for these securities is limited, and this weapon of OMO is becoming more and more like the RBI playing second fiddle to the government's debt management. In India, the bank rate, though a prime instrument of monetary policy, has been used sparingly. The RBI has been using the quantitative weapons as instruments to influence interest rates that continue to be the major force of monetary policy in the country. An increase in interest rates has important direct and indirect effects on both lenders and borrowers apart from movements to and for the country.

Varying reserve requirements is yet another quantitative credit control instrument the RBI uses to regulate expansion of bank credit. The central bank of a country enjoys the statutory right to determine the cash requirements of commercial banks. Under this policy, the RBI requires commercial banks to maintain a stipulated percentage of their deposits as reserves. This is one of the traditional instruments through which the country's central bank can regulate the money supply by changing the reserve requirement. An increase in reserve requirement will mean that banks will be required to hold more resources to support the existing deposits, thereby reducing the loanable funds with them. This leads to a reduction in credit. This instrument is ideal as a temporary measure to control high liquidity situations.

The RBI has used this instrument of credit control whenever there has been inflationary situation. The central bank influences the power of credit creation by commercial banks through (i) cash reserve ratio (CRR) and (ii) statutory liquidity ratio (SLR). The CRR is that portion of total deposits of a bank which it has to keep as cash reserves with the RBI. The RBI has been using this instrument quite liberally. The ceiling provided for CRR in the Reserve Bank Act is 15 per cent. The CRR on external deposits has also often been changed in recent years.

The SLR refers to that portion of total deposits of a commercial bank which it has to keep with itself in the form of cash reserves. SLR supplements CRR and is so devised with a view to preventing commercial banks from circumventing the impact of CRR by encashing their government security holdings. The major stock of statutory liquid assets include cash in hand, reserves with the RBI, government securities and approved securities of Industrial Financial Corporation of India (IFCI), The National Bank for Agriculture and Rural Development (NABARD), Industrial Development Bank of India (IDBI) and those of state electricity boards and road transport undertakings. The SLR has been used by the RBI quite often in recent times. It hit a ceiling of 38.5 per cent on 23 March, 1990. After the recommendation of the Narasimham Committee to reduce SLR to a reasonable level, it was brought down to 25 per cent on both demand and time liabilities. The reduction in SLR is in line with the avowed policy of the government to reduce the fiscal deficit so as to prevent the central government borrowing from commercial banks and to enable them extend credit to agriculture, industry, and more importantly to continue the thrust of financial sector reforms. Presently, there is a demand for abolition of SLR altogether.

Qualitative Credit Control Methods

The methods of credit control discussed above are the quantitative credit control methods. The selective credit controls are used to regulate credit for specific purposes. These controls operate on the distribution of total credit by encouraging the flow of credit into certain sectors and discouraging its flow into certain other sectors of economy. The important selective credit controls include credit rationing, direction against the erring banks, changes in margin requirements, differential rate of interest and moral suasion.

  1. Consumer credit regulation: This form of selective control was practised in several countries including India. Under this system, whenever there is inflationary pressure in the economy, commercial banks are advised to regulate terms and conditions of credit extended to consumers for purchase of vehicles, costly electronic goods, etc. so that people do not add to inflation by spending on these non-essential items. The RBI can limit the amount of credit for the purchase of any listed article as well as prescribe the time limit for repayment. The curb on credit is removed during recessionary periods to encourage consumer spending.
  2. Direct action: It may be initiated by the RBI against erring commercial banks and other financial institutions. The direct action may be a set of coercive measures such as denial of discounting facility, charging penal rates of interest and fixing of quantitative credit ceiling.
  3. Altering margin requirements: This kind of selective credit control is used to curb speculative activities. For instance, the RBI has the power to raise margin requirements of those essential goods hoarded by wholesalers. If ordinarily the margin requirement is 40 per cent, the wholesaler can get 60 per cent loan against the pledged goods. But if the margin is raised to 50 per cent by the RBI, he can get only 50 per cent of the value of furnished goods.
  4. Moral suasion: This is another selective credit control measure used by the central bank. The RBI, which is said to be the Brahma, Vishnu and Siva by virtue of its powers to license opening of a bank, to audit its accounts and maintain it in good shape and order its closure when it goes astray, uses its moral authority to exhort banks to fall in line voluntarily with its directives. In a market driven economy, it is moral suasion rather than formal monetary control that prompt financial institutions to follow appropriate directions from the central bank.
  5. Rationing of consumer credit: This is a selective credit control measure through which the RBI can regulate the purpose for which commercial banks extend credit. RBI may fix the maximum amount of loans provided by a bank. This measure, known as variable portfolio ceiling, ensures that financial resources are diverted into channels specified by the planning commission.
  6. Control through directives: The RBI, as the central monetary authority, is empowered to issue directives to commercial banks with particular reference to their lending policies affecting the purpose of loans, the margin required to be maintained, etc.; the RBI can also issue a blanket level moratorium against entering into any specific unwarranted transaction.
  7. Differential rate of interest: This is one of the selective credit control instruments practised in India. Under this method, certain sections of people such as poor vendors, marginalized sections of people and such of those who the public authorities wish to uplift may be offered loans at rates of interests that are lower than prevailing market rates.

Credit Authorization Scheme

Credit authorization scheme (CAS) is yet another scheme of selective credit control introduced by the RBI in November 1965 under which commercial banks had to seek the sanction of the RBI before extending credit exceeding INR 60 million by April 1980 for both public sector and private sector borrowers. However, the scheme was gradually softened in July 1987 to permit greater access to credit to meet the genuine demands in production sectors without clearance from the RBI.

In view of the liberalization and deregulation policy of the government, the RBI abolished CAS in October 1988.

Credit Monitoring Arrangement

The RBI did not loosen all its controls on commercial banks even after 1988. The RBI under the credit monitoring arrangement (CMA) still monitors and scrutinizes all sanctions of bank loans if they exceeded (i) INR 50 million to any single party for working capital requirement, and (ii) INR 20 million in the case of term loans. In recent years, the RBI has been using selective credit controls to achieve its objective of controlling credit. RBI has been using this instrument off and on as a credit squeeze to combat inflation, and banks by and large have been complying with the central bank's directives. According to RBI, “the success of these controls is to be judged in a limited sphere, viz. their impact on the pressure of demand originating from bank credit in this sense, the measures should be deemed successful, but for their operation, it is likely that the price situation might have been somewhat worse.”9

Case 13.1 Reserve Bank's Control over Investment Decisions of Commercial Banks

The RBI has refused to relax the ceiling it has imposed on banks looking to invest in their insurance joint ventures by disallowing the Jammu & Kashmir Bank from putting more money in MetLife India. Insurance is a cash guzzler, and the RBI move is intended to discourage banks from spending more capital on the insurance joint ventures they have promoted. According to existing guidelines, banks can invest only up to 10 per cent of their net worth in such insurance joint ventures. The regulations, made in 2000, also stipulate that the total amount invested by a bank in all its subsidiaries and joint ventures, in which it has equity participation, should not exceed 20 per cent of its net worth. The RBI decision will have implications on life insurers such as ING Vysya Life, ICICI Prudential Life and Kotak Mahindra Life, which have banks as their promoters. There are several other state-owned, bank-sponsored insurance companies which have come up last year. But these ventures are a long way from hitting the 10 per cent ceiling.

When RBI had issued the guidelines, the limit was not seen as stringent since most insurance companies began with a start-up capital of INR 1000 million. Following rapid growth in the past three years until the financial crisis in October, most promoters had increased investments in their life companies beyond INR 10,000 million. When asked if RBI had denied permission to J&K Bank to increase stake in MetLife India, a bank spokesman said they were not looking to hike stake. “We are interested in maintaining our stake. The current regulations allow us to invest up to 10 per cent of our net worth. We are at that level.” he said.

MetLife India managing director Rajesh Relan said, “MetLife India is a well-capitalized company with strong shareholders, who have made timely capital contributions. We are not in the know of any such constraints and any comment in this regard would be merely reacting to a speculation.” J&K Bank originally held 25 per cent in the multi-party joint venture, where the promoter was Shapoorji Palonji, and MetLife held 26 per cent, the maximum allowed to any foreign insurer. In the financial year 2009, MetLife India expanded rapidly, resulting in the J&K Bank's stake coming down.

 

Sources: Mayur Shetty, “J&K Bank's MetLife plan hits block”, The Economic Times, 4 May, 2009.

The Evaluation of the Indian Monetary Policy

Monetary policy in India is being operated mainly with the objective of ensuring a reasonable degree of price stability consistent with the goals of economic growth. Towards this end, the RBI has been pursuing the policy of “controlled monetary expansion”, in its own words. Even while the central bank initiated steps to expand bank credit to meet the needs of trade and industry so as to help the process of economic growth, it was using credit control instruments to ensure that loans and advances extended by commercial banks do not feed hoarding and speculation.

However, it is to be admitted that the monetary policy has failed mainly on the price front. It may be correct to say as it was said in the context of cooperatives that it is not monetary policy (as an instrument of credit) that has failed India, but it is India that has failed monetary policy. This is because of the inherent weaknesses the country's banking and financial systems possess. The following are the weaknesses:

  1. Non-banking credit higher than bank credit: The RBI has limited impact on credit controls because the bank credit available in the economy is much smaller than credit offered by non-banking institutions and agencies. Besides, banks have access to non-deposit resources such as the call-money market over which the RBI does not have much control.
  2. High liquidity in currency: Being a developing country with poor banking habits of people, a large part of the money stock is held in the form of currency. Payments in advanced countries are made by cheques and credit cards and rarely in cash whereas in India ordinary commercial settlements are mostly made in cash. The RBI controls credit by fixing terms and conditions for deposits and other monetary instruments held by the banks. With currency being a major component of commercial activities, this is beyond the reach of the RBI.
  3. Rigidity in policy: RBI's credit policy that is being pursued in recent years is quite rigid and lacks flexibility. Past experience and not one based on the assessment of the current situation drives monetary policy. Thus, the monetary policy lacks the wherewithal to address the issues that develop during the current stage of economic growth and therefore fails to address them directly and achieve any measure of success.
  4. Problems brought by liberalization: Post-liberalization, it has become difficult to put in place an effective monetary policy because of (a) ever-increasing foreign direct investment in the aftermath of economic liberalization and globalization; (b) greater freedom enjoyed by commercial banks in a growing economy; (c) entry of foreign banks with rapid technological innovations in products and processes such as use of credit cards, ATMs, etc. all of which have caused increased money supply; and (d) more liberal credit policy and increasing consumerism have been diverting money towards unproductive uses.
  5. Impact of government's policy of inclusive growth: In a developing country with steep unequal distribution of income and wealth, the policy of government to promote inclusive growth has to be supported by the central bank. For instance, there is a section of hitherto neglected people consisting of small farmers and artisans in rural areas who have to be exempted from excessive credit curbs. This makes the task of monetary policy more difficult.
  6. Deficiency in the monitoring system: The RBI's monitoring system, like those of other market regulators, is weak and unscientific. It lacks alert, adequate and qualified investigators and other professionals. It also lacks proper statistical system to support follow-up action. Often, the RBI's monitoring system functions like an extended arm of the government, lethargic, bureaucratic and lacking in focus.
  7. Ever rising fiscal needs of the economy: If the monetary authority has to be successful in the management of credit, it will have to enjoy real autonomy, independence and a certain degree of control over the creation of reserve money. However, this is not the case in India. With government finances coming under great pressure in recent years due to compulsions of development and election-oriented populist measures, there is an increasing monetization of the budget deficit, making it difficult for the RBI to rein in any discipline in monetary policy and management.
  8. Lack of autonomy in money management: Though in theory, the RBI is an autonomous central bank, in reality it is not so. There is too much of interference from the finance ministry. As pointed out by Sukhmoy Chakravarty committee's report, there is a considerable mismatch between the responsibilities of the RBI to monitor and regulate the country's monetary system and the moral authority it has to do so. It is a most essential and imperative need in the contexts of sweeping changes in the financial world of increasing globalization that the RBI is given undisputed and unquestioned authority as an independent professional institution to regulate and monitor the monetary system without fear or favour.
FISCAL POLICY

Fiscal policy refers to that part of a government's overall economic policy that deals with the use of taxation through the budget as an adjunct to monetary policy. It is concerned with raising government's income through taxes, direct and indirect, commercial and administrative revenues, and deciding the level and pattern of expenditure. The government can control the level of demand in the economy by creating budgetary surpluses and other means. Looked at differently, it can be referred to as “a macroeconomic policy tool used by the government to regulate the total level of economic activity within a nation. Examples of fiscal policy include setting the level of government expenditures and the level of taxation.”10 It can also be explained as a set of “federal government policies with respect to taxes, spending and debt management, intended to promote the nation's macroeconomic goals, particularly with respect to employment, gross national product, price level stability and equilibrium in balance of payments”.11

Objectives

The Great Depression of 1930s gave birth to fiscal policy under Keynes' influence. Changes in government expenditure and revenue programmes that aim at the short-run goals of full employment and economic stability are called fiscal policy. Usually, the government expenditure programmes are expansionary in effect and revenue or taxation is contractionary in effect. The net effect of the combined revenue-expenditure programme is likely to be expansionary because of the operation of the multiplier effect. The government manipulates its expenditure and taxation programmes in such a way that full employment as well as price stability can be attained. The name fiscal policy is given to such deliberate adjustments in revenue and expenditure policies.

The following are the major objectives of fiscal policy:

Attain Full Employment

The attainment of full employment is regarded as the primary objective of fiscal policy. However, in the true sense of the term, full employment is not attainable. Thus, a situation of full employment is an ideal situation in which there is no significant number of factor units continuously not employed for a considerable length of time. It is to be noted that the reduction or elimination of unemployment enables a country to promote the welfare of the largest number of people. In the case of developing countries, this objective of fiscal policy is very important. Fiscal policy in these countries should aim at increasing employment and lowering underemployment. Since population grows rapidly, economic growth is possible only if the rate of increase in employment opportunities and, hence, in income is much higher than the growth rate in population. Fiscal policy should be used therefore to build socio-economic overheads, to undertake for the benefit of the rural poor, local labour-intensive public works and encourage private enterprise by offering grants, concessions, subsidies, tax holidays, cheap loans and the like. All these measures will help to realize the employment objective of fiscal policy.

Case 13.2 RBI Fines Bank of Rajasthan

The Reserve Bank of India imposed a monetary penalty of INR 2.5 million on Bank of Rajasthan, said a press release issued on Thursday.

The penalty has been levied for violation of the RBI's directions with regard to acquisition of immovable properties; deletion of records in the bank's IT systems; non-adherence to ‘Know Your Customer' and anti-monetary laundering guidelines in the opening and conduct of some accounts; irregularities in the conduct of accounts of a corporate group and failure to provide certain documents sought by the RBI and misrepresenting that such documents were not available.

The RBI had issued a show-cause notice to the bank, in response to which the bank submitted a written reply. Based on the reply, the RBI came to the conclusion that the violation was substantiated and warranted imposition of penalty, said the release.

 

Sources:: Bureau, “RBI fines Bank of Rajasthan,” The Hindu Business Line, 25 February, 2010.

Increase Rate of Investment

Fiscal policy is often used as an effective instrument to promote and accelerate the rate of investment both in the private sector and public sector. This can be done by reducing consumption, both actual and potential, and by increasing the incremental saving ratio.

Economists suggest the following measures to augment the incremental saving ratio in a developing economy: (i) enhancing the prevalent rate of taxes; (ii) imposing new and productive taxes; (iii) creating surplus from public enterprises; (iv) public borrowing; (v) resorting to deficit financing while ensuring it does not lead to inflationary pressure; (vi) direct physical controls; and (vii) seeking and obtaining external assistance to supplement domestic savings which may be inadequate to fund huge development expenditure. Of course, of all these investments taxation as a sort of forced savings is the most potent instrument of promoting investment.

Stabilize the General Price Level

Another short-run goal of fiscal policy is the stability of the general price level. Fluctuations in the price level may upset all mathematics of economic calculation. For instance, a sharp fall in the general price level dampens the possibility of attaining full employment. Similarly, a high rate of price inflation has also adverse effects on the economy. In view of this, a stable general price level has been accepted as an important objective of fiscal policy.

Progressive direct taxes supplemented by appropriate indirect taxes are effective fiscal measures for counteracting inflationary pressures in the economy. These taxes, if properly administered, will siphon off excess liquidity in the system.

In this connection, one must take note of the possible conflict of the two aspects of economic stability. According to Keynes, fiscal policy (i.e., decrease in tax rates and increase in government expenditure) boosts aggregate demand until full employment is reached without any danger of inflation. Similarly, by lowering aggregate demand via fiscal policy, a rise in price level can be avoided when demand threatens to exceed the full employment output. Thus, in the Keynesian framework, price stability and full employment can be achieved simultaneously. But, post-Keynesians have shown that there are cases of conflict between price stability and full employment. A. W. Phillips in the late 1950s had shown that these two stability requirements cannot be achieved simultaneously, and the government has to take a policy decision whether to pursue one or the other or a suitable combination of the two.

Promote Economic Growth with Equity

With the development of the Harrod-Domar growth model, which is a logical extension of Keynesian economics, fiscal policy has shifted its emphasis on economic growth, i.e. an annual rate of increase in the total output. This objective has assumed an increasing importance in less developed countries than in mature economies. In a developing economy like ours where monetary policy alone does not deliver good results due to the lack of growth in money and capital markets, fiscal policy can be used as an adjunct to monetary policy in accelerating the rate of capital formation. Moreover, fiscal policy plays a significant role in planning for economic growth. Under planning, a physical plan has to match a financial plan. “The implementation of the financial plan and the achievement of balances in real and money terms obviously will have to rely largely on fiscal measures.”12 Attainment of a higher growth rate requires: (i) improvement in levels of education and technical and organizational skills and (ii) higher rate of capital accumulation. Without government backing and patronage, the possibility of rising capital formation is difficult. So, government must play an active role in promoting growth.

Mobilize Resources and Redistribute Income

In the context of growth with equity, the two other important goals of fiscal policy are: (i) resource mobilization and (ii) income redistribution to reduce income inequalities or to ensure social justice. Economic development requires the transfer of funds from savers to the government for the financing of various government activities. The primary instrument of resource mobilization for purposes of development is, of course, taxation which involuntarily curtails consumption. Another instrument is public borrowing. Fiscal policy should not only aim at mobilization of resources but also aim at allocation of resources in the socially desired lines or in accordance with plan priorities. In order to strike a higher growth rate, the fiscal policy should aim at attaining a socially optimum pattern of investment.

The role of fiscal policy as an important fiscal measure to increase national income and redistribute it in a manner so as to bring down the wide disparities in income and wealth between different sections of society can hardly be exaggerated. Extreme inequalities in income and wealth can cause social disparities, lead to political and economic instability and act as a roadblock to economic growth.

The government can redistribute income and wealth of the masses by increasing their real incomes and reducing higher income levels. By large investments in socio-economic overheads, the volume of output, employment and real income of the poor can be raised. By resorting to progressive and wide range of taxation that would cover income, wealth, estates and expenditure, it may be possible to reduce the high levels of income of the rich and wealthy.

Reduce Inequalities in Income and Wealth

Finally, fiscal policy has the objective of reducing income and wealth inequalities. By manipulating various types of taxes and expenditures, the government may help uplift the poor. This explains why the Taxation Inquiry Commission, appointed by the Government of India, in its report in 1953–54 had made the following comment: “The demand that the instrument of taxation should be used as a means of bringing about a redistribution of income more in consonance with social justice cannot be kept in abeyance.”13

We can sum up the role of fiscal policy by referring to its main objectives thus: (i) attainment of full employment; (ii) increasing the rate of investment; (iii) achieving of the rate and pattern of growth of national income and, hence, economic development in accordance with the country's objectives and priorities; (iv) mobilization of resources and their efficient and rational allocation for economic development; (v) reasonable price level stability; and (vi) reduction of inequalities.

Instruments

Fiscal policy endeavours to achieve its objectives through the use of three instruments in its armoury—taxation, public expenditure and public debt management.

Taxation

The main instruments of tax policy of the Government of India through which the objectives of resource mobilization and income redistribution are sought to be achieved are various types of direct and indirect taxes. The tax system can also be used to encourage or restrict private expenditure on consumption and investment

Taxes tend to fall into two categories: direct and indirect. Direct taxes are levied directly on an individual's income or wealth whereas indirect taxes are levied on consumers' expenditure or outlay. Major Indian direct taxes are personal income tax and corporation tax, and major Indian indirect taxes are excise duties and customs duties. Payment of direct taxes is compulsory even though there is no quid pro quo, while it is not so with the indirect taxes. In the case of direct tax, the impact and incidence of the tax is on the same person while in indirect tax, the impact may be on the manufacturer and the incidence is on the ultimate consumer.

  1. Direct taxation: Examples of direct taxation include income tax, corporation tax (on companies' profits), capital gains tax (a tax on the profits of sales of certain assets), wealth tax (imposed by certain countries, which is a tax on ownership of property or wealth) and a capital transfer tax (a tax on gifts to replace death duties). Direct taxes are mainly collected by the central government.
  2. Indirect taxation: Examples of indirect taxation include customs duties, motor vehicle tax, excise duty, octroi and sales tax. Indirect taxes are collected by both the central and state governments, but mainly by the central government.

In a good tax system, there should be a proper balance between direct and indirect taxes. The revenue will be optimum and loss of incentives minimum.

Non-tax revenue is derived from the following sources: (i) fiscal and other services, (ii) interest receipt, (in) profits and dividends of public sector enterprises and (iv) general services.

Public Expenditure

Expenditure by the government may take various forms. It may be normal government expenditure on defence, police and public administration; planned development including expenditure on roads, parks etc; and expenditure on relief works, subsidies of various kinds, etc. while taxes reduce the income of the general public by transferring their income to the government, public expenditure transfers income from the government to the general public.

Public Debt Management

Government borrowing and public debt influence the volume of liquid assets with the public. For instance, when the general public subscribes to a public loan programme of the government, their liquid funds are transferred to it. When government repays the loan, funds are transferred to the general public.

Public borrowing is an effective anti-inflationary measure for mopping up surplus liquidity with the public. It is better than taxation as it does not adversely affect incentives to save and invest. Besides, the lure of interest offered provides an additional incentive. A good public borrowing programme can be a useful tool of economic growth by diverting resources from unproductive areas such as investing money in real estates, costly jewellery, gold and diamond to productive channels. Government may use this measure to fund specific development projects such as building railways, power generation and irrigation projects.

However, public borrowing in poor countries is limited in scope due to low income, low savings and the high propensity to consume of the vast majority of poor people, apart from the existence of less developed and organized money and capital markets. In such instances of poor mobilization from voluntary savings from the masses, government may resort to compulsory borrowing to augment capital formation. In the words of R. Nurkse, “Since individuals are interested not only in their consumption, but also in the size of their asset holdings, there is a case for forced loans as an alternative to taxation. They may be little more than tax receipts and yet make a difference to the incentive to work and to produce as was found during the war period when the unspendable cash reserves accumulated as a result of rationing thus made consumers feel much better off. Forced loans in place of taxation would be a method of forced saving in forms as well as in substance.”14

All the three instruments of fiscal policy namely tax policy, public expenditure and public debt management are important to control deflation and promote full employment. Tables 13.1 and 13.2 show the receipts and expenditures of the Government of India in 2007–08 and 2009–10.

Fiscal Policy and Economic Stabilization

According to Keynesian economists, advanced economies are susceptible to wide fluctuations in economic activities, periods of prosperity interspersed with periods of depression and vice versa due to differences in aggregate demand. Depression and its milder version, recession are due to deficiency in aggregate demand. Keynes advocated fiscal policy to make up for this deficiency in effective demand. This, according to Keynes, can be done either (a) by inducing the general public to increase consumption or investment or both or (b) by increasing government expenditure. The fiscal policy including tax system and public debt policy of the government should be made so as to promote private consumption and expenditure.

The tax policy during a period of depression attempts at leaving a higher quantum of purchasing power in the hands of the public to make them consume more and invest. This can be done by reducing income tax, corporate tax and other direct taxes that will promote saving and investment, and by lessening excise and sales taxes which will promote greater consumption. However, economists agree that though this will have by and large a favourable effect, it will raise the possibility that entrepreneurs may offset it by reducing investment in a depression hit economy.

Public expenditure during depression should be so devised by increasingly taking up projects that are not normally undertaken with a view to pushing up aggregate demand. Public authorities may take up what is called compensatory public spending, i.e. public authorities undertaking the same amount of investment contracts as are lost by private entrepreneurs. The other instrument of economic stabilization is pump priming. Here, the objective of fiscal policy is to revive and escalate economic activity through a stimulating effect on the economy. However, often it is very difficult to distinguish one form of public expenditure from the other. Pump priming has more pronounced multiplier effect on income and employment.

Examples of public expenditure as a stabilization fiscal policy measure include public works such as the construction and maintenance of roads, railways, airports, canals, schools, parks, etc.

 

Table 13.1 Receipts of the Government of India for 2008—09 and 2009—10

 

Source: Government of India, available at http://indiabudget.nic.in/ub2009–10/bag/bag3.htm

 

Table 13.2 Expenditures of the Government of India for 2008–09 and 2009–10

 

Source: Government of India, available at http://indiabudget.nic.in/ub2009–10/bag/bag3.htm

 

Public borrowing, as we have seen earlier, is another means used by governments to combat depression.

The Evaluation of Fiscal Policy

Like any other economic policy, fiscal policy too has to face a number of constraints in its implementation in developing countries. These constraints generally arise because the objectives of fiscal policy may not match those of other parts of economic policy such as monetary policy, physical and administrative controls. Moreover, pursuit of any one objective of fiscal policy should offset any stabilizing consequences arising from the pursuit of competing objectives. In this context, how do we devise a satisfactory measure of fiscal policy performance?

One yardstick of the success of fiscal policy may be based on the potency of budgetary changes upon the level of demand, and therefore, on the level of income. Take for instance, the impacts of a change in tax on the disposable income, which initially impacts the volume of expenditures. This process, in turn, will get magnified in the process of income creation by the operation of multiplier. “The reason for making this distinction is that the multiplier will itself be function of the tax and expenditure structure of the budget. Generally (although there may be exceptions), the greater the responsiveness of the budget function to changing levels of GNP, the greater will be the degree of automatic stabilization incorporated in the budget system.” 15 This raises an important question. Would fiscal policy in one country be less effective because the government had insulated the economy against autonomous disturbance, while it is open to such influences in another, and therefore more effective? It is well understood fact that fiscal changes that augment the degree of automatic stabilization are found to reduce the potency of discretionary budgetary measures. This kind of situation suggests that instead of relying on domestic demand as a measure of performance of fiscal measures, it would be prudent to fine-tune the fiscal policy to the realization of stabilization and other objectives. But, then many objectives such as growth, welfare, social justice, etc. are subjective and lack precise definitions. Besides, different policy measures are directed towards realization of different goals. For instance, while indirect taxes such as excise duties and commodity taxes are used for raising revenue, direct taxes have a redistributive effect. Deficit finance, while being a considerable source of revenue to a cash-strapped government in a developing economy, may cause prices to rise. Subsidy tends to divert resources from investment goods to consumption goods. “In such cases, though it is possible to attempt individual assessment of individual environment, yet it is impossible to have a collective assessment of a fiscal policy-mix. From the standpoint of management of the economy, the fiscal authority is, however, more interested in aggregate rather than individual impact.”16

SUMMARY
  • Every government pursues an economic policy that reflects the broad objectives for the benefit of its people. Though there are many objectives, five are considered to be the most basic and fundamental; these are: (i) faster economic growth, (ii) reduction in inequalities of income and wealth, (iii) full employment, (iv) price stability and (v) balance of payments equilibrium.
  • Monetary and fiscal Policies are two important tools of a country's macroeconomic policy. The objective of monetary policy is to maintain price stability, full employment and economic growth whereas fiscal policy aims to change aggregate demand, control inflation and overcome recession. The monetary policy regulates the money supply and the cost and availability of credit. Fiscal policy causes a deliberate change in government revenue and expenditure with a view to influencing the price level and the quantum of national output. However, we should note that the two policies are complementary, one complementing and supplementing the other.
  • Monetary policy refers to the policy adopted by the monetary authority of a country with respect to the supply of money, the rate of interest and other matters. Monetary policy is based on the assumption that money in a modern complex economic system performs a dynamic function.
  • The monetary policy deals with the following: (a) the control of financial institutions; (b) active purchases and sales of paper assets by the monetary authority as a deliberate attempt to affect changes in monetary conditions; and (c) passive purchases and sales of paper assets.
  • Monetary policy has evolved over centuries. It can be traced to the establishment of the Bank of England in 1694 as a central bank of England. Along with the Bank of England, the concept of monetary policy as an executive decision of the central bank came to be established.
  • Functions of monetary policy are (i) to ensure the most suitable interest structure; (ii) to ensure a correct balance between the demand for and supply of money; (iii) to ensure the provision of adequate credit facilities for a growing economy, and at the same time, putting an end to its undue expansion that may cause inflation, and also overseeing the channelling of credit to users as per the pre-planned decisions on investment; (iv) the establishment, functioning and growth of financial institutions of the economy; and (v) managing public debts.
  • The following are the objectives of monetary policy: (i) the safeguarding of the country's gold and forex reserves; (ii) price stability; (iii) foreign exchange stability; (iv) managing cyclical fluctuations and adopting suitable stabilization measures; (v) ensuring full employment; (vi) ensuring balance of payments equilibrium, and (vii) accelerating economic growth primarily in developing economies.
  • The monetary authority uses various tools to control the supply of money. These instruments can be divided into two categories: quantitative and qualitative credit controls. Main methods of quantitative credit control are bank rate policy, open market operation and changes in statutory reserve requirements, i.e. cash reserve requirement and statutory liquidity ratio. The qualitative methods of credit control are also known as selective credit control methods. These include credit rationing, direct action, changes in margin requirements and moral suasion.
  • As a developing economy, India's major objective of monetary policy has been to accelerate economic development while maintaining price and financial stability. The RBI has been adopting a monetary policy that aims at controlled monetary expansion whose twin objectives are (a) to ensure that there is no paucity of funds for all legitimate economic activities and (b) the availability of funds is not excessive to cause inflation. The selective credit controls are used to regulate credit for specific purposes. The important selective credit controls include credit rationing, direction against the erring banks, changes in margin requirements, differential rate of interest and moral suasion.
  • The following are the weaknesses found in the administration of monetary policy in India: (i) non-banking credit higher than bank credit; (ii) high liquidity in currency; (iii) rigidity in policy; (iv) problems brought by liberalization; (v) impact of government's policy of inclusive growth; (vi) deficiency in the monitoring system; (vii) ever rising fiscal needs of the economy; and (viii) lack of autonomy in money management.
  • Fiscal policy refers to that part of a government's overall economic policy that deals with the use of taxation through the budget as an adjunct to monetary policy. The government can control the level of demand in the economy by creating budgetary surpluses and other means. The Great Depression of 1930s gave birth to fiscal policy under Keynes' influence.
  • The following are the major objectives of fiscal policy: (i) full employment; (ii) to increase the rate of investment; (iii) stability of general price level; (iv) promoting economic growth with equity; (v) resource mobilization and income redistribution; and (vi) reducing inequalities in income and wealth.
  • Fiscal policy endeavours to achieve its objectives through the use of three instruments in its armoury, namely taxation, public expenditure and public debt management.
  • Taxes tend to fall into two categories: direct and indirect.
  • According to Keynesian economists, advanced economies are susceptible to wide fluctuations in economic activities with periods of prosperity interspersed with periods of depression and vice versa due to differences in aggregate demand. Keynes advocated fiscal policy to make up for this deficiency in effective demand. This, according to Keynes, can be done either (a) by inducing the general public to increase consumption or investment or both or (b) by increasing government expenditure.
  • The tax policy during a period of depression attempts at leaving a higher quantum of purchasing power in the hands of the public to make them consume more and invest. Public expenditure during depression should be devised such that by projects which are normally not undertaken are increasingly taken up with a view to pushing up aggregate demand.
KEY WORDS
aggregate demand balance of payments equilibrium central bank
credit planning economic stability equity
fiscal needs fiscal policy full employment
growth with equity inclusive growth income redistribution
margin requirement monetary authority monetary management
monetary policy moral suasion price stability
quantitative controls rate of interest rate of investment
rationing of credit resource mobilization selective controls
DISCUSSION QUESTIONS
  1. What is meant by economic policy?
  2. Discuss the various objectives of economic policy.
  3. What are the objectives of Indian monetary policy? Through what instruments is it implemented in India?
  4. “The functioning of monetary system must necessarily be in consonance with national development strategy”. In the light of this statement, discuss the role that should be assigned to monetary policy in India.
  5. Account for the recent shift from conventional quantitative controls to qualitative controls as techniques of monetary control. How far has this been successful?
  6. “It is said that monetary policy in any country has to be consistent not only with the tax expenditure policies of the government but also with the foreign exchange policy”. Do you agree? Analyse the recent development in this regard.
  7. “Monetary policy in India is largely conditioned by the fiscal needs of the state”. Elaborate.
  8. Discuss the main features of post-liberalization objectives of monetary policy.
  9. Distinguish between “credit planning” and “credit rationing”. Do you think the credit planning can be used as an effective tool of monetary management in India? Discuss.
  10. “Unorganized money market is mainly responsible for the failure of RBI's monetary policy.” Discuss.
  11. Examine the techniques adopted by the RBI in controlling the quantity and quality of credit.
  12. Discuss the role of the RBI in controlling credit during the plan period.
  13. Explain what is meant by the growth of money supply in India.
  14. What is fiscal policy? What are its objectives? How does it help economic development?
  15. Explain the interrelation between monetary and fiscal policy. In the changing business environment, what type of fiscal policy would you recommend?
  16. “If the basic goals of economic development in India are to be realized, there is no alternative to fiscal prudence.” Comment.
  17. “Monetary policy to be effective has to be in harmony with the fiscal policy.” Examine.
  18. Explain the causes of fiscal deficit in 1980s and 1990s. Discuss the policy measures initiated in 1991 for fiscal reforms in India.
  19. Describe how fiscal policy can be used to influence the level of business activity in a country.
  20. Define and explain with illustrations fiscal policy.
  21. Discuss the main objectives of fiscal policy in (a) developed countries and (b) developing countries.
  22. What is fiscal policy? Examine its objectives with reference to a developing economy.
  23. Describe how fiscal policy can be used to influence the level of business activity in a country.
SUGGESTED READINGS

Blinder, Alan S. Central Banking in Theory and Practice. Cambridge, Mass.: MIT Press, 1998.

Chelliah, Raja J. Fiscal Policy in Underdeveloped Countries. London: George Allen and Unwin, 1971.

Chelliah, Raja J. (Tax Reforms Committee). Interim Report (Dec 1991) and Final Report Part I (August 1992) and Part II (Jan 1993). New Delhi: Ministry of Finance, Government of India.

Colm, Gerhard. Essays in Public Finance and Fiscal Policy. New York, N.Y.: Oxford University Press, 1955.

Dalton, Hugh. Principles of Public Finance. London: Routledge and Kegan Paul, 1954.

Direct Taxation Enquiry Committee (Chairman: Wanchoo). Final Report, New Delhi: Ministry of Finance, Government of India, 1971.

Enoch, Charles and Anne Maria Guide. “Are Currency Boards a cure for all monetary problems?” Finance and Development 35(4): December 1998.

Glahe, Fred R. Macroeconomics: Theory and Policy. New York: Harcourt Brace Jovanovich Inc, 1977.

Heyne, P. T., Boettke, P. J. and D. L. Prychitko. The Economic Way of Thinking. tenth edition. Upper Saddle River, N.J.: Prentice Hall, 2002.

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