25. Monetary Policy and Fiscal Policy – Macroeconomics: Theory and Policy

25

Monetary Policy and Fiscal Policy

After studying this topic, you should be able to understand

  • Monetary policy aims at achieving certain well-defined macroeconomic objectives.
  • To achieve the objectives of monetary policy, the central bank has at its disposal the quantitative and the qualitative measures of monetary policy.
  • The effective working of monetary policy is hindered due to the existence of different obstacles.
  • Fiscal policy refers to the government’s policy regarding government expenditure, taxation and public borrowing with the view to achieving certain well-defined macroeconomic objectives.
  • To implement fiscal policy, the government has at its behest several instruments which include taxation, government expenditure and public borrowing. Fiscal policy actions which can tackle the problem of instability include: automatic stabilizers and discretionary fiscal policy.
  • The full employment budget and actual budget differs due to the cyclical factor in the budget.
  • The full employment budget surplus differs from the actual budget surplus only in respect of tax collections.
  • The increase in government spending crowds out private investment spending.
INTRODUCTION

This chapter examines the monetary policy and the fiscal policy and their functioning. An attempt has also been made at understanding the goals which these policies aim at achieving. Are they successful in achieving these goals or do they face some limitations which prevent them from achieving them? All these issues will be examined at length in the chapter.

MEANING OF MONETARY POLICY

Monetary policy is an operation by the monetary authorities of the country to achieve certain well-defined macroeconomic objectives/goals. It is generally the central bank of the country which undertakes the implementation of the monetary policy. It operates through changes in the quantity of money. Hence, monetary policy has its immediate impact in the money market.

 

Monetary policy is an operation by the monetary authorities of the country to achieve certain well defined macroeconomic objectives.

Monetary policy, it is to be noted, has much wider connotations than the credit policy. While both are administered by the central bank of the country, the credit policy is concerned with changes in the supply of credit and the monetary policy with changes in the supply of money. To avoid confusion, often the two are clubbed together under the head of monetary policy.

 

Excess reserves are reserves in excess of the required reserves.

RECAP
  • The central bank of the country undertakes the implementation of the monetary policy through changes in the quantity of money.
INSTRUMENTS OF MONETARY POLICY

The main objectives which the monetary policy aims at achieving include economic growth, a higher rate of employment, stable prices, equality in the distribution of income and wealth, a stable balance of payments and many others depending on the need of the time.

To achieve these objectives, monetary policy has at its disposal instruments which give the central bank the power to control the money supply and hence achieve these objectives.

These instruments can be divided into two categories:

  1. Quantitative or general measures
  2. Qualitative or selective measures

Quantitative or General Measures of Monetary Policy

Open Market Operations

It is the sale and purchase of government securities and treasury bills by the central bank. It is an instrument of monetary control which is most powerful and which is most widely used by the central bank. The central bank carries out the open market operations through the commercial banks. Hence, these operations affect the bank deposits and reserves and thus influence their capacity to create money.

 

Open market operations are the sale and purchase of government securities and treasury bills by the central bank.

Suppose the central bank follows:

  1. A contractionary monetary policy: It aims at reducing the supply of money in the hands of the public and also at decreasing the creation of credit. To achieve this, it offers government securities and treasury bills for sale through the commercial banks. When the public and other institutions purchase these securities through cheques drawn on the commercial banks, there is a withdrawal of money from their accounts with the banks. Hence, there occurs a decrease in the cash reserves of banks thereby reducing their capacity to create credit. There is, thus, a decrease in the money supply.
  2. An expansionary monetary policy: It aims at raising the supply of money in the hands of the public and also at increasing the creation of credit. To achieve this, it purchases government securities and treasury bills through the commercial banks. When the public and other institutions sell these securities, there is an increase in the flow of money to their accounts with the banks. Hence, there occurs an increase in the bank’s deposits and also in their cash reserves. This improves their capacity to create credit. There is, thus, an increase in the money supply.

Effectiveness of open market operations: Open market operations are one of the most popular instruments of monetary policy. In the UK, USA and other countries, they are regarded as one of the most efficient instruments of monetary control.

Advantages of open market operations

  1. They are highly flexible and can be used in widely varying amounts.
  2. They are easily reversible in time.
  3. They can be often used in widely differing amounts.
  4. Unlike the other instruments of monetary policy, they do not involve any public announcements. Hence, they do not have any announcement effects. i.e. there are no reactions in the market consequent to open market operations.

For open market operations to be successful at least three conditions need to be satisfied:

  1. It is necessary that the market for government securities, the gilt edged market is well-developed and well-organized.
  2. It is necessary that the central bank has enough capacity to buy and sell government securities.
  3. It is necessary that in the pursuit of these operations, the chief consideration for the central bank is only of monetary control.

In India, it seems that out of all these conditions only condition (b) seems to be satisfied. The central bank of the country, the Reserve Bank of India has sufficient capacity to buy and sell securities. As for condition (a), the market for government securities is not well organized. Regarding condition (c), the RBI has often been weighed down by considerations other than monetary control and more towards, say, public debt management.

Variations in Reserve Requirements

Commercial banks maintain a certain proportion of their time and demand liabilities in the form of cash reserves. These can be divided under two heads:

  1. Required reserves: These are cash balances which banks hold to meet their statutory reserve requirements. This is a legal requirement imposed on the banks by the central bank. The purpose of these reserves is to safeguard the interest of the depositors and to prevent the banking system from a total collapse. It also enables the central bank to be able to control the liquidity. As per these requirements, the banks have to maintain a certain minimum reserve deposit ratio. Hence, a fraction of each bank’s total deposits have to be maintained as cash balances with the central bank.

     

    Required reserves are cash balances which banks hold to meet their statutory reserve requirements.

    When the central bank pursues

    1. a contractionary monetary policy, it raises the cash reserve ratio (CRR). With an upward revision in the CRR, banks are required to hold larger proportion of their cash balances with the central bank for the same amount of their liabilities. This reduces the bank’s ability to extend loans leading to a decrease in the money supply. In essence, the CRR impounds funds available with the banks.
    2. an expansionary monetary policy, it will reduce the CRR. With a reduction in the reserve requirement ratio, banks are required to hold a smaller proportion of their cash balances with the central bank for the same amount of their liabilities. This improves the bank’s ability to extend loans leading to an increase in the money supply.
  2. Excess reserves: These are reserves in excess of the required reserves. A part of these maybe held as cash on hand or in the form of vault cash with the banks themselves. The rest may be kept as excess balances with the central bank. They are held by the banks for meeting basically two purposes:
    1. Currency drains which is the net withdrawal of currency by the depositors.
    2. Clearing drains which is the net loss of cash due to the interbank clearing of checks.
BOX 25.1

As per the existing law, the central bank of India, RBI has the power to impose statutorily a cash reserve ratio (CRR) on banks which can be anywhere between 3 and 15 per cent of their net demand and time deposits. The RBI has been using this instrument often for monetary control. When the RBI hiked the CRR by 25 basis points to 8.25 per cent effective 2008 May 24, the small–almost token–CRR hike led to a withdrawal of around US$ 2.22 billion from the banking system. During the fiscal year 2008–09, frequent changes in the CRR were resorted to in tandem with current and evolving macroeconomic situation and liquidity conditions in the global and domestic financial markets. In 2008 November CRR was down to 5.5 per cent. 2009 January saw another reduction of 50 basis points in CRR in order to gear up the economy to cope up with the global recession. CRR stood at 5 per cent at fiscal close.

Effectiveness of Variations in Reserve Requirements: As compared to open market operations, it is often alleged that variations in reserve requirements are an inferior tool of monetary policy because:

  1. They lead to lumpy and discontinuous changes in the deposits and the reserves.
  2. Changes in reserve requirements are newsworthy, they produce announcement effects.

    However, the counter argument given in support of variations in reserve requirements is that:

    1. Banks can be given sufficient notice of the changes so that they can be introduced gradually with banks having sufficient time to adjust their portfolios in accordance.
    2. During times of inflation, the reserves of banks would be increasing rapidly. Hence, banks would not find it difficult to meet a higher CRR and thus they would not face any problems in giving their complete cooperation to the monetary authorities in controlling the money supply.
    3. Often, the central bank is unable to use open market operations for the purposes of monetary control. Hence, it has to resort to variations in reserve requirements if it wishes to ensure monetary stability in the economy.

      It is increasingly felt that the variable reserve ratio, on its own, is not a sufficient instrument of controlling the money supply. Thus, to make it an effective instrument it needs to be supplemented by the other instruments of monetary policy.

The Statutory Liquidity Requirement

Besides the CRR, banks are subject to control through yet another requirement, the statutory liquidity ratio, the SLR as it is often known.

 

The statutory liquidity requirement is a statutory requirement where the banks are required to maintain a certain fixed proportion of their demand and time liabilities in the form of designated liquid assets.

Under the SLR, banks are statutorily required to maintain a certain fixed proportion of their demand and time liabilities in the form of designated liquid assets. This ratio of liquid assets to demand and time liabilities is known as statutory liquidity ratio. The SLR can be defined as:

where, ER = excess reserves which are total reserves minus the required reserves with the central bank
    I* = investment in encumbered securities which are securities against which no loans have been taken by the bank from the central bank
  CB = current account balances with other banks
     L = total demand and time liabilities of the bank
BOX 25.2

In India, the SLR was first imposed on the banks in the year 1949. It was fixed at 20 per cent. It remained at this level for about a period of 15 years until it was increased to 25 per cent in the year 1964. After that, it was often changed and stood at 24 per cent at end of fiscal year 2008–09. RBI is empowered to increase this ratio up to 40 per cent.

The purpose behind the SLR was to prevent the commercial banks from negating the impact of an increase in CRR by converting their liquid assets into cash so that their loanable funds remain intact. An increase in SLR thus impedes the bank’s leveraged capacity to pump more money into the economy.

By increasing the SLR, the central bank attempts to allocate an increasingly larger share of bank resources to the government and the specified public sector agencies. However, the central bank has not been very successful in its effort because in meeting the SLR, the banks have preferred to acquire other approved securities, rather than the government securities since these other securities give higher yields.

Effectiveness of SLR: In India, like the CRR, the SLR has not been very successful as an instrument of monetary policy. Also, it has not been a very flexible instrument of monetary policy and has often been revised in the upward direction for considerations other than monetary control.

Bank Rate Policy

The bank rate or the discount rate is the rate of interest at which the central bank rediscounts eligible bills of exchange or other commercial papers. When the banks are short of reserves, they borrow from the central bank by getting their bills of exchange rediscounted. In simpler terms, the bank rate is the rate of interest charged by the central bank on the loans and advances made by it to the commercial banks. The central bank is a ‘lender of the last resort’ for the commercial banks.

 

Bank rate or the discount rate is the rate of interest at which the central bank rediscounts eligible bills of exchange or other commercial papers.

It is at the discretion of the central bank to change the bank rate.

  1. When the central bank pursues an expansionary monetary policy, it lowers the bank rate. Hence, it becomes cheaper for the commercial banks to borrow from the central bank’s discount window. Thus, a decrease in the bank rate increases the money supply. A decrease in the bank rate is followed by a fall in the market rates of interest all along the line since the banks revise their lending rates downwards. This is followed by an expansion in bank credit and is a sign for the onset of a cheap money policy in the economy.
  2. When the central bank pursues a contractionary monetary policy, it raises the bank rate. Hence, it becomes costlier for the commercial banks to borrow from the central bank’s discount window, discouraging them to borrow from the central bank. Thus, an increase in the bank rate decreases the money supply. An increase in the bank rate is followed by a rise in the market rates of interest all along the line since the banks revise their lending rates upwards to absorb the higher cost of borrowed reserves. This is followed by a tighter bank credit and is a sign for the onset of a tighter money policy in the economy.

Effectiveness of Bank Rate Policy: In reality, it is difficult to predict the effect of the changes in the bank rate on the amount of the banks borrowings. This effect will depend on a number of factors:

  1. The extent to which the bank is dependent on borrowed reserves.
  2. The extent to which the differential between the banks lending rates and borrowed rates is sensitive to the bank’s demand for borrowed reserves.
  3. The extent to which the other rates of interest change in response to the changes in the borrowed reserves.
  4. The demand for loans and the extent to which loans are available from other sources.

Limitations of the Bank Rate Policy

  1. The bank rate is often more sticky in comparison to the other rates. Also, the changes in it are discontinuous.
  2. Changes in the bank rate have announcement effects, i.e. there are reactions in the market due to a mere announcement of a change being brought about in the bank rate. Hence, the central bank may avoid bringing about changes in the bank rate.
  3. Over the years, the flexibility in the money market has gone down. Hence, the response of the money and credit markets to changes in the bank rate is not very adequate for monetary policy to be effective.
  4. Most commercial banks nowadays are often financially self reliant and thus not fully dependent on the central bank for finance.
  5. In certain countries, there has developed a private market for loans and those banks which are in need of loans borrow from those who have excess reserves.
BOX 25.3

Changes in the bank rate in India in the initial years were not very frequent. Since 1962, it has been varied more often. From 10 per cent in 1990–91 it came down to 6 per cent in 2006–07 and remained at that level till 2009 March. The repo rate (in 2009 April) stood at 4.75 per cent while the reverse repo rate at 3.25 per cent. Between 2008 October and 2009 March, the central bank cut the repo rate at which it lends to banks by 425 basis points in desperate attempts to help boost economic activity.

Repo (Repurchase) Rate and Reverse Repo (Repurchase) Rate

The repo rate is the rate at which the central bank infuses short-term liquidity into the system. In simpler terms, it is the rate at which the central bank lends to the banks.

 

Repo rate is the rate at which the central bank infuses short-term liquidity into the system.

The reverse repo rate is the rate at which banks park their short-term excess liquidity with the central bank in exchange for government securities. It is the rate at which the central bank borrows from the banks. Hence, the reverse repo rate is the return earned by the banks on their excess funds with the central bank. An increase in this rate tempts banks to park their short-term excess liquidity with the central bank thus squeezing out loose cash from the system which in turn helps in reducing inflationary pressures. When yields on government securities go up, the financial markets feel liquidity crunch and lending rates to retail and corporate sector harden.

 

Reverse repo rate is the rate at which banks park their short-term excess liquidity with the central bank in exchange for government securities.

BOX 25.4

Difference between Bank Rate and Repo Rate: Bank rate is the rate at which RBI provides finance to commercial banks in India. Banks can avail different types of refinance from RBI at rates that are linked to bank rate. Thus, banks can borrow at this rate depending on their eligibility for refinance.

Repo, on the other hand, is a money market instrument, which enables collateralized short-term borrowing and lending through sale/purchase operations in debt instruments. Under a repo transaction, a holder of securities (a bank) sells them to an investor (RBI, in this case) with an understanding to repurchase the same at a predetermined date and rate. Thus, in repo, the forward clean price of the bonds is determined in advance at a level which varies from the spot clean price by accounting for the disparity between repo interest and coupon earned on the security. Thus, a bank can borrow under repo provided it has the extra securities which it can lend temporarily to RBI for borrowing short-term funds.

The reverse repo rate is linked to the repo rate. The spread between the reverse repo rate and the repo rate is maintained generally at 100 basis points with the repo rate being the higher of the two.

Qualitative or Selective Measures of Monetary Policy

The quantitative measures control the total volume of credit and the cost of credit in the economy and, hence, the expansion or contraction in the total amount of credit and thus the supply of money.

On the other hand, the qualitative measures control the direction and distribution of credit in the economy. This can have two aspects:

  1. Positive aspect in that these measures can be used to encourage the flow of credit in particular directions.
  2. Negative aspect in that these measures can be used to restrict the flow of credit to particular sectors.

Some qualitative credit control measures are:

Rationing of Credit

This has been often used in many countries. Credit rationing is resorted to when there occurs a shortage of institutional credit. The more powerful and the financially strong sectors, which in fact may not really need the credit, may be able to capture the major share of the credit. The sectors which may in fact be in dire need of funds may not be able to procure them. To prevent such a situation from occurring, the central bank may resort to credit rationing. They may do so by

  1. Charging higher rates of interest on the bank loans which go beyond certain limits.
  2. Setting limits on the quantum of loans to larger firms and industries.

Change in Margin Requirements

This is a tool of monetary policy that works indirectly to influence lending and, thus, regulate the capital markets. The margin requirement specifies the minimum maintainable ratio of the value of the securities charged to the amount borrowed.

Changes in margin requirements are used to control speculative activities. If the wholesalers start hoarding some particular essential goods so that they can create a shortage and push up the price of these goods, then in that case the central bank can raise the margin requirement for these goods.

Moral Suasion

This is a combination of persuasion and pressures which a central bank asserts to bring the erring banks in line so that they function in accordance with the central bank’s directives. The central bank can exercise these through letters, meetings and discussions with the banks on the various matters. In fact, moral suasion is the only instrument which can be used both for quantitative and qualitative credit control.

 

Moral suasion is a combination of persuasion and pressures which a central bank asserts to bring the erring banks in line so that they function in accordance with the central bank’s directives.

Direct Action

This refers to the coercive actions resorted to by the central bank against those banks who do not function according to its directives. These may be by way of denial of discretionary rediscounting facilities, charging of penal interest rates, etc.

 

Direct action refers to the coercive actions resorted to by the central bank against those banks who do not function according to its directives.

Effectiveness of Qualitative Credit Control Measures, this will depend on a number of factors:

  1. The extent of restrictions on the credit: These may not be sufficient. The selective credit controls are generally security oriented and not purpose oriented. Hence, the influential borrowers may succeed in using the borrowed funds for purposes like speculation in the stock markets rather than for the priority sectors.
  2. The availability of finance from other sources: Besides the availability of finance from banks, another major source of funds for the traders is the unregulated credit market. Further, the existence of black money constraints the ability of the central bank to curtail speculative hoarding and other such activities.
  3. The extent to which supply is not able to fulfill the demand: The greater is the shortage of funds, the more will be the speculation in the market. Hence, it is necessary that the credit controls are imposed well in advance so that timely action can be taken.

It is increasingly felt that the selective credit controls cannot be successful on their own. They need to be supplemented with the general credit controls. Also, they are more in the form of short-term rather than long-term solutions.

Deficit Financing: Government’s Instrument of Monetary Control

It refers to ways in which the deficit in the government’s budget is financed. In the less developed countries, it is financed by credit from the central bank. The central bank merely prints more currency and then puts them into circulation on behalf of the government.

Deficit financing leads to an increase in the money supply leading to an increase in the expenditure in the economy. Thus, whenever there exists a slack in demand, deficit financing is resorted to increase the aggregate demand in the economy. Hence, deficit financing fills up the gap in the government expenditure and the revenue that it gets from taxation, public borrowing and external finance.

However, one major problem that is associated with deficit financing is that it always results in inflation. The increase in the money supply leads to an increase in the money in the hands of the public. This creates a demand for goods and services. However, the supply of goods is not able to keep up with the demand. Hence, there occurs an inflationary pressure in the economy.

RECAP
  • Quantitative measures of monetary policy include open market operations, variations in reserve requirements, bank rate policy and repo rate.
  • Qualitative measures of monetary policy include rationing of credit, change in margin requirements, moral suasion and direct action.
MONETARY POLICY DEVELOPMENTS IN INDIA

In the first six months of 2008–09, the monetary policy of the RBI was oriented towards controlling the monetary expansion. The government also implemented various fiscal measures to control inflation in the economy. The major policy rates were also changed accordingly by the RBI to pursue a contractionary monetary policy. The repo rate (RR) was increased from 7.75 per cent in the beginning of 2008 April to 9.0 per cent with effect from 2008 August. However, the reverse repo rate was left the same at 6.0 per cent. The cash reserve ratio was increased from 7.50 per cent at the beginning of 2008 April to 9.0 per cent with effect from 2008 August.

However, the situation underwent an abrupt change in the latter half of the year. Due to the international financial crisis, there occurred an outflow of foreign exchange. There was a reversal of policy by the RBI in the form of decreases in the repo and reverse repo rate, the cash reserve ratio and also the statutory liquidity ratio. The repo rate was decreased from 9.0 per cent in 2008 August to 5.0 per cent in 2009 March. The reverse repo rate was also reduced from 6.0 per cent to 3.5 from 2009 March. SLR was decreased from 25 per cent of the net demand and time liabilities to 24 per cent from 2008 November. The CRR was also reduced from 9.0 to 5.0 per cent from 2009 January.

LIMITATIONS OF MONETARY POLICY
  1. The Existence of a time lag: This is perhaps one of the major problems in the path of the working of monetary policy. There exists a substantial time lag between the time that there is a realization for the need for a monetary policy and the time by which the response of the policy in bringing about changes in aggregate demand is felt.

    The time lags can be divided under two heads:

    1. Inside lags: These include the recognition lag and the action lag. The recognition lag relates to the considerable time taken by the central bank in realizing that there are problems and, hence, a need to tackle them through the monetary policy. The action lag may occur due to the considerable time gap involved during the recognition phase and the actual implementation of the policy.
    2. Outside lags: Once the policy has been implemented, the problem occurs in that it may take a considerable time for the households and firms to respond to those policies. Hence, there may occur a considerable time lapse for the impact of these changes to be felt on aggregate demand and the output.

      The issue of time lags is very important for the success of the monetary policy in achieving its various goals. If the time lag is short, then the chances of monetary policy being successful are strong. However, with long time gaps it is quite possible that the situation may have undergone a complete change and implementation of the policy may worsen rather than improve the situation.

  2. The presence of non-bank financial intermediaries: Besides commercial banks, the other entities which play a major role in the money and capital markets are the financial intermediaries, other than the banks. These include the development banks, mutual saving funds, insurance companies, etc.

    Like banks, these intermediaries cannot directly create money. However, they can influence money indirectly through their actions. Suppose the central bank is pursuing a tight monetary policy, these non-bank financial intermediaries can, to some extent negate the impact of such a policy through an increase in the velocity of money, and also by attracting idle funds and converting them into active balances.

  3. The underdeveloped nature of the money and capital markets: One of the major problems in the implementation of monetary policy in the less developed countries is that their money and the capital markets are highly fragmented, disconnected and disorganized. In such economies, sectors like the agriculture sector is unorganized and its main source of funds are the moneylenders who do not fall under the supervision of the central bank and, hence, are outside its control.

The presence of these factors not only increases the time lag involved but also to some extent limits the effectiveness of monetary policy in achieving its goals.

RECAP
  • The existence of a time lag, presence of non-bank financial intermediaries and the underdeveloped nature of the money and capital markets limit the effectiveness of monetary policy in achieving its goals.
MEANING OF FISCAL POLICY

The government of a country can influence the economy not only through the monetary policy but also through the fiscal policy. Fiscal policy refers to the government’s policy regarding government expenditure, taxation and public borrowing with the view to achieving certain well-defined macroeconomic objectives.

It was only with the coming of Keynes that fiscal policy gained importance. Prior to Keynes, monetary policy was more popular. Also, economists like Adam Smith strongly propagated the belief that in an economy the role of the government should be kept at a minimum. An economy which functioned on its own without any interference of any kind would be an ideal economy. It was believed that an economy would always function at the full employment level and hence the government’s role should be limited to maintaining law and order and in providing the essential services.

 

Fiscal policy refers to the government’s policy regarding government expenditure, taxation and public borrowing with the view to achieving certain well-defined macroeconomic objectives.

The coming of the Great Depression and the failure of monetary policy to tackle the severe unemployment problems arising from it made one realize the need for fiscal policy. Further, the ‘new economics’ by Keynes with the emphasis on aggregate demand strengthened the belief that the time was right to renew the dwindling faith of the public in the effectiveness of fiscal policy. Also, government expenditure and taxation were gaining importance. It was obvious that the government could increase or decrease aggregate demand through its expenditures, taxation and transfers. However, the monetarists attacked this argument because they believed that with the exception of some circumstances, in general, increases in government expenditures do not add to aggregate demand but in fact are responsible for crowding out private investment of an equal amount.

Most economists do not agree with the crowding out arguments and promote the view that fiscal policy is certainly an effective instrument in achieving the macroeconomic policy objectives. In the developed nations of the world, fiscal policy is effective in maintaining economic stability while in the developing countries its role is all the more important in achieving economic growth, development and also in tackling employment and the problems emanating from it.

RECAP
  • In the developed nations, fiscal policy is effective in maintaining economic stability while in the developing countries it is important in achieving economic growth, development and also in tackling employment.
INSTRUMENTS OF FISCAL POLICY

To implement fiscal policy, the government has at its behest several instruments:

Taxation

One of the most important sources of revenue for the government in most countries is taxation. In the developing countries, the government is making an attempt at increasing the proportion of the national income which is collected as taxes. Taxes can be analysed under two headings:

Direct Taxes

  1. Corporate income taxes which are collected from firm’s economic profits. These form a very small proportion of the total revenue of the government for many reasons:
    1. Since the corporate sector forms a very small part of the economy, its contribution to the total revenue will also be small.
    2. Often to encourage industrial development, the government offers incentives in the form of tax rebates and investment subsidies.

    However, it is important to note that in spite of all problems corporate income taxes are easier to collect as compared to the personal income tax.

  2. Personal income tax again account for a very small proportion of the total revenue of the government for many reasons:
    1. A large proportion of the people have low incomes and are thus not in a position to pay tax.
    2. There are administrative weaknesses which are responsible for tax evasions.
  3. Taxes on wealth and property can account for a large proportion of the total revenue of the government for many reasons:
    1. Since they are collected from the rich class which has property, they are not likely to have an adverse influence on the incentive to work.
    2. Such taxes can reduce the income and wealth inequalities to some extent.

Indirect Taxes

  1. Sales tax and excise duty which are paid by all, the rich and the poor. However, luxury goods are taxed at a higher rate than the necessities.
  2. Customs duty includes exports duty and imports duty. They are easy to implement as the number of commodities involved in trade are limited and easy to monitor.

    In the developed countries, the direct taxes are a more important source of revenue for the government as compared to the developing countries where indirect taxes are more important.

Government Expenditure

Since the Great Depression, the government’s role in economic activity is continuously on the increase for several reasons:

  1. It was realized that the private sector was not in a position to pull the economy out of the Depression on its own.
  2. The private sector did not posses either the ability or the willingness to embark on the ambitious projects which were necessary to put the economy on the path of growth and development.

    Hence, it was realized that government expenditure is imperative for an economy in the form of investments in capital goods industries, building the infrastructure and payments of wages and salaries. Besides, the government has to fulfill various social obligations which include expenditure on education, public health services, unemployment compensations, pensions and other welfare considerations.

Public Borrowing

Though public borrowing is the second most important source of revenue (taxation is the most important source of revenue) it is unlike taxes. All the borrowings from the public must be repaid in the future.

Public borrowing can take two forms:

  1. Compulsory loans where bonds are issued by the government for a period varying from five to ten years. Employees’ contribution to provident fund falls under this category.
  2. Voluntary loans where bills and securities are issued by the government.

    Since taxation is insufficient to finance the growing public expenditures, the government in most countries has to resort to borrowing from the public. The developmental expenditures are increasing at such a great speed that in most countries the government has to finance these expenditures by raising loans from the public.

(Deficit financing has also often been included as an instrument of fiscal policy. Since it has already been discussed earlier in this chapter it is not repeated again.)

RECAP
  • One of the most important sources of revenue for the government in most countries is taxation
  • Public borrowing is the second most important source of revenue.
FISCAL POLICY AND STABILIZATION IN THE ECONOMY

In any economy, due to the business cycles there are many ups and downs causing instability in the economy.

An Automatic Stabilizer

An automatic stabilizer is a built-in mechanism in any economy which automatically reduces the change in the output in response to a change in the level of the autonomous demand. The changes in the taxes and in the government expenditures vary automatically and in the desired direction to bring about stability in the economy.

 

An automatic stabilizer is a built-in mechanism in any economy which automatically reduces the change in the output in response to a change in the level of the autonomous demand.

The business cycles are often caused due to the changes in the level of the autonomous demand, particularly investment. Sometimes, the investors are optimistic and go in for high levels of investment while at other times the investors are pessimistic and go in for low levels of investment. The automatic stabilizer diminishes the effects on the output level due to the swings in the investment. There is no deliberate action or interference by the government to bring about stability.

Two automatic stabilizers are:

  1. A proportional income tax: When the gross national product of an economy increases, the tax revenue increases automatically because some tax payers progress into the higher income and tax brackets. When the gross national product of an economy decreases, the tax revenue decreases automatically because some tax payers retreat into the lower brackets. Hence, the tax revenues automatically move in the requisite direction thus bringing about stabilization in the economy.
  2. Unemployment benefits: In many economies, unemployment benefits are paid to the workers who are without a job. These make it possible for the unemployed to consume even during a recession. Hence, there is no decrease in the level of consumption and in aggregate demand. As a result, output remains stable even during recessions due to the unemployment benefits.

    On the other hand, during a boom the number of unemployed falls and hence there is a decrease in the unemployment benefits. Hence, the increases in the level of consumption and in aggregate demand are controlled to some extent. Thus, output remains stable even during periods of boom.

    Existence of automatic stabilizers reduces the fluctuations which occur in the output due to the business cycles. However, a major limitation of automatic stabilizers is that though they can prevent a downturn in the output level from becoming worse but they cannot prevent a downturn from taking place. This is because they come into effect only when a downturn has occurred. Hence, they cannot on their own prevent a downturn and initiate an upturn.

Discretionary Fiscal Policy

Discretionary fiscal policy refers to the deliberate changes in the government expenditure and the tax rates by the government in an economy in order to bring about stability in the economy.

It is important to note that the above explanation of discretionary fiscal policy is more applicable for a developed country where the main concern is with stabilization. However, as far as a developing country is concerned, the discretionary fiscal policy would be designed more towards achieving economic development.

A major limitation in the implementation of fiscal policy is the time lag involved in its implementation. Not only is there a delay in making decisions relating to the fiscal policy actions to achieve a particular goal, even once the decision has been made there are innumerable delays in the implementation and the execution of the policies. The time lag involved at the different stages of the fiscal policy actions leads to a decrease in the effectiveness of the policy.

RECAP
  • A major limitation of automatic stabilizers is that though they can prevent a downturn in the output level from becoming worse but they cannot prevent a downturn from taking place.
  • A major limitation in the implementation of fiscal policy is the time lag involved in its implementation.
FULL EMPLOYMENT BUDGET SURPLUS

In an economy, the effect of any fiscal plan on the economic activity is associated with the size of the fiscal budget:

  1. When the government expenditure is greater than government revenues, there exists a deficit in the budget and the government policy is stimulative or expansionary.
  2. When government expenditure is smaller than government revenues, there exists a surplus in the budget and the government policy is restrictive or contractionary.

However, it is incorrect to measure the direction of the fiscal policy as expansionary or contractionary by analysing a budget deficit or a budget surplus. A budget may be in deficit during a recession when there is a decrease in the tax revenue. On the other hand, a budget may be in surplus during a boom when there is an increase in the tax revenue.

To measure the effect of fiscal policy on the level of output, a policy measure is necessary which is independent and not related to the business cycles. The full employment budget surplus is often quoted to be such a policy measure.

A related concept is the budget surplus, BS. The budget surplus is the excess of government revenue over its total expenditures. While the government revenue is in the form of taxes, its total expenditures are in the form of purchases of goods and services and transfer payments.

 

The budget surplus is the excess of government revenue over its total expenditures.

Thus, BS = TA – G – TR
where, BS = budget surplus
  TA = tY = proportional tax
    G = government expenditure on goods and services
  TR = transfer payments
Thus, BS = tYG – TR

A negative budget surplus is an excess of government expenditure over government revenue. In simpler terms, it is a budget deficit.

The full employment budget surplus measures the budget surplus at the full employment level of income. It is also known as the high employment surplus, the standardized budget surplus or the cyclically adjusted surplus (or deficit). If Y* is the full employment income level, then BS* = tY* – G – TR.

 

The full employment budget surplus measures the budget surplus at the full employment level of income.

Thus, BS* – BS = t (Y* – Y).

It is important to note that

  1. If the actual output level is higher than the full employment level, then the full employment budget surplus is smaller less than the actual surplus.
  2. If the actual output level is smaller than the full employment level, then the full employment budget surplus is larger than the actual budget surplus.

While the full employment budget and actual budget differ due to the cyclical factor in the budget, the full employment budget surplus differs from the actual budget surplus only in respect of tax collections.

The full employment budget surplus is a convenient way of analysing the impact of the budget and the effect of any fiscal plan on the economic activity.

The full employment budget surplus has been depicted in Fig. 25.1 where BS is the line depicting the budget surplus. It has been plotted as a function of income, given the fiscal policy choices in terms of t, G and TR. When the income level is high, the budget is in surplus or the budget surplus is high as the government revenue from tax is large. When the income level is low, the budget is in deficit or there is a budget deficit as the government revenue from tax is small.

In the figure suppose that the full employment level of output or income is at Y*. The full employment budget surplus is BS*.

  1. At an income level of Y′, the government will have a balanced budget where the government expenditure matches the government revenue.
  2. At lower levels of income, for example, if the income level is below the full employment level at Y1, the budget will be in a deficit or there is a negative budget surplus. This occurs in spite of there being a surplus at the full employment level. This may happen, for example during recessions, when G + TR are larger than the collections from taxes.
  3. At higher levels of income, G + TR is smaller than the collections from taxes.

The changes in the budget often occur due to changes in fiscal policy:

  1. An increase in the government expenditure: An increase in government expenditures will decrease the budget surplus.

    Change in income due to the increase in government expenditures can be expressed as

    Figure 25.1 Budget Surplus

    But a fraction of this increased income is collected as taxes. Thus, there is an increase in tax revenue equal to

    Change in budget surplus:

    The change in the budget surplus is clearly negative. Thus, an increase in the government expenditure will decrease the budget surplus.

  2. A rise in the tax rate: An increase in the tax rate reduces the disposable income but increases the budget surplus.

We have observed that while an increase in the government expenditure decreases the budget surplus, an increase in the tax rate increases the budget surplus. It may appear that the budget surplus is a suitable measure of analysing the directions and effects of fiscal policy.

Besides the fiscal policy choices relating to t, G and TR, the budget deficit or surplus also depends on factors that affect the level of income. Thus, the budget surplus suffers from a serious defect in case it is used to measure the effects of fiscal policy. The problem is that there can occur a change in the budget surplus even due to a change in autonomous private investment expenditure. An increase in investment expenditures increases the income level. This leads to an increase in tax revenues and hence there is an increase in budget surplus or a decrease in the budget deficit. In this, it is quite obvious that the government has played no part in bringing about a change in the deficit.

RECAP
  • An increase in the government expenditure or a decrease in the tax rate will decrease the budget surplus.
  • Besides the fiscal policy choices relating to t, G and TR, the budget deficit or surplus, also depends on factors that affect the level of income.
LIMITATIONS OF FISCAL POLICY
  1. The existence of a time lag Similar to monetary policy, this is perhaps one of the major problems in the path of the working of fiscal policy. There exists a considerable time lag between the time there is a realization for the need for a fiscal policy and the time by which the response of the policy in bringing about changes in aggregate demand is felt.

    The time lags can be divided under two heads:

    1. Inside lags These include the considerable time taken by the parliament or the state legislaturesb in giving their consent to the changes in the fiscal policy. There are long bureaucratic procedures which govern the changes required in taxation and government expenditures.
    2. Outside lags Once the approvals have been given, the changes in the fiscal policy act directly on aggregate demand and the output.

      It is imperative to observe that in case of fiscal policy, inside lags are longer than the outside lags. However, the existence of the lags is certainly responsible for reducing the efectiveness of the fiscal policy. The policy makers, keeping in mind the existence of the lags, may oft en try to take the future into consideration in their attempts to bring about stability in the economy. But since the future is uncertain and difficult to predict, they may actually land up doing just the opposite, that is destabilize the economy. Hence, the policymakers should refrain from intervening in the functioning of the economy unless it is absolutely necessary to do so since they may do more harm than good.

  2. The underdeveloped nature of the less developed countries limits the effectiveness of the fiscal policy The major problems in the implementation of fiscal policy in the less developed countries are:
    1. In such economies, sectors like the agriculture sector are often non-monetized. It is difficult for the administrators to asses the taxes to be paid by this sector which is formed mainly by the farmers and the self employed. Often, the agricultural sector is either exempt from taxation or subject to a minimal tax. Hence, the entire burden of the tax has to be borne by the monetized sector which is unjust and inequitable because the rich and the powerful landowners are able to get away without paying little or no tax.
    2. In most such countries, the tax laws are highly complicated with various types of exemptions and deductions. As a result, many interpretations and loopholes coexist which in turn make the tax laws a fertile ground for long drawn litigation. The tax rates which ideally should be progressive end up being regressive favouring the smart, who incidentally are also rich, and who are able to take advantage of the loopholes while the general public and fixed income group bears the brunt of the tax. There are problems even at the level of the tax enforcement. The tax machinery is generally highly inefficient and prone to corruption which results in revenue leakages from the government coffers.
    3. The excessive burden of public debt: Often, the resources which are generated through tax and other sources may prove to be insufficient for the ever increasing expenditures necessary for development of the economy. Hence, the authorities have to raise public debt, or in other words borrowings, both internal and external.

The problems associated with public debt are innumerable. Not only have the loans to be paid back, the interest payments have also to be made at regular intervals. The problem is more acute in the case of external borrowings where all repayments are in terms of foreign currency. This will necessitate that the country earns sufficient foreign exchange to be in a position to pay back the debt. Often, a country may be caught in an external debt trap where it is forced to take on a fresh loan to pay back just the interest on the earlier loan. Even with internal borrowings, the government may have to take recourse to deficit financing which leads to inflation and related problems.

RECAP
  • The existence of a time lag, underdeveloped nature of the less developed countries and the excessive burden of public debt limit the effectiveness of the fiscal policy.
CROWDING OUT AND ITS IMPORTANCE

Crowding out is a situation which takes place when an expansionary fiscal policy causes an increase in the rate of interest of interest leading to a decrease in private spending, especially the investment level.

 

Crowding out is a situation which takes place when an expansionary fiscal policy causes an increase in the rate of interest leading to a decrease in private spending, especially the investment level.

In Figure 25.2, effects of an expansionary fiscal policy have been analysed in terms of the IS–LM framework. The initial equilubrium is determined by the intersection of the curves IS1 and LM at point E1. Due to an expansionary fiscal policy, the equilibrium shifts to E2 and not E′. The income level increases to Y2 and not Y′. The reason for this can be explained in terms of the rise in the rate of interest from r1 to r2. This has a contractionary effect on investment. Thus, the increase in government spending crowds out private investment spending. The adjustments which occur in the interest rate have a dampening effect on the increase in output which is caused by the increase in government spending. It is to be noted that the higher the increase in the rate of interest rate due to increase in government spending, the greater will be the crowding out effect.

Figure 25.2 Effects of Expansionary Fiscal Policy

The crowding out depends on certain factors:

  1. The flatter is the LM curve, the lower is the increase in interest rates and thus the higher is the increase in income.
  2. The flatter is the IS curve, the lower is the increase in the interest rate and thus the lower is the increase in income.
  3. The larger the value of the multiplier, the higher the increase in the interest rate and the income.

The importance of crowding out can be analysed by considering following three cases:

  1. In an economy where there exist unemployed resources, a fiscal expansion may increase the level of output but it may not increase the interest rate, as shown in Fig. 25.3. The reason may be the increase in the supply of money by the monetary authorities in order to accommodate the fiscal expansion. This would prevent the rise in the interest rate.

    Monetary accommodation is also described as monetizing the budget deficit. It involves the printing of more money by the monetary authorities. Such a situation has been depicted in Figure 25.3 where both the IS and LM curves shift to the right and equilibrium shifts from E1 to E’. The income level increases from Y1 to Y′ while the rate of interest remains unchanged at r1. There need not occur a decrease in investment and hence there may not be any crowding out.

  2. In an economy where the level of output is below the full employment level, a fiscal expansion increases the level of aggregate demand but now the firms can hire additional workers to increase the output level. There will be an increase in both the rate of interest and income level. However, there occurs an increase in savings in the economy which will make possible the financing of a larger budget deficit without there being a total displacement of private investment. Hence, there will not be a full crowding out.
  3. In an economy where the level of output is at the full employment level, a fiscal expansion increases the level of aggregate demand which will lead to an increase in the price level. This will decrease the real money balances causing the LM curve to shift to the left, raising interest rates until the initial increase in the aggregate demand is totally crowded out.

Figure 25. 3 A Fiscal Expansion and Monetary Accommodation

RECAP
  • In an economy where there exist unemployed resources, there may not be any crowding out.
  • In an economy where the level of output is below the full employment level, there will not be a full crowding out.
  • In an economy where the level of output is at the full employment level, there will be complete crowding out.
SUMMARY
INTRODUCTION
  1. This chapter examined monetary policy and fiscal policy and their functioning.
  2. An attempt has also been made at understanding the goals which these policies aim at achieving.
MEANING OF MONETARY POLICY
  1. Monetary policy is an operation by the monetary authorities of the country to achieve certain well-defined macroeconomic objectives/goals.
  2. It is generally the central bank of the country which undertakes the implementation of the monetary policy. It operates through changes in the quantity of money.
INSTRUMENTS OF MONETARY POLICY
  1. The main objectives which the monetary policy aims at achieving include economic growth, a higher rate of employment and price stability.
  2. To achieve the objectives of monetary policy, there exist various instruments which can be divided into two categories: quantitative or general measures and qualitative or selective measures.
  3. Quantitative or general measures of monetary policy control the total volume of credit and the cost of credit in the economy and thus the supply of money. They include open market operations, variations in reserve requirements, statutory liquidity requirement, bank rate policy, repo rate and reverse repo rate.
  4. Open market operations refer to the sale and purchase of government securities and treasury bills by the central bank. It is an instrument of monetary control which is most powerful and which is most widely used by the central bank.
  5. The advantages of open market operations are: they are highly flexible, easily reversible in time and do not have any announcement effects.
  6. Variations in reserve requirements can be divided under two heads, required reserves and excess reserves.
  7. Required reserves are cash balances which banks hold to meet their statutory reserve requirements. The purpose of these reserves is to safeguard the interest of the depositors. It also enables the central bank to be able to control liquidity.
  8. Excess reserves are reserves in excess of the required reserves. They are held by the banks for meeting currency drains and clearing drains.
  9. It is often alleged that variations in reserve requirements are an inferior tool of monetary policy because they lead to lumpy and discontinuous changes in the deposits and also in that they produce announcement effects.
  10. Under the statutory liquidity requirement, banks are statutorily required to maintain a certain fixed proportion of their demand and time liabilities in the form of designated liquid assets.
  11. In India, like the CRR, the SLR has not been very successful as an instrument of monetary policy.
  12. Bank rate policy or the discount rate is the rate of interest at which the central bank rediscounts eligible bills of exchange or other commercial papers.
  13. The limitation of the bank rate policy is that it is more sticky in comparison to the other rates and the changes in it are discontinuous and have announcement effects.
  14. The repo rate is the rate at which the central bank infuses short-term liquidity into the system. In simpler terms, it is the rate at which the central bank lends to the banks. The reverse repo rate is the rate at which banks park their short-term excess liquidity with the central bank in exchange for government securities. It is the rate at which the central bank borrows from the banks.
  15. Qualitative or selective measures of monetary policy control the direction and distribution of credit in the economy. They include rationing of credit, change in margin requirements, moral suasion and direct action.
  16. Credit rationing is resorted to when there occurs a shortage of institutional credit.
  17. Change in margin requirements works indirectly to influence lending and thus regulate the capital markets.
  18. Moral suasion is a combination of persuasion and pressures which a central bank asserts to bring the erring banks in line so that they function in accordance with the central bank’s directives.
  19. Direct action refers to the coercive actions resorted to by the central bank against banks who do not function according to its directives.
  20. Deficit financing refers to ways in which the deficit in the government’s budget is financed. The central bank merely prints more currency and then puts them into circulation on behalf of the government.
  21. One major problem that is associated with deficit financing is that it always results in inflation.
LIMITATIONS OF MONETARY POLICY

The limitations of monetary policy are the existence of a time lag, presence of non-bank financial intermediaries reducing the impact of the monetary policy through an increase in the velocity of money and the underdeveloped nature of the money and capital markets.

MEANING OF FISCAL POLICY
  1. Fiscal policy refers to the government’s policy regarding government expenditure, taxation and public borrowing with the view to achieving certain well-defined macroeconomic objectives.
  2. It was only with the coming of Keynes that fiscal policy gained importance.
  3. The monetarists believed that with the exception of some circumstances, in general, increases in government expenditures do not add to aggregate demand but in fact are responsible for crowding out private investment of an equal amount.
INSTRUMENTS OF FISCAL POLICY
  1. To implement fiscal policy, the government has at its behest several instruments which include taxation, government expenditure and public borrowing.
  2. Taxation is one of the most important sources of revenue for the government in most countries. Taxes can be analysed under two headings: direct taxes which include corporate income taxes, personal income tax and taxes on wealth and property and indirect taxes which include sales tax, excise duty and customs duty.
  3. In the developed countries, the direct taxes are a more important source of revenue for the government as compared to the developing countries where indirect taxes are more important.
  4. Since the Great Depression, the government’s role in economic activity is continuously on the increase. It was realized that government expenditure is imperative for an economy in the form of investments in capital goods industries, building the infrastructure and payments of wages and salaries.
  5. Though public borrowing is the second most important source of revenue, it is unlike taxes. All the borrowings from the public must be paid back in the future. Public borrowing can take two forms: compulsory loans and voluntary loans where bills and securities are issued by the government.
FISCAL POLICY AND STABILIZATION IN THE ECONOMY
  1. In any economy, due to the business cycles there are many ups and downs causing instability in the economy. Fiscal policy actions can tackle the problem of instability.
  2. Two automatic stabilizers are: a proportional income tax and unemployment benefits. A major limitation of automatic stabilizers is that though they can prevent a downturn in the output level from becoming worse but they cannot prevent a downturn from taking place.
  3. Discretionary fiscal policy refers to the deliberate changes in the government expenditure and the tax rates by the government in an economy in order to bring about stability in the economy. A major limitation in the implementation of fiscal policy is the time lag involved in its implementation.
LIMITATIONS OF FISCAL POLICY
  1. The effective working of fiscal policy is hindered due to the existence of different obstacles.
  2. The existence of a time lag which includes inside lags and outside lags. In case of fiscal policy, inside lags are longer than the outside lags.
  3. The underdeveloped nature of the less developed countries limits the effectiveness of the fiscal policy. It is difficult for the administrators to asses the taxes to be paid by agriculture sector. In most countries, the tax laws are highly complicated.
  4. Often, the resources which are generated through tax and other sources may prove to be insufficient and the authorities may have to resort to public debt.
CROWDING OUT AND ITS IMPORTANCE
  1. Crowding out is a situation which takes place when an expansionary fiscal policy causes an increase in the rate of interest leading to a decrease in private spending, especially the investment level.
  2. An increase in government spending crowds out private investment spending. It is to be noted that the higher the increase in the rate of interest rate due to increase in government spending, the greater will be the crowding out effect.
  3. The importance of crowding out can be analysed by considering three cases.
  4. In an economy where there exist unemployed resources, a fiscal expansion may not lead to any crowding out.
  5. In an economy where the level of output is below the full employment level, there will not be a full crowding out.
  6. In an economy where the level of output is at the full employment level, there will be a full crowding out.
REVIEW QUESTIONS
TRUE OR FALSE QUESTIONS
  1. Monetary policy is an operation by the monetary authorities of the country.
  2. The two categories of instruments of monetary policy at the disposal of the central bank are the quantitative or general measures and the qualitative or selective measures.
  3. Required reserves are cash balances which the central bank holds to meet its statutory reserve requirements.
  4. According to the statutory liquidity requirement, banks are required to maintain a certain fixed proportion of their liabilities in the form of designated liquid assets.
  5. Reverse repo rate is the rate at which the central bank infuses short-term liquidity into the system.
VERY SHORT-ANSWER QUESTIONS
  1. What is the difference between monetary policy and credit policy?
  2. Mention the main objectives which the monetary policy aims at achieving.
  3. Name the two categories of instruments of monetary policy at the disposal of the central bank.
  4. What are excess reserves? Why are they held by the banks?
  5. What is the difference between the repo rate and the reverse repo rate?
SHORT-ANSWER QUESTIONS
  1. What is the meaning of monetary policy?
  2. What is an open market operation?
  3. What is fiscal policy? Discuss.
  4. Why are variations in reserve requirements said to be an inferior tool of monetary policy as compared to open market operations?
  5. Write a short note on the bank rate policy.
LONG-ANSWER QUESTIONS
  1. What are the instruments of monetary policy? How are the two categories different from each other?
  2. ‘Open market operation is an instrument of monetary control which is most powerful and which is most widely used by the central bank’. Discuss.
  3. How can fiscal policy actions tackle the problem of stabilization in the economy?
  4. ‘To implement fiscal policy, the government has at its behest several instruments which include taxation, government expenditure and public borrowing.’ Comment.
  5. What is crowding out? Why is it important?
ANSWERS
TRUE OR FALSE QUESTIONS
  1. True. Monetary policy is an operation by the monetary authorities of the country to achieve certain well-defined macroeconomic objectives.
  2. True. These instruments give the central bank the power to control the money supply and, hence, achieve the macroeconomic objectives.
  3. False. Required reserves are cash balances which commercial banks hold to meet their statutory reserve requirements.
  4. True. This is a statutory requirement where the banks are required to maintain a certain fixed proportion of their demand and time liabilities in the form of designated liquid assets.
  5. False. Reverse repo rate is the rate at which banks park their short-term excess liquidity with the central bank in exchange for government securities.