Monetary Policy and Fiscal Policy - Meaning, Objective, Instruments and Difference, Indian Economy Notes

byKumar Nirmal Prasad - 0

Monetary and Fiscal Policy
Meaning, Objective, Instruments and Difference
Indian Economy Notes

Meaning and Definition of Monetary Policy

Monetary Policy is a strategy used by the Central Bank to control and regulate the money supply in an economy. It is also known as credit policy. In India, the Reserve Bank of India looks after the circulation of money in the economy.

There are two types of monetary policies, i.e. expansionary and contractionary. The policy in which the money supply is increased along with minimization of interest rates is known as Expansionary Monetary Policy. On the other hand, if there is a decrease in money supply and rise in interest rates, that policy is regarded as Contractionary Monetary Policy.

According to A.G. Hart "A policy which influences the public stock of money substitute of public demand for such assets of both that is policy which influences public liquidity position is known as a monetary policy." From the above discussion, it is clear that a monetary policy is related to the availability and cost of money supply in the economy in order to attain certain broad objectives.

Objectives and Role of Monetary Policy:

The objectives of a monetary policy in India are similar to the objectives of its five year plans. In a nutshell planning in India aims at growth, stability and social justice. After the Keynesian revolution in economics, many people accepted significance of monetary policy in attaining following objectives.

1. Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth.

2. Price Stability: All the economics suffer from inflation and deflation. It can also be called as Price Instability. Both inflation and deflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities.

3. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate.

4. Balance of Payments (BOP) Equilibrium: Many developing countries like India suffer from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved.

5. Full Employment: Full Employment refers to absence of involuntary unemployment. In simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs. However, it does not mean that there is Zero unemployment. In that senses the full employment is never full. Monetary policy can be used for achieving full employment.

6. Equal Income Distribution: Many economists used to justify the role of the fiscal policy are maintaining economic equality. However, in recent years’ economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality.

Instruments of Monetary Policy or Credit Control Tools

The instruments used by the central Bank for controlling the supply of bank money are classified into two categories namely
A)     General Instruments  (Quantitative Credit Control)and
B)      Selective Instruments (Qualitative Credit Control).
A)     The General Instruments of Credit Control:  These instruments are called general because they are uniformly applicable to all commercial banks and in respect of loans given for all purposes. The general instruments are as follows:
                    i.      The Bank rate policy: Bank rate is the official rate at which the central bank of the country rediscounts bills offered by the commercial banks.
When the central bank wants to bring about a reduction in bank credit, it raises the bank rate. The effect is that the commercial banks raise the market rate in order to retain their profit margin. Rise in the market rate brings about a reduction in the volume of bills offered by the customers to the commercial banks. If the volume of bills is less, the amount of money going out from the commercial banks to the people is less i.e.: the supply of money is less.
If the central bank wants to bring about an expansion of Bank credit it lowers the bank rate. The commercial banks can lower the market rate due to which the people offer more bills for discounting and the supply of money increases.
                  ii.      Open Market Operations:  The Central bank enters in to the bond market and purchases or sells government securities for bringing about expansion or reduction of credit.
                iii.       Variable Reserve Ratio: Every commercial bank in the country is under a legal obligation to keep a certain proportion of their deposits in the form of cash with the central bank of the country. The ratio of these cash deposits to the total deposits of a commercial bank is called the cash reserve ratio. RBI is authorised to change the rate within that margin depending upon the requirements of the time.  When the banks keep more cash with the central bank they are left with less cash for advancing loans. The supply of credit money declines.
                 iv.            Statutory Liquidity Ratio (SLR): It is legally obligatory on the part of all commercial banks to invest a certain part of their deposits in government bonds. The ratio of the money invested in government bonds to the total deposits is called the statutory liquidity ratio. The RBI is authorised to fix and change the SLR within this margin.
When it wants to bring about a reduction of credit, it increases the SLR. The commercial banks have to invest a larger part of their deposits in government bonds. To that extent they are left with less cash for advancing loans that puts a brake on their capacity to extend credit.
                   v.            Repo Rate: This is the rate at which RBI advances short term funds to the commercial banks. A rise in the repo rate means that the commercial banks have to pay higher rates of interest to RBI. Consequently they have to charge higher rates of interest to their customers. The cost of money is raised. The demand for money falls and the amount of money flowing from the RBI to the commercial banks and thereafter from the commercial banks to the public is reduced.
B)      Selective Instruments of Credit Control: These instruments of monetary policy can be used in respect of any particular bank or in respect of a loan given against a particular security. Hence they are called selective instruments. The prominent amongst them are as follows:
i.        Regulation of credit margin: Whenever a commercial bank gives a loan against a tangible security, it maintains a margin between the value of the security and the amount of the loan given. This is necessary for maintaining safety of the bank. It also provides an instrument to the central bank to control the volume of credit given against a particular security.  This instrument is especially used for preventing cornering of stocks of essential raw materials.
ii.      Direct Action:  The central bank gives instructions to the commercial banks in respect of their lending policies. If a particular bank ignores the instructions RBI can take disciplinary actions against it. The action consists of charging a penal rate of interest to the offending bank, stopping lending to that bank or rejecting the bills offered by that bank for discounting. In any case the bank has to raise the rate charged to the customers which drives the customers away from that bank.
iii.    Moral suasion: The central bank interacts with the commercial banks and urges them to adopt a particular credit policy. The commercial banks accept the policy suggested by the central bank because they have a respect for the central bank.
Moral suasion is better than direct action. It is preventive whereas direct action is curative. A frequent direct action taken by the central bank spoils the atmosphere between the central bank and the commercial banks. Hence as far as possible the central bank relies upon moral suasion.
iv.     Consumer credit: The commercial banks advance loans to enable their customers to purchase durable costly consumer goods. The central bank can prescribe the rate of interest which they have to charge on these loans. It can also fix the installments in which the loans are to be recovered. If the rate of interest is raised and the number of installments is reduced it is difficult for the people to use them. The demand for the concerned consumer commodity falls.
v.       Publicity: The central bank of the country gives a wide publicity to its policy through its publications. The commercial banks accept that policy even when the central bank does not insist upon it. This method is also widely used by the central banks in developing countries.
Conclusion: In a developing country like India, the selective instruments are used more. They produce positive as well as negative effect. They directly bring about the desired change. They can be effective even if the country does not like a well organized money market and capital market.

Meaning and Definition of Fiscal Policy

When the government of a country employs its tax revenue and expenditure policies to influence the overall demand and supply for commodities and services in the nation’s economy is known as Fiscal Policy. It is a strategy used by the government to maintain the equilibrium between government receipts through various sources and spending over different projects.

If the revenue exceeds expenditure, then this situation is known as fiscal surplus, whereas if the expenditure is greater than the revenue, it is known as the fiscal deficit. The main objective of the fiscal policy is to bring stability, reduce unemployment and growth of the economy. The instruments used in the Fiscal Policy are the level of taxation & its composition and expenditure on various projects.

Difference between Fiscal Policy and Monetary Policy

The economic position of a country can be monitored, controlled and regulated by the sound economic policies. The fiscal and monetary policies of the nation are the two measures, which can help in bringing stability and developing smoothly. Fiscal policy is the policy relating to government revenues from taxes and expenditure on various projects. Monetary Policy, on the other hand, is mainly concerned with the flow of money in the economy.

Fiscal policy alludes to the government’s scheme of taxation, expenditure and various financial operations, to attain the objectives of the economy. On the other hand, monetary policy, scheme carried out by the financial institutions like the Central Bank, to manage the flow of credit in the country’s economy. The common difference between Fiscal policy and monetary policy are given below:

Basis

Fiscal Policy

Monetary Policy

Meaning

The tool used by the government in which it uses its tax revenue and expenditure policies to affect the economy is known as Fiscal Policy.

The tool used by the central bank to regulate the money supply in the economy is known as Monetary Policy.

Nature

The fiscal policy changes every year.

The change in monetary policy depends on the economic status of the nation.

Administration

Fiscal policy is administered by Ministry of Finance.

Monetary Policy is administered Central Bank

Related to

Government Revenue & Expenditure

Banks & Credit Control

Focus

Economic Growth

Economic Stability

Instruments

Tax rates and government spending are key instruments of monetary policy.

Interest rates, CRR and SLR are key instruments of monetary policy.

Objectives and Role of Fiscal Policy

1. Increase in Savings: This policy is also used to increase the rate of savings in the country. In the developing countries rich class spends a lot of money on luxuries. The government can impose taxes on them and can provide the basic necessities of life to the poor class on low rate. In this way by providing incentives, savings can be increased.

2. To Encourage Investment: The government can encourage the investment by providing various incentives like the tax holiday in the various sectors of the economy. The capital can be shifted from less productive sectors to more productive sectors. So the resources of the country can be utilized maximum.

3. To Achieve Equal Distribution of Wealth: Fiscal policy is very useful for the achievement of equal distribution of wealth. When the wealth is equally distributed among the various classes then their purchasing power increases which ensures the high level of employment and production.

4. To Control Inflation: Fiscal policy is very useful weapon for controlling the rate of inflation. When the expenditure on non-productive projects is reduced or the rate of taxes are increased then the purchasing power of the people reduces.

5. To Reduce the Regional Disparity: In the less developing countries the regional disparity is found. Some areas are more developed while the others are less developed. Government provides the infrastructure facilities in less developed areas. The tax holiday incentive is also provided in these areas which is very useful in increasing the per capita income.

6. Stabilization of Price Level: Fiscal policy is also used to achieve desirable level of prices in the country. It means the cost and price should be at such level that production and employment may increase.

Instruments of Fiscal Policy

Following are the main instruments of fiscal policy:

1. Public Expenditure: Expenditure means expenditure incurred by the government of a country. It generates sufficient influence on aggregate demand and development activities of a country. The expenditure can be of two types:

a. Expenditure incurred by the government to get goods and services. It directly influences aggregate demand.

b. Public expenditure incurred on pensions, scholarships, educational and medical facilities to people etc. This expenditure is known as Transfer Payment. It also raises aggregate demand.

2. Public revenue and taxation: A government needs income for the performance of a variety of functions and meeting its expenditure. Thus, the income of the government through all sources like taxes, borrowings, fees, and donations etc. is called public revenue or public income. In a modern welfare state, public revenue is of two types:

(a)    Tax revenue and

(b)    Non-tax revenue.

(a) Tax Revenue: A fund raised through the various taxes is referred to as tax revenue. Taxes are compulsory contributions imposed by the government on its citizens to meet its general expenses incurred for the common good, without any corresponding benefits to the tax payer. Seligman defines a tax thus: “A tax is a compulsory contribution from a person to the government to defray the expenses incurred in the common interest of all, without reference to specific benefits conferred.

Examples of Tax Revenue 

Ø  Income Tax (on income of the individual as well as joint Hindu families, Companies, AOP, BOI etc) 

Ø  Custom Duty, import and export duty.

Ø  Goods and Services Tax

(b) Non Tax Revenue: The revenue obtained by the government from sources other than tax is called Non-Tax Revenue. The sources of non-tax revenue are: Fees, Fines or Penalties, Surplus from Public Enterprises, Special assessment of betterment levy, Grants and Gifts etc.

3. Public Debt: The third instrument of fiscal policy is public debt. Public debt refers to all types of borrowings by the govt. from among the institutions, organisations and the public. The government has to take the help of public debt if public expenditure exceeds public revenue. Public debt can be of:

a) Internal Debt: Internal debt comprises of all borrowings and market loans which were formerly called permanent or funded debt. In consists of all internal borrowings and market loans. It includes treasury bills issued by the govt. of India to the RBI, state govt., Commercial Banks and other parties.

b) External Debt: External debt includes loans taken by the govt. of India against the non – negotiable, non – interest hearing securities issued to international financial institutions like the IMF, IBRD, IDA, ADB, etc. Besides these the loans taken by the govt. of India from friendly countries are also included. External debt also includes loans taken from the IMF trust fund.

c) Other Outstanding Liabilities: This include all outstanding liabilities against the various small savings schemes, public provident fund and state provident fund contributions, income tax annuity deposit schemes, interest bearing reserve funds of the department of the Railways, Post and telegraphs, etc.

4. Deficit Financing: Deficit means an excess of public expenditure over public revenue. A public expenditure has to be incurred for economic development. This amount can be collected only through the public debt, taxation etc. So deficit financing has to be introduced. When there emerges a deficit due to excess of public expenditure over public revenue, this deficit is met with either by borrowing from the central bank or by issuing new notes. Deficit financing can be used to meet government expenditure. It increases aggregate demand.

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