Monetary and Fiscal Policies

MONETARY POLICY
Meaning of Monetary Policy
Refers to those policy measures of the central bank which are adopted to
control and regulate the supply of money, the cost and availability of credit in
a country.
The policy pursued by the central bank of a country for administering and
controlling countrys money supply including currency and demand deposits
and managing the foreign exchange rates.
The central bank of a country through its monetary policy manipulates the
money supply, credit, government expenditure, and rates of interest in such
a manner so that the monetary system may be benefited to the maximum
extent.
Objectives of Monetary Policy
1. Stability of Exchange Rates;
2. Price Stability;
3. Full Employment; and
4. Economic Growth with Stability.
1. Stability of Exchange Rates.
Stability of exchange rates is maintained through the device of devaluation
or revaluation of the currency, as the case may be. Now, in most of the
countries the monetary policy is directed towards achieving economic
stability.
2. Price Stability
3. Full Employment
Full employment refers to a situation in which all those who are able and
willing to work at the prevailing rates of wages get employment
opportunities.
It may not be very difficult for most countries to achieve the level of full
employment but the real problem is how to maintain it in the long run.
Periodical fluctuations in the business activities may cause unemployment in
the economic system.
4. Economic Growth with Stability
While for most of the developed countries the objective of monetary policy is
to maintain equality between saving and investment at ht full employment

level, the monetary policy in the undeveloped countries is directed towards

achieving high rate of economic growth.
Economic growth refers to a process whereby an economys real national
income increases over a long period of time. By increase in real national
income we mean more availability of goods and services in a country during
a given period of time. Thus, economic growth means the transformation of
society of a country from a state of under development to a high level of
economic achievement.
The main hindrance in economic growth is the lack of investment activities in
the underdeveloped countries.
Monetary policy may be a mixture of cheap and tight monetary
management, so as to encourage and discourage investment according to
the requirement, so as to encourage and discourage investment according
to the requirements of business activities.
Besides, the monetary policy should also aim at maintaining stability in the
economy. Monetary policy should be directed towards achieving high rate of
growth over a long period of time.
Monetary Policy in a Developing Economy
Underdeveloped countries do posses plenty of natural and manpower
resources but they are unutilized or underutilized. Most of the
underdeveloped countries suffer from the problems of low level of real per
capita income, business fluctuations, price instability, lack of credit facilities,
lack of capital formation, balance of payments disequilibrium, etc.
An effective and proper monetary policy will not only provide adequate
financial resources for economic development but also help the
underdeveloped countries to set up and accelerate the rate of output,
employment and income. It may also help these countries in containing
inflationary pressures and achieving balance of payment equilibrium.

Main objectives of monetary policy in a developing economy

1. Inducement to Saving
Capital formation which is a prerequisite to economic growth depends upon
saving. Monetary policy in an underdeveloped country helps in promoting
savings, their mobilization, and their investment in productive activities.
Monetary authority has to provide adequate banking institutions, which may
later on be utilized for investment purposes. In order to induce savings, the
monetary authority has to offer various incentives to the savers in the form of
high rate of interest, safety of deposits, etc.
2. Investment of Savings
The objective of economic growth cannot be achieved unless and until the
savings are utilized in productive investment activities.

The rate of investment is very low in underdeveloped countries on account

of the absence of profitable productive activities, lack of entrepreneurial
ability and low marginal efficiency of capital (the percentage yield earned on
an additional unit of capital). The central bank in such a situation can resort
to cheap money policy to promote investment activities.
3. Appropriate Policy as regard to Rate of Interest
High rate of interest, as they are generally witnessed in underdeveloped
countries, discourage both public and private investment. The monetary
authority, therefore, is required to formulate such a policy as regards the rate
of interest which may induce the investors to go in for more loans and
advances from the commercial banks and other financial institutions.
4. Maintenance and Monetary Equilibrium
Monetary policy in an underdeveloped country should be directed towards
achieving equality between demand for money and supply of money. In
the initial stages of economic development there is need to expand credit
facilities but once a certain level of growth is achieved credit restrictions of
various kinds must be imposed by the central bank.
5. To make Balance of Payment Favourable
Most of the underdeveloped countries have to import capital goods,
machinery, equipments, technical know-how, etc. in the initial stage of their
development. Consequently, their imports exceed the exports and balance of
payments becomes unfavourable.
Monetary policy should be directed towards maintaining stability in exchange
rates and removing disequilibrium in the balance of payments.
6. Price Stability
Internal price stability is an important objective of monetary policy in
underdeveloped countries. Violent fluctuations in the internal price level not
only disrupt the smooth working of an economy but these also lead to
insecurity and social injustice. While inflation creates enormous hardships
for the wage-earners and consumers, deflation proves disastrous for both
entrepreneurs and wage-earners.
Increasing cost of labour and material also increases the cost of various
projects, which adversely affect the rate of economic growth.
Different monetary measures can be adopted for inflationary and
deflationary conditions. If inflationary pressures are mounting in the
economy, the monetary authority can resort to stringent monetary action, so
as to restrict the supply of money and credit in the country. For example,
measures like high bank bank rate, selling of government securities,
raising the reserve ratio, raising the margin requirement, etc., can be
adopted to contain inflation.

Similarly, a different set of measures like lowering the bank rate, purchasing
government securities in open market, lowering reserve ratio, reducing the
margin requirements, etc., can be adopted to control deflation.
Thus, it is clear that the monetary authority in a developing economy can
follow the policy of monetary expansion and monetary contraction to
stabilise the internal price level.
Limitations of Monetary Policy in Developing Countries
Monetary policy can play a very crucial and significant role in the economic
development of developing countries. However, the success of the monetary
policy is limited by certain factors, the more important amongst these are as
follows:
(i) Underdeveloped Monetary and Capital Market
Most of the developing countries do not have a well-developed and fullyorganised money and capital market. In the absence of such developed
money markets it is not possible to effectively implement the various credit
control policies by the central bank.
(ii) Lack of Integrated Structure of Rate of Interest
In the developing countries a sizable proportion of the total financial
resources comes from the unorganized banking sector. In the absence of an
integrated and well-organised structure of rate of interest the central bank
fails to influence the market rate of interest through changes in the bank
rate.
In fact, any increase or decrease in the bank rate must be reflected in the
form of increased or decreased market rate of interest, but it does not
happen in the developing countries.
(iii) Banking Habits of the People
In the developing countries most of the exchange transactions are
conducted with the help of money. People very seldom use credit
instruments to perform exchange transactions. It is for this reason that the
credit control policy of the central bank does not have desired effect on the
business activities.
(iv) Lack of Co-operation by the Commercial Bank
Commercial banks are the institutions which help in the implementation of
the monetary policy pursued by the central bank. In developing countries,
however, the commercial banks fail to provide sufficient co-operation to
the central bank and in some cases they also flout the directives given by
the central bank. Monetary policy cannot succeed unless and until there
exists a proper coordination and co-operation between the central bank and
commercial banks.
(v) Literacy and Social Obstacles
Most of the developing countries suffer from mass illiteracy, superstitions,
dogmatism and other social evils. People do not understand the significance
of banking institutions. Neither they keep their deposits with the banks nor

do they avail the opportunities of loans and advances from the banks. The
success of monetary policy depends upon the widespread banking
institutions, banking habits of the people, adequate development of
credit facilities, adequate quantity of bank deposits, entrepreneurial
ability, etc.
In brief, the monetary policy in a developing country suffer from several
limitations. The monetary authority on the one hand, has to create conditions
whereby the banking and financial institutions may flourish, and, on the other
hand, it has to
exercise various restrictions and controls to regulate the supply of current and credit in
economy. The monetary authority has also to manipulate the credit policy in such a way as to
step up saving and investment activities for accelerating the rate of economic growth.

FISCAL POLICY
Monetary policy alone cannot achieve the objectives of sustained economic growth, stability and
social justice in a developing economy. It is, therefore, essential to supplement the monetary
policy by an effective fiscal policy. Monetary and fiscal policies taken together can prove to be
very effective in achieving the objective of growth with stability.
Meaning of Fiscal Policy
Fiscal policy refers to government spending, taxing, borrowing and debt management.
The government through its fiscal policy can influence the nature of economic activities in a
country.
Fiscal policy is a policy under which the government uses its expenditure and revenue
programmes to produce desirable effects and avoid undersirable effects on national income,
production and employment.
It refers to a process of shaping public taxation and public expenditure so as to help dampen the
swings of the business cycle and to contribute towards the maintenance of a progressive, high
employment economy free from excessive inflation or deflation. In other words, the modern
fiscal policy is a technique to attain and maintain full employment by manipulating public
expenditure and revenue in such a way as to keep an equilibrium between effective demand
and supply of goods and services at a particular time. In brief, the modern fiscal policy is nothing
but the application of principle of functional finance.
Objective of Fiscal Policy in a Developing Country
(i) taxation policy,
(ii) public expenditure policy, and
(iii) public debt policy.
All these constituents must work together to make the fiscal policy sound and effective.

Main objectives of fiscal policy in a developing economy

1. Mobilisation of Resources
Most of the developing countries are caught in the vicious circle of poverty. Vicious circle of
poverty refers to the circular constellation of forces, tending to act and react in such a way as to
keep a poor country in a state of poverty. The most important objective of fiscal policy in a
developing country should be to break this vicious circle of poverty.
In order to achieve the above objective it is of utmost importance to increase the rate of
investment and capital formation to accelerate the rate of growth. The government may
resort to voluntary and forced saving to collect enough resources for investment.
Incremental saving ratio, i.e. the marginal propensity to save, can be maximized by a number
of methods which may include direct physical controls, increase in the rates of existing taxes,
imposition of new taxes, operating surplus of the public enterprises, public borrowings, deficit
financing, etc.
2. Acceleration of Economic Growth
The aim of fiscal policy in a developing country is to accelerate the rate of growth so that the
real income of the country may increase in the long run.

The government, through its taxation policy, public borrowings, deficit financing, etc., can
provide incentives for saving and investment. The revenue resources collected through taxes
should be invested in productive activities. Public expenditure should be diverted towards
new and more useful development activities.
The government may also grant tax relief and subsidies to the entrepreneurial class to
boost the investment activities. Expansion of investment opportunities will certainly have a
favourable effect on the level of business activities and rate of economic growth.
The poorer section of the society should be exempted from taxes.
Growth breeds inflation. It is, therefore, essential to contain inflationary pressure in the
economy through the curtailment of consumption expenditure and avoidance of unproductive
investment. In developing countries, the level of per capita income is very low. As a result of
this, adequate voluntary savings do not take place. The government, therefore, has to depend
on taxation and public borrowings for raising revenue resources to finance development
programmes.
3. To Minimise the Inequalities of Income and Wealth
To maintain the equality of income and wealth is not only an objective of economic growth, but a
precondition to it.
The government, therefore, should formulate its fiscal policy in such a manner so that it may
reduce the inequalities of income and wealth. A mere increase in national income does not
necessarily promote economic growth. It is all the more essential to reduce the existing
inequalities of income and wealth. Extreme inequalities create political and social
discontentment and generate instability in the economy.
The following measures can be taken to reduce the inequalities of income and wealth:
(i) Progressive taxes may be imposed on the rich people so that the unnecessary
consumption expenditure is curtailed.
(iii) Luxury goods should be highly taxed and the proceeds so collected be diverted to
productive investment activities.
(iv) The government must spend more on the social services or on the items which benefit
the poor people most. Education, health, etc.
4. To Increase Employment Opportunities
One of the important objectives of fiscal policy in a developing country is to increase the
employment was regarded as the most important objective under the influence of Keynes.
Without providing full employment to the available manpower, the objective of economic growth
will remain incomplete. The government through her fiscal policy can help in creating and
promoting an atmosphere where people may get employment opportunities.
The government in a developing country can resort to the following methods to raise the
level of employment in the country.
(i) Public Spending

Public expenditure is the most potent weapon to fight against unemployment.

The level of employment depends upon effective demand. The government can influence
effective demand either by making more public expenditure or by resorting to such fiscal
methods which may raise the level of private expenditure.
The role of public expenditure becomes very significant during the period of depression when
the private entrepreneurs are not keen to take up investment activities. The government can
resort to counter cyclical fiscal policy, which means that taxes and government spending be
varied in an anti-cyclical direction; government spending being cut and taxes increased in the
expanding phase of cycle, and government spending increased and taxes cut during the
contraction phase. Increased government expenditure will open new job opportunities in the
economy, which mean creation of demand for goods and services.
Mention may also be made of pump priming and compensatory expenditure to raise the level
of employment in the economy. Pump priming refers to increase in private expenditure
through an injection of fresh purchasing power in the form of an increase in private
expenditure through an injection of fresh purchasing power in the form of an increase in
public expenditure.
It is argued that such an initial public expenditure may set in motion a process of recovery from
the condition of depression. Pump-priming is based on the assumption that a temporary
additional expenditure will generate lasting process to raise the level of employment and
income. Compensatory expenditure, on the other hand, refers to the variations in the
government budget expenditure to compensate the deficiency in private demand so as to
maintain high level of investment, employment and income stability. In the words of Keynes,
government expenditure becomes a balancing factor in order to maintain national income at a
given level. Such an expenditure may be progressively raised during depression phase of the
business cycle, and progressively reduced in the recovery phase.
(ii) Taxation Policy
Taxation policy of the government can play a very important role in raising the level of
employment in a developing economy.
Unemployment is the result of low propensity to consume.
The government can resort to redistributive tax policy to remove the deficiency in the propensity
to consume. While the rich people have a low propensity to consume the poor have a very
high propensity.
The government can impose heavy takes on the rich people and the proceeds of these taxes
may be distributed among the poor. Progressive taxes on the rich persons are socially desirable
and economically advantageous.
It should, however, be noted that the progressive taxes should not adversely affect the
inducement to save and invest. Similarly, the money transferred from the rich to the poor
should not be wasted on conspicuous expenditure but utilized for essential consumption
expenditure and investment.
While explaining the effect of taxation policy o employment it would be pertinent to mention the
idea of functional finance which was propounded by Prof. A. P. Lerner. The central idea behind

the theory of functional finance is that fiscal policy be judged by its effects on the economy as a
whole and not by any established doctrine of finance.
(iii) Public Debt Policy
Taxation policy does not prove to be very effective in the developing countries.
People in these countries have a low level of per capita income, therefore, the scope of raising
the tax rates or imposing fresh taxes is very limited. The government, therefore, has to resort to
public borrowing to meet the various public expenditure obligations.
Public debt policy can be used to control the non-essential private consumption expenditure and
to raise small savings for financing the development expenditure. The government for this
purpose can issue debentures, bonds, etc., with attractive rates of interest to encourage people
to purchase these titles. In case the government fails to collect sufficient finance through these
methods, it may resort to compulsory savings of the public.
We cannot, however, depend very much upon public debt policy for raising the level of
employment in a developing economy. Public debt will prove effective only when these debts
are collected through the idle balance with the people. If the public borrowing results in a fall in
current consumption expenditure or is financed through curtailment in investment, it will not
have desired effects on the level of employment and income.
5. Price Stability
A package of fiscal measures can be adopted to contain inflation. Some of the important
measures are:
(i) The excess purchasing power of the people should be withdrawn through taxes,
compulsory savings and public borrowings.
(ii) Some anti-inflationary taxes like taxes on luxury items, etc., should be imposed.
(iii) Besides liquid assets, cash-balances should also be taxed.
(v) Tax policy should encourage voluntary savings and control non-essential consumption
expenditure.

Limitations of Fiscal Policy in Developing Countries

Fiscal policy has achieved great success in the developed countries, but in case of developing
countries it suffers from several limitations. In fact, the nature and fundamental characteristics of
the developing countries are responsible for partial success of the fiscal policy. Some of the
limitations of the fiscal policy are as follows: First, the tax structure in the developing
countries is rigid and narrow. Thirdly, there is lack of statistical information as regard to the
income, expenditure, saving, investment, employment, etc. Lack of adequate data makes it
difficult for the public authorities to formulate a rational and effective fiscal policy.
Secondly, a sizable portion of the developing countries is non-monetised. As a result of
this, the fiscal measures pursued by the government do not prove to be very effective and
fruitful.
Fourthly, unless the people understand the implications of the fiscal policy and fully cooperate with the government in its implementation, it cannot succeed. In developing
countries, majority of the people are illiterate, and they do not understand the implications of
fiscal policy.

Fifthly, people are not conscious about their responsibilities and role in the developmental
programmes. There are cases of large-scale tax evasion with their impact on the fiscal policy
as well. In the event of tax evasion the government may fail to collect the stipulated amount
from the taxes.
Lastly, fiscal policy or for that matter any other policy requires an efficient administrative
machinery to formulate and successfully implement the policy. In developing countries,
different political groups and parties work on different lines and in different directions to
achieve their political ends without bothering about the welfare of the people at large. The
administration is corrupt and inefficient, and is incapable to execute the fiscal policy honestly
and effectively.