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Policy Responses To Ease Credit Crisis








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Credit Crisis
Policy Responses To Ease Credit Crisis

The various policies adopted by government and central bank across the
world to ease credit crisis could be summed under following heads:

 Monetary Policy
 Fiscal Policy

Before discussing on how they can ease credit crisis, we need to know the

What these policies are?

What are the effects of these on Economy?

Policy works because it has artists pulling the strings.

Monetary Policy

Monetary policy is the process by which the government, central bank, or

monetary authority of a country controls
(i) the supply of money,
(ii) availability of money, and
(iii) cost of money or rate of interest.
Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as either being an expansionary policy, or a
contractionary policy, where an expansionary policy increases the total
supply of money in the economy, and a contractionary policy decreases the
total money supply. Expansionary policy is traditionally used to combat
unemployment in a recession by lowering interest rates, while
contractionary policy involves raising interest rates in order to combat
inflation. Monetary policy should be contrasted with fiscal policy, which
refers to government borrowing, spending and taxation.
Monetary policy rests on the relationship between the rates of interest in an
economy, that is the price at which money can be borrowed, and the total
supply of money. Monetary policy uses a variety of tools to control one or
both of these, to influence outcomes like economic growth, inflation,
exchange rates with other currencies and unemployment
The primary tool of monetary policy is open market operations. This entails
managing the quantity of money in circulation through the buying and
selling of various credit instruments, foreign currencies or commodities.
The other primary means of conducting monetary policy include:
(i) Discount window lending (i.e. lender of last resort);
(ii) Fractional deposit lending (i.e. changes in the reserve
(iii) Moral suasion (i.e. cajoling certain market players to achieve
specified outcomes);
(iv) "Open mouth operations" (i.e. talking monetary policy with the

Trends in central banking

The central bank influences interest rates by expanding or contracting the

monetary base, which consists of currency in circulation and banks' reserves
on deposit at the central bank. The primary way that the central bank can
affect the monetary base is by open market operations or sales and purchases
of second hand government debt, or by changing the reserve requirements.
If the central bank wishes to lower interest rates, it purchases government
debt, thereby increasing the amount of cash in circulation or crediting banks'
reserve accounts.
Alternatively, it can lower the interest rate on discounts or overdrafts (loans
to banks secured by suitable collateral, specified by the central bank). If the
interest rate on such transactions is sufficiently low, commercial banks can
borrow from the central bank to meet reserve requirements and use the
additional liquidity to expand their balance sheets, increasing the credit
available to the economy.
Recent attempts at liberalizing and reforming the financial markets
(particularly the recapitalization of banks and other financial institutions in
US elsewhere) are gradually providing the latitude required in order to
implement monetary policy frameworks by the relevant central banks.
Target Market
Monetary Policy: Long Term Objective:
Interest rate on A given rate of change in the
Inflation Targeting
overnight debt CPI
Price Level Interest rate on
A specific CPI number
Targeting overnight debt
Monetary The growth in money A given rate of change in the
Aggregates supply CPI
Fixed Exchange The spot price of the
The spot price of the currency
Rate currency
Low inflation as measured by
Gold Standard The spot price of gold
the gold price
Usually unemployment + CPI
Mixed Policy Usually interest rates

The different types of policy are also called monetary regimes, in parallel to
exchange rate regimes. A fixed exchange rate is also an exchange rate
regime; The Gold standard results in a relatively fixed regime towards the
currency of other countries on the gold standard and a floating regime
towards those that are not. Targeting inflation, the price level or other
monetary aggregates implies floating exchange rate unless the management
of the relevant foreign currencies is tracking the exact same variables (such
as a harmonised consumer price index).
Fiscal Policy

Fiscal policy is an additional method to determine public revenue and public

expenditure. In the recent years importance of fiscal policy has increased
due to economic fluctuations. Fiscal policy is an important instrument in the
modern time. A fiscal policy is a policy under which government uses its
expenditure and revenue programme to produce desirable effects and avoid
undesirable effects on the national income, production and employment.

Objectives of fiscal policy:

The objectives of fiscal policy may be regarded as follows;
 To achieve desirable price level: The stability of general prices is

necessary for economic stability. The maintenance of a desirable price

level has good effects on production, employment and national
income. Fiscal policy should be used to remove; fluctuations in price
level so that ideal level is maintained.
 To achieve desirable consumption level: A desirable consumption

level is important for political, social and economic consideration.

Consumption can be affected by expenditure and tax policies of the
government. Fiscal policy should be used to increase welfare of the
economy through consumption level.
 To achieve desirable employment level: The efficient employment

level is most important in determining the living standard of the

people. It is necessary for political stability and for maximization of
production. Fiscal policy should achieve this level.
 To achieve desirable income distribution: The distribution of income

determines the type of economic activities the amount of savings. In

this way, it is related to prices, consumption and employment. Income
distribution should be equal to the most possible degree. Fiscal policy
can achieve equality in distribution of income.
 Increase in capital formation: In under-developed countries deficiency

of capital is the main reason for under-development. Large amounts

are required for industry and economic development. Fiscal policy
can divert resources and increase capital.
 Degree of inflation: In under-developed countries, a degree of

inflation is required for economic development. After a limit,

inflationary be used to get rid of this situation.

Instruments of Fiscal Policy:

1. Public expenditure
2. Taxes
3. Public debts

The above mentioned instruments are used by the public authorities to

achieve desirable level of production, consumption and National Income.
During inflationary trend more and more taxes are levied on the community.
In this way, purchasing power of the people can be decreased and desirable
price level is achieved. During inflation public expenditure is decreased so
that all in production may decrease high prices and increase the value of
money. During deflationary period taxes are reduced and public expenditure
is increased. In this way incentives to invest are increased and national
income begins to rise. For economic development public debts are
necessary. In under developed countries, due to insufficient resources
economic development is not possible. Public loans are drawn internally and
The above mentioned methods are called budgetary policy of the
government. This policy can increase national income, production level and
maintain full employment level. Fiscal policy, taking the scope of budgetary
policy, refers to government policy that attempts to influence the direction
of the economy through changes in government taxes, or through some
spending (fiscal allowances).

The two main instruments of fiscal policy are government spending and
taxation. Changes in the level and composition of taxation and government
spending can impact on the following variables in the economy:
 Aggregate demand and the level of economic activity

 The pattern of resource allocation

 The distribution of income.

Fiscal policy refers to the overall effect of the budget outcome on economic
activity. The three possible stances of fiscal policy are neutral, expansionary
and contractionary:
 A neutral stance of fiscal policy implies a balanced budget where G =
T (Government spending = Tax revenue). Government spending is
fully funded by tax revenue and overall the budget outcome has a
neutral effect on the level of economic activity.
 An expansionary stance of fiscal policy involves a net increase in
government spending (G > T) through a rise in government spending
or a fall in taxation revenue or a combination of the two. This will
lead to a larger budget deficit or a smaller budget surplus than the
government previously had, or a deficit if the government previously
had a balanced budget. Expansionary fiscal policy is usually
associated with a budget deficit.
 Contractionary fiscal policy (G < T) occurs when net government
spending is reduced either through higher taxation revenue or reduced
government spending or a combination of the two. This would lead to
a lower budget deficit or a larger surplus than the government
previously had, or a surplus if the government previously had a
balanced budget. Contractionary fiscal policy is usually associated
with a surplus.

Methods of funding

Governments spend money on a wide variety of things, from the military

and police to services like education and healthcare, as well as transfer
payments such as welfare benefits.
This expenditure can be funded in a number of different ways:
(i) Taxation
(ii) Seignorage, the benefit from printing money
(iii) Borrowing money from the population, resulting in a fiscal deficit.
(iv) Consumption of fiscal reserves.
(v) Sale of assets (e.g., land).


 The main goal of the fiscal policy in developing countries is the
promotion of the highest possible rate of capital formation.
Underdeveloped economies are in the constant deficit of the capital in
the economy and thus, in order to have balanced growth accelerated
rate of capital formation is required. For this purpose the fiscal policy
has to be designed in a way to raise the level of aggregate savings and
to reduce the actual and potential consumption of people.
 To divert existing resources from unproductive to productive and
socially more desirable uses. Hence, fiscal policy must be blended
with planning for development.
 To create an equitable distribution of income and wealth in the
 To protect the economy from the ills of inflation and unhealthy
competition from foreign countries.
 To maintain relative price stability through fiscal measures.
 The approach to fiscal policy must be aggregate as well as segmental.
the sectoral imbalances can be curbed by appropriate segmental fiscal
 The government expenditure on developmental planning projects
must be increased. For this deficit financing can be used. It refers to
creation of additional money supply either by creation of new money
by printing by government or by borrowing from the central bank.
 Public borrowing, loans from foreign nations etc can be used in the
development of the resources for public sector.
 Fiscal policy in the developing economy has to operate within the
framework of social, cultural and political conditions which inhibit
formation and implementation of good economic policies.
 In order to reduce inequalities of wealth and distribution, taxation
must be progressive and government spending must be welfare-
 The hindrances in the effective implementation of fiscal policy in the
developing countries are loopholes in taxation laws, corrupt tax
administration, a high population growth, extravagant governmental
spending on non-developmental items, an orthodox society etc.

Considering the current scenario in respond to credit crisis following

Monetary and Fiscal measures have been and could be taken:

Monetary Measures

1. Decrease the CRR(Cash Reserve Ratio)

2. Decrease the Repo rate/Fed Rate

3. Increase Open Market Operations(i.e. purchasing bonds and

marketable securities from market)
4. Decrease the Interest Rates
5. Issuing Bail Out Packages
6. Decrease Exchange Rates
7. Promotes foreign investments by increasing the minimum permeable

limit.(Regulatory Measures)
8. Encourage external commercial borrowing(Regulatory Measures)
9. Decrease PLR(Prime Lending Rate)

Fiscal Measures

1. Increase Public Expenditure

2. Decrease Tax Rates
3. Issuing or Printing New Currency
4. Consumption of Fiscal Reserves/Surplus Budget

5. Purchase of Assets