Monetary Policy

Monetary policy is a set of actions that can be undertaken by a nation's central

bank to control the overall money supply and achieve sustainable economic
growth.

The Monetary Policy is the plan of action undertaken by the monetary

authority, especially the central banks, to regulate and control the demand
for and supply of money to the public and the flow of credit so as to
achieve the macroeconomic goals.

By managing the money supply, a central bank aims to influence

macroeconomic factors including inflation, the rate of consumption, economic
growth, and overall liquidity.

In addition to modifying the interest rate, a central bank may buy or sell
government bonds, regulate foreign exchange (forex) rates, and revise the
amount of cash that the banks are required to maintain as reserves.

Types of Monetary Policy

Expansionary Monetary Policy: The expansionary monetary policy is

adopted when the economy is in a recession, and the unemployment is the
problem. The expansion policy is undertaken with an aim to increase the
aggregate demand by cutting the interest rates and increasing the supply of
money in the economy. The money supply can be increased by buying the
government bonds, lowering the interest rates and the reserve ratio. By
doing so, the consumer spending increases, the private sector borrowings
increases, unemployment reduces and the overall economy grows.
Expansionary policy is also called as “easy monetary policy”.
Although the expansionary monetary policy is useful during the slow period
in a business cycle, it comes with several risks. Such as the economist
must know when the money supply should be expanded so as to avoid its
side effects like inflation. There is often a time lag between the time the
policy is made and the time it is implemented across the economy, so up-
to-the-minute analysis of the policy is quite difficult or impossible. Also, the
central bank and legislators must know when to stop the supply of money
in the economy and apply a Contractionary  Policy.
 2. Contractionary Monetary Policy: The Contractionary Monetary
policy is applied when the inflation is a problem and economy needs
to be slow down by curtailing the supply of money. The inflation is
characterized by increased money supply and increased consumer
spending. Thus, the Contractionary policy is adopted with an aim to
decrease the money supply and the spendings in the economy. This
is primarily done by increasing the interest rates so that the borrowing
becomes expensive.

Tools of Monetary Policy in India

The Central bank designed the tools of monetary policy. Several central
banks will create a common three tools for monetary policy irrespective of
the nation. So the basic tools of monetary policy in India are:
Discount Rates
The discount rate is one of the basic terms of monetary policy. The
monetary policy aims to stabilize and regulate the nation's economy, which
can be fulfilled by a change in discount rates. If the discount rate is
reduced, the investors can get less money and take loans from other
Banks. It helps any increase in the liquidity of cash. It creates growth in the
economy. If the discount rate is high, all the procedures are vice versa.

Requirement of Reserves
Every nation has to maintain some reserves of all kinds of resources,
especially financial resources. To maintain these reserves, the government
should understand the basic requirements of that particular country. 10 to
these results are certain portions of the available funds or investments to
the reserve bank. As a result, the Bank of India holds a specific part of the
existing money in the form of cash. It is used to lend its customers and also
for businesses. It keeps reserves from the deposits and provides them in
the form of loans. It also earns some money which may help to maintain
the necessities of the Central Bank and the subsidiary Banks.

Growth in Open Market Operations

We all know that a market is a place where we can buy and sell goods.
Here the open market refers to the buying and selling of securities from
various countries. This is another tool of monetary policy that is designed
for trading activity, and it is directed and regulated by the various countries
of central banks of that particular Nation with which we make a deal.

What are the Instruments of Monetary Policy?

Instruments of monetary policy in India are categorized into two types. One
is qualitative, and the other one is quantitative instruments. These are
designed based on the toons of monetary policy which is prescribed by The
Reserve Bank of India. Instruments of monetary and credit control will act
as an excellent weapon for the country to regulate the demand and supply
of resources to that particular nation. So, they have designed these
instruments.

Qualitative Instruments
 Credit Rationing
 Licensing
 Requirement of margins
 Dynamic interest rates
 The consumer rate is to be regulated

Quantitative Instruments
 Open market operations
 Bank rates
 Repo rates and reverse repo rates
 Liquidity
 Change in requirement
 Objectives of the Monetary Policy

‘Growth with Stability’ is the backbone of the monetary policy. Some of the
major objectives of monetary policies are the management of inflation or
unemployment, and maintenance of currency exchange rates.

The policy helps in the regulation of the availability, cost, and use of money.
Here are the primary objectives of the monetary policy

Growth with Stability

The central bank adopts a various policies of growth with stability. In simple

terms, tt the The central bank provides sufficient credit for the increasing needs
of the different sectors of the economy. Also, it controls inflation within a
certain limit.

Regulation, Supervision, and Development of Financial Stability

the central bank gives a lot of importance to maintaining confidence of a

country’s financial system through adequate regulation and controls. It also
ensures that the objective of growth is not sacrificed. Therefore, we can say
that the central ban focuses on the regulation, supervision, and development of
financial stability.

Promoting Priority Sector

the priority sector includes agriculture, export, small-scale enterprises, and the
weaker section of the population. Central Bank consistently ensures that the
banking system provides timely and adequate credit to these sections at
affordable costs.

Employment Generation

The monetary policy of a country can influence the rate of investment and its
allocation among the different economic activities of the country with varying
labor intensities. Therefore, it helps in employment generation.

External Stability

Traditionally, the central bank determines the exchange rate and also controls
the foreign exchange market. The central bank has indirect control over
external stability through managed flexibility. Through this mechanism, the
central bank influences the exchange rate by buying or selling foreign
currencies in the open market.
Encouraging Savings and Investments

In order to encourage people to save, the central bank offers attractive interest
rates. Further, a high saving rate leads to investment.Therefore, the monetary
management via influencing interest rates can mobilize savings and thereby
investments in the country.

Redistribution of Income and Wealth

Since the the central bank controls inflation and deploys affordable credit to the
weaker sections of the society, it can redistribute income and wealth to the
weaker sections of the economy.

Regulation of NBFIs

NBFIs or Non-Banking Financial Institutions like insurance firms, venture

capitalists, currency exchanges, some microloan organizations, and pawn
shops, etc. play an important role in the economy

the central bank does not directly control the functioning of these institutions.
However, through the monetary policy, it can indirectly influence the policies
and functions of the NBFIs.

What Is Fiscal Policy?

Fiscal policy refers to the use of government spending and tax policies to
influence economic conditions,especially macroeconomic conditions,
including aggregate demand for goods and services, employment, inflation,
and economic growth.

Fiscal policy is based on Keynesian economics, a theory by economist John

Maynard Keynes. This theory states that the governments of nations can play a
major role in influencing the productivity levels of the economy of the nation
by changing (increasing or decreasing) the tax levels for the public and thus by
modifying public spending.

During a recession, the government may adopt expansionary fiscal policy by

lowering tax rates to increase aggregate demand and fuel economic growth.

In the face of mounting inflation and other expansionary symptoms, a

government may pursue a contractionary fiscal policy.

Various Types of Fiscal Policies

Contractionary Fiscal Policy

This involves cutting government spending or raising taxes. Thus, the tax revenue

generated is more than government spending. Also, it cuts on the aggregate demand
in the economy. So, the economic growth leading to the reduction in inflationary
pressures of the economy.

Expansionary Fiscal Policy

This is generally used to give a boost to the economy. Thus, it speeds up the growth
rate of the economy. Also, during the recession period when the growth in national
income is not enough to maintain the current living of the population.

So, a tax cut and an increase in government spending would boost economic growth
and decrease the unemployment rates. Although this is not a sustainable solution.
Because this can lead to a budget deficit. Thus, the government should use this with
caution.

Neutral Fiscal Policy

This policy implies a balance between government spending and  Furthermore, it
means that tax revenue is fully used for government spending. Also, the overall
budget outcome will have a neutral effect on the level of economic activities.

Importance and Objectives of Fiscal Policy

In the developing country, the importance and objectives of fiscal policy are
the following:

1. Full Employment:
The first and foremost objective of fiscal policy is to achieve and maintain
full employment in an economy. the state should spend sufficiently on
social and economic sectors which will help to create more employment
opportunities and increase the productive efficiency.

2. Price Stability

The fiscal policy endeavors to bring stability in prices by removing demerits

of increase/decrease in prices. The impact of the price increase can be
reduced by providing subsidy or decreasing taxes.

3. Economic Stability

One of the objectives of fiscal policy is to provide economic stability in the

country by reducing the adverse impact of international cyclical fluctuations.
The fiscal policy provides economic stability by controlling external and
internal forces.

4. Control on Inflation
The fiscal policy may aim at controlling inflation. The purchasing power of
the public can be reduced by increasing taxes. It will help to check inflation
and price rise.

5. Rapid Economic Development

The government spends its revenue on those activates which will facilitate

the rapid economic development of the country. By spending on
infrastructure (Both physical and social), maintaining law and order,
protecting national boundaries and providing services for social welfare the
government promotes rapid economic development.

6. Proper Allocation of Resources

The optimum allocation of resources should be done in such a way that

it increases employment opportunities and facilitates judicious distribution
and checks misuse of national wealth. The resources can be transferred
from luxurious activities to essential activities or areas through fiscal
policy.

7. Capital Formation

fiscal policy can be used to increase the level of savings, investment, and
capital formation. Consumption can be reduced and savings can be
increased through appropriate fiscal and taxation policy. It will increase
capital formation in the country.

8. Increase In the Rate of Investment

The fiscal policy also aims at increasing the rate of investment in the
private and public sector. fiscal policy is adopted in such a way that it
reduces consumption and encourages savings.

Major tools of Fiscal Policy

Capital Expenditure
Capital expenditure refers to what a government spends on amenities such as
schools, roads, and hospitals. This spending adds to a country’s capital stock.
Besides, it affects the productivity of a country

Current Government Spending

Current government spending includes goods and services, which it regularly
provides. Such services include defense, health, and education. This
expenditure aims at at improving a country’s labor productivity.

Transfer Payments
Transfer payments are payments that the government makes through the
social security systems. Transfer payments ensure a minimum level of income
for low-income individuals. Also, they provide ways in which the government
can change the distribution of income in society

Government Revenue Tools

Indirect Taxes
Indirect taxes refer to taxes imposed on specific goods such as cigarettes,
alcohol, fuel and services. VAT is an example of an indirect tax. Health and
education can be excluded from indirect taxes.

Direct Taxes
Levies on profit, income, and wealth are direct taxes. Taxes charged on
deceased property can both raise revenue and distribute wealth. They include
capital gains taxes, national insurance taxes, and other corporate taxes.

Meaning

Definition: Inflation refers to the sustained or considerable rise in the

general price level of goods and services over a period of time. Inflation is
the rate at which the value of a currency is falling and,consequently, the
general level of prices for goods and services is rising.

Inflation is the pace at which a currency's value declines and as a result,

the general level of costs for goods and services rises. Although the price
fluctuations of individual goods can easily be calculated over time human
interests reach well beyond one or two such product

Forms of Inflation

Demand Pull Inflation

This is when the aggregate demand in an economy exceeds the aggregate supply.

This increase in the aggregate demand might occur due to an increase in the money
supply or income or the level of public expenditure.

Cost-Push Inflation

Supply can also cause inflationary pressure. If the aggregate demand remains
unchanged but the aggregate supply falls due to exogenous causes, then the price
level increases

Open Inflation

This is the simplest form of inflation where the price level rises continuously and is
visible to people. You can see the annual rate of increase in the price level.

Repressed Inflation

Let’s say that there is excess demand in an economy. Typically, this leads to an

increase in price.

However, the Government can take some repressive measures like

price control, rationing, etc. to prevent the excess demand from increasing
the prices.

Hyper-Inflation
In hyperinflation, the price level increases at a rapid rate. In fact, you can expect
prices to increase every hour. Usually, this leads to the demonetization of an
economy.

Creeping and Moderate Inflation

Creeping – In this case, the price level increases very slowly over an extended
period of time.

Moderate – In this case, the rise in the price level is neither too fast nor too slow –
it is moderate.

True Inflation

This takes place after the full employment of all the factor inputs of an economy.
When there is full employment, the national output becomes perfectly inelastic.
Therefore, more money simply implies higher prices and not more output.

Semi-Inflation

Even before full employment, an economy might face inflationary pressure due to

bottlenecks from certain sectors of the economy

Causes of Inflation

Increase in public spending, hoarding, tax reductions, price rise in international

markets are the causes of inflation. These factors lead to rising prices. Also,

increasing demands causes higher prices which leads to Inflation. In this article, we

will discuss the meaning of inflation and what causes it.

ving understood the inflation meaning, let’s take a quick look at the factors that
cause inflation.
Primary Causes

In an economy, when the demand for a commodity exceeds its supply, then the
excess demand pushes the price up. On the other hand, when the factor prices
increase, the cost of production rises too. This leads to an increase in the price level
as well.

Increase in Public Spending

In any modern economy, Government spending is an important element of the total

spending. It is also an important determinant of aggregate demand.

Usually, in lesser developed economies, the Govt. spending increases which

invariably creates inflationary pressure on the economy.

Deficit Financing of Government Spending

There are times when the spending of Government increases beyond what taxation
can finance. Therefore, in order to incur the extra expenditure, the Government
resorts to deficit financing.

For example, it prints more money and spends it. This, in turn, adds to inflationary
pressure.

Increased Velocity of Circulation

In an economy, the total use of money = the money supply by the Government x the
velocity of circulation of money.

When an economy is going through a booming phase, people tend to spend money
at a faster rate increasing the velocity of circulation of money.

Population Growth
As the population grows, it increases the total demand in the market. Further,
excessive demand creates inflation.

Hoarding

Hoarders are people or entities who stockpile commodities and do not release them
to the market. Therefore, there is an artificially created demand excess in the
economy. This also leads to inflation.

Genuine Shortage

It is possible that at certain times, the factors of production are short in supply. This
affects production. Therefore, supply is less than the demand, leading to an increase
in prices and inflation.

Exports

In an economy, the total production must fulfill the domestic as well as foreign
demand. If it fails to meet these demands, then exports create inflation in the
domestic economy.

Trade Unions

Trade union work in favor of the employees. As the prices increase, these unions
demand an increase in wages for workers. This invariably increases the cost of
production and leads to a further increase in prices.

Tax Reduction

While taxes are known to increase with time, sometimes, Governments reduce taxes

to gain popularity among people. The people are happy because they have more
money in their hands.

However, if the rate of production does not increase with a corresponding rate, then
the excess cash in hand leads to inflation.
The imposition of Indirect Taxes

Taxes are the primary source of revenue for a Government. Sometimes,

Governments impose indirect taxes like excise duty, VAT, etc. on businesses.

As these indirect taxes increase the total cost for the manufacturers and/or sellers,
they increase the price of the product to have a minimal impact on their profits.

Price-rise in the International Markets

Some products require to import commodities or factors of production from the

international markets like the United States. If these markets raise prices of these
commodities or factors of production, then the overall production cost in India
increases too. This leads to inflation in the domestic market.

Non-economic Reasons

There are several non-economic factors which can cause inflation in an economy.
For example, if there is a flood, then crops are destroyed. This reduces the supply of
agricultural products leading to an increase in the prices of the commodities.

Investment in Gold, Real estate, stocks, mutual funds, and other assets are some of
the ways to deal with Inflation.