MACROECONOMIC POLICIES

MONETARY POLICIES
MACROECONOMIC
POLICIES

MONETARY POLICY

Regulated by Central
Bank and Commercial
Banks
MONETARY POLICY
Monetary policy refers to the steps taken by the RBI to regulate the cost & supply
of money & credit in order to achieve the socio-economic objectives of the
economy. Monetary policy influences the supply of money the cost of money or
the rate of interest and the availability of money.
Monetary policy is an economic policy that manages the size and growth rate of
the money supply in an economy. It is a powerful tool to regulate
macroeconomic variables such as inflation and unemployment.

According to D.C. ROWAN , `` Discretionary act undertaken by the authorities

designed to influence (a)The supply of money, (b)Cost of money or rate of interest
and , (c)The availability of money.”

• Basis of Monetary Policy is that there is a long run relationship between the
amount of money and inflation.
• Demand for Money – the amount people wish to hold as cash as opposed to other
assets.
• The Supply of Money – the amount of money in circulation in the economy
 OBJECTIVES OF MONETARY POLICY
Full Employment :
Full employment has been ranked among the foremost objectives of monetary policy. It is an important goal not only
because unemployment leads to wastage of potential output, but also because of the loss of social standing and self-
respect.
Price Stability :
One of the policy objectives of monetary policy is to stabilise the price level. Both economists and laymen favour this
policy because fluctuations in prices bring uncertainty and instability to the economy.
Economic Growth :
One of the most important objectives of monetary policy in recent years has been the rapid economic growth of an
economy. Economic growth is defined as “the process whereby the real per capita income of a country increases over
a long period of time.”
Balance of Payments :
Another objective of monetary policy since the 1950s has been to maintain equilibrium in the balance of payments.
Controlled Expansion :
Control business cycle, Promote export and substitute imports, Promotes savings and expansion, By ensuring more
credit for priority sector.
To Regulate and Expand Banking :
Give directives to different banks for setting up branches for promoting agriculture credit.
TOOLS OF MONETARY POLICY
They affect the level of aggregate demand through the supply of money, cost of
money and availability of credit. Of the two types of instruments, the first category
includes bank rate variations, open market operations and changing reserve
requirements. They are meant to regulate the overall level of credit in the economy
through commercial banks. The selective credit controls aim at controlling specific
types of credit. They include changing margin requirements and regulation of
consumer credit.
 Bank Rate
A bank rate is the interest rate at which a nation's central
bank lends money to domestic banks, affecting domestic
banks' monetary policy
Quantitative Measures
General or Indirect Repo Rate
rate at which commercial banks borrow money by selling their
securities to the Central bank of our country i.e Reserve Bank of
India (RBI) to maintain liquidity, in case of shortage of funds or
due to some statutory measures. It is one of the main tools of
RBI to keep inflation under control.

Reverse Rate
changes in the reserve ratio directly impacts the
amount of loanable funds available.

Interest Rate
MSF (Marginal Standing Facility)
a window for banks to borrow from the Reserve
Bank of India in an emergency situation when inter-
bank liquidity dries up completely
 TOOLS OF MONETARY POLICY
Quantitative Measures
General or Indirect

Cash Reserve Ratio (CRR) Statutory Liquidity ratio(SLR)

It refers tothe minimum percentage of a bank’s total
deposits by the customers required tobe kept with the
Central Bank in the form of cash reserves.
HIGH CRR – less credit availability –will reduce the money
supply
Low CRR – more credit availability will increase the
money supply
Every bank is required to maintain a fixed percentage of its
assets in the form of cash or other liquid assets, called SLR.
SLR(Statutory Liquidity ratio) is a requirement peculiar to
India. In addition to ensuring that banks can fall back on the
readily saleable government deposits in the event of a run
on the bank, it was a prescription to divert bank deposits to
meet government investment expenditure.
HIGH SLR – less credit availability –will reduce the money
supply
Low SLR– more credit availability will increase themoney
supply
 TOOLS OF MONETARY POLICY

Quantitative Measures
General or Indirect

Banks as well as other financial institutions, such as insurance companies, mutual funds and corporate with surplus
cash are big investors in government securities.
When RBI wishes to inject liquidity into the market, it has another option of buying government securities.When
RBI offers to buy the securities at a rate that is better than the rate prevailing in the market, some of the investors
can sell their holdings and the cash inflow would lead to credit creation of a large magnitude.
Similarly, when RBI sells government securities at a higher rate than market rate, RBI absorbs funds and the
banking system contracts credit by a large magnitude to reduce liquidity. This is known as open market
operation.
 TOOLS OF MONETARY POLICY
Qualitative Measures
Selective or Direct DIRECTACTION :
The central bank may initiate direct action against member banks in case these do no
comply with itsdirectives.
Direct action includes derecognition of a commercial bank as a member of the
country’s banking system.

MORAL SUASION
It is a combination of both ‘persuasion’ and‘pressure’.
The Central bank tries to persuade the commercial banks to follow its directives of
monetary policy. Otherwise, it can pressurize them to follow its policy directives.

RATIONING OF CREDIT
It refers to fixation of credit quotas for different business activities.
The commercial banks cannot exceed the quota limits while grantingloans.
 TOOLS OF MONETARY POLICY
Qualitative Measures
Selective or Direct Margin Requirement :
The margin requirement of loan refers to the difference between the current value of
the security offered for loans and the value of loans granted .

Selective Credit Controls :

Selective credit controls are used to influence specific types of credit for particular
purposes. They usually take the form of changing margin requirements to control
speculative activities within the economy. When there is brisk speculative activity
in the economy or in particular sectors in certain commodities and prices start
rising, the central bank raises the margin requirement onthem.
The result is that the borrowers are given less money in loansagainst
specified securities. For instance, raising the margin requirement to 60% means
that the pledger of securities of the value of Rs10,000 will be given 40% of their
value, i.e. Rs4,000 as loan. In case of recession in a particular sector, the central
bank encourages borrowing by lowering margin requirements.
 Expansionary vs. Contractionary
Monetary Policy

Expansionary Monetary Policy

This is a monetary policy that aims to increase the money supply in the economy
by decreasing interest rates, purchasing government securities by central
banks, and lowering the reserve requirements for banks. An expansionary
policy lowers unemployment and stimulates business activities and consumer
spending. The overall goal of the expansionary monetary policy is to fuel
economic growth. However, it can also possibly lead to higher inflation.

Contractionary Monetary Policy

The goal of a contractionary monetary policy is to decrease the money supply in
the economy. It can be achieved by raising interest rates, selling government
bonds, and increasing the reserve requirements for banks. The contractionary
policy is utilized when the government wants to control inflation levels.
FISCAL POLICIES
MACROECONOMIC
POLICIES

MONETARY POLICY

Government Income Government Expenditure

 FISCAL POLICY
•The fiscal policy is concerned with the raising of government revenue and
incurring of government expenditure. To generate revenue and to incur
expenditure.
•To generate revenue and to incur expenditure, the government frames a
policy called budgetary policy or fiscal policy. So, the fiscal policy is
concerned with government expenditure and government revenue.
•Fiscal policy has to decide on the size and pattern of flow of expenditure
from the government to the economy and from the economy back to the
government.
•In broad term fiscal policy refers to "that segment of national economic
policy which is primarily concerned with the receipts and expenditure of
central government.
•Influence Aggregate Demand –
• Tax regime influences consumption (C) and investment (I)
• Government Spending (G)
• Influences key economic objectives.
• Also used to influence non-economic objectives and provide framework
for supply side policy.
• e.g. education and health, poverty reduction, welfare reform,
investment, regional policies, promotion of enterprise, etc.
TYPES OF FISCAL POLICY
TYPES OF FISCAL POLICY
OBJECTIVES OF FISCAL POLICY
Development by effective Mobilization of Resources
The financial resources can be mobilized by:
•Public Savings : The resources can be mobilized through public savings by reducing
government expenditure and increasing surpluses of public sector enterprises.
•Private Savings : Through effective fiscal measures such as tax benefits, the government
can raise resources from private sector and households.
•Taxation : Through effective fiscal policies, the government aims to mobilize resources by
way of direct taxes as well as indirect taxes because most important source of resource
mobilization in India is taxation.
Efficient allocation of Financial Resources
•The central and state governments have tried to make efficient allocation of financial
resources. These resources are allocated for Development Activities which includes
expenditure on railways, infrastructure, etc.
•While Non-development Activities includes expenditure on defense, interest payments,
subsidies, etc.
•But generally the fiscal policy should ensure that the resources are allocated for generation of
goods and services which are socially desirable.
•Therefore, India's fiscal policy is designed in such a manner so as to encourage production of
desirable goods and discourage those goods which are socially undesirable.
 OBJECTIVES OF FISCAL POLICY
Reduction in inequalities of Income and Wealth
• Fiscal policy aims at achieving equity or social justice by reducing income inequalities
among different sections of the society. The direct taxes such as income tax are charged more on the
rich people as compared to lower income groups.
•Indirect taxes are also more in the case of semi-luxury and luxury items, which are mostly consumed
by the upper middle class and the upper class.

Price Stability and Control of Inflation

• One of the main objective of fiscal policy is to control inflation and stabilize price. Therefore,
the government always aims to control the inflation by Reducing fiscal deficits, introducing tax savings
schemes, Productive use of financial resources, etc.
Increase capital
•The objective of fiscal policy in India is also to increase the rate of capital formation so as to
accelerate the rate of economic growth.
•In order to increase the rate of capital formation, the fiscal policy must be efficiently designed to
encourage savings and discourage and reduce spending.
OBJECTIVES OF FISCAL POLICY
Increase National Income
•The fiscal policy aims to increase the national income of a country. This is because
fiscal policy facilitates the capital formation. This results in economic growth, which
in turn increases the GDP, per capita income and national income of the country.
Foreign Exchange Earnings
•Fiscal policy attempts to encourage more exports by way of Fiscal Measures like,
exemption of income tax on export earnings, exemption of sales tax and octroi, etc.
•Foreign exchange provides fiscal benefits to import substitute industries.
EFFECTS OF FISCAL POLICY
MEASURES OF FISCAL POLICY
 Key Differences between FISCAL Policy and
MONETARY Policy
• The policy of the government in which it utilizes its tax revenue and expenditure policy to influence
the aggregate demand and supply for products and services the economy is known as Fiscal Policy.
The policy through which the central bank controls and regulates the supply of money in the economy
is known as Monetary Policy.
• Fiscal Policy is carried out by the Ministry of Finance whereas the Monetary Policy is administered by
the Central Bank of the country.
• Fiscal Policy is made for a short duration, normally one year, while the Monetary Policy lasts longer.
• Fiscal Policy gives direction to the economy. On the other hand, Monetary Policy brings price stability.
• Fiscal Policy is concerned with government revenue and expenditure, but Monetary Policy is
concerned with borrowing and financial arrangement.
• The major instrument of fiscal policy is tax rates and government spending. Conversely, interest rates
and credit ratios are the tools of Monetary Policy.
• Political influence is there in fiscal policy. However, this is not in the case of monetary policy.
CRITICISM OF FISCAL POLICY
• Disincentives of Tax Gains and Cuts :
Increasing Taxes to reduce AD may cause discourage to work, if this occurs there will be a fall
in productivity and AS could fall. However higher taxes do not necessarily reduce
incentives to work if the income effect dominates.
• Side Effects on Public Spending :
Reduced govt. spending to Increase AD could adversely effect public services such as public
transport and education causing market failure and social inefficiency.
• Poor Information :
Fiscal policy will suffer if the govt. has poor information. E.g. If the govt. believes there is
going to be a recession, they will increase AD, however if this forecast was wrong and the
economy grew too fast, the govt. action would cause inflation.
• Time lags :
If the govt. plans to increase spending this can take along time to filter into the economy and
it may be too late. Spending plans are only set once a year. There is also a delay in
implementing any changes to spending patterns.
• Budget Deficit :
Expansionary fiscal policy (cutting taxes and increasing Govt. spending) will cause an
increase in the budget deficit which has many adverse effects. Higher budget deficit will
require higher taxes in the future and may cause crowding out.
HIGHLIGHTS OF RELATIONSHIP
BETWEEN POLICIES
• Both are used to achieve macroeconomic objectives.
• Both influence output and interest rates.
• Helps to obtain optimum policy mix.
EXAMPLE :
• Prior to 1991 when economic reforms were initiated the basic goal of monetary policy was
to neutralize the impact of large fiscal deficits of the Government. To boost public sector
investment for accelerating economic growth there was large increase in Government
expenditure under various Five Year plans which was financed by borrowing by the
Government and deficit financing (i.e., monetization of budget deficit).
• Both Government borrowing from the market and deficit financing leads to the increase in
aggregate demand and have therefore potential for causing inflation. Therefore, to ensure
adequate funds to meet the borrowing requirements of the Government the statuary liquidity
ratio (SLR) of the banks was raised to the maximum limit of 38.5 per cent. That is, banks
were to buy government securities to this extent.
• Besides, to check inflation, cash reserve ratio (CRR) of banks was raised to a high level of
15 per cent. The high cash reserve leaves less funds with the banks to lend to the private
commercial sector. In this way large expansion of credit for private sector was prevented.
 Which is more effective MONETARY or
FISCAL policy?
• Monetary policy is set by the Central Bank, and therefore reduces political influence whereas
Fiscal policy can have more supply side effects on the wider economy. E.g. to reduce inflation –
higher tax and lower spending would not be popular, and the government may be reluctant to
pursue this. Also, lower spending could lead to reduced public services, and the higher income
tax could create disincentives to work.
• Monetarists argue expansionary fiscal policy (larger budget deficit) is likely to cause crowding
out Expansionary fiscal policy (e.g. more government spending) may lead to special interest
groups pushing for spending which isn’t really helpful and then proves difficult to reduce when
the recession is over
• Monetary policy is quicker to implement. Interest rates can be set every month. A decision to
increase government spending may take time to decide where to spend the money.
• Monetary policy in a planned economy of India cannot be framed independently of fiscal policy
as achieving growth with price stability are the objectives of both these policies.
• In India the Reserve Bank of India has often adopted accommodative monetary policy to
Government’s fiscal policy.