Economic Fluctuations and Stabilization

Policies

Monetary Policy & Fiscal Policy

Dr Ritesh Kumar Mishra

Department of Finance and Business Economics, University of Delhi
 Stabilization and Business Cycle

• Economists use the term stabilization policy to refer to policy actions aimed at
reducing the severity of short-run economic fluctuations.

• Because output and employment fluctuate around their long-run natural levels,
stabilization policy dampens the business cycle by keeping output and employment
as close to their natural levels as possible.

• The stabilization policies (monetary and fiscal policies) are used to control or
minimize the fluctuations of business cycles in an economy.

• Events like – Recent slow down in Indian Economy (2019), Global financial crisis (2009),
Eurozone crisis and Great Depression (1929-33) – highlight the role of stabilization
policies.
 Business Cycle: a simple introduction

• Business cycles are defined as:

 Fluctuations in aggregate economic activity in which many economic activities expand and
contract together in a recurring, but not a periodic, fashion (Arthur Burns and Wesley Mitchell,
1946; Mishkin, 2014, pp. 208).

• So business cycles recur—that is, they happen over and over again—but not always at
the same magnitude or after intervals of the same length (Burns and Mitchell, 1946).

• The variability of economic cycles makes them challenging to forecast.

• Economists often refer to business cycle contractions as recessions, which is generally

defined as periods when economic activity declines and real GDP falls.

• A particularly severe business cycle contraction is called a depression.

 Business Cycle Basics

• Changes in economic activity:

• Expansion (when investment, employment, output and income increase)

• Contraction

• Phases of Business Cycle:

• Prosperity (Boom) – Peak

• Recession
• Depression – Trough
• Recovery
Business Cycle Basics
Business Cycle: India’s GDP
 Business Cycle Basics

• Shocks to the economy, such as bursts in consumer and business optimism, surges in
government spending, and oil price shocks can cause aggregate economic activity to
deviate from its potential level in the short run.

• This deviation, shown in Figure 8.1 (see the previous slide) as Y - YP, is referred to as
the output gap.

• Business cycles can also be characterized as upward and downward swings of the
output gap.

• One challenge policy makers face is that output gaps can be hard to measure, because
it is not easy to decide when resources have been fully utilized.

• Thus estimates of potential output may be inaccurate.

 Using Monetary Policy to Control RECESSION

• Monetary Policy:

• Monetary policy is the macroeconomic policy laid down by the central bank.

• It involves management of money supply and interest rate and is the demand
side economic policy used by the government of a country to achieve
macroeconomic objectives like inflation, consumption, growth and liquidity.

• In India, monetary policy of the Reserve Bank of India is aimed at managing the
quantity of money in order to meet the requirements of different sectors of the
economy and to increase the pace of economic growth.
 Objectives & Central Bank’s Preference
[In case of difficulty, do not focus on equations]

• We can derived the MR curve by minimizing the central bank’s loss function subject to the
Phillips curve constraint.

• The key equations are:

• Central Bank Loss Function (LF):

• Phillips Curve (PC):

• Monetary Rule Curve (MR):

Tradeoff Between Inflation and Unemployment (PC)
 RBI’s Money & other Economic Variables: QTM

• With this basic foundation, we can now discuss the broad macroeconomic effects of
monetary policy.

• The quantity theory of money, remains the leading explanation for how money affects
the economy in the long run.

• The starting point of the quantity theory of money is the insight that people
hold money to buy goods and services.

• The more money they need for such transactions, the more money they hold.
 RBI’s Money and other Economic Variables

• Thus, the quantity of money in the economy is related to the number of rupees
exchanged in transactions.

• The link between transactions and money is expressed in the following equation,
called the quantity equation:
 Inflation: a brief introduction
• Inflation – is defined as the increase in general price level.

• Classification of Inflation:

• Benign Inflation (2 – 4%)

• Malign Inflation (Very high)

• Types of Inflation

• Demand pull inflation

• Cost push inflation
• Expectation induced inflation, etc.
 Classification of Inflation for policy intervention
• For policy interventions central banks generally focus on two measures of inflation:

• Headline Inflation
• Core Inflation

• Headline inflation – includes prices of food and fuel items

• Core inflation – excludes the prices of food and fuel items

• Measurement of inflation:

• Wholesale price based index (WPI)

• Consumer price based index (CPI)
 Objectives of Monetary Policy: India

• The primary objective of monetary policy (See Mohan and Ray, 2019; www.rbi.org):

• is to maintain price stability while keeping in mind the objective of growth. Price
stability is a necessary precondition to sustainable growth.

• May 2016 – the RBI Act, 1934 was amended to provide a statutory basis for the
implementation of the flexible inflation targeting (FIT) framework.

• The amended RBI Act also provides for the inflation target to be set by the Government
of India, in consultation with the Reserve Bank, once in every five years.

• The CPI base inflation target for the period from August 5, 2016 – March 31, 2021 is 4%
(with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent).
 The Monetary Policy Framework: India

• Central banks throughout the world (i.e. the FED and RBI) use a very short-term
interest rate on safe debt as their primary policy tool.

• The framework aims at setting the policy (repo) rate based on an assessment of the
current and evolving macroeconomic situation.

• And modulation of liquidity conditions to anchor money market rates at or around the
repo rate.

• Repo rate changes transmit through the money market to the entire the financial
system, which, in turn, influences aggregate demand – a key determinant of inflation
and growth.

• So, RBI directly controls the Repo rate, which is a short-term nominal rate, but
economic activity, or real variables are influenced by real interest rate.
 Real Interest rate

•How does the RBI’s control of the policy rate enable it to control the real interest rate, through
which monetary policy impacts the economy?

•The real interest rate, r, is the nominal interest rate, i, minus expected inflation, πe.

•Changes in nominal interest rates can change the real interest rate only if actual and expected
inflation remain unchanged in the short run.

•When prices are sticky (as is the case in short-run), changes in monetary policy will not have an
immediate effect on inflation and expected inflation.

•As a result, when the RBI lowers the policy rate, real interest rates fall; and when it raises the
policy rate, real interest rates rise.
 Types of Interest rates

• Broadly speaking, the different types of interest rates are:

• Nominal interest rate

• Real interest rate
• Policy rate
• Natural or Neutral rate

• The policy rate is a nominal interest rate, but we know that, it is the real interest
rate that affects household and business spending, thereby determining the level of
equilibrium output.
 Instruments of Monetary Policy: India

• There are several direct and indirect instruments that are used for implementing
monetary policy:
www.rbi.org

• Policy Rate:
• Repo Rate
• Reverse Repo Rate

• Marginal Standing Facility (MSF)

• Bank Rate
• Cash Reserve Ratio (CRR) – in RBI
• Statutory Liquidity Ratio (SLR)
• Open Market Operations(OMO)
 Applying Monetary Policy

Monetary Policy Tools Inflation Deflation Depression

Interest Rate (Repo Rate) Increase Decrease Decrease

Cash Reserve Ratio (CRR) Increase Decrease Decrease

Statutory Liquidity Ratio (SLR) Increase Decrease Decrease

Open Market Operations (OMO) Sell Bonds (Buy Rs.) Buy Bonds (sell Rs.) Buy Bonds (sell Rs.)
Fiscal Policy
Understanding the Balance Sheet of the Government – The Budget
Understanding the Government’s Balance sheet – Budget at a Glance (2020-2021)
 Some Budget Related Concepts

• Union Budget is broadly divided into two parts:

• Revenue account
• Capital account

• These two are further divided into receipts and expenditure:

• Capital account is divided into: Capital receipts & Capital expenditure.

• Revenue account is divided into: Revenue receipts & Revenue expenditure.
 Some Budget Related Concepts
• The expenditure incurred by the government is broadly divided into two parts:

• Capital expenditure – expenditure which results in creation or acquisition of assets.

• Revenue expenditure – expenditure used for operational expenses and liabilities and does
not create any kind of assets.

• Capital Expenditure: The Union government defines capital expenditure as the

money spent on the acquisition of assets.

• Revenue Expenditure: Part of government expenditure that does not result in the
creation of assets.
 Capital Expenditure
• What are the examples of Capital Expenditure?

• Capital expenditure is the part of the government spending that goes into the creation of
assets like schools, colleges, hospitals, roads, bridges, dams, railway lines, airports and
seaports.

• Capital expenditure also covers the acquisition of equipment and machinery by the
government, including those for defense purposes.

• Capital expenditure also includes investment by the government that yields profits or
dividend in future.

• Loans and advances granted by the Central Government to the State and the Union
Territory Governments, Government companies, Corporations and other parties.
 Capital Receipts
• What are the examples of Capital Receipts?

• The capital receipts are loans raised by the Government from the public (these are termed
as market loans)
• Borrowings by the Government from the Reserve Bank of India and other parties through
the sale of Treasury Bills,
• The loans received from foreign Governments and bodies,
• Disinvestment receipts
• Recoveries of loans from State and Union Territory Governments and other parties.
Capital Receipts (Budget 2020-21)
 Revenue Budget  

• Modern governments collect huge sums of money. Expenditure of these large amounts has
become an extremely complex task.

• The Revenue Budget consists of the revenue receipts of the Government (Tax revenues and
other Non Tax revenues) and the expenditure met from these revenues.

• Apart from spending on salaries and pensions, the government also spends on the
construction of schools, colleges, hospitals, roads, bridges, railways, airports and seaports.

• It also incurs expenses on securing the country from internal and external enemies.
 Revenue Expenditure 
• What is included in revenue expenditure?

• The Union government’s revenue expenditure comprises money spent on revenue account:

• The amount spent on running its elaborate machinery.

• All grants given to state governments and Union territories are also treated as revenue
expenditure, even if some of these grants may be used for the creation of capital assets.

• In India, the payment of subsidies is also included in revenue expenditure. The central
government pays subsidy under three major heads – food subsidy, fertilizer subsidy and
fuel subsidy.

• Making interest payments on debt

 Revenue receipts
• What is included in revenue receipts ?

• Revenue receipts of the Government are of two types:

• Tax revenues
• Other Non Tax revenues

• Tax revenues comprise proceeds of taxes and other duties levied by the Union.

• Other non-tax receipts of the Government mainly consist of interest and dividend on
investments made by the Government, fees and other receipts for services rendered by the
Government.
Revenue receipts – Tax Revenue (Budget 2020-21)
Revenue receipts – Non - Tax Revenue (Budget 2020-21)
 Revenue Deficit

• Revenue deficit arises when the government's revenue expenditure exceeds the total revenue
receipts.

• Revenue deficit includes those transactions that have a direct impact on a government’s
current income and expenditure.

• This represents that the government’s own earnings are not sufficient to meet the day-to-day
operations of its departments.

• Revenue deficit turns into borrowings when the government spends more than what it earns
and has to resort to the external borrowings.
 Revenue Deficit
• How is it calculated?

Revenue Deficit: Total revenue receipts – Total revenue expenditure

• How is Revenue deficit met?

• To overcome such a financial situation, the government can take these measures:
• Through the borrowings or sale of existing assets, the deficit could be met from the capital
receipts.
• The government can increase its non-tax or tax receipts.
• The government could try to reduce unnecessary expenditures.
 Revenue Deficit
• What does Revenue Deficit indicate?

• Revenue Deficit is shown as a reference indicator in the Medium-term Fiscal Policy

Statement (MTFP).

• The Revenue Deficit of the government has several implications, such as, it has to be met
from the capital receipts, because of which a government either borrows or sells its existing
assets. This brings in a reduction in assets.

• Also, to meet its consumption expenditure, since the government uses capital receipts, it
leads to an inflationary situation in the economy.

• With more and more such borrowings, along with interest, the burden to repay the liability
also increases which, in the future, results in huge revenue deficits.
Budget at a Glance (https://www.indiabudget.gov.in/doc/Budget_at_Glance/bag1.pdf)
 Fiscal Deficit

• Fiscal Deficit is the difference between the total income of the government (total taxes and
non-debt capital receipts) and its total expenditure.

• A fiscal deficit situation occurs when the government’s expenditure exceeds its income.

• This difference is calculated both in absolute terms and also as a percentage of the Gross
Domestic Product (GDP) of the country.

• A recurring high fiscal deficit means that the government has been spending beyond its
means.
 Fiscal Deficit
• What constitutes the government’s total income or receipts (and expenditures)?

• It has two components revenue receipts and non-tax revenues.

Revenue receipts of the

 Non-tax revenues Expenditures of the
government
government:
• Interest Receipts
• Corporation Tax
• Dividends and Profits • Revenue Expenditure
• Income Tax
• External Grants • Capital Expenditure
• Custom Duties
• Other non-tax revenues • Interest Payments
• Union Excise Duties
• Receipts of union • Grants-in-aid for creation
• GST and taxes of Union
territories of capital assets
territories.
 Fiscal Deficit

• Fiscal Deficit formula: How is Fiscal Deficit calculated?

Fiscal Deficit = Total expenditure of the government (capital and revenue expenditure) – Total
income of the government (Revenue receipts + recovery of loans + other receipts)

• How is Fiscal Deficit met?

• The government meets fiscal deficit by borrowing money. In a way, the total borrowing
requirements of the government in a financial year is equal to the fiscal deficit in that year.
 Primary Deficit
• Primary Deficit indicates the borrowing requirements of the government, excluding interest.

• It is the amount by which the total expenditure of a government exceeds the total income.

• Note that primary deficit does not include the interest payments made.

• Also, primary deficit shows the borrowing requirements needed for meeting the expenditure
of the government.

• Primary Deficit = Fiscal Deficit (Total expenditure – Total income of the government) –
Interest payments (of previous borrowings)
Rupee Comes From (Budget 2020-21)
Rupee Goes To (Budget 2020-21)
 FRBM Act (2003-04)
• What is FRBM Act? Why is it always discussed around the Budget?

• The Fiscal Responsibility and Budget Management (FRBM) Act was enacted in 2003 which set targets for the
government to reduce fiscal deficits. The targets were put off several times.

• In May 2016, the government set up a committee under NK Singh to review the FRBM Act. The government
believed the targets were too rigid. The committee recommended that the government should target a fiscal
deficit of 3 per cent of the GDP in years up to March 31, 2020 cut it to 2.8 per cent in 2020-21 and to 2.5
percent by 2023.

• In Budget 2017, Finance Minister Arun Jaitley deferred the fiscal deficit target of 3% of the GDP and chose a
target of 3.2%, citing the NK Singh committee report. The Comptroller and Auditor General of India had pulled
up the government for deferring the targets which it said should have been done through amending the Act.

• In Budget 2018, the government is not likely to meet its fiscal deficit target of 3.2% due to several factors such
as low GST collections, spike in oil prices and pressure to spend more due to upcoming elections. 
Will the Budget suspend the FRBM’s fiscal deficit goals?(The Hindu, January 24, 2020 00:15 IST)
Will the Budget suspend the FRBM’s fiscal deficit goals?(The Hindu, January 24, 2020 00:15 IST)
 Fiscal Policy

• Taken broadly, fiscal policy involves decisions about government spending and
taxation.

• Or we can define fiscal policy as policy makers’ decisions to change government

spending or taxes

• Like any household or office budget, the government’s budget reflects both outlays
(in the form of government spending) and income (in the form of tax revenue).

Expenditure Income
Government purchases Personal taxes
Transfer payments Contributions for social insurance
Grants in aid Taxes on production and imports (tariffs )
Net interest payments Corporate taxes
 Budget deficits and Surpluses

• The Central government is not required to balance its budget. But zero or less deficit
is always preferred.

• When government revenue exceeds spending, the government runs a Budget

surplus (well, that’s a dream for us !!).

• When government spending outstrips revenue, the government runs a Budget

deficit (Oh, that’s a reality for us !!).

• The formula for the government budget deficit is as follows:

Debt–to–GDP
 Tools of Fiscal Policy
• There are three main tools of fiscal policy:

• Taxation
• Government Expenditure
• Transfers and Grants in aid

• Applying fiscal policy

Tools Inflation Depression

Taxation Increase Decrease
Government Expenditure Decrease Increase
Transfers Decrease Increase
Tax Payers Money and Fiscal Austerity
 Recent Development in Indian Economy

• Major events:

• The Government of India announced the demonetisation of all ₹500 and ₹1,000 banknotes

of the Mahatma Gandhi Series – 8th November, 2016.

• GST implemented – Midnight of 1st July, 2017.

• Insolvency and Bankruptcy Code, 2016 (IBC).

Recent Development in Indian Economy
Recent Development in Indian Economy
Recent Development in Indian Economy
Thank You