Monetary policy and Fiscal

Policy
• Monetary policy (MP) which is regarded as an indispensable tool of
economic management of the economy is one of those familiar
economic concepts which is difficult to define precisely.
• MP is a policy which employs central bank’s control of the supply of
money as an instrument for achieving the objectives of general
economic policy.
• Since the common objectives of economic policy are the attainment
of full employment , price stability, balance of payments equilibrium
and rapid economic growth, the effectiveness of MP depends upon
the degree to which it succeeds in achieving these objectives.
• The various instruments of MP which central bank employs to achieve
the goals of economic policy can be classified into general or
quantitative instruments and the selective or qualitative instruments.
• The quantitative instruments of credit control are:
• Open market operations
• Variation of reserve ratio
• Bank rate
• OMO is the purchase and sell of government securities by the central
bank to control the volume of aggregate bank credit in the economy.
• The theory of OMO is simple.
• During a boom which is considered dangerous for economic stability, the
central bank sells government and other approved securities from its
securities portfolio in the market to reduce the aggregate supply of money
in the economy.
• Buyers of these securities pay the central Bank by drawing on their cash
deposits in banks.
• Since the commercial banks hold deposits with the central bank payment
of the former to the later means a reduction in their cash reserves forces
the bank to reduce their advances and they refuse further loans.
• This reduces investment based on bank credit.
• Consequently, the boom in the economy is checked.
• To fight the slump in the economy, the central bank buys government and other
approved securities in the securities market.
• It pays for these securities by issuing cheques drawn on itself to individuals and
institutional sellers of securities.
• The individuals deposit these cheques in their deposit accounts in the commercial
banks.
• The commercial banks realize the proceeds of these cheques from the central
bank.
• Thus their cash reserves increase.
• The banks use these additional cash reserves to support the
additional loans.
• Thus aggregate commercial bank credit expands leading to greater
investment, more employment and higher prices in the economy.
• Consequently, by buying and selling securities in the money and
capital markets, the central bank influences the credit creating
operations of the commercial banks and through these operations it
influences economic conditions in the country.
• 2. Variation of reserve ratio
• The instrument of variable minimum legal cash reserves ratio
requirement affects not only the total amount of commercial bank’s
reserves but also the amount of their excess cash reserves which in
turn affects the total ability to lend.
• Thus the central bank can carry out its expansionary monetary policy
by increasing their total cash reserves and vice versa.
• 3. Bank rate
• Bank rate is the rate at which the central bank gives loans to
commercial banks against the security of government and other
approved first class securities.
• By making appropriate changes in bank rate, the central bank controls
the volume of total credit by influencing the lending rates of
commercial banks as a determinant of the total loans and investment
in the country.
• During boom, the central bank increases its bank rate and during
slump, central bank decreases its bank rate
• Selective or qualitative credit control
• Apart from these three general instruments there are selective credit
control instruments which are employed by the central bank from time to
time.
• Unlike the general instruments which affect the total volume of credit
directly, the selective instruments of monetary policy affect the type of
credit extended by the banks--- these instruments affect the composition
rather than the size of the loan portfolios of commercial banks.
• The immediate object of credit controls is to regulate both the amount and
the terms on which credit is extended by the banks for selective purposes.
• Selective credit control instruments:
• (i) Direct action is an action which is employed by the central bank to forbid
commercial banks to grant credit in a prescribed manner and for prescribed purposes.
• DA in more than one form has been employed by the central bank as an alternative to
their discount rate policy or open market operations or together with both these
methods.
• (ii) Minimum statutory cash reserve ratio
• The instrument of SCRR is very effective in reinforcing the bank rate policy and open
market operations.
• At present banks are compelled either by law or by custom to keep certain percentage
of their total deposits with the central bank in the form of minimum legal cash
reserves.
• The importance of the instrument in controlling credit in the
economy follows from the fact that an increase or decrease in the
minimum legal cash reserves ratio by decreasing or increasing the
excess cash reserves of the bank decreases or increases their
optimum credit creating capacity.
• (iii) Regulation of consumer credit
• The regulation of consumer credit is quite important in combating
inflation by restricting the aggregate consumer demand for those goods
which are in short supply in the industrially advanced countries like
America where consumer credit is largely used to finance domestic
purchases.
• However, in the context of UDCs where consumer credit is conspicuous
by its absence and the banks do not participate in financing the
purchases of consumer durables to any significant degree, this method
cannot be effective in curbing the inflationary pressures in the economy.
• Regulation of margin requirements
• This instrument of SCC was designed to assist the FRS in controlling
the volume of credit used for speculation of securities.
• In 1936, the board of governors employed the method to restrain the
activities of bears by fixing the margin requirements of 50 percent for
short sales.
• This method is quite an effective means of controlling the volume of
credit in a speculation minded country like America.
• Moral suasion
• AS a method of credit control, moral suasion has been used by central
banks in many countries.
• Moral suasion implies the persuading the commercial banks by the
central bank to cooperate with it in pursuing a proper monetary and
credit policy.
• It can be successful only if the commercial banks accept the leadership
of the central bank.
This depends on the strength of the central bank and the prestige it
commands among the member banks in the economy.
• Publicity
• Apart from moral suasion, central banks employ the instrument of publicity
in order to publicize economic facts in the weekly statements of their assets
and liabilities, money bulletins containing review of credit and business
conditions, and detailed annual reports stating their operations and
activities, the state of affairs of the money market and the banking system
and general review of the trade, industry, agriculture etc. In the country.
• By restoring to publicity, the central bank
enlists public opinion in favor of its monetary policy and thereby
combats opposition to its policies among political, financial and business
interests.
Fiscal Policy

• AS an instrument of macroeconomic policy, the goals of fiscal policy

are likely to be different in different countries and in the same country
in different situations.
• For example, while in a developed economy operating either at full
employment or near full employment level, the goal of fiscal policy
should be maintenance of full employment, the main concern in a
developing country has to be the promotion of economic growth
with stability and reduction in economic inequalities.
• Broadly speaking, overall fiscal policy involves two types of important
decisions.
• While one of these two decisions is related to the goal of full
employment, the other is concerned with determining social
priorities.
• The second policy decision is concerned with the issue of allocation of
economy’s productive resources as between different rival uses----
should more resources be allocated for education, health care public
housing, slum clearance, transport etc.
• When resources are fully employed and the economy is tormented by
inflation, the appropriate fiscal remedy is to create a budget surplus in
order to reduce the aggregate spending
• If the total tax collections exceed the total government expenditure,
the reduction in private spending caused by tax collections is not fully
offset by government expenditure.
• Consequently, total spending will be less than what it would have
been had the budget been balanced.
• This policy will directly attack the cause of inflation---the rate of
increase in aggregate spending which exceeds the rate of increase in
the volume of goods and services which are available for making the
purchases in the economy.
• In depression, the economy suffers from rising unemployment, falling income
and shrinking economic activity.
• In depression when the existing aggregate private spending is too low to
achieve full employment, the government must increase public spending by
undertaking public works program on a massive scale and indirectly inducing
people to spend more.
• The amount government spending incurred on unemployment doles and
payments made to veterans and the aged should be increased.
• Aggregate spending can be increased also by reducing taxes.
• The effect of tax cut would be to increase the amount of disposable income
of individuals and business firms.
• To relieve the economy from depression, it is not enough to increase
the aggregate consumption; aggregate investment should be
simultaneously raised.
• Fiscal policy can induce changes aggregate investment demand by
making appropriate changes in the tax structure.