CENTRAL UNIVERSITY OF SOUTH BIHAR, GAYA

School of Law & Governance

Role of Monetary policy and fiscal policy in economic development

ANESH KUMAR
B.A.LL.B. (Hons.)
2ndSemester (2019-24)
Enrollment Number: CUSB1913125021
Section: A

Course Title: Economics-II( Macroeconomics)

Course Code: BALAW2004C04

Submitted to:

DR.SANJAY KUMAR
Associate Professor of Economics
Central University of South Bihar

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 ACKNOWLEDGEMENT

It is my immense pleasure to record my deep sense of gratitude and sincere

appreciation to each and every one of those who helped, guided, suggested,
cooperated and inspired me in this endeavour.

I will be failing in my duty if I do not acknowledge the debt of gratitude and

heartfelt thanks that I owe to my esteemed and drastic Guru and Guide
Dr. Sanjay Kumar Assistant Professor of Economics, Central University of
South Bihar, Gaya. He is person with multiple talent and creativity, and he is
always a light for the students for reaching their respective goals. I am proud and
thankful to have an opportunity to complete my work under his valuable
guidance, suggestions, encouragement meticulous examination, remarkable
comments and wholehearted cooperation, which has been decisive in the timely
completion of this work.

Last but not the least; I take the opportunity to express my gratitude to friends,
classmates and family members for immense support and wholehearted
encouragement.

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 TABLE OF CONTENT

Sl. No. Topic Page No.

1. Monetary policy- Introduction 4

2. Objectives of Monetary policy 5 -6

3. Instruments of Monetary policy 7-10

4. Relevance of monetary policy 11

5. Fiscal policy 12-15

6. Objectives of fiscal policy 16-17

7. Tools of Fiscal policy 18

8. Fiscal deficit and Revenue deficit 19

9. Conclusion 20

10. Bibliography 21

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 MONETARY POLICY- INTRODUCTION

Monetary policy is that policy which correct the situations of excess and deficient
demand by regulating interest rate and availability of credit in the economy.
Monetary policy is a Central bank' actions and communications that manage the
money supply. The money supply includes forms of credit, cash, checks, and money
market mutual funds. The most important of these forms of money is credit. Credit
includes loans, bonds, and mortgages.

It is the process by which the monetary authority of a country controls the supply of
money, often targeting a rate of interest for the purpose of promoting economic
growth and stability. The official goals usually include relatively stable prices and
low unemployment. Monetary theory provides insight into how to craft optimal
monetary policy.
It is referred to as either being expansionary or contractionary, where an
expansionary policy increases the total supply of money in the economy more
rapidly than usual, and contractionary policy expands the money supply more slowly
than usual or even shrinks it. Expansionary policy is traditionally used to try to
combat unemployment in a recession by lowering interest rates in the hope that easy
credit will entice businesses into expanding. Contractionary policy is intended to
slow inflation in hopes of avoiding the resulting distortions and deterioration of asset
values.
According to A. J. Shapiro, “Monetary Policy is the exercise of the central bank’s
control over the money supply as an instrument for achieving the objectives of
economic policy.” In the words of D.C. Rowan, “The monetary policy is defined as
discretionary action 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.”

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 OBJECTIVES OF MONETARY POLICY

1. RAPID ECONOMIC GROWTH

It is the most important objective of monetary policy. The monetary policy can
influence the economic growth by controlling real interest rate and its resultant
impact on the investment.
Example: if RBI opts for a cheap or easy credit policy by reducing interest rates,
the investment level in the economy can be encouraged.

2. PRICE STABILITY
All the economics suffer from inflation and deflation; it can also be called as price
stability. Both are harmful to economy. Thus monetary policy having an objective
of price stability tries to keep the value of money stable. It helps in reducing the
income and wealth inequalities.
Example: - When the economy suffers from recession the monetary policy should
be an easy money policy‘ but when there is inflationary situation there should be
dear money policy.

3. EXCHANGE RATE STABILITY

Exchange rate stability should be there into the economy to bring in confidence to
other countries for trading purpose. However, to maintain exchange rate stability,
internal price stability needs to be maintained. A fall in exchange rate is caused by
an excess demand for foreign exchange over its supply. In other words, if demand
for imports is greater than the demand for exports. The exchange rate will rise at the
international value of the currency will fall. To maintain stability in the international
value of currency, a restrictive monetary policy will have to be adopted to bring
about a reduction in money supply and the imports.

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4. BALANCE OF PAYMENT EQUILIBRIUM
Many developing countries like India suffer from the disequilibrium in the balance
of payment. The RBI through its monetary policy tries to maintain equilibrium in
the balance of payment.

5. FULL EMPLOYMENT
These days, the most important objective of monetary policy is attainment of full
employment with consideration of inflation. The policy of full employment can be
pursued through monetary measures as they can help in achieving and maintaining
the rates of savings and investment at a level, which would ensure full employment.
For this, monetary policy may help in raising the aggregate rate of savings and
proper channelization of savings to desirable directions of investments.
Several monetary measures can be adopted for raising the level of savings. The
rates of interest may be increased and banking facilities may be expanded.
Similarly, for boosting investment, bank credit may be offered for investment.
Besides, monetary instruments may be, used to ensure that the banking system
contributes to financing the planned public investments.
•Example: if monetary policy is expansionary then credit supply can be encouraged.
It could help in creating more jobs in different sectors of the economy.

6.EQUAL INCOME DISTRIBUTION

Monetary policy can make special provisions for the neglect supply such as
agriculture, small scale industries; village industries etc. and provide them cheaper
credit for longer term. Thus monetary policy helps in reducing economic
inequalities among different sections of society.

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 INSTRUMENTS OF MONETARY POLICY

The instruments of monetary policy are device which are used by the monetary
authority in order to attain some predetermined objectives. There are two types of
instruments of the monetary policy as shown below:
(A) Quantitative Instruments or General Tools
The Quantitative Instruments are also known as the General Tools of monetary
policy. These tools are related to the Quantity or Volume of the money. The
Quantitative Tools of credit control are also called as General Tools for credit
control. These methods maintain and control the total quantity or volume of credit
or money supply in the economy. These methods are indirect in nature and are
employed for influencing the quantity of credit in the country. The general tool of
credit control comprises of following instruments.
Bank Rate Policy (BRP)
The Bank Rate Policy (BRP) is a very important technique used in the monetary
policy for influencing the volume or the quantity of the credit in a country. The bank
rate refers to rate at which the central bank (i.e. RBI) rediscounts bills and provides
advance to commercial banks against approved securities. It is "the standard rate at
which the bank is prepared to buy or rediscount bills of exchange or other
commercial paper eligible for purchase under the RBI Act". The Bank Rate affects
the actual availability and the cost of the credit. Any change in the bank rate
necessarily brings out a resultant change in the cost of credit available to
commercial banks.
If the RBI increases the bank rate than it reduce the volume of commercial banks
borrowing from the RBI. It deters banks from further credit expansion as it becomes
a more costly affair. On the other hand, if the RBI reduces the bank rate, borrowing
for commercial banks will be easy and cheaper. This will boost the credit creation.
Thus any change in the bank rate is normally associated with the resulting changes
in the lending rate and in the market rate of interest.

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Cash Reserve Ratio(CRR) and Statutory Liquidity Ratio(SLR)
The Commercial Banks have to keep a certain proportion of their total assets in the
form of Cash Reserves. Some part of these cash reserves are their total assets in the
form of cash. Apart of these cash reserves are also to be kept with the RBI for the
purpose of maintaining liquidity and controlling credit in an economy. These
reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity
Ratio (SLR).
The CRR refers to some percentage of commercial bank's net demand and time
liabilities which commercial banks have to maintain with the central bank and SLR
refers to some percent of reserves to be maintained in the form of gold or foreign
securities. Any change in the VRR (i.e. CRR + SLR) brings out a change in
commercial banks reserves positions. Thus by varying VRR commercial banks‘
lending capacity can be affected. Changes in the VRR helps in bringing changes in
the cash reserves of commercial banks and thus it can affect the banks credit creation
multiplier. RBI increases VRR during the inflation to reduce the purchasing power
and credit creation. But during the recession or depression it lowers the VRR
making more cash reserves available for credit expansion.

Open Market Operation (OMO)

The open market operation refers to the purchase and/or sale of short term and long
term securities by the RBI in the open market. This is very effective and popular
instrument of the monetary policy. The OMO is used to wipe out shortage of money
in the money market, to influence the term and structure of the interest rate and to
stabilize the market for government securities, etc. It is important to understand the
working of the OMO.
If the RBI sells securities in an open market, commercial banks and private
individuals buy it. This reduces the existing money supply as money gets transferred
from commercial banks to the RBI. Contrary to this when the RBI buys the
securities from commercial banks in the open market, commercial banks sell it and
gets back the money they had invested in them. Obviously the stock of money in
the economy increases.

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This way when the RBI enters in the OMO transactions, the actual stock of money
gets changed. Normally during the inflation period in order to reduce the purchasing
power, the RBI sells securities and during the recession or depression phase she
buys securities and makes more money available in the economy through the
banking system.

(B) Qualitative Instruments or Selective Tools

The Qualitative Instruments are also known as the Selective Tools of monetary
policy. These tools are not directed towards the quality of credit or the use of the
credit. They are used for discriminating between different uses of credit. It can be
discrimination favoring export over import or essential over nonessential credit
supply. This method can have influence over the lender and borrower of the credit.
The Selective Tools of credit control comprises of following instruments:-

CEILING ON CREDIT
The RBI has imposed ceiling on bank credit against the security of certain
commodity. This imposes a limit on the amount of credit to different sectors like
hire-purchase and installment sale of consumer goods. Under this method the down
payment, installment amount, loan duration, etc. is fixed in advance. Such measures
ensure financial discipline in the banking sector.

FIXING MARGIN REQUIREMENTS

The margin refers to the "proportion of the loan amount which is not financed by
the bank". Or in other words, it is that part of a loan which a borrower has to raise
in order to get finance for his purpose. A change in a margin implies a change in the
loan size. This method is used to encourage credit supply for the needy sector and
discourage it for other non-necessary sectors. This can be done by increasing margin
for the non-necessary sectors and by reducing it for other needy .

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Example: - If the RBI feels that more credit supply should be allocated to agriculture
sector, then it will reduce the margin and even 85-90 percent loan can be given.

PUBLICITY
This is yet another method of selective credit control. Through it Central Bank
(RBI) publishes various reports stating what is good and what is bad in the system.
This published information can help commercial banks to direct credit supply in the
desired sectors. Through its weekly and monthly bulletins, the information is made
public and banks can use it for attaining goals of monetary policy.

CREDIT RATIONING
Central Bank fixes credit amount to be granted. Credit is rationed by limiting the
amount available for each commercial bank. This method controls even bill
rediscounting. For certain purpose, upper limit of credit can be fixed and banks are
told to stick to this limit. This can help in lowering banks credit exposure to
unwanted sectors.

MORAL SUASION
It implies to pressure exerted by the RBI on the Indian banking system without any
strict action for compliance of the rules. It is a suggestion to banks. It helps in
restraining credit during inflationary periods. Commercial banks are informed about
the expectations of the central bank through a monetary policy. Under moral suasion
central banks can issue directives, guidelines and suggestions for commercial banks
regarding reducing credit supply for speculative purposes.

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 Relevance of Monetary policy

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. Where currency is under a monopoly of issuance, or
where there is a regulated system of issuing currency through banks which are tied
to a central bank, the monetary authority has the ability to alter the money supply
and thus influence the interest rate (to achieve policy goals).

It is important for policymakers to make credible announcements. If private agents

(consumers and firms) believe that policymakers are committed to lowering
inflation, they will anticipate future prices to be lower than otherwise. If an
employee expects prices to be high in the future, he or she will draw up a wage
contract with a high wage to match these prices . Hence, the expectation of lower
wages is reflected in wage-setting behavior between employees and employers
(lower wages since prices are expected to be lower) and since wages are in fact
lower there is no demand pull inflation because employees are receiving a smaller
wage and there is no cost push inflation because employers are paying out less in
wages.

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 FISCAL POLICY
Fiscal policy refers to the revenue and expenditure policy of the government. It is
the means by which a government adjusts its spending levels and tax rates to monitor
and influence a nation’s economy. The economists now hold the government
intervention through fiscal policy is essential in the matter of overcoming recession
or inflation as well as of promoting and accelerating economic growth.
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.

DEFINITION

According to J.M. Culbertson, “By fiscal policy we refer to government actions

affecting its receipts and expenditures which we ordinarily takes as measured by the
government’s net receipts, its surplus or deficit.” The Government may offset
undesirable variations in private consumption and investment by anti-cyclical
variations of public expenditures and taxes.

Arthur smithies defines fiscal policy as “a policy under which the government uses
its expenditure and revenue programmes to produce desirable effects and avoid
undesirable effects on the national income, production and employment.” Though
the ultimate aim of fiscal policy is the long run stabilisation of the economy, yet it
can only be achieved by moderating short run economic fluctuations..
Otto Eckstein defines fiscal policy as “Changes in taxes and expenditures which
aim at short run goals of full employment and price -level stability.”

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 OBJECTIVES OF FISCAL POLICY

The importance of fiscal policy is high in underdeveloped countries. The state has
to play active and important role. In a democratic society direct methods are not
approved. So, the government has to depend on indirect methods of regulations. In
this way, fiscal policy is a powerful weapon in the hands of government by means
of which it can achieve the objectives of development. The principle objectives of
fiscal policy are given below :

1. Development by Effective Mobilisation of Resources

The principal objective of fiscal policy is to ensure rapid economic growth and
development. This objective of economic growth and development can be achieved
by mobilisation of Financial Resources such as taxation, public savings and private
savings.

2. 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 defence, 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.

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3. 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. The government
invests a significant proportion of its tax revenue in the implementation of Poverty
Alleviation Programmes to improve the conditions of poor people in society.

4. 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.

5. Employment Generation
The government is making every possible effort to increase employment in the
country through effective fiscal measure. Investment in infrastructure has resulted in
direct and indirect employment. Lower taxes and duties on small-scale industrial
(SSI) units encourage more investment and consequently generates more
employment.

6. Balanced Regional Development

Another main objective of the fiscal policy is to bring about a balanced regional
development. There are various incentives from the government for setting up
projects in backward areas such as cash subsidy, concession in taxes and duties in
the form of tax holidays, finance at concessional interest rates, etc.

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7. Reducing the Deficit in the Balance of Payment
Fiscal policy attempts to encourage more exports by way of fiscal measures like
exemption of income tax on export earnings, exemption of central excise duties and
customs, exemption of sales tax and octroi, etc.
The foreign exchange is also conserved by providing fiscal benefits to import
substitute industries, imposing customs duties on imports, etc. The foreign exchange
earned by way of exports and saved by way of import substitutes helps to solve
balance of payments problem. In this way adverse balance of payment can be
corrected either by imposing duties on imports or by giving subsidies to export.

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 TOOLS OF FISCAL POLICY

Fiscal policy is an important instrument to stabilize the economy, that is, to

overcome recession and control inflation in the economy. Fiscal policy through
variations in government expenditure and taxation profoundly affects national
income, employment, output and prices. Various instruments of Fiscal policy are:
1. Government Expenditure

It is the principal component of fiscal policy. The Government of a country incurs

various types of expenditure mainly on public works program such as the
construction of roads, dams and expenditure on education and public welfare
programs, defence etc.
It is by changing any or all types of expenditure that the government seeks to
correct the situations of excess demand and deficient demand in the economy.
When there is excess demand, government expenditure is reduced and when there
is deficient demand, government expenditure is increased. A rise in government
expenditure acts as an injection into the circular flow of income in the economy.
It is required when liquidity needs to be released to combat deflation. Likewise a
cut in government expenditure acts like a withdrawal from the circular flow of
income in the economy. It is required when liquidity needs to be soaked to combat
inflation.

2. Taxation

Taxes are a compulsory payment made to government by the households and the
producing sectors. By increasing the tax burden on the households and the
producers, the government reduces purchasing power in the economy. On the
other hand by lowering the tax burden, the government increases the purchasing
power. Thus when deficient demand is to be corrected or when aggregate demand
needs to be increased ,tax burden on the household and the producers is reduced
likewise when excess demand is to be corrected or aggregate demand needs to be
increased, tax burden on the households and the producers is increased.

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3. PUBLIC DEBT
By borrowing from the public the government creates public debt. In a situation of
deficient demand or when aggregate demand needs to be increased, the government
reduces its borrowing from the public. So that people are left with greater liquidity
or cash balances and aggregate expenditure remains high. On the other hand when
there is a situation of excess demand or when aggregate demand needs to be reduced,
the government steps a public borrowing by offering a attractive rate of interest. This
reduces liquidity with the people. Accordingly, aggregate expenditure also reduces.

4. BORROWING FROM THE RBI

Borrowing by the government from the RBI is another element of fiscal policy. It is
increased to fight deflationary gap and reduced to fight inflationary gap. Higher
borrowing releases greater liquidity in the economy, as required when there is
deflationary gap. When borrowing is reduced the amount of liquidity in the economy
is also reduced, as desired when there is inflationary gap in the economy.

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 Relevance of fiscal policy

Fiscal policy is an important tool for managing the economy because of its ability to
affect the total amount of output produced—that is, gross domestic product. The first
impact of a fiscal expansion is to raise the demand for goods and services. This
greater demand leads to increases in both output and prices. The degree to which
higher demand increases output and prices depends, in turn, on the state of the
business cycle. If the economy is in recession, with unused productive capacity and
unemployed workers, then increases in demand will lead mostly to more output
without changing the price level. If the economy is at full employment, by contrast,
a fiscal expansion will have more effect on prices and less impact on total output.

Fiscal policy is an important instrument to stabilize the economy, that is, to

overcome recession and control inflation in the economy. Fiscal policy through
variations in government expenditure and taxation profoundly affects national
income, employment, output and prices.

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 REVENUE DEFICIT
Revenue deficit is the excess of government revenue expenditure to its revenue
receipts. This does not include items of capital receipts and capital expenditure.
Revenue deficit indicates that the government doesn’t have the sufficient revenue
for normal functioning of government departments. In other words when
government starts spending more than it earns, it results in revenue deficit.
Revenue deficit= Revenue expenditure- Revenue receipts.

FISCAL DEFICIT
Fiscal deficit is estimated accounting for all receipts and expenditure of the
government fiscal deficit is the excess of total expenditure over total receipts.
Fiscal deficit= Total expenditure( Revenue expenditure + capital expenditure)-
Total receipts other than borrowings(Revenue receipts + capital receipts other than
borrowings).
Revenue deficit and Fiscal deficit as % of GDP

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 CONCLUSION

Monetary and fiscal policies in any country are two macroeconomic stabilization
tools. However, these two policies have often been pursued in different countries in
different directions. Monetary policy is often pursued to achieve the objective of low
inflation to stabilize the economy from output and price shocks. On the other hand,
fiscal policy is often biased towards high growth and employment even at the cost
of higher inflation. For achieving an optional mix of macroeconomic objectives of
growth and price stability, it is necessary that the two policies complement each
other.
Both monetary and fiscal policies are used to regulate economic activity over time.
They can be used to accelerate economic growth when an economy starts to slow or
to moderate growth and activity when economy starts to overheat. In addition, fiscal
policy can be used to redistribute income and wealth.
Monetary policy can play a vital role in the economic development of
underdeveloped countries by minimizing fluctuations in prices and general
economic activity by achieving an appropriate balance between the demand for
money and supply of money. Fiscal and monetary policy in India endeavors to
maintain a judicious balance between price stability, economic growth and financial
stability.
With many economic reforms through monetary policy and fiscal policy there has
been a substantial growth in GDP of India over the years. The government plans to
achieve GDP growth rate in double figures. In 2009-10 grew at 10.3%. If the GDP
growth rate is in double figures, it would be beneficial for the poor and marginalized
sections to come out of proverty.

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 BIBLIOGRAPHY

Books

• Introductory Macroeconomics by T.R. Jain

• Principles of Macroeconomics by Mankiw

Websites

1. www.investopedia.com
2. www.moneycontrol.com
3. www.financialexpress.com
4. www.business-standard.com

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