Fiscal and Monetary Policy

Question 1

Fiscal Policy

Answer 1

It is the process of shaping government taxation and expenditure to achieve desired economic and social objectives.
Involves the use of government spending and taxation to influence the economy
Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty.

Question 2

Objectives of fiscal policy

Answer 2

1. To help in optimum allocation of scarce resources and its maximum utilization: Idle are to be mobilized and allocated to different sectors of the economy in accordance with national priorities. Hence, suitable fiscal policy is to be formulated in this direction.
2. To accelerate the rate of capital formation. Fiscal policy should help in mobilizing the small savings both in rural and urban areas so as to raise the level of capital formation in the country.
3. To encourage investment: Fiscal policy should direct investment in the desired channels both in the public and in the private sectors by providing suitable incentives.
4. To ensure price stability: Appropriate fiscal policy has to be formulated in order to control the demon of inflation, deflation and stagflation and ensure a reasonable degree of price stability in the country.
5. To control the operation of business cycles: An appropriate fiscal policy has to be formulated so as to counteract the adverse and dampening effects of trade cycles, to minimize business fluctuations and achieve a reasonable degree ofeconomic stability in the economy.
6. To ensure full employment condition: Fiscal policy should help in exploiting all kinds of resources available in the country in the best possible manner and ensure full employment condition in the economy.
7. To accelerate the rate of economic growth. The main objective of the fiscal policy is to stimulate and accelerate the rate of economic growth in the country. All instruments of fiscal policy have to be employed in order to give a big push to the process of development in the country.
8. To ensure equitable distribution of income and wealth: In the course of economic development, it is quite possible that monopoly houses would grow and income and wealth gets concentrated in the hands of only a few powerful and influential persons. Hence, suitable fiscal policy has to be adopted to reduce income disparities and ensure distributivejustice to the common man.
9. To reduce and minimize regional and sectoral imbalances: In most of the countries there is wide spread disparities in the levels of development in different regions of the country. Suitable fiscal policy has to be designed to avoid, minimize and reduce regional and sectoral imbalances and ensures balanced growth in the country.
10. To mobilize real and financial resources for public sector in larger quantity. Public sector has assumed greater significance in planned economic development of a country in recent years. Hence, an appropriate fiscal policy is to be designed to mobilize all kinds of real and financial resources for the successful working of the public sector.

Question 3

Objectives of fiscal policy in developing countries

Answer 3

1. Help to break the vicious circle of poverty: It is possible only through increasing the rate ofinvestments in all sectors simultaneously. Hence, suitable fiscal policy has to be formulated to mobilize financial resources required for heavy doses of investments.
2. Help to diversify the flow of resources: The existing scarce resources are to be diverted from unproductive and speculative areas and directed towards the most productive uses and socially desirable channels so as to maximize net social gains to the common man.
3. Help to raise living standards: The government has to take concrete measures to ensure the supply of social goods on a large-scale. In order to achieve this objective; suitable fiscal policy has to be formulated. For example, through public distribution system, minimum quantities of certain items are to be supplied at subsidized rates.
4. Help to achieve full employment and stimulate growth rates: Suitable fiscal policy has to be formulated to exploit all kinds of resources so that the economy can reach the stage of full employment condition. Full employment condition results in optimum national output, higher aggregate demand, and income.
5. Help to reduce economic inequalities: Through a rational fiscal policy, the government has to take adequate measures to control the growth of monopoly houses, minimize economic inequalities and ensure distributive justice to all.
6. Help to control inflation and deflation: Rapid economic growth requires price stability. It is the duty of the government to adopt all kinds ofmeasures through suitable fiscal instruments to control inflation, deflation and stagflation so as to achieve a reasonable degree of price stability. It should also help in mobilizing excess purchasing power in the hands of people through suitable taxation policy.
7. Help to create more job opportunities: The government through appropriate fiscal policy has to mobilize huge funds and invest them in different sectors of the economy. Higher investment results in higher economic growth rate and creation ofmore employment.

Question 4

Instruments of fiscal Policy

Answer 4

Budget 
Taxation 
Public Expenditure
Public Works 
Public Debt

Question 5

Budget

Answer 5

Different budgetary principles have been formulated by the economists, prominently known as:

(1) Annual budget
(2) cyclical balanced budget
(3) fully managed compensatory budget

Question 6

Taxation

Answer 6

• Taxation is a powerful instrument of fiscal policy in the hands of public authorities which greatly effect the changes in disposable income, consumption and investment.
• An anti- depression tax policy: This increases disposable income of the individual, promotes consumption and investment. There will be more funds with the people for consumption and investment purposes at the time of tax reduction.
• Anti-Inflationary Tax Policy: An anti-inflationary tax policy, on the contrary, must be directed to plug the inflationary gap. During inflation, fiscal authorities should not retain the existing tax structure but also evolve such measures (new taxes) to wipe off the excessive purchasing power and consumer demand. To this end, expenditure tax and excise duty can be raised.

Question 7

Public Expenditure

Answer 7

• The active participation of the government in economic activity has brought public spending to the front line among the fiscal tools.
• The appropriate variation in public expenditure can have more direct effect upon the level of economic activity than even taxes.
• The increased public spending will have a multiple effect upon income, output and employment exactly in the same way as increased investment has its effect on them.
• Similarly, a reduction in public spending, can reduce the level of economic activity through the reverse operation of the government expenditure multiplier.

Question 8

There are two forms of expenditure

Answer 8

Public works

Transfer payments

Question 9

Transfer payments

Answer 9

Transfer payments are the payments such like interest on public debt, subsidy, pension, relief payment, unemployment, insurance and social security benefits etc.

Question 10

Public works

Answer 10

Are durable goods, primarily fixed structure, produced by the government. They include expenditures on public works as roads, rail tracks, schools, parks, buildings, airports, post offices, hospitals, irrigation canals etc.
The expenditure on capital assets (public works) is called capital expenditure.

Question 11

Public debt

Answer 11

Public debt is a sound fiscal weapon to fight against inflation and deflation.
It brings about economic stability and full employment in an economy.
The government borrowing may assume any of the following forms mentioned as under:
Borrowing from Non-Bank Public
Borrowing from Banking system
Drawing from treasury
Printing of money

Question 12

Monetary policy

Answer 12

Monetary policy is a part over all economic policy of a country.
It is employed by the government as an effective tool to promote economic stability and achieve certain predetermined objectives.
Monetary Policy deals with the total money supply and its management in an economy.
It is essentially a programme of action undertaken by the monetary authorities generally the central bank to control and regulate the supply of money with the public and the flow of credit with a view to achieving economic stability and certain predetermined macro economic goals

Question 13

Objectives of monetary policy

Answer 13

Neutral money policy: According to this policy, money is only a technical devise having no other role to play. It should be a passive factor having only one function, namely to facilitate exchange. It should not inject any disturbances.

Price stability: It is to be remembered that price stability does not mean that prices of all commodities are kept constant or fixed over a period of time. It refers to the absence of sharp variations or fluctuations in the average price level in the country.

Exchange rate stability:Maintenance of stable or fixed exchange rate was one of the major objects of monetary policy for a long time under the gold standard.

Control of trade cycles: Operation of trade cycles has become very common in modern economies. A very high degree offluctuations in over all economic activities is detrimental to the smooth growth of any economy.

Full employment:In recent years it has become another major goal of monetary policy all over the world. Advanced countries normally work at nearfull employment conditions. Their major problem is to maintain this high level of employment situation through various economic polices. This object has become much more important and crucial in developing countries as there is unemployment and under employment of most of the resources

Equilibrium in the balance of payments:This objective has assumed greater importance in the context of expanding international trade and globalization. Today most of the countries of the world are experiencing adverse balance ofpayments on account of various reasons. It is a situation where in the import payments are in excess of export earnings. In order to achieve a higherrate of economic growth, balance of payments equilibrium is very much required and as such monetary authorities have to take suitable action in this direction.

. Rapid economic growth:This is comparatively a recent objective of monetary policy. Achieving a higher rate of per capita output and income over a long period of time has become one of the supreme goals of monetary policy in recent years.

Question 14

Objectives of monetary policy in developing countries

Answer 14

It has to promote economic development by creating, mobilizing and providing adequate credit to different sectors of the economy. Supply of sufficient financial resources, its proper direction, canalization and utilization, control of inflation and deflation etc. would create proper background forlaying a solid foundation for rapid economic development.

In order to achieve various objectives of monetary policy and to meet the ever-growing development requirements of the economy, the central bank of the country has to operate effectively.

Inducement to savings:It has to encourage the saving habits of the common man by providing all kinds of monetary incentives. It has to take the necessary steps to expand the banking facilities in the country and mobilize savings made by them. Special steps are to be taken to mobilize rural small savings.

Investment of savings:It should help in converting savings into productive investments. For this purpose, it has to create an institutional base and investment climate in the country. People should have variety of opportunities to invest their hard earned money and earn adequate retunes on them.

Developing banking habits:Monetary authorities have to take effective and imaginary steps to popularize the use of various credit instruments by the common man.

The monetary authorities have to take different measures to convert non-monetized sector or bartersector into monetized sector and make people use credit money extensively in their day-to-day life. Increase in total money supply should be in accordance with the degree of monetization of the economy.

Monetary equilibrium:It is the responsibility of the monetary authorities to maintain a proper balance between demand formoney and supply of money and ensure adequate liquidity position in the economy so that neitherthere will be excess supply of money nor shortage in the circulation of money.

Maintaining equilibrium in the balance of payments:It is the job of the monetary authorities to employ suitable monetary measures to set right disequilibrium in the balance of payments of a country.

Creation and expansion of financial institutions: Monetary authorities of the country have to take effective steps to improve the existing currency and credit system. They should help in developing banking industry, credit institutions, cooperative societies, development banks and other types of financial institutions, to mobilize more savings and direct them to productive activities.

Integration of organized and unorganized money markets:The money markets are under developed, undeveloped, highly unorganized and they are not functioning on any well laid down principles. In fact, there is no proper integration between organized and unorganized money markets. This has come in the way of well-developed money markets in these countries. Hence, money markets are to be brought under the purview of the central bank ofthe country.

Integrated interest rate structure:The monetary authorities have to minimize the existence of different interest rates in different segments of the money market and ensure an integrated interest rate structure.

Debt management:Monetary authorities have to decide the total volume of internal as well as external borrowings, timing of the issue of bonds, stabilizing their prices, the interest rates to be paid for them, nature of debt servicing, time and methods of debt redemption, the number of instalments, time of repayment etc. The primary aim of the debt management policy is to create conditions in which public borrowing is increased from year to year on a big scale without giving any jolt to the system and this must be at cheap rates to keep the burden of the debt as low as possible. Thus, debt management of the country is to be successfully organized by the monetary authorities.

Long term loan for industrial development:The monetary policy should be framed in such a way as to promote rapid industrial development in a country by providing adequate finance for them.

Reforming rural credit system:The existing rural credit system is defective and as such it has to be reformed to assist the rural masses.

To create a broad and continuous market for government securities:It is the responsibility of the monetary authorities of the country to develop a well-organized securities market so that funds are easily available for the needy people. Thus, the objectives of monetary policy are manifold in nature in developing countries and a properbalance between them is required very much to achieve desired goals of the government.

Question 15

Tools of monetary policy

Answer 15

Quantitative techniques of credit control: They include bank rate policy, open market operations and variable reserve ratio.
Qualitative techniques of credit controls: They include change in margin requirements, rationing of credit, regulation of consumers credit, moral suasion, issue of directives, direct action and publicity etc.

Question 16

Quantitative

Answer 16

The Central Bank Rate: This is the rate at which the central bank of a country is willing to discount first class bills. If the Bank Rate is raised, the market rates and other lending rates of the money market also go up. Conversely, the lending rates go down when the central bank lowers its bank rate. These changes affect the supply and demand for money. Borrowing is discouraged when the rates go up and encouraged when they go down. The flow of foreign short term capital also is affected. There is an inflow of foreign funds when the rates are raised and an outflow when they are reduced. Internal price level tends to fall with the contraction of credit. And it tends to rise with its expansion.

Open Market Operations: This refer to the purchase or sale of government securities, short-term as well as long-term, by the central bank. When the central bank sells securities cash balances with the commercial banks decline, they are compelled to reduce their lending. Thus credit contracts. On the other hand purchases of securities enable commercial banks to expand credit. This method is sometimes adopted to make the bank rate effective

Reserve requirements Ratio: Variations of reserve requirements affect the liquidity position of the banks and hence their ability to lend. By raising the reserve requirements inflationary trend can be kept under control. The lowering of the reserve ratio makes more cash available with the banks. Cash Reserves maintained by commercial banks is called statutory reserve and the reserve over and above the statutory reserves is called excess reserve.

Question 17

Qualitative techniques

Answer 17

Moral suasion: It is the use of persuasion rather than compulsion by the Central Bank to get other financial institutions to adopt a pattern of behaviors that is favorable to effective conduct of the monetary policy.

Special deposits: Sometimes, commercial and merchant banks are required by law to hold a non-interest bearing special deposit with the Central Bank to complement other contractionary monetary policy measures.

Selective credit control: It involves issuance of credit guidelines to commercial and merchant banks to direct their credit facilities to the so-called favored or preferred sectors of the economy.

Credit ceiling: It is a directive by the Central Bank prescribing the growth rate of credit expansion by the commercial and merchant banks. This is to ensure stability in both the domestic and external sectors of the economy.

Question 18

Limitations of monetary policy in less developed countries

Answer 18

There is a large non-monetized sector which hinders the success of monetary policy in such countries. People mostly live in rural areas where barter is practiced. Consequently, monetary policy fails to influence this large segment of the economy.

Undeveloped Money and Capital Markets: The money and capital markets are undeveloped. These markets lack in bills, stocks and shares which limit the success of monetary policy.

Non-bank financial intermediaries like the indigenous bankers operate on a large scale in such countries but they are not under the control of the monetary authority. The factor limits the effectiveness of monetary policy in such countries.

The majority of commercial banks possess high liquidity so that they are not influenced by the credit policy of the central bank. This also makes monetary policy less effective.

In almost every underdeveloped country foreign owned commercial banks exist. They also render monetary policy less effective by selling foreign assets and drawing money from their head officers when the central bank of the country is following a tight monetary policy.

Monetary policy is also not successful in such countries because bank money comprises a small proportion of the total money supply in the country. As a result, the central bank is not in a position to control credit effectively.

The well-to-do people do not deposit money with banks but use it in buying jewelry, gold, real estate, in speculation, in conspicuous consumption, etc. Such activities encourage inflationary pressures because they lie outside the control of the monetary authority.