1.Monetary Policy

8/13/2019 1.Monetary Policy

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MONETARY POLICY

Monetary policy is the policy statement, traditionally bi-annual , through which the RBI targets a key set ofindicators to ensure price stability in the economy.

These factors include :

money supply

Interest rate

Inflation


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RBIs monetary policy has been characterized as one ofcontrolled expansion ie., adequate financing ofeconomic growth and the same time , ensuringreasonable price stability.

Before initiating measures for the expansion orcontraction of money supply, the RBI generally measuresthe extent of money and credit available in the

economy at a given time.


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Indices to measure money and credit

M1: This represents money supply with the public.

M1 has two components:

(a) currency with the public

(b) deposits of the public with the banks

Currency with the public is the sum total of notes incirculation and circulation of rupee coins and smallcoins minus the cash on hand with banks.

Deposits of public with banks is the sum total of

demand deposits with banks and other deposits of the

public with the RBI.


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M2 : this represents the total of M1 plus post officesavings and bank deposits

M3: It is the sum total of M2 and the time deposits with

bank.

M4 : this represents M3 plus total post office deposits.

M1 is called narrow money while

M3 represents aggregate monetary resources of themoney stock of the entire banking sector .

REPRESENTATIVE SOURCES OF M3:

A) The net bank credit to the government

B) Bank credit to the commercial sectorC) Net foreign exchange assets of the banking sector

D) The government currency liabilities to the public


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Definition Monetary Policy

By monetary policy we mean the regulation of themoney supply and the control of the cost and availabilityof credit by the central bank of the country through the

use of deliberate and discretionary action for achievingthe objectives of general economic policy.


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Monetary Policy-- Objectives

1. Maximum feasible output

2. High rate of economic growth

3. Fuller employment

4. Price stability

5. Greater equity in the distribution of income and wealth

6. Healthy balance of payments.

Gupta opines that When monetary policy is conducted with

a view to long-run price stability at maximum feasible output,

other goals of economic policy viz fuller employment, a highrate of growth, greater equality and healthy balance of

payments are also promoted to the maximum extent


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Expansion and Contraction of MoneyEXPANSION:

Money is pumped into the economy trough the issue ofcurrency by the RBI, budgetary operations of the governmentand borrowings by the government from foreign countries.

Expansion is always encouraged in a country, infact, the

growth in money supply must be higher than the growth in thereal national income.

This stems from to two reasons.

a) As income grow, the demand for money as one of thecomponents of savings trends to increase

b) An increase in money supply is also necessitated by thegradual reduction of non-monetised sector of theeconomy


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But in our country the rate of increase in money supplyhas been far in excess of the rate of growth in real

national incomes. Hence inflationary pressure is there oneconomy.

CONTRACTION:

Unlimited expansion of money and credit results in hyper-

inflation, which hits all sections of society, particularly thepoor. The RBI has a responsibility to ensure that money iswithin manageable limits and inflation is not too harsh.For this purpose , the RBI has been using different controlmeasures, called credit control measures.

(A)General (quantitative ) controls

(B) Selective (qualitative) controls


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GENERAL CREDIT CONTROLS

(i) BANK RATE

Bank rate: also called discount rate, bank rate refers atwhich the Central Bank rediscounts or lends money tocommercial banks. During inflationary periods, the bankrate is hiked so as to increase the rate of interest on

borrowings. The reverse course of action is taken duringthe periods of falling prices. Change in bank rates by RBI

1965 6%

1973 7%

1974 9%

1983 10%

1991 11% - 12%

2000 Reduced to 8%

2003 Cut down to 6%


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A) Open Market Operations :refers to purchase orsale of securities, foreign exchange and gold by

the government.Purchase of securities and gold from public results

in extension of money.

Sale of securities and gold results in contraction of

money supply.B) Special Facilities to Some Groups:the ReserveBank advices commercial banks to advance liberallyto special groups like Small-Scale-industries,

cooperatives , small transport operators, selfemployed etc., .This also results in expansion ofmoney.


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c) Liberalisation of the Bill Market Scheme:under this,

commercial banks get additional financefrom theReserve Bank. With additional funds at their disposal,commercial banks will be able to advance credit further.

D) Development Banks: since Independence , the RBIhas setup a series of development banks like IFCI, IDBIetc., through which funds are available to financeeconomic activities.


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(ii) CASH RESERVE REQUIREMENTS (CRR)

Under the RBI Act 1935, every commercial bank has to

keep certain minimum cash reserve with the RBI.The RBI is empowered to vary the CRR between 3percent and 15 percent of demand and time deposits.

CRR was changed over time:

CRR is a powerfulweapon

1973 7%1984 9%

1987 Increased by 0.5%

1991 Hiked to 15%

1994 Decreased to 14%

1997 Cut down to 10%

1993 june onwards 4.5 %


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(iii) STATUTORY LIQUIDITY RATIO (SLR)

In addition to CRR, every commercial bank should keep

a certain percentage of its total demand and timedeposits with the RBI in the form of liquid assets like cash,gold etc., Maintenance of adequate liquid assets is abasic principle of sound banking.

As per the Banking Regulation Act 1949 the commercialbanks need to maintain a minimum ratio of liquidassets.The RBI has empowered to change the ratio.

1972 Raised from 25% to 30%

1973 32%

1981 35%

1984 36%

1987 37.5%

1991 Raised to 38.5% & reduced to 25%


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(iv)REFINANCE POLICY

The system of refinance provide by the RBI tocommercial banks affects their credit. The system ischanged periodically to allow or disallow certain flowsby the banks.

The scope of refinance as an instrument of creditcontrols depends on the liquidity position of the

commercial banks.

Over the years, the commercial banks dependence onthe RBI for refinance has come down except in the caseof subsidised refinance of agriculture and rural credit.

The effectiveness of refinance policy has therefore comedown.


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SELECTIVE CREDIT CONTROLS

Selective credit controls affect particular sectors of theeconomy and the include such measures as:

(i) Insisting on minimum margins for lending against specificsecurities;

(ii) Fixing ceiling on the amounts of credit for certain

purposes;(iii) Charging discriminatory rates of interest on certain types

of advance;

(iv) Moral suasion; RBI appeals to the good sense of banks notto do or do certain things

(v) Direct action ; refusal BY Reserve Bank to rediscount bills ofa particular commercial bank which has failed to complythe directives of the former.(cancellation of license)


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An Evaluation of Monetary Policy

The inability of the Reserve Bank to deny or regulatecredit to the Central Government due to both legal andpractical considerations has been interpreted by thecommittee( Sukhamony Chakravarthy Committee) as an

important factor in the Reserve Banks helplessness incontrolling the rise in money supply.

With regard to the role of RBI in controlling inflation,

criticism is equally strong. It is said that the monetarypolicy operated by the RBI did not play any effectiverole in containing inflation in the economy.


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WEAKNESS STRENGTH

Higher proportion of non-banking credit

Decision making andimplementation is fasterthan fiscal policy

No check on price

High currency-deposit ratiorendering the RBIs role less

effective

More reliance on selectivecredit control measures and

less on quantitative controlsmaking RBIs pressure oncommercial bank less severe

Selective application ofcredit constraint

Defective statistical andmonetary system

Has been responsive to theneeds of the economy

Growing fiscal needs to theeconomy


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FISCAL POLICY


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FISCAL POLICY

What does mean by fiscal policy?

FISC denotes public treasury and the fiscal policyindicates how the government attempts to realize revenue,spending and managing the deficit.

In short fiscal policy tells the methods adopted by thegovernment in taxation , public expenditure and publicdebt.


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DEFINITION:

According to Prof. R.Lipsey and Prof.Peter Teiner,

Fiscal policy is defined as the conscious attempt ofthe government to achieve certain macro economicgoals of policy by altering the volume and pattern ofits revenues and expenditures and the balance

between them.The major economic goals of fiscal policy are tomaintain a high average level of employment andbusiness activity, to minimize fluctuations in

employment activity, prevent inflation & to produceand promote economic growth


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The major economic goals of fiscal policy are tomaintain a high average level of employment and

business activity, to minimize fluctuations inemployment activity, prevent inflation & to produceand promote economic growth


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Fiscal policy operates through the budget. In fact, fiscalpolicy is also known as budgetary policy.

The budget means an estimate of revenue and

expenditure.Fiscal policy denotes the use of taxes and governmentexpenditure:

Government expenditures----- two distinct forms

(i) Government purchase: comprise spending on goodsand services--- purchase of tanks, construction ofroads, salaries for judges etc.,

(ii) Government transfer payments, which boost theincomes of targeted groups such as elderly or

unemployed .Government expenditures also effect the overall level ofspending in the economy & thereby influence the levelof GDP.


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Taxation:

Taxation affects the overall economy in two ways:

(i) Taxes affect peoples income , taxes tend o affectthe amount people spend on goods/services aswell as the amount of private saving

(i) Taxes affects the prices of goods & factors ofproduction for example more heavily businessprofits are taxed, the more business arediscouraged in new capital goods.


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Fiscal Policy

Fiscal policy refers to the policy of the governmentregarding taxation, public expenditure and public debt.Governments all over the world have been using fiscalmeasures to regulate their economic and businessactivities in order to achieve such objectives as:

Accelerating the rate of investment

Promoting socially desirable investments

Achieving rapid economic development

Achieving full employment

Promoting foreign trade

Reducing inequalities of income

Establishing a welfare state


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Keynes argued for intervention by the government tocure depression and inflation by adopting appropriatetools of macroeconomic policy ie., fiscal policy andmonetary policy.

1.Monetary Policy

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