Programme: BA Semester: III Subject : Economics Paper

Programme: BA

Semester: III

Subject : Economics

Paper: Macro Economic Analysis

Module: Macro Economic Policy Targets and Instruments

Fiscal Policy

Fiscal Policy is the mechanism by means of which a government makes adjustments to its

planned spending and the imposed tax rates to monitor and thus in turn influence the performance

of a country’s economy. It is implemented along with the monetary policy by means of which

the central bank of the nation influences the nation’s money supply. Together these policies go

hand in hand to direct a country’s economic goals.

Fiscal policy is based on Keynesian economics, a theory by economist John Maynard Keynes.

This theory states that the governments of nations can play a major role in influencing the

productivity levels of the economy of the nation by changing (increasing or decreasing) the tax

levels for the public and thus by modifying public spending.

This influence exerted by the policy helps in curbing inflation, increasing employment and most

importantly it helps in maintaining a healthy value of the currency. Fiscal policy has a major role

in managing the economy. An incompetent policy may lead to huge setbacks for the economy

and may also lead to a recession.

FISCAL POLICY MEANING

Fiscal policy means the use of taxation and public expenditure by the government for

stabilization or growth of the economy.

Fiscal policy is a policy to change tax and government spending to protect economy

stabilization.

Fiscal policy is the means by which a government adjusts its spending levels and tax rates to

monitor and influence a nation's economy. It is the sister strategy to monetary policy through

which a central bank influences a nation's money supply.

It is the policy concerning the revenue expenditure and debt of the government for achieving

certain objectives like control of inflation, public expenditure.

Fiscal policy is defined as “the conscious attempt of government to achieve certain macro goals

of policy by altering the volumes and pattern of its revenue and expenditure and balance

between them”.

Fiscal policy is related to income and expenditure of the government. It is an instrument for

promoting economic growth, employment, social welfare etc. Fiscal policy means any decision

to change the level, composition or timing of government or to change the rate and structure of

tax.

Fiscal Policy refers to a policy concerning the use of state treasury or the government finances

to achieve the macro-economic goals”

“Government policy of changing its taxation and public expenditure programmes intended to

achieve its objective”.

“Government uses its expenditure and revenue program to produce desirable effects on

National Income, production and employment”.

DEFINITION

Fiscal policy can be defined as the policy of the government regarding changes in taxes,

government spending and government borrowing to affect aggregate demand in the economy.

According to Kaushik Basu “Fiscal policy deals with the taxation and expenditure decisions of

the government. These include, tax policy, expenditure policy, investment or disinvestment

strategies and debt or surplus management”.

According to Prof. D.C. ROWAN, “fiscal policy is defined as the discretionary action by the

government to change the level of government expenditure on goods and services and transfer

payment and the yield of taxation at any given level of output”.

According to Arthur Smith “A policy under which government uses its expenditure and

revenue program to produce desirable effects and avoid undesirable effects in the national

income, production and employment”.

According to Culbarston, “By fiscal policy we refer to government actions affecting its receipts

and expenditures which ordinarily as measured by the government’s receipts, its surplus or

deficit.”

STANCES OF FISCAL POLICY

• Neutral: A Neutral position applies when the budget outcome has neutral effect on the level

of economic activity where the govt. spending is fully funded by the revenue collected from

the tax. This is the equilibrium phase for the economy. In this case the government spending

is entirely funded by tax revenue and there is no need of borrowing.

• Expansionary Fiscal Policy: An increase in government spending and/or a decrease in taxes

designed to increase aggregate demand in the economy, thus increasing real output and

decreasing unemployment. This is the phase where the government spending exceeds tax

revenue. This happens during the time of recessions. An Expansionary position is when there

is a higher budget deficit where the govt. spending is higher than the revenue collected from

the tax.

• Contractionary fiscal policy: A decrease in government spending and/or an increase in taxes

designed to decrease aggregate demand in the economy and control inflation. This is the phase

where the government spending is lower than tax revenue. This is undertaken to pay down

government debt. An Contractionary position is when there is a lower budget deficit where the

govt. spending is lower than the revenue collected from the tax.

Main Objectives of Fiscal Policy in India

Before moving on the discussion on objectives of India’s Fiscal Policies, firstly know that the

general objective of Fiscal Policy.

General objectives of Fiscal Policy are given below:

1. To maintain and achieve full employment.

2. To stabilize the price level.

3. To stabilize the growth rate of the economy.

4. To maintain equilibrium in the Balance of Payments.

5. To promote the economic development of underdeveloped countries.

Fiscal policy of India always has two objectives, namely improving the growth performance of

the economy and ensuring social justice to the people.

The fiscal policy is designed to achieve certain objectives as follows:-

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. The central

and state governments in India have used fiscal policy to mobilise resources.

The financial resources can be mobilised by:-

a. Taxation: Through effective fiscal policies, the government aims to mobilise resources by

way of direct taxes as well as indirect taxes because most important source of resource

mobilisation in India is taxation.

b. Public Savings: The resources can be mobilised through public savings by reducing

government expenditure and increasing surpluses of public sector enterprises.

c. Private Savings: Through effective fiscal measures such as tax benefits, the government can

raise resources from private sector and households. Resources can be mobilised through

government borrowings by ways of treasury bills, issuance of government bonds, etc., loans

from domestic and foreign parties and by deficit financing.

2. 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.

3. Price Stability and Control of Inflation: One of the main objectives 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.

4. Employment Generation: The government is making every possible effort to increase

employment in the country through effective fiscal measures. 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 generate more employment. Various

rural employment programmes have been undertaken by the Government of India to solve

problems in rural areas. Similarly, self employment scheme is taken to provide employment to

technically qualified persons in the urban areas.

5. Balanced Regional Development: there are various projects like building up dams on

rivers, electricity, schools, roads, industrial projects etc run by the government to mitigate the

regional imbalances in the country. This is done with the help of public expenditure.

6. Reducing the Deficit in the Balance of Payment: some time government gives export

incentives to the exporters to boost up the export from the country. In the same way import

curbing measures are also adopted to check import. Hence the combine impact of these

measures is improvement in the balance of payment of the country.

7. Increases National Income: it’s the strength of the fiscal policy that is brings out the desired

results in the economy. When the government want to increase the income of the country then

it increases the direct and indirect taxes rates in the country. There are some other measures

like: reduction in tax rate so that more peoples get motivated to deposit actual tax.

8. Development of Infrastructure: when the government of the concerned country spends

money on the projects like railways, schools, dams, electricity, roads etc to increase the welfare

of the citizens, it improves the infrastructure of the country. A improved infrastructure is the

key to further speed up the economic growth of the country.

9. Foreign Exchange Earnings: when the central government of the country gives incentives

like, exemption in custom duty, concession in excise duty while producing things in the

domestic markets, it motivates the foreign investors to increase the investment in the domestic

country.

5 Major Instruments of Fiscal Policy

Some of the major instruments of fiscal policy are as follows:

A. Budget B. Taxation C. Public Expenditure D. Public Works E. Public Debt.

A. Budget:

The budget of a nation is a useful instrument to assess the fluctuations in an economy.

Different budgetary principles have been formulated by the economists, prominently

known as:

(1) Annual budget,

(2) cyclical balanced budget and

(3) fully managed compensatory budget.

Let us briefly explain them:

1. Annual Balanced Budget:

The classical economists propounded the principle of annually balanced budget. They defended

it with force till the deep-rooted crisis of 1930’s.

The reasons for their reacceptance of this principle are as under:

(i) They maintained that there should be balance in income and expenditure of the government;

(ii) They felt that automatic system is capable to correct the evils;

(iii) Balanced budget will not lead to depression or boom in the economy;

(iv) It is politically desirable as it checks extravagant spending of the state;

(v) This type of budget assures full employment without inflation;

(vi) The principle is based on the notion that government should increase the taxes to get more

money and reduce expenditure to make the budget balanced.

However, this principle is subject to certain objections.

These objections are as under:

(i) Classical version that balanced budget is neutral is not well based. In practice, a balanced

budget can be expansionary.

(ii)The assumptions of full employment and automatic adjustment are too untenable in a

modern economy.

(iii)Some economists also argue that annually balanced budget involves lesser burden of the

taxes.

2. Cyclically Balanced Budget:

The cyclical balanced budget is termed as the ‘Swedish budget’. Such a budget implies

budgetary surpluses in prosperous period and employing the surplus revenue receipts for the

retirement of public debt. During the period of recession, deficit budgets are prepared in such

a manner that the budget surpluses during the earlier period of inflation are balanced with

deficits.

The excess of public expenditure over revenues are financed through public borrowings. The

cyclically balanced budget can stabilize the level of business activity. During inflation and

prosperity, excessive spending activities are curbed with budgetary surpluses while budgetary

deficits during recession with raising extra purchasing power.

This policy is favoured on the following account:

(i) The government can easily adjust its finances according to the needs;

(ii)This policy works smoothly in all times like depression, inflation, boom and recession;

(iii) Cyclically balanced budget simply ensures stability but gives no guarantee that the system

will get stabilized at the level of full employment.

3. Fully Managed Compensatory Budget:

This policy implies a deliberate adjustment in taxes, expenditures, revenues and public

borrowings with the motto of achieving full employment without inflation. It assigns only a

secondary role to the budgetary balance. It lays down the emphasis on maintenance of full

employment and stability in the price level. With this principle, the growth of public debt and

the problem of interest payment can be easily avoided. Thus, the principle is also called

‘functional finance.’

The fully managed compensatory budget has been criticized on the following grounds:

(i) It considers that the government should give blanket guarantee against unemployment.

(ii) This policy is not automatic.

(iii) It brings political upheavals as it delays the implementation of appropriate fiscal measures.

(iv) A country is burdened with debt in the long run period.

(v) This policy is a prolonged lag which in practice has a disturbing effect on the economy.

B. Taxation:

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 increases disposable income of the individual, promotes consumption

and investment. Obviously, there will be more funds with the people for consumption and

investment purposes at the time of tax reduction.

This will ultimately result in the increase in spending activities i.e. it will tend to increase

effective demand and reduce the deflationary gap. In this regard, sometimes, it is suggested to

reduce the rates of commodity taxes like excise duties, sales tax and import duty. As a result

of these tax concessions, consumption is promoted. Economists like Hansen and Musgrave,

with their eye on raising private investment, have emphasized upon the reduction in corporate

and personal income taxation to overcome contractionary tendencies in the economy.

Now, a vital question arises about the extent to which unemployment is reduced or mitigated

if a tax reduction stimulates consumption and investment expenditure. In such a case, reduction

of unemployment is very small. If such a policy of tax reduction is repeated, then consumers

and investors both are likely to postpone their spending in anticipation of a further fall in taxes.

Furthermore, it will create other complications in the government budget.

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.

The burden of taxation may be raised to the extent which may not retard new investment. A

steeply progressive personal income tax and tax on windfall gains is highly effective to curb

the abnormal inflationary pressures. Export should be restricted and imports of essential

commodities should be liberated.

The increased inflow of supplies from origin countries will have a moderate impact upon

general prices. The tax structure should be such which may impose heavy burden on higher

income group and vice versa. Therefore, proper care must be taken that the government policies

should not bring violent fluctuations and impede economic growth. To sum up, despite certain

short-comings of taxation, its significance as an effective anti-cyclical and growth inducing

investment cannot be forfeited.

Taxation Policy:

The structure of tax rates has to be varied in the context of conditions prevailing in an economy.

Taxes determine the size of disposable income in the hands of general public and therefore, the

quantum of inflationary and deflationary gaps. During depression tax policy has to be such as

to encourage private consumption and investment; while during inflation, tax policy must

curtail consumption and investment.

During depression, a general reduction in corporate and income taxation has been favoured by

economists like Prof. A H. Hansen, M. Kalecki, and R.A. Musgrave on the ground that this

leaves higher disposable incomes with people inducing higher consumption while low

corporate taxation encourages ‘venture capital’, thereby promoting more investment.

But there are others who express grave doubts about the supposed stimulating effect of taxation

reliefs on investment. It has been argued that even a heavy reduction in taxes does not alter an

entrepreneur’s decisions.

Mr. Kalecki expressed the view that the policy of reducing taxes for increasing consumption

and stimulating private investment is not a practical solution of the unemployment problem

because income-tax cannot be changed so often. The government will have to evolve a long-

term fiscal policy.

Public Debt:

A sound programme of public borrowing and debt repayment is a potent weapon to fight

inflation and deflation. Government borrowing can be in the form of borrowing from non-bank

financial intermediaries, borrowing from commercial banking system, drawings from the

central bank or printing of new money.

Borrowing from the public through the sale of bonds and securities which curtails consumption

and private investment is anti-inflationary in effect. Borrowing from the banking system is

effective during depression if banks have got excess cash reserves.

Thus, if unused cash lying with banks can be lent to the government, it will cause a net addition

to the national income stream. Withdrawals of balances from treasury are inflationary in nature

but these balances are likely to be so small as to be of little importance in the economic system.

However, the printing of new money is highly inflationary.

During war, borrowing becomes necessary when inflationary pressures become strong. In a

period of inflation, therefore, public debt has to be managed in such a way as reduces the money

supply in the economy and curtails credit. The government will do well to retire debt through

a budget surplus.

During depression, on the opposite, taxes are reduced and public expenditures are increased.

Deficits are financed by borrowings from the public, commercial banks or the central bank of

the country. The public borrowing of otherwise idle funds will have no adverse effect on

consumption or on investment. When budgets are deficit, it is very difficult to retire debts.

Actually, it pays to accumulate debt during depression and redeem it during a period of

expansion. Along with this, the monetary authority (the central bank) must aim at a low bank

rate to keep the burden of debt low. Thus, ‘public debt becomes an important tool of anti-

cyclical policy.

Public Expenditure:

Public expenditure can be used to stimulate production, income and employment. Government

expenditure forms a highly significant part of the total expenditure in the economy. A reduction

or expansion in it causes significant variations in the total income. It can be instrumental in

adjusting consumption and investment to achieve full employment.

During inflation, the best policy is to reduce government expenditure in order to control

inflation by giving up such schemes as are justified only during deflation. While expenditures

are reduced, attempts are made to increase public revenues to generate a budget surplus.

Though it is true that there is a limit beyond which it may not be possible to reduce government

spending (say on account of political, and military considerations), yet the government can

vary its expenditure to some extent to reduce inflationary pressures.

It is during depression that public spending assumes greater importance. A distinction is made

between the concepts of public spending during depression, that is, the concepts of pump

priming and the ‘compensatory spending’. Pump priming means that a certain volume of public

spending will help to revive the economy which will gradually reach satisfactory levels of

employment and output. What this volume of spending may be is not specific. The idea is that,

when private spending becomes deficient, then a small dose of public spending may prove to

be a good starter.

Compensatory spending, on the other hand, means that public spending is undertaken with the

clear view to compensating for the decline in private investment. The idea is that when private

investment declines, public expenditure should expand and as long as private investment is

below normal, public compensatory spending should go on. These expenditures will have

multiplier effects of raising the level of income, output and employment.

The compensatory public expenditure may take the forms of relief expenditure, subsidies,

social insurance payments, public works etc.

Essential requisites of compensatory public spending are:

(1) It must have the maximum possible leverage effects;

(2) It must not be mutually offsetting;

(3) It must create economically and socially desirable assets. But pump priming expenditures

are of limited relevance in advanced economies where the deficiency of investment is not

merely cyclical but also secular.

Public Works:

Public expenditures meant for stabilisation are classified into two types:

(i) Expenditures on public works such as roads, schools, parks, buildings, airports, post-offices,

hospitals, canals and other projects.

(ii) Transfer payments, such as interest on public debt, pensions, subsidies, relief payment,

unemployment insurance, social security benefits etc.

The expenditure on building up of capital assets is called capital expenditure and transfer

payments are called current expenditure. It has been recommended that governments should

keep ready with them a list of public works which may be taken up when the economy shows

signs of recession.

Such a programme of public investment will tone up the general morale of businessmen for

investing. The primary employment in public works programmes will induce secondary and

tertiary employment. As soon as the economy is put on the expansion track, such programmes

may be slackened and may be given up completely so that at any time public investment does

not compete with private investment.

Public works programmes suffer from a few limitations and practical difficulties. It is

unrealistic to expect that public works will fill all the investment gaps of the private sector of

the economy. To be genuinely effective in promoting investment during depression, public

works require proper timing, proper financing and general approval of business and investing

opportunities.

Public works programmes cannot be varied easily along with the trade cycle because many

projects like river dams take a long time for completion and many others like schools and

hospitals cannot be postponed, for if these are needed, these have to be built anyway.

Again, certain heavy projects requiring a long time for completion and started during

depression cannot be given up without serious loss of goodwill to the government. Then, there

are problems of forecasting, of being able to know when a period of inflation or deflation may

set in and of determining quickly the exact nature of programmes to be undertaken. Besides,

there are delays in getting them started. Again, they impose a heavy debt burden and sometimes

cause misallocation of resources, for projects may be located in one region while the

unemployed resources are located in another region.

It is because of these limitations of public works that some economists favour a comprehensive

programme of social security measures like pensions, subsidies, unemployment, insurance etc.

These will not only raise consumption during depression but also stabilise it in the long-run. If

such a programme of social security is financed through progressive taxation, the purpose

would be better served. The wise course would be to coordinate the programmes of social

security measures and public works.

Functional Fiscal policy

In economics fiscal policy is the use of government revenue collection and expenditure to

influence a country's economy. The use of government revenues and expenditures to influence

macroeconomic variables developed as a result of the Great Depression, when the previous

laissez-faire approach to economic management became unpopular. Fiscal policy is based on

the theories of the British economist John Maynard Keynes, whose Keynesian economics

theorized that government changes in the levels of taxation and government spending

influences aggregate demand and the level of economic activity. Fiscal and monetary policy

are the key strategies used by a country's government and central bank to advance its economic

objectives. The combination of these policies enables these authorities to target inflation and

to increase employment. Additionally, it is designed to try to keep GDP growth at 2%–3% and

the unemployment rate near the natural unemployment rate of 4%–5%. This implies that fiscal

policy is used to stabilize the economy over the course of the business cycle.

1. Allocation Function:

The provision for social goods, or the process by which total resource use is divided between

private and social goods and by which the mix of social goods is chosen. This provision may

be termed as the allocation function of budget policy. Social goods, as distinct from private

goods, cannot be provided for through the market system.

The basic reasons for the market failure in the provision of social goods are: firstly, because

consumption of such products by individuals is non rival, in the sense that one person’s

partaking of benefits does not reduce the benefits available to others.

The benefits of social goods are externalised. Secondly, the exclusion principle is not feasible

in the case of social goods. The application of exclusion is frequently impossible or

prohibitively expensive. So, the social goods are to be provided by the government.

2. Distribution Function:

Adjustment of the distribution of income and wealth to assure conformance with what society

considers a ‘fair’ or ‘just’ state of distribution. The distribution of income and wealth

determined by the market forces and laws of inheritance involve a substantial degree of

inequality. Tax transfer policies of the government play an important role in reducing the

inequalities in income and wealth in the economy.

3. Stabilization Function:

Fiscal policy is needed for stabilization, since full employment and price level stability do not

come about automatically in a market economy. Without it the economy tends to be subject to

substantial fluctuations, and it may suffer from sustained periods of unemployment or inflation.

Unemployment and inflation may exist at the same time. Such a situation is known as

stagflation.

The overall level of employment and prices in the economy depends upon the level of aggregate

demand, relative to the potential or capacity output valued at prevailing prices. Government

expenditures add to total demand, while taxes reduce it. This suggests that budgetary effects

on demand increase as the level of expenditure increases and as the level of tax revenue

decreases.

4. Economic Growth:

Moreover, the problem is not only one of maintaining high employment or of curtailing

inflation within a given level of capacity output. The effects of fiscal policy upon the rate of

growth of potential output must also be allowed for. Fiscal policy may affect the rate of saving

and the willingness to invest and may thereby influence the rate of capital formation. Capital

formation in turn affects productivity growth, so that fiscal policy is a significant factor in

economic growth.

Fiscal policy as an instruments of eradication of unemployment and income inequalities

There are Five fiscal means:

1. Tax Policy

2. Public Borrowing

3. External Finance

4. Deficit Finance

5. Surpluses of Public Enterprises

1. Tax Policy:

A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer

(an individual or legal entity) by a governmental organization in order to fund government

spending and various public expenditures. A failure to pay, along with evasion of or

resistance to taxation, is punishable by law. Taxes consist of direct or indirect taxes and

may be paid in money or as its labour equivalent. Most countries have a tax system in place

to pay for public, common, or agreed national needs and government functions. Some levy

a flat percentage rate of taxation on personal annual income, but most scale taxes based on

annual income amounts. Most countries charge a tax on an individual's income as well as

on corporate income. Countries or subunits often also impose wealth taxes, inheritance

taxes, estate taxes, gift taxes, property taxes, sales taxes, payroll taxes or tariffs. Gunnar

Myrdal says “Governments can intervene to promote equity, and reduce inequality and

poverty, through the tax and benefits system”. This means employing a progressive tax and

benefits system which takes proportionately more tax from those on higher levels of

income, and redistributes welfare benefits to those on lower incomes.

2. Role of Public Borrowing in Mobilization of Resources:

Governments must borrow if their revenue is insufficient to pay for expenditure – a situation

called a fiscal deficit. Borrowing, which can be short term or long term, involves the sale of

government securities. Bonds are long term securities that pay a fixed rate of return over a

long period until maturity, and are bought by financial institutions and companies looking for

a safe return. Bonds issued by the government are called gilts – short for gilt-edged, meaning

they are as good as gold and payment of interest and at redemption is guaranteed. Treasury

bills are issued into the money markets to help raise short term cash, and last only 90 days,

whereupon they are repaid.

• Very Large resources are needed for economic development which cannot be raised

by taxation.

• Too much taxation creates dissatisfaction among the people while public debt has no

such defect.

• Public debt imposes burden on future generation

3. External Finance:

External debt is the portion of a country's debt that is borrowed from foreign lenders,

including commercial banks, governments, or international financial institutions. These

loans, including interest, must usually be paid in the currency in which the loan was

made. To earn the needed currency, the borrowing country may sell and export goods to

the lending country.

• Borrowing from abroad

• Additional source of investment

• Increases Investment

4. Deficit Finance: Deficit financing means generating funds to finance the deficit which

results from excess of expenditure over revenue. The gap being covered by borrowing

from the public by the sale of bonds or by printing new money.

Need of deficit financing:

For developing countries like India, higher economic growth is a priority. A higher

economic growth requires finances. With the private sector being shy of making huge

expenditure, the responsibility of drawing financial re ..

• Deficit financing is advocated for the implementation of development projects.

• Breaking of vicious circle of poverty

5. Surpluses of Public Enterprises: Profits of state undertakings also are an important source

of revenue these days, owing to the expansion of the public sector. For instance, the central

government runs railways. Surplus from railway earnings can be normally contributed to the

revenue budget of the central budget. Likewise, profits from the state transport corporation

and other public undertakings can be important sources of revenue for the budgets of state

governments. Similarly, other commercial undertakings in the public sector such as

Hindustan Machine Tools, Bokaro Steel Plant, State Trading Corporation etc. can make

profits to support the central budget. Earnings from state enterprises depend upon the prices

charged by them for their goods and services and the surplus derived therefrom. Thus, the

pricing policy of state undertakings should be self-supporting and reasonably profit-oriented.

Again, prices are charged with an element of quid pro quo i.e., directly in proportion to the

benefits conferred by the services rendered.

A price is a form of revenue derived by the government by selling goods and services

of public enterprises. Thus, price is the revenue obtained from business activity undertaken

by the public authorities. Many public enterprises like postal services run on cost-to-cost

basis. The prices are charged just to cover the cost of rendering such services. However, in

certain cases, when the state has an absolute monopoly, prices having a high profit element

are charged. Such monopoly profits of a state enterprise are in the nature of a tax. The

difference between price and fee is this: the former usually can never be less than the cost of

production or service, while the latter may not necessarily cover the cost of service.

Monetary policy

“Monetary policy involves the influence on the level and composition of aggregate demand by

the manipulation of interest rates and the availability of credit”-D.C. Aston.

Monetary policy implies those measures designed to ensure an efficient operation of the

economic system or set of specific objectives through its influence on the supply, cost and

availability of money.

The concept of monetary policy has been defined in a different manner according to different

economists;

R.P. Kent has defined the monetary policy as “The management of the expansion and

contraction of the volume of money in circulation for the explicit purpose of attaining a specific

objective such as full employment.”

Dr.D.C. Rowan remarked, “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.”

According to Prof. Crowther, “Monetary Policy consists of the steps taken or efforts made to

reduce to a minimum the disadvantages that flow from the existence and operation of the

monetary system. It is a policy to regulate the flow of monetary resources in the economy to

attain certain specific objectives.” D.C. Aston has defined:”Monetary policy involves the

influence on the level and composition of aggregate demand by the manipulation of interest

rates and the availability of credit.”

According to G.K. Shaw; “By monetary policy we mean any conscious action undertaken by

the monetary authorities to change the quantity, availability or cost (rate of interest) of money.

A broader definition might also take into account action designated to influence the

composition and the age profile of the national debt, as for example, open market operations

geared to purchase the short term securities and seal of long term bonds.”

In the words of Mr. C.K. Johri; “It would comprise those decisions of the government and

Reserve Bank of India which affect the volume and composition of money supply in the size

and distribution of credit (including Co-operative Banks Credit) the level and structure of

interest rates and the effect of these variables upon the factors determining output and prices.”

The difference between monetary and fiscal policy: Monetary policy involves changing the

interest rate and influencing the money supply.

Fiscal policy involves the government changing tax rates and levels of government spending

to influence aggregate demand in the economy.

They are both used to pursue policies of higher economic growth or controlling inflation.

Monetary policy:

Monetary policy is usually carried out by the Central Bank/Monetary authorities and

involves:

• Setting base interest rates (e.g. Bank of England in UK and Federal Reserve in the

US)

• Influencing the supply of money. E.g. Policy of quantitative easing to increase the

supply of money.

How monetary policy works

• The Central Bank may have an inflation target of 2%. If they feel inflation is going to

go above the inflation target, due to economic growth being too quick, then they will

increase interest rates.

• Higher interest rates increase borrowing costs and reduce consumer spending and

investment, leading to lower aggregate demand and lower inflation.

• If the economy went into recession, the Central Bank would cut interest rates.

Fiscal policy

Fiscal policy is carried out by the government and involves changing:

• Level of government spending

• Levels of taxation

1. To increase demand and economic growth, the government will cut tax and increase

spending (leading to a higher budget deficit)

2. To reduce demand and reduce inflation, the government can increase tax rates and cut

spending (leading to a smaller budget deficit)

Which is more effective monetary or fiscal policy?

In recent decades, monetary policy has become more popular because:

• Monetary policy is set by the Central Bank, and therefore reduces political influence

(e.g. politicians may cut interest rates in the desire to have a booming economy before

a general election)

• Fiscal policy can have more supply side effects on the wider economy. E.g. to reduce

inflation – higher tax and lower spending would not be popular, and the government

may be reluctant to pursue this. Also, lower spending could lead to reduced public

services, and the higher income tax could create disincentives to work.

• Monetarists argue expansionary fiscal policy (larger budget deficit) is likely to

cause crowding out – higher government spending reduces private sector expenditure,

and higher government borrowing pushes up interest rates. (However, this analysis is

disputed)

• Expansionary fiscal policy (e.g. more government spending) may lead to special

interest groups pushing for spending which isn’t really helpful and then proves

difficult to reduce when the recession is over.

• Monetary policy is quicker to implement. Interest rates can be set every month. A

decision to increase government spending may take time to decide where to spend the

money.

However, the recent recession shows that monetary policy too can have many limitations.

• Targeting inflation is too narrow. During the period 2000-2007, inflation was low but

central banks ignored an unsustainable boom in the housing market and bank lending.

• Liquidity trap. In a recession, cutting interest rates may prove insufficient to boost

demand because banks don’t want to lend and consumers are too nervous to spend.

Interest rates were cut from 5% to 0.5% in March 2009, but this didn’t solve recession

in the UK.

• Even quantitative easing – creating money may be ineffective if banks just want to

keep the extra money on their balance sheets.

• Government spending directly creates demand in the economy and can provide a

kick-start to get the economy out of recession. Thus in a deep recession, relying on

monetary policy alone, may be insufficient to restore equilibrium in the economy.

• In a liquidity trap, expansionary fiscal policy will not cause crowding out because the

government is making use of surplus saving to inject demand into the economy.

• In a deep recession, expansionary fiscal policy may be important for confidence – if

monetary policy has proved to be a failure.

Objectives of Monetary Policy:

(i) Neutrality of money

(ii) Stability of exchange rates

(iii) Price stability

(iv) Full Employment

(v) Economic Growth

(vi) Equilibrium in the Balance of Payments.

1. Neutrality of Money:

Economists like Wicksteed, Hayek and Robertson are the chief exponents of neutral money.

They hold the view that monetary authority should aim at neutrality of money in the economy.

Any monetary change is the root cause of all economic fluctuations. According to neutralists,

the monetary change causes distortion and disturbances in the proper operation of the economic

system of the country.

They are of the confirmed view that if somehow neutral monetary policy is followed, there will

be no cyclical fluctuations, no trade cycle, no inflation and no deflation in the economy. Under

this system, money is kept stable by the monetary authority. Thus the main aim of the monetary

authority is not to deviate from the neutrality of money. It means that quantity of money should

be perfectly stable. It is not expected to influence or discourage consumption and production

in the economy.

2. Exchange Stability:

Exchange stability was the traditional objective of monetary authority. This was the main

objective under Gold Standard among different countries. When there was disequilibrium in

the balance of payments of the country, it was automatically corrected by movements. It was

popularly known, “Expand Currency and Credit when gold is coming in; contract currency and

credit when gold is going out.” This system will correct the disequilibrium in the balance of

payments and exchange stability will be maintained.

It must be noted that if there is instability in the exchange rates, it would result in outflow or

inflow of gold resulting in unfavorable balance of payments. Therefore, stable exchange rates

play a key role in international trade. Thus, it is clear from this fact that: the main objective of

monetary policy is to maintain stability in the external equilibrium of the country. In other

words, they should try to eliminate those adverse forces which tend to bring instability in

exchange rates.

(i) It leads to violent fluctuations resulting in encouragement to speculative activities in the

market.

(ii) Heavy fluctuations lead to loss of confidence on the part of domestic and foreign capitalists

resulting in adverse impact in capital outflow which may also result in capital formation and

growth.

(iii) Fluctuations in exchange rates bring repercussions in the internal price level.

3. Price Stability:

The objective of price stability has been highlighted during the twenties and thirties of the

present century. In fact, economists like Crustar Cassels and Keynes suggested price

stabilization as a main objective of monetary policy. Price stability is considered the most

genuine objective of monetary policy. Stable prices repose public confidence because cyclical

fluctuations are totally eliminated.

It promotes business activity and ensures equitable distribution of income and wealth. As a

consequence, there is general wave of prosperity and welfare in the community. Price stability

also impedes economic progress as there is no incentive left with the business community to

increase production of qualitative goods.

It discourages exports and encourages imports. But it is admitted that price stability does not

mean ‘price rigidity’ or price stagnation’. A mild increase in the price level provides a tonic

for economic growth. It keeps all virtues of a stable price.

4. Full Employment:

During world depression, the problem of unemployment had increased rapidly. It was regarded

as socially dangerous, economically wasteful and morally deplorable. Thus, full employment

assumed as the main goal of monetary policy. In recent times, it is argued that the achievement

of full employment automatically includes prices and exchange stability.

However, with the publication of Keynes’ General Theory of Employment, Interest and Money

in 1936, the objective of full employment gained full support as the chief objective of monetary

policy. Prof. Crowther is of the view that the main objective of monetary policy of a country is

to bring about equilibrium between saving and investment at full employment level.

Similarly, Prof. Halm has also favoured Keynes’ view. Prof. Gardner Ackley regards that the

concept of full employment is ‘slippery’. Classical economists believed in the existence of full

employment which is the normal feature of an economy. Full employment, thus, exists when

all those who are ready to work at the existing wage rate get work. Voluntary, frictional and

seasonal unemployed are also called employed.

According to their version, full employment means absence of involuntary unemployment.

Therefore, it implies not only employment of all types of labourers but also includes the

employment of all economic resources. It is not an end in itself rather a pre-condition for

maximum social and economic welfare.

Keynes equation of income, Y = C + I throws light as to how full employment can be secured

with monetary policy. He argues that to increase income, output and employment, it is

necessary to increase consumption expenditure and investment expenditure simultaneously.

This indirectly solves the problem of unemployment in the economy. Since the consumption

function is more or less stable in the short period, the monetary policy should aim at raising

investment expenditure.

As monetary policy is the government policy regarding currency and credit, in this way,

government measures of currency and credit can easily overcome the problem of trade

fluctuations in the economy. On the other side, when the economy is facing the problem of

depression and unemployment, private investment can be stimulated by adopting ‘cheap money

policy’ by the monetary authority.

Therefore, this policy will serve as an effective and ideal stimulant to private investment as

there is pessimism all round in the economy. Further, the objective of full-employment must

be integrated with other objectives, like price and exchange stabilization.

The advanced countries like U.S.A. and U.K. are normally working at full employment level

as their main concern is how to maintain full employment and avoid fluctuations in the level

of employment and production. While, on the contrary, the main problem in underdeveloped

country is as to how to achieve full employment.

Therefore, in such economies, monetary policy can be designed to meet with the problem of

under employment and disguised unemployment and by further creating new opportunities for

employment. The most suitable and favourable monetary policy should be followed to promote

full-employment through increased investment, which in turn having multiplier and

acceleration effects.

After achieving the objective of full-employment, monetary policy should aim at exchange and

price stability. In short, the policy of full employment has the far-reaching beneficial effects.

(a) Keeping in view the present situation of unemployment and disguised unemployment

particularly in more growing populated countries, the said objective of monetary policy is most

suitable.

(b) On humanitarian grounds, the policy can go a long way to solve the acute problem of

unemployment.

(c) It is useful tool to provide economic and social welfare of the community.

(d) To a greater extent, this policy solves the problem of business fluctuations

5.Economic Growth:

In recent years, economic growth is the basic issue to be discussed among economists and

statesmen throughout the world. Prof. Meier defined “Economic growth as the process whereby

the real per capita income of a country increases over a long period of time.” It implies an

increase in the total physical or real output, production of goods for the satisfaction of human

wants.

In other words, it means utilization of all the productive natural, human and capital resources

in such a manner as to ensure a sustained increase in national and per capita income over time.

Therefore, monetary policy promotes sustained and continuous economic growth by

maintaining equilibrium between the total demand for money and total production capacity and

further creating favourable conditions for saving and investment. For bringing equality

between demand and supply, flexible monetary policy is the best course.

In other words, monetary authority should follow an easy or tight monetary policy to suit the

requirements of growth. Again, monetary policy in a growing economy, has to satisfy the

growing demand for money. Thus, it is the responsibility of the monetary authority to circulate

the proper quantity and quality of money.

6. Equilibrium in the Balance of Payments:

Equilibrium in the balance of payments is another objective of monetary policy which emerged

significant in the post war years. This is simply due to the problem of international liquidity on

account of the growth of world trade at a more faster speed than the world liquidity.

It was felt that increasing of deficit in the balance of payments reduces, the ability of an

economy to achieve other objectives. As a result, many less developed countries have to curtail

their imports which adversely effects development activities. Therefore, monetary authority

makes efforts that equilibrium should be maintained in the balance of payments.

Monetary Policy Tools

Monetary Policy Tools

1. Quantitative Tools

a. Open Market Operations

b. Bank Rate

c. Cash Reserve Requirement

d. Liquidity ratio

2. Qualitative Tools

a. Credit rationing

b. Credit ceiling

c. Moral persuasion

d. Direct action

D. Statutory Liquidity ratio

In India the Reserve Bank used to change the lending capacity and therefore credit

availability in the economy.

• To increase loanable resources of the banks, Reserve Bank can lower the SLR, This

when Reserve Bank lowers SLR the credit availability for the private sector will

increase.

• To decrease loanable resources of the banks, Reserve Bank can increase the SLR, This

when Reserve Bank increase SLR the credit availability for the private sector will

decrease.

2. Qualitative Tools

a. Credit rationing : when we take the loan from the bank then most of the time banks

gives us loan against the Mortgage of any kind of property and asset of us .

b. Credit ceiling : under this RBI give the direction to the commercial banks that they

have to increase or decrease the down payment rate from the customer for increase or decrease

the money flow in the economy.

c. Moral succession: under this RBI verbally request the commercial banks for

decrease or increase the interest rates. Moral suasion and credit monitoring arrangement are

other methods of credit control. The policy of moral suasion will succeed only if the Central

Bank is strong enough to influence the commercial banks.

In India, from 1949 onwards, the Reserve Bank has been successful in using the method of

moral suasion to bring the commercial banks to fall in line with its policies regarding credit.

Publicity is another method, whereby the Reserve Bank marks direct appeal to the public and

publishes data which will have sobering effect on other banks and the commercial circles.

Problem: Recession

When the economy is faced with Recession and Unemployment the central bank undertakes

open market operations and buys securities in the open market.

The Central Bank may lower the bank rate or Discount rate. At this rate commercial Banks will

be induced to borrow more from the central Bank and will be able to issue more credit at the

lower rate of interest to businessmen and investors.

Thirdly, The Central Bank may reduce the Cash Reserve Ratio (CRR) to be kept by the

commercial banks. With lower reserve requirements, a large amount of funds is released for

providing loans to businessmen and investors.

SLR, To increase lendable resources of the banks, RBI Can lower this Statutory Liquidity

Ratio. Thus when RBI lowers Statutory Liquidity Ratio, the, credit availability for the priate

sector will increase.

Problem: Inflation

When the economy is faced with Inflation the central bank undertakes open market operations

and sells government securities in the open market to reduce lending capacity of banks.

The Central Bank may increase the bank rate or Discount rate. At this rate commercial Banks

will not be induced to borrow more from the central Bank and will not be able to issue more

credit at the lower rate of interest to businessmen and investors.

Thirdly, The Central Bank may increase the Cash Reserve Ratio (CRR) to be kept by the

commercial banks. With higher reserve requirements, a less amount of funds is released for

providing loans to businessmen and investors.

SLR, to reduce lendable resources of the banks, RBI Can increase this Statutory Liquidity

Ratio. Thus when RBI increases Statutory Liquidity Ratio, the, credit availability for the

private sector will decrease.

Effectiveness of Credit Control Measures:

The effectiveness of credit control measures in an economy depends upon a number of factors.

First, there should exist a well-organised money market. Second, a large proportion of money

in circulation should form part of the organised money market. Finally, the money and capital

markets should be extensive in coverage and elastic in nature.

Extensiveness enlarges the scope of credit control measures and elasticity lends it adjustability

to the changed conditions. In most of the developed economies a favourable environment in

terms of the factors discussed before exists, in the developing economies, on the contrary,

economic conditions are such as to limit the effectiveness of the credit control measures.

Interplay operation of Fiscal and Monetary policies in the economy

(a) Increase in Government Expenditure to Cure Recession.

For a discretionary fiscal policy to cure depression, the increase in Government

expenditure is an important tool, Government may increase expenditure by starting public

works, such as building roads, dams, ports, telecommunication links, irrigation works,

electrification of new areas etc. For undertaking all these effect of this increase in expenditure

is both direct and indirect. The direct Effect is the increase in income of those who sell materials

and supply labour for these projects. The output of these public works also goes up together

with the increase in incomes Not only that, Keynes showed that increase in Government

expenditure also has an indirect effect in the form of the working of a multiplier, those who get

more Incomes spend them further on consumer goods depending on their marginal propensity

to consume. As during the period of recession there exists excess capacity in the consumer

goods industries, the increase in demand for them brings about expansion in their output which

further generates employment and incomes for the unemployed workers and so the new

incomes and re-spent and the process of multiplier goes on working till it exhausts itself.

How large should be the increase in expenditure so that equilibrium is established at

full employment or potential level of output. This depends on the magnitude of GNP gap

caused by deflationary gap on the one hand and the size of multiplier on the other. It may be

recalled that the size of the multiplier depends on the marginal propensity to consume. The

impact of increase in Government expenditure in a recessionary condition is illustrated in the

below Figure. Suppose to begin with the economy is operating at full employment or potential

level of output YF with aggregate demand curve C+I2 +G2 intersecting 450 line at point E

2. Now, due to some adverse happening, inverter’s expectations of making profits from

investment projects become dim causing a decline in investment. With the decline C+I1 +G1

which will bring the economy to the new equilibrium position at point E1 and there determine

Y11 level of output or income. The fall in output will create involuntary un-the economy. Thus,

emergence of deflationary gap equal to E2B, aggregate demand curve will shift down to the

new position C+I1+G1 which will bring the economy to the new equilibrium position at point

E1 and thereby determine Y1 level of output or income. The fall in output will create

involuntary unemployment of labour and also excess capacity will come to exist in the

economy. Thus, emergency of deflationary gap equal to E2B

and the reverse working of the multiplier has brought about conditions of recession in

the economy. It will be observed from the figure that, to overcome recession if the Government

increases its expenditure by E1H, the aggregate demand curve will shift upward to original

position C+I2 +G2 and as a result the aggregate demand curve will shift upward to original

position C+I2 +G2 and as a result the equilibrium level of income will increase to the full-

employment or potential level of output YF and in this way the economy would be lifted out of

depression, Note that the increase ( Y) In and in this way the economy by Y1 YF is not only

equal to the increase in government expenditure by G or E1H but a multiple of it depending on

marginal propensity to consume.

Expansionary /Easy monetary policy: “Easy monetary policy, also called expansionary

monetary policy, tends to encourage growth by expanding the money supply

C+I2+G2

C+I1+G2

E2

E1

450

C+I+G

Y1 YF National Income

Y

O X

H

B Deflationary Gap

GNP Gap

G

When the economy is faced with Recession and Unemployment the central bank undertakes

open market operations and buys securities in the open market.

The Central Bank may lower the bank rate or Discount rate. At this rate commercial Banks will

be induced to borrow more from the central Bank and will be able to issue more credit at the

lower rate of interest to businessmen and investors.

Thirdly, The Central Bank may reduce the Cash Reserve Ratio (CRR) to be kept by the

commercial banks. With lower reserve requirements, a large amount of funds is released for

providing loans to businessmen and investors.

SLR, To increase lendable resources of the banks, RBI Can lower this Statutory Liquidity

Ratio. Thus when RBI lowers Statutory Liquidity Ratio, the, credit availability for the priate

sector will increase.

Problem: Recession and Unemployment

1. Buys securities in the open market

2. Discount rate

3. Reduce CRR

4. Reduce SLR

Money Supply Increases

Interest Rate falls

Investment Increases

Aggregate Demand Increases

Aggregate output Increases

C+I2+

GC+I1+

G

E2

E1

C+I+

G

Y

I

Inflation

When the economy is faced with Inflation the central bank undertakes open market operations

and sells government securities in the open market to reduce lending capacity of banks.

The Central Bank may increase the bank rate or Discount rate. At this rate commercial Banks

will not be induced to borrow more from the central Bank and will not be able to issue more

credit at the lower rate of interest to businessmen and investors.

Thirdly, The Central Bank may increase the Cash Reserve Ratio (CRR) to be kept by the

commercial banks. With higher reserve requirements, a less amount of funds is released for

providing loans to businessmen and investors.

SLR, to reduce lendable resources of the banks, RBI Can increase this Statutory Liquidity

Ratio. Thus when RBI increases Statutory Liquidity Ratio, the, credit availability for the

private sector will decrease.

Reducing Government Expenditure to Check Inflation

C+I2+G2

C+I1+G2

H

E

450

C+I+G

YF Y2

National Income

Y

O X

A

B

Inflationary Gap G

Expendit

ure

How the reduction in government expenditure will help in checking inflation is shown

in Figure. It will be seen from this figure that an aggregate demand curve C + I + G1 intersects

450 line at point E and determines equilibrium national income at full -employment level of

income Y F However if due to excessive Government expenditure and a large budget deficit,

the aggregate demand curve shifts upward to C + I + G2 , this will determine Y2 level of

income which is greater than full employment or potential output level YF .Since output cannot

increase beyond YF, income will rise only in money terms through rise in prices, real income

or output remaining unchanged .To put in other words ,while the economy does not have

labour, capital and other resources sufficient to produce Y2 level of output. This excess demand

pushes up the price level so that level of only nominal income increases real income or output

remaining constant. It is thus clear that with the increase in aggregate demand beyond the full-

employment level of output to C + I + G2 causes excess demand equal to EA to emerge in

the economy. It is this excess demand EA relative to full-employment output YF which causes

the price level to rise and thus creates inflationary situation in the economy. This excess

demand EA at full-employment level has therefore been called inflationary gap. The task of

fiscal policy is to close this inflationary gap by reducing government expenditure or raising

taxes. with equilibrium at point H and nominal income equal to Y2 if Government expenditure

equal to HB (which is equal to inflationary gap AE ) is reduced , aggregate demand curve will

shift downward to C +I + G1 which will restore the equilibrium at the full employment level

YF. The reduction in government expenditure equal to HB through the operation of multiplier

will result in a multiple decline in the live of national income or output will be seen from figure

that the decrease in government expenditure by HB as lead to a much bigger decline in output

by Y2YF ideal government expenditure should cut down its expenditure on non-development

or unproductive heads such as defence, unnecessary subsidies it may however be noted that in

India to control inflation the government has been reduce capital expenditure which is mainly

of development nature and has therefore been validly criticised.

Expansionary /Easy monetary policy: “Easy monetary policy, also called

expansionary monetary policy, tends to encourage growth by expanding the money supply

Problem: Recession and Unemployment

Measures: Central Bank

1. Buys securities in the open market

2. Discount rate

3. Reduce CRR

4. Reduce SLR

Money Supply Increases

Interest Rate falls

Investment Increases

Aggregate Demand Increases

Aggregate output Increases