OBJECTIVES OF THE STUDY 1. To study the changing role and importance of selected monetary instruments in India 2.

To examine the effectiveness of monetary policy in ensuring price stability in India 3. To find out to what extent monetary policy facilitated economic growth in India and its general impact in the post- reform period

Impact of Monetary and Fiscal olicy on Indian Economy

CH! TE" #$ I%T"ODUCTIO%

Monetary and fiscal policies in any country are two macroeconomic stabili ation tools. !owever" these two policies have often been pursued in different countries in different directions. Monetary policy is often pursued to achieve the ob#ective of low inflation to stabili e the economy from output and price shoc$s. %n the other hand" fiscal policy is often biased towards high growth and employment even at the cost of higher inflation. &or achieving an optimal mix of macroeconomic ob#ectives of growth and price stability" it is necessary that the two policies complement each other. !owever" the form of complementarities will vary according to the stage of development of the country's financial mar$ets and institutions. (ith increasing autonomy of central ban$ in the conduct of monetary policy from fiscal dominance during the last few decades" there has been a renewed interest in the issue of monetary and fiscal policy coordination. )nother development" which led to spawning a number of studies on this issue" was the *tability and +rowth ,act -*+,. and formation of /uropean Monetary 0nion -/M0.. 0nder this arrangement" individual countries pursue independent fiscal policies within the *+," but have a common monetary policy. Thus" this arrangement has underscored the importance of monetary and fiscal policy coordination. &urthermore" the recent global financial crisis has once again demonstrated the importance of coordinated response of monetary and fiscal policies. *overeign debt problem in many countries in the euro area" in particular" has also underlined the need for monetary and fiscal policies coordination. In the context of developing economies" it is often viewed that there is complete fiscal dominance and the central ban$ is subservient to the fiscal authority. Therefore" it is argued that the issue of coordination may not arise since the very concept of coordination arises only when the two institutions are independent. !owever" it is argued that actual execution of the two policies could significantly differ from what could be expected from the institutional arrangements. &urthermore" irrespective of the dependence1independence of the two policies" there will be interaction between these two policies. The nature of the interaction" however" will be conditioned by the institutional framewor$. The institutional arrangements have been changing in many developing countries as they are moving towards ma$ing central ban$s more independent" implying time varying behaviour of the interaction &

Impact of Monetary and Fiscal olicy on Indian Economy between the two policies" which has important implications for the ob#ectives of macroeconomic stabili ation. Thus" from the macroeconomic policy point of view" it is important to empirically verify the nature of the interaction. In India also" several changes have ta$en place in the monetary and fiscal policy framewor$s" particularly since the beginning of the 1223s. *ome of these include complete phasing out of automatic monetisation of fiscal deficit through creation of ad hoc treasury bills -also called ad hocs. in 1224 and prohibiting 56I from buying government securities in the primary mar$et from )pril 2337 under the &iscal 5esponsibility and 6udget Management -&56M. )ct" 2333. These changes are 8uite significant and have altered the basic nature of the interaction between monetary and fiscal policies. !owever" the central government continues to incur large fiscal deficits" which has implications for the demand management by the 5eserve 6an$. In this bac$drop" the pro#ect empirically examines the interaction between monetary and fiscal policies in India in the recent period. In particular" the focus is on examining the monetary and fiscal policy responses to shoc$s in output and inflation.

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Impact of Monetary and Fiscal olicy on Indian Economy

CH! TE" &$ MO%ET!"Y O(ICY) Detailed St*dy

&+#+ ,-at is Monetary olicy. Monetary policy is the management of money supply and interest rates by central ban$s to influence prices and employment. Monetary policy wor$s through expansion or contraction of investment and consumption expenditure. Monetary policy is the process by which the government" central ban$ -56I in India." or monetary authority of a country controls9 -i. -ii. -iii. The supply of money )vailability of money :ost of money or rate of interest" in order to attain a set of ob#ectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being an expansionary policy" or a contractionary policy" where an expansionary policy increases the total supply of money in the economy" and a contractionary policy decreases the total money supply. /xpansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates" while contractionary policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy" which refers to government borrowing" spending and taxation

&+&+ ,-y it is needed. (hat monetary policy ; at its best ; can deliver is low and stable inflation" and thereby reduces the volatility of the business cycle. (hen inflationary pressures build up" it is monetary policy only which raises the short-term interest rate -the policy rate." which raises real rates across the economy and s8uee es consumption and investment. The pain is not concentrated at a few points" as is the case with government interventions in commodity mar$ets. Monetary policy in India underwent significant changes in the 1223s as the Indian /conomy became increasing open and financial sector reforms were put in place. In the 12<3s" /

Impact of Monetary and Fiscal olicy on Indian Economy monetary policy was geared towards controlling the 8uantum" cost and directions of credit flow in the economy. The 8uantity variables dominated as the transmission :hannel of monetary policy. 5eforms during the 1223s enhanced the sensitivity of price signals from the central ban$" ma$ing interest rates the increasingly =ominant transmission channel of monetary policy in India.

&+'+ O01ecti2es of Monetary olicy The ob#ectives are to maintain price stability and ensure ade8uate flow of credit to the productive sectors of the economy. *tability for the national currency -after loo$ing at prevailing economic conditions." growth in employment and income are also loo$ed into. The monetary policy affects the real sector through long and variable periods while the financial mar$ets are also impacted through short-term implications. There are four main >channels> which the 56I loo$s at9

?uantum channel9 money supply and credit -affects real output and price level through changes in reserves money" money supply and credit aggregates.. Interest rate channel. /xchange rate channel -lin$ed to the currency.. )sset price.

Monetary decisions today ta$e into account a wider range of factors" such as9

short term interest rates @ long term interest ratesA velocity of money through the economyA exchange rate @ credit 8uality bonds and e8uities -corporate ownership and debt. government versus private sector spending1savings international capital flow of money on large scales

Impact of Monetary and Fiscal olicy on Indian Economy

&inancial derivatives such as options" swaps and future contracts etc.

&+/+ Types of monetary policy In practice" all types of monetary policy involve modifying the amount of base currency -M3. in circulation. This process of changing the li8uidity of base currency through the open sales and purchases of -government-issued. debt and credit instruments is called open mar$et operations. :onstant mar$et transactions by the monetary authority modify the supply of currency and this impacts other mar$et variables such as short term interest rates and the exchange rate. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals. The different types of policy are also called monetary regimes" in parallel to exchange rate regimes. ) fixed exchange rate is also an exchange rate regimeA The +old standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation" the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is trac$ing the exact same variables -such as a harmoni ed consumer price index..
Inflation tar4etin4

0nder this policy approach the target is to $eep inflation" under a particular definition such as :onsumer ,rice Index" within a desired range. The inflation target is achieved through periodic ad#ustments to the :entral 6an$ interest rate target. The interest rate used is generally the interban$ rate at which ban$s lend to each other overnight for cash flow purposes. =epending on the country this particular interest rate might be called the cash rate or something similar. The interest rate target is maintained for a specific duration using open mar$et operations. Typically the duration that the interest rate target is $ept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or 8uarterly basis by a policy committee.

Impact of Monetary and Fiscal olicy on Indian Economy

rice le2el tar4etin4

,rice level targeting is similar to inflation targeting except that :,I growth in one year is offset in subse8uent years such that over time the price level on aggregate does not move. *omething similar to price level targeting was tried by *weden in the 1233s" and seems to have contributed to the relatively good performance of the *wedish economy during the +reat =epression. )s of 233B" no country operates monetary policy based on a price level target.
Monetary a44re4ates

In the 12<3s" several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit -M3" M1 etc.. In the 0*) this approach to monetary policy was discontinued with the selection of )lan +reenspan as &ed :hairman. This approach is also sometimes called monetarism. (hile most monetary policy focuses on a price signal of one form or another" this approach is focused on monetary 8uantities.
Fi6ed e6c-an4e rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates" which can be ran$ed in relation to how rigid the fixed exchange rate is with the anchor nation. 0nder a system of fiat fixed rates" the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead" the rate is enforced by non-convertibility measures -e.g. capital controls" import1export licenses" etc... In this case there is a blac$ mar$et exchange rate where the currency trades at its mar$et1unofficial rate. 0nder a system of fixed-convertibility" currency is bought and sold by the central ban$ or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. -In this case" the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to ero..

Impact of Monetary and Fiscal olicy on Indian Economy 0nder a system of fixed exchange rates maintained by a currency board every unit of local currency must be bac$ed by a unit of foreign currency -correcting for the exchange rate.. This ensures that the local monetary base does not inflate without being bac$ed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard -anchor. currency.
8old standard

The gold standard is a system in which the price of the national currency as measured in units of gold bars and is $ept constant by the daily buying and selling of base currency to other countries and nationals. -i.e. open mar$et operations" cf. above.. The selling of gold is very important for economic growth and stability. The gold standard might be regarded as a special case of the C&ixed /xchange 5ateC policy. )nd the gold price might be regarded as a special type of C:ommodity ,rice IndexC. Today this type of monetary policy is not used anywhere in the world" although a form of gold standard was used widely across the world prior to 1241. &or details see the 6retton (oods system. Its ma#or advantages were simplicity and transparency.

&+3+ Monetary olicy Tools

Monetary 0ase

Monetary policy can be implemented by changing the si e of the monetary base. This directly changes the total amount of money circulating in the economy. ) central ban$ can use open mar$et operations to change the monetary base. The central ban$ would buy1sell bonds in exchange for hard currency. (hen the central ban$ disburses1collects this hard currency payment" it alters the amount of currency in the economy" thus altering the monetary base.
"eser2e re9*irements

The monetary authority exerts regulatory control over ban$s. Monetary policy can be implemented by changing the proportion of total assets that ban$s must hold in reserve with the central ban$. 6an$s only maintain a small portion of their assets as cash available for :

Impact of Monetary and Fiscal olicy on Indian Economy immediate withdrawalA the rest is invested in illi8uid assets li$e mortgages and loans. 6y changing the proportion of total assets to be held as li8uid cash" the &ederal 5eserve changes the availability of loan able funds. This acts as a change in the money supply. :entral ban$s typically do not change the reserve re8uirements often because it creates very volatile changes in the money supply due to the lending multiplier.
Disco*nt ;indo; lendin4

Many central ban$s or finance ministries have the authority to lend funds to financial institutions within their country. 6y calling in existing loans or extending new loans" the monetary authority can directly change the si e of the money supply.
Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. The &ederal 5eserve can set the discount rate" as well as achieve the desired &ederal funds rate by open mar$et operations. This rate has significant effect on other mar$et interest rates" but there is no perfect relationship. In the 0nited *tates open mar$et operations are a relatively small part of the total volume in the bond mar$et. %ne cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool D open mar$et operationsA one must choose which one to control. In other nations" the monetary authority may be able to mandate specific interest rates on loans" savings accounts or other financial assets. 6y raising the interest rate-s. under its control" a monetary authority can contract the money supply" because higher interest rates encourage savings and discourage borrowing. 6oth of these effects reduce the si e of the money supply.
C*rrency 0oard

) currency board is a monetary arrangement which pegs the monetary base of a country to that of an anchor nation. )s such" it essentially operates as a hard fixed exchange rate" whereby local currency in circulation is bac$ed by foreign currency from the anchor nation at a fixed rate. Thus" to grow the local monetary base an e8uivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the <

Impact of Monetary and Fiscal olicy on Indian Economy local monetary authority to inflate or pursue other ob#ectives. The principal rationales behind a currency board are three-fold9 1. To import monetary credibility of the anchor nationA 2. To maintain a fixed exchange rate with the anchor nationA 3. To establish credibility with the exchange rate -the currency board arrangement is the hardest form of fixed exchange rates outside of dollari ation.. In theory" it is possible that a country may peg the local currency to more than one foreign currencyA although" in practice this has never happened -and it would be a more complicated to run than a simple single-currency currency board..

&+5+ Instr*ments of monetary policy in India The monetary policy is nothing but controlling the supply of Money. The big =addy" i.e. The 56I ta$es a loo$ at the present levels and also ta$es a call on what should be the desired level to promote growth" bring stability of price -low inflation. and foreign exchange. The various instruments of monetary policy that the 56I has and can use are9 !+ =*antitati2e meas*res$ Open Mar>et operations$ !ere" the 56I enters into sale and purchase of government securities and treasury bills. *o the 56I can pump money into circulation by buying bac$ the securities and vice versa. In absence of an independent security mar$et -all 6an$s are state owned.A this is not really effective in India. Ban> rate policy$ ,opularly $nown as repo rate and reverse repo rate" it is the rate at which the 56I and the 6an$s buy or exchange money. This results into the flow of ban$ credit and thus affects the money supply. Cas- "eser2e ratio ?C""@$ This is the percentage of total deposits that the ban$s have to $eep with 56I. )nd this instrument can change the money supply overnight.

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Impact of Monetary and Fiscal olicy on Indian Economy Stat*tory (i9*idity "e9*irement ?S("@$ This is the proportion of deposits which 6an$s have to $eep li8uid in addition to :55. This also has a bearing on money supply.

B+ =*alitati2e meas*res$ Credit rationin4$ Imposing limits and charging a higher1lower rate of interests in selective sectors is what we see is being done by 56I. Moral s*asion$ (e hear of 56I>s directive of priority lending in )griculture sector. *eems more of a directive rather than persuasion.

&+7+ T-e ne; F*nctions of monetary policies t-at -a2e emer4ed To reinforce the emphasis on price stability and well-anchored inflation expectations while ensuring a monetary and interest rate environment that supports export and investment demand in the economy so as to enable continuation of the growth momentum. To re-emphasi e credit 8uality and orderly conditions in financial mar$ets for securing macroeconomic and" in particular" financial stability while simultaneously pursuing greater credit penetration and financial inclusion. To respond swiftly with all possible measures as appropriate to the evolving global and domestic situation impinging on inflation expectations and the growth momentum.

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Impact of Monetary and Fiscal olicy on Indian Economy

CH! TE" '$ FISC!( O(ICY) Detailed St*dy

'+#+ Meanin4 of Fiscal olicy$ The fiscal policy is concerned with the raising of government revenue and incurring of government expenditure. To generate revenue and to incur expenditure" the government frames a policy called budgetary policy or fiscal policy. *o" the fiscal policy is concerned with government expenditure and government revenue.

&iscal policy has to decide on the si e and pattern of flow of expenditure from the government to the economy and from the economy bac$ to the government. In broad terms" fiscal policy refers to Cthat segment of national economic policy which is primarily concerned with the receipts and expenditures of central government.C In other words" fiscal policy refers to the policy of the government with regard to taxation" public expenditure and public borrowings. The importance of fiscal policy is high in underdeveloped countries. The state has to play active and important role. In a democratic society direct methods are not approved. *o" the government has to depend on indirect methods of regulations. In this way" fiscal policy is a powerful weapon in the hands of government by means of which it can achieve the ob#ectives of development. '+&+ Main O01ecti2es of Fiscal olicy in India The fiscal policy is designed to achieve certain ob#ectives as follows9#+ De2elopment 0y effecti2e Mo0ilisation of "eso*rces The principal ob#ective of fiscal policy is to ensure rapid economic growth and development. This ob#ective of economic growth and development can be achieved by Mobilisation of &inancial 5esources. The central and the state governments in India have used fiscal policy to mobili e resources. The financial resources can be mobilised by9 Taxation9 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.

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Impact of Monetary and Fiscal olicy on Indian Economy

,ublic *avings9 The resources can be mobilised through public savings by reducing

government expenditure and increasing surpluses of public sector enterprises.

,rivate *avings9 Through effective fiscal measures such as tax benefits" the government

can raise resources from private sector and households. 5esources can be mobilised through government borrowings by ways of treasury bills" issue of government bonds" etc." loans from domestic and foreign parties and by deficit financing. &+ Efficient allocation of Financial "eso*rces The central and state governments have tried to ma$e efficient allocation of financial resources. These resources are allocated for =evelopment )ctivities which includes expenditure on railways" infrastructure" etc. (hile Eon-development )ctivities includes expenditure on defense" interest payments" subsidies" etc. 6ut generally the fiscal policy should ensure that the resources are allocated for generation of goods and services which are socially desirable. Therefore" India>s fiscal policy is designed in such a manner so as to encourage production of desirable goods and discourage those goods which are socially undesirable. '+ "ed*ction in ine9*alities of Income and ,ealt&iscal policy aims at achieving e8uity or social #ustice by reducing income ine8ualities 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 ,overty )lleviation ,rogrammes to improve the conditions of poor people in society.

/+

rice Sta0ility and Control of Inflation

%ne of the main ob#ectives of fiscal policy is to control inflation and stabili e price. Therefore" the government always aims to control the inflation by reducing fiscal deficits" introducing tax savings schemes" ,roductive use of financial resources" etc. #'

Impact of Monetary and Fiscal olicy on Indian Economy 3+ Employment 8eneration The government is ma$ing every possible effort to increase employment in the country through effective fiscal measure. Investment in infrastructure has resulted in direct and indirect employment. Fower taxes and duties on small-scale industrial -**I. units encourage more investment and conse8uently it generates more employment. Garious rural employment programmes have been underta$en by the +overnment of India to solve problems in rural areas. *imilarly" self employment scheme is ta$en to provide employment to technically 8ualified persons in the urban areas.

5+ Balanced "e4ional De2elopment )nother main ob#ective of the fiscal policy is to bring about a balanced regional development. There are various incentives from the government for setting up pro#ects in bac$ward areas such as :ash subsidy" :oncession in taxes and duties in the form of tax holidays" &inance at concessional interest rates" etc.

7+ "ed*cin4 t-e Deficit in t-e Balance of ayment &iscal policy attempts to encourage more exports by way of fiscal measures li$e /xemption of income tax on export earnings" /xemption of central excise duties and customs" /xemption of sales tax and octroi" etc. The foreign exchange is also conserved by providing fiscal benefits to import substitute industries" imposing customs duties on imports" etc. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem. In this way adverse balance of payment can be corrected either by imposing duties on imports or by giving subsidies to export.

:+ Capital Formation The ob#ective of fiscal policy in India is also to increase the rate of capital formation so as to accelerate the rate of economic growth. )n underdeveloped country is trapped in vicious -danger. circle of poverty mainly on account of capital deficiency. In order to increase the rate of capital formation" the fiscal policy must be efficiently designed to encourage savings and discourage and reduce spending.

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Impact of Monetary and Fiscal olicy on Indian Economy <+ Increasin4 %ational Income The fiscal policy aims to increase the national income of a country. This is because fiscal policy facilitates the capital formation. This results in economic growth" which in turn increases the +=," per capita income and national income of the country.

#A+ De2elopment of Infrastr*ct*re +overnment has placed emphasis on the infrastructure development for the purpose of achieving economic growth. The fiscal policy measure such as taxation generates revenue to the government. ) part of the government>s revenue is invested in the infrastructure development. =ue to this" all sectors of the economy get a boost. ##+ Forei4n E6c-an4e Earnin4s &iscal policy attempts to encourage more exports by way of &iscal Measures li$e" exemption of income tax on export earnings" exemption of sales tax and octroi" etc. &oreign exchange provides fiscal benefits to import substitute industries. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem.

'+'+ Stances of fiscal policy The three possible stances of fiscal policy are neutral" expansionary and contractionary. The simplest definitions of these stances are as follows9

) neutral stance of fiscal policy implies a balanced economy. This results in large tax revenue. +overnment spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

)n expansionary stance of fiscal policy involves government spending exceeding tax revenue.

) contractionary fiscal policy occurs when government spending is lower than tax revenue. #3

Impact of Monetary and Fiscal olicy on Indian Economy !owever" these definitions can be misleading because" even with no changes in spending or tax laws at all" cyclical fluctuations of the economy cause cyclical fluctuations of tax revenues and of some types of government spending" altering the deficit situationA these are not considered to be policy changes. Therefore" for purposes of the above definitions" Cgovernment spendingC and Ctax revenueC are normally replaced by Ccyclically ad#usted government spendingC and Ccyclically ad#usted tax revenueC. Thus" for example" a government budget that is balanced over the course of the business cycle is considered to represent a neutral fiscal policy stance.

'+/+ Met-ods of f*ndin4 +overnments spend money on a wide variety of things" from the military and police to services li$e education and healthcare" as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways9

Taxation *eignior age" the benefit from printing money 6orrowing money from the population or from abroad :onsumption of fiscal reserves. *ale of fixed assets -e.g." land..

)ll of these except taxation are forms of deficit financing. Borro;in4$ ) fiscal deficit is often funded by issuing bonds" li$e treasury bills or consols and gilt-edged securities. These pay interest" either for a fixed period or indefinitely. If the interest and capital repayments are too large" a nation may default on its debts" usually to foreign creditors. Cons*min4 prior s*rpl*ses$ ) fiscal surplus is often saved for future use" and may be invested in local -same currency. financial instruments" until needed. (hen income from taxation or other sources falls" as during an economic slump" reserves allow spending to continue at the same rate" without incurring additional debt. #5

Impact of Monetary and Fiscal olicy on Indian Economy

CH! TE" /$ IM !CT OF MO%ET!"Y B FISC!( O(ICY O% I%DI!% ECO%OMY

/+#+ Ho; Does Monetary olicy Impact t-e Economy. 6ecause of the impact monetary policy has on financing conditions in the economy -not #ust the costs" but also the availability of credit or ban$s' willingness to assume specific ris$s. but also because of its influence on expectations about economic activity and inflation" monetary policy can affect the prices of goods" asset prices" exchange rates as well as consumption and investment. Interest rate cuts" for example" lower the cost of borrowing" which results in higher investment activity and the purchase of consumer durables. The expectation that economic activity will strengthen may also prompt ban$s to ease lending policy" which in turn enables businesses and households to boost spending. In a low interest-rate environment" shares become a more attractive buy" raising households' financial assets. This may also contribute to higher consumer spending" and ma$es companies' investment pro#ects more attractive. Fower interest rates also tend to cause currencies to depreciate9 =emand for domestic goods rises when imported goods become more expensive. )ll of these factors raise output and employment as well as investment and consumer spending. !owever" this stepped-up demand may cause prices and wages to rise if goods and labor mar$ets are fully utili ed. The process through which monetary policy decisions impact on an economy in general and the price level in particular is $nown as the monetary policy transmission mechanism. The individual lin$s through which monetary policy impulses proceed are $nown as transmission channels. /+&+ T-e Impact of Monetary olicy Imp*lses on t-e Economy /very monetary policy impulse -e.g. an interest rate change by the central ban$" change in the monetary base resulting from changes in the minimum reserve rate. has a lagged impact on the economy. Moreover" it is uncertain how exactly monetary policy impulses are transmitted to the price level or how real variables develop in the short and medium term. #7

Impact of Monetary and Fiscal olicy on Indian Economy The difficulty of the analysis is to ad#ust the effects of the individual channels for external factors. The effect of such external factors ; e.g. supply and demand shoc$s" technical progress or structural change ; may be superimposed on the effect of central ban$ measures" and it is difficult to isolate monetary policy effects on various variables for analytical purposes. Moreover" the time lag in the reaction of the real sector to monetary measures renders the analysis more difficult. !ence" monetary policy must be forward loo$ing. T-e indi2id*al transmission c-annels are descri0ed in detail 0elo;$ Interest rate channel9 )n expansion of the money supply by the central ban$ feeds through to a reduction of short-term mar$et rates through this channel. )s a result" the real interest rate and capital costs decline" raising investment. )dditionally" consumers save less and opt for current consumption over future consumption. This" in turn" causes demand to strengthen. !owever" this stepped-up demand may cause prices and wages to rise if goods and labor mar$ets are fully utili ed. :redit channel9 The credit channel in effect brea$s down into two different channels9 6an$ lending channel9 :entral ban$s' monetary policy decisions influence commercial ban$s' refinancing costsA ban$s are inclined to pass the changes on to their customers. If financing costs diminish" investment and consumer spending rise" contributing to an acceleration of growth and inflation. !owever" following an increase in interest rates" the ris$ that some borrowers cannot pay bac$ their loans in due course may increase so much that ban$s will not grant loans to these borrowers. )s a result" borrowers would be forced to cut bac$ on planned expenditure. 6alance sheet channel9 Monetary policy may have a direct impact on corporate policy" because companies may borrow to improve return on e8uity as long as the return on debt ; in effect the lending rate ; is lower than the return on assets. !ence" the return on assets is a weighted arithmetic mean of the return on e8uity and the lending rate" which are respectively weighted by the share of e8uity and debt in total assets. :onse8uently" lower interest rates improve the return on e8uity. &or this reason" non-profitable enterprises may show a positive return on e8uity. !owever" this may reinforce the influence of interest rates on investment behavior" which is referred to as the financial accelerator effect. #:

Impact of Monetary and Fiscal olicy on Indian Economy /xchange rate channel9 /xpansionary monetary policy affects exchange rates because deposits denominated in domestic currency become less attractive than deposits denominated in foreign currencies when interest rates are cut. )s a conse8uence" the value of deposits denominated in domestic currency declines relative to that of foreign currencydenominated deposits and the currency depreciates. aggregate output to augment. This depreciation ma$es domestic goods cheaper than imported goods" causing demand for domestic goods to expand and This channel does not operate if a country has a fixed exchange rateA conversely" the more open an economy is" the stronger this channel is. /xchange rate fluctuations may also influence aggregate demand by affecting the balance sheets of ban$s and companies whose balance sheets include a large share of foreign currency-denominated debt. Interest rate reductions that entail a depreciation of the national currency raise the debt of domestic ban$s and companies which have foreign currencydenominated debt contracts. *ince assets are typically denominated in domestic currency and therefore do not increase in value" net worth declines automatically. If balance sheets deteriorate" the ris$ that some borrowers cannot pay bac$ their loans in due course may increase so much that ban$s will not grant loans to these borrowers. )s a result" borrowers would be forced to cut bac$ on planned expenditures. (ealth channel9 Monetary policy impulses are also transmitted through the price of assets such as stoc$s and real estate. &luctuations in the stoc$ or real estate mar$ets that are influenced by monetary policy impulses have important impacts on the aggregate economy. The expansionary monetary policy effects of lower interest rates ma$e bonds less attractive than stoc$s and result in increased demand for stoc$s" which bids up stoc$ prices. :onversely" interest rate reductions ma$e it cheaper to finance housing" causing real estate prices to go up. There are three different types of transmission mechanisms involving asset prices9 Investment effects9 Tobin's 8 theory explains an important mechanism through which movements in stoc$ prices can affect the economy. Tobin's 8 is defined as the mar$et value of firms divided by the replacement cost of capital. If 8 is high" the mar$et price of firms is high relative to the replacement cost of capital" and new plant and e8uipment capital is cheap relative to the mar$et value of firms. :ompanies can then issue stoc$ and get a high price for it relative to the cost of the facilities and e8uipment they have bought. Investment #<

Impact of Monetary and Fiscal olicy on Indian Economy spending will rise because firms can now buy a relatively large amount of new investment goods with only a small issue of stoc$. )n interest rate cut entailing a rise in stoc$ prices will therefore reduce companies' capital costs and conse8uently boost investment spending. (ealth effects9 Modigliani's life cycle model states that consumption is determined by the lifetime resources of consumers. These life cycle resources consist primarily of financial assets" mostly stoc$" and real estate. Interest rate cuts entail a rise in stoc$ and real estate prices and accordingly boost household wealth. )t the same time" consumers' life cycle resources expand" in turn lifting consumer spending and aggregate demand. 6alance sheet effects9 ) rise in stoc$ and real estate prices improves corporate and household balance sheets ali$e. !igher net worth translates into higher collateral for lending to companies and households. This in turn increases lending" investment spending and hence increases aggregate spending.

/+'+ Ho; effecti2e is monetary policy in India ?! critical analysis@ The specter of inflation has led the 5eserve 6an$ of India -56I. to repeatedly raise interest rates and increase ban$s' reserve re8uirements in classic monetary policy responses. The 56I also faces the challenge of simultaneously managing the exchange rate in the face of porous controls on international capital flows. (hile the exchange rate has depreciated recently as capital inflows have cooled" the hot button issue #ust a few months ago was whether the exchange rate should be $ept from appreciating. *ome economists argued for preventing exchange rate appreciation" and managing the inflationary impact of capital inflows by selling government bonds" thus soa$ing up excess li8uidity. %thers favored an Hexport-competitiveI exchange rate policy" but also argued that monetary policy was irrelevant as current inflationary symptoms were arising from temporary supply-side shoc$s. The HradicalI position -at least by Indian policy standards. has been that the 56I should focus on fighting inflation" but give itself more room to do so by allowing the exchange rate to ad#ust to mar$et conditions. %ne version of this stance is that raising the interest rate is less effective as an inflation-fighting policy than

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Impact of Monetary and Fiscal olicy on Indian Economy allowing the rupee to appreciate" as financial repression and underdeveloped financial mar$ets $eep interest rate changes from rippling through the economy strongly enough. There are several empirical analyses of the Hmonetary transmission mechanismI in India. These suggest that the interest rate channel of monetary policy has strengthened since 122<" which should not come as a surprise since there has been considerable financial liberali ation" accompanied by a revision of the 56I's policy approach. The responses of firms to monetary tightening vary by si e and" while greater in the period 122<-2333 versus the prior half-decade" seem to involve a reversal of initial cutbac$s in corporate debt. *till" interest rates do affect firm borrowing behavior. ) better feel for the aggregate impacts of monetary policy comes from an economy wide analysis. This suggests the interest rate is an effective inflation-fighting tool in India even though" as the authors say" Hthe financial mar$et in India is not yet matured.I The results even indicate that output recovers with a lag in the face of such interest rate increases. )ll this sounds 8uite good from the perspective of what policyma$ers are currently doing" though there is no modeling of inflation expectations in India that we are aware of" and that issue seems to also be driving monetary policy. Indian monetary policy is still very accommodative and interest rates need to rise more to prevent global supply-side shoc$s from seeping into the broader economy. /+/+ Ho; is monetary policy affected 0y fiscal policy. &iscal policies have a significant impact on economic growth and inflation. It is therefore important for monetary authorities to follow fiscal policy developments closely. There are many channels through which fiscal policy affects the economy and prices. The level and composition of government expenditure and revenue" as well as budget deficits and public debt" are $ey variables in this process. 6udgetary policies remain the exclusive competence of the Member *tates in *tage. In particular" the Treaty's excessive deficit procedure" further developed and clarified in the *tability and +rowth ,act" aims to limit the ris$s to price stability that might otherwise arise from national fiscal policies. &or example" an excessive increase in government spending at a time when the economy is already operating at close to full capacity could" by stimulating aggregate demand" lead to bottlenec$s and generate inflationary pressures. &iscal imbalances" with large budget deficits and mounting public &#

Impact of Monetary and Fiscal olicy on Indian Economy debt" have characteri ed many inflationary episodes in history. &iscal discipline is therefore a basic component of macroeconomic stability. )s well as unbalanced budgets" high levels of government debt can also be detrimental. If a government has to meet si eable interest expenses every year" the fiscal situation can become unsustainable and this may endanger price stability .!igh levels of debt may also have adverse effects on the real economy and the financial environment. In particular" excessive recourse to capital mar$ets by governments tends to raise the cost of capital and this may reduce private investment -Hcrowding outI.. +iven the potential problems associated with fiscal imbalances" the avoidance of excessive deficits represents an important commitment to maintaining fiscal policies conducive to overall macroeconomic stability. &iscal policies affects the monetary policies in elements of transmission in short term. In long term it affects the sustainability of monetary policies. In monetary transmission include the following transmission channels Domestic demand$ In every household the spending for total year has been decided and if in this situation if the fiscal policies have been changed by the government then the there will be change in household spending and change in domestic demand. *o the change in fiscal policies affects the monetary transmission channel in short run. Thus the spending affects the interest rates. Capital mar>et$ If from the capital mar$et money is ta$en by the government in big way" then it leads to increase in return on investment on new pro#ects .Thus" the private firm will become disinterested to fund the new pro#ects. Indirect ta6es$ If government increases the taxes on individual then it will lead to increase in the interest rates and inflation will also rise. The rise in inflation will lead to decrease in the demand .The government has to come to rescue the people by consolidation of economy. The consolidation will be done by the higher wages and lower nominal interest rates .Thus inflation rise causes extra pressure on wages.

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Impact of Monetary and Fiscal olicy on Indian Economy /+3+ Economic effects of Fiscal olicy +overnments use fiscal policy to influence the level of aggregate demand in the economy" in an effort to achieve economic ob#ectives of price stability" full employment and economic growth. Jeynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to simulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool for building the framewor$ for strong economic growth and wor$ing towards full employment. In theory" the resulting deficits would be paid for by an expanded economy during the boom that would follow. +overnments can use a budget a surplus to do 2 things9 to slow the pace of strong economic growth and to stabili e prices when inflation is too high. Jeynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy" thus stabili ing prices. The economists generally debate the effectiveness of fiscal policy. The argument mostly centers on crowding out" a phenomena where government borrowing leads to higher interest rates that offset the simulative impact of spending. (hen the government runs a budget deficit" funds will need to come from public borrowing through issue of government bonds" overseas borrowing or moneti ing the debt. (hen governments fund a deficit with issuing of government bonds" interest rates can increase across the mar$et" because the government borrowing creates higher demand for credit in financial mar$ets. This causes lower aggregate demand for goods and services" contrary to the ob#ective of a fiscal stimulus. *ome neoclassical economists generally emphasi e crowding out while Jeynesians argue that fiscal policy can still be effective especially in a li8uidity trap where" crowding out in minimal. *ome classical and neoclassical economists argue that crowding out completely negatives any fiscal stimulusA this is $nown as the Treaty Gie which the Jeynesian economists re#ects. In the classical view" expansionary fiscal policy also decreases net exports" which has a mitigating effect on the national output and income. (hen the government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because" all other things being e8ual" the bonds issued from country executing expansionary fiscal policy now offer a higher rate of return. In other words" companies wanting to finance pro#ects must &'

Impact of Monetary and Fiscal olicy on Indian Economy compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country" foreign investors must obtain that country's currency. Therefore when foreign capital flows into the country undergoing fiscal expansion" demand for that country's currency increases. The increased demand causes that country's currency to appreciate. %nce the currency appreciates" goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. :onse8uently" exports decrease and imports increase. %ther possible effect with fiscal stimulus includes the time lag between the implementation of the policy and detectable effects in the economy" and inflationary effects driven by increased demand. In theory" fiscal policy does not cause inflation when it uses resources that would have otherwise been idle. &or instance" if fiscal policy employs a wor$er who otherwise would have been unemployed" there is no inflationary effectA however" if the stimulus employs a wor$er who otherwise would have had a #ob" the stimulus is increasing labour demand while labour supply remains fixed" leading to wage inflation and therefore price inflation. /+5+ Effects of Fiscal olicy ?Deficit@ on Indian Economy Interest rates B in2estments Interest rates @ the bond prices are inversely related to each other. (hen interest rates move up" it causes the bond prices to fall @ vice ; versa. *ay for example" you have a bond" which is yielding 13K now. *uddenly" the interest rates in the economy move up to 11K. Eow your bond is giving fewer yields than the mar$et return. %bviously its price is going to fall in such a case. 5everse is the case when interest rates fall" the bond price will move up because it is giving more returns than the mar$et return. *o movements in interest rates have serious implications for individual investments. Inflation and economy Inflation affects the economy on three sides. %ne" it is directly lin$ed to interest rates. The interest rates prevailing in an economy at any point of time are nominal interest rates" i.e." real interest rates plus a premium for expected inflation. =ue to inflation" there is a decrease in purchasing power of every rupee earned on account of interest in the future" therefore the &/

Impact of Monetary and Fiscal olicy on Indian Economy interest rates must include a premium for expected inflation. In the long run" other things being e8ual" interest rates rise one for one with rise in inflation. Two" it effects the e6c-an4e rate. The exchange rates between the currencies of two countries depend upon the level of inflation prevailing in the two countries. )ccording to ,urchasing ,ower ,arity principle" the change in the value of one currency vis ; a ; vis another" is approximately e8ual to the inflation differential of the two countries. *o the inflation levels provide an indication of the movement of currencies against each other.

Three" there is also an inverse inflation between inflation @ economic 4ro;t-. %ther things being e8ual" economic growth is e8ual to the difference between money supply growth @ inflation. Money s*pply and t-e economy Money supply also effects the economy on three sides. %ne" money supply is used to control the inflation in an economy. %n the demand side" whenever money supply in the economy increases" consumer-spending increases immediately in the economy because of increased money in the system. 6ut supply can't vary in the short ; term" so there is a temporary mismatch of demand @ supply in the economy which exerts an upward pressure on inflation. This argument assumes that demand drives supply" which is generally the case. %n the supply side" due to an increase in demand" supply can only be increased by capacity additions. This causes the cost of production to rise @ that is reflected in inflation. Two" money supply also has a direct relationship with the 4ro;t- of an economy. 0ntil an economy reaches full ; employment level" the economy growth is the difference between money supply growth rate @ the inflation" other things being e8ual. (hen an economy reaches full employment level" the growth in money supply is set off by a growth in inflation" other things being e8ual. This happens because output can't rise after full employment @ therefore inflation increases one for one with the money supply. Three" money supply also has a relationship with interest rates. %ne variable can be used to control the other. 6oth can't be controlled simultaneously. If the 56I wants to peg the interest rate at a certain level" it has to supply whatever money is demanded at that level of &3

Impact of Monetary and Fiscal olicy on Indian Economy interest rate. If it wants to fix the money supply at a certain level" the demand @ supply of money will determine the interest rates. 0sually it is easier for 56I to control the interest rates through its open mar$et operations -%M%.. *o" the money supply is allowed to vary but 56I controls it by playing around with interest rates through its %M%. Cas- "eser2e "atio ?C""@ B stat*tory li9*idity ratio ?S("@ and an economy :55 is the percentage of its total deposits a ban$ has to $eep with 56I in cash or near cash assets @ *F5 is the percentage of its total deposits a ban$ has to $eep in approved securities. The purpose of :55 @ *F5 is to $eep a ban$ li8uid at any point of time. (hen ban$s have to $eep low :55 or *F5" it increases the money available for credit in the system. This eases the pressure on interest rates @ interest rates move down. )lso" when money is available at lower interest rates" it is given on credit to the industrial sector which pushes the economic growth. C*rrent acco*nt deficit and economy :urrent account balance is the difference between exports @ imports of the country" added to it is net earnings from invisibles. (hen a country is running a current account deficit" it implies that the domestic savings are sufficient enough to fund domestic investment. The deficit has to come from capital account surplus" i.e." more foreign capital inflows. This trend ma$es an economy vulnerable to a crisis" if the foreign investment is of short ; term in nature because it can be ta$en away at any point of time @ can have a run on a country's currency. The *outh /ast )sian crisis is a classic example of this. C*rrency fl*ct*ations :urrency mainly fluctuates because of three reasons. &irst is inflation. Theoretically" the rate of change in exchange rate is e8ual to the difference in inflation rates prevailing in the 2 countries. *o" whenever" inflation in one country moves" say increases relative to other country" its currency falls down. Two" when the c*rrent acco*nt 0alance of country is running in deficit. This means that the importers of the country will demand more of foreign currency to pay for their imports. The demand supply mismatch will cause the currency to fall. Third is spec*lation. (hen big players speculate in a particular currency" the currency moves accordingly. &5

Impact of Monetary and Fiscal olicy on Indian Economy Depreciation of a c*rrency$ 4ood or 0ad =epreciation of a currency effects an economy in two ways" which are in a way counter to each other. %n the one hand" it ma$es the exports of a country more competitive" thereby increasing them. %n the other hand" it decreases the value of a currency relative to other currencies" thereby decreasing the importance of that currency. *o" the policy ma$ers have to stri$e a balance between the two. Money mar>et in an economy Money mar$et forms the basis of term structure of interest rates. Money mar$et includes call money mar$et" mar$et for sovereign securities @ other instruments of short ; term nature li$e commercial paper. The interest rates follow a general principle" as the term to maturity increases" the interest rates also increases because current consumption is always preferred to future consumption. *o one has to pay premium for longer maturity. The call money mar$et forms the basis for short ; term interest rates. )ny institution who wants to lend overnight can place its funds in this mar$et. The rates for sovereign securities are slightly above call rates because their term to maturity is high. Fi$e that" the interest rates are determined according to the interaction of demand of @ supply for funds according to their maturity. Money mar$et forms the basis for the yield curve. Difference 0et;een real B nominal 8D Eominal +=, measures the value of output in a particular period at the prices of that period or in current rupees. Eominal +=, changes from year to year because of two reasons. %ne" there is a change in the physical output of goods @ services @ two" the mar$et prices of goods @ services produced also change. 5eal +=, measures the changes in physical output in the economy between different time periods by valuing all goods produced in the two periods at some base year>s prices" or in constant rupees. It means that the today>s output of goods @ services will be multiplied by base year>s prices to get the real +=, of current period. In other words" real +=, is nothing but nominal +=, ad#usted for inflation.

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Impact of Monetary and Fiscal olicy on Indian Economy Inflation tar4etin4 B interest rate tar4etin4 ) sustained increase in money supply in the economy will" in the long run" lead to an e8ual increase in the inflation @ in the short run" it will lead to a decrease in interest rates" but in the long run" the real interest rates will come down to the same level because of an e8ual increase in inflation. *o there is always a trade off that the monetary authority of a country has to ma$e between the two things. If it allows money supply to grow to $eep interest rates down" it is called interest rate targeting @ if it $eeps money supply in chec$ to $eep inflation under control" it is called inflation targeting. The 56I" right now" is targeting inflation because if it is able to $eep inflation in chec$" the interest rates will be automatically come in chec$ as the nominal interest rate is e8ual to real interest plus inflation @ real interest rates remain constant in the long run. Interest rates change because of changes in inflation.

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Impact of Monetary and Fiscal olicy on Indian Economy CH! TE" 3$ I%TE"!CTIO% BET,EE% FISC!( !%D MO%ET!"Y O(ICY

&iscal policy and monetary policy are the two tools used by the *tate to achieve its macroeconomic ob#ectives. (hile the main ob#ective of fiscal policy is to increase the aggregate output of the economy" the main ob#ective of the monetary policies is to control the interest and inflation rates. The celebrated I*1FM model is one of the models used to depict the effect of interaction on aggregate output and interest rates. The fiscal policies have an impact on the goods mar$et and the monetary policies have an impact on the asset mar$ets and since the two mar$ets are connected to each other via the two macro variables D output and interest rates" the policies interact while influencing the output or the interest rates.

Traditionally" both the policy instruments were under the control of the national governments. Thus traditional analyses made with respect to the two policy instruments to obtain the optimum policy mix of the two to achieve macroeconomic goals as the two were perceived to aim at mutually inconsistent targets. 6ut in recent years" owing to the transfer of control with respect to monetary policy formulation to :entral 6an$s" formation of monetary unions -li$e /uropean Monetary 0nion formed via the *tability and +rowth ,act. and attempts being made to form fiscal unions" there has been a significant structural change in the way in which fiscal-monetary policies interact.

There is a dilemma as to whether these two policies are complementary" or act as substitutes to each other for achieving macroeconomic goals. ,olicy ma$ers are viewed to interact as strategic substitutes when one policy ma$er>s expansionary -contractionary. policies are countered by another policy ma$er>s contractionary -expansionary. policies. &or example9 if the fiscal authority raises taxes or cuts spending" then the monetary authority reacts to it by lowering the policy rates and vice versa. If they behave as strategic complements" then an expansionary -contractionary. policy of one authority is met by expansionary -contractionary. policies of other.

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Impact of Monetary and Fiscal olicy on Indian Economy The issue of interaction and the policies being complement or substitute to each other arises only when the authorities are independent of each other. 6ut when" the goals of one authority is made subservient to that of others" then the dominant authority solely dominates the policy ma$ing and no interaction worthy of analysis would arise. )lso" it is worthy to note that fiscal and monetary policies interact only to the extent of influencing the final ob#ective. *o long as the ob#ective of one policy is not influenced by the other" there is no direct interaction between them.

3+#+ !cti2e and passi2e monetary and fiscal policies ,rofessor /ric Feeper has defined9 ,assive fiscal policy is one in which the authority raises or reduces taxes to balance the budget intertemporally. )ctive fiscal policy is one in which the tax and spending levels are determined independent of intertemporal budget consideration. )ctive monetary policy is one that pursues its inflation target independent of fiscal policies. ,assive monetary policy is one that sets interest rates to accommodate fiscal policies. In case of an active fiscal policy and a passive monetary policy" the economy faces an expansionary fiscal shoc$ that raises the price levels and money growth as monetary authority is forced to accommodate these shoc$s. 6ut in case both the authorities are active" then the expansionary pressures created by the fiscal authority is contained to some extent by the monetary policies.

3+&+ S*pply s-oc> =uring a negative s*pply s-oc>" the fiscal and monetary authorities are seen to follow conflicting policies as the fiscal authorities would follow expansionary policies to bring the output at its original state while the monetary authorities would follow

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Impact of Monetary and Fiscal olicy on Indian Economy contractionary policies so as to reduce the inflation created due to shortage in output caused by the s*pply s-oc>.

3+'+ Demand s-oc> =uring a demand s-oc> -a sudden significant rise or fall in a44re4ate demand due to external factors. without a corresponding change in output that results in inflation or deflation which can also be termed as inflation or a deflation shoc$" it is observed that the two policies wor$ in harmony. 6oth the authorities would follow expansionary policies in case of a negative demand shoc$ in order to bring bac$ the demand at its original state while they would follow contractionary policies during a positive demand shoc$ in order to reduce the excess aggregate demand and bring inflation under control.

3+/+ Cost p*s- s-oc>s ) cost-push shoc$ is defined as a change in inflation that is not a result of pressures in the economy. The macroeconomic goal under such a situation is to optimise between reducing inflation and reducing the gap between the actual output and the desired level of output. ) contractionary monetary policy under such a scenario raises the real interest rates which in turn not only reduces consumption thereby dampening aggregate demand and inflation but also raises the labour supply as wor$ers are willing to sacrifice current leisure along with current consumption. This further dampens the inflation rates. %n the other hand" a change in government spending is able to influence aggregate demand alone and hence is less effective in comparison to monetary policy. Moreover a deviation from the given level of government spending has an impact on optimal provision of public goods which then has direct welfare costs. !ence the optimal fiscal policy is to $eep the government spending gap -i.e. the gap between the actual and the socially desired levels of government spending. close to ero. Thus" when an economy is hit by a cost push shoc$ and given that the only policy instrument in the hand of '#

Impact of Monetary and Fiscal olicy on Indian Economy fiscal authority is public spending -ignoring the impacts of taxes and debt." the monetary policy dominates fiscal policies in reviving the economy. 6ut this holds true only when the economy has ero government debt. %nce government debt becomes positive" then a non ero government spending gap becomes essential to absorb any repercussions of cost push shoc$s or monetary policy responses. This is because the rise in real interest rates raises the cost of debt which then re8uires the fiscal authority to deviate from its natural rate of public spending so as to nullify the impact of increasing interest rates.

3+3+ Fiscal s-oc> and policy rate s-oc> In case of a positive fiscal shoc$ i.e. increase in fiscal deficits" the aggregate output rises beyond the potential output thus raising the aggregate demand. *ubse8uently" this leads to dissavings and lowering of investments which further depresses output in the long run. Monetary authorities react in a countercyclical way to this and in the long run adopts 8uantitative easing to counter the fall in output caused due to fiscal expansion. In case of policy shoc$s" caused by a sudden positive -negative. changes in policy rates such as stat*tory li9*idity ratio" cash reserve ratio or the repo rates" the fiscal authority initially reacts by following expansionary -contractionary. policy subse8uently narrows down -expands up.

3+5+ resence of monetary *nion (hen an economy is a part of a monetary union" its monetary authority is no longer able to conduct its monetary policies independently as per the re8uirements of the economy. 0nder such situation the interactions between fiscal and monetary policies undergo certain changes. +enerally" the monetary union follows policies to $eep the overall inflation at such levels so as to $eep the overall gap between the actual aggregate consumption and desired consumption close to ero. &iscal polices are then used to minimise the country specific welfare losses arising out of such policies. )lso" fiscal policies are used to stabili e the terms of trade and '&

Impact of Monetary and Fiscal olicy on Indian Economy maintain them at their natural levels. +iven the common monetary policies and the price levels for all the nations under the union" the fiscal authority of the home country is led to follow contractionary policies in case of deterioration in terms of trade.

3+7+ Effect of price ri4idities In case of a shoc$" while the weighted average inflation is at optimum levels" the inflation level of the nations hit by such a shoc$ is far from optimum. In such a scenario" given that the degree of price rigidities in all the nations are e8ual" then the fiscal policies would achieve the dual goal of attaining optimum public spending and maintaining the natural levels of terms of trade only when the shoc$s hitting the nations under the union are perfectly correlated else either of the ob#ective is achieved at the cost of other as monetary policies fail to influence the terms of trade owing to e8uality of the degree of price rigidities amongst the nations. 6ut in case of varying degrees of price rigidities amongst the nations" terms of trade is no longer insulated from monetary policies. This is so because" the monetary policies would be directed towards $eeping the inflation of the nations with higher degree of price rigidities at optimum levels so as to reduce their terms of trade losses and the fiscal policies of the rest of the countries would assume a relatively effective role in stabilising the national inflation as the price levels would respond to the change in public spending. In short" lower the degree of price rigidities in an economy belonging to a monetary union" greater would be the relative role of fiscal policies in economic stabilisation and vice versa.

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Impact of Monetary and Fiscal olicy on Indian Economy

CH! TE" 5$ CH!((E%8ES FO" MO%ET!"Y B FISC!( O(ICY

C-allen4es 0efore monetary policy$ 1. &inancial mar$ets are unperturbed with the flattening of yield curves" the compression of ris$ spreads and the search for yields continues unabated. 2. +lobal imbalances have actually increased with no fears of hard landing" but with some sense of readying for a bumpy soft landing. Movements in ma#or exchange rates are not reflecting fundamentals in an environment of generali ed elevation in asset prices and abundant li8uidity. 3. *trong global economic growth could be accompanied by emerging pressures on core inflation. The challenge facing us is to #udge the compatibility of the current pace of growth with non-accelerating inflation. In the event of a #udgment that the current growth momentum is more cyclical than structural" the stance of monetary policy would need to reflect sensitivity to the inevitability of a downturn. %n the other hand" the #udgment that structural factors predominate would warrant a different policy stance.

B. )n overriding concern faced by the 5eserve 6an$ is the persistently high growth of ban$ credit" with attendant worries relating to the 8uality of ban$ credit The sharp increase in credit to sectors such as housing" commercial real estate and retail loans have also been worrisome on account of the vulnerability of ban$s to credit concentration ris$s.

L. It is difficult to arrive at a clear #udgment as to what rate of credit growth is too high in relation to potential growth.

7. *ome of the models integrate policy behavior with the ban$ing system" the demand for a broad monetary aggregate" and a rich array of goods and financial mar$et variables" providing a more complete understanding of the monetary transmission mechanism. (ea$ economic assumptions and large models combine to reveal difficulties with sorting out policy effects that other approaches fail to bring out. '/

Impact of Monetary and Fiscal olicy on Indian Economy

C-allen4es 0efore Fiscal olicy$ #+ Ta6 and E6pendit*re rofiles of India$ The pressures for high and growing

government expenditure in India are manifold. 6ecause of their low per-capita incomes and high incidence of poverty" India faces an urgency to have high rates of economic growth. This places a strong burden on policy to ensure rapid economic growth whereas" at the same time" the limited efficacy of policy instruments and governance inade8uacies imply that the effective scope for policy is constrained. &+ Fiscal Deficit Iss*es in India$ The exercise of fiscal policy in India has its limits. The combination of low revenues and inelastic expenditures means that expenditures routinely" and even increasingly" outpace revenues. (ith poor credit and bond mar$ets and downwardly inflexible fiscal expenditures" some of the financing of the resultant deficit spills over onto the external sector and the central ban$. +iven financing constraints many developing countries li$e India have to opt" to a considerable extent" on non-bond -monetary. financing of the deficit. This then establishes a direct lin$s between fiscal policy and the monetary base of the central ban$ blurs the distinction between fiscal and monetary policy and compromises central ban$ independence. '+ %orms for Ta6 and E6pendit*re "eforms in India$ %ne of the principal aims of a meaningful tax1expenditure reforms policy would be to bolster the savings and investment rates in the economy in order to raise growth rates. ) higher growth rate" it is widely accepted" is the best way to lower poverty over the medium term. 5aising the rate of savings and the rate of growth of the economy becomes a circular issue D the higher the rate of savings the higher the rate of growth of the economy and the higher the rate of growth the higher the rate of savings at least at low absolute levels of per capita income. Their results also point to the possibility of incomplete. In other words" a given rise in public savings is accompanied by a less than commensurate drop in private savings. :onsumers would reali e that any increase in public expenditure would be paid for by taxes and ad#ust private saving commensurately. )n important canon of tax reform is that as an economy develops reliance on indirect taxation" as a source of revenue should decline. '3

Impact of Monetary and Fiscal olicy on Indian Economy

/+ E6pendit*re "eform$ Tax reforms should be complemented with appropriate ad#ustment of government expenditures. Typically this calls for reduction of current subsidies and augmentation of subsidies for well-defined capital pro#ects. The impact of public expenditure is usually ascertained through an ex-post incidence analysis. The 8uestion typically as$ed" is given some tax or public expenditure9 i. who pays or receives the benefits of public spendingA ii. how much does everyone receive in accounting termsA iii. how much does everyone receive when ta$ing into account behavioral responses to taxes or the free delivery of public servicesA iv. what are the indirect effects of the program. *uch analyses enable the researcher to ascertain the actual distribution of the amount budgeted as a tax receipt or a public expenditure and helps decide whether public expenditures are worth their cost.

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Impact of Monetary and Fiscal olicy on Indian Economy

CH! TE" 7$ CO%C(USIO%

The ob#ectives of fiscal policy such as economic development" price stability" social #ustice" etc. can be achieved only if the tools of policy li$e ,ublic /xpenditure" Taxation" 6orrowing and deficit financing are effectively used. Though there are gaps in India>s fiscal policy" there is also an urgent need for ma$ing India>s fiscal policy a rationalised and growth oriented one. The success of fiscal policy depends upon ta$ing timely measures and their effective administration during implementation.

The role of fiscal policy in India is as important as it is complex. India faces the unenviable tas$ of accelerating their rates of economic growth to reduce poverty is a short span of time even as they face greater uncertainty" in the face of globali ation" about $ey elements of their fiscal policy such as the tax base. &urthermore" the exercise of fiscal policy is often circumscribed by increasing pressures from the regulatory and exchange rate regimes in place and sub#ect to considerable pressure from external parameters such as competing countries' tax rates. It would be difficult" for example" for a given developing country to have corporate tax rates very different from its competitors or burden monetary policy with high fiscal deficits which could lead to sharp depreciation of the exchange rate. Eevertheless" the onus on fiscal policy remains substantial.

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