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Course:

Economics and Econometrics

Unit-7:
Fiscal and Monetary Policy
and their Impact

Table of Contents
7.1. Learning Objectives ..................................................................................................................... 3
7.2. Fiscal Policy .................................................................................................................................. 3
7.2.1. Budgetary Policy..................................................................................................................... 3
7.2.2. Revenue and Capital Accounts ................................................................................................ 3
7.2.3. Budgetary Surplus or Deficit ................................................................................................... 4
7.2.4. Crowding-out Effect ............................................................................................................... 4
7.2.5. Government Spending ............................................................................................................. 5
7.2.6. Fiscal Policy in India............................................................................................................... 5
7.2.7. Revenue Expenditure ............................................................................................................ 11
7.2.8. Capital Expenditure .............................................................................................................. 11
7.3. Fiscal Deficit ............................................................................................................................... 11
7.3.1. How Fiscal Deficit Happens .................................................................................................. 11
7.4. Why High Fiscal Deficit is Bad? ................................................................................................ 12
7.5. Primary Deficit ........................................................................................................................... 13
7.6. Monetary Policy .......................................................................................................................... 13
7.6.1. Management of Monetary Policy .......................................................................................... 15
7.6.2. Central Bank ......................................................................................................................... 15
7.6.2.1. Roles and Functions of a Central Bank .......................................................................... 16
7.7. Central Bank and Monetary Policy ........................................................................................... 17
7.7.1. Quantitative and Qualitative Measures .................................................................................. 18
7.7.1.1. Quantitative Credit Control Measures ............................................................................ 18
7.7.1.2. Qualitative Credit Control Measures .............................................................................. 19
7.8. Monetary and Credit Policy in India ......................................................................................... 20
7.9. Effectiveness of the Monetary Policy ......................................................................................... 21
7.10. Summary ................................................................................................................................... 22
7.11. References ................................................................................................................................. 23
7.11.1. Book References ................................................................................................................. 23
7.11.2. Web References .................................................................................................................. 23

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7.1. Learning Objectives


By the end of this unit, you will be able to:
Recognise the choices governments and central banks face and its impact on the economy as
a whole
Describe the roles of banks in policy implementation
Analyse the governments fiscal and monetary policy documents
Identify the direction of fiscal and monetary policy and their effectiveness and linkages

7.2. Fiscal Policy


Fiscal and monetary policies are the two important instruments in the hands of the modern public
authority gaining ever-increasing importance in macroeconomic analysis and policy. In his General
Theory (1936), Keynes asserted that large-scale public expenditure is to be made from time to time to
avoid cyclical fluctuations in economic activities while maintaining high levels of employment and
income.
Almost all modern governments today collect resources to the extent of 30 percent or more of the
national income and spend this on a variety of economic activities. This is in contrast to economists
before Keynes who opposed large-scale fiscal policy and government expenditure. They were of the
view that government spending causes unnecessary intervention in private economic activities thus
arguing that the free enterprise system is a self-equilibrating one and public intervention will only cause
disturbances in its smooth working.
But Keynes pointed out that throughout the 19th century, western free enterprise economies have
suffered frequent problems of cyclical fluctuation including Great Depression (1929-33) where output
and employment levels fell by 40 percent for a prolonged time.
7.2.1. Budgetary Policy
Budgetary policy relates to two important implements: government expenditure and
taxes. The idea of collecting taxes is so that the government can carry out expenditure on
various public facilities.
7.2.2. Revenue and Capital Accounts
Fiscal policy is popular with the modern public authorities. The annual budget of the government is the
tool for planning and implementation of the fiscal policy. A budget is an estimated or anticipated
account of government receipts and expenditure in the next financial year. It is discussed and voted (for
or against) in the Parliament and implemented by the Executive
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The budget has two components namely, revenue or current account and capital account.
The revenue account displays receipts from tax collection while the capital account
shows all debt liabilities and payments of interest on loans.
7.2.3. Budgetary Surplus or Deficit
If the current or revenue account receipts are exactly equal to proposed expenditure, then
the budget is said to balanced where G = T (Government spending = Tax revenue).
If the revenue receipts fall short of the proposed expenditure (G>T), then it is a case of a
deficit budget.
On the other hand, if revenue receipts exceed the proposed expenditure (G < T), then it is
called surplus budget.
In case of surplus budget, the public revenue exceeds public expenditure. It then becomes possible for
the government to repay some debt burden. It is also possible to raise tax rates and to withdraw some
purchasing power from circulation. A surplus budget (which is also known as contractionary) policy is
useful under inflationary conditions.
During inflation, the general price level shows a strong tendency to move sharply upwards. Therefore,
such a situation can be corrected by withdrawing some purchasing power from the people. This helps to
bring down the level of effective demand.
In case of a deficit budget, the government expenditure has exceeded receipts. Therefore, the
government intends to spend more and increase the size of the aggregate or effective demand. This can
be done by raising fresh debts to finance extra expenditure. Alternatively, the tax rates can also be
reduced in order to enable people to spend more.
The deficit budget is also known as an expansionary policy. This is because through deficits and
enhanced public spending, the overall level of effective demand can be expanded. Such a policy is
pursued during the period of deflation. Under such conditions the price level is depressed, the output
level is falling and the level of unemployment is increasing. Therefore, the rising level of effective
demand is expected to act as a remedy.
7.2.4. Crowding-out Effect
Expansionary and contractionary fiscal policies have been popular with modern public authorities and
have been effective over the past years in many economies all over the world. However, it has certain
flaws. It is pointed out that extra government expenditure is financed through public borrowings. As a
result of this, the money available for loans is reduced and there is a greater demand for loanable funds
in the money and capital markets. With a sudden rise in the demand, the price of loanable funds or the
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rate of interest starts rising. Again extra public expenditure, which gives rise to an upward movement of
the price level, also has a similar effect on the rate of interest.
Rising level of the interest rate has a discouraging effect on private investment activity.
Thus, increased public investment expenditure causes a fall in the private investment
activity. This is called the 'crowding-out' effect. It is claimed therefore, that fiscal policy
is likely to develop a self-defeating tendency.

During the phase of inflation, contraction in public expenditure can be equally selfdefeating. In this case with a fall in the effective demand, the rate of interest will tend to
fall and will encourage private investment activity. This is exactly the opposite case and
therefore, can be called the 'crowding-in' effect.
7.2.5. Government Spending
Governments spend money on a wide variety of things, from the military and police to services like
education and healthcare, as well as transfer payments such as welfare benefits. The expenditure is
funded through taxation, seignorage (printing money), borrowings and sale of government assets.
7.2.6. Fiscal Policy in India
The main changes in fiscal policy happen once a year in the Budget. The Budget indicates the
government's economic thinking and determines activities such as exports and foreign direct
investment, which indirectly impact our finances.
The Budget has both short-term and long-term effects on finances. Short-term effects take place via
taxes and prices. Tax rates determine disposable income. Income tax rates laid down in the budget make
a big difference to salaried people, who have fixed incomes. The indirect taxes like excise and customs
duties laid down in the Budget impact product prices, and hence spending decisions. In the next section
we will discuss the highlights of Indian budget.
Note: In India, the annual budget is presented on last working day of February.

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Table 7.1. Union Budget of Indian Government, July 2009 (In Crores of Indian Rupees)
2007-2008
2008-2009
2008-2009
2009-2010
Actuals
Budget
Revised
Budget
Estimates
Estimates
Estimates
1. Revenue Receipts
541864
602935
562173
614497
2. Tax Revenue (net to Centre)
439547
507150
465970
474218
3. Non-tax Revenue
102317
95785
96203
140279
4. Capital Receipts (5+6+7)
170807
147949
338780
406341
5. Recoveries of Loans
5100
4497
9698
4225
6. Other Receipts
38795
10165
2567
1120
7. Borrowings and
126912
133287
326515
400996
other Liabilities
8. Total Receipts (1+4)$
712671
750884
900953
1020838
9. Non-plan expenditure
507589
507498
617996
695689
10. On Revenue Account of
420861
448352
561790
618834
which,
11. Interest Payments
171030
190807
192694
225511
12. On Capital Account
86728
59146
56206
76855
13. Plan Expenditure
205082
243386
282957
325149
14. On Revenue Account
173572
209767
241656
278398
15. On Capital Account
31510
33619
41301
46751
16. Total Expenditure (9+13)
712671
750884
900953
1020838
17. Revenue Expenditure
(10+14)
18. Capital Expenditure
(12+15)
19. Revenue Deficit (17-1)
20. Fiscal Deficit {16-(1+5+6)}
21. Primary Deficit (20-11)

594433

658119

803446

897232

118238

92765

97507

123606

241273
(4.4)
326515
(6.0)
133821
(2.5)

282735
(4.8)
400996
(6.8)
175485
(3.0)

52569
(1.1)
126912
(2.7)
-44118
-(0.9)

55184
(1.0)
133287
(2.5)
-57520
-(1.1)

Source: Union Budget website, Government of India

Lets us take the Union Budget presented in Parliament in July 2009. The first term is revenue receipts.
Revenue receipts are arranged into two categories, namely Tax revenue and Non-tax revenue. Tax
revenue comprises revenues generated from income tax, corporate tax, service tax, taxes raised from
Union Territories, wealth tax, customs and excise duties.
Non tax revenues comprise among others interest receipts, dividends and profits. The second term is
capital receipts. Capital Receipts includes the market loans, external loans, small savings, and
government provident funds, accretions to various deposit accounts, depreciation and reserve funds of
various government departments.
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Note: Revenue receipts and capital receipts together implies the government's total cash inflow.
The figure 7.1 gives the breakup of tax and non-tax revenues for the year 2009-10.
Abstract of Receipts
In crores of Rupees
2008-2009
2008-2009
2009-2010
Budget Estimates Revised Estimates Budget Estimates
Revenue Receipts
1. Tax Revenue
Gross Tax Revenue
Corporation Tax
Income Tax
Wealth Tax
Customs
Union Excise Duties
Service Tax
Taxes of the Union Territories
Less. NICCD transferred to the National
Calamity Contingency Fund
Less States Share
Net Tax Revenue
2. Non -Tax Revenue
Interest Receipts
Dividend and Profits
Other Non Tax Revenue
Receipts of Union Territories
Total Non Tax Revenue
Total Revenue Receipts

687716
226361
138314
325
118930
137874
64460
1451

627849
222000
122600
400
108000
108359
65000
1590

641079
256725
112850
425
98000
106477
65000
1602

1800
178786
607160

1800
180179
486970

2600
184381
474218

19036
43204
32631
815

19036
39736
36682
749

19174
49750
70601
754

86786
602936

88203
562173

140279
614497

Figure 7.1. Breakup of Tax and Non-tax Revenues of India for 2009-2010
Source: Government of India Budget documents

The figure 7.2 gives the breakup of capital receipts of India for the year 2009-2010.

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2008-2009
2010
Budget
A. Non Debt Receipts
1. Recoveries of loans & advances
2. Miscellaneous capital receipts
B. Debt Receipts
3. Market Loans
4. Short term Borrowings
5. External Loan (Net)
6. Securities issued against Small Savings
7. State Provident Funds (Net)
8. Other Receipts (Net)
C. Total Capital Receipts

In crores of Rupees
2008-2009
2009Revised

Budget

4497.51
10165.00

9698.29
2566.51

4224.89
1120.00

100571.00
12429.00
10989.27
9872.52
4800.00
(-)12600.22

261972.00
57500.00
9603.20
323.45
00.00
(-)38667.57

397957.46
0.00
046.57
13255.52
5000.00
(-)31263.82

140724.08

308795.88

406340.62

Figure 7.2. Breakup of Capital Receipts for 2009-2010


Source: Government of India Budget documents

The government expenditure is divided into plan and non-plan expenditure.


Plan expenditures are estimated after discussions between each of the ministries
concerned and the Planning Commission. Plan expenditure forms a sizeable proportion
of the total expenditure of the Central Government.
The demands for Grants of the various ministries show the plan expenditure under each head separately
from the non-plan expenditure.
Non-plan revenue expenditure is accounted for:
by interest payments
subsidies mainly on food and fertilisers
wage and salary payments to government employees
grants to States and Union Territories governments
pensions
police
economic services in various sectors
other general services such as tax collection, social services, and grants to foreign
governments

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Non-plan capital expenditure mainly includes defense, loans to public enterprises, loans
to States, Union Territories and foreign governments.
Figures 7.3 displays the non-plan expenditure by broad categories.
NON-PLAN EXPENDITURE BY BROAD CATEGORIES
PARTICULARS
Budget
Received
2008-2009
2008-2009
1. Interact payments and debit servicing
190807.47 192898.39
1.01. Interest payments
188407.47 191444.39
1.02. Prepayment premium for reduction of debt
2400.00
1250.00
2. Defense
106800.00 114000.00
2.1. on Revenue Account
57593.00
73600.00
2.2. on Capital Account
48007.00 41000.00
3. Subsidies
3.1. Major subsidies
88637.38 122362.38
3.1.1. Food
32666.59
43827.20
3.1.2. Indigenous (urea) fertilizers
12900.37
16516.37
3.1.3. Imported (urea) fertilizers
7238.89
10981.28
3.1.4. Sale or Decontrolled fertilizers
10847.10
48351.10
with concessions to farmers
Total fertilizers subsidy
30986.36
75843.75
3.1.5. Petroleum subsidy
2884.43
2876.43
3.2. Interest subsidies (statement no- 6)
2829.15
4083.19
3.3. Other subsidies (statement no-8)
2084.07
2827.11
Total- subsidies
71430.80 129242.68
4. Assistant to states for calamity relief @
800.00
3264.70
5. Debit waiver and debit relief scheme for farmers
16000.00
6. General elections
20.00
17.00
7. Postal deficits
968.34
3824.77
8. Subsidy for railways for dividend relief and other
1707.89
1736.17
Concessions
9. Reimbursement of loses to railway on operating
600.00
648.00
strategic railway lines
10. General services
62126.22
69282.77
10.01. Organs of state
2014.09
2786.69
10.02. Tax collections
4089.06
5569.45
10.03. Elections
214.50
390.19
1339.27
1668.44
10.04. Secretarial-General service
10.05. Police
15561.82
20711.43
2211.95
3338.49
10.06. External Aff
10.07. Pensions
25085.49
32690.08
Page 9 of 23

Budget
2009-2010
226610.88
223110.86
2400.00
141703.00
86879.00
54824.00
106678.97
62489.72
9780.25
5947.94
34252.06
49980.25
3109.00
2600.68
3099.36
111276.88
2600.00
16000.00
860.00
6395.20
2088.43
800.00
78249.00
3350.20
6627.08
291.00
1956.56
25389.69
3395.84
34980.35

10.08. Public work


10.09. Intelligence Bur
10.10. Others
11. Social service
11.01. Education
of which grants to UGC /IIMs/IITs
11.02. Sports & Youth Services
11.03. Art & culture
11.04. Medical, public health and family welfare
11.05. Housing & Urban Development
11.06. Information & Broadcasting
On which grants to Prasar Bharathi
11.07. Labor welfare
11.08. Social security &welfare
11.09. Secretarial social service
11.10. Others
12. Economic Service
12.01. Agriculture & Allied Services
12.02. Foreign Trade & Export Promoting
12.03. Energy
12.04. Industry & Minerals
12.05. Transport
12.06. Science Technology & Environment
12.07. Meteorology
12.08. Mitigation & Flood Control
12.09. Census, Surveys & Statistics
12.10. Tourism
12.11. Secretarial Economic Services
12.12. Other Communication Services
12.13. Other
13. Non Plan Grants to State Governments (Statement
no -10)
14. Non Plan Grants to Union Territory Governments
(Statement no -10)
15. Grants to Foreign Governments (Statement no -11)
16. Non Plan Capital Outlay (Statement no -8)*
17. Non Plan Loans to State Governments (Statement
no -10)
18. Non Plan Loans to UTG (Statement no -10)
19. Non Plan Grants and Loans to Public Enterprises
(Statement no -9)
20. Loans to Foreign Governments (Statement no -11)
21. Other Non Loans
Page 10 of 23

718.41
484.51
405.12
10384.70
4244.18
2561.40
72.89
412.44
1555.75
464.36
1185.41
963.65
1454.24
695.38
186.82
103.23
16788.29
4972.04
183294
-622.45
1414.95
1550.63
2915.68
152.26
204.69
290.45
43.05
789.04
2066.28
158.73
37255.07

842.69
650.44
635.97
13120.26
5925.28
3542.34
96.02
495.03
1961.58
471.96
1391.11
1137.14
1679.04
769.03
226.85
110.35
19881.61
5891.37
2804.31
-150.39
1434.11
1910.08
4068.21
198.31
216.33
378.85
46.34
940.04
1676.39
202.55
47618.48

1048.32
720.19
489.77
18491.19
7778.60
4411.00
91.38
561.15
2726.70
529.60
172271
1137.14
1551.41
2917.55
278.97
333.12
18305.21
2437.80
1846.32
799.00
1600.77
1985.61
4668.50
233.60
314.44
463.75
64.00
1157.43
2485.31
268.68
42484.80

799.19

1185.71

1050.29

1481.91
10687.00
17.00

1435.12
13894.37
16.76

1610.91
21068.39
17.0

72.00
684.63

72.00
799.32

72.00
3485.08

4.00

814.81

125.01

22. Expenditure of UTG without Legislature (Statement


no -3)
@ Amount met from National Calamity Contingency
Fund
GRAND TOTAL

2.04
2073.36

37.04
2876.84

133.72
315.97

-1800.00
507498.03

-3264.70
617996.87

-2500.00
695688.68

Figure 7.3. Non-Plan Expenditure by Broad Categories


Source: Government of India Budget documents

7.2.7. Revenue Expenditure


Revenue expenditure is meant for the normal running of government departments and
various services, interest charges on debt incurred by the government and subsidies.
Broadly speaking, expenditure which does not result in creation of assets is treated as
revenue expenditure. All grants given to state governments and other parties are also
treated as revenue expenditure even though some of the grants may be for creation of
assets.
7.2.8. Capital Expenditure
Capital expenditure consists of payments for acquisition of assets like land, buildings,
machinery, equipment, as also investments in shares etc, and loans and advances granted
by the Central government to state and union territory governments, government
companies, corporations and other parties.
Note: The excess of revenue expenditure over revenue receipts is called as revenue deficit.

7.3. Fiscal Deficit


Fiscal deficit is the difference between the revenue receipts plus certain non-debt capital
receipts and the total expenditure including loans (net of repayments). This indicates the
total borrowing requirements of the government from all sources.
In India, the fiscal deficit is financed by obtaining funds from Reserve Bank of India, called deficit
financing. The fiscal deficit is also financed by obtaining funds from the money market (primarily from
banks).
7.3.1. How Fiscal Deficit Happens
The government needs money to meet its expenses, which can be revenue and capital expenses.

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Revenue expenses are the day-to-day expenses, such as salaries payable to the
government employees and armed forces, the expenses incurred in running various
government departments, and so on.
Capital expenses include what is incurred for creating assets and improving infrastructure.

In 2008-09, the major items of expense which overshot budget estimates were the subsidy bill (the
government foots a subsidy on food and fertilisers distributed at a concessional rate).
The key source of revenue for the government is the taxes it collects; both direct and indirect. There are
also non-tax sources from which the government earns money. These may be revenue receipts (usually
recurring in nature) such as dividends received from public sector companies, fees, fines and forfeitures
or capital receipts (mostly one-time), money got through disinvestment of public sector undertakings,
recovery of loans, borrowings, and so on.
A higher fertiliser subsidy, the farm loan waiver scheme, implementation of the Sixth Pay Commission,
which hiked salaries for government employees retrospectively, result in the widening of the deficit.
Increased spending on social welfare projects which may yield no immediate monetary benefit to the
government might worsen the situation. A steep increase in non-Plan revenue expenses and a decline in
capital investments also chipped in. While expenses shot up, the last two quarters of 2008-09 also
turned the heat on the government as tax collections slowed as they contracted by 13 per cent (on yearon-year basis) in October, 15 per cent in November and 25 per cent in December.
Note: A long-term solution to contain fiscal deficit is to curtail it by either economising on expenses or
by raising taxes.

7.4. Why High Fiscal Deficit is Bad?


Fiscal failures of both the Centre and states resulted in undermining the capacity to undertake
investments in infrastructure. Crowding out of private investment occurs due to higher public
borrowings. In 2003, to control the fiscal deficit that seemed to be ballooning, the government brought
legislation (FRMB) to set limits for fiscal and revenue deficits.
A Task Force was constituted to look into framing of the Bill. In its report it argued that fiscal
correction in early stages must be revenue driven. It must achieve a lower liabilities/GDP ratio and
remove tax distortions. The Act prohibited the government from borrowing to finance revenue
expenditure. It also went into the question of front loaded adjustments vs. the back loaded adjustments.
It preferred the front loaded one to take advantage of the booming economy both in domestic sector as
well as international conditions. An improvement in Central Tax/GDP ratio had the potential to
consolidate and improve the finances of the States. It also suggested early reforms due to the lag that
appears between the undertaking of the reforms and their full impact.
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7.5. Primary Deficit


Primary deficit corresponds to the net borrowing, which is required to meet the expenditure excluding
the interest payment. The primary deficit can be summed up into equation 7.1.
Primary Deficit = Fiscal Deficit Interest Payment

Eq. 7.1

7.6. Monetary Policy


Monetary policy is more popular with classical economists and could be used either as an alternative to
fiscal policy or as complementary to fiscal policy. Classical economists advocate the use of monetary
policy because it operates only indirectly and helps to avoid direct intervention of the public authority in
economic activities. Let us consider the equation of money, before we go on to analyze monetary
policy.
The equation of money can be stated as shown in equation 7.2.
MV = PY

Eq. 7.2

where,
M = Total quantity of money
V = Velocity of the circulation of one unit of currency
P = Index number of prices
Y = Real national income
The total quantity of money M is in the form of coins and currency. This form of money is issued by
the Central Bank, which is the supreme monetary agency. However, the total supply of money can be
much larger than this because each unit of money is transferable and capable of changing hands
frequently. The total function of money supply as a medium of exchange therefore, depends upon the
average number of times a unit changes hands.
In other words, it is the velocity or frequency of using money units. If this is divided by the quantity 'M',
what we get is velocity or the average number of times a particular unit of currency has been used to
purchase final goods and services over a year.
'P', represents the average price level or index number of prices and 'T', the volume of trade or
transactions. The total volume of all the goods and services is traded at the national level and hence, it
can also be symbolized as real national income 'Y'.
The equation 7.2 may be viewed as an identity. The market value of all goods and services must be
equal to the supply of money multiplied by the velocity of the circulation of one unit of currency.
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Value of money
The equation of money is used mainly for explaining fluctuations in the value of money. It simply
explains total money supply (MV) is equal to total monetary expenditure (PY). While using it for
explaining transitions in the value of money two fundamental assumptions are made. These are
related to the behavior of 'V' and 'Y'. It is assumed that:
i.

'V', the velocity of circulation of the currency depends upon consumption patterns of
the people and the size of their income. Both these things are not likely to alter
significantly in the short run with any changes in the quantity of money (M).
Therefore over a short interval, 'V' can be assumed to be constant.

ii.

The level of real income (Y) depends upon the availability of resource supplies and
technological conditions. These factors are not likely to alter in the short run with the
variations in the quantity of money (M).

If these two assumptions are granted then the only dependent variable that remains in the equation is
the price level 'P'. Hence, the conclusion at once follows: with 'V' and 'Y' remaining constant, 'P' will
vary directly and proportionately with 'M'. This can be illustrated by the following example.
1. Let, M = 300, V = 4, Y = 600, then find out the P or the price level.
Solution: Consider the equation 7.2,
MV = PY
300*4 = P(600)

P = 2.

We can generalise the equation 7.2 to equation 7.3.


MV
Y

P or M

V
Y

P .Eq. 7.3

Since 'V' and 'Y' are constant, 'M' and 'P' must vary directly and proportionately. If M is doubled P
will also be doubled. Similarly, when 'M' is halved, P is also halved.
The price level directly and proportionately depends upon quantity of money. But price level is
inversely related to the value of money. Hence, value of money is inversely proportional to the quantity
of money.
Money is general purchasing power. Therefore, the capacity of a unit of money to purchase more or less
goods will depend upon the level of prices.
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2. Explain the relationship between M, P and the value of money with an


example of the price of chocolates, when the price is Rs. 10 and Rs. 20.
Solution: When the price of chocolate is Rs. 10 per piece, then a Rs. 100 can
purchase 10 ice creams but if its price rises to Rs.20 per piece the same Rs.100 can
purchase only 5 pieces of ice creams.
Therefore, with the rise in the price, the value of the rupee falls. Similarly with a
fall in the price level, the value of the currency rises. We can relate this to the
variations in the quantity of money.
Increase in M

Rise in P

Fall in value of M

Decrease in M

Fall in P

Rise in value of M

This relationship forms the basis of the monetary policy.


7.6.1. Management of Monetary Policy
Monetary authority in the form of the central bank and some government agency together will control
money supply. Monetary management is either to expand or contract supply of currency and credit from
time to time according to the needs of the economy. For this purpose the central bank can employ both
quantitative and qualitative measures.
Before understanding the quantitative and qualitative measures, let us understand the Central Bank and
its role.
7.6.2. Central Bank
In the monetary system of a country central banks plays an important role. The central
bank is an apex institution of the monetary system which seeks to regulate the functioning
of the commercial banks of the country.
The central bank of Indian called the Reserve Bank of India (RBI) was set up in 1935. A Central Banks
main objective is to promote the financial and economic stability of a country.
According to Dekock the guiding principle of a Central Bank is to act in public interest for the welfare
of the country without regard to profit as a primary consideration. Earning of profit for a Central Bank
is thus a secondary consideration.RBI is also responsible for regulating credit and money supply in the
country.
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Today in every country wherever commercial banks exist, a Central Bank is a must. Central banks have
been established and have come into prominence in the present century. With the progress of the
banking business, central banks acquire an essential role. Modern central banks, such as the Federal
Reserve Bank, the Bank of England, the Reserve Bank of India and others perform a variety of
functions.
7.6.2.1. Roles and Functions of a Central Bank
The following are the functions of the central bank:
It acts as a note issuing agency
It acts as a banker to the state
It acts as bankers banker
It controls credit
It acts as a lender of the last resort
It manages exchange rate
Some of the roles and functions are discussed in detail as below.
Note Issuing Agency
The central Bank of India has the monopoly over issuing notes in the country. Except for the one
rupee notes which are issued by the Ministry of Finance of the Government of India, all other
currency notes are issued by RBI. Since 1956, RBI is to keep a minimum reserve of gold and
foreign exchange securities and given this reserve it can issue notes to the extent it thinks
desirable from the point of view of the economic condition of the country.
Banker to the State
As a banker to the government, the Central Bank performs a variety of functions. All the
balances of the central government are kept with RBI. On this, the Central Bank pays no interest.
The Central Bank receives and makes payment on behalf of the government. RBI has to arrange
for issue of new loans and manage public debt. It also gives short term loan to the Government. It
is in charge of supplying currency and maintaining fiduciary reserves and foreign exchange
reserves. It is the only financial agency that can issue currency. It also has to control the rate of
exchange of the currency in foreign trade and maintain the value of currency internally. It needs
to provide financial and loan resources and maintain these accounts for the government.
Bankers Banker
The Central Bank acts as bankers bank in three capacities. It acts as:
Custodian of the cash reserve of the commercial banks
Lender of the last resort
A bank of central clearance, settlement and transfer

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The commercial banks need to keep a fixed portion of their deposit as reserve with the Central Bank.
This reserve can help the Central Bank in the control of issue of credit by commercial bank. In case of
an emergency the commercial bank can turn to the Central Bank for aid. This help may be in the form
of a loan on the strength of foreign securities or by discounting of bills of exchange. Hence, the Central
Bank is known as lender of the last resort.

7.7. Central Bank and Monetary Policy


Until the breakdown of the gold standard because of World War I, the operation of monetary policy was
of limited significance. This is because in most countries, money had always been commodity money
and the central banks that then existed had little discretion and few policy choices open to them. The
breakdown of the gold standard marked the end of the long centuries of commodity moneys. For the
first time, central banks, usually under the control and instruction of governments, could influence
monetary conditions and faced real choices.
The three main objective of the monetary policy of RBI are to:
Ensure price stability
Encourage economic growth
Ensure stability of Indian Rupee exchange rate
The figure 7.4 displays the monetary policy as described by Central Bank.

Operational
Instruments of
Monetary Policy

Intermediate
Targets

For example,
Short-term market
interest rates,
reserve
requirements

Indicators with
a reliable connection
with future inflation.
For example, money
supply, exchange
rate, inflation
forecast

Ultimate policy
Target
Normally inflation,
but could also
include reference to
output or
employment

Figure 7.4. Central Bank and Monetary Policy

The figure 7.5 displays how the Central Bank will perform the credit control.
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Figure 7.5. Central Bank and Credit Control

7.7.1. Quantitative and Qualitative Measures


Commercial bankers are profit making agencies. For them creation and supply of credit is a source of
profits. The total credit money supply is much in excess and a certain multiple of the cash deposits that
they possess. Therefore, commercial banks are likely to run into difficulties whenever their depositors
suddenly increase demand for money.
If the bankers are unable to satisfy the needs of their depositors then they are likely to fail and go
bankrupt. But for the Central Bank, it is a matter of prestige that every bank should operate successfully
and ride over its difficulties. Therefore, the Central Bank keeps a severe control on the credit supply
activities of the banks. In order to achieve its goals, the Central Bank uses two devices such as
quantitative and qualitative measures.
7.7.1.1. Quantitative Credit Control Measures
Quantitative control occurs in the form of:
1. Variable Reserve Ratios (VRR)
2. Open Market operations (OMO)
3. Bank Rate (BR) or Discount Rate
The Central Bank can use one or all the three measures as the situation may demand. If the Central
Bank proposes to follow cheap money or expansionary policy, then it can either reduce reserve ratio
requirement (say from 10 to 8 per cent), or buy the securities from banks and individuals, or reduce the
bank rate or introduce all the three measures. By reducing RR, that is, the reserve requirement of
commercial banks, their capacity to create credit increases. RBI from time to time keeps changing the
Cash Reserve Ratio (CRR) which is an important instrument of monetary control in India.
It may be pointed out here that the money multiplier is inversely proportionate to the reserve
requirement or ratio. That means, if the reserves are increased (for example, from 10 to 15 per cent), the
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money multiplier would be decreased and the capacity of the bankers to create credit will also reduce to
that extent. Therefore, the supply of money would also decrease. But when the reserve requirement is
reduced (for example, from 10 to 8 per cent) by the central bank, the money multiplier would increase
and the capacity for credit expansion would be enhanced. Hence, the supply of money would also
increase.
By buying the securities or bonds, the Central Bank puts more money in the hands of people and
bankers. This helps in the expansion of credit. RBI is shifting to open market operations (OMO), both
outright purchase and sale and, repo and reverse repo transactions, for the liquidity management in the
economy.
Repo means purchase of government securities by RBI with an agreement to sell back at
a specified rate and reverse repo means the sale of government securities by RBI with an
agreement to buy back at a specified rate.
In order to increase money supply in the economy, the RBI purchases government security. It sells
securities to siphon off the liquid cash and reduce money supply. It has emerged as a powerful tool of
monetary policy. The buyer of the security writes a cheque drawn on his bank (commercial bank) in
favor of the Central Bank. The reserves of the commercial bank are reduced while paying the central
bank. Hence, the credit creation capacity of the commercial bank is also reduced.
The Bank Rate is the official rate of interest declared by the central bank. It is that rate
which the Central Bank charges on the rediscount facility and assistance that it provides
commercial banks. The rate of interest charged by commercial banks is somewhat
higher than the bank rate.
A fall in the Bank Rate makes Central Bank assistance cheaper. The bankers are therefore induced to
borrow more from the Central Bank and supply more credit. The rate of interest charged by bankers
also falls, as it is related to the bank rate. Therefore investment demand for bank credit increases.
In the opposite case, the Central Bank can undertake exactly contrary measures to contract the credit
supply. It can increase reserves requirement, sell the securities and raise the bank rate. All these steps
reduce capacity of the bankers to supply credit and also make credit resources dearer. Therefore,
investors demand for bank credit tends to fall.
During periods of inflation when price level is rising sharply, the Central Bank follows a contractionary
policy. However, during periods of deflation when price level is low and declining and output and
employment levels are below full employment capacity, the Central Bank follows expansionary policy.
7.7.1.2. Qualitative Credit Control Measures
Qualitative measures involve direct credit control. Sometimes, quantitative credit control measures are
inadequate or are likely to be harmful. Quantitative methods apply uniformly and to the same extent to
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all bankers. But if the Central Bank finds that only a few or specific bankers are misbehaving then it has
to apply qualitative methods to individual bankers. These may be in the form of special reserve
requirement, moral appeal and advice or even direct action against defaulting bankers.

7.8. Monetary and Credit Policy in India


The monetary and credit policy is the policy statement, traditionally announced twice a year, through
which the Reserve Bank of India seeks to ensure price stability for the economy. These factors include,
money supply, interest rates and inflation. In banking and economic terms, money supply is referred to
as M3, which indicates the level (stock) of legal currency in the economy.
The RBI also announces norms for the banking and financial sector and the institutions which are
governed by it. These would be banks, financial institutions, non-banking financial institutions, Nidhis
and primary dealers (money markets) and dealers in the foreign exchange (forex) market.
Historically, the monetary policy is announced twice a year; as a slack season policy (April-September)
and a busy season policy (October-March) in accordance with agricultural cycles. These cycles also
coincide with the halves of the financial year. However, with the share of credit to agriculture coming
down and credit towards the industry being granted whole year around, the RBI has moved in for just
one policy in April-end since 1998-99. However, a review of the policy does take place later in the year.
The figure 7.6 displays the highlights of monetary policy in India for the year 2009-2010.
Monetary Policy
Highights of the policy are as follows:
a.
b.
c.
d.

e.

f.

g.
h.
i.
j.

Slow recovery of global economy from recession.


Frozen credit markets have thawed and equity markets have begun to recover.
Consumption demand remains subdued as unemployment level have risen
The large domestic demand bolstered by government consumption, provision of fore and rupee
liquidity coupled with sharp cuts in policy rates, a sound banking sector and well functioning
financial markets helped cushion the economy from the worst impact of the crisis.
The money supply (M3) growth on a year-on-year basis at 20.0 per cent as on July 3,2009 has
been well above the 17.0 per cent trajectory projected in the annual policy statement of April
2009
Monetary management since mid September 2008 has been skidded by the continued need to
provide liquidity to mitigate the impact of the global financial crisis and to improve the growth
prospects in the medium term.
Since mid-September 2008 the Reserve Bank has reduced policy rates significantly: the repo
rate by 425 basis points and the reverse repo rate by 275 basis points.
The CRR was also reduced by 400 basis points
The Bank Rate has been retained unchanged at 6.0 per cent
The repo rate under the Liquidity Adjustment Facility (LAF) has been retained unchanged at
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4.75 per cent.


k. The Reserve Bank will maintain an accommodative monetary stance until there are definite
and robust signs of recovery.
Figure 7.6. Monetary Policy in India for 2009-2010

Initially, the Reserve Bank of India announced all its monetary measures twice a year in the Monetary
and Credit Policy. Of late, monetary policy has become dynamic in nature as RBI reserves its right to
alter it from time to time, depending on the state of the economy.

7.9. Effectiveness of the Monetary Policy


Demand for money, as a proportion of the total income is stable. Therefore, during the expansionary
phase when a greater amount of money income is received, people tend to spend the surplus income
quickly. Such spending causes aggregate or effective demand to increase and the curve to shift upwards.
Moreover in the short run, some resources may be underutilized or unemployed. In that case, such extra
expenditure induces some increase in employment. But once the full employment condition is
established, there is no further scope for real output and employment to increase. If the expansionary
policy persists and monetary expenditure continues to increase, then it will cause a pure inflationary rise
in the price level. Thus, in the short run monetary policy may have an impact.
The effectiveness of the monetary policy depends upon the following factors.
Accuracy of Inflation Forecasts
Monetary policy as a tool to preempt the inflationary pressures will be effective to the extent of the
accuracy of inflation forecasts. If inflation is higher than forecast, it may result in a situation where
interest rates might be too low to be effective antidote to inflation. An unexpected rise in cost push
inflation due to supply shocks might impact inflationary forecasts casting a shadow on the effectiveness
of monetary policy.
Time Lags
Interest rate changes may take up to 18 months to have their full effects. Current spending will not stop
immediately following changes in interest rates. However, higher interest rates may deter future projects
from starting.
Interest Elasticity of Demand
This measures how responsive demand is to a change in interest rates. A high level of consumer
confidence may not deter consumer spending making it relatively inelastic with respect to interest rates.
Effects of Interest Rates Unequally Shared
The impact of rising interest rates effects may not be distributed equally across segments. This means
the effect will differ across consumers.
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Other Variables
Interest rates affect other variables in the economy. Higher interest rates increase the value of the
currency (through hot money flows). This causes problems for exporters worsening current account.
Higher interest rates also have a disproportionate effect on the volatile real estate market.
Inflation Expectations
If people have low inflation expectations then, it is much easier to keep inflation low. The average man
as a consumer or a firm goes by 'expectations' about future changes in the monetary policy.
Normally, the average annual growth rate of price level is said to be permissible and desirable to the
extent of 4 per cent. This can compensate for real growth rate of income (GDP). But if people expect
higher or lower rate of inflation in the future then their reactions alter and cause disturbances in the
economy. Therefore, the best thing for the monetary authority to do is to maintain a steady growth rate
of money supply and maintain steady rate of inflation.
The monetarists believed that the monetary policy should be able to allow for a rise in the growth rate
and at the same time not result in either inflation or deflation.
Levels of Government Debt
Increasing levels of government debt can generate upward pressure on interest rates. To attract enough
people to buy government bonds, interest rates on these securities rise and thus, creating this upward
pressure.

7.10. Summary
Here is a quick recap of what we have learnt so far.
During monetary expansion, lower interest rates cause an increase in both consumer and fixed
capital spending thereby increasing current equilibrium national income.
An expansion in fiscal policy adds directly to Aggregate Demand (AD), but if financed by higher
government borrowing, creates higher interest rates and lower investment. The net result (by
adjusting the increase in government spending) (G) is the same increase in current income.
As the investment spending is lower, the capital stock is lower than it would have been, resulting
in lower future income.
When the economy is in a recession, business and consumer confidence is very low. Deflationary
pressures are taking hold. In such a situation, monetary policy may be ineffective in increasing
current national spending and income.
Few economists argue that the short term changes in monetary policy do impact quite quickly
and strongly on consumer and business behavior. Instances can be cited of domestic demand in
both the United States and the UK.
There may be factors which make fiscal policy ineffective aside from the usual crowding out
phenomena. Future-oriented consumption theories hold that individuals undo government fiscal
policy through changes in their own behavior.
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Fiscal policy cannot be seen in isolation and has to be viewed in conjunction with monetary
policy.

7.11. References
7.11.1. Book References
Oliver Blanchard, Macroeconomics, Pearson Education Publications, 4th edition, 2007
Ahuja, Macroeconomics Theory and Policy, S.Chand Publications, 2008
Gregory Mankiw, Macroeconomics, Worth Publications, 6th edition, 2008, Chapter 4 (pg 76 to
90), Chapter 14 (pg 406 to 419), and Chapter 15 (pg 431 to 452)
7.11.2. Web References
Reserve Bank of India
www.rbi.org.in
Ministry of Finance, Government of India
http://www.finmin.nic.in/
Indian monetary policy 2009-10 second quarter review
http://www.stockmarketsreview.com/news/indian_monetary_policy_2009_10_second_quarter_re
view_20091027_1438/

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