RBI Credit Policy

INTRODUCTION
The Reserve Bank of India as the Central Bank of our country was established on 1 st April,
1935 under the Reserve Bank of India Act, 1934. The Bank was started originally as a
shareholders bank and its paid up capital was Rs. 5 crores. The Bank took over the function
of currency issue from the Government of India and the power of credit control from the then
Imperial Bank of India. The Bank was nationalised in the year 1948, soon after
Independence, following a post war trend towards nationalisation of Central Banks all over
the world. Also a centrally administered system had then become necessary to control a
runaway inflation raging in India since 1939, control inflation in the country effectively. And,
as India had to embark upon a programme of economic development and growth, it was
necessary to have a complete control over the activities of banking so that a Central Bank
could be used effectively as an instrument of economic change in the country.
This power of Credit control of RBI as taken from the then Imperial Bank is mainly forming
RBIs Credit Policy. Through credit policy RBI controls flow of credit in domestic market as
one of its important functions involve control over the volume of credit created by the
commercial banks in order to ensure price stability.
The Reserve Bank of India is largely concerned with organisation of a sound and healthy
commercial banking system, ensuring effective co-ordination and control over credit through
appropriate monetary and credit policies followed from time to time. However, in India the
Reserve Bank of India is also concerned with development of rural banking, promotion of
financial institutions and development of money and capital market in India.
Keeping in view, the functions of RBI of credit control along with the developmental aspects,
the credit policy for a nation is formulated in both quantitative measures and qualitative
measures to control both quantity of credit and quality of work to be formulated by that
credit.
Issue of credit policy for Banking Companies :
The bank formulates credit policies, normally by way of an order, by laying down the bank
rate, lending restrictions, merger restrictions, nature of security to be obtained for credit
extension, defining the scope and eligibility of the private sector for borrowing, determining

the cash reserve ratio and statutory liquidity ratio and any other matter having a bearing on
commercial lending in the first instance, and the economy of the country in the second.
It has been customary for RBI to announce a set of measures of both short-term and structural
nature in the two bi-annual statements on monetary and credit policy normally released in
April and October of each year.

CREDIT POLICY & MONETARY POLICY OF RBI

CONCEPTUAL ANALYSIS
Meaning
Monetary policy comprises implementation of measures that will result either in contraction
or expansion of money supply in the economy and thereby regulate inflation in prices. Banks
being purveyors of credit, they act as change agents by regulating the volume of liquidity for
industries as a measure to control prices of goods and services. As the regulatory authority,
the RBI monitors bank credit through directives altering Cash Reserve and Statutory
Liquidity Ratios for Banks, amending its own lending rate, known as the Bank Rate,
stipulating minimum margins to be retained by banks in their advances and also reviewing
commodities governed by the Selective Credit Control.
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. The
Reserve Bank of India enunciates its monetary policy once a year, but announces a midcourse review six months thereafter.
These factors include - money supply, interest rates and the inflation. In banking and
economic terms money supply is referred to as M3 - which indicates the level (stock) of legal
currency in the economy. Besides, 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.1
Historically, the Monetary Policy is announced twice a year - a slack season policy (AprilSeptember) and a busy season policy (October-March) in accordance with agricultural cycles.
These cycles also coincide with the halves of the financial year.
Initially, the Reserve Bank of India announced all its monetary measures twice a year in the
Monetary and Credit Policy. The 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.

1 Salil Panchal, What is RBIs Monetary Policy, Morpheus Inc.. Available at: <
http://m.rediff.com/money/2002/apr/25tut.htm>.

However, with the share of credit to agriculture coming down and credit towards the industry
being granted whole year around, the RBI since 1998-99 has moved in for just one policy in
April-end. However a review of the policy does take place later in the year.2

Objectives and Efficacy

As an integral component of the overall economic policy of the country, the key objectives of
monetary policy of the Bank are:

Regulation of monetary growth consistent with expected growth in output and a

desirable rate of inflation, and

Ensuring adequate expansion of credit for the purpose of meeting genuine credit
requirements of productive sectors of the economy.

Until the economic reforms were introduced during the nineties, the prevailing system of
administered interest rates was geared towards achieving the twin objectives of allocation of
resources for capital formation and directing credit to preferred sectors, often at
concessionary interest rates. The administered interest rate regime clearly circumscribed the
role of interest rate as an effective instrument of monetary management.
The efficacy of the policy hinges on the identification of the targets by the monetary
authority. Conceptually, such targets are distinguished as intermediate and ultimate. Whereas
inflation rate is an agreeable ultimate target of monetary policy, variables such as different
measures of money supply and/or interest rates could be employed to serve as intermediate
targets. In India, while broad money, or what is referred as M-3, growth has been chosen to
function as intermediate target, the operating target is the level of Bank.

2 Ibid.

The objectives are to maintain price stability and ensure adequate flow of credit to the
productive sectors of the economy.
Stability for the national currency (after looking at prevailing economic conditions), growth
in employment and income are also looked into. The monetary policy affects the real sector
through long and variable periods while the financial markets are also impacted through
short-term implications.
There are four main 'channels' which the RBI looks at:

Quantum channel: money supply and credit (affects real output and price level
through changes in reserves money, money supply and credit aggregates).

Interest rate channel.

Exchange rate channel (linked to the currency).

Asset price.

Monetary Policy is the process by which the monetary authority of a country, generally a
Central Bank controls the Supply of money in the Economy by exercising its control over
interest rates in order to maintain- Growth with Stability Regulation, Supervision &
Development of Financial Stability Promoting Priority Sector Generation of
Employment External Stability Encouraging Saving & Investment Redistribution of
income & wealth Role of Monetary Policy in Combating Inflation www.iosrjournals.org 12 |
Page Regulation of NBFI
OBJECTIVES OF MONETARY POLICY OF INDIA :The main objective of monetary policy in India is growth with stability. Monetary
Management regulates availability, cost and use of money and credit. It also brings
institutional changes in the financial sector of the economy. Following are the main
objectives of monetary policy in India :1.

Growth With Stability :-

Traditionally, RBIs monetary policy was focused on controlling inflation through contraction
of money supply and credit. This resulted in poor growth performance. Thus, RBI have now
adopted the policy of Growth with Stability. This means sufficient credit will be available
for growing needs of different sectors of economy and at the same time, inflation will be
controlled with in a certain limit.

2.

Regulation, Supervision And Development Of Financial Stability :-

Financial stability means the ability of the economy to absorb shocks and maintain
confidence in financial system. Threats to financial stability can come from internal and
external shocks. Such shocks can destabilize the countrys financial system. Thus, greater
importance is being given to RBIs role in maintaining confidence in financial system
through proper regulation and controls, without sacrificing the objective of growth.
Therefore, RBI is focusing on regulation, supervision and development of financial system.

3.

Promoting Priority Sector :-

Priority sector includes agriculture, export and small scale enterprises and weaker section of
population. RBI with the help of bank provides timely and adequately credit at affordable
cost of weaker sections and low income groups. RBI, along with NABARD, is focusing on
microfinance through the promotion of Self Help groups and other institutions.

4.

Generation Of Employment :-

Monetary policy helps in employment generation by influencing the rate of investment and
allocation of investment among various economic activities of different labour Intensities.

5.

External Stability :-

With the growth of imports and exports Indias linkages with global economy are getting
stronger. Earlier, RBI controlled foreign exchange market by determining eaxchange rate.
Now, RBI has only indirect control over external stability through the mechanism of

managed Flexibility, where it influences exchange rate by buying and selling foreign
currencies in open market.

6.

Encouraging Savings And Investments :-

RBI by offering attractive interest rates encourage savings in the economy. A high rate of
saving promotes investment. Thus the monetary management by influencing rates of interest
can influence saving mobilization in the country.

7.

Redistribution Of income And Wealth :-

By control of inflation and deployment of credit to weaker sectors of society the monetary
policy may redistribute income and wealth favouring to weaker sections.

8.

Regulation Of NBFIs:-

Non Banking Financial Institutions (NBFIs), like UTI, IDBI, IFCI plays an important role
in deployment of credit and mobilization of savings. RBI does not have any direct control on
the functioning of such institutions. However it can indirectly affects the policies and
functions of NBFIs through its monetary policy.

The monetary policy of RBI is not merely one of credit restriction, but it has also the duty to
see that legitimate credit requirements are met & at the same time credit is not used for
unproductive & speculative purposes. RBI has various weapons of monetary control & by
using them it hopes to achieve its monetary policy. These are:
A. Quantitative Credit Control Methods In India the legal framework of RBIs control over
the credit structure has been provided under RBI act 1934 & Banking regulation Act 1949.
Quantitative Credit Control is used to maintain proper quantity of credit or money supply in
market. Some of the important credit control methods are- Bank Rate Policy Open

Market Operations Cash Reserve Ratio Statutory Liquidity Ratio Repo & Reverse
Repo Rate
B. Qualitative Credit Control Methods Under Selective Credit Control Credit is provided to
selected borrowers for selected purposes. These ares- Ceiling on Credit Margin
Requirements Discriminatory Interest Rate(DIR) Directives Direct Action Moral
Suasion
http://rbidocs.rbi.org.in/rdocs/content/PDFs/90017.pdf
Credit Policy or Monetary policy is, by common agreement, the defining function of a central bank.
Uniquely for a central bank, the Reserve Bank of India undertook a variety of developmental
initiatives in independent India, though monetary policy remained its central preoccupation. The
principal structural features of the Bank's economic and financial environment and the resulting
diversity in the nature of its responsibilities as a central bank have already been discussed in the
introductory chapter. Monetary policy, which is usually understood to represent policies, objectives,
and instruments directed towards regulating money supply and the cost and availability of credit in
the economy, could not remain unaffected by this inherited context. Therefore the Reserve Bank of
India was prone to take a rather wider view of its monetary policy than more traditional central banks,
including within its ambit the institutional responsibility for deepening the financial sector of the
economy. Thanks to the Bank's own initiatives and the stimulus of the ongoing process of planned
development, the institutional context of monetary policy underwent substantial change during our
period. At the same time, tensions between the Bank's concern to regulate credit and its wider
responsibility to spread and deepen the domestic financial system were often not far in the
background. Some of these tensions might be regarded in the light of experience as transient or shortterm while others persist to this day, but their impact on the Bank's decision-malung at the time can
hardly be overlooked.
As important, the financing of planned development in a poor economy was a source both of
challenge and of constraints for the Bank in its role as the monetary policy authority. While the shortterm management of seasonal, inflationary, and balance of payments pressures remained an important
focus of monetary policy, the overall investment targets proposed in the five-year plans provided the
backdrop against which this responsibility had to be discharged. The interactive nature of the
relationship between inflationary pressures in the economy and the mobilization of real resources to
finance the plan effort gave monetary management a particular salience during these years. In
practice, this relationship too translated into a conflict for whose resolution the Bank had much
responsibility but little power. On the one hand, inflation had to be controlled in order to promote
savings and investment and the plan effort. But on the other, having to step in frequently to cover the
budgetary gaps of the central and state governments weakened the Bank's ability to conduct an
independent monetary policy. For the Reserve Bank of India therefore, short-term monetary policy
meant not merely managing clearly identified variables such as the price level or the exchange rate,
but doing so consistent with supporting a given plan effort. Unfortunately but perhaps unavoidably in
the circumstances, th~s reconciliation was generally effected at the cost of the private sector's credit
requirements. Given the formidable constraints they had to negotiate, the Bank's persistent efforts to
balance its diverse responsibilities represent, on closer inspection, an important source of insight for
historians as well as for others interested in the broader issues of economic development. Faced with

the growing gulf between everyday practice and the canons of orthodox central banking, few
contemporary officials recognized they were blazing a trail (whatever may have lain at the end of it),
nor were they conscious of the ingenuity they brought to addressing the challenges facing them. In
tackling these largely short-term challenges, they did not entirely lose sight of the larger picture. But
the practical necessities of decision-making under multiple constraints often led to the adoption,
sometimes against the better judgement of its officers if not always of the Bank, of measures which
created bigger problems in the longer term than the more immediate ones they helped to resolve. As
the logic of decision-making became endogenized in the form of precedents and institutional
evolution, the course was set for departures which however small or partial in the beginning,
exercised over a period of time a tangible influence on the overall effectiveness of the Bank's
monetary policy.
This part of the volume is organized in three separate but related chapters. The first begins with a
broad overview of fiscal developments during the three five-year plan periods covered by this volume
and of the Bank's evolving attitude towards deficit financing and its impact upon monetary variables
in the economy. From being initially passive about the resource assumptions of five-year plans, the
Bank learnt from experience to be more proactive and to urge upon planners the importance of
realistic estimates of growth and resource mobilization targets. Concerns such as this led to efforts to
formulate a monetary budget for the third five-year plan. Apart from defining the context for
monetary policy, deficit financing also raised new questions about currency management and the
effectiveness of the Bank's existing tool-kit of monetary policy. In addressing these questions, the
Bank endeavoured to augment its powers, as well as adapt the Indian currency and monetary
apparatus for the changes and challenges lying ahead. Its efforts in this direction are also discussed in
this chapter. The second and third chapters of this section present a largely chronological account of
the Bank's monetary and credit policies during the years covered by this volume.

Need for Credit policy

The commercial banks maintain accounts with the Reserve Bank of India and borrow money
when necessary from the Reserve Bank of India. The RBI thus provides credit to commercial
banks and commercial banks in turn provide credit to their clients to promote economic
growth and development. However, credit cannot be extended to an unlimited extent because
it would disturb price stability in the country and therefore, it becomes necessary for the RBI
to control the activities of the commercial banks in the interest of the price stability. The RBI
controls the activities of the commercial banks by virtue of the powers vested in it under the
Banking Regulation Act of 1949 and the Reserve Bank of India Act, 1934.

TOOLS OF RBIS CREDIT & MONETARY POLICY

The Monetary Policy of RBI is not merely one of credit restriction, but it has also the duty to
see that legitimate credit requirements are met and at the same time credit is not used for
unproductive and speculative purposes RBI has various weapons of monetary control and by
using them, it hopes to achieve its monetary policy.
QUANTITATIVE CREDIT CONTROL METHODS :In India, the legal framework of RBIs control over the credit structure has been provided
Under Reserve Bank of India Act, 1934 and the Banking RegulationAct, 1949. Quantitative
credit controls are used to maintain proper quantity of credit o money supply in market. Some
of the important general credit control methods are:1. Bank Rate Policy :Bank rate is the rate at which the Central bank lends money to the commercial banks for their
liquidity requirements. Bank rate is also called discount rate. In other words bank rate is the
rate at which the central bank rediscounts eligible papers (like approved securities, bills of
exchange, commercial papers etc) held by commercial banks.
Bank rate is important because it is the pace setter to other market rates of interest. Bank rates
have been changed several times by RBI to control inflation and recession. By 2003, the bank
rate has been reduced to 6% p.a.
2. Open market operations :It refers to buying and selling of government securities in open market in order to expand or
contract the amount of money in the banking system.This technique is superior to bank rate
policy. Purchases inject money into the banking system while sale of securities do the
opposite. During last two decades the RBI has been undertaking switch operations. These
involve the purchase of one loan against the sale of another or, vice-versa. This policy aims at
preventing unrestricted increase in liquidity.
3. Cash Reserve Ratio (CRR)
The Gash Reserve Ratio (CRR) is an effective instrument of credit control. Under the RBl
Act of, l934 every commercial bank has to keep certain minimum cash reserves with RBI.

The RBI is empowered to vary the CRR between 3% and 15%. A high CRR reduces the cash
for lending and a low CRR increases the cash for lending. The CRR has been brought down
from 15% in 1991 to 7.5% in May 2001. It further reduced to 5.5% in December 2001. It
stood at 5% on January 2009. In January 2010, RBI increased the CRR from 5% to 5.75%. It
further increased in April 2010 to 6% as inflationary pressures had started building up in the
economy. As of March 2011, CRR is 6%.
4. Statutory Liquidity Ratio (SLR)
Under SLR, the government has imposed an obligation on the banks to maintain a certain
ratio to its total deposits with RBI in the form of liquid assets like cash, gold and other
securities. The RBI has power to fix SLR in the range of 25% and 40% between 1990 and
1992 SLR was as high as 38.5%. Narasimham Committee did not favour maintenance of high
SLR. The SLR was lowered down to 25% from 10thOctober 1997.It was further reduced to
24% on November 2008. At present it is 25%.
5. Repo And Reverse Repo Rates
In determining interest rate trends, the repo and reverse repo rates are becoming important.
Repo means Sale and Repurchase Agreement. Repo is a swap deal involving the immediate
Sale of Securities and simultaneous purchase of those securities at a future date, at a
predetermined price. Repo rate helps commercial banks to acquire funds from RBI by selling
securities and also agreeing to repurchase at a later date.
Reverse repo rate is the rate that banks get from RBI for parking their short term excess funds
with RBI. Repo and reverse repo operations are used by RBI in its Liquidity Adjustment
Facility. RBI contracts credit by increasing the repo and reverse repo rates and by decreasing
them it expands credit. Repo rate was 6.75% in March 2011 and Reverse repo rate was 5.75%
for the same period. On May 2011 RBI announced Monetary Policy for 2011-12. To reduce
inflation it hiked repo rate to,7.25% and Reverse repo to 6.25%
SELECTIVE OR QUALITATIVE CREDIT CONTROL METHODS :Under Selective Credit Control, credit is provided to selected borrowersfor selected purpose,
depending upon the use to which the control try to regulate the quality of credit - the direction
towards the credit flows. The Selective Controls are :1. Ceiling On Credit

The Ceiling on level of credit restricts the lending capacity of a bank to grant advances
against certain controlled securities.
2. Margin Requirements
A loan is sanctioned against Collateral Security. Margin means that proportion of the value of
security against which loan is not given. Margin against a particular security is reduced or
increased in order to encourage or to discourage the flow of credit to a particular sector. It
varies from 20% to 80%. For agricultural commodities it is as high as 75%. Higher the
margin lesser will be the loan sanctioned.
3. Discriminatory Interest Rate (DIR)
Through DIR, RBI makes credit flow to certain priority or weaker sectors by charging
concessional rates of interest. RBI issues supplementary instructions regarding granting of
additional credit against sensitive commodities, issue of guarantees, making advances etc. .
4. Directives
The RBI issues directives to banks regarding advances. Directives are regarding the purpose
for which loans may or may not be given.
5. Direct Action
It is too severe and is therefore rarely followed. It may involve refusal by RBI to rediscount
bills or cancellation of license, if the bank has failed to comply with the directives of RBI.
6. Moral Suasion
Under Moral Suasion, RBI issues periodical letters to bank to exercise control over credit in
general or advances against particular commodities. Periodic discussions are held with
authorities of commercial banks in this respect.

EVALUATION OF MONETARY POLICY :The RBI aims at one time was controlled expansion. On one hand it was taking steps to expand bank
credit. On other hand RBI uses quantitative and qualitative methods to control credit. These two
contradictory objectives limited the success of monetary policy. The performance of monetary policy
can be seen from its achievements and failures, let us discuss.
ACHIEVEMENTS OR THE POSITIVE ASPECTS OF MONETARY POLICY :1. Short Term Liquidity Management :RBI has developed various methods to maintain stability in interest rate and exchange rate like LAF,
OMO and MSS. RBI has also managed its sterlization operations very well.
2. Financial Stability :With the help of controls, regulation and supervision mechanism, RBI has been successful in
maintaining financial stability. During the period of global crisis it has also been able to maintain
macro economic stability.
3. Financial Inclusion :Along with NABARD, RBI has made a great impact in the growth of microfinance. RBI has
supported Self Help Group Model and promoted other microfinance institutions.
4. Adaptability:In India monetary policy is flexible, as it changes with time. RBI has developed new methods of
credit control and shifted from monetary targeting to multiple indicator approach.
5. Increase In Growth:To maintain the growth of economy RBI has used its instruments' effectively. At present India has the
second highest rate of GDP growth after China. Thus monetary policy has played an important role.
6. Increase In Bank Deposits:The increase in bank deposits over the years indicates trust and confidence of people in banking
sector. Effective supervision of RBI over banks and financial institutions is largely responsible for
trust and confidence of public in banking sector.
7. Competition Among Banks :The monetary policy of RBI has resulted in healthy competition among banks in the country. The
competition is due to deregulation of interest rates and other measures taken by RBI. Now-a-days due
to professionalism banks provide better service to customers.
FAILURES OR THE LIMITATIONS OF MONETARY POLICY
1. Huge Budgetary Deficits :RBI makes every possible attempt to control inflation and to balance money supply in the market.
However Central Government's huge budgetary deficits have made monetary policy ineffective. Huge
budgetary deficits have resulted in excessive monetary growth.

2. Coverage Of Only Commercial Banks :Instruments of monetary policy cover only commercial banks so inflationary pressures caused by
banking finance can be controlled by RBI, but in India, inflation also results from deficit financing
and scarcity of goods on which RBI may not have any control.
3. Problem Of Management Of Banks And Financial Institutions :The monetary policy can succeed to control inflation and to bring overall development only when the
management of banks and Financial institutions are efficient and dedicated. Many officials of banks
and financial institutions are corrupt and inefficient which leads to financial scams in this way overall
economy is affected.
4. Unorganised Money Market :Presence of unorganised sector of money market is one of the main obstacle in effective working of
the monetary policy. As RBI has no power over the unorganised sector of money market, its monetary
policy becomes less effective.
5. Less Accountability:At present time, the goals of monetary policy in India, are not set out in specific terms and there is
insufficient freedom in the use of instruments. In such a setting, accountability tends to be weak as
there is lack of clarity in the responsibility of governments and RBI.
6. Black Money :There is a growing presence of black money in the economy. Black money falls beyond the purview
of banking control of RBI. It means large proposition of total money Supply in a country remains
outside the purview of RBI's monetary management.
7. Increase Volatility :The integration of domestic and foreign exchange markets could lead to increased volatility in the
domestic market as the impact of exogenous factors could be transmitted to domestic market. The
widening of foreign exchange market and development of rupee - foreign exchange swap would
reduce risks and volatility.
8. Lack Of Transparency :According to S. S. Tarapore, the monetary policy formulation, in its present form in India, cannot be
continued indefinitely. For a more effective policy, it would be necessary to have greater transparency
in the policy formulation and transmission process and the RBI would need to be clearly demarcated.
CONCLUSION :Thus, from above we can say that despite several problems RBI has made a good effort for effective
implementation of the monetary policy in India.

Monetary policy in India underwent significant changes in the 1990s as the IndianEconomy became
increasing open and financial sector reforms were put in place. in the1980s,monetary policy was
geared towards controlling the qunatam,cost and directionsOf credit flow in the economy. the quantity
variables dominated as the transmissionChannel of monetary policy. Reforms during the
1990s enhanced the sensitivity of priceSignals of price signals from the central bank, making interest
rates the increasinglyDominant transmission channel of monetary policy in India.The openness of the
economy, as measured by the ratio of
merchandise trade(exportsPlus imports) to GDP, rose from about 18% in 1993-94 to about 26% by 20
03-04.Including services trade plus invisibles, external transactions as a proportion of GDPRose from
25% to 40% during the same period.Alongwith the increase in trade as aPercentage of GDP,
capital inflows have increased even more sharply,foreign currencyAssets of the reserve bank of
India(RBI) rose from USD 15.1 billion in the march 1994To over USD 140 billion by
march 15,2005.these changes have affected liquidity
andMonetary management. monetary policy has responded continuously to changes inDomestics and
international macroecomic conditions. In this process, the currentmonetary operating framework has
relied more on outright open market operations andDaily repo and reserve repo operations than on the
use of direct instruments.overightRate are now gradually emerging as the principal operating
target.The Monetary and Credit Policy is the policy statement, traditionally announcedtwice 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 the inflation.

Importance of Monetary Policy

The growing importance of monetary policy and the diminishing role played by fiscal
policing economic stabilization efforts may reflect both political and economic realities.
Fighting inflation requires government to take unpopular actions like reducing spendingor raising
taxes, while traditional fiscal policy solutions to fighting unemployment tend tobe more popular since
they require increasing spending or cutting taxes. Politicalrealities, in short, may favor a bigger role
for monetary policy during times of inflation.One other reason suggests why fiscal policy may be
more suited to fightingunemployment, while monetary policy may be more effective in fighting
inflation. Thereis a limit to how much monetary policy can do to help the economy during a period
ofsevere economic decline, such as the States encountered during the 1930s. The monetarypolicy
remedy to economic decline is to increase the amount of money in circulation,thereby cutting interest
rates. But once interest rates reach zero, the Fed can do no more.The United States has not
encountered this situation, which economists call the "liquiditytrap," in recent years, but Japan did
during the late 1990s. With its economy stagnant andinterest rates near zero, many economists argued
that the Japanese government had toresort to more aggressive fiscal policy, if necessary running up a
sizable governmentdeficit to spur renewed spending and economic growth.