(Online Course) Public Administration for IAS Mains Exams
Topic: Financial Administration: Monetary Policy
Monetary policy is the process by which the government,
central bank, or monetary authority of a country controls (i) the supply of
money, (ii) availability of money, and (iii) cost of money or rate of interest,
in order to attain a set of objectives oriented towards in growth and stability
of the economy. Momentary theory provides insight into how to craft optimal
The other primary means of conducting monetary policy
include: (i) Discount window lending (lender of last resort); (ii) Fractional
deposit lending (changes in the reserve requirement); (iii) Moral suasion
(cajoling certain market players to achieve specified outcomes); (iv) “Open
market operations” (talking monetary policy with the market).
Objectives of Monetary Policy
1. Maximizing growth rates
2. Ensuring price stability
3. Increasing employment opportunities
4. Managing exchange rate stability
Monetary System of India Consists of
1. Reserve Bank of India, Commercial Banks and Non Banking Financial
Institutions (Mutual funds)
2. Capital market
3. Unorganized sector like the money lenders and hundi system.
Instruments of Monetary Policies
1. Bank Rate
2. Statutory Liquidity Ratio (SLR)
3. Cash Reserve Ratio (CSR)
4. Open Market Operation (OMO)
Monetarist macroeconomists have sometimes advocated simply
increasing the monetary supply at a low, constant rate, as the best way of
maintaining low inflation and stable output growth. Therefore, monetary
decisions today take into account a wider range of factors, such as:
- Short term interest rates;
- Long term interest rates;
- Velocity of money through the economy;
- Exchange rates;
- Credit quality;
- Bonds and equities (corporate ownership and debt);
- Government versus private sector spending/savings;
- International capital flows of money on large scales;
- Financial derivatives such as options, swaps, futures contracts, etc.
Between Fiscal and Monetary Policy, former is more effective than later
(i) Fiscal policy is more direct
(ii) Its impact is immediate
(iii) Effectiveness of Monetary Policy depends on the development of monetary
system within the country.
In India there is widespread presence of unorganized sector
making the monetary policy less effective. Integration of money markets is also
one of the constraints faced by Indian economy resulting in prevalence of
different rates of interests.
Fiscal policy was invented by John Maynard Keynes in the
1930s. In economics, fiscal policy is the use of government spending and revenue
collection to influence the economy. The two main instruments of fiscal policy
are government spending and taxation. Changes in the level and composition of
taxation and government spending can impact on the following variables in the
Aggregate demand and the level of economic activity;
The pattern of resource allocation;
The distribution of income.
Fiscal policy refers to the overall effect of the budget
outcome on economic activity. The three possible stances of fiscal policy are
neutral, expansionary and contractionary:
A neutral stance of fiscal policy implies a balanced
budget where G = T (Government spending = Tax revenue)
An expansionary stance of fiscal policy involves a net
increase in government spending (G>T) through rises in government spending
or a fall in taxation revenue or a combination of the two.
A contractionary fiscal policy (G < T) occurs when net
government spending is reduced either through higher taxation revenue or
reduced government spending or a combination of the two.
Methods of Funding
Government 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 can be funded in a number of different ways:
Borrowing money from the population, resulting in a
Consumption of fiscal reserves.
Sale of assets (e.g., land).
Finding the Deficit
A fiscal deficit is often funded by issuing bonds, like
treasury bills or consols. These pay interest, either for a fixed period or
indefinitely. In the interest and capital repayments are too large, a nation may
defaults on its debts, usually to foreign creditors.
Consuming the Surplus
A fiscal surplus is often saved for future use, and may be
invested in local (same currency) financial instruments, until needed. When
income from taxation or other sources falls, as during an economic slump,
reserves allow spending to continue at the same rate, without incurring a
Policy-makers use fiscal tools to manipulate demand in the
economy. For example:
Taxes: If demand is low, the government can decrease
taxes. This increases disposable income, thereby simulating demand.
Spending: If inflations is high, the government can
reduce its spending thereby moving itself from competing for resources in
the market (both goods and services). This is a contractionary policy that
would lower prices.
Both tools affect the fiscal position of the government i.e.,
the budget deficit goes up whether the government increases spending or lowers
taxes. This deficit is financed by debt; the government borrows money to cover
the shortfall in its budget.
Examples of monetary policy tools include:
Interest Rates: Interest rate is the cost of borrowing
or, essentially, the price of money. By manipulating interest rates, the
central bank can make it easier or harder to borrow money. When money is
cheap, there is more borrowing and more economic activity.
Reserved Requirement: Banks are required to hold a
certain percentage (cash reserve ratio, or CRR of their deposits in reserve
in order to ensure that they always have enough cash to meet withdrawal
requests of their request of their depositors.
Currency peg: Weak economies can decide to peg their
currency against a stronger currency. This tool is usually used in cases of
runaway inflation when other means of control it are not working.
Open market operations: The Government can create money
out of thin air and inject it into the economy by buying government bonds
(e.g. treasuries). This raises the level of government debt, increases the
money supply and devalues the currency causing inflation.