Unit – 8 : Monetary Policy and Fiscal Policy
1) Monetary Policy is the process by which the Government, Central Bank controls
i. The money supply ii. Availability of money and iii. Cost of money or rate of interest
In order to attain a set of objective oriented towards the growth and stability of the economy.
2) Monetary policy is referred to as either being expansionary policy or a contractionary policy.
3) An expansionary policy increases the total supply of money in the economy. This is used to combat unemployment in a recession by lowering interest rates.
4) A contractionary policy decreases the total money supply. This is used to combat inflation by raising the interest rates.
5) Tools of Monetary policy:
i. Bank Rate ii. Cash Reserve Ratio iii. Statutory Liquidity Ratio
iv. Market Stabilization Scheme v. Repo Rate vi. Reverse Repo Rate
vii. Open Market Operations
6) Bank Rate: It is also referred as Discount rate, is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries.
7) Changes in the Bank Rate are often used by Central bank to control the money supply.
8) The structure of interest rates is administered by RBI.
9) Cash Reserve Ratio (CRR): The present banking system is called a “Fractional Reserve Banking System, as the banks are required to keep only a fraction of their deposit liabilities in the form of liquid cash with the central bank for ensuring Safety and liquidity of deposits.
10) CRR was introduced in 1950 primarily as a measure to ensure safety and liquidity of bank deposits.
11) Statutory Liquidity Ration (SLR): SLR refers to the amount that all banks requires maintaining in cash or in the form of Gold or approved securities.
12) Approved securities mean dated securities, government bonds, and share of different companies.
13) The SLR is determined as % of Total Demand and Time Liabilities
14) Demand Liabilities
Demand Liabilities' include all liabilities which are payable on demand and they include current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/guarantees, balances in overdue fixed deposits, cash certificates and cumulative/recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as security for advances which are payable on demand. Money at Call and Short Notice from outside the Banking System should be shown against liability to others.
15) Time Liabilities.
Time Liabilities are those which are payable otherwise than on demand and they include fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings bank deposits, staff security deposits, margin held against letters of credit if not payable on demand, deposits held as securities for advances which are not payable on demand and Gold Deposits.
16) Market Stabilization Scheme:
RBI introduced Market Stabilization Scheme after consulting GOI for mopping up liquidity of a more enduring nature. Under this scheme, the GOI issue existing instrument, such as Treasury Bills/ and or dated securities by way of auctions under the MSS, in addition to the normal borrowing requirements, for absorbing liquidity form the system.
17) Repo Rate :
Repo (Repurchase) rate is the rate at which RBI lends short-term money to the banks. Bank lending rates are determined by the movement of Repo Rate.
18) Reverse Repo Rate :
Reverse Repo Rate is the rate at which banks park their short term excess liquidity with the RBI. The RBI uses this tool when it feels there is too much money floating in the Banking System.
19) An Increase in Reverse Repo means that the RBI will borrow money from the Banks at a higher rate of interest, so banks would prefer to keep their money with the RBI.
20) Open Market Operations :
Under this, RBI buys or sells government bonds in the secondary market.
21) By absorbing bonds, it drives up bond yields and injects money into the market. When it sells the bonds, it done so to such the money out of the system.
22) RBI’s monetary policy ‘s objectives:
- Monitor the global and domestic economic conditions and respond swiftly as required.
- Ensure higher bank credit expansion to achieve higher growth but at the same time protect the credit quality
- Maintain price stability and financial stability
- Give thrust on Interest Rate Management, Inflation Management and Liquidity Management.
23) Fiscal Policy :
Fiscal Policy is the use of government spending and revenue collection the economy.
Fiscal Policy refers to the overall effect of the budget outcome on economic activity.
24) FRMB Act : Fiscal Responsibility and Budget Management Act – 2003
25) Dr E A S Sharma Committee January, 2000 recommended draft legislation on fiscal responsibility.
26) FRBM requirements are
- The Government to place before Parliament 3 statement each year along with Budgets, Covering Medium Term Fiscal Policy, Fiscal Policy Strategy and Macroeconomic Framework
- Center to reduce the fiscal deficit (Generally 3% of GDP) and more categorically to “Eliminate revenue deficit’ by 31-03-2008. Government to set a ceiling on guarantee (0.5% o GDP)
- Act prohibits the Center form borrowing from the RBI, i.e. it bans ‘Deficit financing’ through money creation. The RBI is also barred from subscribing to primary issues of Central Government Securities.
- The Finance Minister is required to keep Parliament informed through quarterly review on the implementation, and to take corrective measure.
- The main theme of the FRBM Act is to reduce the dependence of the Government on borrowings and help to reduce the fiscal deficit in a phased manner.