Monetary and Fiscal Policy

Monetary Policy

Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank" in India it is Reserve bank of India

The Central Bank attempts to achieve economic stability by varying the quantity of money in circulation, the cost and availability of credit, and the composition of a country's national debt. The Central Bank has three instruments available to it in order to implement monetary policy:

1. Open market operations

2. Reserve requirements

3. The 'Discount Window'

Open market operations are just that, the buying or selling of Government bonds by the Central Bank in the open market. If the Central Bank were to buy bonds, the effect would be to expand the money supply and hence lower interest rates, the opposite is true if bonds are sold. This is the most widely used instrument in the day to day control of the money supply due to its ease of use, and the relatively smooth interaction it has with the economy as a whole.

Reserve requirements are a percentage of commercial banks', and other depository institutions', demand deposit liabilities that must be kept on deposit at the Central Bank as a requirement of Banking Regulations. Though seldom used, this percentage may be changed by the Central Bank at any time, thereby affecting the money supply and credit conditions. If the reserve requirement percentage is increased, this would reduce the money supply by requiring a larger percentage of the banks, and depository institutions, demand deposits to be held by the Central Bank, thus taking them out of supply. As a result, an increase in reserve requirements would increase interest rates, as less currency is available to borrowers. This type of action is only performed occasionally as it affects money supply in a major way. Altering reserve requirements is not merely a short-term corrective measure, but a long-term shift in the money supply.

Lastly, the Discount Window is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), there by affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over.

By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates ,and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole.

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Fiscal Policy

Definition of Fiscal Policy:

Fiscal policy is an additional method to determine public revenue and public expenditure. In the recent years importance of fiscal policy has increased due to economic fluctuations. Fiscal policy is an important instrument in the modern time. Fiscal policy is a policy under which government uses its expenditure and revenue programme to produce desirable effects and avoid undesirable effects on the national income, production and employment.

Objectives of fiscal policy:

The objectives of fiscal policy may be regarded as follows;

1. To achieve desirable price level:

The stability of general prices is necessary for economic stability. The maintenance of a desirable price level has good effects on production, employment and national income. Fiscal policy should be used to remove; fluctuations in price level so that ideal level is maintained.

2. To Achieve desirable consumption level:

A desirable consumption level is important for political, social and economic consideration. Consumption can be affected by expenditure and tax policies of the government. Fiscal policy should be used to increase welfare of the economy through consumption level.

3. To Achieve desirable employment level:

The efficient employment level is most important in determining the living standard of the people. It is necessary for political stability and for maximization of production. Fiscal policy should achieve this level.

4. To achieve desirable income distribution:

The distribution of income determines the type of economic activities the amount of savings. In this way, it is related to prices, consumption and employment. Income distribution should be equal