Macro economics not only explains the business cycle and inflation but it also explains
how to control and avoid these episodes of fluctuations. Macro economics helps to
provide insight into government policies. These policies are
Monetary Policy of any country refers to the regulatory policy in which Central Bank
maintains its control over the supply of money to achieve some goods like stability of
employment and price, balanced economic growth and economic development. In other
words, monetary policy is employing the central bank’s control of supply of money to
achieve general economic stability. In a developing country like India, monetary policy
has wider role to play and they are designed to meet certain requirements. There are
some measures of monetary policy like interest rates, Cash ReserveRatio, selling and
buying of bonds etc.
Many a times there is confusion regarding monetary policy and credit policy but they
defer from each other.
• Monetary Policy is restricted to regulation of cost and availability of credit.
• Credit Policy is of a greater significance since it can affect allocation of bank
credit according to the objective of monetary policy.
• Monetary policy controls total volume of money in maintaining stability in
purchasing power of money.
• Credit Policy is the integral part of Monetary Policy.
Objectives of Monetary Policy
The objectives of Monetary Policy should match with that of the economic policy.
Monetary Policy should have all the objectives necessary for the development of
economy. An economy will grow only if there is growth with stability. We will discuss
some objectives of Monetary Policy1. Price stability- price stability does not mean complete rigidity of price it means
constant price over a period of time. A mild dose of inflation or a mild increase in
price will always work as an incentive for economic growth. Economic growth
has no meaning if it is not reaching the common man. Goods and services should
be available at reasonable rate, mild inflation works better for the economic
growth but high rate of inflation is very harmful, as it leads to unequal distribution
of income, discourages investment and saving, brings check on exports and
encourages imports. On the other hand, deflation is equally bad and has serious
effects on the economy. The availability of goods decreases and there is huge
unemployment, though the purchasing power is high there is hardly anything
available to buy. Price stability thus becomes an important objective for economic
growth, it increases the confidence of the people and creates good atmosphere for
the consumers and investors both.
2. Full employment- employment is necessary to bring people above poverty level;
it improves the standard of living. Employment here means that employment
should be available to all those who are willing to work. After the great
depression this objective has gained an very important place in the monetary
3. Economic growth- economic growth is the increase in production of goods and
services, increase in GNP, increase in per capita income etc. To promote
economic growth there is need to increase the investment levels. Central Bank by
regulating its credit policy can control the credit as per the requirement of the
economy. Inflation should be controlled and the deflation should be prevented.
Tools or Instruments of Monetary Policy:
It can be classified into two categories:1. Quantitative Instruments.
2. Qualitative Instruments.
Let us discuss each one in detail.
1. Quantitative Instruments :It is called quantitative, as they regulate the total quantity of money. In this
category the tools are –
Bank Rate or Discount Rate.
Open Market Operation.
Minimum Reserve Requirements
Bank Rate or Discount Rate- It is the oldest method of credit control.
It was used by Bank of England in 1839. Bank Rate refers to the rate
of interest at which the Central Bank rediscounts approved bills of
exchange. It is used as instrument with the assumption that market
rate of interest respond to the change in bank rate. When bank rate is
raised, this is called a dear money policy, where as when bank rate is
reduced this is called as cheap money policy. When bank rate is raised
the market rate of interest will increase and vice versa.
Let us understand this in detail.
Money held by commercial bank is called reserve. If these reserves are
kept idle, then the returns are nil. Commercial bank tries to keep their
reserve as low as possible. In doing so, they run the risk of running
below the Reserve Requirement level. In such cases they sell the
securities in their possessions and deposit the proceeding at Central
Bank or directly sell it to central bank. So whenever commercial
banks are in need, the central bank lends reserves directly to the banks
for a charge known as bank rate or discount rate.
Open Market Operation:It refers to purchase or sale by Central Bank of any securities to
regulate the credit creating capacity of Commercial Bank. Whenever
the Central Bank purchases the securities, it does payment by cheque
to sellers. The seller will deposit it with the Commercial Bank and the
bank reserve increases; this is done when the central bank wants to
increase the money supply in the economy. When the reserves with the
Commercial Bank increases, the loan giving capacity of Commercial
Bank increases on the other hand, Central Bank will sell the securities
and accepts cheque payments by the people who will be depositing the
cheques in Commercial Bank. This leads to decrease in the reserve
with commercial bank as a result the loan giving capacity will
Minimum Reserve Requirement:Every Commercial Bank has to maintain certain amount of reserve with
Central Bank. Central bank has the power to set the reserve requirement
to control the lending capacity of Commercial Banks. By the changing
the reserve requirement it can control the money supply. Reserve
maintained by commercial bank is called Statutory Reserve and the
reserve over and above the Statutory Reserve is called ‘Excess Reserve’.
Excess Reserve = Total Reserve – Statutory Reserve
Statutory Liquidity Requirement (SLR) is the minimum amount of liquid assets
maintained by the banks which is equal to or not less than a specific percentage of
outstanding deposit liabilities.
Cash Reserve Ratio (CRR):Commercial Bank has to keep deposit with central bank. This amount of funds is equal to
specific percentage of its own deposit liabilities. This is Cash Reserve Ratio.
These reserve requirements of central bank work as a very strong weapon and cause
sharp change in lending capacity of commercial bank.
2 Qualitative Instruments :It is also known as selective instrument of credit control. They are called qualitative
tools, as they influence the type and composition of credit.
These instruments are very popular in developing countries like India.
Some important selective credit control measures are
(1) Credit Rationing:Under this, certain conditions are laid by central bank to see proper regulation of
consumer credit. This is to prevent excess expansion of credit.
(2) Direct Action:- This includes charging penalty interest rates, qualitative credit ceiling
etc on Commercial Bank. It has its direction and restrictive measures which all the
concern banks should follow regarding the lending and investment.
(3) Margin Requirement:- Here margin refers to difference between market value and
amount borrowed against the securities. Bank while advancing loan against security do
not lend the full amount but less, this is done keeping in view the difference between the
value of security and the amount of advance to cover any loss. E.g. : Bank will lend
R.700 for a security worth Rs.1000, the margin is Rs.300 or 30%. Higher the margin
lower is the loan one gets. It can be 30% or 50%.
(4) Moral Persuasion:- This is used by many countries. It has great influence over the
loan policy of banks. There is a co-operation between them. Under this the Central Bank
makes an informal request to Commercial Bank to contract loans in the time of inflation
and expand loans in depression. It helps the Central Bank to secure the willingness and
co-operation, but then that depends on the amount of respect and authority the Central
Bank enjoys among the member banks
Expansionary and Contractionary Monetary Policy
A monetary policy which is expansionary in nature, leads to shift in the demand curve
upwards. As in expansionary monetary policy leads to increase in consumption and
investment which leads to increase in the aggregate demand which leads to increase in
general price level.
A contrationary Monetary Policy in nature will shift the demand downwards as it leads to
decrease in consumption and investment which leads to decrease in aggregate demand.
Lags in Monetary Policy:There is always a loss of time between the need of an action and actual occurrence of it.
This is a lag. To understand this better we take e.g. suppose the economy is in
equilibrium at a time say E1 due to some disturbance at time say E2 and the need for a
corrective measure is required. This disequilibrium is not noticed immediately .By the
time this disequilibrium is noticed and action is taken, it is time E3.By the time, the
action takes shape and the economy starts functioning accordingly the time E4 has
This gap between the time E2 and E4 is called the lag in monetary policy
We will discuss the lag in monetary policy
1. Inside lag
2. Intermediate lag
3. Outside lag.
1. Inside lag:- There is a time gap between the necessity of action to be initiated and
action actually taken. This is called an inside lag. There are two lags in this - Recognition
lag and administration lag
• Recognition lag- lags between requirement of an action and actual
• Administration lag- The central bank takes sometime to implement the
required monetary policy from the time it recognizes the problems.
2. Intermediate lag:- Some time is required for the economy to respond to the action
taken by the instrument of monetary policy. This is intermediate lag.
3. Outside lag:- The time gap between the respond output and employment and the
changes implemented in monetary policy is outside lag. There are two lags in outside
• Decision lag- it is time gap between the interest rate change and change in
• Production lag- when the monetary policy of the public and monetary policy of
business sector changes, a time gap is always involved in aggregate output level
to respond to the change, this is production lag.
Fiscal policy is a policy, which affects aggregate output, employment, saving, investment
etc. A responsible government would contain its expenditure within its revenue and thus
making the budget balanced. The importance of fiscal policy as an economic tool was
realized only after Great Depression in 1930s. During 1930, the private sector was not
able to start recovery because the incentive to invest was not enough and that is when the
government interference established. It is believed that fiscal policy is an effective
method to alter aggregate demand and give way to economic stabilization.
Objectives of Fiscal Policy
The objective of fiscal policy is to increase the rate of investment, reduce unemployment
and controlling inflationary pressure. Some of the objectives are1. Full employment- the importance of fiscal policy as a economic tool was
understood only after the great depression in 1930s, when there was
chronic unemployment situation and their was need to stimulate
employment. Increase in government expenditure will push the aggregate
demand through multiplier effect. This increases the income and
2. Economic stability- economic stability is required for a steady growth in
national income, employment and investment. If there is a condition of
depression then the fiscal policy should be designed in such a way that the
government expenditure will be increased and the taxes will be reduced to
increase the aggregate demand, employment and investment. If the
economy is faced by inflation, the fiscal policy will help to bring stability
in the economy.
Instruments of Fiscal Policy
Economic Stabilization – Automatic stabilizers and Discretionary fiscal policy
Automatic stabilizers: - the tax structure and expenditure are programmed in such a way
that increase in expenditure and decrease in tax in recession and decrease in expenditure
and increase in tax revenue in the period of inflation. It refers to built in response to the
economic condition without any deliberate action on the part of government. It is called
built- in- stabilizer to correct and thus restore economic stability.
It works in the following manner.
Tax revenue:- Tax revenue increases when the income increases, as those who
were not paying tax go into the higher income tax bracket. Tax revenue to the
government will increase when the national income increases. When there is
depression the income decreases and many people fall in the no income tax
bracket and the tax revenue decreases.
welfare payment and unemployment compensation –
During recession many people become unemployed, so the compensation paid by
the government to unemployed automatically increase ,as there is need to increase
aggregate demand employment also increase But during the period of boom
when the business activity is in great momentum the unemployment is low, the
expenditure on this is curbed.
Discretionary Fiscal Policy:Under this, to stabilize the economy deliberate attempts are made by the
government in taxation and expenditure. It entails definite and conscious actions.
Instruments of Fiscal Policy:Some important instruments of fiscal policy are:3. Taxation:- Taxation is always a very important source of revenue for both
developed and developing countries. Tax comes under two heading –Tax
on individual (direct tax) and tax on commodity (indirect tax or
commodity tax).Direct tax includes income tax, corporate tax, taxes on
property and wealth. Indirect tax is tax on the consumptions. It includes
sales tax, excise duty and custom duties.
Direct tax structure can be divided into three bases1. Progressive tax
2. Regressive tax
3. Proportional tax
1. Progressive tax:- Progressive tax says that higher the level of income
greater the volume of tax burden you have to bear. This means as
income increases, the tax contribution should also increase. Low
income group people pay low tax where as the high income group
people pay higher tax.
2. Regressive tax:- It is theoretically possible, though no government
implements such tax structure because that leads to unequal
distribution of income. As your income increases the contribution
through tax decrease. Low income people will pay more and high
income people will pay less.
3. Proportional tax:- When the tax imposed is irrespective of the income
you earn, every income group, high or low pay the same amount of
Indirect tax or consumption tax:Indirect tax differs from direct tax. Tax which is imposed on every unit of
product is known as lump sum tax. E.g. excise tax and sales tax. Taxes
depending on the value of particular product are called ‘ad valorem tax’
e.g. tax on airline tickets.
Value Added Tax (VAT) it was originally introduced by West European
countries but it was introduced in India with few modifications to suit
Indian economic system and called MODVAT. VAT is tax on value added
at each stage of production.
A good tax structure is to control and bring stability in economic system.
There are few requirement of a good tax structure. They are –
The revenue earned through tax structure should be adequate.
The distribution of tax burden should be equal.
The excess burden or Dead Weight Loss should not exceed the amount of revenue
It should help in stabilization and economic growth.
Administration cost should not be more than revenue earned.
Tax burden should be borne by the person who is taxed.
Lion share of government expenditure should come from tax
2. Public Expenditure:The unemployment condition after 1930s Great Depression saw the need of
government to create employment by various public work programmes that
gained importance. Private sector is not always willing to use their resources
in works like railway track, construction of dams, roads etc. Projects which
need heavy investment and returns are low with a long gestation period. The
responsibility of building up such infrastructure for economy and large capital
goods industries has to be taken. Government has many more expenditure
such as free health services, education, monetary assistance for unemployed
youths, pension for senior citizens etc. Lots of expenditures on the defence
activity which is the most important for the security of a nation and subsides
on the essential commodities can not be ignored.
Lags in Fiscal Policy:Fiscal Policy also has lags both inside and outside lag. Inside lag of fiscal policy is longer
than monetary policy but has shorter outside lag. Any significant changes in tax or
expenditure structure needs an approval of the Parliament, this may be a long process.
Outside lag is shorter, as it acts directly on aggregate demand. A fiscal policy due to lags
may destabilize the economy instead of stabilizing it E.g. when the economy is working
below full employment level and there is need to bring up employment, the fiscal policy
is implemented with delay due to the lags, the economy may have already reached full
employment level by itself and when the fiscal policy really starts working it will lead to
Problems in Fiscal Policy
1. Tax laws have many loopholes, deduction, special sessions etc. This makes many
progressive taxes a proportional tax. Fixed income group people end up paying
tax and rich businessmen resort to some loopholes in tax laws and pay a very
small part of their income as tax. Evaluating the income of farmer and other self
employed people is difficult. Tax on agricultural sector is very light and so the tax
burden of taxation is taken by other sector. Ownership of wealth is a serious
problem there are many benami holding, the most severe criticism is corruption
and inefficiency in administration. The result is loss of revenue for government.
Deficit Financing:It was introduced in 1930s it was done to stimulate the private investment as there was
chronic deficiency of demand, under utilization of factors of production and mass
unemployment. Deficit financing for developed country happens when there is excess
expenditure over current revenue receipts and this gap is covered through loans. But for
developing countries like India, Deficit financing is printing more currency and putting
2. Dangers of Deficit Financing:Deficit Financing plays an important role in depression as there is a desperate need to
increase the aggregate demand. Though, deficit financing will pump fresh purchasing
power, but in developing countries the production capacity is not excess so when the
money is pumped in economy that lead to increase in demand quickly but the increase in
supply is not as fast. In times like this extra purchasing power is used in available
consumer goods. This leads to increase in price and may leads to serious inflation
situation. So, reckless deficit financing may lead to serious problems to poor and fixed
income group people.
Fiscal and Monetary policies are ‘indirect’ or ‘general controls’, they affect the
overall aggregate demand of the economy. They affect particular choice of consumer and
producers. Such controls are in the form of licensing, price control, rationing, import
duties, quotas etc. They are executed and designed to overcome specific shortage and
surplus in the economy. A physical policy is to ensure proper allocation of scare
resources like food, raw material, consumer goods and capital equipment etc.
Instruments of Physical Policy
1. Control over consumption and distribution – Consumption can be controlled and
regulated in two ways.
a. By regulating the production of consumer goods directly through a control over
allocation of raw material and by fixing quotas.
b. By controlling the physical demand for goods through price control and rationing.
Price control is less drastic and more comprehensive than rationing and therefore more
useful. The prices of essential goods are fixed at a low level. At the level of such
controlled prices, there always exist excess demand and therefore unless there is
rationing, price controls may lead to queues black marketing hoarding etc. Thus, unless
an efficient network of public distribution, the purpose of price control may get defeated.
Price control may be administered for not only goods in the commodity market, but also
services in the factor market. Profit control, interest control, rent control and wage control
are all examples of factor price control. Commodity and factor price are inter related.
2. Control over investment and production – From the stand point of allocation and
utilization of scarce resources, such control are very essential. The usual methods of
control in this context are fixation of quotas, issue of licenses, strict demarcation of the
areas of small scale, foreign investment etc. In fact, production, distribution and
consumption should be controlled simultaneously. Control over investment must be
combined with price control and regulation of monopolies and restrictive trade practices.
3. Foreign trade controls – The difference between domestic consumption and domestic
production is bridged by foreign trade.
a. Import control – Such controls mostly take the form of prohibition of import of certain
non essential items and liberalization of import of certain essential raw materials and
goods. Import controls are executed through a system of quotas and licenses.
b. Export controls – Export controls depends upon internal support position, domestic
consumption requirement, international market requirements etc. The objectives of such
- Earning foreign exchange
- Conserving the stock of raw material and final products for internal
-Enforcing standard of quality and grading.
For the purpose of export control, there are various measures like export incentive
schemes, export duties etc.