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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
CHAPTER-1
INTRODUCTION
A free mar...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
These issues cannot be settled by...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
A) MEANING OF MONETARY POLICY
Hav...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
B) MEANING OF FISCAL POLICY
Fisca...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
HISTORY OF FISCAL POLICY
Fiscal p...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
intermediaries under the supervis...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
HISTORY OF MONETARY POLICY
Moneta...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
revolution in economics, which de...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
In fact, many economists disagree...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
exchange (to counteract apprecia...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
OBJECTIVES OF MONETARY POLICY:
T...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
has two aspects i.e. the 'BOP Su...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
OBJECTIVES OF FISCAL POLICY
Obje...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
society. The direct taxes such a...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
8. Capital Formation:The objecti...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
CHAPTER-2
REVIEW OF LITERATURE M...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
The primary tool of monetary pol...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
REVIEW OF LITERATURE ON COUNTERC...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
responsiveness of discretionary ...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
LIMITATIONS OF MONETARY POLICY:
...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
5. Money Not Appearing in an Eco...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
LIMITATIONS OF FISCAL POLICY:
1....
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
9. Inflation: - As a result of i...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
ROLE OF MONETARY POLICY IN ECONO...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
Monetary authority should also e...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
ROLE OF FISCAL POLICY IN ECONOMI...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
Commission, Govt of India, obser...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
TYPES OF MONETORY POLICY
In prac...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
Changes to the interest rate tar...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
While most monetary policy focus...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
increasing their money supply. T...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
TYPES OF FISCAL POLICY
Fiscal po...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
During periods of economic growt...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
CHAPTER-3
SUMMARY AND CONCLUSION...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
consumption and pricing behaviou...
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A STUDY ON SO-CIO ECONOMIC ROLE OF
MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I
REFRENCES:
BIBLIOGRAPHY
EPW (Eco...
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Eco project

  1. 1. 1 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I CHAPTER-1 INTRODUCTION A free market economy was once believed to be capable of functioning without interference by government; however, it does not automatically establish optimum demand for goods and services. During the 1920's the quantity theory of money became widely accepted, and the Federal Reserve was believed to be capable of preventing future "booms" and "busts." The great depression shattered those hopes, resulting in increased emphasis on fiscal policy. In 1946 Congress passed the Full Employment Act, which in effect made the government responsible for maintaining high levels of employment without inflation. The essential idea is that the government, through monetary-fiscal policies, should augment or offset private demand in such a way as to maintain high levels of employment and stable prices. Recently emphasis has been given to two additional objectives, promoting economic growth and protecting the balance of payments. Presently economists generally agree that monetary-fiscal policies should and can be used to prevent extreme economic fluctuations. Almost all economists agree that monetary policy should be "tighter" in a period of full employment and inflation than during a period of under-utilization of economic resources. They also agree that government revenues relative to receipts should be higher during inflation periods and lower during recessions. Unfortunately this still leaves much room for disagreement on which of these tools represents the more potent force, on how tight or how easy money should be in particular circumstances, and on the most desirable size of the budget deficit or surplus. Also, opinion differs considerably about length of lags, for both monetary and fiscal policy, between: (1) recognition of a need for action, (2) taking of action, and (3) eventual impact upon the economy.
  2. 2. 2 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I These issues cannot be settled by logical analysis alone. Empirical evidence must be brought to bear upon these areas of conflict. In this discussion I will present the basic theory underlying the fiscal policy approach and the monetary policy approach, cite what I consider to be the relevant evidence and then apply my conclusions to the current debate concerning the desirability of a tax cut as well as the dispute concerning use of monetary policy for reducing a Balance of payments deficit.
  3. 3. 3 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I A) MEANING OF MONETARY POLICY Having discussed the concept of economic development, now let us define the monetary policy and describe its objectives. In General, monetary policy means the policy of credit control and the deliberate management of money supply. As there are different versions on meaning of economic development, here on monetary policy also various definitions drawn by different economists. Paul Eizing defines monetary policy as‖ The attitude of the political authority towards the monetary system of the community under its control‖.KP Kent has defined ― The Management of the expansion and contraction of the volume of money in circulation for the explicit purpose of attaining a specific objective, such as full employment‖ CK Johri states ― Monetary policy comprises those decisions of Government and the Reserve Bank of India which affect the volume and composition of money supply, the size and distribution of credit the level and structure of interest rates and the effects of these variables upon the factors determining output and prices‖ GK Shaw ‗ By Monetary policy we means any conscious action undertaken by the monetary authorities to change the quantity availability or cost of money‖ We have various definitions, some of them are narrow and some are broad definitions of monetary policy. CK Johri and GK Shaw gave broad definitions. In recent years, the use of monetary policy in its broad sense is getting popular, as it is more useful and practical
  4. 4. 4 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I B) MEANING OF FISCAL POLICY Fiscal Policy is one more important component of overall economic policy. Monetary policy deals with the changes in demand for and supply of money where as fiscal policy is concerned with non-monetary instruments. Fiscal policy, by employing its instruments secures the economic stabilization in developed economies and economic growth in underdeveloped countries. Its instruments broadly consist of (i) taxes (ii) Public Borrowing (iii) Public Expenditure. The importance of fiscal policy as an instrument of economic development was first envisaged by Keynes in his General Theory wherein he showed that the total national income was an index of economic activity and brought out the relation between economic activity and total spending. The direct and indirect effects of fiscal policy on aggregate spending in the community were clearly established and as a result the budgetary policy of the government as a weapon of economic control and development came into prominence. But the Keynesian analysis of fiscal policy is, applicable to the advanced and industrialized countries and it has little relevance to underdeveloped countries. Let now look at definitions given by different economists. According to Arthur Smithies, fiscal policy means ― a policy under which the government uses its expenditure and revenue programs to produce desirable effects and to avoid undesirable effects on the national income, production and employment‖ GK Shaw has defined fiscal policy in these words, ―We define fiscal policy to encompass any decision to change the level, composition or timing of government expenditure or to vary the burden, structure or frequency of the tax payment‖. A skilful management of fiscal policy instruments can go long way in maintaining economic stability and ensuring higher rates of economic growth.
  5. 5. 5 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I HISTORY OF FISCAL POLICY Fiscal policy initiated from the theory propounded by John Maynard Keynes, a British economist popularly known as Keynesian economist. He states that government can influence macroeconomic productivity levels by increasing or decreasing tax level and public spending. The first monetary circular in Nigeria was issued in 1969 while a new comprehensive banking decree was promulgated these a me year, to serve as guideline for establishing and conducting banking business in Nigeria. Later, financial system was comprehensively reviewed in 1979. The review called for an increase in banking supervision and regulation to encourage specialization of financial institutions; a comprehensive compound of training and manpowered development in the banking system, and as part of the effort to improve the monetary management function of CBN, all financial institutions were required to make return on financial statistics to the CBN. The implementation of various recommendations took immediate effect. However, following the collapse of the International Oil Marketing the mild 1981, the Nigerian economy, which was mainly oil dependent, began to nosedive with negative consequences for the fiscal and monetary system. Apart from the worsening economic condition in the 1980s, there was political in stability in addition to weak socio-cultural relations. By the end of 1985, it became an imperative evident that the economy had to beer structure din order to overcome monumental problems such as those posed by slow economic growth, unemployment, the debt burden and fundamental imbalance in the structure of production and consumption. In response to this difficult circumstance, the Nigerian government undertook a structural adjustment programmed (SAP) with respect to the economy. The financial system for instance, was first to experience radical structural changes following the adoption of the SAP in June 1986. It was aimed at restructuring the production base of the economy and promoting non-inflationary economic growth. The federal ministry of finance advice the federal government on its fiscal operation in collaborates with the central bank of Nigeria on monetary matters. In 1991, the banks and other financial institution act (BOFID) formally was promulgated to replace the CBN act of 1958 and the banking degree of 1969(including later amendments). The policy brought the non-banking financial
  6. 6. 6 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I intermediaries under the supervision of CBN on the debate that such institutions are capable of influencing the monetary policy set and if not properly monitored can altered the financial sector. Since then, the Nigeria banking system has evolved rapidly in a healthy, competitive and regulative prospect till date.
  7. 7. 7 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I HISTORY OF MONETARY POLICY Monetary policy is associated with interest rates and availabilility of credit. Instruments of monetary policy have included short-term interest rates and bank reserves through the monetary base. For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seignior age, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price. Paper money called "jiaozi" originated from promissory notes in 7th century China. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The successive Yuan Dynasty was the first government to use paper currency as the predominant circulating medium. In the later course of the dynasty, facing massive shortages of specie to fund war and their rule in China, they began printing paper money without restrictions, resulting in hyperinflation. With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established. The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates. During the 1870–1920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913. By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal
  8. 8. 8 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I revolution in economics, which demonstrated how people would change a decision based on a change in the economic trade-offs. Monetarist economists long contended that the money-supply growth could affect the macro economy. These included Milton Friedman who early in his career advocated that government budget deficits during recessions be financed in equal amount by money creation to help to stimulate aggregate demand for output. Later he advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth. However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables. Even Milton Friedman acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times on June 7, 2003. 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. A small but vocal group of people, primarily libertarians and Constitutionalists advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail. Others[who?] see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society (including all governments) to be perpetually in debt.
  9. 9. 9 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I In fact, many economists disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in monetary policy. The sometimes complex financial transactions that make big business (especially international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different people/companies that specialize in monitoring and using risk can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved. Some have claimed that these arguments lost credibility in the global financial crisis of 2008–2009. Trends in central banking The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets. A central bank can only operate a truly independent monetary policy when the exchange rate is floating.[18] If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile. Accordingly, the management of the exchange rate will influence domestic monetary conditions. To maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign
  10. 10. 10 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate. In the 1980s, many economists which argues that central bank monetary policy aggravates the business cycle, creating malinvestment and maladjustments in the economy which then cause downcycle corrections, but most economists fall into either the Keynesian or neoclassical camps on this issue. Developing countries Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation. Recent attempts at liberalizing and reforming financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required to implement monetary policy frameworks by the relevant central banks.
  11. 11. 11 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I OBJECTIVES OF MONETARY POLICY: The objectives of monetary policy have been varying from time to time depending upon the nature of problems facing the countries and the general economic policy pursued by them. The main objectives are: (a) Exchange Stability (b) Price Stability (c) Neutrality of Money (d) Full-Employment (e) Economic Growth (f) Balance of Payments equilibrium. Some times these objectives are mutually incompatible and the monetary authority has to make a choice on the basis of priorities. For instance, the objective of maintaining exchange rate stability may come in conflict with the objective of maintaining internal price stability; Let us now see objectives of monetary policy in detail :- 1. Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth. Faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability. 2. Price Stability: All the economics suffer from inflation and deflation. It can also be called as Price Instability. Both inflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities. When the economy suffers from recession the monetary policy should be an 'easy money policy' but when there is inflationary situation there should be a 'dear money policy'. 3. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain the exchange rate stability. 4. Balance of Payments (BOP) Equilibrium: Many developing countries like India suffers from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. The BOP
  12. 12. 12 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I has two aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved. 5. Full Employment: The concept of full employment was much discussed after Keynes's publication of the "General Theory" in 1936. It refers to absence of involuntary unemployment. In simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs. However it does not mean that there is a Zero unemployment. In that senses the full employment is never full. Monetary policy can be used for achieving full employment. If the monetary policy is expansionary then credit supply can be encouraged. It could help in creating more jobs in different sector of the economy. 6. Neutrality of Money: Economist such as Wicksted, Robertson has always considered money as a passive factor. According to them, money should play only a role of medium of exchange and not more than that. Therefore, the monetary policy should regulate the supply of money. The change in money supply creates monetary disequilibrium. Thus monetary policy has to regulate the supply of money and neutralize the effect of money expansion. However this objective of a monetary policy is always criticized on the ground that if money supply is kept constant then it would be difficult to attain price stability. 7. Equal Income Distribution: Many economists used to justify the role of the fiscal policy is maintaining economic equality. However in resent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality. monetary policy can make special provisions for the neglect supply such as agriculture, small-scale industries, village industries, etc. and provide them with cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can help in reducing economic inequalities among different sections of society.
  13. 13. 13 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I OBJECTIVES OF FISCAL POLICY Objectives of fiscal policy are as follows (i) Securing the most efficient and rational allocation of economic resources (ii) Accelerating the rate of capital formation (iii) Controlling inflation (iv) Securing equitable distribution of income and wealth (v)Attaining and maintaining full employment. 1. Development by effective Mobilisation of Resources The principal objective of fiscal policy is to ensure rapid economic growth and development. This objective of economic growth and development can be achieved by Mobilisation of Financial Resources. The central and the state governments in India have used fiscal policy to mobilise resources. The financial resources can be mobilized by :- 1. Taxation : Through effective fiscal policies, the government aims to mobilise resources by way of direct taxes as well as indirect taxes because most important source of resource mobilisation in India is taxation. 2. Public Savings : The resources can be mobilised through public savings by reducing government expenditure and increasing surpluses of public sector enterprises. 3. Private Savings : Through effective fiscal measures such as tax benefits, the government can raise resources from private sector and households. Resources can be mobilised through government borrowings by ways of treasury bills, issue of government bonds, etc., loans from domestic and foreign parties and by deficit financing. 2. Efficient allocation of Financial Resources: The central and state governments have tried to make efficient allocation of financial resources. These resources are allocated for Development Activities which includes expenditure on railways, infrastructure, etc. While Non-development Activities includes expenditure on defence, interest payments, subsidies, etc. 3. Reduction in inequalities of Income and Wealth: Fiscal policy aims at achieving equity or social justice by reducing income inequalities among different sections of the
  14. 14. 14 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I society. The direct taxes such as income tax are charged more on the rich people as compared to lower income groups. Indirect taxes are also more in the case of semi-luxury and luxury items, which are mostly consumed by the upper middle class and the upper class. The government invests a significant proportion of its tax revenue in the implementation of Poverty Alleviation Programmes to improve the conditions of poor people in society. 4. Price Stability and Control of Inflation:One of the main objective of fiscal policy is to control inflation and stabilize price. Therefore, the government always aims to control the inflation by Reducing fiscal deficits, introducing tax savings schemes, Productive use of financial resources, etc. 5. Employment Generation:The government is making every possible effort to increase employment in the country through effective fiscal measure. Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generates more employment. Various rural employment programmes have been undertaken by the Government of India to solve problems in rural areas. Similarly, self employment scheme is taken to provide employment to technically qualified persons in the urban areas. 6. Balanced Regional Development: Another main objective of the fiscal policy is to bring about a balanced regional development. There are various incentives from the government for setting up projects in backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax holidays, Finance at concessional interest rates, etc. 7. Reducing the Deficit in the Balance of Payment: Fiscal policy attempts to encourage more exports by way of fiscal measures like Exemption of income tax on export earnings, Exemption of central excise duties and customs, Exemption of sales tax and octroi, etc. The foreign exchange is also conserved by Providing fiscal benefits to import substitute industries, Imposing customs duties on imports, etc. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem. In this way adverse balance of payment can be corrected either by imposing duties on imports or by giving subsidies to export.
  15. 15. 15 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I 8. Capital Formation:The objective of fiscal policy in India is also to increase the rate of capital formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped in vicious (danger) circle of poverty mainly on account of capital deficiency. In order to increase the rate of capital formation, the fiscal policy must be efficiently designed to encourage savings and discourage and reduce spending. 9. Increasing National Income: The fiscal policy aims to increase the national income of a country. This is because fiscal policy facilitates the capital formation. This results in economic growth, which in turn increases the GDP, per capita income and national income of the country. 10. Development of Infrastructure: Government has placed emphasis on the infrastructure development for the purpose of achieving economic growth. The fiscal policy measure such as taxation generates revenue to the government. A part of the government's revenue is invested in the infrastructure development. Due to this, all sectors of the economy get a boost.
  16. 16. 16 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I CHAPTER-2 REVIEW OF LITERATURE MONETARY POLICY Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Breton Woods system still ensured that most nations would form the two policies separately. Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central Bank, the People's Bank of China, and the Bank of Japan) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system.
  17. 17. 17 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation. Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies. 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 mouth operations" (talking monetary policy with the market). Theory 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 to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals).
  18. 18. 18 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I REVIEW OF LITERATURE ON COUNTERCYCLICAL FISCAL POLICY There are a number of studies that have examined budgetary policies of the Government in the context of their responsiveness to cyclical fluctuations in the economy. Even though, as is widely believed, there is greater importance of such fiscal stance in developing countries, the stabilizing policies carried out by Western countries have also received considerable attention. The present review of literature is essential in the context of the FRBM Act, which has been enacted not only by many of the states but also the Central Government of India. The issue of FRBM becomes vital since it is very much essential for the Government to fiscally intervene during the time of economic downturns, whereas the enactment of the Act itself binds the Government not to increase its expenditure in a productive manner during such times. There lies the contradiction, which leads one to go for a review of literature. Anybody who has studied Economics can always agree that there exists business cycle in a capitalist economy, and so there exist upturns and downturns. FRBM Act is always good when a capitalist economy is undergoing through rapid economic progress, so that productive Government expenditure do not crowd out private investment. However, some economists may claim that fiscal intervention may not be necessary during bad times because of the existence of ―automatic stabilizers‖. Hence, the enactment of FRBM Act is justified. But there is also the requirement for doing a study, which is empirical in nature so that one knows whether economic intervention by the Government is needed or not during Auerbach (2002) finds that in the recent years, US discretionary fiscal policy appears to have become more active in response to both cyclical conditions and a simple measure of budget balance. Budgetary pressure may weaken the efficacy of expansionary fiscal policy, Auerbach (2002) argues. Fiscal policy, which is contractionary in nature, might have a positive impact on output. The paper by Auerbach (2002) says that automatic stabilizers embedded in the fiscal system have little net change since the 1960s and have contributed to cushioning cyclical fluctuations. The tax revenues itself is very much sensitive to the economic cycle. Auerbach (2002) finds that employment surplus has fallen in response to a rise in the Gross Domestic Product (GDP) gap, consistent with the use of discretionary countercyclical fiscal policy. Auerbach‘s (2002) result suggests a recent increase in the
  19. 19. 19 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I responsiveness of discretionary spending to the budget surplus, with this relationship being statistically significant since 1993. Fiscal policy has been responsive both to cyclical factors and conditions of fiscal balance during recent decades. One method of measuring, according to Auerbach‘s (2002), the strength of automatic stabilizers is related to the gap between the full-employment surplus, and the unadjusted surplus to the contemporaneous gap between GDP and full employment GDP. Auerbach‘s (2002) paper show that discretionary fiscal policy‘s overall impact was minimal compared to that of monetary policy. Automatic stabilizers are directly tied to output fluctuation. The role of current and tax provisions and expectations has been described by Auerbach (2002) using the standard Hall-Jorgenson user cost of capital, which provides a measure of the required gross, before-tax return to measure of the incentive to use capital in production. Auerbach (2002) has used the data from CBO forecast revisions, which are available since summer, 1984, as the pattern of semiannual forecast begins with the winter, 1984 Budget Outlook. For each observation, Auerbach (2002) measures the policy changes with respect to revenues, expenditures, or their difference—the surplus—as the discounted sum of policy changes adopted during the interval for the current and subsequent five fiscal years (relative to each year‘s corresponding measure of potential GDP), with the six weights normalized to sum to 1. Auerbach (2002) has also done calculation on the basis of NBER TAXSIM model using a ‗tax calculator‘ in order to estimate the impact on tax liability of changes in tax-return components of income and deductions. capital and hence a Buti‘s (2001) study find that it takes time, as well, to pass the fiscal measures through the national Parliaments and it takes time for the economy to respond. Hence, once decided, the fiscal policy measures can rarely be adjusted to the changing economic circumstances. Moreover, there are always political constraints: it tends to be much easier for governments to ease fiscal policy than to tighten and once the measure is taken it tends to become irreversible.
  20. 20. 20 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I LIMITATIONS OF MONETARY POLICY: 1. There exist a Non-Monetized Sector In many developing countries, there is an existence of non-monetized economy in large extent. People live in rural areas where many of the transactions are of the barter type and not monetary type. Similarly, due to non-monetized sector the progress of commercial banks is not up to the mark. This creates a major bottleneck in the implementation of the monetary policy. 2. Excess Non-Banking Financial Institutions (NBFI) As the economy launch itself into a higher orbit of economic growth and development, the financial sector comes up with great speed. As a result many Non-Banking Financial Institutions (NBFIs) come up. These NBFIs also provide credit in the economy. However, the NBFIs do not come under the purview of a monetary policy and thus nullify the effect of a monetary policy. 3. Existence of Unorganized Financial Markets The financial markets help in implementing the monetary policy. In many developing countries the financial markets especially the money markets are of an unorganized nature and in backward conditions. In many places people like money lenders, traders, and businessman actively take part in money lending. But unfortunately they do not come under the purview of a monetary policy and creates hurdle in the success of a monetary policy. 4. Higher Liquidity Hinders Monetary Policy In rapidly growing economy the deposit base of many commercial banks is expanded. This creates excess liquidity in the system. Under this circumstances even if the monetary policy increases the CRR or SLR, it dose not deter commercial banks from credit creation. So the existence of excess liquidity due to high deposit base is a hindrance in the way of successful monetary policy.
  21. 21. 21 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I 5. Money Not Appearing in an Economy Large percentage of money never come in the mainstream economy. Rich people, traders, businessmen and other people prefer to spend rather than to deposit money in the bank. This shadow money is used for buying precious metals like gold, silver, ornaments, land and in speculation. This type of lavish spending give rise to inflationary trend in mainstream economy and the monetary policy fails to control it. 6. Time Lag Affects Success of Monetary Policy The success of the monetary policy depends on timely implementation of it. However, in many cases unnecessary delay is found in implementation of the monetary policy. Or many times timely directives are not issued by the central bank, then the impact of the monetary policy is wiped out.
  22. 22. 22 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I LIMITATIONS OF FISCAL POLICY: 1.Lack of Elasticity: - In countries like India tax system is not that elastic as it is supposed to be. Moreover in these economies because of huge tax evasion, it is difficult to earn revenue from taxes. The spread of tax is very few. 2. Non Monetised Sector: - Although each and every activity is now awarded in terms of money, but still a major part of economy of UDC's like India is not monetised. In this part fiscal policy remains unaffected. 3. Inadequate Statistics: - In the countries like India adequate and reliable date is not available. Because of non-availability of reliable and accurate data, the area of fiscal policy remains unaffected. 4. Illiteracy: - Most of the population of India is either illiterate or not in a position to understand economic policies and is implications, that is why they are not able to evaluate the importance of fiscal policy and, therefore, they also try to evade taxes. 5. Limited Sector: - Fiscal policy only affects a few sectors of the economy. Most of the sectors remain untouched e.g. burden of taxes on salaried person whereas big businessmen hardly pay any taxes in spite of high income levels. 6. Delay in decision: - Fiscal policy decision needs approval by the Government. A lot of time required for approvals, that is why decisions are not taken at proper time. 7. Limitations regarding full employment: - As a result of fiscal policy in connection with full employment wage rate increases. Increases in wage rate results into increase in prices instead of increase in production. Employment multiplier decreases and desired increase in employment does not take place. Structural unemployment cannot be tackled by fiscal policy. 8. Defective Tax Structure: - The country been relying more on indirect taxes ultimately affecting poor persons. Contribution to direct taxes has been declining and that of indirect taxes rising.
  23. 23. 23 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I 9. Inflation: - As a result of increase of public expenditure on non-development heads and deficit financing pull inflation has taken place. Also high rate of indirect taxes has resulted in cost push inflation. High rate of direct taxes and increase of black money in the country has given rise to parallel economy and increase in inflation. 10. Huge investment with negative return in public sector: - Huge investments in public sector have become sunk money now because of failure of public sector. Investment of Rs.2,04,054crore was made in public sector enterprises in 1998 and Rs.3,03,400 crore in 2001. Return on this investment has been very low. Also takeover of sick textile mills by government has further increased public expenditure. Huge amount has to be spent to keep such undertakings going thus making the resources of country scarce.
  24. 24. 24 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I ROLE OF MONETARY POLICY IN ECONOMIC DEVELOPMENT: The role of monetary policy in economic development may be discussed under the following lines of approach: Appropriate Adjustment between Demand for and Supply of money Price Stability Credit Control Creation and Expansion of Financial Institutions Suitable Interest Rate Structure Debt Management Monetary policy can play a vital role in the economic development of underdeveloped countries by minimizing fluctuations in prices and general economic activity by achieving an appropriate balance between the demand for money and supply of money. Because, economic development result in increase in more demand for money and it makes imperative for the monetary authority to increase the money supply but either more or less money supply than the requirement result in fluctuations in an economy. Therefore, the gist of the argument is that a proper control upon the supply of money will prevent economic fluctuations and pave the way for rapid development of underdeveloped economies. In the process of economic development, it is unavoidable an increase in prices. Therefore it is imperative for the monetary authority for maintenance of stability in the domestic level of prices and exchange rates. The inflationary trend in price negatively affects the savings and diverts investment into unproductive channels. It is the duty to have a vigil by the monetary authority not only to regulate but also should keep constant heck on the direction of money flow in turn to control price rise. The same inflationary trend will also adversely affect international trade and the foreign exchange earnings which otherwise could help in the development of the country. Thus, monetary policy should adopt such policy, which will check inflation and frequent devaluation of the currency.
  25. 25. 25 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I Monetary authority should also employ quantitative and qualitative credit control tools for the control of inflation, correction of adverse balance of payments and help the process of economic development. Not only that, with these instruments, it can influence and shape the character and pattern of investment and production, in particular selective credit control, unlike quantitative credit control, makes a discrimination between essential and non- essential uses of bank credit and help the funds to flow into desirable and uses without affecting the economy as a whole. This will quicken the pace of economic development. The process of economic development can speed up by establishing more and more financial institutions by developing financial system. These institutions are in less number in underdeveloped economies, therefore, it is difficult to mobilize the savings from the public effectively for economic development and consequently economic growth rate is very low. Monetary authority to extend the sphere of the monetary sector with the expansion of co-operative banking sector to meet the credit needs of ruralites and cut the tentacles of non-magnetized sector in rural areas. There are two subcomponents of monetary policy: cheap and dear money policy. Cheap money policy in other words availability of funds at lower rates of interest to stimulates investment both public and private. Thus, a policy of low interest rates serves as an incentive to investment for economic development. But there is harm if these funds are diverted for hoarding and stockpiling and for other speculative purposes, thus monetary authority should be checked through selective credit controls and thereby directing investment into desirable channels. In contrary to low rates of interest policy, there are economists who suggest a policy of high interest rates to control inflationary conditions. Further they stated that it would stimulate savings and thus increase the supply of investable resources; it would secure the allocation of scarce resources into most productive uses. Therefore, keeping in view the conditions in an economy, countries should be more pragmatic in their approach and must evolve differentiated interest rate policy, which ensure rapid pace of economic development.
  26. 26. 26 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I ROLE OF FISCAL POLICY IN ECONOMIC DEVELOPMENT: K Kurihara regards fiscal policy as a ―desiderate for underdeveloped countries lacking in private initiative, private voluntary saving and private innovation‖. He discusses the fiscal policy of government as an additional saver, an investor and an income redistributors. He observes as par as underdeveloped economy is concerned, budgetary surplus is the relevant position to be achieved and maintained. As an additional investor, government can increase the productive capacity of the economy and secure an accelerated rate of economic growth by changing the pattern of investment and laying emphasis on capacity creating rather than on income-generating aspects. As an innovator, the government should spend on research and experimentation and stimulate innovations and new techniques of production. As an income redistributors and for that fiscal measures can go a long way in reducing economic inequalities. In the words of Nurkse, fiscal policy assumes a new significance in he face of the problem of capital formation in underdeveloped countries‖ The fiscal policy should be construed as to secure full employment conditions and economic growth at rapid rate. The integration of the government budgets with the nation‘s economy budgets can go a long way for the attainment of the objectives of rapid economic development and creation of full employment opportunities. We now proceed to discuss the role of fiscal policy instruments role in economic development Taxation: Of the important sources of public revenue taxation is the most important. Through taxation, governments are collecting from 10- 30 percent levels to the national income in developed countries. Shortage of financial resources is the main obstacle in the way of economic development of the underdeveloped countries. There are certain forces operating in these countries, which increase consumption and reduce savings. The first among them is the population pressure. Besides, the high incomes groups spend much of their incomes on conspicuous consumption and their propensity to consume is further reinforced by the ‗demonstration effect‘ Still worse, a large part of the meager savings is dissipated in unproductive channels like real estate, hoarding, gold, jewellery, speculation, etc the taxation measures can be employed effectively to divert savings of the people into productive channels. In this connection, Report of the Taxation Enquiry
  27. 27. 27 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I Commission, Govt of India, observes, ―A tax system which on the whole, promotes capital formation in its two aspects of saving and investment fulfills an essential desideratum. Public Borrowing: There is a limit to which taxation can be resorted for resource mobilization. If the taxes are excessive, they will adversely affect people‘s desire and ability to work, save and invest. This will obviously retard the paced of economic development. To avoid such a situation, public borrowing may cover the gap in resources required. It will not adversely affect people‘s desire to work, save and invest as lending is voluntary n the lenders not only get back the amount lent but also earn interest on it. Further, public borrowing may add to the incentives of the people to save and invest moreas he lure of earning more interest on lending is there. Public borrowing has its own limitations. The general masses are poor and their propensity to consume is high and hence they have no lending capacity. The rich generally do not like to lend to the government but instead divert their investive resources into speculative channels as they can earn more from there. Absence of organized money and capital markets are some of the other obstacles in the way of public borrowing program. However, government has to do efforts to compulsory borrowing for economic development. But it may be noted that no democratic government can rely on forced loans except for a short period and for certain specified projects. Ultimately, it is the voluntary lending by the people that matters and the government must be prepared to increase its domestic borrowing when the incomes and savings of the people increase as a result of economic and make public borrowing and important tool of resource mobilization. Public Expenditure: Public expenditure is one of the important weapons in the hands of the state to secure economic development of underdeveloped economies. Initially for economic development, infrastructure facilities have to be provided. For which, government initiation is essential condition. Therefore, government has to spent huge amount on its development to pave the way to private entrepreneur to start key industries and also agro- based industries.
  28. 28. 28 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I TYPES OF MONETORY POLICY In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions. Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals. The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such as a harmonized consumer price index). 1.Inflation targeting Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range. The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.
  29. 29. 29 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University. The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Brazil, Canada, Chile, Colombia, the Czech Republic, Hungary, New Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom. 2.Price level targeting Price level targeting is similar to inflation targeting except that CPI growth in one year over or under the long term price level target is offset in subsequent years such that a targeted price-level is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the current and future years. Uncertainty in price levels can create uncertainty around price and wage setting activity for firms and workers, and undermines any information that can be gained from relative prices, as it is more difficult for firms to determine if a change in the price of a good or service is because of inflation or other factors, such as an increase in the efficiency of factors of production, if inflation is high and volatile. An increase in inflation also leads to a decrease in the demand for money, as it reduces the incentive to hold money and increases transaction costs and shoe leather costs. 3.Monetary aggregates In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman. This approach is also sometimes called monetarism.
  30. 30. 30 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities. 4.Fixed exchange rate This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate. Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.) 5.Gold standard The gold standard is a system under which the price of the national currency is measured in units of gold bars and is kept constant by the government's promise to buy or sell gold at a fixed price in terms of the base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of commodity price level targeting.The minimal gold standard would be a long-term commitment to tighten monetary policy enough to prevent the price of gold from permanently rising above parity. A full gold standard would be a commitment to sell unlimited amounts of gold at parity and maintain a reserve of gold sufficient to redeem the entire monetary base. Today this type of monetary policy is no longer used by any country, although the gold standard was widely used across the world between the mid-19th century through 1971.Its major advantages were simplicity and transparency. The gold standard was abandoned during the Great Depression, as countries sought to reinvigorate their economies by
  31. 31. 31 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I increasing their money supply. The Bretton Woods system, which was a modified gold standard, replaced it in the aftermath of World War II. However, this system too broke down during the Nixon shock of 1971. The gold standard induces deflation, as the economy usually grows faster than the supply of gold. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each unit of money increases in value. Absent precautionary measures, deflation would tend to increase the ratio of the real value of nominal debts to physical assets over time. For example, during deflation, nominal debt and the monthly nominal cost of a fixed- rate home mortgage stays the same, even while the dollar value of the house falls, and the value of the dollars required to pay the mortgage goes up. Mainstream economics considers such deflation to be a major disadvantage of the gold standard. Unsustainable (i.e. excessive) deflation can cause problems during recessions and financial crisis lengthening the amount of time an economy spends in recession. William Jennings Bryan rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standard made it harder for everyday citizens to start new businesses, expand their farms, or build new homes. Policy of various nations Bangladesh - Inflation targeting Australia – Inflation targeting Brazil – Inflation targeting Canada – Inflation targeting Chile – Inflation targeting China – Monetary targeting and targets a currency basket Czech Republic – Inflation targeting Colombia – Inflation targeting Hong Kong – Currency board (fixed to US dollar) India – Multiple indicator approach New Zealand – Inflation targeting Norway – Inflation targeting
  32. 32. 32 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I TYPES OF FISCAL POLICY Fiscal policy is the deliberate adjustment of government spending, borrowing or taxation to help achieve desirable economic objectives. It works by changing the level or composition of aggregate demand (AD). There are two types of fiscal policy, discretionary and automatic. 1. Discretionary policy refers to policies that are implemented through one-off policy changes. 2. Automatic stabilisation, where the economy can be stabilised by processes called fiscal drag and fiscal boost. Central government borrowing Government must borrow if its revenue is insufficient to pay for expenditure - a situation called a fiscal deficit. Borrowing, which can be short term or long term, involves selling government bonds or bills. Bonds are long term securities that pay a fixed rate of return over a long period until maturity, and are bought by financial institutions looking for a safe return. Treasury bills are issued into the money markets to help raise short term cash, and last only 90 days, whereupon they are repaid. Local government borrowing If the revenue from the council tax and central government support is insufficient to meet spending commitments, local authorities can also borrow by issuing bonds. Only around 25% of local authority spending is financed by local revenue raising, 75% coming from central government and by borrowing. (Source: Local Government Association) Public Sector Net Borrowing If the borrowing requirements of both central and local government is combined, the amount of borrowing required is called the public sector net borrowing (PSNB). The need to borrow varies considerably with the business cycle.
  33. 33. 33 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I During periods of economic growth, tax yields rise and spending on welfare payments fall, pushing the public finances towards a surplus. During periods of economic slowdown, tax yields fall and welfare payments rise, pushing the economy towards a fiscal deficit. In 2009, the government introduced a new measure of public sector borrowing, called Public Sector Net Borrowing Ex (PSNBEx). This measure excludes payments to the financial sector to ease the credit crisis. The Chancellor‘s golden rules for borrowing The Chancellor‘s golden rules for sustainable investment are firstly, to balance the books over a trade cycle, and secondly, only to borrow to fund capital projects, such as road building. Borrowing, and the financial crisis According to the Institute for Fiscal Studies (IFS), the central government net borrowing requirement in 2009, of approximately £150b, was almost double initial estimates. The main reason for this overshoot was the rescue package for the banking sector, following the global financial crisis. This package included: 1. £37b for re-capitalisation of the main banks, RBS, Lloyds and HBOS. 2. £21b to the Bank of England to help refinance the financial services sector. Fiscal deficits and the National Debt Fiscal deficits occur when the revenue received by a government is less than spending during a financial year. These deficits will create the need to borrow by selling government securities - bills and bonds.
  34. 34. 34 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I CHAPTER-3 SUMMARY AND CONCLUSION The consensus assignment suggests that monetary policy, if it is unconstrained by zero bound or other concerns, should look after business cycle stabilisation and inflation control, and fiscal policy should focus on the control of government debt or deficits. Compared to a fully optimal monetary-fiscal regime, fiscal policy is restricted to only focus on debt, and monetary policy is restricted not to respond to debt. Research on monetary and fiscal policy interactions has been dominated in the last 5-10 years by the convergence of two, previously distinct literatures: studies of dynamic optimal taxation and New Keynesian analysis. This paper has examined what this new research implies for the consensus assignment. The paper looked at various analyses of monetary and fiscal policy in sticky price economies which imply that the costs of excluding fiscal policy from business cycle stabilisation are very small. Large differences across the models used, particularly in terms of the instruments employed and shocks considered rule out many explanations for this result. Instead, we argue that the basic structure of New Keynesian models implies that monetary policy dominates fiscal policy as a means of controlling inflation. This is the case even when monetary policy cannot eliminate the inflationary consequence of shocks, following cost push shocks for example. As a result, justifications of this aspect of the conventional assignment do not need to appeal to political economy or institutional constraints on fiscal actions. At first sight the new literature also suggests that the costs of preventing monetary policy from reacting to debt are small. However this may be predicated on a particular feature of this literature, which is that under commitment it is optimal to let debt follow a random walk, or adjust debt very gradually. As shocks to debt are largely accommodated in this case, there is very little scope for monetary policy to control debt. However, there are a number of reasons for also looking at cases where debt is required to return to its pre-shock level more aggressively, which would be a feature of the time consistent policy for example. In that situation, and if initial levels of debt are high, it may be that changes in interest rates are an efficient method of controlling debt. Monetary policy can both influence debt and stabilise inflation by exploiting the forward looking nature of
  35. 35. 35 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I consumption and pricing behaviour. In this case, debt stabilisation biases or political economy concerns related to deficit bias may be critical in justifying this half of the consensus assignment.
  36. 36. 36 A STUDY ON SO-CIO ECONOMIC ROLE OF MONETARY AND FISCAL POLICY. M.COM MANAGEMENT PART-I REFRENCES: BIBLIOGRAPHY EPW (Economic & political Weekly). Economics of global trade and finance(Johnson). Michal waz (marvel publication). WIBLOGRAPHY www.wikipedia.com. www.google.com.

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