MONETARY AND FISCAL POLICIES

 Introduction

The economy does not always work smoothly. There often occur fluctuations in the level of economic activity. At times the economy finds itself in the grip of recession when levels of national income, output and employment are far below their full potential levels. During recession, there is a lot of idle or unutilized productive capacity, that is, available machines and factories are not working to their full capacity. As a result, unemployment of labour increases along with the existence of excess capital stock.

On the other hand, at times the economy is ‘over heated’ which means inflation (i.e. rising prices) occurs in the economy. Thus, in a free market economy there is a lot of economic instability. The classical economists believed that an automatic mechanism works to restore stability in the economy, recession would cure itself and inflation will be automatically controlled. However, the empirical evidence during the 1930s when severe depression took place in the western capitalist economies and also the evidence of post second world II period amply shows that no such automatic mechanism works to bring about stability in the economy. That is why Keynes argued for intervention by the government to cure depression and inflation by adopting appropriate tools of macro economic policy. 

Macro economic policy refers to the instrument by which a government tries to regulate or modify the economic affairs of the country in keeping with certain objectives. In other words, it “attempts to assess the behaviour of the economy as a whole and to seek ways in which its aggregate performance might be improved”. These are achieved through certain tools of macro economic policy. According to Keynes, Monetary policy was ineffective to lift the economy out of depression. He emphasized the role of fiscal policy as an effective tool of stabilizing the economy. However, in view of the modern economists both fiscal and monetary policies play a useful role in stabilizing the economy.

Monetary and Fiscal policies have powerful effects on the economy. The fact that monetary and fiscal policies have the potential to affect the economy suggests that these policies might be used to improve macro- economic performance. Monetary policy is conducted by the central bank of a country. Fiscal policy is conducted by the Executive and legislative branches of the government and deals with managing a nation’s budget. Monetary and fiscal policies are generally thought of as demand management policies. The purpose of monetary and fiscal policy, taken together is to maintain demand roughly equal to supply in the economy and to maintain the existing price level. The appearance of excess demand will probably cause inflation, while an insufficiency of demand will bring at least temporary unemployment and deflation. 

Monetary policy

According to Harry G. Johnson, “There is probably no field of economics in which the writings of economists are so strongly influenced by both current fashions in opinion and current problems of economic policy as the field of monetary policy.” Monetary policy embraces all the measures that are undertaken by the monetary authorities to bring about desirable changes in the working of the financial system. Monetary policy plays a crucial role in moulding the economic character of a country because money and credit in a modern economy exercise a vital influence upon the course, nature and volume of economic activities. An appropriately conceived monetary policy can significantly aid economic growth by adjusting the money supply to the needs of growth by directing the flow of funds into the desired channels and by making institutional credit available to the specific fields of economic pursuit. Monetary policy can also help in correcting the economic ills of the economy such as inflation or deflation. In short, monetary policy is an important economic tool which can be used to attain many macro economic goals.

 Meaning and Definition

Monetary policy is the process by which the government, central bank or monetary authority manages the supply of money, or trading in foreign exchange markets. Monetary policy is the exercise of the central bank’s control over conditions governing the quantity of money or money supply. It is an instrument for achieving the objective of general economic policy as set out by the national economic goals i.e. economic growth, full employment and price stability by influencing the level of aggregate demand and there by the level of money income. Monetary policy influences the behavior of expenditures, output, employment and prices.

Because monetary policy is concerned with government attempts to provide a more stable economy by regulating the rate of growth of the money supply, no monetary system can work by itself. In modern economy, credit plays an important part. The expansion and contraction of credit through proper Monetary policy is, therefore, required in the best interest of the economy.

Monetary restraint reduces the availability of credit and increases its cost; and retards the flow of expenditures, employment, income and output. Monetary expansion on the other hand has the opposite effects on credit and thus encourages these flows. Monetary policy is usually defined as the central bank’s policy pertaining to the control of the availability, cost and use of money and credit with the help of monetary measures in order to achieve specific goals.

According to Harry G. Johnson, Monetary policy is a “Policy employing the central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy.”

A. G. Hart defines monetary policy as a policy “Which influences the public’s stock of money substitutes or the public’s demand for such assets, or both. That is, policy which influences the public’s liquidity position.”

From both these definitions, it is clear that a monetary policy is related to the availability and cost of money supply in the economy in order to attain certain broad objectives. The central bank of a nation keeps control on the supply of money toattain the objectives of its monetary policy. Monetary policy is only a means to an end and not an end in itself. The aims, objects and scope of monetary policy are conditioned both severally and collectively by the economic environment and philosophy of time. Monetary policy has to be structured and operated within the institutional framework of the money market of the country.

Monetary policy can be explained in two different ways:

In a narrow sense, it is concerned with administering and controlling a country’s money supply including currency notes and coins, credit money, level of interest rates and managing the exchange rates.

In a broader sense, monetary policy deals with all those monetary and non-monetary measures and decisions that affect the total money supply and its circulation in an economy. It also includes several nonmonetary measures like wages and price control, income policy, budgetary operations taken by the government which indirectly influence the monetary situations in an economy.

Objectives of Monetary Policy

Monetary policy, in essence, is the economic policy of the government in the monetary field. Thus, the objective of monetary policy must be regarded as being part of the overall economic objectives to be pursued by the government. Monetary policy should be directed to achieve different objectives, depending on the environment and the time factor.

Monetary policy, being a part of public policy, is obviously designed and directed to achieve different macro economic goals, depending on the basic problems and the nature of economy of the country, from time to time. The primary objective of monetary policy is price stability, which constitutes a pivotal framework condition for economic activity. Price stability ensures that consumers and businesses can make their economic decisions under stable and predictable conditions and thus has a positive impact on economic activity and employment. Monetary policy also has short-term effects on the economy, as key interest rates can be raised in times of economic booms when the economy threatens to overheat and thus endangers price stability. During economic downturns, in contrast, cuts in the key interest rates can help stimulate investment and consumption.

Monetary policy is discernible in developing countries and in India. Much of the early economic theory stressed only on real factors such as savings, investment and technology as main factors of growth.

Objectives of monetary policy have been different in different countries and in different times depending on the nature of problems faced by the monetary authorities of a country. 

1. Neutrality of Money

Economists like Wicksteed, Hayek, Robertson feel that the main objective of the monetary policy is the neutrality of money. The policy of neutral money aims at doing away with the disturbing effects of the changes in the quantity of money on important economic variables like income, output, employment and prices. This policy implies that the quantity of money could be so controlled as to have no negative effect on the prices, output and employment. According to this theory money is to remain neutral, i.e., to cause no fluctuations. Economists have 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.

According to this policy, money is only a technical devise having no other role to play. It should be a passive factor having only one function, namely to facilitate exchange. It should not inject any disturbances. It should be neutral in its effects on prices, income, output, and employment. They considered that changes in total money supply are the root cause for all kinds of economic fluctuations and as such if money supply is stabilized and money becomes neutral, the price level will vary inversely with the productive power of the economy. If productivity increases, cost per unit of output declines and prices fall and vice-versa. According to this policy, money supply is not rigidly fixed. It will change whenever there are changes in productivity, population, improvements in technology etc to neutralize fundamental changes in the economy. Under these conditions, increase or decrease in money supply is allowed to result in either fall or raise in general price level. 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.

In a dynamic economy, this policy cannot be continued and it is highly impracticable in the present day economy.

2. Stability of Exchange Rates

The traditional objective of monetary policy has been the achievement of stable exchange rates. This objective was primary, while stability of prices and output was secondary owing to the paramount importance of international trade in the economies of leading countries like England, Denmark, and Japan etc. For this maintenance and proper conduct of the gold standard was considered to be the primary function of the monetary authorities. This way, minor changes in exchange rates were easily noticed. These led to a lot of speculation and consequent dislocation of economies. This imposed on them period of inflation and deflation. This objective is, now considered to be of only secondary importance, except in case of countries like Japan and England, whose prosperity still depends upon foreign trade.

Maintenance of stable exchange rates is an essential condition for the creation of international confidence and promotion of smooth international trade on the largest scale possible. Instability in exchange rates might lead to undesirable effects such as weakening of the value of currency in the world market, speculation and even flight of capital abroad.

 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. 

3. Maintaining Price Stability

With the suspension of the gold standard, maintenance of domestic price level has become an important aim of monetary policy all over the world. The bitter experience of 1920’s and 1930’s has made all most all economies to go for price stability. Both inflation and deflation are dangerous and detrimental to smooth economic growth. They distort and disturb the working of the economic system and create chaos. Both of them are bad as they bring unnecessary loss to some groups where as undue advantage to some others. They have potential power to create economic inequality, political upheavals and social unrest in any economy. In view of this, price stability is considered as one of the main objectives of monetary policy in recent years. It is to be remembered that price stability does not mean that prices of all commodities are kept constant or fixed over a period of time. It refers to the absence of sharp variations or fluctuations in the average price level in the country. A hundred percent price stability is neither possible nor desirable in any economy. It simply implies relative price stability. A policy of price stability checks cyclical fluctuations and smoothen production and distribution, keeps the value of money stable, prevent artificial scarcity or prosperity, makes economic calculations possible, introduces an  element of certainty, eliminate socio-economic disturbances, ensure equitable distribution of income and wealth, secure social justice and promote economic welfare.

On account of all these benefits, monetary authorities have to take concrete steps to check price oscillations. Price stability is considered as one of the prerequisite condition for economic development and it contributes positively to the attainment of a steady rate of growth in an economy. This is because price stability will build up public morale and instill confidence in the minds of people, boost up business activity, expand various kinds of economic activities and ensure distributive justice in the country. Prof Basu rightly observes, “A monetary policy which can maintain a reasonable degree of price stability and keep employment reasonably full, sets the stage of economic development”. 

4. Full Employment

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. Many well-known economists like Crowther, Halm, Gardner Ackley, William, Beveridge and Lord Keynes have strongly advocated this objective in the context of present day situations in most of the countries. Advanced countries normally work at near full employment conditions.

Their major problem is to maintain this high level of employment situation through various economic policies. This object has become much more important and crucial in developing countries as there is unemployment and under employment of most of the resources. Deliberate efforts are to be made by the monetary authorities to ensure adequate supply of financial resources to exploit and utilize resources in the best possible manner so as to raise the level of aggregate effective demand in the economy. It should also help to maintain balance between aggregate savings and aggregate investments. This would ensure optimum utilization of all kinds of resources, higher national output, income and higher living standards to the common man.

5. Rapid Economic Growth

This is comparatively a recent objective of monetary policy. Achieving a higher rate of per capita output and income over a long period of time has become one of the supreme goals of monetary policy in recent years. A higher rate of economic growth would ensure full employment condition, higher output, income and better living standards to the people. Consequently, monetary authorities have to take the necessary steps to raise the productive capacity of the economy, increase the level of effective demand for various kinds of goods and services and ensure balance between demand for and supply of goods and services in the economy. Also they should take measures to increase the rate of savings, capital formation, step up the volume of investment, direct credit money into desired directions, regulate interest rate structure, minimize economic and business fluctuations by balancing demand for money and supply of money, ensure price and overall economic stability, better and full utilization of resources, remove imperfections in money and capital markets, maintain exchange rate stability, allow the inflow of foreign capital into the country, maintain the growth of money supply in consistent with the rate of growth of output minimize adversity in balance of payments condition, etc. Depending upon the conditions of the economy money supply has to be changed from time to time.

A flexible policy of monetary expansion or contraction has to be adopted to meet a particular situation. Thus, a growth-friendly monetary policy has to be pursued by monetary authorities in order to stimulate 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. 

6. Greater Equality in Income Distribution

As far as the objective of greater equality in the distribution of income and wealth is concerned, most of the economists argue that fiscal policy is likely to be more successful as compared to the monetary policy. Many economists used to justify the role of the fiscal policy is maintaining economic equality. However, in recent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic

According to S.B. Gupta, the best policy in this respect is a policy of long run price stability at maximum feasible output. This may be referred to as the policy of “long-run price stability at maximum feasible output, other goals of economic policy, fuller employment, a high rate of growth, greater equality, and healthy balance of payments are also promoted to the maximum extent”.

7. Equilibrium in the Balance of Payments

This objective has assumed greater importance in the context of expanding international trade and globalization. Today most of the countries of the world are experiencing adverse balance of payments on account of various reasons. It is a situation where in the import payments are in excess of export earnings. Most of the countries which have embarked on the road to economic development cannot do away with imports on a large scale. Imports of several items have become indispensable and without these imports their development process will be halted. Hence, monetary authorities have to take appropriate monetary measures like deflation, exchange depreciation, devaluation, exchange control, current account and capital account convertibility, regulate credit facilities and interest rate structures and exchange rates etc. In order to achieve a higher rate of economic growth, balance of payments equilibrium is very much required and as such monetary authorities have to take suitable action in this direction.  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.