Fiscal policy

Fiscal policy refers to government attempts to influence the direction of the economy
through changes in government taxes, or through some spending (fiscal allowances).

Fiscal policy can be contrasted with the other main type of economic policy, monetary
policy, which attempts to stabilize the economy by controlling interest rates and the supply
of money. The two main instruments of fiscal policy are government spending and taxation.
Changes in the level and composition of taxation and government spending can impact on
the following variables in the economy:

 Aggregate demand and the level of economic activity;

 The pattern of resource allocation;
 The distribution of income.

Fiscal policy:-

Fiscal policy refers to the overall effect of the budget outcome on economic activity. The
three possible stances of fiscal policy are neutral, expansionary and contractionary:

 A neutral stance of fiscal policy implies a balanced budget where G = T

(Government spending = Tax revenue). Government spending is fully funded by tax
revenue and overall the budget outcome has a neutral effect on the level of economic
activity.

 An expansionary stance of fiscal policy involves a net increase in government

spending (G > T) through a rise in government spending or a fall in taxation
revenue or a combination of the two. This will lead to a larger budget deficit or a
smaller budget surplus than the government previously had, or a deficit if the
government previously had a balanced budget. Expansionary fiscal policy is usually
associated with a budget deficit.

 Contractionary fiscal policy (G < T) occurs when net government spending is

reduced either through higher taxation revenue or reduced government spending or
a combination of the two. This would lead to a lower budget deficit or a larger
surplus than the government previously had, or a surplus if the government
previously had a balanced budget. Contractionary fiscal policy is usually associated
with a surplus.

Methods of funding:-

Governments spend money on a wide variety of things, from the military and police to
services like education and healthcare, as well as transfer payments such as welfare
benefits. This expenditure can be funded in a number of different ways:
  Taxation
 Seignorage, the benefit from printing money
 Borrowing money from the population, resulting in a fiscal deficit.
 Consumption of fiscal reserves.
 Sale of assets (e.g., land).

Funding the deficit:-

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols. These pay
interest, either for a fixed period or indefinitely. If the interest and capital repayments are
too large, a nation may default on its debts, usually to foreign creditors.

Some peculiarities exist: for example, the US owes most of its own debt to itself. Compared
to GDP and factoring in inflation, its debt is significantly less than in the past.

Consuming the surplus:-

A fiscal surplus is often saved for future use, and may be invested in local (same
currency) financial instruments, until needed. When income from taxation or other
sources falls, as during an economic slump, reserves allow spending to continue at
the same rate, without incurring a deficit. Hong Kong ran a fiscal surplus of
HK$123.6 billion in fiscal year 2007/08 (ended March 31, 2008), equal to US$15.85
billion or 7.7% of 2007 GDP.

Objectives of fiscal policy:-

The role of fiscal policy in developed economies is to maintain full employment
and stabilize growth. In contrast, in developing countries, fiscal policy is used to
create an environment for rapid economic growth. The various aspects of this
are:

1. Mobilization of resources: Developing economies are characterized by low

levels of income and investment, which are linked in a vicious circle. This can be
successfully broken by mobilizing resources for investment energetically.

2. Acceleration of economic growth: The government has not only to mobilize

more resources for investment, but also to direct the resources to those channels
where the yield is higher and the goods produced are socially acceptable.

3. Minimization of the inequalities of income and wealth: Fiscal tools can be used
to bring about the redistribution of income in favor of the poor by spending
revenue so raised on social welfare activities.

4. Increasing employment opportunities: Fiscal incentives, in the form of tax-

rebates and concessions, can be used to promote the growth of those industries
that have high employment-generation potential.
5. Price stability: Fiscal tools can be employed to contain inflationary and
deflationary tendencies in the economy.

The limitations of Fiscal Policy:-

Fiscal policy has been a great success in developed countries but only partially
so in developing countries. The tax structure in the developing countries is rigid
and narrow. Thus, conditions conducive to the growth of well-knit and integrated
tax policies are absent and sorely missed. Following are some of the reasons that
are hindrances for its implementation in developing countries:

1. A sizeable portion of most developing economies is non-monetized, rendering

fiscal measures of the government ineffective and self-defeating.

2. Lack of statistical information as regards the income, expenditure, savings,

investment, employment etc. makes it difficult for the public authorities to
formulate a rational and effective fiscal policy.

3. Fiscal policy cannot succeed unless people understand its implications and
cooperate with the government in its implication. This is due to the fact that, in
developing countries, a majority of the people are illiterate.

4. Large-scale tax evasion, by people who are not conscious of their roles in
development, has an impact on fiscal policy.

5. Fiscal policy requires efficient administrative machinery to be successful. Most

developing economies have corrupt and inefficient administrations that fail to
implement the requisite measures vis-à-vis the implementation of fiscal policy.

Among the various tools of fiscal policy, the following are the most important:

Reflationary Fiscal Policy

It may be used to boost the level of economic activity during periods of recession
or deceleration in economic activity. This is done by lowering taxes or increasing
government expenditure.

Deflationary Fiscal Policy

During a boom, i.e., when the economy is growing beyond its capacity, inflation
and balance of payment problems might result. This can be achieved by
increasing taxes or by reducing government expenditure.

It would perhaps be too simplistic to conclude that fiscal policy is the most
important tool of financial correction and consolidation, especially that
undertaken by the government. However, there is no reason to neglect this very
powerful tool that is in the hands of governments and central banks the world
over. Used properly, fiscal policy can determine the broad direction the economy
of a given country is going to take.
Economic effects of fiscal policy:-

 Fiscal policy is used by governments to influence the level of aggregate demand in

the economy, in an effort to achieve economic objectives of price stability, full
employment and economic growth. Keynesian economics suggests that adjusting
government spending and tax rates are the best ways to stimulate aggregate
demand. This can be used in times of recession or low economic activity as an
essential tool in providing the framework for strong economic growth and working
toward full employment. The government can implement these deficit-spending
policies due to its size and prestige and stimulate trade. In theory, these deficits
would be paid for by an expanded economy during the boom that would follow; this
was the reasoning behind the New Deal.
 During periods of high economic growth, a budget surplus can be used to decrease
activity in the economy. A budget surplus will be implemented in the economy if
inflation is high, in order to achieve the objective of price stability. The removal of
funds from the economy will, by Keynesian theory, reduce levels of aggregate
demand in the economy and contract it, bringing about price stability.
 Despite the importance of fiscal policy, a paradox exists. In the case of a government
running a budget deficit, funds will need to come from public borrowing (the issue
of government bonds), overseas borrowing or the printing of new money. When
governments fund a deficit with the release of government bonds, an increase in
interest rates across the market can occur. This is because government borrowing
creates higher demand for credit in the financial markets, causing a lower aggregate
demand (AD) due to the lack of disposable income, contrary to the objective of a
budget deficit. This concept is called crowding out. Alternatively, governments may
increase government spending by funding major construction projects. This can
also cause crowding out because of the lost opportunity for a private investor to
undertake the same project. Another problem is the time lag between the
implementation of the policy and detectable effects in the economy. An
expansionary fiscal policy (decreased taxes or increased government spending) is
usually intended to produce an increase in aggregate demand; however, an
unchecked spiral in aggregate demand will lead to inflation. Hence, checks need to
be kept in place.

Major Fiscal Reforms since 1991:-

1. Reduction of fiscal deficit
2. Fiscal Responsibility and Budget Management Act 2003
3. Simplifying tax rules and procedures
4. Strengthening tax administration
5. Widening tax base
6. Rationalization and Reduction of both direct and indirect tax rates
 Monetary policy
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, in order to attain a set of objectives oriented towards the
growth and stability of the economy. Monetary theory provides insight into how to craft
optimal monetary policy.

Monetary policy is referred to as either being an expansionary policy, or a contractionary

policy, where an expansionary policy increases the total supply of money in the economy,
and a contractionary policy decreases the total money supply. Expansionary policy is
traditionally used to combat unemployment in a recession by lowering interest rates, while
contractionary policy involves raising interest rates in order to combat inflation. Monetary
policy should be contrasted with fiscal policy, which refers to government borrowing,
spending and taxation.

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).

Types of monetary policy:-

In practice, all types of monetary policy involve modifying the amount of base currency
(M0) in circulation. This process of changing the liquidity of base currency through the
open sales and purchases of (government-issued) debt and credit instruments is called open
market operations. 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.

Monetary Policy: Target Market Variable: Long Term Objective:

Interest rate on overnight
Inflation Targeting A given rate of change in the CPI
debt
Interest rate on overnight
Price Level Targeting A specific CPI number
debt
The growth in money
Monetary Aggregates A given rate of change in the CPI
supply
Fixed Exchange Rate The spot price of the The spot price of the currency
 currency
Low inflation as measured by the gold
Gold Standard The spot price of gold
price
Mixed Policy Usually interest rates Usually unemployment + CPI change

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 the exact same variables.

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. 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, Canada, Chile, the Euro zone, New Zealand, Norway, Iceland, Poland,
Sweden, South Africa, Turkey, and the United Kingdom.

Price level targeting:-

Price level targeting is similar to inflation targeting except that CPI growth in one year is
offset in subsequent years such that over time the price level on aggregate does not move.
Something similar to price level targeting was tried by Sweden in the 1930s, and seems to
have contributed to the relatively good performance of the Swedish economy during the
Great Depression. As of 2004, no country operates monetary policy based on a price level
target.

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.
While most monetary policy focuses on a price signal of one form or another, this approach
is focused on monetary quantities.

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. 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. Under a system of fixed exchange rates
maintained by a currency board every unit of local currency must be backed by a unit of
foreign currency (correcting for the exchange rate). This ensures that the local monetary
base does not inflate without being backed by hard currency and eliminates any worries
about a run on the local currency by those wishing to convert the local currency to the hard
(anchor) currency. Under dollarization, foreign currency is used freely as the medium of
exchange either exclusively or in parallel with local currency. This outcome can come about
because the local population has lost all faith in the local currency, or it may also be a
policy of the government. These policies often abdicate monetary policy to the foreign
monetary authority or government as monetary policy in the pegging nation must align
with monetary policy in the anchor nation to maintain the exchange rate. The degree to
which local monetary policy becomes dependent on the anchor nation depends on factors
such as capital mobility, openness, credit channels and other economic factors.

Gold standard:-

The gold standard is a system in which the price of the national currency as measured in
units of gold bars and is kept constant by the daily buying and selling of base currency to
other countries and nationals. The selling of gold is very important for economic growth
and stability. The gold standard might be regarded as a special case of the "Fixed
Exchange Rate" policy. And the gold price might be regarded as a special type of
"Commodity Price Index". Today this type of monetary policy is not used anywhere in the
world, although a form of gold standard was used widely across the world prior to 1971.
For details see the Bretton Woods system. Its major advantages were simplicity and
transparency.

Monetary policy tools

Monetary base:-

Monetary policy can be implemented by changing the size of the monetary base. This
directly changes the total amount of money circulating in the economy. A central bank can
use open market operations to change the monetary base. The central bank would buy/sell
bonds in exchange for hard currency. When the central bank disburses/collects this hard
currency payment, it alters the amount of currency in the economy, thus altering the
monetary base.

Reserve requirements:-

The monetary authority exerts regulatory control over banks. Monetary policy can be
implemented by changing the proportion of total assets that banks must hold in reserve
with the central bank. Banks only maintain a small portion of their assets as cash available
for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans.
By changing the proportion of total assets to be held as liquid cash, the Federal Reserve
changes the availability of loanable funds. This acts as a change in the money supply.

Discount window lending:-

Many central banks or finance ministries have the authority to lend funds to financial
institutions within their country. By calling in existing loans or extending new loans, the
monetary authority can directly change the size of the money supply.

Interest rates:-

The contraction of the monetary supply can be achieved indirectly by increasing the
nominal interest rates. Monetary authorities in different nations have differing levels of
control of economy-wide interest rates. In the United States, the Federal Reserve can set
the discount rate, as well as achieve the desired Federal funds rate by open market
operations. This rate has significant effect on other market interest rates, but there is no
perfect relationship. In the United States open market operations are a relatively small part
of the total volume in the bond market.In other nations, the monetary authority may be
able to mandate specific interest rates on loans, savings accounts or other financial assets.
By raising the interest rate(s) under its control, a monetary authority can contract the
money supply, because higher interest rates encourage savings and discourage borrowing.
Both of these effects reduce the size of the money supply.

Some Monetary Policy terms:-

Bank Rate:- Bank rate is the minimum rate at which the central bank provides loans to
the commercial banks. It is also called the discount rate. Usually, an increase in bank rate
results in commercial banks increasing their lending rates. Changes in bank rate affect
credit creation by banks through altering the cost of credit.
Cash Reserve Ratio:- All commercial banks are required to keep a certain amount of its
deposits in cash with RBI. This percentage is called the cash reserve ratio. The current
CRR requirement is 8 per cent.

Inflation:- Inflation refers to a persistent rise in prices. Simply put, it is a situation of too
much money and too few goods. Thus, due to scarcity of goods and the presence of many
buyers, the prices are pushed up. The converse of inflation, that is, deflation, is the
persistent falling of prices. RBI can reduce the supply of money or increase interest rates to
reduce inflation.

Money Supply (M3):- This refers to the total volume of money circulating in the
economy, and conventionally comprises currency with the public and demand deposits
(current account + savings account) with the public. The RBI has adopted four concepts of
measuring money supply. The first one is M1, which equals the sum of currency with the
public, demand deposits with the public and other deposits with the public. Simply put M1
includes all coins and notes in circulation, and personal current accounts. The second, M2,
is a measure of money, supply, including M1, plus personal deposit accounts - plus
government deposits and deposits in currencies other than rupee. The third concept M3 or
the broad money concept, as it is also known, is quite popular. M3 includes net time
deposits (fixed deposits), savings deposits with post office saving banks and all the
components of M1.

Statutory Liquidity Ratio:- Banks in India are required to maintain 25 per cent of
their demand and time liabilities in government securities and certain approved securities.
These are collectively known as SLR securities. The buying and selling of these securities
laid the foundations of the 1992 Harshad Mehta scam.

Repo:- A repurchase agreement or ready forward deal is a secured short-term (usually 15

days) loan by one bank to another against government securities. Legally, the borrower
sells the securities to the lending bank for cash, with the stipulation that at the end of the
borrowing term, it will buy back the securities at a slightly higher price, the difference in
price representing the interest.

Open Market Operations:- An important instrument of credit control, the Reserve

Bank of India purchases and sells securities in open market operations. In times of
inflation, RBI sells securities to mop up the excess money in the market. Similarly, to
increase the supply of money, RBI purchases securities.

Some questions which are related to fiscal and monetary policies

1.What is RBI's Monetary Policy?

The Reserve Bank of India will announce its Monetary and Credit Policy for the first half
of the financial year 2002-03 on April 29. In a world of policies in the financial sector,
nothing could get as alien as the Monetary Policy. Terms like M3, CRR, SLR, PLR and
OMO would make you think that the typical IT-bug has caught the financial sector. But
take a closer look as the Monetary and Credit Policy is crucial to all of us and more so to
the banking sector. For the uninitiated, this policy determines the supply of money in the
economy and the rate of interest charged by banks. The policy also contains an economic
overview and presents future forecasts.

2. What is the Monetary Policy?

The Monetary and Credit Policy is the policy statement, traditionally announced twice a
year, through which the Reserve Bank of India seeks to ensure price stability for the
economy. These factors include - money supply, interest rates and the inflation. In banking
and economic terms money supply is referred to as M3 - which indicates the level (stock) of
legal currency in the economy. Besides, the RBI also announces norms for the banking and
financial sector and the institutions which are governed by it. These would be banks,
financial institutions, non-banking financial institutions, Nidhis and primary dealers
(money markets) and dealers in the foreign exchange (forex) market.

3. When is the Monetary Policy announced?

Historically, the Monetary Policy is announced twice a year - a slack season policy (April-
September) and a busy season policy (October-March) in accordance with agricultural
cycles. These cycles also coincide with the halves of the financial year. Initially, the Reserve
Bank of India announced all its monetary measures twice a year in the Monetary and
Credit Policy. The Monetary Policy has become dynamic in nature as RBI reserves its right
to alter it from time to time, depending on the state of the economy. However, with the
share of credit to agriculture coming down and credit towards the industry being granted
whole year around, the RBI since 1998-99 has moved in for just one policy in April-end.
However a review of the policy does take place later in the year.

4. How is the Monetary Policy different from the Fiscal Policy?

Two important tools of macroeconomic policy are Monetary Policy and Fiscal Policy. The
Monetary Policy regulates the supply of money and the cost and availability of credit in the
economy. It deals with both the lending and borrowing rates of interest for commercial
banks. The Monetary Policy aims to maintain price stability, full employment and
economic growth. The Reserve Bank of India is responsible for formulating and
implementing Monetary Policy. It can increase or decrease the supply of currency as well
as interest rate, carry out open market operations, control credit and vary the reserve
requirements. The Monetary Policy is different from Fiscal Policy as the former brings
about a change in the economy by changing money supply and interest rate, whereas fiscal
policy is a broader tool with the government. The Fiscal Policy can be used to overcome
recession and control inflation. It may be defined as a deliberate change in government
revenue and expenditure to influence the level of national output and prices. For instance,
at the time of recession the government can increase expenditures or cut taxes in order to
generate demand. On the other hand, the government can reduce its expenditures or raise
taxes during inflationary times. Fiscal policy aims at changing aggregate demand by
suitable changes in government spending and taxes. The annual Union Budget showcases
the government's Fiscal Policy.

5. What are the objectives of the Monetary Policy?

The objectives are to maintain price stability and ensure adequate flow of credit to the
productive sectors of the economy. Stability for the national currency (after looking at
prevailing economic conditions), growth in employment and income are also looked into.
The monetary policy affects the real sector through long and variable periods while the
financial markets are also impacted through short-term implications. There are four main
'channels' which the RBI looks at:

 Quantum channel: money supply and credit (affects real output and price level through
changes in reserves money, money supply and credit aggregates).
 Interest rate channel.
 Exchange rate channel (linked to the currency).
 Asset price.

6. All this is more linked to the banking sector. How does the Monetary Policy
impact the individual?

In recent years, the policy had gained in importance due to announcements in the interest
rates. Earlier, depending on the rates announced by the RBI, the interest costs of banks
would immediately either increase or decrease. A reduction in interest rates would force
banks to lower their lending rates and borrowing rates. So if you want to place a deposit
with a bank or take a loan, it would offer it at a lower rate of interest. On the other hand, if
there were to be an increase in interest rates, banks would immediately increase their
lending and borrowing rates. Since the rates of interest affect the borrowing costs of
corporate and as a result, their bottom lines (profits), the monetary policy is very
important to them also. But over the past 2-3 years, RBI Governor Bimal Jalan has
preferred not to wait for the Monetary Policy to announce a revision in interest rates and
these revisions have been when the situation arises. Since the financial sector reforms
commenced, the RBI has moved towards a market-determined interest rate scenario. This
means that banks are free to decide on interest rates on term deposits and loans. Being the
central bank, however, the RBI would have a say and determine direction on interest rates
as it is an important tool to control inflation. The bank rate is a tool used by RBI for this
purpose as it refinances banks at this rate. In other words, the bank rate is the rate at
which banks borrow from the RBI.

7. How was the scenario prior to recent liberalization?

Prior to recent liberalization, the RBI resorted to direct instruments like interest rates
regulation, selective credit control and CRR (cash reserve ratio) as monetary instruments.
One of the risks emerging in the past 5-7 years (through the capital flows and liberalization
of the financial sector) is that potential risk has increased for institutions. Thus, financial
stability has become crucial and there are concerns relating to credit flows to the
agricultural sector and small-scale industries.

8. What do the terms CRR and SLR mean?

CRR, or cash reserve ratio, refers to a portion of deposits (as cash) which banks have to
keep/maintain with the RBI. This serves two purposes. It ensures that a portion of bank
deposits is totally risk-free and secondly it enables that RBI control liquidity in the system,
and thereby, inflation. Besides the CRR, banks are required to invest a portion of their
deposits in government securities as a part of their statutory liquidity ratio (SLR)
requirements. The government securities (also known as gilt-edged securities or gilts) are
bonds issued by the Central government to meet its revenue requirements. Although the
bonds are long-term in nature, they are liquid as they can be traded in the secondary
market. Since 1991, as the economy has recovered and sector reforms increased, the CRR
has fallen from 15 per cent in March 1991 to 5.5 per cent in December 2001. The SLR has
fallen from 38.5 per cent to 25 per cent over the past decade.

9. What impact does a cut in CRR have on interest rates?

From time to time, RBI prescribes a CRR or the minimum amount of cash that banks have
to maintain with it. The CRR is fixed as a percentage of total deposits. As more money
chases the same number of borrowers, interest rates come down.

10. Does a change in SLR and gilts products impact interest rates?

SLR reduction is not so relevant in the present context for two reasons: First, as part of the
reforms process, the government has begun borrowing at market-related rates. Therefore,
banks get better interest rates compared to earlier for their statutory investments in
government securities. Second, banks are still the main source of funds for the government.
This means that despite a lower SLR requirement, banks' investment in government
securities will go up as government borrowing rises. As a result, bank investment in gilts
continues to be high despite the RBI bringing down the minimum SLR to 25 per cent a
couple of years ago. Therefore, for the purpose of determining the interest rates, it is not
the SLR requirement that is important but the size of the government's borrowing
programme. As government borrowing increases, interest rates, too, rise. Besides, gilts also
provide another tool for the RBI to manage interest rates. The RBI conducts open market
operations (OMO) by offering to buy or sell gilts. If it feels interest rates are too high, it
may bring them down by offering to buy securities at a lower yield than what is available in
the market.

11. How does the Monetary Policy affect the domestic industry and exporters
in particular?

Exporters look forward to the monetary policy since the central bank always makes an
announcement on export refinance, or the rate at which the RBI will lend to banks which
have advanced pre-shipment credit to exporters. A lowering of these rates would mean
lower borrowing costs for the exporter.

12. The stock markets and money move similarly, in some ways. Why?

This is not entirely true. The factor connecting money and stocks is interest rates. People
save to get returns on their savings. In true market conditions, this made bank deposits or
bonds and stocks, competitors for people's savings. A hike in interest rates would tend to
suck money out of shares into bonds or deposits, a fall would have the opposite effect. This
argument has survived econometric tests and practical experience.

13. Is the money supply related to jobs, wages and output?

At any point of time, the price level in the economy is determined by the amount of money
floating around. An increase in the money supply - currency with the public, demand
deposits and time deposits - increases prices all round because there is more currency
moving towards the same goods and services. Typically, the RBI follows a least-inflation
policy, which means that its money market operations as well as changes in the bank rate
are generally designed to minimize the inflationary impact of money supply changes. Since
most people can generally see through this strategy, it limits the impact of the RBI's
monetary moves to affect jobs or production. The markets, however, move to the RBI's
tune because of the link between interest rates and capital market yields. The RBI's policies
have maximum impact on volatile foreign exchange and stock markets. Jobs, wages and
output are affected over the long run, if the trends of high inflation or low liquidity persist
for very long period. If wages move slower than other prices, higher inflation will drive real
wages lower and encourage employers to hire more people. This in turn ramps up
production and employment. This was the theoretical justification of a long-term trend that
showed that higher inflation and employment went together; when inflation fell,
unemployment increased.

14. What are the measures to regulate money supply?

The RBI uses the interest rate, OMO, changes in banks' CRR and primary placements of
government debt to control the money supply. OMO, primary placements and changes in
the CRR are the most popular instruments used. Under the OMO, the RBI buys or sells
government bonds in the secondary market. By absorbing bonds, it drives up bond yields
and injects money into the market. When it sells bonds, it does so to suck money out of the
system. The changes in CRR affect the amount of free cash that banks can use to lend -
reducing the amount of money for lending cuts into overall liquidity, driving interest rates
up, lowering inflation and sucking money out of markets. Primary deals in government
bonds are a method to intervene directly in markets, followed by the RBI. By directly
buying new bonds from the government at lower than market rates, the RBI tries to limit
the rise in interest rates that higher government borrowings would lead to.