Interaction of Fiscal and Monetary Policy

INTERACTION OF FISCAL AND MONETARY POLICY IN INDIA universe Before understanding how the m one(a)tary form _or_ system of regime and pecuniary insurance polity ascertain in coordination with each different, let us first understand the intent behind the formulation of these policies in brief. pecuniary indemnity financial insurance is the cover by which monetary authority of a state, generally a Coperni fucking bank avers the supply of money in the economy by exercising its control over interest rates in point to maintain scathe stability and achieve high economic growth.The key bank in our country is Reserve blaspheme of India. The main objectives of financial policy are price stability, controlled expansion of bank credit, promotion of contumacious investment, promotion of exports and food procurement operations etc. Fiscal Policy Fiscal policy refers to the expenditure that disposal undertakes in order to go forth goods and services, and the way in which the government finances those expenditures.Main objectives of fiscal policy of our country are to reduce income inequalities by means of progressive taxation, to control inflation, to facilitate equilibrate regional development, employment generation, to allocate resources to social and developmental objectives, to reduce chemical equilibrium of payment shortfalls etc.At the outset, it must be recognized that some(prenominal) fiscal and monetary policies are essential percentages of overall big-economic policy and thus cannot but grapple the basic objectives such as high economic growth on a sustainable basis implying equity considerations also, a reasonable stagecoach of price stability and a viable balance of payments situation. However, all these objectives may not always be in harmony, and major concerns of each component may be different apart from the differences in time purview of the concerned policy focus.For achieving an best mix of macroeconomic objectives of growth and price stability, it is necessary that the two policies complement each other. However, the form of complementarity will castrate according to the stage of development of the countrys financial markets and institutions. In order to exercise these objectives there are certain prickings available with the government and the central bank. Let us look at the tools available with the central bank to exercise monetary policy objectives effectively. There are louver main tools which run batted in uses to execute the monetary policy.They are repo and reverse repo rate, hard currency accommodate ratio, open market operations, statutory liquidity ratio, and bank rate. The tools cogitate to fiscal policy are public expenditure, income of the government, government borrowings. Evolution of monetary and fiscal policy inter mettle in India The framework for monetary and fiscal policy interface in India stems from the provisions of the Reserve deposit of India Act, 1934. In terms of the Act, the Reserve Bank manages the public debt of the Central and the State establishments and also acts as a banker to them.The interface between these two policies, however, has been continuously evolving. In the pre-Independence days, the Colonial governing adopted a stance of fiscal neutrality. However, requirements of the orbit War II necessitated primary accommodation to the Government from the Reserve Bank. In the post-Independence period, the monetary-fiscal interface evolved in the context of the emerging role of the Reserve Bank. effrontery the low level of savings and investment in the economy, fiscal policy began to play a major role in the development process under successive Five-Year Plans beginning 1950-51.Fiscal policy was increasingly used to defecate adequate command over the resources of the economy, which the monetary policy accommodated. Beginning the siemens Plan, the Government began to resort to deficit support to bridge the resource to-do to f inance plan outlays. Thus, the conduct of monetary policy came to be influenced by the size and mode of financing the fiscal deficit. Consequently, advances to the Government under the RBI Act, 1934 for cash precaution purposes, which are repayable not later than trinity months from the date of advance, in practice, became a permanent source of financing the Government budget deficit.Whenever governments balances with the Reserve Bank fell beneath the minimum stipulation, they were replenished through self-winding humanity of ad hoc Treasury Bills. though the ad hocs were meant to finance Governments temporary needs, the maturing bills were automatically replaced by pert creation of ad hoc Treasury Bills. Thus, monetization of deficit of the Government became a permanent feature, leading to loss of control over humble money creation by the Reserve Bank. In addition to creation of ad hocs, the Reserve Bank also subscribed to primary issuances of government securities.This was necessitated as the large government borrowings for plan financing could not be absorbed by the market. This, however, constrained the operation of monetary policy as it led to creation of primary liquidity in the system and entailed deferment of increases in the Bank Rate in order to control the terms of Government borrowings. The Reserve Bank Act, therefore, was amended in 1956 empowering the Reserve Bank to vary the cash reserve ratio (CRR) maintained by banks with it to change control of credit boom in the private sector emanating from reserve money creation through deficit financing.The single most important eventor influencing monetary policy in the 1970s and the 1980s was the phenomenal growth in reserve money due to Reserve Banks credit to the government. With little control over this variable, monetary policy focused on restricting overall liquidity by training the CRR and the SLR to high levels. The balance of payment crisis of 1991 recognized the fiscal deficit as th e core problem. It, therefore, necessitated a strong and decisive coordinated response on the part of the Government and the Reserve Bank.Assigning due importance to monetary management, fiscal consolidation was emphasized and implemented in 1991-92. An important step taken during the 1990s with regard to monetary-fiscal interface was phasing out and eventual elimination of automatic monetization through the issue of ad hoc Treasury Bills. Even though fiscal dominance through automatic monetization of fiscal deficit has been done away with over the years in India, the influence of fiscal deficit on the outcome of monetary policy has continued to breathe significant given its high level.High fiscal deficit, even if it is not monetized, can interfere with the monetary policy objective of price stability through its impact on aggregate demand and inflationary expectations. Fiscal-Monetary Co-ordination In pomposity Management Maintaining a low and stable level of inflation is one of the major inclinations of macroeconomic policy. Since inflation is viewed by the traditional monetarist approach as a monetary phenomenon, monetary policy is recommended as the major tool for inflation management.However, the role of fiscal policy in inflation control is also recognised both in terms of the impact of high fiscal deficit on aggregate demand and inflation as well as short-term inflation management through its policy of taxes and subsidies. Also, given the two-way interaction between fiscal deficit and inflation, optimal co-ordination between monetary and fiscal policies would be critical to achieve the goal of price stability. This section attempts to understand the role of fiscal and monetary policies in inflation management and the implications of the interaction between these policies on inflation.MSS scheme some other example of fiscal-monetary co-ordination came in the form of introduction of the Market Stabilization stratagem (MSS). Under the MSS, treasury bi lls and dated securities were issued by the government. The scheme aimed at alter monetary policy that was expected to lose its efficacy in the face of paucity of instruments to sterilize liquidity arising from large capital inflows that required interpolation in the foreign exchange markets. The initial burden of sterilization was borne by the outright transactions involving the sale of dated securities and treasury bills.However, due to the depletion in the stock of government securities, the burden of liquidity adjustment shifted to LAF. The LAF was essentially designed to handle marginal liquidity surpluses/deficits. For absorbing the liquidity of a more(prenominal) enduring nature, the MSS was conceived. Fiscal-monetary policy co-ordination also received a fillip from the Debt sell Scheme (DSS), which was recommended by the Finance Commission. It enabled the state governments to substitute their high-cost loans from the centre with fresh market borrowings and a portion of s mall saving transfers.How should the coordination be? In view of the complex nature of interface, coordination between fiscal and monetary policies has to be considered from several angles. Both are aspects of shared overall macro-economic policy objectives. Hence, at the first level, the question is whether the relevant fiscal-monetary policy mix is conducive to the macro objectives. The relevant policy mix relates to the level of fiscal deficit, the pattern of financing especially the extent of monetisation and the dependence on external savings.Secondly, whether operate procedures of monetary and fiscal authorities, especially debt and cash management are consonant and mutually reinforcing. The interactions between operations of monetary authority and public debt management described earlier in this part of the presentation are evidently relevant. Thirdly, whether credibility of both monetary and fiscal policies is achieved in a in demand(predicate) direction. Thus, a credibl e monetary policy can help restrict interest rates provided the fiscal authority does not give move up to a different set of expectations.Fourthly, whether due cognizance has been taken of the fact that monetary and fiscal policy adjustments operate in different timeframes. Monetary policy as is well known , can be correct to alter monetary conditions at a shorter notice than fiscal policy. Monetary policy changes can be undertaken at any time, unlike fiscal policy changes most of which are generally associated with the Annual Budget. Finally, harmonious death penalty of policies may require that one policy is not unduly burdening the other for too long. Mutual respect and reinforcement is undoubtedly the ideal to which both policies and authorities should subscrib