Interaction of Fiscal and Monetary Policy

INTERACTION OF FISCAL AND MONETARY POLICY IN INDIA Introduction Before understanding how the pecuniary insurance and financial policy operate in coordination with separately other, let us first understand the objective behind the formulation of these policies in brief. Monetary Policy Monetary policy is the process by which monetary authority of a country, generally a central bank underwrites the supply of money in the economy by exercising its control all over interest rates in order to maintain price perceptual constancy and achieve high economic growth.The central bank in our country is take into account Bank of India. The main objectives of monetary policy atomic number 18 price stability, controlled expansion of bank honorable mention, promotion of fixed investment, promotion of exports and food procurement operations and so forth Fiscal Policy Fiscal policy refers to the expenditure that government undertakes in order to provide goods and services, and the way in which the government pays those expenditures.Main objectives of pecuniary policy of our country are to reduce income inequalities through progressive taxation, to control inflation, to facilitate reliefd regional development, employment generation, to allocate imaginations to social and developmental objectives, to reduce balance of wages deficits etc.At the out jell, it must be recognized that both fiscal and monetary policies are essential components of overall macro-economic policy and thus cannot but share the radical objectives such as high economic growth on a sustainable basis implying equity considerations alike, a reasonable degree 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 unlike apart from the differences in time horizon of the concerned policy focus.For achieving an optimal mix of macroeconomic objectives of growth and price stability, it is n ecessary that the two policies complement each other. However, the form of complementarity will vary according to the stage of development of the countrys financial markets and institutions. In order to exercise these objectives there are accepted tools 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 five main tools which rbi uses to execute the monetary policy.They are repo and reverse repo rate, cash reserve ratio, open market operations, statutory liquid soil ratio, and bank rate. The tools colligate to fiscal policy are public expenditure, income of the government, government borrowings. Evolution of monetary and fiscal policy interface in India The framework for monetary and fiscal policy interface in India stems from the provisions of the Reserve Bank of India Act, 1934. In terms of the Act, the Reserve Bank manages the public debt of the Central and the State Governments 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 Government adopted a stance of fiscal neutrality. However, requirements of the World War II necessitated immemorial 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. Given 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 gain adequate command over the resources of the economy, which the monetary policy accommodated. Beginning the Second Plan, the Government began to resort to deficit financing to bridge the resource gap to finance plan outlays. Thus, the conduct of monetary policy came to be influenced by the s ize and mode of financing the fiscal deficit. Consequently, advances to the Government under the RBI Act, 1934 for cash management purposes, which are repayable not later than three months from the date of advance, in practice, became a permanent source of financing the Government work out deficit.Whenever governments balances with the Reserve Bank fell below the minimum stipulation, they were replenished through automatic creation of ad hoc Treasury Bills. Though the ad hocs were meant to finance Governments temporary needs, the maturing bills were automatically replaced by fresh creation of ad hoc Treasury Bills. Thus, monetization of deficit of the Government became a permanent feature, lede to loss of control over base 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 postponement of increases in the Bank Rate in order to control the cost 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 alter control of credit boom in the private sector emanating from reserve money creation through deficit financing.The single most important factor in influencing monetary policy in the 1970s and the 1980s was the phenomenal growth in reserve money collectable to Reserve Banks credit to the government. With little control over this variable, monetary policy focused on restricting overall liquidity by raising the CRR and the SLR to high levels. The balance of payment crisis of 1991 recognized the fiscal deficit as the 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(prenominal) 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 run 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 concern on inwardness demand and inflationary expectations. Fiscal-Monetary Co-ordination In Inflation Management Maintaining a low and stable level of inflation is one of the major goals of macroeconomic policy. Since inflation is viewed by the tradition al 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 Another example of fiscal-monetary co-ordination came in the form of introduction of the Market Stabilization stratagem (MSS). Under the MSS, treasury bills and dated securities were issued by the government. The scheme aimed at improving 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 intervention 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 enduring nature, the MSS was conceived. Fiscal-monetary policy co-ordination also received a fillip from the Debt Swap 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 small saving transfers.How should the coordination be? In view of the complex nature of interface, coordina tion 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 tributary 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 operating(a) procedures of monetary and fiscal authorities, especially debt and cash management are consistent and mutually reinforcing. The interactions between operations of monetary authority and public debt management exposit earlier in this part of the presentation are obviously relevant. Thirdly, whether credibility of both monetary and fiscal policies is achieved in a desirable direction. Thus, a probable monetary policy can help moderate interest rates provided the fiscal authority does not give rise 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 know , can be adjusted to alter monetary conditions at a shorter notice than fiscal policy. Monetary policy changes can be undertaken at both time, unlike fiscal policy changes most of which are generally associated with the Annual Budget. Finally, harmonious implementation 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