Unit E
Fiscal and Monetary Policies
Why We Need?
The Basics
• Fiscal Policy:
• government spending
• taxing
• borrowing
• Monetary Policy:
• regulating the economy by controlling the amount
of money in circulation and the level of interest
rates
The Basics of Fiscal Policy
• The players
– Finance Ministry
– PMO
• Taxes = revenues
• Spending = outlays
• Subsidies = Fund Transfer
FM Discretionary and Mandatory
Spending
• The Union Budget can be divided into two types
of spending according to how PMO appropriates
the money:
• discretionary
– refers to the portion of the budget which goes through
the annual appropriations process each year
• mandatory
– Required by statute – Social Security, etc.
Annual Budget Process
Step 1: FM Submits a Budget Proposal;
Step 2: Parliament Passes a Budget Resolution
Step 3: Loksabha Subcommittees 'Markup' Appropriation Bills;
Step 4: The House and Parliament Vote on Appropriation Bills and
Reconcile Differences;
Step 5: The Prime Minister Signs each Appropriation Bill and the Budget
is Enacted.
Fiscal Policies to Encourage
Growth
• EXPANSIONARY
• Increase Spending and Lower Taxes
– More money stimulates the economy
– Cuts taxes increases disposable income
– Businesses expand and create jobs
Expected Result: increased growth and higher
employment
EXPANSIONARY FISCAL POLICY
the multiplier at work...
$5 billion initial
increase in spending
Price level
AS
Full $20 billion
increase in
aggregate
demand
P1
AD2
$490
AD1
$510
Real GDP (billions)
Fiscal Policies to Stabilize
• CONTRACTIONARY
• Increase Taxes and Lower Spending
– Increase taxes to slow the economy and
reduce inflation
– Less disposable income
– Slower business activity leads to lower
profits
Result: low inflation rates and stable growth
CONTRACTIONARY FISCAL POLICY
the multiplier at work...
$5 billion initial
decrease in spending
Price level
AS
P2
Full $20 billion
decrease in
aggregate
demand
P1
AD3
AD4
$510 $522
Real GDP (billions)
Graphs of Fiscal Policy Trends and
Recent Developments
Source: Office of Management and Budget,
FISCAL DEFICIT
FISCAL DEFICIT IN INDIA
FISCAL DEFICIT IN INDIA
Part II –
Monetary Policy
Monetary Policy
• RESERVE BANK OF INDIA:
– The Reserve Bank of India was established on April 1, 1935 in
accordance with the provisions of the Reserve Bank of India Act,
1934.
– The Central Office of the Reserve Bank was initially established in
Calcutta but was permanently moved to Mumbai in 1937. The
Central Office is where the Governor sits and where policies are
formulated.
– Though originally privately owned, since nationalisation in 1949, the
Reserve Bank is fully owned by the Government of India.
• Monetary Policy is Fast
• instantaneous impact on markets and banking /
financial system
• Not burdened by the political process or government
bureaucracy of fiscal policy
Monetary Policy Tools
MONETARY POLICY AND EQUILIBRIUM GDP
Real rate of interest, i
Sm1 Sm2 Sm3
10
10
8
8
6
6
Dm
0
Quantity of money demanded and supplied
AS
Price level
Investment
Demand
P3
P2
P1
AD3(I=$25)
AD2(I=$20)
AD1(I=$15)
Real domestic output, GDP
0
Amount of investment, i
If the Money Supply
Increases to Stimulate
the Economy…
Interest Rate Decreases
Investment Increases
AD & GDP Increases
with slight inflation
Increasing money supply
continues the growth –
but, watch Price Level.