Interaction of Fiscal and Monetary Policy

Topics: Monetary policy, Keynesian economics, Public finance Pages: 5 (1624 words) Published: April 18, 2013
Before understanding how the fiscal policy and monetary policy operate in coordination with each 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 controls the supply of money in the economy by exercising its control over interest rates in order to maintain price stability and achieve high economic growth. The central bank in our country is Reserve Bank of India. The main objectives of monetary policy are price stability, controlled expansion of bank credit, promotion of fixed investment, promotion of exports and food procurement operations etc. 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 finances those expenditures. Main objectives of fiscal policy of our country are to reduce income inequalities through progressive taxation, to control inflation, to facilitate balanced regional development, employment generation, to allocate resources to social and developmental objectives, to reduce balance of payment deficits etc. At the outset, it must be recognized that both fiscal and monetary policies are essential components of overall macro-economic policy and thus cannot but share the basic objectives such as high economic growth on a sustainable basis implying equity considerations also, 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 different 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 necessary that the two policies complement each other. However, the form of complementarity will vary according to the stage of development of the country’s financial markets and institutions. In order to exercise these objectives there are certain 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 liquidity ratio, and bank rate. The tools related 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 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. 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 size and mode of financing the fiscal deficit. Consequently, advances to the Government...
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