economic_policies

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Making a policy would be like driving a car:Making a policy would be like driving a car:policymakers would simplypolicymakers would simply ajust ajust theirtheir

instruments to keep the economy on theinstruments to keep the economy on thedesired path.desired path.



Making economic policy, however, is lessMaking economic policy, however, is lesslike driving a car than it is like piloting alike driving a car than it is like piloting a

large ship.large ship.



A car changes direction almost A car changes direction almost immediately after the steering wheel isimmediately after the steering wheel is

turned.turned.



A novice pilot is likely to oversteer and, A novice pilot is likely to oversteer and,after noticing the mistake, overreact byafter noticing the mistake, overreact by

steering too much in the oppositesteering too much in the oppositedirection.direction.



The ships path could become unstable, asThe ships path could become unstable, asthe novice responds to previous mistakesthe novice responds to previous mistakes

by making larger and larger corrections.by making larger and larger corrections.



Like a ships pilot, economic policymakersLike a ships pilot, economic policymakersface the problem of long lags. Indeed, theface the problem of long lags. Indeed, the

problem for policymakers is even moreproblem for policymakers is even moredifficult, because the lengths of the lagsdifficult, because the lengths of the lagsare hard to predict.are hard to predict.

These long and variable lags greatlyThese long and variable lags greatly

complicate the conduct of monetary andcomplicate the conduct of monetary andfiscal policy.fiscal policy.



The Inside lagThe Inside lag-- is the time between ais the time between ashock to the economy and the policyshock to the economy and the policy

action responding to that shock.T

his lagaction responding to that shock.T

his lagarises because it takes time forarises because it takes time forpolicymakers first to recognize that apolicymakers first to recognize that ashock has occurred and then to put shock has occurred and then to put

appropriate polices into effect.appropriate polices into effect.



The outside lagThe outside lag-- is the time between ais the time between apolicy action and its influence on thepolicy action and its influence on the

economy.T

his lag arises because policeseconomy.T

his lag arises because policesdo not immediately influence spending,do not immediately influence spending,income, and employment.income, and employment.



A long inside lag is a central problem with using A long inside lag is a central problem with usingfiscal policy for economic stabilization.fiscal policy for economic stabilization.

This is especially true in the US, where changesThis is especially true in the US, where changesin spending or taxes require the approval of thein spending or taxes require the approval of thepresident and both houses of Congress.president and both houses of Congress.

The slow and cumbersome legislative process

The slow and cumbersome legislative processoften leads to delays, which make fiscal policyoften leads to delays, which make fiscal policy

an imprecise tool for stabilizing the economy.an imprecise tool for stabilizing the economy.

This inside lag is shorter in countries withThis inside lag is shorter in countries with

parliamentary systems, such as the UK, becauseparliamentary systems, such as the UK, becausethe party in power can often enact policythe party in power can often enact policychanges more rapidly.changes more rapidly.



Monetary policy has a much shorter inside lagMonetary policy has a much shorter inside lagthan fiscal policy, because a central bank canthan fiscal policy, because a central bank candecide on and implement a policy change in lesdecide on and implement a policy change in lesthan a day, but monetary policy has a substantialthan a day, but monetary policy has a substantialoutside lag.outside lag.

Monetary policy works by changing the moneyMonetary policy works by changing the moneysupply and interest rates, which in turn influencesupply and interest rates, which in turn influenceinvestment and aggregate demand.investment and aggregate demand.

Many firms make investment plans far inMany firms make investment plans far inadvance, however, so a change in monetaryadvance, however, so a change in monetarypolicy is thought not to affect economic activitypolicy is thought not to affect economic activityuntil about six months after it is made.until about six months after it is made.



The long and variable lags associated withThe long and variable lags associated with

monetary and fiscal policy certainly makemonetary and fiscal policy certainly makestabilizing the economy more difficult stabilizing the economy more difficult



Monetary PolicyMonetary Policy

M.P is an important macroM.P is an important macro--economiceconomicinstrument through which the macroinstrument through which the macro--economic objectives of a country is sought economic objectives of a country is sought to be achieved.to be achieved.

The broad objectives of M.P are to obtainThe broad objectives of M.P are to obtainEconomic growth, Price stability, FullEconomic growth, Price stability, Full

employment, Exchange rate stability andemployment, Exchange rate stability andEquilibrium in the Balance of payment.Equilibrium in the Balance of payment.



Objectives of Monetary PolicyObjectives of Monetary Policy

TheThe objectivesobjectives of of monetarymonetary policy policy havehave

changedchanged fromfrom timetime toto timetime andand countrycountry toto

countrycountry dependingdepending uponupon thethe naturenature of of problems problems facedfaced by by thethe monetarymonetary authorityauthority..

However,However, thethe generallygenerally listedlisted goalsgoals of of

monetarymonetary policy policy areare asas followsfollows::



1)1) Economic GrowthEconomic Growth

2)2) Full Employment.Full Employment.

3)3) Price Stability.Price Stability.4)4) Exchange Rate Stability.Exchange Rate Stability.

5)5) Equilibrium in the Balance of Payments.Equilibrium in the Balance of Payments.



1) Economic Growth:1) Economic Growth:

Sustained economic growth is the basic as wellSustained economic growth is the basic as well

as the prime objective of monetary policy in allas the prime objective of monetary policy in all

countries; rich as well as the poor.countries; rich as well as the poor.

Sustained economic growth refers to aSustained economic growth refers to a

continuous growth in the productive capacity of continuous growth in the productive capacity of the economy resulting in a continuous growth inthe economy resulting in a continuous growth in

the total quantity of goods & services producedthe total quantity of goods & services produced

in an economyin an economy..



To achieve sustained economic growth, theTo achieve sustained economic growth, the

Central bank¶s monetary policy must aim atCentral bank¶s monetary policy must aim at

maintaining a high level of aggregate demand inmaintaining a high level of aggregate demand inthe economy.the economy.

In the Indian context, monetary policy canIn the Indian context, monetary policy can

promote growth by increasing the quantum of promote growth by increasing the quantum of credit and by reducing the cost of credit.credit and by reducing the cost of credit.

Firms need credit to finance their working capitalFirms need credit to finance their working capital

requirement , importing raw materials andrequirement , importing raw materials andmachines and for financing investment in projectsmachines and for financing investment in projects

for building fixed capital.for building fixed capital.



A dequate A dequate availabilityavailability of of credit credit at at lowlowinterest interest ratesrates willwill encourageencourage investment investment

andand economiceconomic growthgrowth.. DuringDuring thethe prepre--reformreform period,period, thethe RBIRBI

followedfollowed aa tight tight monetarymonetary policypolicy therebythereby

reducingreducing thethe supplysupply of of moneymoney andandincreasingincreasing thethe cost cost of of credit credit..

ThisThis policypolicy waswas givengiven upup inin thethe post post

reformsreforms byby deregulatingderegulating interest interest rates,rates,reducingreducing CRRCRR andand SLRSLR andand therebytherebyincreasingincreasing supplysupply of of moneymoney inin thetheeconomyeconomy..



2) Full Employment:2) Full Employment:

TheThe CentralCentral Bank¶sBank¶s monetarymonetary policy policy mustmust be be

gearedgeared toto achieveachieve fullfull employmentemployment of of allall thethe

availableavailable productive productive resourcesresources inin thethe economyeconomy..

InIn thethe contextcontext of of developingdeveloping countriescountries likelike IndiaIndia

whichwhich isis predominantly predominantly agriculturalagricultural fromfrom thethe

employmentemployment point point of of view,view, monetarymonetary policy policy willwill

be be irrelevantirrelevant inin tacklingtackling thethe problems problems of of

seasonalseasonal andand disguiseddisguised unemploymentunemployment whichwhichareare substantiallysubstantially highhigh inin IndiaIndia.. ««..



3)Price Stability:3)Price Stability:

TheThe term,term, µpriceµprice stability¶stability¶ impliesimplies thatthat therethere

shouldshould notnot be be violentviolent changeschanges inin price price--levellevel atat allall

timestimes.. MonetaryMonetary policy policy mustmust aimaim atat avoidingavoiding or or

neutralizingneutralizing both both thethe peaks peaks andand troughstroughs of of

business business cyclescycles.. MonetaryMonetary authoritiesauthorities mustmust

prevent prevent thethe economyeconomy fromfrom being being caughtcaught inin

inflationaryinflationary spiralspiral andand goinggoing downdown inin deflationarydeflationaryspinspin.. ««..



4)Exchange Rate Stability:4)Exchange Rate Stability:

StabilityStability inin foreignforeign exchangeexchange raterate impartsimparts

InternationalInternational confidenceconfidence inin thethe valuevalue of of thethe domesticdomestic

currencycurrency andand promotes promotes aa sustainedsustained growthgrowth inin thethe

internationalinternational tradetrade..

AA persistent persistent fallfall inin thethe exchangeexchange raterate wouldwould encourageencourage

speculativespeculative activityactivity inin foreignforeign marketmarket andand break break--downdown

of of internationalinternational confidenceconfidence inin thethe internationalinternational valuevalueof of aa currencycurrency maymay alsoalso resultresult inin thethe flightflight of of foreignforeign

capitalcapital thusthus plunging plunging thethe economyeconomy intointo aa currencycurrency

crisiscrisis..



M.P influences the supply of money and the rateM.P influences the supply of money and the rateof interest in order to stabilize the economy at of interest in order to stabilize the economy at

full employment or near full employment level byfull employment or near full employment level bychanging the level of aggregate demand in thechanging the level of aggregate demand in theeconomy.economy.

Business Cycles are sought to be controlled withBusiness Cycles are sought to be controlled with

the help of the tools of M.Pthe help of the tools of M.P Thus during recession, money supply isThus during recession, money supply is

increased and interest rates are bought down toincreased and interest rates are bought down toincrease the level of aggregate demand in theincrease the level of aggregate demand in the

economy because it is the level of aggregateeconomy because it is the level of aggregatedemand that determines the level of demand that determines the level of employment, output and income in an economy.employment, output and income in an economy.



Similarly, during the times of high inflation,Similarly, during the times of high inflation,price rise is sought to be controlled byprice rise is sought to be controlled by

reducing the money supply and raising thereducing the money supply and raising theinterest rates which brings about a fall in theinterest rates which brings about a fall in theaggregate demand and prices.aggregate demand and prices.

In the context of a developing country likeIn the context of a developing country likeIndia, monetary policy aims to achieveIndia, monetary policy aims to achievesustained economic growth in the different sustained economic growth in the different sectors of the economy.sectors of the economy.



Instruments of Monetary PolicyInstruments of Monetary Policy

General instruments of Monetary Policy.General instruments of Monetary Policy.

Bank Rate or Discount Rate Policy:Bank Rate or Discount Rate Policy:

Open Market Operations:Open Market Operations:

Cash Reserve Ratio:Cash Reserve Ratio: A ssume that the total deposits with commercial banks A ssume that the total deposits with commercial banksare equal to Rs. 1000 crores and CRR is 5%. Theare equal to Rs. 1000 crores and CRR is 5%. Thecommercial banks will have to maintain Rs. 50/commercial banks will have to maintain Rs. 50/-- crorescroresworth reserves with the central bank. The excessworth reserves with the central bank. The excess

reserves with the commercial bank being Rs. 950 crores,reserves with the commercial bank being Rs. 950 crores,the banking system will be able to create credit twentythe banking system will be able to create credit twentytimes its excess reserves i:e 950 x 100/5 crores= Rs.times its excess reserves i:e 950 x 100/5 crores= Rs.19000/19000/-- crores.crores.



Pursuing a tight or dear monetary policy, thePursuing a tight or dear monetary policy, thecentral bank decides to raise the reservecentral bank decides to raise the reserve

requirements to 10%. With 10 % reserverequirements to 10%. With 10 % reserverequirements, the excess reserves will be Rs.requirements, the excess reserves will be Rs.900 crores and the banking system will be900 crores and the banking system will beable to create credit only ten times its excessable to create credit only ten times its excessreserves i.e , Rs. 900 x 100/10 crores = Rs.reserves i.e , Rs. 900 x 100/10 crores = Rs.9000 crores.9000 crores.



Selective Instruments of MonetarySelective Instruments of MonetaryPolicyPolicy

1)1) Margin Requirements:Margin Requirements:

2)2) Regulation of Consumer Credit:Regulation of Consumer Credit:

3)3) Rationing of Credit:Rationing of Credit:4)4) Issue of Directives:Issue of Directives:

5)5) Moral Suasion:Moral Suasion:

6)6) Direct A ction:Direct A ction:



Limitations of Monetary PolicyLimitations of Monetary Policy

1)1) Limited in scopeLimited in scope

2)2) Preference for Currency Money overPreference for Currency Money overBank MoneyBank Money

3)3) Money Market DualismMoney Market Dualism

4)4) Parallel EconomyParallel Economy

5)5) Lack of Independence and A utonomy of Lack of Independence and A utonomy of

the Central Bankthe Central Bank6)6) Less Effective in Controlling Booms andLess Effective in Controlling Booms and

RecessionsRecessions

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