Monetary Policy and Fiscal Policy: Caiib Paper 1 (Module A), Unit 8

Monetary Policy and Fiscal Policy: Caiib Paper 1 (Module A), Unit 8

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So, here we are providing “Unit 8: Monetary Policy and Fiscal Policy” of “Module A: Economic Analysis” from “Paper 1: Advanced Bank Management (ABM)”.

The Article is Caiib Unit 8: Monetary Policy and Fiscal Policy

♦Monetary Policy

 Monetary Policy is the process by which the Government, Central Bank controls

  • The money supply
  • Availability of money
  • Cost of money or rate of interest

In order to attain a set of objective oriented towards the growth and stability of the economy.  Monetary policy is referred to as either being expansionary policy or a contractionary policy.

Expansionary policy

  • An expansionary policy increases the total supply of money in the economy. This is used to combat unemployment in a recession by lowering interest rates.

Contractionary policy

  • A contractionary policy decreases the total money supply. This is used to combat inflation by raising the interest rates.
Tools of Monetary policy:
  • Bank Rate
  • Cash Reserve Ratio
  • Statutory Liquidity Ratio
  • Market Stabilization Scheme
  • Repo Rate
  • Reverse Repo Rate
  • Open Market Operations

Bank Rate

It is also referred as Discount rate, is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries.

Bank Rate as an instrument of Monetary policy has been very limited in India because of these basic factors:

  1. The Structure of interest rates is not automatically linked to the bank rate
  2. Commercial banks enjoy specific refinance facilities, and not necessarily rediscount their eligible securities with RBI at Bank rate
  3. The bill market is under-developed and the different sub-markets of the money market are not influenced by the bank rate.

 Cash Reserve Ratio (CRR):

  • The present banking system is called a “Fractional Reserve Banking System, as the banks are required to keep only a fraction of their deposit liabilities in the form of liquid cash with the central bank for ensuring Safety and liquidity of deposits.
  • CRR was introduced in 1950 primarily as a measure to ensure safety and liquidity of bank deposits.
  • This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio.

Statutory Liquidity Ration (SLR):

  • SLR refers to the amount that all banks requires maintaining in cash or in the form of Gold or approved securities.  Approved securities mean dated securities, government bonds, and share of different companies.
  •  The SLR is determined as % of Total Demand and Time Liabilities

Note: The maximum limit of SLR is 40% and minimum limit of SLR is 0 In India

 Demand Liabilities

  • Demand Liabilities’ include all liabilities which are payable on demand and they include current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/guarantees, balances in overdue fixed deposits, cash certificates and cumulative/recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as security for advances which are payable on demand. Money at Call and Short Notice from outside the Banking System should be shown against liability to others.

Time Liabilities:

  • Time Liabilities are those which are payable otherwise than on demand and they include fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings bank deposits, staff security deposits, margin held against letters of credit if not payable on demand, deposits held as securities for advances which are not payable on demand and Gold Deposits.

 Market Stabilization Scheme:

  • RBI introduced Market Stabilization Scheme after consulting GOI for mopping up liquidity of a more enduring nature. Under this scheme, the GOI issue existing instrument, such as Treasury Bills/ and or dated securities by way of auctions under the MSS, in addition to the normal borrowing requirements, for absorbing liquidity form the system.

 Repo Rate:

  • Repo (Repurchase) rate is the rate at which RBI lends short-term money to the banks. Bank lending rates are determined by the movement of Repo Rate.

 Reverse Repo Rate:

  • Reverse Repo Rate is the rate at which banks park their short term excess liquidity with the RBI. The RBI uses this tool when it feels there is too much money floating in the Banking System.
  •  An Increase in Reverse Repo means that the RBI will borrow money from the Banks at a higher rate of interest, so banks would prefer to keep their money with the RBI.

 Open Market Operations:

  • Under this, RBI buys or sells government bonds in the secondary market.  By absorbing bonds, it drives up bond yields and injects money into the market. When it sells the bonds, it done so to such the money out of the system.

Refinance Facilities: RBI Provide Sector- specific refinance facilities aimed at achieving sector specific objectives through provision of liquidity at a cost linked to the policy repo rate.

Liquidity Adjustment facility (LAF): It consists of overnight and term repo/ reserve repo auctions.

Term Repos: Since October 2013, The RBI has introduced term repos (of different tenors, such as,  7/14/28 days), to inject liquidity over a period that is longer than overnight. The aim of term repo is to help develop inter-bank money market.

Marginal Standing Facility (MSF): It is a special window for banks to borrow from RBI against approved government securities in an emergency situation like an acute cash shortage. MSF rate is higher then Repo rate.

 RBI’s monetary policy‘s objectives:
  • Monitor the global and domestic economic conditions and respond swiftly as required.
  •  Ensure higher bank credit expansion to achieve higher growth but at the same time protect the credit quality
  • Maintain price stability and financial stability
  • Give thrust on Interest Rate Management, Inflation Management and Liquidity Management.

♦Fiscal Policy

  • In economics and political science, fiscal policy is the use of government revenue collection and expenditure to influence a country’s economy.
  • Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and supply of money. The two main instrument of fiscal policy are government spending and taxation. Changes In the level and composition of taxation and government spending can have impact on the following variable in the economy.
  1. Aggregate demand and the level of economic activity
  2. The pattern of resources allocation
  3. The distribution of income
  • Fiscal Policy is the use of government spending and revenue collection the economy. Fiscal Policy refers to the overall effect of the budget outcome on economic activity.


FRBM requirements are

  • The Government to place before Parliament 3 statement each year along with Budgets, Covering Medium Term Fiscal Policy, Fiscal Policy Strategy and Macroeconomic Framework
  • Center to reduce the fiscal deficit (Generally 3% of GDP) and more categorically to “Eliminate revenue deficit’ by 31-03-2008. Government to set a ceiling on guarantee (0.5% o GDP)
  • Act prohibits the Center form borrowing from the RBI, i.e. it bans ‘Deficit financing’ through money creation. The RBI is also barred from subscribing to primary issues of Central Government Securities.
  • The Finance Minister is required to keep Parliament informed through quarterly review on the implementation, and to take corrective measure.
  • The main theme of the FRBM Act is to reduce the dependence of the Government on borrowings and help to reduce the fiscal deficit in a phased manner.

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