GOVERNMENTS ROLE: FISCAL AND MONETARY POLICY

PRESENTED BY: MANSI ANAND 8106 DIVYA CHADHA 8108 MEGHA SISAUDIA 8109 AVINASH SARAF 8110

THE INDIAN ECONOMY

Pre-liberalization period (1947-1991)- License Raj Mixed Economy system post liberalization (Post 1991) Progress towards free market economy by the turn of 20th century
CURRENT STATISTICS
GDP GDP Growth GDP per capita GDP by sector $1.53 trillion (nominal: 10th; 2010) 8.5% (2010-11) $1,265 (nominal: 138th; 2010) Services (55.3%), Industry (28.6%), Agriculture (16.1%) (2010)

Inflation (CPI) 9.44% (June 2011)

WHY IS GOVERNMENT INTERVENTION NEEDED?

To correct for market failure

Regulation of oligopolies/cartel behaviour Direct provision of public goods (defence) Policies to introduce competition into markets (de-regulation) Progressive taxes, Direct tax on wealth , etc. Provisions (PDS) Benefits (Pensions)

To achieve a more equitable distribution of income and wealth

To improve the performance of the economy

Create equilibrium where private sector fails to do so Maintaining the appropriate levels of money supply in the economy

MODES OF GOVERNMENT INTERVENTION

MONETARY POLICY

FISCAL POLICY

LAWS AND PROVISIONS

MANAGING COMPETITION

MONETARY POLICY
Meaning Process by which the monetary authority of a country controls: The supply of money Availability of money Cost of money or rate of interest Purpose Promoting economic growth and stability Impacts Inflation Exchange rates with other currencies Unemployment

ADVANTAGES
Effective in fighting inflation Helps to respond quickly Fine-tuning easier Political Immunity

DISADVANTAGES

Cannot prevent fiscal dominance

Conflicting goals

Cannot actually restrict investment Cannot push in money easily

TYPES OF MONETARY POLICY

EXPANSIONARY MONETARY POLICY CONTRACTIONARY MONETARY POLICY

EXPANSIONARY MONETARY POLICY

Expansionary monetary policy expands (increases) the supply of money and is followed during deflation. y Expansionary monetary policy causes an increase in bond prices and a reduction in interest rates. y Lower interest rates lead to higher levels of capital investment. y The lower interest rates make domestic bonds less attractive, so the demand for domestic bonds falls and the demand for foreign bonds rises. y The demand for domestic currency falls and the demand for foreign currency rises, causing a decrease in the exchange rate. (The value of the domestic currency is now lower relative to foreign currencies) y A lower exchange rate causes exports to increase, imports to decrease and the balance of trade to increase.

CONTRACTIONARY MONETARY POLICY

This policy decreases the money supply and is followed during inflation.
y Contractionary monetary policy causes a decrease in bond prices and y y

an increase in interest rates. Higher interest rates lead to lower levels of capital investment. The higher interest rates make domestic bonds more attractive, so the demand for domestic bonds rises and the demand for foreign bonds falls. The demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate. (The value of the domestic currency is now higher relative to foreign currencies) A higher exchange rate causes exports to decrease, imports to increase and the balance of trade to decrease.

INSTRUMENTS OF MONETARY POLICY

QUANTITATIVE MEASURES QUALITATIVE MEASURES

QUANTITATIVE MEASURES
CASH RESEVE RATIO STATUTORY LIQUIDITY REQUIREMENT BANK RATE POLICY OPEN MARKET OPERATIONS

CASH RESERVE RATIO

The cash reserve ratio is the percentage of total deposits which commercial banks are required to maintain in the form of cash reserve with the central bank. bank. The objective of cash reserve is to prevent shortage of cash for meeting the cash demand by the depositors. depositors. By changing the CRR, the central bank can change the money supply overnight. overnight. When economic conditions demand a contractionary monetary policy, the central bank raises the CRR. And when CRR. economic conditions demand monetary expansion ,the central bank cuts down the CRR. CRR.

STATUTORY LIQUIDITY REQUIREMENT

In India ,the RBI has imposed another reserve requirement in addition to CRR. It is called statutory liquidity requirement. CRR. requirement. The SLR is the proportion of the total deposits which commercial banks are statutorily required to maintain in the form of liquid assets in addition to cash reserve ratio. ratio. The SLR is raised under contractionary monetary policy and is decreased under expansionary policy. policy.

BANK RATE POLICY

y Bank rate is the official minimum rate of interest at which central

bank lends money to commercial banks. So bank rate is known as the central bank s lending rate.
y In order to correct excess demand or inflationary situations,

Central Bank increase bank rate. Consequent upon an increase in bank rate, commercial banks raise their lending rate to the general public. This makes the borrowing from commercial banks costlier.
y In case of deficient demand the bank rate is reduced which in turn

increases the borrowings and capital investment.

OPEN MARKET OPERATIONS

The open market operations is sale and purchase of government securities and Treasury Bills by the central bank of the country. country. When the central bank decides to pump money into circulation, it buys back the government securities, bills and bonds. bonds. When it decides to reduce money in circulation it sells the government bonds and securities. securities. The central bank carries out its open market operations through the commercial banks. banks.

QUALITATIVE MEASURES
CONSUMER CREDIT REGULATION MORAL SUASION CHANGE IN LENDING MARGINS DIRECT ACTION

CONSUMER CREDIT REGULATION

y If there is excess demand for certain consumer durables

leading to their high prices, central bank can reduce consumer credit by (a) increasing down payment, and (b) reducing the number of installments of repayment of such credit.
y On the other hand, if there is deficient demand for certain

specific commodities causing deflationary situation, central bank can increase consumer credit by (a) reducing down payment and (b) increasing the number of installments of repayment of such credit.

MORAL SUASION
y Moral suasion means persuasion and request. To arrest inflationary

situation central bank persuades and request the commercial banks to refrain from giving loans for speculative and non-essential purposes.
y On the other hand, to counteract deflation central bank persuades

the commercial banks to extend credit for different purposes.

y Central bank also appeals commercial banks to extend their

wholehearted co-operation to achieve the objectives of monetary policy. Being the monetary authority directions of the central bank are usually followed by commercial banks.

CHANGE IN LENDING MARGINS

The banks provide loans only up to a certain percentage of

the value of the mortgaged property. property.

The gap between the value of the mortgaged property and

amount advanced is called Lending Margin. Margin.

The central bank is empowered to increase the lending

margin with a view to decrease the bank credit. credit.

DIRECT ACTION
This method is adopted when a commercial bank does not cooperate the central bank in achieving its desirable objectives. Direct action may take any of the following forms: y Central banks may charge a penal rate of interest over and above the bank rate upon the defaulting banks;
y Central bank may refuse to rediscount the bills of those banks

which are not following its directives;

y Central bank may refuse to grant further accommodation to

those banks whose borrowings are in excess of their capital and reserves.

KEY HIGHLIGHTS

MONETARY POLICY STATEMENT OF RBI 2011-2012

y Short term lending rate (repo) hiked by 50 bps from 6.75 to 7.25 y y y y y y

pc. Repo rate to be only effective policy rate to better signal monetary policy stance from now on. Reverse repo to be fixed 100 bps lower than the repo rate. Short-term borrowing rate (reverse repo) up by 50 bps to 6.25 pc. Cash reserve ratio (CRR) and bank rate left unchanged at 6 pc each. Interest rates on savings bank deposits hiked to 4 pc from 3.5 pc. Economic growth projected lower at 8 pc for FY 12.

y WPI inflation projection lowered to 6 pc. y Objective is to contain inflation by curbing demand-side y y y y y

pressures. Favours aligning of fuel prices with international crude prices to avert widening of fiscal deficit. Banks to get a new overnight borrowing window under Marginal Standing Facility at 8.25 pc. Likelihood of oil prices moderating significantly is low. Malegam Committee recommendations on MFI sector broadly accepted. Bank loan to MFIs on or after April 1, 2011, will be treated as priority sector loans.

HOW MONETARY POLICY CONTROLS INFLATION?

CENTRAL BANK

CASH

SECURITIES AND TRESURY BILLS

BANK RATE

CASH RESERVE RATIO

STATUTORY LIQUID RATIO

COMMERCIAL BANKS

CORPORATES
REDUCED BORROWING OF LOANS

INDIVIDUALS
REDUCE LIQUIDITY IN MARKET

FISCAL POLICY

Fiscal policy refers to the policy of the government as regards taxation, public borrowing and public expenditure with the objective to provide desirable effects on the national income, production, employment and general price level. The word fiscal is derived from the word fisc which means treasury.

KEYNISIAN ECONOMICS
 The Great Depression 1930 was the beginning of fiscal policy and Govt. involvement in the economy.  Keynes argued that since in depression private investors were reluctant to undertake investment because of unexpected return, Government should undertake investment.  This investment will have multifold impact on income because of the working of multiplier.

OBJECTIVES
Development by effective Mobilisation of Resources. Efficient allocation of Financial Resources Reduction in inequalities of Income and Wealth Price Stability and Control of Inflation. Employment Generation Balanced Regional Development Development of Infrastructure

STANCES OF FISCAL POLICY

y Neutral Fiscal Policy: Government runs with a balanced budget

where government spending is equal to tax revenues. G=T

y Reflationary (Expansionary) Fiscal Policy : happens when

the government is running a large deficit budget. Here, the government borrows money to inject funds into the economy so as to increase the level of aggregate demand and economic activity. G>T

y Deflationary (Contractionary) Fiscal Policy : happens when

the government runs a budget surplus. The government is injecting fewer funds into the economy than it is withdrawing through taxes. The level of aggregate demand and economic activity falls. G<T

ECONOMIC STABILIZATION
Discretionary Fiscal Policy Discretionary Fiscal Policy implies deliberate changes undertaken by the government of the country in the tax rates and planned outlays in an effort to stabilise the economy.

Automatic Stabilizers An automatic stabilizer is an expenditure programme or tax law that automatically increases expenditure (or decreases taxes) when an economy enters a recession and automatically decreases expenditure (or increases taxes) when an economy enters a period of inflation.

AUTOMATIC STABILIZERS
y Tax revenues: When the economy is expanding rapidly

the amount of tax revenue increases which takes money out of the circular flow of income and spending. y Welfare spending: A growing economy means that the government does not have to spend as much on meanstested welfare benefits such as income support and unemployment benefits. y Budget balance and the circular flow: A fastgrowing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit.

TOOLS AND TECHNIQUES

Following are the Tools and Techniques of Fiscal Policy in India.
A. Taxation Policy B. Government Expenditure Policy C. Deficit Financing Policy D. Public Debt Policy

TAXATION POLICY
A tax is a compulsory payment, levied on a person or association, to meet the expenditure incurred on conferring common benefits upon the people of a country. Taxation policy is relating to new amendments in direct tax and indirect tax as per finance bill Govt. of India passes every year. Taxes are the main source of earning for the Govt. More taxes, more burden on people, decrease production and purchasing power. Less taxes, increase govt. dependence on Public Debt and Deficit financing which increase inflation.

CLASSIFICATION OF TAXES
Direct taxes Direct taxes are the taxes which are not shifted i.e. the incidence of which falls on persons that pay them to the government. For example, income tax and wealth tax.

Equity Certainty Relative Elastic Economical Anti-inflationary

Tax Evasion Arbitrary Rates Inconvenient Narrow Coverage Sectoral Imbalance

Indirect Taxes Indirect taxes are the taxes in which the burden of paying tax is passed on the third party. For example service tax, VAT, excise duty, custom duty

Convenient Difficult to evade Wide Coverage Elastic Influence on pattern of Production Social Welfare

High cost of collection Increase income inequalities Affect consumption Uncertainty Inflationary Possibility of tax evasion

INCOME TAX
The provisions of Indian Income-Tax are governed by Indian Income-Tax Act, 1961 which extends to the whole of India and became effective from 1st April 1962.
y Personal Tax- Tax on the personal income of assessee from

salary, house property, business/profession, capital gains and income from other sources.
y Corporate Tax- A tax levied on corporations' profits, because

corporations are legal entities separate from their owners, they may be taxed as if they were persons. A corporate tax, then, is the equivalent of the income tax for natural persons.

INCOME TAX SLAB (PY 2011-12, AY 2012-13)

Resident Individual
INCOME Upto 1,80,000 Next 3,20,000 Next 3,00,000 TAX RATE NIL 10% 20%

Resident Woman
INCOME Upto 1,90,000 Next 3,10,000 Next 3,00,000 TAX RATE NIL 10% 20%

Above 8,00,000 30%

Above 8,00,000 30%

Senior Citizen 60yrs and above

INCOME Upto 2,50,000 Next 2,50,000 Next 3,00,000 TAX RATE NIL 10% 20%

Very Senior Citizen 80yrs and above

INCOME Upto 5,00,000 Next 3,00,000 TAX RATE NIL 20%

Above 8,00,000 30%

Above 8,00,000 30%

Every assessee has to pay primary educational cess @ 2% and secondary and higher educational cess @ 1% on such tax

WEALTH TAX
Wealth tax came into existence on 1st April 1957 under wealth tax act 1957. Wealth tax is derived from the property owned by the proprietor. Wealth tax will be charged in respect of the net wealth on the corresponding valuation date@1% of the amount by which the net wealth exceeds Rs. 15 lakhs.

SALES TAX
y Sales tax is levied on the sale of a commodity which is produced or

imported and sold for the first time.

y The sales tax is an indirect form of tax, it is the responsibility of

seller of the commodity to collect or recover the tax from the purchaser
y Each state has its own sales tax act and levies the tax at various

rates on within the state sales.

y The Central Sales Tax (CST) Act 1956 that comes under the

direction of Central Government takes into consideration all the interstate sales of commodities.

Rates under VAT(sales tax) system within state:

y 0% for the essential commodities y 1% on gold bullions as well as expensive stones y 4% on capital merchandise, industrial inputs, and commodities of mass

consumption y 12.5% on all other items y Variable rates (depending on state) are applicable for tobacco, liquor, petroleum products, etc.

Central sales tax shall equal to the rate of local sales tax but max. 2%

EXCISE AND CUSTOM DUTY

EXCISE DUTY
y Excise Duty is an indirect tax levied and collected on the goods

manufactured in India. y Administered through The Central Excise Act, 1944 y The rates at which the excise duty is to be collected are stipulated in the Central Excise Tariff Act, 1985.

CUSTOM DUTY
y Custom duty is an indirect tax levied and collected on the goods

imported in India y Administered through Indian Custom Act 1962 y The rates at which taxes under custom duty is charged are given under Custom tariff act, 1975

SERVICE TAX
y First introduced in India in 1994, by then finance

minister Dr. Manmohan Singh.

y Provision of service tax are in Finance Act 1994 y At beginning Service tax was imposed on only 3

services but at present service tax is payable on more than 100 services
y Service Tax shall be collected by service provider @

10% + education cess 3% of such tax

PUBLIC BORROWING
If revenue collected through taxes & other sources is not adequate to cover government expenditure government may resort to borrowing. Various sources of public borrowing are: y Internal y External y Borrowing from RBI

DEFICIT FINANCING
y Deficit financing refers to means of financing the

deliberate excess of expenditure over income through printing of currency notes or through borrowings.
y Deficit financing is primarily to cover the fiscal

deficit of the government. y Borrowing from the central bank of the country (RBI), withdrawal of accumulated cash balances and issue of new currency are included within its purview.

BUDGET DEFICIT
y Budgetary Deficit is the difference between all

receipts and expenditure of the government, both revenue and capital.

BUDGET DEFICIT= TOTAL EXPENDITURE TOTAL RECEIPTS

y The

concept of budgetary deficit has lost its significance after the presentation of the 1997-98 Budget.

FISCAL DEFICIT
y Fiscal Deficit is a difference between total expenditure

(both revenue and capital) and revenue receipts plus certain non-debt capital receipts like recovery of loans, proceeds from disinvestment.
FISCAL DEFICIT = TOTAL EXP. (REV. RECIEPTS+ NON- DEBT CAPITAL RECEIPTS)

y This

concept fully reflects the indebtedness of the government and throws light on the extent to which the government has gone beyond its means and the ways in which it has done so.

TABLE 236 : COMBINED DEFICITS OF THE CENTRAL AND STATE GOVERNMENTS (As percentage to GDP)

YEAR

GROSS FISCAL DEFICIT 2 9.43 9.86 9.48 8.42 7.20 6.46 5.38 4.12 8.50 9.59

GROSS PRIMARY DEFICIT 3 3.53 3.65 3.04 2.03 1.31 0.96 -0.01 -1.13 3.35 4.29

REVENUE DEFICIT 4 6.69 7.05 6.72 5.87 3.63 2.68 1.29 0.19 4.14 5.06

1 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10

TABLE 105 : CENTRES GROSS FISCAL DEFICIT

YEAR

GFD RECEIPTS

GFD EXPENDITURE

GROSS FISCAL DEFICIT

GROSS FISCAL DEFICIT ( AS PERCENTAGE OF GDP)

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

194730 204952 233985 280765 310415 348658 434921 580659 540825 603252 722212

313546 345907 379057 404038 436209 495093 577494 707571 877817 1017293 1103620

118816 140955 145072 123273 125794 146435 142573 126912 336992 414041 381408

5.65 6.19 5.91 4.48 3.88 3.95 3.33 2.56 6.05 6.64 5.50

IMPACT OF DEFICIT FINANCING

Govt. borrow from RBI

Money Supply increase

Rate of interest decrease

If not backed by Supply, inflation

Investment Increase, increasing aggregate demand

Deficit financing: a necessary evil in developing economy

GOVERNMENT EXPENDITURE
The expenditure incurred by public authorities like central, state and local governments to satisfy the collective social wants of the people is known as public or government expenditure.
It accelerates the growth rate of the economy, provides more employment opportunities, raises income, standard of living, reduces poverty and inequalities in income distribution, encourages private sector investment, brings regional balance in the economy. During times of inflation, government controls inflation by reducing its expenditure.

TYPES OF GOVERNMENT EXPENDITURE

Functional Classification

Revenue and Capital Expenditure

Transfer and Non-Transfer Expenditure

Development and Non-Development Expenditure

LIMITATIONS

y Recognition lags and policy time lags y The importance of the national income multiplier

imperfect information
y Fiscal Crowding-Out