The document discusses fiscal policy and monetary policy in India. It explains that fiscal policy involves using government budgets to achieve macroeconomic goals like stabilization and growth, while monetary policy concerns the supply of money and credit in the economy. It discusses various instruments of monetary policy used by the Reserve Bank of India, including bank rates, reserve ratios, open market operations, and interest rates. It provides an overview of the objectives and approaches of monetary policy in India from the 1950s to the 2000s, including a shift towards more market-based mechanisms and coordination with fiscal policy to control inflation.

1. Income Determination Model USAID Reform Project Dr. Brijesh C. Purohit

2. Fiscal Policy: It comprises of deliberate use of budgets (of central and state govts.) To achieve macroeconomic objectives, in particular stabilization And growth Fiscal Policy is a term reserved for the policy government has in balancing Government Spending with Tax Revenues. (Net) Taxes (T) = Leakage (Withdrawal) from the CFoI Government Spending (G) = Injection to CFoI

6. So expansionary Fiscal Policy ( G > T ) tends to lead to higher interest rates, which in turn tend to reduce private investments and private consumption, and thus reduce the expansionary effect of the fiscal policy, and increasing the tendency for government spending to crowd out private spending.

11. The IS curve shows the equilibrium relationships between the rate of interest (established in the money market) with the level of national income , assuming that the remaining injections and withdrawals (G, T, X and IM) stay as before. If these other ( exogenous ) injections and withdrawals change , then the IS curve itself will shift .

13. Thus, if government spending (G) is increased (and/or taxes (T) are reduced) - an expansionary Fiscal Policy - and the IS curve will shift to the right - because an expansionary fiscal policy will increase levels of national income for each and all levels of savings and investment, each and all levels of the interest rate.

14. The IS Curve slopes downwards because lower interest rates (r down) encourages investment and consumption and thus increases national income (Y). It thus represents the combinations of r and Y which are consistent with equilibrium in the goods and services markets (the circular flow of income). Note this. The CFoI is, in effect, a description of equilibrium in the markets for goods and services (and factors of production) -equilibrium in the 'real' (non money) part of the economy.

15. The relationship between income and the interest rate through the money market is represented as the L-M curve – the L iquidity preference (demand for money) and M oney supply relationship: The LM curve shows all those combinations of Y and r which are consistent with an equilibrium in the Money Market ( given a fixed money supply and a constant velocity of circulation)

17. The LM curve will shift to the right if the money supply is increased, or if interest rates are reduced, in the money market through monetary policy . An expansionary monetary policy shifts the LM curve to the right. A contractionary monetary policy shifts the LM curve to the left. Notice, too, the effect of inflation (an increase in the price level (P)) on this relationship. If the price level increases in the economy, then the stock of money in the economy cannot finance the same level of real transactions as before. We will need more money for any given level of Y at higher price levels than at low price levels. With a fixed supply of money, the greater demand for money at a higher price level means a higher rate of interest at a higher price level for any given Y. So inflation shifts the LM curve to the left.

18. IS and LM interactions The IS curve captures the essential relationship between the rate of interest and income in the markets for goods and services (the circular flow of income). The LM curve captures the essential relationship between the rate of interest and income in the money market. For the two markets to be consistent with each other - the same rate of interest ruling in both the goods and services market and in the money market - there can only be one equilibrium level of national income (Y*), shown by the intersection of the IS curve with the LM curve .

23. Money defined as a generally acceptable means of payment or of settling debt. It has three main functions: a) medium of exchange between buyers and sellers b) unit of account ( for accounts, debt, financial assets etc.) c) store of value or purchasing power enabling income earners to set aside a part of their income to yield future consumption Medium of Exchange: Currency and demand deposits (readily drawn) with the commercial banks Store of value: Time deposits of Commercial banks (as if to store its value)

24. Four measures of money supply: M1= Currency (currency notes and coins) with the public+ demand deposits with banks (commercial and cooperatives)+ other deposits with RBI M2= M1+ Post office savings bank deposits M3= M1+ time deposits with banks (commercial and cooperatives) M4= M3+ total deposits with the post office saving organisation Degree of Liquidity and comprehensiveness

25. Over time, a large and continuous rise in money supply Trends in M1: During 50s….50% ……… .60s…two times ……… .70s…three times ……… ..80s…four times ……… ..90s… about three times Trends in M3: During 70s…..five times ……… ..80s….four times ………… 90….three times

26. Factors affecting Money supply: Deficit financing bank credit Foreign exchange reserves: if FE receipts exceed payment in FE: FE is surrendered to bank in return for Rs. FE falls short of payment in FE: money is paid to banks to get FE to meet obligation

27. Monetary policy also known as Money and Credit Policy: It concerns itself with the supply of money as also credit to economy Till 1998-99: It was announced twice in a year: Oct….for Oct..March….to coincide with busy season April…for April to Sept…to coincide with lean season of agri. With decline in agri. And rise in industrial credit since 1999-2000 in April RBI makes an annual policy statement and a review in Oc t

28. Monetary policy provides: a) an overview of economy b) specifies measures that RBI intends to take to influence such key factors like…money supply….interest rates….inflation c)lays down norms for financial insts. Like banks, fin.cos.etc. relating to CRR, capital adequacy

29. Since 1951 and till 1990s…. Two sets of objectives pursued… a)controlled expansion of money b)sectoral deployment of funds Done keeping in mind plan priorities Special attention… Core industries (coal, iron, steel and engg.) foodgrains (rice, wheat etc.) priority sectors ( agri., SSI) weaker sections of population

31. In India, for instance, In 90s… growth of economy remain primary aim control of inflation urgent concern (91….double digit….17%) 8th (92-97)…aimed at achieving trend rate of inflation 5% MP of 90s favored…process of stabilization and structural adjustment initiated in 91

33. Third imp. Instrument… Cash Reserve Ratio: Banks’ Cash Holding/Total Deposit Liabilities Fourth Imp. Instrument is Statutory Liquidity Ratio(SLR)… RBI imposes an obligation on banks to buy govt. Securirties (of Low interest rates)(25% at present) To achieve the objective of sectoral deployment of credit.. Direct (Quantity)… Reserve ratios Quantitative controls on RBI lending to banks and commercial sector Quantitative credit controls Indirect Instruments… administrative setting of various interest rates: e.g. RBI lending commercial bank lending deposits

34. In 1960s .. Emphasis was on indirect measures with little variation in reserve ratios In1970s… Emphasis shifted to direct approaches and persisted since then Shift from indirect to direct measures was prevalent more due to rising deficit or inflation Monetary instrument in India, both direct and indirect, operate Through administrative controls or fiat The crisis like droughts, oil crisis in 1966,1969, 1973 were dealt with effectively by cutting down domestic credit

36. Major developments in 1980s … Increasing deficit … to control money supply: … .SLR..up to 38.5% by 1990 … ..CRR up to 15% >>>net RBI credit to GOI was given as a separate estimate since 1987 RBI attempted estimates of demand for money: relationship between reserve money and money supply real income increases income elasticity of demand for money acceptable increase in price level

37. In 1980….inflation…7.1%….aimed to 5% In second half of 1980s: steps towards expanding and activating money market in short term securities e.g. treasury bills of 182 days discount and finance house of India was set up instruments like certificates of deposits, commercial papers, participation certificates etc. These acted as transmission channel for MP