LESSON – 40

Monetary and Fiscal Policies

In Developing Countries

Learning outcomes

After studying this unit, you should be able to:

Define Monetary policy and Fiscal policy

Know different types of market structure
Distinguish between Monetary policy and Fiscal policy
Relate national income and economic welfare
Know per capita as an indicator of economic welfare

INTRODUCTION:
As you all know that the ultimate objective of the developing countries is to attain the
highest level of economic growth. These countries posses enormous natural and
manpower resources, but most of these resources are unutilized or underutilized. The
process of economic development has started with a low key-not and the real rate of
economic growth has been far below the targeted rate of growth. The main obstacles
have been the paucity of capital resource, technical know-how, and lack of well-defined
order of priorities. The State in the recent past has started taking an active and keep
interest in the developmental activities, but it has attained limited success. The State is
equipped with monetary and fiscal policies to keep an over-all control over the economy.
We shall not examine the role, efficacy, and limitations of monetary and fiscal policies in
the developing countries.
1. MONETARY POLICY
Meaning of Monetary Policy
Monetary policy, generally, refers to those policy measures of the central bank
which are adopted to control and regulate the supply of money, the cost and availability
of credit in a country. Monetary policy consists of those monetary decisions and
measures the aim of which is to influence the monetary system. According to Paul
Einzig, an ideal monetary policy may be defined “as the effort to reduce to a minimum
the disadvantages and increase the advantages, resulting from the existence and
operation of a monetary sytem.”1
Broadly speaking, by monetary policy is meant the policy pursued by the central
bank of a country for administering and controlling country’s money supply including
currency and demand deposits and managing the foreign exchange rates. The central
bank of a country through its monetary policy manipulates the money supply, credit,
government expenditure, and rates of interest in such a manner so that the monetary
system may be benefited to the maximum extent.

Objectives of Monetary Policy

Economists have conflicting and divergent views as regard the objectives of
monetary policy. Economists have from time to time mentioned different objectives of
the monetary policy. In fact the objectives of monetary policy change according to the
changes in the business activities an level of economic development. Broadly speaking,
the following are the main objectives of monetary policy:
1. Stability of Exchange Rates;
2. Price Stability;
3. Neutrality of Money;
4. Full Employment; and
5. Economic Growth with Stability.

We shall now discuss in brief each one of the above objectives of the monetary policy.

1. Stability of Exchange Rates. Most of the economics of the world today are open
economies. These economies have maintained trade relations with other countries.
International trade transactions take place on the basis of a fixed rate of exchange. Any
change in the equilibrium rate of exchange will have deep repercussions on the balance
of payments of a country. It is, therefore, essential to maintain stability in the exchange
rates.
In gold standard, the exchange rate stability was maintained through the
automatic working of the system. Free movement of gold from one country to another
helped in correcting the disequilibrium in the balance of payments, whenever and d
wherever it arose. But, the country had to sacrifice the domestic price stability for the
sake of stability in exchange rates. The gold standard was finally abandoned after World
War I, and since then the objective of stability of exchange rates has lost its significance.
However, in paper currency standard, stability of exchange rates is maintained through
the device of devaluation or overvaluation of the currency, as the case may be. Now, in
most of the countries the monetary policy is directed towards achieveing economic
stability.
2. Price Stability . Economists like Gustav Cassel and Keynes argue that
domestic price stability should be the main objective of central bank’s monetary policy.
Violetn fluctuations in prices create the problem of inflation and deflation which cause
enormous hardships to consumers, wage-earners and other factor-owners. Both post-
war inflation and great depression of 30’s have convinced the economists that the
objective of monetary policy should be the stabilization of the domestic price level even if
this stabilisation may mean destabilization of the exchange rates.
The objective of price stability has been criticized on several grounds. Modern
economists believe that the objective of monetary policy should not be restricted only to
the price stability but to the stabilization of the economic activity at full employment level
in the economy. Moreover, the term ‘price stability’ is very vague. Price level may mean
wholesale prices, retail prices, labour prices, and so on. The stabilization of general
price level is compatible with rising or falling of individual prices. Above all, the objective
of price stability ignores the realistic requirements of a dynamic society. Thus, on
account of the aforesaid limitations the objective of price stability has lost its significance
in present times. It is now resorted to along with the currently more important objective,
i.e. full employment.
3. Neutrality of Money. Prof. Hayek and some other economists belonging to
the a Austrian School have emphasized upon the neutrality of money as the objective of
monetary policy. The neutral money policy is based upon the assumption that money
should only play the role of medium of exchange and should not work as a measure of
value. In other words, the money supply should be regulated in such a manner that it
may not affect the output, price, employment, etc. It is only by keeping the supply of
money as constant that it can play neutral role.
 It is, however, wrong to assume that by keeping the supply of money as constant
the fluctuations in the price level can be avoided. Even the money supply remains
unchanged, but if velocity of circulation increases or decreases, it will definitely disturb
the price level. Thus, it is clear that the monetary authority cannot make the money
neutral just by keeping its supply unchanged.
4. Full Employment. Full employment refers to a situation in which all those
who are able and willing to work at he prevailing rates of wages get employment
opportunities. Full employment, however, does not mean complete or total employment.
Even at full employment level 2% to 5% resources may remain unemployed. Various
forms of unemployment like involuntary unemployment, seasonal unemployment,
frictional unemployment and structural unemployment may exist at full employment level.
It may not be very difficult for most countries to achieve the level of full employment but
the real problem is how to maintain it in the long run. Periodical fluctuations in the
business activities may cause unemployment in the economic system. The monetary
policy, therefore, should be directed to ensure that current investment exceeds current
saving and this can be done by creation of credit money or by the creation of additional
bank deposits or by higher velocity of circulation. When full employment is achieved,
efforts should be made to maintain equality between saving and investment at the full
employment level. According to Crowther, “the obvious objective of the monetary policy
of a country should be to attain equilibrium between saving and investment at the point
of full employment.”
5. Economic Growth with Stability. While for most of the developed countries the
objective of monetary policy is to maintain equality between saving and investment at ht full
employment level, the monetary policy in the undeveloped countries is directed towards achieving
high rate of economic growth. Monetary authority in an underdeveloped economy can use
different tools to promote economic growth.
Economic growth refers to a process whereby an economy’s real national income
increases over a long period of time. By increase in real national income we mean more
availability of goods and services in a country during a given period of time. Thus,
economic growth means the transformation of society of a country from a state of under
development to a high level of economic achievement.
The main hinderance in economic growth is the lack of investment activities in
the underdeveloped countries. Monetary policy can play a very crucial role in promoting
the investment activities. Monetary policy can also discourage investment in less-
productive or less-useful activities. In other words, monetary policy may be a mixture of
‘cheap’ and ‘tight’ monetary management, so as to encourage and discourage
investment according to the requirement, so as to encourage and discourage investment
according to the requirements of business activities. Besides, the monetary policy
should also aim at maintaining stability in the economy. Monetary policy should be
directed towards achieving high rate of growth over a long period of time.

Monetary Policy in a Developing Economy

Prof. Ragnar Nurkse defines underdeveloped countries as “those which
compared with the advanced countries are under-equipped with capital in relation to
their population and natural resources.” Underdeveloped countries do posses plenty of
natural and manpower resources but they are unutilized or underutilized. Most of the
underdeveloped countries suffer from the problems of low level of real per capita
income, business fluctuations, price instability, lack of credit facilities, lack of capital
formation, balance of payments disequilibrim, etc. An effective and proper monetary
policy will not only provide adequate financial resources for economic development but
also help the underdeveloped countries to set up and accelerate the rate of output,
employment and income. It may also help these countries in containing inflationary
pressures and achieving balance of payment equilibrium .

The following are the main objectives of monetary policy in a developing economy.

1. Inducement to Saving. Capital formation which is a prerequisite to economic growth

depends upon saving. Monetary policy in an underdeveloped country helps in promoting
savings, their mobilization, and their investment in productive activities. Monetary
authority has to provide adequate banking institutions, which may later on be utilized for
investment purposes. In order to induce savings, the monetary authrotiy has to offer
various incentives to the savers in the form of high rate of interest, safety of deposits,
etc.
2. Investment of Savings. According to Prof. Meier and Prof. Baldwin, “the
problem of inadequate savings cannot be solved merely by creating new institutions, but
the problem can be solved only by saving profitable investment of savings.” The
objective of economic growth cannot be achieved unless and until the savings are
utilized in productive investment activities. The rate of investment is very low in
underdeveloped countries on account of the absence of profitable productive activities,
lack of entrepreneurial ability and low marginal efficiency of capital. The central bank in
such a situation can resort to cheap money policy to promote investment activities.
3. Appropriate Policy as regard to Rate of Interest. The structure of the rate of
interest is generally not conductive to economic growth in underdeveloped countries—
the rates of interest do not only differ according to different time-schedules but these
also differ in different regions and business activities. High rate of interest, as they are
generally witnessed in underdeveloped countries, discourage both public and private
investment. The monetary authority, therefore, is required to formulate such a policy as
regards the rate of interest which may induce the investors to go in for more loans and
advances from the commercial banks and other financial institutions.
4. Maintenance and Monetary Equilibrium. Monetary policy in an
underdeveloped country should be directed towards achieving equality between demand
for money and supply of money. In the initial stages of economic development there is
need to expand credit facilities but once a certain level of growth is achieved credit
restrictions of various kinds must be imposed by the central bank. In practice, however,
it is very difficult to say as to when the monetary authority should impose credit
restrictions to control the supply of money.
5. To make Balance of Payment Favourable. Most of the underdeveloped
countries have to import capital goods, machinery, equipments, technical know-how, etc.
in the initial stage of their development. Consequently, their imports exceed the exports
and balance of payments becomes unfavourable. Monetary policy should be directed
towards maintaining stability in exchange rates and removing disequilibrium in the
balance of payments.
6. Price Stability. Internal price stability is an important objective of monetary
policy in underdeveloped countries. Violent fluctuations in the internal price level not
only disrupt the smooth working of an economy but these also lead to insecurity and
social injustice. While inflation creates enormous hardships for the wage-earners and
consumers, deflation proves disastrous for both entrepreneurs and wage-earners.
Increasing cost of labour and material also increases the cost of various projects, which
adversely affect the rate of economic growth.
It should be noted that the effects of price instability are always cumulative in
character. Therefore, monetary authority in a developing country should pursue such a
monetary policy which may help in maintaining price stability over a long period so that
the development activities may go uninterrupted. Different monetary measures can be a
adopted for inflationary and deflationary conditions. If inflationary pressures are
mounting in the economy, the monetary authority can resort to stringent monetary
action, so as to restrict the supply of money and credit in the country. For example,
measures like high bank bank rate, selling of government securities, raising the reserve
ratio, raising the margin requirement, etc., can be adopted to contain inflation. Likewise,
a different set of measures like lowering the bank rate, purchasing government securities
in open market, lowering reserve ratio, reducing the margin requirements, etc., can be
adopted to control deflation.
Thus, it is clear that the monetary authority in a developing economy can follow
the policy of monetary expansion and monetary contraction to stabilise the internal price
level. We can, therefore, conclude that the ultimate objective of monetary policy in the
developing countries is to achieve sustained economic growth with stability.

Limitations of Monetary Policy in Developing Countries

Monetary policy can play a very crucial and significant role in the economic development
of developing countries. However, the success of the monetary policy is limited by
certain factors, the more important amongst these are as follows:
(i) Underdeveloped Monetary and Capital Market. Most of the developing
countries do not have a well-developed and fully-organised money and capital market.
In the absence of such developed money markets it is not possible to effectively
implement the various credit control policies by the central bank.
(ii) Lack of Integrated Structure of Rate of Interest. In the developing
countries a sizable proportion of the total financial resources comes from the
unorganized banking sector. In the absence of an integrated and well-organised
structure of rate of interest the central bank fails to influence the market rate of interest
through changes in the bank rate. In fact, any increase or decrease in the bank rate
must be reflected in the form of increased or decreased market rate of interest, but it
does not happen in the developing countries.
(iii) Banking Habits of the People. In the developing countries most of the
exchange transactions are conducted with the help of money. People very seldom use
credit instruments to perform exchange transactions. It is for this reason that the credit
control policy of the central bank does not have desired effect on the business activities.
(iv) Lack of Co-operation by the Commercial Bank. Commercial banks are
the institutions which help in the implementation of the monetary policy pursued b ythe
central bank. In developing countries, however, the commercial banks fail to provide
sufficient co-operation to the central bank and in some cases they also flout the
directives given by the central bank. Monetary policy cannot succeed unless and until
there exists a proper coordination and co-operation between the central bank and
commercial banks.
(v) Literacy and Social Obstacles. Most of the developing countries suffer from
mass illiteracy, superstitions, dogmatism and other social evils. People do not
understand the significance of banking institutions. Neither they keep their deposits with
the banks nor do they avail the opportunities of loans and advances from the banks.
The success of monetary policy depends upon the widespread banking institutions,
banking habits of the people, adequate development of credit facilities, adequate
quantity of bank deposits, entrepreneurial ability, etc.
In brief, the monetary policy in a developing country suffer from several
limitations. The monetary authority on the one hand, has to create conditions whereby
the banking and financial institutions may flourish, and, on the other hand, it has to
exercise various restrictions and controls to regulate the supply of current and credit in
economy. The monetary authority has also to manipulate the credit policy in such a way
as to step up saving and investment activities for accelerating the rate of economic
growth.

2. FISCAL POLICY

Monetary policy alone cannot achieve the objectives of sustained economic

growth, stability and social justice in a developing economy. It is, therefore, essential to
supplement the monetary policy by an effective fiscal policy. Monetary and fiscal
policies taken together can prove to be very effective in achieving the objective of growth
with stability.
Meaning of Fiscal Policy. Fiscal policy refers to government spending, taxing,
borrowing and debt management. The government through its fiscal policy can
influence the nature of economic activities in a country. According to Arthur Smithies,
“Fiscal policy is a policy under which the government uses its expenditure and revenue
programmes to produce desirable effects and avoid undersirable effects on national
income, production and employment.” Fiscal policy is used as a balancing device in the
development of an economy. It refers to a process of shaping public taxation and public
expenditure so as to help dampen the swings of the business cycle and to contribute
towards the maintenance of a progressive, high employment economy free from
excessive inflation or deflation. In other words, the modern fiscal policy is a technique to
attain and maintain full employment by manipulating public expenditure and revenue in
such a way as to keep an equilibrium between effective demand and supply of goods
and services at a particular time. In brief, the modern fiscal policy is nothing but the
application of principle of functional finance.
There are mainly three constituents of the fiscal policy; these are: (i) taxation policy, (ii)
public expenditure policy, and (iii) public debt policy. All these constituents must work together to
make the fiscal policy sound and effective.

Objective of Fiscal Policy in a Developing Country.

The objectives of fiscal policy differ from country to country according to the level
of economic advancement. The role of fiscal policy in developed countries is to maintain
the level of full employment, and to stabilize the rate of growth. While in an
underdeveloped and developing economy, the role of fiscal policy is to accelerate the
rate of capital formation and investment, change the pattern of investment, maintaining
adequate supply of essential consumer goods on the one hand, and capital goods on
the other, encourage, the investment activities into socially desirable channels,
maintaining price stability, and above all to make the distribution of national product just
and equitable.
These objectives of fiscal policy may come in conflict with one another. For
example, the objective of high rate of economic growth may come in conflict with the
distributive objective of the fiscal policy. Likewise, equitable distribution of income and
wealth may adversely affect the inducement to produce more and thus retard the rate of
economic growth. Thus, reconciliation has to be achieved between these conflicting
objectives of fiscal policy. The main objectives of fiscal policy in a developing economy
may be summarized as follows:
1. Mobilisation of Resources. Most of the developing countries are caught in the
‘vicious circle of poverty.’ Prof. Higgins remarks that “the road to the growth of
developing economies is paved with vicious circles.” Vicious circle of poverty refers to
the circular constellation of forces, tending to act and react in such a way as to keep a
poor country in a state of poverty. The most important objective of fiscal policy in a
developing country should be to break this vicious circle of poverty.
In order to achieve the above objective it is of utmost importance to increase the
rate of investment and capital formation to accelerate the rate of growth. The
government may resort to voluntary and forced saving to collect enough resources for
investment.
‘Incremental saving ‘ratio’, i.e. the marginal propensity to save, can be maximized
by a number of methods which may include direct physical controls, increase in the rates
of existing taxes, imposition of new taxes, operating surplus of the public enterprises,
public borrowings, deficit financing, etc.
Growth breeds inflation. It is, therefore, essential to contain inflationary pressure
in the economy through the curtailment of consumption expenditure and avoidance of
unproductive investment. In developing countries, the level of per capital income is very
low. As a result of this, adequate voluntary savings do not take place. The government,
therefore, has to depend on taxation and public borrowings for raising revenue
resources to finance development programmes.

2. Acceleration of Economic Growth. The aim of fiscal policy in a developing country

is to accelerate the rate of growth so that the real national income of the country may
increase in the long run. The government, through its taxation policy, public borrowings,
deficit financing, etc., can provide incentives for saving and investment. The revenue
resources collected through taxes should be invested in productive activities. Public
expenditure should be diverted towards new and more useful development activities.
The government may also grant tax relief and subsidies to the entrepreneurial class to
boost the investment activities. Expansion of investment opportunities will certainly have
a favourable effect on the level of business activities and rate of economic growth.

3. To Minimise the Inequalit8ies of Income and Wealth. To maintain the equality fo

income and wealth is not only an objective of economic growth, but a precondition to it.
The government, therefore, should formulate its fiscal policy in such a manner so that it
may reduce the inequalities of income and wealth. A mere increase in national income
does not necessarily promote economic growth. It is all the more essential to reduce the
existing inequalities of income and wealth. Extreme inequalities create political and
social discontentment and generate instability in the economy. The following measures
can be taken to reduce the inequalities of income and wealth:
(i) Progressive taxes may be imposed on the rich people so that the unnecessary
consumption expenditure is curtailed.
(ii) The poorer section of the society should be exempted from taxes.
(iii) Luxury goods should be highly taxed and the proceeds so collected be
diverted to productive investment activities.
(iv) The government must spend more on the social services or on the items
which benefit the poor people most.
(v) The fiscal policy must discourage unearned income.
In brief, the problem of reducing inequalities of income and wealth may be solved
through redistributive public expenditure and redistributive tax policy.
4. To Increase Employment Opportunities. One of the important objectives of fiscal
policy in a developing country is to increase the employment was regarded as the most
important objective under the influence of Keynes. Prof. Lewis is of the opinion that
without providing full employment to the available manpower, the objective of economic
growth will remain incomplete. The government through her fiscal policy can help in
creating and promoting an atmosphere where people may get employment
opportunities.
The government in a developing country can resort to the following methods to
raise the level of employment in the country.
(i) Public Spending. Public expenditure is the most potent weapon to fight
against unemployment. The level of employment depends upon effective demand. The
government can influence effective demand either by making more public expenditure or
by resorting to such fiscal methods which may raise the level of private expenditure.
The role of public expenditure becomes very significant during the period of depression
when the private entrepreneurs are not keen to take up investment activities. The
government can resort to ‘counter cyclical fiscal policy,’ which means that taxes and
government spending be varied in an anti-cyclical direction; government spending being
cut and taxes increased in the expanding phase of cycle, and government spending
increased and taxes cut during the contraction phase. Increased government
expenditure will open new job opportunities in the economy, which mean creation of
demand for goods and services.
Mention may also be made of ‘pump priming’ and ‘compensatory expenditure’ to
raise the level of employment in the economy, Pump priming refers to increase in private
expenditure through an injection of fresh purchasing power in the form of an increase in
private expenditure through an injection of fresh purchasing power in the form of an
increase in public expenditure. It is argued that such an initial public expenditure may
set in motion a process of recovery from the condition of depression. Pump-priming is
based on the assumption that a temporary additional expenditure will generate lasting
process to raise the level of employment and income. Compensatory expenditure, on
the other hand, refers to the variations in the government budget expenditure to
compensate the deficiency in private demand so as to maintain high level of investment,
employment and income stability. In the words of Keynes, “government expenditure
becomes a balancing factor in order to maintain national income at a given level. Such
an expenditure may be progressively raised during depression phase of the business
cycle, and progressively reduced in the recovery phase.”
(ii) Taxation Policy. Taxation policy of the government can play a very
important role in raising the level of employment in a developing economy.
Unemployment is the result of low propensity to consume. The government can resort
to redistributive tax policy to remove the deficiency in the propensity to consume. While
the rich people have a low propensity to consume the poor have a very high propensity.
The government can impose heavy takes on the rich people and the proceeds of these
taxes may be distributed among the poor. Progressive taxes on the rich persons are
socially desirable and economically advantageous. It should, however, be noted that the
progressive taxes should not adversely affect the inducement to save and invest.
Similarly, the money transferred from the rich to the poor should not be wasted on
conspicuous expenditure but utilized for essential consumption expenditure and
investment.
While explaining the effect of taxation policy o employment it would be pertinent
to mention the idea of ‘functional finance’ which was propounded by Prof. A. P. Lerner.
The central idea behind the theory of functional finance is that fiscal policy be judged by
its effects on the economy as a whole and not by any established doctrine of finance.
 (iii) Public Debt Policy. Taxation policy does not prove to be very effective in
the developing countries. People in these countries have a low level of per capita
income, therefore, the scope of raising the tax rates or imposing fresh taxes is very
limited. The government, therefore, has to resort to public borrowing to meet the various
public expenditure obligations.
Public debt policy can be used to control the non-essential private consumption
expenditure and to raise small savings for financing the development expenditure. The
government for this purpose can issue debentures, bonds, etc., with attractive rates of
interest to encourage people to purchase these titles. In case the government fails to
collect sufficient finance through these methods, it may resort to compulsory savings of
the public.
We cannot, however, depend very much upon public debt policy for raising the
level of employment in a developing economy. Public debt will prove effective only when
these debts are collected through the idle balance with the people. If the public
borrowing results in a fall in current consumption expenditure or is financed through
curtailment in investment, it will not have desired effects on the level of employment and
income.
5. Price Stability. As we have already discussed, a developing country does not
posses adequate capital resources of finance developmental expenditure. The scope of
taxes and public borrowing is also limited. Therefore, the government has to resort to
deficit financing. In most of the developing countries deficits in the State’s budget are
met by printing more currency notes. Increase in the supply of money creates
inflationary conditions in the economy. Increasing prices do not only create hardships for
the wage-earners and customers, these also raise the cost of development projects.
Though some economists have favoured mild inflation as an incentive for capital
formation, they have emphasized that large-scale inflation would retard economic
growth.
Thus, fiscal policy should aim at curbing inflationary pressure inherent in a
developing economy. While the demand for consumer goods is very large, the supply
remains relatively inelastic due to imperfections of markets and structural rigidities,
which impede the supply of essential goods. Imbalance between the demand and the
supply leads to inflationary pressure in the economy. On account of increase in the
prices of essential goods, the demand for increase in the wage rates gains momentum,
and thus the economy is caught in the vicious circle of high prices and high wages.
Thus, a demand-pull inflation tends to generate cost-push inflation in a developing
country.
A package of fiscal measures can be adopted to contain inflation. Some of the
important measures are given below:
(i) The excess purchasing power of the people should be withdrawn through
taxes, compulsory savings and public borrowings.
(ii) Some anti-inflationary taxes like supertax, expenditure tax, taxes on
luxury items, etc., should be imposed.
(iii) Besides liquid assets, cash-balances and capital assets should also be taxed.
(iv) The policy must be progressive so that it may affect only that section of the
society which is benefited most by inflation and does not harm the poorer section.
(v) Tax policy should encourage voluntary savings and control non-essential
consumption expenditure.
Fiscal measures may have limited success to check inflationary pressures,
therefore, these must be supplemented with monetary measures to make them more
effective.
 Though deflationary conditions are not so common in developing countries as
inflationary conditions, but if such a situation occurs, an appropriate fiscal policy with
emphasis on public expenditure can be followed to relieve the economy from the
quagmire of depression.

Limitations of Fiscal Policy in Developing Countries.

Fiscal policy has achieved great success in the developed countries, but in case
of developing countries it suffers from several limitations. In fact, the nature and
fundamental characteristics of the developing countries are responsible for partial
success of the fiscal policy. Some of the limitations of the fiscal policy are as follows:
First, the tax structure in the developing countries is rigid and narrow. There is
complete absence of conditions conductive to the growth of well-knit and integrated tax
policy.
Secondly, a sizable portion of the developing countries is non-monetised. As a
result of this, the fiscal measures pursued by the government do not prove to be very
effective and fruitful.
Thirdly, there is lack of statistical information as regard to the income,
expenditure, saving, investment, employment, etc. Lack of adequate data makes it
difficult for the public authorities to formulate a rational and effective fiscal policy.
Fourthly, unless the people understand the implications of the fiscal policy and
fully co-operate with the government in its implementation, it cannot succeed. In
developing countries, majority of the people are illiterate, and they do not understand the
implications of fiscal policy.
Fifthly, people are not conscious about their responsibilities and role in the
developmental programmes. There are cases of large-scale tax evasion with their
impact on the fiscal policy as well. In the event of tax evasion the government may fail
to collect the stipulated amount from the taxes.
Lastly, fiscal policy or for that matter any other policy requires an efficient
administrative machinery to formulate and successfully implement the policy. In
developing countries, different political groups and parties work on different lines and in
different directions to achieve their political ends without bothering about the welfare of
the people at large. The administration is corrupt and inefficient, and is incapable to
execute the fiscal policy honestly and effectively.

3. FISCAL AND MONETARY INTERACTIONS

For monetary policy to be effective it is necessary that the monetary authority

should have an effective say in regulating money supply which, in turn, requires that the
monetary authority must have a reasonable degree of control over the creation of
reserve money. Obviously, there are exogenous factors such as movements in the
foreign exchange assets which affect the level of reserve money. The degree of
independence in regulating reserve money depends upon the institutional arrangement
governing the functioning of the monetary authority. Over the years, the practice has
grown under which the entire budget deficit of the Central Government has been taken
over by the Reserve Bank of India, leading to an automatic monetisation of the deficit.
The issues that arise in the coordination of fiscal and monetary policies in India
can be understood by a brief review of the borrowing programmes of the Government.
There has been a significant rise in government borrowing since 1971. The volume of
treasury bills outstanding including those funded into special securities rose from Rs.
2,500 crores in March 1971 to Rs. 39,700 crores in March 1987. Other marketable debt
of the Central Government rose during the same period from Rs. 4,000 crores to Rs.
42,000 crores. Marketable debt of the State Governmetns too rose sharply from Rs.
1,200 crores in 1971 to Rs. 7,200 crores in 1986. Net Reserve Bank credit to
Government also rose significantly from Rs. 3,800 crores in 1971 to Rs. 45,800 crores in
1987. Out of the increase in treasury bills and other marketable debt outstanding of the
order of Rs. 81,900 crores, the absorption by the Reserve Bank accounted for about 60
per cent. The Reserve Bank owned more than 93 per cent of treasury bills outstanding
in 1987.
The developments mentioned above highlight two important features of the
Government borrowing programme. First, the scale of borrowing was maintained at
relatively high level and budgetary deficit represented by the increase in volume of
treasury bills outstanding has gone up sharply. Government finances have come under
increasing pressure in recent years. Surpluses on revenue account have given way to
deficits. Interest payments as a proportion of tax receipts have shown a sharp rise to 35
per cent in 1992-93. Secondly, the market borrowings of the Government have
generally been at lower than market rates even though the rates of return offered on
other types of borrowings have been high taking into account the fiscal concession. The
discount rates on treasury bills which had risen 4.6 per cent per annum in mid-1974
have been pegged at that level and even today remain at that level. Banks and the life
insurance and general insurance enterprises are required to invest a prescribed
proportion of the funds mobilized by them in Government securities commercial banks
could not absorb fally the Government securities which were floated. As the earnings
from holding these securities were not attractive and the banks had other alternative
avenues for utilizing their funds more profitably, they held Government securities only to
the extent they were required to hold them under statutory obligations. In these
circumstances, the Reserve Bank of India, which manages the public debt, becomes the
residual to Government securities and treasury bills. As Government incurred deficits
every year, the question of retirement of treasury bills did not arise. The Reserve Bank
had, therefore, to address itself to the difficult task of neutralizing to the extent possible
the expansionary impact of deficits after taking into account the short-term movements
ments in its holding of net foreign exchange assets the increasing liquidity of the baking
system resulting from rising levels of reserve money had to be continually mopped up.
The instrument of open market operations is not available for this task, given the interest
rate structure. The task of absorbing excess liquidity in the system had to be undertaken
mainly by increasing the CRR. At some point, this can result in some crowding out of the
credit to commercial sector. With frequent and sharp increase the CRR has reached its
statutory limit.
The forth budget deficits and their absorption by the reserve Bank highlight not
only the close link between fiscal policy and monetary policy cut also the need for close
coordination between the two. The essence of coordination between fiscal policy and
monetary policy lies in reaching an agreement on the extent of expansion in Reserve
Bank credit to Government year to year. This will set a limit on the extent of fiscal deficit
and its magnetization and thereby provide greater manipulability to the monetary
authorities to regulate the money. Its in this context that introduction of a system of
monetary targeting mutually agreed upon between the Government and the central bank
assumes added significance.
POINTS FOR QUICK REVISION:
(1) Monetary policy refers to those policy measures of the
central bank which are adopted to control and regulate
the supply of money, the cost and availability of credit
in a country .
(2) The generally accepted important objectives of
monetary policy can be enumerated as : (i) Stability of
exchange rate, (ii) Price stability, (iii) Neutrality of
money, (iv) Full employment and (v) Economic growth.
(3) Monetary policy alone cannot achieve the objectives of
sustained economic growth, stability and social justice
in a developing economy. It is to be supplemented by
effective fiscal policy. Fiscal policy refers to
government spending, taxiing, borrowing and debt
management.
(4) Major objectives of fiscal policy are : (i) mobilization
of resources, (ii) accelerating economic growth, (iii) to
minimize the inequalities of income and wealth, (iv) to
increase employment opportunities.
(5) Major instrument of fiscal policy are : (i) taxation
policy, (ii) public expenditure policy, and (iii) public
debt policy.
POINTS TO PONDER:
 ___________________________________
Monetary policy
Meaning:
___________________________________
Monetary policy, generally, refers to
those policy measures of the central bank ___________________________________
which are adopted to control and regulate the
supply of money, the cost and availability of
credit in a country. ___________________________________
___________________________________
___________________________________
___________________________________

___________________________________
Objectives of Monetary Policy

Stability of Exchange Rates;

___________________________________
Price Stability;
Neutrality of Money; ___________________________________
Full Employment; and
Economic Growth with Stability. ___________________________________
___________________________________
___________________________________
___________________________________

Limitations of Monetary Policy in Developing

___________________________________
Countries

Underdeveloped Monetary and Capital

___________________________________
Market
Lack of Integrated Structure of Rate of ___________________________________
Interest
Lack of Co-operation by the Commercial
Bank
___________________________________
Literacy and Social Obstacles
Banking Habits of the People ___________________________________
___________________________________
___________________________________
 ___________________________________
FISCAL POLICY
Meaning:
___________________________________
Fiscal policy is a policy under which
the government uses its expenditure and ___________________________________
revenue programmes to produce desirable
effects and avoid undersirable effects on
national income, production and ___________________________________
employment.”
___________________________________
___________________________________
___________________________________

Objective of Fiscal Policy in a ___________________________________

Developing Country
Mobilisation of Resources
___________________________________
Acceleration of Economic Growth
To Minimise the Inequalit8ies of Income ___________________________________
and Wealth
To Increase Employment Opportunities ___________________________________
Price Stability

___________________________________
___________________________________
___________________________________
Questions for self assessment:
1. The obvious aim of the monetary policy of a country
is to attain equilibrium between saving and
investment at the point of full employment. “ Discuss.
2. What is meant by monetary policy? What should be
the objectives of monetary policy in a developing
country?
3. Discuss the objectives of fiscal policy in a developing
country.
4. Explain how the objective of full employment and
stability is achieved through fiscal policy in a
developing country.
5. write short notes on:
6. How is fiscal policy different from monetary policy/
What are the objectives of fiscal policy in a
developing economy like India?
7. “Fiscal and monetary policy have to be
complementary to achieve the goals of a developing
economy.” Do you agree with the above statement?
Discuss in detail.