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MONETARY POLICY
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.
2. Price Stability
3. Full Employment
Full employment refers to a situation in which all those who are able and
willing to work at the prevailing rates of wages get employment
opportunities.
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.
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.
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.
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.
2. 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 percentage yield earned on
an additional unit of capital). The central bank in such a situation can resort
to cheap money policy to promote investment activities.
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.
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.
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.
The government through its fiscal policy can influence the nature of economic activities in a
country.
“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.”
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.
1. Mobilisation of Resources
Most of the developing countries are caught in the ‘vicious circle of poverty.’ 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.
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.
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 capita 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.
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.
(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. Education, health, etc.
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.
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.”
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.
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
A package of fiscal measures can be adopted to contain inflation. Some of the important
measures are:
(i) The excess purchasing power of the people should be withdrawn through taxes,
compulsory savings and public borrowings.
(ii) Some anti-inflationary taxes like taxes on luxury items, etc., should be imposed.
(iii) Besides liquid assets, cash-balances should also be taxed.
(v) Tax policy should encourage voluntary savings and control non-essential consumption
expenditure.
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.