Fig 3.5: Steps in Environmental Forecasting Identification of Relevant Variables: There are so many different variables are present in the environment which has different relevance for different business. For instance, skilled labour is important for IT industries but unskilled labour is in high demand in construction business. So, one variable is relevant for one industry and it might be not relevant for other industry. It is very important to identify the critical environmental variables and also understand their respective trend and anticipate their future trends to avoid misleading effects. Pearce and Robinson has highlighted the basis of selecting the relevant variables in following ways i. Include the variables with significant effect even though there are less chances of their occurrence. ii. Skip major disasters like Nuclear War. iii. Aggregate relevant variables into gross. iv. Consider all dependent variables separately Collection of Information: It involves identification of the type of information and its relevant source, and selection of methods of data collection. Selection of Forecasting Techniques: The selection depends on the availability of information, amount and accuracy of information, the cost, time-frame, the competence of manager and experts working on it, importance of forecasts and nature of forecast decision. These techniques are further classified into Quantitative and Qualitative. Qualitative Forecasting techniques are very 51 CU IDOL SELF LEARNING MATERIAL (SLM)
significant when business needs to consider political, legal, social and technological factors. While for Quantitative method validity and accuracy of data is must. Monitoring: It is vital aspect of Forecasting as relevant factors may get change with time or period. Also, the trends of variables keep on changing from time to time abruptly, so strong monitoring methods ensures the proper efficiency of forecasting method 3.5 SUMMARY It is a continuous process wherein the role of manager is to examine the factors of external environment for achieving optimum performance of business. Environmental Scanning/Analysis has two approaches: 1. Outside -in (Macro approach): Develops alternative scenarios 2. Inside – out (Micro approach): Forecasts immediate future environment The process of environmental scanning / analysis is split into four stages- Scanning, Monitoring, Forecasting and Assessment Environmental scanning is extensively a process or method of information- collecting, searching, organizing and understanding. Types of Environmental Scanning- Ad-Hoc - It is conducted to handle specific problem Continuous - scanning is conducted at regular intervals Periodic- where a specialized team is allocated the function of scanning Techniques of Environmental Scanning: SWOT- explore all elements of business strengths, weaknesses, opportunities and threats ETOP - It is the method in which external environment of business is structured by considering its factors. Verbal and written information for analysing the trends Environmental Forecasting - anticipating the future performance of an organization 3.6 KEYWORDS 52 Environmental scanning is extensively a process or method of information- collecting, searching, organizing and understanding Assessment: the action of assessing someone or something. CU IDOL SELF LEARNING MATERIAL (SLM)
Forecasting - predict or estimate (a future event or trend). Monitoring - observe and check the progress or quality of (something) over a period of time; keep under systematic review Environmental Forecasting - anticipating the future performance of an organization, 3.7 LEARNING ACTIVITY 1. What is the role of Monitoring step in Environmental Scanning Process. ___________________________________________________________________________ ___________________________________________________________________________ 2. Explain the strategies that can be incorporated with SWOT analysis ___________________________________________________________________________ ___________________________________________________________________________ 3.8 UNIT END QUESTIONS A. Descriptive Questions Short Answers: 1. Discuss the approaches of Environmental Scanning. 2. Write a note on Verbal and Written information Technique of Environmental Scanning. 3. Explain the concept of Environmental Scanning 4. Elaborate the process of Environmental Scanning 5. Why forecasting the future trend is an important aspect of Scanning Process. Long Answers: 1. Explain SWOT Analysis 2. Discuss ETOP with example 3. Explain the process of Environmental Forecasting 4. How you will define the significance of environmental analysis 5. Compare SWOT and ETOP. B. Multiple Choice Questions: 1. The method to analyze the environment and recognize the impact of direct or indirect elements of environment on the business. a. Monitoring 53 CU IDOL SELF LEARNING MATERIAL (SLM)
b. Scanning c. Evaluating d. Assessing 2. In which method, Survey is conducted to co-relate the implications of different environmental factors for short – run. a. Ad-Hoc b. Periodic c. Random d. Continuous 3. It highlights such factors that can be harmful if used against the company by its competitors or the company lags behind in it represents______________ of an organization. a. Threats b. Strengths c. opportunities d. Weakness 4. When organization can ____________ its strength to the market forces then opportunities are used for gaining advantages by the organization a. co-relate b. identify c. ignore d. be flexible 5._______________ depends on the availability of information, amount and accuracy of information, the cost, time-frame, the competence of manager and experts working on it, importance of forecasts and nature of forecast decision a. Analysis b. Feedback c. Environmental Forecasting 54 CU IDOL SELF LEARNING MATERIAL (SLM)
d. Improvenment in the process. Answer 1 – b; 2 – a; 3 -d; 4 – a; 5 – a; 3.9 REFERENCES Text Books: Francis Cherunilam , Business and Environment, Text and Cases, [Himalaya Publishing House], C. Fernando, Business Environment Kindle Edition, Pearson K.Aswathappa, Essentials Of Business Environment, Himalaya Publishing House SHAIKH SALEEM, BUSINESS ENVIRONMENT, Pearson Ian Worthington, Chris Britton, The Business Environment , Financial Times/ Prentice Hall. Reference Books: Engineering Economic-Dr. Rajan Mishra by University Science Press The Gazette of India, Ministry of Law and Justice, New Delhi. No.311, June’16, 2006. Morrison J, The International Business Environment, Palgrave MISHRA AND PURI, Indian Economy, Himalaya Publishing House, New Delhi Business Environment Raj Aggarwal Excel Books, Delhi Strategic Planning for Corporate Ramaswamy V McMillan, New Delhi Dahl Modern political analysis. Englewood Cliffs, N.J: Prentice-Hall. Open Text Source: Dhamija, Dr. Ashok (2009). Prevention of Corruption Act. LexisNexis India. p. 2049. ISBN 9788180385926. Subrata K. Mitra and V.B. Singh. 1999. Democracy and Social Change in India: A Cross-Sectional Analysis of the National Electorate. New Delhi: Sage Publications. ISBN 81-7036-809-X (India HB) ISBN 0-7619-9344-4 (U.S. HB). Bakshi; P M (2010). Constitution Of India, 10/e. Universal Law Publishing Company Limited. pp. 48–.ISBN 978-81-7534-840-0. International Journal of Scientific and Research Publications, Volume 2, Issue 12, December 2012 www.yourarticlelibrary.com https://courses.lumenlearning.com/ 55 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 4: DIFFERENT ECONOMIC SYSTEMS AND ECONOMIC POLICIES Structure 4.0 Learning Objective 4.1 Introduction 4.2 Economic System 4.3 Types of Economic System 4.3.1 Capitalist Economy 4.3.2 Socialist Economy 4.3.3 Mixed Economy 4.4 Types of Economics on the Basis of Level of Development. 4.5 Summary 4.6 Keywords 4.7 Learning Activity 4.8 Unit End Questions 4.9 References 4.0 LEARNING OBJECTIVES After studying this Unit, you will be able to Explain the significance of Economy and Economic System Highlight the features of Capitalist, Socialist and Mixed Economy Analyze the basis of classification of economic system Co-relate the economic development with the type of economic system adopted by different countries 56 CU IDOL SELF LEARNING MATERIAL (SLM)
4.1 INTRODUCTION The function of economy is dependent on the correlation and existence of socio-cultural and political factors. All business activities are conducted according to the prevailing economic system of the country. Economic activity is part of our daily life like a simple activity of buying food pack from the grocery shop that involves transaction of money to exporting a big consignment of medicines to foreign land that involves lots of formalities and procedure. Economic activities differ from region to region within the country and from country to country. Presence of natural resources, skilled and unskilled labour and government policy all are the deciding factor for different types of business undertakings. India is an agricultural land, because since long time Indian were primarily engaged in agricultural activities for their livelihood and then slowly different allied industries came into existence like poultry, pesticide and fertilizers, etc. The development and growth of different industries is possible when economic system is inclined for the same. Economic system organizes all essential economic institutions, economic resources and economic initiatives together for production of goods and services that will satisfy the needs and wants of the people of country and sets interchange of money for availing different form of utility. 4.2 ECONOMIC SYSTEM Economic system is the way to collect the resources and allocate the resources across the different region of the country. It monitors the inputs of production, administer different level of institution and agencies and built economic structure of the country. Economic system sustains livelihood. It provides employment and to develop the means necessary for meeting the needs of human beings. The structure of earning livelihood has got changed and now more complexities are involved in sustaining such opportunity. The changing elements of environmental factors and norms related to the economic activity has completely changed the characteristics of economic activities. Economy has inter-linked aspects that involves production, consumption and money supply and it should follow ethical norms and stick to legal structure of the region and country. Important features of Economy are as follows: Economy is man-made. Economic institutions are designed, terminated, modified and restructured. After Independence, Zamindari system got eliminated from our land and now we have more comprehensive laws and acts related to land matters. USSR has adopted communisim in 1917 over capitalism and then finally adopted mixed structure in 1989. The structure and pattern of economic activities keeps on changing. 57 CU IDOL SELF LEARNING MATERIAL (SLM)
Manufacturing and utilization are the main activities of an economy and money acts as channel for interchange. Manufacturer and customer adopt dual role i.e., they are same individual. As manufacturer they manufacture goods and services and consumes the same as well. Privatization is gaining more popularity now-a -days as an intervention of government is not much required. 4.3 TYPES OF ECONOMIES There are different types of Economic System which are adopted across the World. This classification is based on inclination of power and authority, administration of an economic activity, emphasis placed on different objectives and means to achieve all. The dominance on the means of production or resources or ownership either to Government or to private business owners or joint form between Government and Private Player forms the basis of classification of the economic system. Economies are described on the basis of autonomy, profit motives and social welfare. Economic system is classified as follows: Capitalist Economic Mixed System Economy Socialist Fig 4.1: Types of Economic System 4.3.1 Capitalist Economy: Adam Smith, the father of modern economy has given the supporting theory and framework for Capitalist Economic System. The main feature of this system are principle of laissez faire is followed, autonomy is in the hands of private entrepreneurs or business owners, market forces are the deciding factor justifies the uncontrollable nature of the economic system will help the economy to utilize its full capacity for growth and there will be sky high development. So, as per this system, government has no role or no involvement in economic activities. Highlights of Capitalist Economy are as follows: 58 CU IDOL SELF LEARNING MATERIAL (SLM)
(i) Privately owned property: Right to own, buy, sell, transfer any property which an individual has earn or inherited. The property can be used for production of goods and services and thus profit earned will be enjoyed by the person and his family. There are no legal bindings involved in it. It also has been proved that when Individual has complete charge of its property then they put more hard work and dedication to make it fruitful and gain good returns for the same. Alternatively, if property is owned by the state then the efficiency of individual contribution gets reduced and benefits are not completely enjoyed. The popularity of capitalism is because of this important feature where individual enjoys the property and after death that is passed to legal heirs. (ii) Liberty of enterprise: A very important aspect of Capitalist is Liberty. Entrepreneurs, group of owners are free to choose any business or industry and decide upon various factors of production. They can select any market for selling their goods and services. Owner and group of investors bear all the risk of uncertainty, liability for profit and loss. Employees and workers are free to select any industry or occupation for their livelihood. There are no formalities involved for business and employees for entry and exit from specific industry. Liberty is allowed till no harm is made to any society, group or state. Such economic system has very distinct industries from consumer and capital goods, services of different types, untapped and unfamiliar sectors, Technology oriented business, etc. Such factors are responsible for accelerated economic development and wide variety of industries. (iii) Consumer’s Predominance: Consumer wish is the command for business. Consumer dominates the quality and quantity of goods produced. Consumer enjoys freedom of choice, saving or spending money. Even the prices of goods and services are dependent on the interactivity of consumer. Market system also influence the choice and selection of consumer, but consumer is the decision maker. Consumer predominance is based on following factors like level of earning, availability of choices for goods and services, limits placed on consumption but still consumer enjoys his dominance. (iv) Profit Motive: Profit is the driving force in any economic system. The emergence of the economic activity is concentrated on earning profits. That will validate the interest and risk taken up by the entrepreneurs or investors. The profit motive enhances the passion of business, efforts are more dedicated and production system is more efficient and technology is incorporated at various stages to ensure competitiveness in the market. Hunger and ambition to grow provides great platform for wide variety of product lines and spur in quality. To gain and enjoy more profit drives the economic development of the country. (v) Competition: Malpractices, unfair trade norms, unethical procedure can easily get submerged in Capitalist Industry structure. There is no government interference, no guideline to follow, no restriction to adhere to, no accountability for the society as it is opposite of what 59 CU IDOL SELF LEARNING MATERIAL (SLM)
Capitalist structure is all about. It can also lead to emergence of monopoly and consolidation of power in hands of few. Still competition exist between large organizations. Competition is an important characteristic of the Capitalist, so government impose certain restriction to protect market from monopolies. For example, in US- The well-known capitalist economy of the World has file case against Microsoft to prevent market from its monopoly in software industry. (vi) Price Mechanism: The demand and supply in the market determines the price of goods and services. If demand is more than supply, then price will increase and vice a versa. Enterprises that adapt to this system of market they make up normal profit while who do not adjust are wiped off the market. Market forces also decides the specific industry to develop more as compare to others, as small players will enter in sector that gives more profit. (vii) Limited government interference: Government is assumed to collect taxes and not to interfere in the working of industries and markets. The Government should extend support to the enterprises. But now this view point is getting faded as there is increase in awareness that industrial growth should aid in society welfare. Now-a-days Government plays a role of savior that helps economic system in times of Depression, Recession, wars, etc. Countries like USA, UK, France, Netherland, Spain, Portugal, Australia etc. are known as capitalistic countries where government plays important contribution in economic development. 4.3.2 Socialist Economy: In the socialist or centrally planned economies all the productive resources are owned and controlled by the government in the overall interest of the society. A central planning authority takes the decisions. The socialist economy has the following main features. (i) Collective Ownership of means of Production: In a Socialist economy means of production are owned by the government on behalf of the people. The institution of private property is abolished and no individual is allowed to own any production unit and accumulate wealth and transfer it to their heirs. However, people may own some durable consumer goods for their personal use. (ii) Social Welfare Objective: The decisions are taken by the government at macro level with the objective of maximization of social welfare in mind rather than maximization of individual profit. The forces of demand and supply do not play any important role. Careful decisions are taken with the welfare objectives in mind. 60 CU IDOL SELF LEARNING MATERIAL (SLM)
(iii) Central Planning: Economic planning is an essential feature of a socialist economy. The Central Planning Authority keeping the national priorities and availability of resources in mind allocates resources. Government takes all economic decisions regarding production, consumption and investment keeping in mind the present and future needs. The planning authorities fix targets for various sectors and ensure efficient utilization of resources. (iv) Reduction in Inequalities: The institutions of private property and inheritance are at the root of inequalities of income and wealth in a capitalist economy. By abolishing these twin institutions a socialist economic system is able to reduce the inequalities of incomes. It is important to note that perfect equality in income and wealth is neither desirable nor practicable. (v) No class conflict: In capitalist economy the interests of the workers and management are different. Both of them want to maximize their own individual profit or earnings. This results in class conflict in capitalist economy. In socialism there is no competition among classes. Every person is a worker so there is no class conflict. All are co-workers. Socialism in today’s world Countries such as Russia, China and many eastern European countries are said to be socialist countries. But they are changing now and encouraging liberalization in their countries for their economic development. 4.3.3 Mixed Economy: A mixed economy combines the best features of capitalism and socialism. Thus, mixed economy has some elements of both free enterprise or capitalist economy as well as a government controlled socialist economy. The public and private sectors co-exist in mixed economies. The main characteristics of a mixed economy are as follows: (i) Co-existence of public and private sectors: The private sector consists of production units that are owned privately and work on the basis of profit motive. The public sector consists of production units owned by the government and works on the basis of social welfare. The areas of economic activities of each sector are generally demarcated. Government uses its various policies e.g. licensing policy, taxation policy, price policy, monetary policy and fiscal policy to control and regulate the private sector. (ii) Individual Freedom: Individuals take up economic activities to maximize their personal income. They are free to choose any occupation and consume as per their choice. But producers are not given the freedom to exploit consumers and labourers. Government puts some restrictions keeping in mind the welfare of the people. For instance, government may put restrictions on the production and consumption of harmful goods. But within rules, 61 CU IDOL SELF LEARNING MATERIAL (SLM)
regulations and restrictions imposed by the government, for the welfare of the society the private sector enjoys complete freedom. (iii) Economic Planning: The government prepares long-term plans and decides the roles to be played by the private and public sectors in the development of the economy. The public sector is under direct control of the government as such production targets and plans are formulated for them directly. The private sector is provided encouragement, incentives, support and subsidies to work as per national priorities. (iv) Price Mechanism: Prices play a significant role in the allocation of resources. For some sectors the policy of administered prices is adopted. Government also provides price subsidies to help the target group. The aim of the government is to maximize the welfare of the masses. For those who can not afford to purchase the goods at market prices, government makes the goods available either free of cost or at below market (subsidized) prices. Thus in a mixed economy people at large enjoy individual freedom and government support to protect the interests of weaker sections of the society. Indian economy is considered a mixed economy as it has well defined areas for functioning of public and private sectors and economic planning. Even countries such as USA, UK, etc. which were known as capitalistic countries are also called mixed economies now because of active role of their government in economic development. 4.4 TYPES OF ECONOMICS ON THE BASIS OF LEVEL OF DEVELOPMENT: On the basis of level of development economies can be classified in two categories: (i) Developed economy (ii) Developing economy. The countries are labeled developed or rich and developing or poor on the basis of real national and per capita income and standard of living of its population. Developed countries have higher national and per-capita income, high rate of capital formation i.e. high savings and investment. They have highly educated human resources, better civic facilities, health and sanitation facilities, low birth rate, low death rate, low infant mortality, developed industrial and social infrastructures and a strong financial and capital market. In short, developed countries have high standard of living. Developing countries are low on the ladder of development. They are sometimes also called underdeveloped, backward or poor countries. But economists prefer to call them developing countries because it gives a sense of dynamism. The national and per capita income is low in these countries. They have backward agricultural and industrial sectors with low savings, investment and capital formation. Although these countries have export earnings but generally, they export primary agricultural 62 CU IDOL SELF LEARNING MATERIAL (SLM)
products. In short, they have low standard of living and poor health and sanitation, high infant mortality, high birth and death rates and poor infrastructure. Thus, economic development depends on many factors and has different meanings. 4.5 SUMMARY An economic system is the socio-economic and political framework within which an economy functions. A free-enterprise economy also known also as capitalism, market-driven economy, Laissez-Faire and free-market economy, postulates that free and unfettered trade help economies grow to their fullest potential. Private property is the most important feature of capitalism. Other characteristics include consumer sovereignty, freedom of enterprise, free play of enlightened self- interest of individuals and profit motive being the mainspring of economic activity and the engine of progress. A socialistic economy is one where conscious and deliberate choice of economic priorities is made by some public authorities. Some features of a planned economy are: a central planning authority, pre-determined and well-defined objectives, fixation of targets, administration of controls and growing role of the public sector. Socialism is founded on the principle that resources belong to the entire society and they should be owned by all members of the society represented by the State. In such an economy, all the means of production including landed property are vested in the hands of the State. Economic development is carried out through centralized planning. It is a public sector oriented economic system. A mixed economy incorporates the merits of both socialism and capitalism while eliminating the pitfalls found in both of them. In such an economy, both public and private sectors coexist Balance between the private and the public sectors has been achieved by adopting certain policies that permitted both the sectors to play their role in a well-planned manner; formulation of the Industrial Policy Resolution of 1948 and 1956, and also the Industries (Development and Regulations) Act. 4.6 KEYWORDS Price mechanism refers to the system where the forces of demand and supply determine the prices of commodities and the changes therein Economic system: is the socio-economic and political framework within which an economy functions. Laissez-faire system: The driving principle behind laissez-faire, a French term that translates to \"leave alone\" (literally, \"let you do\"), is that the less the government is 63 CU IDOL SELF LEARNING MATERIAL (SLM)
involved in the economy, the better off business will be, and by extension, society as a whole. A socialistic economy is one where conscious and deliberate choice of economic priorities is made by some public authorities. Co-exist - exist at the same time or in the same place. 4.7 LEARNING ACTIVITY 1. Why Class Conflict is included as a feature of Capitalist Economy? ___________________________________________________________________________ ___________________________________________________________________________ 2. Equality of opportunity is an important feature of Socialist Economy. Discuss your views. ___________________________________________________________________________ __________________________________________________________________________ 4.8 UNIT END QUESTIONS A. Descriptive Questions Short Answers: 1. State the salient features of an economy. 2. Explain the concept of Economic system. 3. Enlist the demerits associated with Capitalist Economy. 4. Define Socialist Economy. 5. Why Government Control and Regulation of the Private Sector is necessary in Mixed Economy? Long Answers: 1. State and explain the advantages of Capitalist Economy 2. Explain on the basis of level of development how economies are classified? 3. Why Public Sector is emphasized in Socialist Economy? 4. Discuss the Demerits of Socialist Economy. 5. Brief about the features of Indian Mixed Economy. B. Multiple Choice Questions 1. The ______________plays an important role of coordinating agent in Capitalist Economy 64 CU IDOL SELF LEARNING MATERIAL (SLM)
a. price system b. legal system c. judicial system d. Joint FDI 2. The prices of products and services are also determined by the interaction of consumers through market forces. This feature is known as ______________ a. Private Property b. Consumer Sovereignty c. Enlightened Self -interest d. Profit Motive 3. Identify the feature of Socialist Economy 65 a. Private Property b. Co-existence of public and private sectors c. Public ownership of property d. Absence of government interference 4. What believes in a secular State? a. Capitalist Economy b. Mixed Economy c. Market Economy d. Socialism 5. In Mixed economy both public and private sectors ___________ a. coexist b. does not exist together c. are parallel in nature d. are joint Answer 1 -a ; 2 -b ; 3 - c ; 4 -d ; 5 – a 4.9 REFERENCES Text Books: Francis Cherunilam , Business and Environment, Text and Cases, [Himalaya Publishing House], C. Fernando, Business Environment Kindle Edition, Pearson CU IDOL SELF LEARNING MATERIAL (SLM)
K.Aswathappa, Essentials Of Business Environment, Himalaya Publishing House SHAIKH SALEEM, BUSINESS ENVIRONMENT, Pearson Ian Worthington, Chris Britton, The Business Environment , Financial Times/ Prentice Hall. Reference Books: Engineering Economic-Dr. Rajan Mishra by University Science Press The Gazette of India, Ministry of Law and Justice, New Delhi. No.311, June’16, 2006. Morrison J, The International Business Environment, Palgrave MISHRA AND PURI, Indian Economy, Himalaya Publishing House, New Delhi Business Environment Raj Aggarwal Excel Books, Delhi Strategic Planning for Corporate Ramaswamy V McMillan, New Delhi Dahl Modern political analysis. Englewood Cliffs, N.J: Prentice-Hall. Open Text Source: Dhamija, Dr. Ashok (2009). Prevention of Corruption Act. LexisNexis India. p. 2049. ISBN 9788180385926. Subrata K. Mitra and V.B. Singh. 1999. Democracy and Social Change in India: A Cross-Sectional Analysis of the National Electorate. New Delhi: Sage Publications. ISBN 81-7036-809-X (India HB) ISBN 0-7619-9344-4 (U.S. HB). Bakshi; P M (2010). Constitution Of India, 10/e. Universal Law Publishing Company Limited. pp. 48–.ISBN 978-81-7534-840-0. International Journal of Scientific and Research Publications, Volume 2, Issue 12, December 2012 www.yourarticlelibrary.com https://courses.lumenlearning.com/ 66 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 5- DIFFERENT TYPES OF ECONOMIC 67 POLICIES: Structure 5.0 Learning Objectives 5.1 Introduction 5.2 Monetary Policy 5.2.1Concept and Meaning 5.2.2 Objectives of Monetary Policy 5.2.3 Measures of Money 5.3 Monetary Policy and Money Supply 5.4 Instruments of Monetary Policy 5.4.1 General Methods 5.4.2 Selective Methods 5.5 Impact of Monetary Policy 5.6 Fiscal Policy 5.6.1 Concept and meaning 5.6.2 Objectives of Fiscal Policy 5.6.3 Role of Fiscal Policy 5.7Difference between Monetary and Fiscal Policy 5.8 Techniques of Fiscal Policy 5.8.1 Taxation Policy (Tax Structure of Government of India) 5.8.2 Public Expenditure Policy 5.8.3 Public Debt Policy 5.8.4 Deficit Financing Policy 5.9 Fiscal Policy Reforms Introduced by the Government of India 5.10 Summary 5.11 Keywords 5.12 Learning Activity 5.13 Unit End Questions 5.14 References 5.0 LEARNING OBJECTIVES: After studying this Unit, you will be able to Explain the Objectives of Monetary Policy. Illustrate the relationship between Monetary and Money Supply Analyze the General and Selective instruments of Monetary Policy CU IDOL SELF LEARNING MATERIAL (SLM)
Outline the impact of Monetary Policy Explain the Objectives and Role of Fiscal Policy. Compare the features of Monetary and Fiscal Policy Analyze the Techniques of Fiscal Policy Describe the importance of Reforms in Fiscal Policy 5.1 INTRODUCTION: Economic system needs system to monitors its functioning. Such control mechanism is implemented with the help of fiscal and monetary policy. Fiscal policy is defined on the basis of revenue generated by the government while RBI in India (Central Bank) administer the monetary policy. The main objective of these policies is to either increase the GDP (gross domestic product) and economic development which is termed as expansionary initiatives, or in case they are meant to deal with inflation then they are termed as contractionary initiatives. Government extends all support to revive the down fall of the economy. Steps like government can opt for increase in spending to increase the demand when demand is low. Government can decrease the tax amount to increase the spending’s. To achieve economic development, price stability and full employment, Government always deceive the level of aggregate demand. RBI approve the implementation of quantitative or qualitative measures to monitor the money supply in the country. Generally, such control is executed by changing CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio) that administer the operations and disposable funds of financial institutions to influence the economic growth, unemployment, inflation and rates of exchange of currency. Economic development and balance in the economy is achieved by executing the measures of monetary and fiscal policy together. 5.2 MONETARY POLICY: The main purpose of implementing Monetary policy is to accelerate the economic development and stabilize price and wages by modifying the money supply and credit by changing the interest rates. Monetary policy is one of the important dimensions of the country’s national bank. The trends of inflation traced during after World War II has emphasized the importance of monetary policy. If money supply is modified, then inflation can be controlled. RBI acts as the monetary supremacy of India and thus handles monetary policy. Every year, in April, Reserve Bank of India declares Monetary Policy which is followed by quarterly reviews in July, October and January. But RBI has power to declare any modifications any time. There are two contributing aspects of monetary policy as: PART A: development concerned with macroeconomic and monetary aspect PART B: Records of all measures implemented earlier with new measures initiated. 68 CU IDOL SELF LEARNING MATERIAL (SLM)
The important elements of monetary policy are financial markets stability, interest rates, credit delivery, etc. Monetary policy also manages the availability of financial resources for regulating economic and financial growth. Monetary policy has widened its scope and covers various aspects like availability of credit to efficient sector, encouragement of investment and trade and price stability. 5.2.1CONCEPT AND MEANING: Monetary policy is all about money supply, economic stability and building trust in the currency. To deal the unemployment issues in recession, measures of expansionary Monetary policy are implemented to reduce the interest rate for providing growth opportunity to the business. Contractionary Monetary policy is meant for decreasing the growth of money supply or even narrow it for avoiding deterioration of asset values during inflation. Monetary policy monitors controls (i) the supply of money, (ii) availability of money, and (iii) cost of money. It is concerned with the correlation of total supply of money and the interest rate of borrowing the money, i.e., Credit. When Monopoly of issuance comes into play and currency of the country falls under its purview or issuance of currency’s are with banks which have alliances with Central bank , the RBI has the power to influence the interest rates and modify the money supply in order to maintain economic stability. Well-known definitions of Monetary Policy are are as follows: According to Prof. Harry Johnson, “A policy employing the central banks control of the supply of money as an instrument for achieving the objectives of general economic policy is a monetary policy.” G.K. Shaw defines it as “any conscious action undertaken by the monetary authorities to change the quantity, availability or cost of money.” General Definitions are: Broader economic objectives termed as Macro-economic objective of the country like development and liquidity; inflation control is possible by implementing various measures of monetary policy which is govern by central bank. Interest rate is directly proportional to the money supply growth and size in the economy of the country. Three important instruments of monetary policy that are applied through RBI is i. Selling and buying of national debt ii. Change introduced in credit restrictions iii. Reserves are modified to introduce alteration of interest rates. 69 CU IDOL SELF LEARNING MATERIAL (SLM)
Money supply is the core of monetary policy which includes credit, cash, checks, and money market and mutual funds. Out of these, the most significant is credit, that includes loans, bonds, mortgages, and other agreements to repay. Monetary policy defines the administrative framework of the central bank of the country. It plays very essential part in controlling aggregate demand and inflation. In India, monetary policy of the Reserve Bank of India is a critical measure to achieve balanced development of different sectors of the economy. 5.2.2 OBJECTIVES OF MONETARY POLICY: The important objectives of monetary policy are as follows: 1. Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth. Faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability. 2. Regulation, Supervision and Development of Financial Stability: Financial stability means the ability of the economy to absorb shocks and maintain confidence in financial system. Threats to financial stability can come from internal and external shocks. Such shocks can destabilize the country’s financial system. Thus, greater importance is being given to RBI’s role in maintaining confidence in financial system through proper regulation and controls, without sacrificing the objective of growth. Therefore, RBI is focusing on regulation, supervision and development of financial system. 3. Price Stability: All the economics suffer from inflation and deflation. It can also be called as Price Instability. Both are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities. When the economy suffers from recession the monetary policy should be an 'easy money policy' but when there is inflationary situation there should be a 'dear money policy'. 4. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain the exchange rate stability. 70 CU IDOL SELF LEARNING MATERIAL (SLM)
5. Balance of Payment: Many developing countries like India suffer from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved. 6. Full Employment: The concept of full employment was much discussed after Keynes's publication of the \"General Theory\" in 1936. It refers to absence of involuntary unemployment. In simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs. However it does not mean that there is a Zero unemployment. In that senses the full employment is never full. Monetary policy can be used for achieving full employment. If the monetary policy is expansionary then credit supply can be encouraged. It could help in creating more jobs in different sector of the economy. 7. Promoting Priority Sector: Priority sector includes agriculture, export and small scale enterprises and weaker section of population. RBI with the help of bank provides timely and adequately credit at affordable cost of weaker sections and low income groups. RBI, along with NABARD, is focusing on microfinance through the promotion of Self Help groups and other institutions. 8. Encouraging Savings and Investments: RBI by offering attractive interest rates encourages savings in the economy. A high rate of saving promotes investment. Thus the monetary management by influencing rates of interest can influence saving mobilization in the country. 9. Regulation of NBFIs: Non – Banking Financial Institutions (NBFIs), like UTI, IDBI and IFCI plays an important role in deployment of credit and mobilization of savings. RBI does not have any direct control on the functioning of such institutions. However it can indirectly affects the policies and functions of NBFIs through its monetary policy 10. Neutrality of Money: Economist such as Wicksted, Robertson has always considered money as a passive factor. According to them, money should play only a role of medium of exchange and not more than that. Therefore, the monetary policy should regulate the supply of money. The change in money supply creates monetary disequilibrium. Thus monetary policy has to regulate the supply of money and neutralize the effect of money expansion. However this objective of a monetary policy is always criticized on the ground that if money supply is kept constant then it would be difficult to attain price stability 71 CU IDOL SELF LEARNING MATERIAL (SLM)
11. Equal Income Distribution: Many economists used to justify the role of the fiscal policy is maintaining economic equality. However in recent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality. Monetary policy can make special provisions for the neglect supply such as agriculture, small-scale industries, village industries, etc. and provide them with cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can help in reducing economic inequalities among different sections of society. 12. Improvement in Standard of Living: It is also the major objective of the monetary policy that it should improve the quality of life in the country. 5.2.3 MEASURES OF MONEY: Money Supply: The supply of money means the total stock of money (paper notes, coins and demand deposits of bank) in circulation which is held by the public at any particular point of time. Briefly, money supply is the stock of money in circulation on a specific day. Thus two components of money supply are: i. Currency (Paper notes and coins) ii. Demand deposits of commercial banks Supply of money is only that part of total stock of money which is held by the public at a particular point of time. In other words, money held by its users (and not producers) in spendable form at a point of time is termed as money supply. The stock of money held by government and the banking system are not included because they are suppliers or producers of money and cash balances held by them are not in actual circulation. In short, money supply includes currency held by public and net demand deposits in banks. Sources of Money Supply: 1. Government (which issues one-rupee notes and all other coins) 2. RBI (which issues paper currency) 3. Commercial banks (which create credit on the basis of demand deposits) Measures of Money Supply: There are four measures of money supply in India which are denoted by M1, M2, M3 and M4. This classification was introduced by the Reserve Bank of India (RBI) in April 1977. Prior to this till March 1968, the RBI published only one measure of the money supply, M or defined as currency and demand deposits with the public. This was in keeping with the traditional and Keynesian views of the narrow measure of the money supply. From April 1968, the RBI also started publishing another measure of the money supply which it called Aggregate Monetary Resources (AMR). This included M1 plus time deposits of banks held by the public. This was a broad measure of money supply which was in line 72 CU IDOL SELF LEARNING MATERIAL (SLM)
with Friedman’s view. But since April 1977, the RBI has been publishing data on four measures of the money supply which are discussed as under. Out of four alternative measures of money supply i.e. M1, M2, M3 and M4, M1 is the most commonly used measure of money supply because components are regarded most liquid assets. Each measure is briefly explained below: M1. The first measure of money supply, M1 consists of: M1 = C + DD + OD (i) C- Currency with the public which includes notes and coins of all denominations in circulation excluding cash on hand with banks: (ii) DD-Demand deposits are deposits which can be withdrawn at any time by the account holders. Current account deposits are included in demand deposits. But savings account deposits are not included in DD because certain conditions are imposed on the amount of withdrawals and number of withdrawals. Demand deposits with commercial and cooperative banks, excluding inter-bank deposits; and (iii) OD-‘Other deposits’ with RBI which include current deposits of foreign central banks, financial institutions and quasi-financial institutions such as IDBI, IFCI, etc., other than of banks, IMF, IBRD, etc. The RBI characterizes as narrow money. M2. The second measure of money supply is M2 which consists of M1plus post office savings bank deposits. Since savings bank deposits of commercial and cooperative banks are included in the money supply, it is essential to include post office savings bank deposits. The majority of people in rural and urban India have preference for post office deposits from the safety viewpoint than bank deposits. M2 = M1 + saving deposits with Post Office Saving Banks M3. The third measure of money supply in India is M3, which consists of M1, plus time deposits with commercial and cooperative banks, excluding interbank time deposits. The RBI calls M3 as broad money. M3= M1 + Net Time-deposits of Banks M4. The fourth measure of money supply is M4 which consists of M3plus total post office deposits comprising time deposits and demand deposits as well. This is the broadest measure of money supply. M4 = M3 + Total deposits with Post Office Saving Organization (excluding NSC) In fact, a great deal of debate is still going on as to what constitutes money supply. Savings deposits of post offices are not a part of money supply because they do not serve as 73 CU IDOL SELF LEARNING MATERIAL (SLM)
medium of exchange due to lack of cheque facility. Similarly, fixed deposits in commercial banks are not counted as money. Therefore, M1 and M2 may be treated as measures of narrow money whereas M3and M4 as measures of broad money. Of the four inter-related measures of money supply for which the RBI publishes data, it is M3 which is of special significance. It is M3 which is taken into account in formulating macroeconomic objectives of the economy every year. Since M1 is narrow money and includes only demand deposits of banks along-with currency held by the public, it overlooks the importance of time deposits in policy making. That is why, the RBI prefers M3 which includes total deposits of banks and currency with the public in credit budgeting for its credit policy. It is on the estimates of increase in M3 that the effects of money supply on prices and growth of national income are estimated. In fact is an empirical measure of money supply in India, as is the practice in developed countries. The Chakravarty Committee also recommended the use of M3for monetary targeting without any reason. In practice, M1 is widely used as measure of money supply which is also called aggregate monetary resources of the society. All the above four measures represent different degrees of liquidity, with M4 being the most liquid and M4 is being the least liquid. It may be noted that liquidity means ability to convert an asset into money quickly and without loss of value. Liquidity and Ranking: Name Type Liquidity M1 Narrow Money Highest M2 Narrow Money Less than M1 M3 Broad Money Less than M2 M4 Broad Money Lowest Liquidity 5.3 MONETARY POLICY AND MONEY SUPPLY: In the context of developing economies like India, monetary policy acquires a wider role and it has to be designed to meet the particular requirements of the economy. It stimulates or discourages spending on goods and services and, thus, influences economic activities and prices by regulating the supply of money, and the cost and availability of credit to producers and consumers in the economy. Households and business units make spending and investment decisions based upon current and expected future monetary policy actions. The 74 CU IDOL SELF LEARNING MATERIAL (SLM)
various sectors of the economy respond in different ways, depending on the extent to which they are borrowers or lenders and the importance and relative availability of credit to the sector. By affecting the demand side of the economy, monetary policy tries to damp or perhaps even eliminate business. Fluctuations - economy-wide recessions and booms arising from fluctuations in aggregate demand. In India, the three major objectives of economic policy are growth, social justice (equitable distribution of income and wealth) and price stability. Of these, price stability is perhaps the one that can be pursued most effectively by the monetary authorities of the country. The monetary policy of an economy operates through three important instruments, viz., and the regulation of money supply, control over aggregate credit and the interest rate policy. In pre- reform period, given the largely underdeveloped state of financial system, regulated nature of financial markets and plan priorities, the RBI often resorted to the direct instruments of monetary policy like CRR, SLR and interest rate for allocating credit and regulating money supply in the economy. Gradual liberalization and globalization of the economy, strengthening and development of the financial system, restrictions on the automatic monetization of fiscal deficit and various other changes in the economy had made it possible for the RBI to operate with the indirect instruments of monetary policy such as bank rate, repo rate and OMOs (open market operations). Accordingly, there has been a distinct shift in the monetary policy framework and operating procedures from direct instruments of monetary control to market based indirect instruments in the recent years. The thrust has been to provide the market mechanism a greater role in the economy, to provide the banks more operational flexibility and to bring the allocative efficiency in the economy. In the recent years, the thrust of the monetary policy was to reduce the annual inflation rate. Since the year 2009 the inflation in India has crossed historical records and reached to unprecedented levels, and lying in the range of 9 - 14 %. The monetary authorities are striving hard to curb the inflation by adopting several monetary policy measures, the important amongst which are changes in CRR, repo and reverse repo rate, which directly influence the money supply in the market with immediate effect without creating any distortions in the economy. That is the reason, they are perceived to be the most appropriate by the monetary authorities to curb the existing inflation, and hence changed 16 times during the year 2009 to 2011. Monetary policy which aims at changing the money supply in order to achieve the national economic goals requires the following conditions to be satisfied. 1. A close correspondence must exist between the theoretical definition of money and the empirical (measurable) definition of money. 2. The monetary authority must be able to control the empirically defined money supply and to meet the intermediate monetary targets (such as monetary growth rate, interest rate etc) with the help of the instruments such as bank rate, open market operations etc. 75 CU IDOL SELF LEARNING MATERIAL (SLM)
3. The empirical definition of money must be closely and predictably related to ultimate national goals. Achievement of monetary growth rate or interest rate targets is not enough. Such achievement must also change economic variables in the desired manner. Monetary policy requires a meaningful and practical definition of money. Since changes in the supply of money affect important economic variables, they can also influence the attainment of ultimate national economic goals. The goals of internal price stability, international balance of payments equilibrium, economic growth, high employment are all directly or indirectly affected by the changes in money supply. Variations in currency are not possible except over comparatively long period. Thus, changes in currency do not play an important role in the formulation of monetary policy. 5.4 INSTRUMENTS OF MONETARY POLICY: The various credit policy or monetary instruments used by a Central Bank of Country can be divided as follows: Monetary Instruments/ Methods of Credit Control General Methods /Quantitative Selective Methods /Qualitative Methods Methods Bank Rate Policy Marginal Requirements Open Market Operations Consumer Credit Variable Reserves Ratios Regulation o Cash Reserves Ratio (CRR) Publicity o Statutory Reserve Ratio Credit Rationing (SLR) Moral Suasion Control through Directives Fig 5.1: Instruments of Monetary Policy Direct Actions 76 CU IDOL SELF LEARNING MATERIAL (SLM)
The general methods affect the total quantity of credit or economy in general. The selective methods on the other hand, affect certain selected sectors or certain qualitative distinctions are made between different sectors and segments of the economy; and selectivity is applied in regulating the flow of credit. The Reserve Bank of India (RBI), Act confers on the Banks the usual powers available to central banks generally and the Banking Regulation Act provides special powers of regulation for the operations of commercial and co-operative banks, which formed the statutory basis for the credit regulation in India. 5.4.1 GENERAL CREDIT CONTROLS/ QUANTITATIVE METHODS: In this method, it is important that the three instruments namely Bank rate policy, Open market operations and Variable reserves ratios are inter-related and operates in co-ordination. All the three instruments affect the bank reserves. Open Market Operation and Reserve Ratios directly affect the reserve base, while Bank Rate Policy affects indirectly by variations in the cost of acquiring the reserves. The use of any one instrument rather than another at any point is determined by the nature of the situation and the range of influence it is desired to wield as well as the rapidity with which the change is required to be brought about. The effects of Bank Rate changes are not confined to the banking system and the short-term money market; it has wide repercussions on the economy as a whole. Open market Operations are suitable for carrying out day-to-day adjustments on even smaller scale. A change in Reserve Ratios produces an impact at once and affects the banks generally. i. Bank Rate Policy: The Bank Rate Policy is a very important technique used in the monetary policy for influencing the volume or the quantity of the credit in a country. The bank rate refers to rate at which the central bank (i.e. RBI) rediscounts bills and prepares of commercial banks or provides advance to commercial banks against approved securities. It is \"the standard rate at which the bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchase under the RBI Act\". The Bank Rate affects the actual availability and the cost of the credit. Any change in the bank rate necessarily brings out a resultant change in the cost of credit available to commercial banks. If the RBI increases the bank rate than the volume of commercial banks borrowing from the RBI gets reduced. It deters banks from further credit expansion as it becomes a more costly affair. Even with increased bank rate the actual interest rates for a short term lending go up checking the credit expansion. On the other hand, if the RBI reduces the bank rate, borrowing for commercial banks will be easy and cheaper. This will boost the credit creation. As per the Bank rate theory, an increase in the Bank rate reduces the extent of borrowings from the money market, the level 77 CU IDOL SELF LEARNING MATERIAL (SLM)
of inventory holding, investment, employment and prices. A reduction in the Discount Rate has the opposite effects. The Central bank, may therefore, attempt to contain an inflationary situation by raising the Bank Rate and fight a depression or recession by lowering it. Thus any change in the bank rate is normally associated with the resulting changes in the lending rate and in the market rate of interest. However, the efficiency of the bank rate as a tool of monetary policy depends on existing banking network, interest elasticity of investment demand, size and strength of the money market, international flow of funds, etc. The importance of Bank rates lies in the fact that it acts as a pace-setter to all the other rates of interests. ii. Open Market Operation (OMO): The open market operation refers to the purchase and/or sale of short term and long term securities by the RBI in the open market. This is very effective and popular instrument of the monetary policy. The OMO is used to wipe out shortage of money in the money market, to influence the term and structure of the interest rate and to stabilize the market for government securities, etc. It is important to understand the working of the OMO. If the RBI sells securities in an open market, commercial banks and private individuals buy it. This reduces the existing money supply as money gets transferred from commercial banks to the RBI. Contrary to this when the RBI buys the securities from commercial banks in the open market, commercial banks sell it and get back the money they had invested in them. Obviously the stock of money in the economy increases. This way when the RBI enters in the OMO transactions, the actual stock of money gets changed. Normally during the inflation period in order to reduce the purchasing power, the RBI sells securities and during the recession or depression phase it buys securities and makes more money available in the economy through the banking system. Thus under OMO there is continuous buying and selling of securities taking place leading to changes in the availability of credit in an economy. However there are certain limitations that affect OMO viz; underdeveloped securities market, excess reserves with commercial banks, indebtedness of commercial banks, etc. iii. Variations in the Reserve Ratios: The Commercial Banks have to keep a certain proportion of their total assets in the form of Cash Reserves. Some part of these cash reserves are their total assets in the form of cash. Apart of these cash reserves are also to be kept with the RBI for the purpose of maintaining liquidity and controlling credit in an economy. These reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR). The CRR refers to some percentage of commercial bank's net demand and time liabilities which commercial banks have to maintain with the central bank and SLR refers to some percent of reserves to be maintained in the form of gold or foreign securities. In India the CRR by law remains in between 3-15 percent while the SLR remains in between 25-40 percent of bank reserves. Any change in the VRR (i.e. CRR + SLR) brings out a change in commercial banks reserves 78 CU IDOL SELF LEARNING MATERIAL (SLM)
positions. Thus by varying VRR commercial banks’ lending capacity can be affected. Changes in the VRR helps in bringing changes in the cash reserves of commercial banks and thus it can affect the banks credit creation multiplier. RBI increases VRR during the inflation to reduce the purchasing power and credit creation. But during the recession or depression it lowers the VRR making more cash reserves available for credit expansion. a. Cash Reserve Ratio (CRR): It is defined as that portion of total deposits which a commercial bank is required to keep with the RBI in the form of cash reserves. In 2013, it was 4.0% which implies that every commercial bank has to keep 4% of its total deposits with the RBI. In a situation of excess demand, RBI raises the CRR. This will reduce the cash deposits left with commercial banks to be loaned out. This is another method to control the availability of credit. b. Statutory Liquidity Ratio (SLR): It is defined as that portion of total deposits which a commercial bank has to keep with itself in the form of liquid assets. In a situation of excess demand, RBI raises the SLR. The result is the reduction in surplus cash reserves of commercial banks which can be offered for credit. This will discourage credit in an economy. The SLR in India, at present is 21.50 % for entire net demand and time liabilities of scheduled commercial banks. 5.4.2 SELECTIVE CREDIT REGULATIONS / QUALITATIVE METHODS: These tools are not directed towards the quality of credit or the use of the credit. They are used for discriminating between different uses of credit. It can be discrimination favouring export over import or essential over non-essential credit supply. This method can have influence over the lender and borrower of the credit. It refers to regulation of credit for specific purposes or branches of economic activity. It is associated with the distribution or direction of available credit supplies. They are designed specifically to curb excesses in selected area without affecting other types of credit. They attempt to achieve a reasonable stabilization of the prices of particular commodities on the demand side, by regulating the availability of bank credit for purchasing and holding them. It should be however noted that prices are determined by the interaction of demand and supply, and if the supply is substantially short then moderate price rise strategy is used instead of arresting the basic trend. In India, such controls have been used to prevent speculative hoarding of commodities like food grains and essential raw materials and also check an undue rise in their prices. The selective credit controls are treated as useful supplement to general credit regulations as the effectiveness of both the method get increased together. It comprises of following instruments: i. Fixing Margin Requirements: 79 CU IDOL SELF LEARNING MATERIAL (SLM)
The margin refers to the \"proportion of the loan amount which is not financed by the bank\". Or in other words, it is that part of a loan which a borrower has to raise in order to get finance for his purpose. A change in a margin implies a change in the loan size. This method is used to encourage credit supply for the needy sector and discourage it for other non- necessary sectors. This can be done by increasing margin for the non-necessary sectors and by reducing it for other needy sectors. Example:- If the RBI feels that more credit supply should be allocated to agriculture sector, then it will reduce the margin and even 85-90 percent loan can be given. ii. Consumer Credit Regulation: Under this method, consumer credit supply is regulated through hire-purchase and instalments sale of consumer goods. Under this method the down payment, instalments amount, loan duration, etc. is fixed in advance. This can help in checking the credit use and then inflation in a country. iii. Publicity: This is yet another method of selective credit control. Through it Central Bank (RBI) publishes various reports stating what is good and what is bad in the system. This published information can help commercial banks to direct credit supply in the desired sectors. Through its weekly and monthly bulletins, the information is made public and banks can use it for attaining goals of monetary policy. iv. Credit Rationing: Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill rediscounting. For certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help in lowering banks credit exposure to unwanted sectors. v. Moral Suasion: It implies to pressure exerted by the RBI on the Indian banking system without any strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the central bank through a monetary policy. Under moral suasion central banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes vi. Control through Directives: Under this method the central bank issue frequent directives to commercial banks. These directives guide commercial banks in framing their lending policy. Through a directive the central bank can influence credit structures, supply of credit to certain limit for a specific 80 CU IDOL SELF LEARNING MATERIAL (SLM)
purpose. The RBI issues directives to commercial banks for not lending loans to speculative sector such as securities, etc. beyond certain limit. vii. Direct Action: Under this method the RBI can impose an action against a bank. If certain banks are not adhering to the RBI's directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBI may refuse credit supply to those banks whose borrowings are in excess to their capital. Central bank can penalize a bank by changing some rates. At last, it can even put a ban on a particular bank if it does not follow its directives and work against the objectives of the monetary policy. These are various selective instruments of the monetary policy. However, the success of these tools is limited by the availability of alternative sources of credit in economy, working of the Non-Banking Financial Institutions (NBFIs), profit motive of commercial banks and undemocratic nature off these tools. But a right mix of both the general and selective tools of monetary policy can give the desired results. 5.5 IMPACT OF MONETARY POLICY: Impact of cut in CRR on Interest Rates: From time to time, RBI prescribes a CRR or the minimum amount of cash that banks have to maintain with it. The CRR is fixed as a percentage of total deposit. As more money chases the same number of borrowers, interest rates come down. Impact of change in SLR and Gilt Products on Interest Rates: SLR reduction is not so relevant in the present context for two reasons. First, as part of the reform process, the government has begun borrowing at market-related rates. Therefore, banks get better interest rates compared to what they used to get earlier for their statutory investments in government securities. Second, banks are still the main source of funds for the government. This means that despite lower SLR requirements, banks investment in government securities will go up as government borrowing rises. As a result, bank investment in gilts continues to be high despite the RBI bringing down the minimum SLR to 25% a couple of years ago. Therefore, for the purpose of determining the interest rates, it is not the SLR requirement that is important but the size of the government’s borrowing programme. As government borrowing increases, interest rate, too, rise. Besides, the gilts also provide another tool for the RBI to manage interest rates. The RBI conducts OMO by offering to buy or sell gilts. If it feels that interest rates are too high, it may bring them down by offering to buy securities at a lower yield than what is available in the market 81 CU IDOL SELF LEARNING MATERIAL (SLM)
Impact of Open Market Operation: The monetary policy of the seventies and first half of the eighties had excluded the open market operations instrument. This is because active Government securities market was non-existent. Active Government securities market could not emerge because of the fact that rates of interest offered on Government paper that is, treasury bills and dated Government securities were much below prevailing market rates of interest. Late Prof. S. Chakravarty, the head of Monetary Reforms Committee recommended raising of interest rates on Government securities to ensure profitability of banks and activism of the open market operations. This recommendation was accepted and in the late eighties interest rates of Government securities were raised. In the post reform period, as a first step yields on government securities were made market determined by sale of Government securities through open auction. Furthermore, the interest rate structure was simultaneously rationalised and banks were given the freedom to determine their prime lending rates and other main rates of interest. These measures by RBI facilitated the use of open Market operations as an effective instrument for liquidity management including control of short-term fluctuations in the foreign exchange market. Impact of Bank Rate: Before 1991, changes in bank rate as an instrument of monetary control were quite rare. The bank rate remained unchanged at 10 per cent in the whole decade 1981-91. In the post-reform period Reserve Bank has moved towards a situation in which changes in bank rate give signals to the commercial banks and other financial institutions about the emerging financial situation of the economy so that they could adjust their interest rates accordingly, Besides, bank rate serves as a reference rate on the basis of which commercial banks can fix their- prime lending rates. To control inflationary pressures in the Indian economy Reserve Bank raised bank rate from 10 per cent to 11 per cent in July 1991 and further to 12 per cent in October 1991. Raising of lending rates of interest on the advances to the businessmen was intended to discourage demand for credit. However, it may be noted that the role of bank rate as an instrument of credit control is limited because of the following factors: First, before mid-1990s, because of the administered nature of interest rates the bank rate was not used as a reference rate by the banks for the purpose of fixing their lending rates. Secondly, even now when lending rates of banks have been freed, there is not much refinance being made available at the bank rate so that banks can ignore this as a reference in setting their own lending rates. Thirdly, at present lending rates of interest are determined by demand for and supply of funds in the money market. In fact, the monetary policy regarding bank rate is itself influenced by the prevailing economic situation. 82 CU IDOL SELF LEARNING MATERIAL (SLM)
Impact of Liquidity Adjustment Facility (LAF): Another important change in the instrument of monetary policy is the introduction of Liquidity Adjustment Facility (LAF) from June 2000 to adjust on a daily basis liquidity in the banking system so that it remains within reasonable limits. Besides, through Liquidity Adjustment Facility, the RBI regulates short-term interest rates while its bank rate policy serves as a signalling device for its interest rate policy in the intermediate period. These short-term interest rates of RBI are called repo rate and reverse repo rate. Impact on Domestic Industry and Exporters: The exporters look forward to the monetary policy since the Central Bank always makes an announcement on export refinance, or the rate at which the RBI will lend to banks which have advanced pre-shipment credit to exporters. A lowering of these rates would mean lower borrowing costs for the exporter. Impact on Stock Markets and Money Supply: Most people attribute the link between the amount of money in the economy and movements in stock markets to the amount of liquidity in the system. This is not entirely true. The factor connecting money and stocks is interest rates. People save to get returns on their savings. A hike in interest rates would tend to suck money out of shares into bonds or deposits; a fall would have the opposite effect. This argument has survived econometric tests and practical experience. Impact of Money Supply on Jobs, Wages and Output: At any point of time, the price level in the economy is determined by the amount of money floating around. An increment in the money supply- currency with the public demand deposits, and time deposit – increases prices all around because there is more currency moving towards the same goods and services. Typically, the RBI follows a least inflation policy, which means that its money market operations as well as changes in the bank rate are generally designed to minimise the inflationary impact of money supply changes. Since most people can generally see through this strategy, it limits the impact of the RBI’s monetary moves on jobs or production. The markets, however, move to the RBI’s tune because of the link between interest rates and capital market yields. The RBI’s policies have maximum impact on volatile forex and stock markets. The jobs, wages, and output are affected over the long run, if the trends of high inflation or low liquidity persist for a very long period. If the wages move slower than other prices, higher inflation will drive real wages lower and encourage employers to hire more people. This, in turn, ramps up production and employment. This was the theoretical justification of a long term trend that showed that higher inflation and employment went together, whereas, when inflation fell, unemployment increased. Impact on Money Supply: The RBI uses the interest rate, OMO, changes in the CRR are the most popular instruments used. Under the OMO, the RBI buys or sells government bonds in 83 CU IDOL SELF LEARNING MATERIAL (SLM)
the secondary market. By absorbing bonds, it drives up bond yields and injects money into the market. When it sells bonds, it does so to suck money out of the system. The changes in CRR affect the amount of free cash that banks can use to lend— reducing the amount of money for lending cuts into overall liquidity, driving interest rates up, lowering inflation, and sucking money out of markets. Primary deals in government bonds are a method to intervene directly in markets, followed by the RBI. By directly buying new bonds from the government at lower than market rates, the RBI tries to limit the rise in interest rates that higher government borrowings lead to. 5.6 FISCAL POLICY: The term fiscal has been derived from the Greek word fisc, meaning a basket to symbolize the public purse. Fiscal policy thus means the policy related to the treasury of the government. Fiscal policy is a part of general economic policy of the government which is primarily concerned with the budget receipts and expenditures of the government. All welfare projects are completed under this policy. It also suggests measures to control economic fluctuations which may become violent and create great upheavals in the socio-economic structure of the economy. It also outlines the influence of resource utilization on the level of aggregate demand through affecting the level of aggregate consumption and investment expenditure. 5.6.1 CONCEPT AND MEANING: Fiscal policy means the use of taxation and public expenditure by the government for stabilization or growth. The fiscal policy is concerned with the raising of government revenue and incurring of government expenditure. To generate and to incur expenditure, the government frames a policy called budgetary policy or fiscal policy. So, the fiscal policy is concerned with government expenditure and government revenue. Fiscal Policy has to decide on the size and pattern of flow of expenditure from the government to the economy and from the economy back to the government. So, in broad term, fiscal policy refers to that segment of national economic policy which is primarily concerned with the receipts and expenditure of central government. In other words, fiscal policy refers to the policy of the government with regard to taxation, public expenditure and public borrowings. The importance of fiscal policy is high in underdeveloped countries. The state has to play active and important role. In a democratic society direct method are not approved. So, the government has to depend on indirect methods of regulations. In this way, fiscal policy is a powerful weapon in the hands of government by means of which it can achieve the objectives. 84 CU IDOL SELF LEARNING MATERIAL (SLM)
Fiscal policy is the term used to describe all of the government’s decisions regarding taxation and spending. When governments want to increase the money available to populace, they lower the taxes and raise spending (expansionary fiscal policy); in contrast, when they want to decrease the money available to populace, they raise the taxes and lower spending (contractionary fiscal policy) Government spending and the policies guiding the public expenditure of the government do influence macroeconomic conditions. These policies affect tax rates, interest rates and government spending, in an effort to control the economy.Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation’s economy. Fiscal policy and monetary policy go hand in hand with each other. Both are interdependent on each other. Fiscal policy serves as an important tool to influence the aggregate demand. The instruments of fiscal policy are government spending and taxation. Depending upon existing situation of the economy, government can employ either expansionary or contractionary fiscal policy. Expansionary fiscal policy increases the aggregate demand whereas contractionary or deflationary fiscal policy reduces the aggregate demand. Changes in the level, timing and composition of government spending and taxation have an important effect on the economy. Fiscal policy is the policy of government related to its own expenditure and taxes in order to influence the aggregate demand (AD).It is one of the very important demand –side policies. Demand –side policies focus on changing the AD or shifting the AD curve in the aggregate demand and aggregate supply (AD-AS) model in order to achieve the goals of price stability, full employment, and economic growth. There are four components of AD: consumer spending(C), investment spending (I), government spending (G), and net exports(X-M), where X=exports and M=imports. Fiscal policy influences all of these four components of AD. Government can influence ‘C’ by imposing taxes on consumers, i.e., personal income taxes. It can influence ‘I’ by imposing taxes on business profits. Similarly, government can easily change its own spending. It influences ‘X-M’ by means of subsidies provided to the domestic producers, import tax, and so on. Different economist has given different definitions of Fiscal policy as follows: According to Culbarston, “By fiscal policy we refer to government actions affecting its receipts and expenditures which we ordinarily taken as measured by the government’s receipts, its surplus or deficit.” The government may offset undesirable variations in private consumption and investment by compensatory variations of public expenditures and taxes. 85 CU IDOL SELF LEARNING MATERIAL (SLM)
Arthur Smithies defines fiscal policy as “a policy under which the government uses its expenditure and revenue programmes to produce desirable effects and avoid undesirable effects on the national income, production and employment.” Though the ultimate aim of fiscal policy in the long-run stabilisation of the economy, yet it can be achieved by moderating short-run economic fluctuations. In this context, Otto Eckstein defines fiscal policy as “changes in taxes and expenditures which aim at short-run goals of full employment and price-level stability. According to U. Hicks “Fiscal policy is concerned with the manner in which all the different elements of public finance, while still primarily concerned with carrying out their own duties, may collectively be geared to forward the aims of economic policy.” 5.6.2: OBJECTIVES OF FISCAL POLICY: The fiscal policy is designed to achieve the following objectives: Development by Effective Mobilization of Resources: The principal objective of fiscal policy is to ensure rapid economic growth and development. This objective of economic growth and development can be achieved by Mobilization of Financial Resources. The central and the state governments in India have used fiscal policy to mobilize resources. The financial resources can be mobilized by: Taxation: Through effective fiscal policies, the government aims to mobilize resources by way of direct taxes as well as indirect taxes because most important source of resource mobilization in India is taxation. Public Savings: The resources can be mobilized through public savings by reducing government expenditure and increasing surpluses of public sector Private Savings: Through effective fiscal measures such as tax benefits, the government can raise resources from private sector and households. Resources can be mobilized through government borrowings by ways of treasury bills, issue of government bonds, etc., loans from domestic and foreign parties and by deficit financing. Efficient Allocation of Financial Resources: The central and state governments have tried to make efficient allocation of financial resources. These resources are allocated for Development Activities which includes expenditure on railways, infrastructure, etc. While Non-development Activities includes expenditure on defence, interest payments, subsidies, etc. But generally the fiscal policy should ensure that the resources are allocated for generation of goods and services which are socially desirable. Therefore, India's fiscal policy is designed in 86 CU IDOL SELF LEARNING MATERIAL (SLM)
such a manner so as to encourage production of desirable goods and discourage those goods which are socially undesirable. Reduction in Inequalities of Income and Wealth: Fiscal policy aims at achieving equity or social justice by reducing income inequalities among different sections of the society. The direct taxes such as income tax are charged more on the rich people as compared to lower income groups. Indirect taxes are also more in the case of semi-luxury and luxury items, which are mostly consumed by the upper middle class and the upper class. The government invests a significant proportion of its tax revenue in the implementation of Poverty Alleviation Programmes to improve the conditions poor people in society. Price Stability and Control of Inflation: One of the main objectives of fiscal policy is to control inflation and stabilize price. Therefore, the government always aims to control the inflation by reducing fiscal deficits, introducing tax savings schemes, Productive use of financial resources, etc. Employment Generation: The government is making every possible effort to increase employment in the country through effective fiscal measure. Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generate more employment. Various rural employment programmes have been undertaken by the Government of India to solve problems in rural areas. Similarly, self-employment scheme is taken to provide employment to technically qualified persons in the urban area. Balanced Regional Development: Another main objective of the fiscal policy is to bring about a balanced regional development. There are various incentives from the government for setting up projects in backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax holidays, Finance at concessional interest rates, etc. Reducing the Deficit in the Balance of Payment: Fiscal policies attempts to encourage exports by way of fiscal measures like Exemption of income tax on export earnings, Exemption of central excise duties and customs, Exemption of sales tax and octroi, etc. The foreign exchange is also conserved by providing fiscal benefits to import substitute industries, imposing customs duties on imports, etc. 87 CU IDOL SELF LEARNING MATERIAL (SLM)
The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem. In this way adverse balance of payment can be corrected either by imposing duties on imports or by giving subsidies to exports. Capital Formation: The objective of fiscal policy in India is also to increase the rate of capital formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped in vicious (danger) circle of poverty mainly on account of capital deficiency. In order to increase the rate of capital formation, the fiscal policy must be efficiently designed to encourage savings and discourage and reduce spending Increasing National Income: The fiscal policy aims to increase the national income of a country. This is because fiscal policy facilitates the capital formation. This results in economic growth, which in turn increases the GDP, per capita income and national income of the country. Development of Infrastructure: Government has placed emphasis on the infrastructure development for the purpose of achieving economic growth. The fiscal policy measure such as taxation generates revenue to the government. A part of the government's revenue is invested in the infrastructure development. Due to this, all sectors of the economy get a boost. Foreign Exchange Earnings: Fiscal policy attempts to encourage more exports by way of Fiscal Measures like, exemption of income tax on export earnings, exemption of sales tax and octroi, etc. Foreign exchange provides fiscal benefits to import substitute industries. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problems. 5.6.3 ROLE OF FISCAL POLICY: 1. Allocation: The provision for social goods, or the process by which total resource use is divided between private and social goods and by which the mix of social goods is chosen. This provision may be termed as the allocation function of budget policy. Social goods, as distinct from private goods, cannot be provided for through the market system. The basic reasons for the market failure in the provision of social goods are: firstly, because consumption of such products by individuals is non rival, in the sense that one person’s partaking of benefits does not reduce the benefits available to others. 88 CU IDOL SELF LEARNING MATERIAL (SLM)
The benefits of social goods are externalised. Secondly, the exclusion principle is not feasible in the case of social goods. The application of exclusion is frequently impossible or prohibitively expensive. So, the social goods are to be provided by the government. 2. Distribution: Adjustment of the distribution of income and wealth to assure conformance with what society considers a ‘fair’ or ‘just’ state of distribution. The distribution of income and wealth determined by the market forces and laws of inheritance involve a substantial degree of inequality. Tax transfer policies of the government play an important role in reducing the inequalities in income and wealth in the economy. 3. Stabilization: Fiscal policy is needed for stabilization, since full employment and price level stability do not come about automatically in a market economy. Without it the economy tends to be subject to substantial fluctuations, and it may suffer from sustained periods of unemployment or inflation. Unemployment and inflation may exist at the same time. Such a situation is known as stagflation. The overall level of employment and prices in the economy depends upon the level of aggregate demand, relative to the potential or capacity output valued at prevailing prices. Government expenditures add to total demand, while taxes reduce it. This suggests that budgetary effects on demand increase as the level of expenditure increases and as the level of tax revenue decreases. 4. Economic Growth: Moreover, the problem is not only one of maintaining high employment or of curtailing inflation within a given level of capacity output. The effects of fiscal policy upon the rate of growth of potential output must also be allowed for. Fiscal policy may affect the rate of saving and the willingness to invest and may thereby influence the rate of capital formation. Capital formation in turn affects productivity growth, so that fiscal policy is a significant factor in economic growth. 5.7 DIFFERENCE BETWEEN MONETARY AND FISCAL POLICY: Both “Monetary Policy” and “Fiscal Policy” are used to regulate the economy, i.e. to either increase or decrease the pace of economic growth to some extent. Let us consider the major differences between them as follows: Monetary Policy: Monetary Policy is the policy determined and implemented by the Reserve Bank of India with no intervention by the Government of India. 89 CU IDOL SELF LEARNING MATERIAL (SLM)
In a Monetary Policy the RBI intervenes in a host of ways to control inflation monitor interest rates and control money supply in the economy. For example, the central bank may intervene to hike interest rates and thereby control inflation in the economy. On the other hand if inflation is low, it may cut interest rates in the economy. The main aim of RBI’s monetary policy is to keep a check on inflation and maintain an optimum level of GDP growth at the same time. If RBI raised the interest rate too high then that might help in checking inflation but at the same time deter economic activity and slow down GDP growth and if they keep the rates too low then that will promote economic activity but it will also spur inflation. They have to keep a balance between both so one is not sacrificed for the sake of the other. Monetary policy is carried out by RBI and manifests itself by setting interest rates like the Repo and Reverse Repo as well as determining levels of CRR and SLR which influence money supply and credit flow in the economy. It may also improve liquidity by cutting the cash reserve ratio for banks. The Reserve Bank of India also conducts open market operations, wherein the central bank, buys and sells government bonds. The monetary policy regulates the cost and availability of credit in the economy. It deals with both the lending and borrowing rates of interest for commercial banks. The monetary policy aims to maintain the price stability, full employment and economic growth. It can carry out open-market operations (OMO), control credit, and vary the reserve requirements. The monetary policy is different from fiscal policy as the former brings about a change in the economy by changing money supply and interest rate, whereas fiscal policy is a broader tool of the government. Fiscal Policy Fiscal Policies are largely determined by the government of India. Fiscal policy is the policy that determines how the government spends money, and taxes people to pay for those expenses. This would include measures like tweaking with the direct and indirect tax collection to control the fiscal deficit. When the government's deficit runs high it may add a slew of taxes to boost revenues. However, it has to be cautious as the same could also backfire. Fiscal policy largely aims at stabilizing the economy; boosting revenues for the government and helping the economy grow. The government uses its tax levers to help the economy. While “Monetary Policy” is the tool in the hands of the Central Bank to regulate the economy, “Fiscal Policy” on the other hand, is the tool in the hands of the “government” to regulate the economy. So, if the government wants to help the economy to speed up, it may decide to reduce taxes so that people have higher 90 CU IDOL SELF LEARNING MATERIAL (SLM)
disposable incomes to spend on goods and services. This naturally would lead to an increase in demand and supply and thereby stimulate all the interlinked industries. Secondly, the government may also decide to increase its own spending by way of building infrastructure such as airports, railways, bridges and roads. There are several ancillary sectors that get impacted the moment the government decides to increase its spending. The demand for the production of organizations operating in these sectors increases bringing profits and prosperity. On the other hand, if the government decides to slow down the economy because of “running away” inflationary growth, it will do the opposite by way of increasing taxes and decreasing its own spends. The fiscal policy can be used to overcome recession and control inflation. It may be defined as a deliberate change in the government revenue and expenditure to influence the level of national output and prices. During the times of recession when government increases its spending or cuts taxes – that’s termed as a fiscal stimulus package the instruments of fiscal policy are used to boost the economy. India has had three fiscal stimulus packages following the last recession which involved tax cuts and boosts in spending, and were similar to stimulus measures used by countries around the world. Also, government can reduce its expenditures or raise taxes during inflationary times. Fiscal policy aims at changing aggregate demand by suitable changes in government expenditure and taxes. 5.8 TECHNIQUES OF FISCAL POLICY 5.8.1: TAXATION POLICY: Taxes are the main source of revenue for the government. Government levies both direct and indirect taxes in India. Direct taxes are those which are paid directly by the assessee to the government e.g., income tax, wealth tax, etc. Indirect taxes are paid indirectly by the public to the government i.e., the taxes are charged by trader/manufacturer from the public and then paid to government e.g., excise duty, custom duty, value added tax (VAT), service tax, etc. Direct taxes are progressive in nature i.e., the rate of tax increases with the increase in level of income/wealth so people with low income will pay tax at lower rates and people with higher income will pay tax at higher rates. Indirect taxes are not progressive. These are charged from all segments of the society at the same rate, i.e. both rich and poor have to pay indirect taxes at the same rate. In India, in the year 2007-08, direct taxes constituted 49 percent of the total tax collection and indirect taxes constituted 51 percent. Main purposes of the taxation policy in India are as follows: Mobilisation of Resources: Tax revenue in India has been rising every year. Government mobilizes resources through taxation for economic development. In the year 2007-08, about 64 percent of revenue of central and state government of India 91 CU IDOL SELF LEARNING MATERIAL (SLM)
came from tax revenue. Rate of taxes have come down but the collection of tax has increased. To Promote Saving: For this purpose various tax concession, tax deductions are given on savings e.g., Provident Fund, National saving Certificates, Life Insurance Policies, Government Bonds, Mutual Funds, etc. To Promote Investment: Various tax rebates, tax concessions and tax holiday benefits are given to promote the investment in remote and backward or rural areas. Similarly, tax rebates and concessions are given to export-oriented units, so as to encourage investment in these industries. To Bring Equality of Income and Wealth: To achieve this objective different kinds of progressive direct taxes are levied e.g. income tax, wealth tax, etc. i.e., rate of tax is increased with the increase in the income. Similarly, excise duties are levied at higher rate on luxury goods and at lower rates on necessary goods. Tax Structure of Government of India: India has a well-developed tax structure with clearly demarcated authority between Central and State Governments and local bodies. Central Government levies taxes on the following: Income Tax: Tax on income of a person Customs duties: Duties on import and export of goods Central Goods and Service Tax (CGST): Indirect Tax levied on manufacture, sale and consumption of goods and services. Integrated Goods and Service Tax (IGST): For inter-state transfer of goods and services. State Governments can levy the following taxes: State Goods and Service Tax(SGST): Indirect Tax levied on Intrastate manufacture, sale and consumption of goods and services. Stamp duties and Land Revenue: Since land is a matter on which only State Governments can govern, thus the Stamp duties on transfer of immovable properties are levied by State Governments. State Excise on Liquor and certain agricultural goods. Apart from the above, certain powers of taxation have been devolved in the hands of local bodies. These local governing bodies can levy taxes on water, property, shop and establishment charges etc. 92 CU IDOL SELF LEARNING MATERIAL (SLM)
Direct Taxes: They are called so as the burden of taxation falls directly on the tax payer. Under the Income Tax Act, 1961 The Central Government levies direct taxes on the income of individuals and business entities as well as Non business entities also. The taxation level depends on the residential status of individuals. The thumb rule of residential status is that an individual becomes resident in India if he has remained in India for more than 182 days in a particular residential year. If he becomes resident in India, then his global income i.e. income earned even outside India is taxable in India. This has to be noted very carefully by Expatriates on deputation to India. They need to plan their stay in such a manner as to avoid becoming a resident in India. The following para explains this in a slightly more detailed manner: Tax Resident: An individual is treated as resident in a year if present in India: 1. For 182 days during the year or 2. For 60 days during the year and 365 days during the preceding four years. A resident who was not present in India for 730 days during the preceding seven years or who was non-resident in nine out of ten preceding years treated as not ordinarily resident. A person not ordinarily resident is taxed like a non-resident but is also liable to tax on income accruing abroad if it is from a business controlled in or a profession set up in India. What is taxable for a Non-Resident? Non-residents are taxed only on income that is received in India or arises or is deemed to arise in India. He is entitled to get benefit of any double taxation avoidance agreement that his country of residence has signed with India. Then he shall be liable for taxes at rates mentioned in the Indian domestic tax laws or the rates mentioned in the Double Taxation Avoidance Agreement whichever is lower. What is taxable for a Resident? The global income of a resident is taxable irrespective of whether earned or related or received in India. Amounts invested in certain investments like Employee Provident Fund, Public Provident Fund, Tax saving Fixed Deposits, are also eligible for deduction under section 80C upto Rs.1,50,000 per year. Corporate Taxation: 93 CU IDOL SELF LEARNING MATERIAL (SLM)
The rate at which Corporates are taxed in India is 30% plus a 3% cess. Thus the total comes to 30.9%. Further if the taxable income is more than Rs. 10 million, then there is an additional surcharge of 12% on the base tax rate. Dividend Distribution Tax (DDT): Under Section 115-O of the Income Tax Act, any amount declared, distributed or paid by a domestic company by way of dividend shall be chargeable to dividend tax. So if a company declares divided, it has to pay an effective rate of 16.995% on the dividends declared. This is apart from the 30.9 % taxes mentioned above. The rationale for this tax is that after paying this tax, the dividend so declared becomes tax free in the hands of the recipient of dividend. Minimum Alternative Tax (MAT): Normally, a company is liable to pay tax on the income computed in accordance with the provisions of the income tax Act, but many a times due to exemptions under the income tax Act, there is huge actual profit as shown in the profit and loss account of the company but no taxable income. To overcome this issue, and in order to bring such companies under the income tax act net, the concept of Minimum Alternate Tax (MAT) has been introduced. The present rate of MAT is 19.05%. Another aspect which must be looked into is the concept of Witholding Taxes; also called as Tax Deduction at Source (TDS). Tax Deduction at Source (TDS): As per the provisions of the Indian tax laws, certain payments are covered under tax withholding norms. Under this, the person responsible for making any payment is required to withhold a certain specified percentage of the payment amount as taxes and deposit it with the Government treasury. In addition, the person is required to prepare a certificate of tax deduction and provide it to the person on whose behalf the deductions are made. Every quarter i.e. 3 months, returns have to be filed by the deduct or and credit must be given to the deducted in the returns. The following are the areas where tax withholding is most common in the Indian scenario: Salaries: The salaried employees of the drawing beyond the minimum taxable salary would be covered under the tax withholding requirements and annual tax withholding returns are to be submitted with the Revenue authorities. 94 CU IDOL SELF LEARNING MATERIAL (SLM)
Contractors: Payments made to a contractor for carrying out any work would require withholding of tax at source from such payments, if certain threshold limits are crossed. Typical examples of such payments will include: Advertising payments Broadcasting and telecasting payments Office renovation payments Vehicle hire payments Catering payments. Job Work Courier Professional Services: Payments made for professional and technical fees to Doctors, Chartered Accountants, Lawyers, Management Consultants, Engineers, Architects and other professionals would fall under this section and tax would be required to be withheld from their payments. Such withheld tax shall be deposited with the Government. Rentals: Payments for rentals would attract tax deduction at source. Indirect Taxes Indirect tax is generally imposed on suppliers or manufacturers who pass it on to the consumers using their good or services. The following are the list of Indirect Taxes as: 1. Service Tax: Applicable on the services provided by a company and paid by the recipient of their services, collected by and deposited with the central government. 2. Value Added Tax: Popularly known as VAT, it is levied on the sale of movable goods or goods sold directly to the customers. It is exacted by the respective state governments on intra-state sales. 3. Excise duty: Levied on the goods produced or manufactured in India, paid by the manufacturers of different goods. It is often recovered from the customers. 4. Custom Duty: Applicable on the goods which are imported into India from other countries. In some cases, it is also levied on the goods being transported out of India. 5. Entertainment tax: Levied on all financial transactions related to entertainment such as movie shows, amusement parks, video games, arcades, and sports activities, charged by the respective state governments. 95 CU IDOL SELF LEARNING MATERIAL (SLM)
6. Stamp Duty: Levied on the transfer of immovable property located within the state, charged by the State Government and may vary in rates. Also applicable on all legal documents. 7. Securities Transaction Tax: Levied at the time of trade of securities through Indian Stock Exchange. In India, there are many different Indirect Taxes which are applicable on different kinds of goods, imports, manufacturing and services. GST: Merging of various indirect taxes As there are many different types of indirect taxes levied on the expense incurred by a buyer, the government has made an effort to simplify the taxing process and merged all these indirect taxes into a common indirect tax called the Goods and Service Tax (GST). Merging of all these taxes has reduced the hassles of compliances associated with all these indirect taxes, improving tax governance in the country. Introduced in 2017, the GST has eliminated the cascading effect of multiple taxes. 5.8.2 PUBLIC EXPENDITURE POLICY: It influences the economic activities of a country to a great extent. In 2007-08, share of public expenditure in national income was 14.5 percent. Public expenditure may be of two kinds i.e. developmental and non-developmental, Developmental expenditure is of great importance with reference to the economic growth of the country. Developmental activities like development of means of transport, extension means of irrigation, completion of power projects and expansion of educational and health facilities requires huge amount of capital that cannot be contributed by the private sector alone, so increase in public expenditure is must. The following measures undertaken by the Government can help to increase the public expenditure which is as follows: o Development of Public Enterprises: Basic and heavy industries requires huge capital and also involves more risks. So, private sector in the country cannot setup such establishment without any support. Since Industrial Policy, 1956 resolution, Government of India is actively involved in development of such industries. o Support to Private Sector: In order to accelerate the rate of economic growth in the country, government is encouraging private sector by giving various subsidies, concessional loans, tax concessions, etc. o Development of Infrastructure: Government spends huge amount for the development of infrastructure that includes development of railways, power projects, roads, air ports, ports, hospitals, bridges, dams, etc. which is important prerequisites for the economic development of any nation. o Social Welfare: Government spends huge amount on public health, education, safe drinking water, sanitation, welfare of weaker section of society, etc. 96 CU IDOL SELF LEARNING MATERIAL (SLM)
5.8.3 PUBLIC DEBT POLICY: Government needs lot of funds for the economic development of the country. No government can mobilise so much funds by way of taxes alone. There are many reasons for it, viz. a) most of the population is poor; b) adverse effect of more taxes on savings and investments; c) taxes are levied only till taxable capacity of the people. It therefore, becomes inevitable for the government to mobilise resources for economic development by resorting to public debt. Public debt is obtained from two kinds of sources: o Internal Debt: It should be mobilised in a manner that it has no adverse effect on private investment. It is more beneficial to collect small savings as it encourages the people to save more. Special efforts should be made to mobilise rural small savings. In India, small savings are being collected from large number of people through commercial banks and post offices. Internal debt constituted 95.9 percent of total public debt in the year 2007-08. o External Debt: India cannot meet its financial requirements from internal debt alone. It has got to borrow from abroad as well. The main advantage of foreign loans is that these loans are received in foreign currency. External debt constituted 95.9 percent of total debt in the year 2007-08. 5.8.4 DEFICIT FINANCING POLICY: It refers to financing the budgetary deficit. Budgetary deficit here means excess of government expenditure over government income (including borrowings). Deficit financing in India means, “Taking loan from the Reserve Bank of India by the government to meet the budgetary deficit”. Reserve Bank gives this loan by issuing new currency notes. Consequently, money supply increases. Increase in money supply leads to fall in the value of money. Fall in value of money in turn leads to increase in price level. So deficit financing should be kept low as it leads to price rise in the economy. But in India, level of income is low. As a result, power to save in is also and their taxable capacity is also low. Due to low saving, there is a low rate of capital formation which leads to low rate of economic growth. Hence to accelerate the rate of economic growth, it becomes inevitable to increase saving and investment. Deficit financing is a kind of forced savings. On account of deficit financing, price level rises and people get less number of goods in exchange for the same amount of money than before. Government of India has also been taking resort to deficit financing since the beginning of the plans. Thus, due to deficit financing, on the one hand, necessary funds are made available for economic growth and on the other, inflation in the country increases. It is, therefore, essential that deficit financing be kept with safe limits. Presently our government is not using deficit financing for meeting its financial requirements. 97 CU IDOL SELF LEARNING MATERIAL (SLM)
5.9 FISCAL POLICY REFORMS INTRODUCED BY THE GOVERNMENT OF INDIA: 1. Simplification of Taxation System: With a view to simplify the taxation system as recommended by Raja Chelliah Taxation Reform Committee, ex-Finance Minister Dr. Manmohan Singh and Finance Minister Sh. Chidhambaram have taken several steps. These measures have provided big relief to tax payers. It is also imperative that administrative machinery should be made efficient and honest with simplification of taxation system. 2. Improving Tax to GDP Ratio: In recent years government has taken several measures to improve tax-GDP ratio. In year 2002-03 this ratio was 14.4 percent. In the year 2009-10 it has improved to 16.6 percent. It shows that scope of tax has increased. 3. Reduction in Rates of Direct Taxes: Policy of fiscal reforms aims at lowering the rate of taxes. Tax revenue is to be increased by reducing the tax rate. Government of India has been gradually lowering the rates of direct and indirect taxes in its successive budgets. In 1997-98 budgets, the maximum rate of income tax was reduced to 30 percent. Rate of Corporation Tax has also been reduced. In the budget for the year 2009-10, maximum rate of income tax is 30 percent. As a result of these reforms, collection of tax revenue has increased considerably. Although rates of taxes have been reduced yet the tax revenue has been rising constantly. In 1990-91, direct tax revenue was 1.9 percent of gross domestic product (GDP). In 2009-10, it rose to 6 percent of GDP. Of the total tax revenue, the ratio of direct tax revenue has increased from 19% in the year 1990-91 to 58% in the year 2009-10. Consequent upon different reform measures taken in respect of direct taxes, revenue from taxes has increased appreciably. 4. Reforms in Indirect Taxes: For the last many years the government has been making persistent efforts to reform the indirect tax structure e.g. lowering of the tax rates, increasing scope of tax, etc. Under reforms concerning customs, import duties were gradually reduced so as to bring down the cost of production. It has enabled the domestic industry to compete in the international market. Reduction in import duty has brought down the prices of imported goods to the benefit of the consumers. In year 2001-02, government adopted Central Value Added Tax (CENVAT). In CENVAT, three tier excise duties of 8%, 16% and 24% are started. In the year 2008-09 and 2009-10, excise duty rates have been reduced to boost aggregate demand, so as to protect the domestic economy from global recession. In place of retail sales tax, Value Added Tax has been introduced. All states /UTs have implemented VAT w.e.f. April 1, 2005. VAT is charged on value addition at each stage of production or distribution. For example, when raw materials are changed into work in process, some value addition takes 98 CU IDOL SELF LEARNING MATERIAL (SLM)
place. Similarly, when work in process is converted into finished goods, again some value addition takes place. In VAT, tax is charged on each stage of value addition. In VAT, three tax rates have been determined, for gold and silver VAT rate is 1%, for basic goods it is 4% and for other commodities, VAT rate is 12.5%. 5. Introduction of Service Tax: In the year 1994-95, service tax has been started in India. In year 2007-08, rate of service tax was 12 percent. In year 2009-10, service tax rate has been reduced to 10 percent. Initially this tax was applicable on a few seconds but now 114 services have been covered under this tax. 6. Reduction in Non-plan Government Expenditure: One of the major objectives of fiscal reforms was to put a check on unnecessary government expenditure. Government took several measures in this direction; for example superfluous appointments were banned, disinvestments in public enterprises incurring chronic losses. As a result of these measures, total non-plan expenditure of the central government that stood at 17.3 percent of GDP in 1990-91 came down to 11.3 percent in 2009-10. Thus, the central government has partially succeeded in scaling down percentage of non-plan expenditure. However, non-plan expenditure of government in absolute monetary terms instead of going down has actually been on increase. Rise in the non-plan expenditure of the government must be a matter of concern in so far as economic development is concerned. 7. Reduction in Subsidies: Central Government has to make huge payments by way of subsidies, for instance, fertilizer subsidies, export subsidies, food subsidies, etc. Government has been making serious efforts to reduce subsidies. No doubt, the total amount being spent on subsidies has been rising, but as a percentage of GDP it has been falling. In 1990-91, subsidies constituted 2.3 percent of GDP but in 2007-08 their share fell to 1.4 percent. But in the year 2008-09, it again increased to 2.2% of GDP.In 2009-10, subsidies constituted 1.8% of GDP. 8. Improvement in Tax Collection: For improving tax collection and to check tax evasions various schemes have been launched by government from time to time viz.,- allotting Permanent Account Number (PAN), strengthening the norms of Tax Deduction at Source (TDS), Special Bearer Bond Scheme, Voluntary Disclosure Schemes, making e-filing of tax returns mandatory for certain assesses, extension of e-payment, facility of taxes, etc. Tax authorities have been given wide powers to conduct tax-raids. 99 CU IDOL SELF LEARNING MATERIAL (SLM)
9. Closure of Sick Public Sector Companies: Government has been closing loss making and sick public sector companies. This step has been taken to reduce the burden of these loss making units on government exchequer. 10. Disinvestment of Public Sector Units: Disinvestment here refers to selling the shares of public sector units to private hands. Through disinvestment government gets huge funds. This has enabled the government to overcome financial crunch. 11. Efforts to Reduce Government Administrative Expenses: For this government has offered attractive voluntary retirement scheme to its employees to overcome the problem of over staffing. Government has banned or reduced sanctioning new posts in some of its departments. Government has also reduced grants to various states, and privately managed institutions. 12. Enactment of Fiscal Responsibility and Budget Management Act: Government has enacted Fiscal Responsibility and Budget Management Act, 2003. The main purpose of this Act is to reduce fiscal deficit and for this, the target has been fixed for reducing fiscal deficit with the minimum annual reduction of 0.5 % of Gross Domestic Product (GDP). 13. Reduction in Central Sales Tax (CST): Government has reduced CST from 3 % to 2% from June 1, 2008. From 1st April 2011, CST has been abolished. 14. Introduction of Goods and Service Tax (GST): Central government is gradually reducing central sales tax, excise duty on goods and is increasing service tax. Government is moving towards imposing a uniform tax on goods and services named GST with effect from April 1, 2011. Goods and Service Tax is a comprehensive value added tax on goods and services levied and collected on the value added at each stage of sales and purchase. GST will have two components, comprising of Central GST and State GST. 5.10 SUMMARY: To increase the rate of investment and capital formation, so as to accelerate the rate of economic growth. To increase the rate of saving and discourage actual and potential consumption. To diversify the flow of investment and spending from unproductive uses to socially most desirable channels. 100 CU IDOL SELF LEARNING MATERIAL (SLM)
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