MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY

Monetary Policy:
Monetary policy is concerned with the changes in the supply of money and credit. It
refers to the policy measures undertaken by the government or the central bank to influence the
availability, cost and use of money and credit with the help of monetary techniques to achieve
specific objectives. Monetary policy aims at influencing the economic activity in the economy
mainly through two major variables, i.e., (a) money or credit supply, and (b) the rate of interest.

The techniques of monetary policy are the same as the techniques of credit control at the
disposal of the central bank. Various techniques of monetary policy, thus, include bank rate,
open market operations, variable cash reserve requirements, selective credit controls. R.P. Kent
defines monetary policy as “the management of the expansion and contraction of the volume of
money in circulation for the explicit purpose of attaining a specific objective such as full
employment.” According to A.J. Shapiro, “Monetary Policy is the exercise of the central bank’s
control over the money supply as an instrument for achieving the objectives of economic
policy.” In the words of D.C. Rowan, “the monetary policy is defined as discretionary action
undertaken by the authorities designed to influence (a) the supply of money, (b) cost of money or
rate of interest and (c) the availability of money.”

The monetary policy in an open economy works through two main economic variables,
i.e, money supply and the rate of interest. The efficient working of the monetary policy,
however, requires the fulfillment of three basic conditions (a) The country must have highly
organised, economically independent and efficiently functioning money and capital markets
which enable the monetary authority to make changes in money supply and the rate of interest as
and when needed. (b) Interest rates can be regulated both by administrative controls and by
market forces, so that consistency and uniformity exists in interest rates of different sectors of the
economy. (c) There exists a direct link between interest rates, investment and output so that a
reduction in the interest rate (for example) leads to an increase in investment and an expansion in
output without any restriction.

The proper objective of the monetary policy is to be selected by the monetary authority
keeping in view the specific conditions and requirements of the economy. Various objectives or
goals of monetary policy are:

(i). Neutrality of Money

(ii). Exchange Stability
(iii). Price Stability
(iv). Full Employment
(v). Economic growth
These objectives are discussed in detail in the following sections.

Neutrality of money:

Economists like Wicksteed, Hayek, Robertson, advocated that the main objective of the
monetary policy is to maintain complete neutrality of money. The policy of neutrality of money
seeks to do away with the disturbing effect of changes in the quantity of money on important
economic variables, like income, output, employment and prices. According to this policy,
money supply should be controlled in such a way that money should be neutral its effects. In
other words, the changes in money supply should not change the total volume of output and total
transactions of goods and services in the economy.

The policy of neutrality of money is based on the assumption that money is purely a
passive factor. It functions only as a medium of exchange. In the absence of money, barter (i.e.,
direct exchange of goods for goods) determines the relative values of goods. The function of
money is only to reflect these relative values and not to distort them. On the basis of the
assumption of the passive or neutral role of money, the advocates of the neutrality of money hold
the view that money should not be allowed to interfere in the neutral functioning of the economic
forces both on the supply and demand sides, such as productive efficiency, cost of production,
consumer preferences.

The exponents of the neutral money policy believe that monetary exchanges are the root
cause of all economic ills. They cause disturbances in the smooth working of the economic
system. They are responsible for the occurrence of trade cycles. They bring changes in the real
variables like income, output, employment and relative prices. They cause imbalance between
demand and supply, consumption and production. Thus, economic fluctuations (inflation and
deflation) are the result of non-neutral money (involving changes in money supply) and stability
in the economic system with no inflation and deflation requires the adoption of neutral money
policy (involving constant money supply).

Thus according to the policy of neutral money, if the money is made neutral and the
money supply is kept constant, there will be no disturbances in the economic system. In such a
situation, relative prices will change according to the changes in the demand and supply of goods
and services, economic resources will be allocated according to the wants of the society, and
there will be no inflation and deflation. However, this does not mean that the money supply
should be kept constant under all circumstances:

(i). The supply of money will have to be changed from time to time to provide for the
changes in the velocity of the money; in the periods of a fall in the velocity of money, the
supply of money has to be increased and in periods of rise in the velocity of money, the
supply of money has to be reduced. It is, in fact, the volume of effective money supply
(including both the volume of standard and bank money as well as the velocity of
circulation of the money) which should be kept constant.
(ii). The money supply will also be changed to neutralise the basic changes in the economic
structure of the country. Such basic changes are changes in population, changes in the
techniques of production, innovations, etc.

Exchange stability:

Exchange rate policy has been the traditional objective of monetary policy under gold
standard. It was considered the primary objective, while stability of prices was considered
because of the great importance of international trade among the leading countries of the world.
Main arguments made in favour of exchange stability and against exchange instability are given
below:

(i). Stable exchange rates are essential for the promotion of smooth international trade.
(ii). Fluctuations in the exchange rates lead to lack of confidence in the particular currency
and might result in the flight of capital from the country whose currency is unstable in
value.
(iii). Frequent changes in the exchange rates encourage speculation in the exchange markets.
(iv). Fluctuations in exchange rates also lead to fluctuations in the internal price level.
(v). Fluctuations in the exchange rates adversely affect the economic and political
relationship among the countries.
(vi). International lending and investment is seriously affected as a result of fluctuating
exchange rates.

The objective of exchange stability is achieved through establishing equilibrium in the balance of
payments. The Monetary policy plays an important role in bringing balance of payments
equilibrium without disturbing the stable exchange rate. A country with a deficit in balance of
payments, for example, adopts a restrictive monetary policy. Contraction of currency and credit
as a result of the restrictive monetary policy brings down the price level within the country. This
will encourage exports and discourage imports. Increase in exports and decrease in imports will,
in turn, correct the disequilibrium in the balance of payments position.

Exchange rate stability as an objective of monetary policy has been cricitised on two
grounds: (a) Exchange rate stability is generally achieved at the expense of internal price
stability. But, fluctuations in the internal price level cause serious disturbances in the economy
and adversely affect its smooth working and progress. (b) With stable exchange rates, the
inflationary and deflationary conditions of some countries are passed on to other countries. This
puts the country with stable exchange rates at the mercy of the other countries, thereby seriously
affecting the economy of that country.

In the modern times, when International Monetary Fund has been established to deal with
problem of maintaining exchange rate stability among the member countries and most of the
countries of the world are members if this institution, the exchange stability as an objective of
monetary policy of a country has lost much of its force. The modern welfare governments are
more concerned with establishing internal price stability rather than maintaining exchange
stability.

Price Stability:

With the abandonment of gold standard after the World War II, exchange stability was
replaced by price stability as an objective of monetary policy. Greater attention was paid to the
problem of removing violent fluctuations in the domestic fluctuations in the prices through
various monetary controls and regulations. Price stability refers to the absence of any market
trend or sharp short-run movements in the general price level. Price stability does not mean that
each and every price should be kept fixed; it means that the average of prices or the general price
level, as measured by the wholesale price index, should not be allowed to fluctuate beyond
certain minimum limit. Stable price level does not mean fixed or frozen price level. Economists
generally regard 2 to 4% annual rise in prices as the stable price level.

Argument in Favour of Price stability: The price stabilisation is advocated on the basis of the
following arguments:

(i). Price instability leads to great disturbances in the economy and price stability ensures
smooth functioning of the economy and creates conditions for stable growth.
(ii). Inflation and deflation representing cumulative rise and fall in prices respectively are
both economically disturbing and socially undesirable. They create problems of
production and distribution.
(iii). Inflation is socially unjust because it redistributes income and wealth in favour of the
rich.
(iv). Deflation leads to the reduction of income and output and cause wide spread
unemployment.

Arguments Against Price Stability: The policy of price stabilisation has been criticised on the
following grounds:

(i). The concept of price stability is vague because it is difficult to determine the price level
which is to be stabilised.
(ii). The concept of price stability also does not make it clear which prices are to be stabilised-
wholesale prices or retail prices, consumer goods prices or producer goods prices.
(iii). Price changes are the symptoms, and not the cause of business fluctuations. Price stability
deals only with symptoms and not the disease; it may not bring stability in business
activity.
(iv). Variations in prices are necessary for the successful working of the price mechanism in a
capitalist economy and the price mechanism plays an important role in the optimum
allocation of resources in the economy. The policy of price stabilisation renders the price
mechanism unnecessary and ineffective.
Full Employment:

With the publication of Keynes’ General Theory of Employment, Interest and

Money(1936), full employment became the ideal goal of monetary policy. Keynes emphasised
the role of monetary policy in promoting full employment of human and natural resources in the
country. He advocated cheap money policy, i.e. expansion of currency and credit and reduction
in rate of interest, to achieve the goal of full employment. Full employment of labour and full
utilization of other productive resources are important from the point of view of maximising
economic welfare in the country.

Meaning of Full Employment. The concept of full employment is vague and ambiguous. It has
been differently interpreted by different economists. However, one thing is clear that full
employment does not mean complete absence of unemployment. In other words, full
employment does mean that each and every person in the country who is fit and free is employed
productively. In fact, full employment is compatible with some amount (i.e. 3 to 4%) of seasonal
and frictional unemployment. According to Beveridge, full employment means that
“unemployment is reduced to short intervals of stand by, with the certainty that very soon one
will be wanted in one’s old job again or will be wanted in a new job within one’s power.”

Full Employment in Developed and Underdeveloped Countries. The problem of full

employment is different for developed and underdeveloped countries. The developed countries,
like England and America, may already have achieved the level of full employment and the
problem in these countries is to maintain this level by avoiding all kinds of fluctuations. On the
other hand, the underdeveloped countries, like India are characterized by wide-spread
unemployment and underemployment. So the problem in these countries is to remove
unemployment by providing job to all those who are willing to work. Thus, the problem in an
underdeveloped country is to achieve full employment, whereas that, in a developed country is to
maintain full employment.

Achievement and Maintenance of Full Employment Level. Monetary policy can help the
economy to achieve full employment. According to Keynes, unemployment is mainly due to
deficiency of investment and the level of full employment can be achieved by increasing
investment and making it equal to the saving at the full employment level. The main task of
monetary policy is to expand money supply and reduce rate of interest to that optimum level
which raises the investment demand and equates it with full employment saving. The monetary
policy aiming at increasing investment and ultimately achieving full employment is commonly
called cheap money policy. Cheap money policy stimulates investment by expanding money
supply and reducing the interest rate.

Economic Growth:

Traditionally, monetary policy has been regarded as a short-run policy primarily aiming at
achieving the objectives of price stability and full employment. But, quite recently the emphasis
has been shifted from full employment or price stability to economic growth as the main
objective of monetary policy. The monetary policy is now no longer considered as a short-run
policy of securing full-employment level free from cyclical fluctuations. On the other hand the
main objective of monetary policy now is to achieve the long run goal of ever-increasing rate of
economic growth.

In the U.S.A. Employment Act of 1946 made it obligatory on the federal government to
take all possible measures not only to promote maximum employment, but also maximum
production in the country. The objective of economic growth is also important from the point of
view of the underdeveloped countries. The real problem in these countries is not short-run
cyclical fluctuations in production and employment, but is one of the long run structural changes
aiming at creating conditions necessary for economic development. Thus, the main objective of
monetary policy is an underdeveloped country should be to play an active part in the process of
economic development.

In fact, economic growth has been aptly made the primary objective of monetary policy.
The following arguments can be advanced in favour of economic growth:

(i) The objective of full employment cannot possibly be achieved without raising the rate
of economic growth.
(ii) Increasing the rate of economic growth is necessary if the people are to be provided
with ever-rising living standards.
(iii) Rapid economic growth is essential for the survival of the developing countries in the
present competitive world.
(iv) The objective of economic growth takes into consideration the broader long-term
perspective. It is concerned with economic and technological progress of the country.
(v) According to Woodworth, the objective of economic growth deserves priority
because of two reasons: (a) Despite the enormous improvement in the living
standards in the western world, poverty still remains the world’s burning economic
problem. (b) Economic growth is an essential ingredient of the economic and political
institutions.

Some economists have opposed the growth objective of monetary policy in

underdeveloped countries. According to Howard Ellis, for example, any monetary policy
promoting economic growth in an underdeveloped country is doomed to frustration because
such countries are highly susceptible to inflationary pressures. But, the majority of the
economists are in favour of the monetary policy having economic growth and are of the view
that monetary policy should explicitly adopt economic growth as its primary objective.

Economic growth has been defined as the process whereby the real national income of a
country increases over a long period of time. In this process, money can play an important
role as a mobilizing agent. Most of the countries, particularly the less developed countries,
 possess the physical and human resources necessary for economic growth, but their resources
remain un-utilized largely due to lack of necessary finances. Under such conditions, an
expansionary monetary policy, by providing necessary monetary resources, will be able to
mobilize the unutilized resources and thus will activate and accelerate the process of
economic growth.

The monetary policy aiming at promoting economic growth must satisfy two conditions:

(i) The monetary policy must be flexible. In other words, it must be able to establish
equilibrium between aggregate demand for money and aggregate supply of goods and
services. When aggregate demand for money exceeds the aggregate supply of goods a
restrictive monetary policy should be adopted. On the contrary, when aggregate
supply of goods and services exceeds aggregate monetary demand, an expansionary
monetary policy should be adopted. Thus, a flexible monetary policy ensures price
stabilization which is necessary for economic growth.
(ii) The monetary policy should be able to promote capital formation. In other words, it
should create favourable atmosphere for promoting saving and investment in the
country. For this, the aim of the monetary policy should be to remove price
fluctuations and establish reasonable price stability.

FISCAL POLICY

Meaning

Fiscal policy is a powerful instrument of stabilization. “By Fiscal policy we refer to

government actions affecting its receipts and expenditures which we ordinarily take as measured
by the government’s net receipts, its surplus or deficit.” The government may offset undesirable
variations in private consumption and investment by anticyclical variations of public
expenditures and taxes. Arthur Smithes 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 is the long run stabilization of the economy, yet it can be only 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”.
Instruments of Fiscal Policy

Fiscal policy through variations in government expenditure and taxation profoundly affects
national income, employment, output and prices. An increase in public expenditure during
depression adds to the aggregate demand for goods and services and leads to a large increase in
income via the multiplier process; while a reduction in taxes has the ‘effect of raising disposable
income thereby increasing consumption and investment expenditures of the people. On the other
hand, a reduction of public expenditure during inflation reduces aggregate demand, national
income, employment, output and prices; while an increase in taxes tends to reduce disposable
income thereby reducing consumption and investment expenditures. Thus the government can
control deflationary and inflationary pressures in the economy by a judicious combination of
expenditure and taxation programmes. We discuss below the various instruments of fiscal policy.

1. Budgetary Policy- Contracyclical Fiscal policy

The budget is the principal instrument of fiscal policy, budgetary policy exercises control
over size and relationship of government receipts and expenditures. We discuss below the
common budget policies that can be adopted for stabilizing the economy.

(i). Budget Deficit- Fiscal Policy During Depression. Deficit budgeting is an important
method of overcoming depression. When government expenditures exceed receipts,
larger amounts are put into the stream of national income than they are withdrawn. The
deficit represents the net expenditure of the government which increases national income
2
by the multiplier times the increase in net expenditure. If The MPC is , the multiplier
3
will be 3; and if the net increase in government expenditure is Rs 100 crores it will
increase national income to Rs 300 crores(=100× 3). Thus the budget deficit has an
expansionary effect on aggregate demand whether the fiscal process leaves marginal
propensities unchanged or whether a redistribution of disposable receipts occurs.
(ii). Surplus Budget- Fiscal Policy during Boom. Surplus in the budget occurs when the
government revenues exceed expenditures. The policy of surplus budget is followed to
control inflationary pressures within the economy. It may be through increase in taxation
or reduction in government expenditure or both. This will tend to reduce income and
aggregates demand by the multiplier times the reduction in government or/ and private
consumption expenditure ( as a result of increased taxes).
(iii). Balanced Budget Multiplier. Another expansionist fiscal policy is the balanced budget.
In this policy, the increases in taxes and in government expenditures are of an equal
amount. This has the impact of increasing net national income. This is because the
reduction in consumption resulting from the tax is not equal to the government
expenditure. This is explained in terms of what is known as the balanced budget theorem
or multiplier.
2. Compensatory Fiscal Policy

The compensatory fiscal policy aims at continuously compensating the economy against
chronic tendencies towards inflation and deflation by manipulating public expenditures and
taxes. It, therefore, necessitates the adoption of fiscal measures over the long run rather than once
for all measures at a point of time. When there are deflationary tendencies in the economy, the
government should increase its expenditures through deficit budgeting and reduction in taxes.
This is essential to compensate for the lack in private investment and to raise effective demand,
employment, output and income within the economy. On the other hand, when there are
inflationary tendencies, the government should reduce its expenditures by having a surplus
budget and raising taxes in order to stabilize the economy at the full employment level. The
compensatory fiscal policy has two approaches: (1) built-in-stabilizers and (2) discretionary
fiscal policy.

(1) Built-in Stabilisers

The technique of built-in-flexibility or stabilizers involves the automatic adjustment of
the expenditure and taxes in relation to cyclical upswings and downswings within the
economy without deliberate action on the part of the government. Under this system,
changes in the budget are automatic and hence this technique is also known as automatic
stabilizers. The various automatic stabilizers are corporate profits tax, income tax, excise
taxes, old age, survivors and unemployment insurance and unemployment relief
payments. As instruments of automatic stabilization, taxes and expenditures are related to
national income. Given an unchanged structure of tax rates, tax yields vary directly with
movements in national income, while government expenditures vary inversely with
variations in national income. In the downward phase of the business cycle when national
income is declining, taxes which are based on a percentage of national income
automatically decline, thereby reducing the tax yield. At the same time, government
expenditures on unemployment relief and social security benefits automatically increase.
Thus there would be an automatic budget deficit which would counteract deflationary
tendencies. On the other hand, in the upward phase of the business cycle when national
income is rising rapidly, the tax yield would automatically increase with the rise in tax
rates. Simultaneously, government expenditures on unemployment relief and social
security benefits automatically decline. These two forces would automatically create a
budget surplus and thus inflationary tendencies would be controlled automatically.

(2) Discretionary Fiscal Policy

Discretionary Fiscal policy requires deliberate changes in the budget by such actions as
changing tax rates or government expenditures or both. It may generally take three forms:
(i) changing taxes with government expenditure constant, (ii) changing government
expenditure with taxes constant, and (iii) variations in both expenditures and taxes
simultaneously.
First when taxes are reduced, while keeping government expenditure unchanged,
they increase the disposable income of households and businesses. This increases private
spending. But the amount of increase will depend on whose taxes are cut, to what extent,
and on whether the taxpayers regard the cut temporary or permanent. If the beneficiaries
of tax are in the higher middle income group, the aggregate demand will increase much.
If they belong to the lower income group, the aggregate demand will not increase much.
If they are businessmen with little incentive to invest, tax reductions will not induce them
to invest. Lastly, if the taxpayers regard tax reduction as temporary, this policy will again
be less effective. So this policy is more effective in controlling inflation by raising taxes
because high rates of taxation will reduce disposable income of individuals and
businesses thereby curtailing aggregate demand.
The second method is more useful in controlling deflationary tendencies. When
the government increases its expenditure on goods and services, keeping taxes constant,
aggregate demand goes up by the full amount of the increase in government spending. On
the other hand, reducing government expenditure during inflation is not so effective
because of high business expectations in the economy which are not likely to reduce
aggregate demand.
The third method is more effective and superior to the other two methods in
controlling inflationary and deflationary tendencies. To control inflation, taxes may be
increased and government expenditure reduced. On the other hand, taxes may be reduced
and government expenditure be raised to fight depression.

MONETARY-FISCAL MIX

Consider a situation where an expansionary mix monetary-fiscal policies is

adopted to achieve full employment in the economy. This is illustrated in Figure 1 where
the economy is in the initial situation at A on the basis of the interaction of IS 1 and LM1
curves. This situation depicts OR2 interest rate and OY1 income level. Now an
expansionary fiscal policy is adopted in the form of increase in government expenditure
or decrease in taxes. This shifts the curve IS1 to IS2. This will have the effect of raising
the interest rate further to OR3 if an expansionary monetary policy is not adopted
simultaneously. So in order to reduce the interest rate and encourage investment for
achieving full employment, the monetary authority increases the money supply through
an open market purchase of securities. This tends to shift the curve LM 1 to the right in the
position of LM2 curve. Now fiscal policy has led to the new IS 2 curve and monetary
 policy to the LM2 curve. Both the curves intersect at B whereby the interest rate is
lowered to OR1 and the level of income rises to the full employment level OYF.

I
n
t LM1
e
r R
3
e
E
s R2 LM2
t A
R R1
a B
t
e IS1 IS2

Y1 YF

Figure:1 Income
 LM
I
n E
t R LM1
e
r
R1
e E1
s R2
t E2
IS
R
a
t IS1
e

YF Y1

Income

Figure :2

Let us take another situation when the economy is at the full employment level of income
OYF where the IS curve intersects the LM curve at point E in figure 2. But due to some
reasons, the economy’s growth rate has slowed down. In order to overcome this, more
investment is required to be made in the economy. For this, the monetary authority
increases the money supply which leads to the shifting of the curve LM to the right to
LM1. The LM1 curve intersects the IS curve at point E 1 which lowers the interest rate to
OR1 and raises the income level to OY1. But the rise in national income being higher than
the full employment income level, this policy is inflationary. Therefore, the economy
requires a change in the monetary-fiscal policy mix.
For this the expansionary monetary policy should be combined with a restrictive
fiscal policy. Accordingly, the government reduces its investment expenditure or/and
increases taxes so that the IS curve shifts to the left to IS 1. Now the IS1 curve intersects
the LM1 curve at point E2 so that the new equilibrium is established at a lower interest
rate OR2 and income OYF which is the full employment income level. This level can be
maintained by the present monetary-fiscal policy mix because the lower interest rate
would keep large investment spending in the economy and reduced government
expenditure or high taxes would control inflation.