Unit-2

Money Market

Money market are financial markets where short-term

instruments with maturities of up to one year are traded.
They facilitate liquidity and the efficient management of
short term funding needs for both businesses and the
government. The money market provides a platform for
participants such as banks, corporations and government
entities to borrow and lend funds at short durations. It
ensures the smooth functioning of the financial system by
managing liquidity and interest rates and contributes to
economic stability and growth.
Role/Importance/Functions of Money Market
The money market plays a crucial role in the financial system by providing short-term
liquidity and facilitating the efficient allocation of capital. Here are some key functions:
1. Providing Liquidity: It offers a platform for institutions to manage their short-term
funding needs. Banks, governments, and corporations can borrow and lend money for
short periods, often overnight or for a few days.
2. Financing Trade and Industry: The money market helps finance trade and industry by
providing short-term loans. This ensures that businesses have the necessary funds to
operate smoothly.
3. Investment Opportunities: It provides a safe place for investors to park their excess
funds. Instruments like Treasury bills, commercial paper, and certificates of deposit
offer relatively low-risk investment options.
4. Supporting Central Bank Policies: The money market aids central banks in
implementing monetary policy. By influencing short-term interest rates, central banks
can control money supply and maintain economic stability.
5. Enhancing Financial Stability: By ensuring that financial institutions have access to
short-term funds, the money market helps maintain stability in the financial system.
 Components of Money Market
•Treasury Bills (T-Bills): Issued by the Government of India(RBI), T-Bills are
short-term securities with maturities of 91 days, 182 days, or 364 days. They
are issued at a discount and redeemed at face value upon maturity.

•Certificates of Deposit (CDs): These are time deposits issued by banks and
financial institutions with maturities ranging from 7 days to one year and is
bought by individual investors and corporate houses looking for better returns
than savings account. CDs offer higher interest rates compared to regular
savings accounts. They provide a means for banks to raise short term funds
from the market.

•Commercial Paper (CP): Unsecured short-term debt instruments issued by

large corporations with high credit rating to meet short-term funding needs or
finance working capital. CPs generally have maturities ranging from 7 days to
one year and is bought by other companies, banks and investors.
• Call Money Market: This is an inter-bank market where banks lend and
borrow funds on an overnight basis. The call money market helps banks
manage short-term liquidity requirements.
• Repurchase Agreements (Repos) and Reverse Repos: These are
short-term borrowing and lending arrangements where securities are sold
with an agreement to repurchase them at a later date. Repos are used by
banks and financial institutions to manage liquidity, while reverse repos
are used to absorb excess liquidity from the system.
• Term Money Market: It involves borrowing and lending of funds for
periods longer than overnight but less than one year. Term money is used
by financial institutions to manage liquidity over slightly longer periods
compared to call money.
• Money Market Mutual Funds: Investment funds that pool money from
investors to purchase short-term, low-risk securities. They offer liquidity
and a higher return than traditional savings accounts.
 Structure of Indian Money Market

Money Market

Regulatory Market
Participants
Framework Infrastructure

Clearing &
Financial Trading
Banks Corporations Government Investors Settlement
Institutions Platform
Systems
1. Regulatory Framework: The central banks plays a crucial role in
regulating and overseeing the money markets. The RBI conducts
monetary policy operations, manages liquidity and ensures market
stability. Further SEBI regulates certain aspects of money market
instruments, especially those related to securities and mutual funds.
2. Participants:
▪ Banks: Major participants in the money market, involved in lending
and borrowing in the call money market, issuing and investing in CDs
and participating in repos and reverse repos.
▪ Financial Institutions: It includes entities like NBFCs which issues CDs
and engage in various money market activities.
▪ Corporations: It issues CPs to raise short term funds and manage
working capital.
▪ Government: It issues T-Bills and uses the money market to manage
short term funding needs and implement monetary policy.
 ▪ Investors: It includes institutional investors, retail investors and mutual
funds who invest in various money market instruments such as CDs, CPs,
etc.
3. Market Infrastructure:
▪ Trading Platforms: Electronic trading platforms facilitate the trading of
money market instruments, ensuring transparency and efficiency. The
RBI and other entities use electronic platforms for trading money
market instruments.
▪ Clearing and Settlement Systems: Mechanisms that ensure smooth
clearing and settlement of transactions in the money market. Managed
by institutions like the Clearing Corporation of India Ltd. (CCIL), which
ensures the smooth clearing and settlement of money market
transactions.
The Reserve Bank of India
Objectives of RBI:

► To regulate the issue of banknotes

► To maintain reserves with a view to securing monetary stability
► To operate the credit and currency system of the country to its
advantage.
► To maintain price stability while keeping in mind the objective of
growth.
Structure of RBI
► The Reserve Bank of India is controlled by a central board of
directors. The directors are appointed for a 4-year term by the
Government of India in keeping with the Reserve Bank of India Act.
► The Central Board consists of:
• Governor
• 4 Deputy Governors
• 2 Finance Ministry representatives
• 4 directors to represent local boards headquartered in Mumbai,
Kolkata, Chennai, and New Delhi
► The executive head of RBI is the Governor.
► The Governor is accompanied by 4 deputy governors.
Functions of Reserve Bank of India (RBI)

Major functions of the RBI can be seen under the following 2 heads:
Monetary Functions of RBI
The Reserve Bank of India's monetary functions include those pertaining
to money and the amount of money in the economy. Primary roles falling
under this category consist of:
Issuer of Bank Notes: The Reserve Bank of India has the monopoly of
issuing currency notes except for 1 Rupee note and coins.
• The 1 Rupee note and the coins of all denominations are minted
and issue by the Government of India, not the RBI. But, they
are circulated by the RBI.
• The RBI issues currency notes under a system called Minimum
Reserve System.
► Banker to the Government: The RBI acts as a banking agent and financial
advisor to the Central as well as the State Governments. In this capacity,
the RBI:
• Manages Government accounts and treasuries.
• Keeps deposits of the Government.
• Lends to the Governments without any interest for the short term
• Buys and sells Government Securities (G-Secs) on the Government’s
behalf.
• Gives monetary and financial advice to the Governments.
► Bankers’ Bank: The RBI is the banker of all Scheduled commercial banks
(SCBs). In this capacity, it performs the following functions:
• Keeps the reserves of banks in the form of Cash Reserve Ratio (CRR)
with itself.
• Provides financial assistance to banks against mortgaged securities
• Rediscounts Bills of Exchange.
► Lender of Last Resort: It also acts as a lender of last resort for the
Scheduled Commercial Banks (SCBs). Usually, banks and other
financial institutions borrow and lend among themselves to meet their
financial needs. But, in times of crisis, the SCBs approach the RBI to
get financial assistance.
► Custodian and Manager of Foreign Exchange Reserves: In order to
stabilize the external value of Indian currency, the RBI maintains the
reserves of foreign currencies to stabilize the exchange rate.
• This function of the RBI also helps promote international trade.
► Controller of Credit or Money Supply: It uses its monetary policy
tools to control the volume of money supply according to the
economic situation of the nation.
• This helps in controlling inflation and deflation and hence
stabilizing the general price level in the economy.
General Functions of RBI
The General Functions of the RBI include functions related to general regulation and
promotion of the banking system so as to maintain the health and growth of the
banking system in the country. Major functions included in this category are as follows:
► Regulator of the Banks: The RBI Act of 1934 and the Banking Regulation Act of 1949
entrust the RBI with the powers to regulate the banks in the country. In this
capacity, the RBI performs functions such as:
• Licensing banks,
• Prescribing minimum requirements of paid-up capital and reserves, etc.
► Promotional Functions: The RBI works towards the promotion of the Indian
Financial System through functions such as
• Enabling expansion of the Commercial Banks in terms of their branches in the
country or aboard,
• Promoting banking habits of people,
• Promoting financial inclusion,
• Consumer education and protection,
• Promoting Digital India initiatives in financial sector, etc.
•
Role of RBI:
The role of RBI in economic development are:
► 1. Development of banking system
► 2. Development of financial institutions
► 3. Development of backward areas
► 4. Economic stability
► 5. Economic growth
► 6. Proper interest rate structure
The promotional role of RBI includes:
► 1. Promotion of commercial banking
► 2. Promotion of cooperative banking
► 3. Promotion of industrial finance
► 4. Promotion of export finance
► 5. Promotion of credit to weaker sections
► 6. Promotion of credit guarantees
► 7. Promotion of differential rate of interest scheme
► 8. Promotion of credit to priority sections including rural & agricultural sector
Monetary Policy Committee(MPC)

Monetary Policy Committee (MPC) is a body established by central

banks to make key decisions regarding monetary policy. In India,
the MPC was set up in 2016 as part of the Reserve Bank of India
(RBI) to bring transparency and accountability in setting monetary
policy. It consists of six members - three officials from the RBI,
including the Governor who acts as the chair, and three external
experts appointed by the Government of India. The main function
of the MPC is to set the policy interest rate (repo rate) with the
primary objective of maintaining price stability while keeping in
mind the objective of growth. The MPC meets at least four times a
year and its decisions are made public to ensure transparency in
the policymaking process.
Monetary Policy Committee (MPC) Structure
1. Composition- MPC consists of six members. Three members are from the RBI,
including the Governor (who acts as the chairperson), the Deputy Governor in
charge of monetary policy, and one officer of the RBI nominated by the
Central Board. The other three members are external experts appointed by
the Government of India. These appointments are made based on the
recommendations of a search-cum-selection committee which is also
constituted by the Government.
2. Appointments and Terms- The external members are appointed for a term
of four years and are not eligible for reappointment. The internal members
serve as long as they hold their respective positions within the RBI.
3. Decision-Making- Decisions within the MPC are made by majority vote with
each member having one vote. In case of a tie, the Governor has the casting
(deciding) vote. The main objective of the MPC is to maintain price stability
while keeping in mind the objective of growth. The target inflation rate for
the committee to achieve is set by the Government of India, which as of
recent has been 4% with a tolerance band of 2-6%.
4. Meetings and Transparency- MPC is required to meet at least four
times a year, and the meetings are spaced at intervals of at least 45
days. The minutes of the meetings, along with the decisions on the policy
repo rate and the stance of monetary policy, are published to ensure
transparency. These minutes also include the votes of each member and
their rationale for their decisions.
Role of Monetary Policy Committee(MPC)
❖ Determining Interest Rates: The primary role of the MPC is to set the
benchmark interest rate (repo rate for the economy. This rate influences the
lending and borrowing rates across banks and financial institutions, affecting
economic activities such as investment and consumer spending.
❖ Inflation Targeting: MPC aims to ensure price stability, primarily by targeting
inflation. In India, the inflation target is set by the government- currently
defined as 4% with a tolerance band of +/-2%. The MPC adjusts monetary
policy to maintain inflation within this target range.
❖ Stabilizing the Economy: Through its monetary policy tools, the MPC works
to stabilize the economy by mitigating fluctuations in growth and
employment. It responds to both domestic and international economic shocks
by adjusting policy measures appropriately.
❖ Promoting Economic Growth: While the primary focus is often on inflation,
the MPC also aims to foster conditions that promote economic growth. This
involves balancing inflation targeting with measures that encourage
investment and consumption, thereby supporting overall
economic development.
❖ Regulating Money Supply: MPC controls the money supply in the economy
through its policy decisions. By increasing or decreasing the repo rate, it
indirectly influences how easily banks can obtain money and, consequently,
how much money is circulating in the economy.
❖ Maintaining Financial Stability: MPC contributes to the overall financial
stability of the country by ensuring that the monetary policy does not lead to
market volatilities. Through careful assessment and foresight, it tries to
preempt and mitigate financial imbalances that could lead to crises.
❖ Transparency and Accountability in Monetary Policy: MPC enhances
transparency and accountability in the central bank's decision-making process.
By publishing minutes of its meetings and the rationale behind its decisions, it
provides clarity to the public and market participants, thereby enhancing the
credibility of the central bank.
❖ Communicating with the Public: Part of the MPC's role involves communicating
its decisions and outlook to the public and market participants. This helps in
managing expectations regarding future monetary policy actions and economic
conditions, which is crucial for market stability and confidence.
Policy Rates of Monetary Policy
Committee:

► Repo Rate :This is the rate at which the central bank lends
short-term money to commercial banks against securities. A lower
repo rate makes borrowing cheaper for banks, which in turn can
lower interest rates on loans and boost economic activity.
Conversely, a higher repo rate can help to curb inflation by
making borrowing more expensive.
► Reverse Repo Rate: This rate is the opposite of the repo rate, it
is the rate at which the central bank borrows money from
commercial banks. The reverse repo rate helps control the money
supply within the economy by giving banks a profitable option to
park their funds with the central bank.
► Marginal Standing Facility Rate (MSF): This rate is generally set slightly
above the repo rate. Banks can borrow overnight funds from the central
bank against approved government securities under this facility. The MSF
rate provides a safety valve against unanticipated liquidity pressures
outside of the normal inter-bank offerings.
► Bank Rate: This is the long-term rate at which the central bank lends to
financial institutions. It's generally aligned with the MSF rate and acts as
a benchmark for various lending rates in the economy. It influences the
rates that banks extend to their most creditworthy customers.
► Cash Reserve Ratio (CRR): Although not a rate per se, the CRR mandates
the percentage of a bank's total deposits that must be kept in reserve
with the central bank in the form of cash. This tool is used to control the
amount of money that banks can lend out, thereby managing liquidity.
► Statutory Liquidity Ratio (SLR): Similar to the CRR, the SLR is the
percentage of net total deposits that banks need to maintain in the form
of gold, cash, or other approved securities before offering credit to
customers. It regulates the credit growth of banks.
Monetary Policy
Monetary policy is a set of actions taken by a country's central bank to
influence the amount of money and credit in the economy. It refers to the
actions undertaken by a central bank to regulate the supply of money and
credit in an economy with the goal of achieving macroeconomic objectives
such as price stability, full employment, and sustainable economic growth.
The goal of monetary policy is to achieve price stability and manage
economic fluctuations. Central banks influence monetary conditions primarily
through the manipulation of interest rates, open market operations, and
reserve requirements. By adjusting these instruments, central banks aim to
control inflation, stimulate or restrain economic activity, stabilize financial
markets, and manage exchange rates. Monetary policy operates alongside
fiscal policy (government taxation and spending) as a key tool for
macroeconomic management, and its effectiveness depends on various
economic factors, including the level of economic activity, inflation
expectations, and the transmission mechanisms through which policy actions
affect the broader economy.
Functions of Monetary Policies:
1. Price Stability: Maintaining price stability is one of the primary
objectives of monetary policy in India. The RBI sets inflation targets
and uses monetary tools to control inflationary pressures, aiming to
achieve a moderate and stable rate of inflation over the medium
term.
2. Inflation Control: Monetary policy aims to control inflation by
adjusting key policy rates such as the repo rate, reverse repo rate,
and marginal standing facility (MSF) rate. These rates influence
borrowing costs for banks and, consequently, affect lending rates in
the economy.
3. Interest Rate Management: Monetary policy in India involves
managing interest rates to support economic growth while ensuring
price stability. By adjusting policy rates, the RBI influences the cost
and availability of credit, which affects investment, consumption, and
overall economic activity.
4. Liquidity Management: RBI conducts open market operations(OMOs), repo
auctions, and liquidity adjustment facilities (LAF) to manage liquidity conditions in
the banking system. These measures aim to ensure adequate liquidity to meet the
credit needs of the economy without fueling inflationary pressures.
5. Exchange Rate Stability: Monetary policy plays a role in maintaining stability in
the exchange rate to support external trade and investment flows. The RBI may
intervene in the foreign exchange market to manage exchange rate fluctuations and
maintain competitiveness in the global economy.
6. Promotion of Financial Markets: Monetary policy initiatives support the
development and efficiency of financial markets in India. The RBI implements
measures to enhance market infrastructure, improve transparency, and foster
innovation in financial products and services.
7. Credit Allocation: Monetary policy influences credit allocation by guiding banks'
lending behavior through regulatory measures, prudential norms, and credit controls.
The RBI may introduce sector-specific lending targets or regulations to channel credit
towards priority sectors such as agriculture, small-scale industries, and exports.
8. Financial Stability: Monetary policy contributes to maintaining financial stability
by monitoring and addressing risks in the financial system. The RBI conducts
macroprudential regulation, supervises financial institutions, and implements
measures to mitigate systemic risks and prevent financial crises.
Monetary Policy Tools:

Various instruments are used by the RBI to control the money supply in
the economy. The tools can be categorized into two categories:
► Quantitative Tools – Quantitative tools of monetary policy refer to
the measures used by central banks to regulate the money supply and
interest rates in an economy. These tools are used to achieve the
central bank's macroeconomic objectives, such as low inflation, full
employment, and economic growth.
► Qualitative Tools – Qualitative tools of monetary policy refer to the
non-quantitative measures used by central banks to regulate the
money supply and interest rates in an economy. These tools are used
to influence the behavior of commercial banks, financial institutions,
and individuals, and to achieve the central bank's macroeconomic
objectives.
Quantitative Credit Control Tools:
1. Statutory Liquidity Ratio (SLR): The Statutory Liquidity Ratio (SLR) is the
minimum percentage of deposits that every commercial bank must hold in
liquid cash or other securities. The SLR is used to ensure that commercial
banks have sufficient liquidity to meet the demands of their depositors. An
increase in the SLR reduces the lending capacity of commercial banks, as they
are required to hold more liquid assets. This, in turn, reduces the money
supply in the economy and helps to control inflation. Conversely, a decrease in
the SLR increases the lending capacity of commercial banks, leading to an
increase in the money supply and economic growth.
2. Cash Reserve Ratio (CRR): The Cash Reserve Ratio (CRR) is the percentage of
total deposits that commercial banks must hold in cash with the Reserve Bank
of India (RBI). The CRR is used to ensure that commercial banks have sufficient
cash reserves to meet the demands of their depositors. An increase in the CRR
reduces the lending capacity of commercial banks, as they are required to
hold more cash reserves. This, in turn, reduces the money supply in the
economy and helps to control inflation. Conversely, a decrease in the CRR
increases the lending capacity of commercial banks, leading to an increase in
the money supply and economic growth.
3. Repo Rate: The Repo Rate is the interest rate at which commercial banks
borrow funds from the RBI. It is used to regulate the money supply in the
economy by influencing the borrowing costs of commercial banks. An
increase in the Repo Rate increases the borrowing costs of commercial
banks, which in turn increases the lending rates for borrowers. This reduces
the demand for loans, leading to a decrease in the money supply and helping
to control inflation. Conversely, a decrease in the Repo Rate reduces the
borrowing costs of commercial banks, leading to a decrease in lending rates
and an increase in the money supply.
4. Reverse Repo Rate: The Reverse Repo Rate is the interest rate at which
the RBI borrows money from commercial banks. It is used to absorb excess
liquidity in the economy by borrowing from commercial banks. An increase in
the Reverse Repo Rate makes it more attractive for commercial banks to
lend to the RBI, reducing the excess liquidity in the economy and helping to
control inflation. Conversely, a decrease in the Reverse Repo Rate reduces
the attractiveness of lending to the RBI, leading to an increase in excess
liquidity and economic growth.
5. Open Market Operations (OMO): Open Market Operations (OMO) involve
the simultaneous buying and selling of government securities and Treasury
Bills by the RBI. It refer to the buying and selling of government securities by
RBI to regulate the short-term money supply. If RBI wants to induce liquidity
or more funds in the system, it will buy government securities and inject
funds into the system. On the other hand, if the RBI, wants to curb the
amount of money in the system, it will sell government securities to the
banks thereby reducing the amount of cash that banks have. OMO is used to
regulate the money supply in the economy by influencing the liquidity in the
market.
6. Bank Rate (Discount Rate): The Bank Rate, also known as the Discount
Rate, is the interest rate at which commercial banks borrow money from the
RBI. It is used to regulate the money supply in the economy by influencing
the borrowing costs of commercial banks. An increase in the Bank Rate
increases the borrowing costs of commercial banks, which in turn increases
the lending rates for borrowers. This reduces the demand for loans, leading
to a decrease in the money supply and helping to control inflation.
Conversely, a decrease in the Bank Rate reduces the borrowing costs of
commercial banks, leading to a decrease in lending rates and an increase in
the money supply.
Qualitative Credit Control Tools:
1. Selective Credit Control: Selective Credit Control is a measure used to
regulate the flow of credit to specific sectors of the economy. The purpose
of Selective Credit Control is to promote economic growth and development
by directing credit to priority sectors, such as agriculture, small-scale
industries, and exports. By controlling the flow of credit to specific sectors,
the RBI can influence the allocation of resources in the economy and
promote growth in priority areas. The RBI uses various instruments to
implement Selective Credit Control, including:
► Sectoral credit limits: The RBI sets limits on the amount of credit
that can be extended to specific sectors.
► Priority sector lending: The RBI directs commercial banks to lend a
certain percentage of their total credit to priority sectors.
► Interest rate subsidies: The RBI provides interest rate subsidies to
borrowers in priority sectors.
2. Moral Suasion: Moral Suasion is a measure used to persuade commercial
banks to follow certain guidelines or policies. The purpose of moral suasion is
to influence the behavior of commercial banks and promote the objectives of
monetary policy. By using moral suasion, the RBI can influence the lending
decisions of commercial banks and promote the allocation of credit to
priority sectors. The RBI uses various instruments to implement moral
suasion, including:
► Guidelines and circulars: The RBI issues guidelines and circulars to
commercial banks, outlining its expectations and policies.
► Meetings and discussions: The RBI holds meetings and discussions
with commercial banks to persuade them to follow its policies.
► Public statements: The RBI makes public statements to influence the
behavior of commercial banks and promote its policies.
3. Publicity: Publicity is a measure used to publish information about the
economy and the banking system to influence public opinion and behavior. It is
to promote transparency and accountability in the banking system and to
influence public behavior. By publishing information about the economy and
the banking system, the RBI can influence public opinion and behavior,
promoting the objectives of monetary policy. The RBI uses various instruments
to implement Publicity, including:
► Press releases: The RBI issues press releases to publish information
about the economy and the banking system.
► Annual reports: The RBI publishes annual reports, outlining its policies
and performance.
► Research papers: The RBI publishes research papers, analyzing
economic trends and issues.
4. Margin Requirements: Margin Requirements are the minimum margins
that commercial banks must maintain against their advances. It is to regulate
the flow of credit and prevent excessive speculation. By setting margin
requirements, the RBI can influence the lending decisions of commercial
banks and prevent excessive speculation.
5. Direct Action: Direct Action is a measure used to take direct control of
commercial banks and other financial institutions. It is used to prevent the
failure of commercial banks and other financial institutions, and to maintain
financial stability. By taking direct control of commercial banks and other
financial institutions, the RBI can prevent their failure and maintain financial
stability.
Fiscal Policies

Fiscal Policy refers to the use of government spending and taxation to

influence the economy's overall level of activity. It involves decisions
regarding government expenditures on goods and services, taxation
rates, and public borrowing. Fiscal policy aims to achieve
macroeconomic objectives such as economic growth, price stability, full
employment, and income distribution. Expansionary fiscal policies
involve increased government spending and/or tax cuts to stimulate
economic activity during downturns, whereas contractionary fiscal
policies involve reduced spending and/or tax hikes to cool down an
overheating economy and combat inflation. Fiscal policy operates
alongside monetary policy as a tool for macroeconomic management,
with both policies working in tandem to stabilize the economy and
promote long-term prosperity. Effective fiscal policy requires careful
consideration of economic conditions, fiscal sustainability, and
distributional effects.
 Functions of Fiscal Policies:
1. Economic Stabilization: Fiscal policy plays a critical role in managing
inflation and recessions. During periods of high inflation, the government
may reduce spending or raise taxes to cool down the economy. In contrast,
during a recession, it may increase spending or lower taxes to stimulate
demand and encourage economic recovery. Further, it smooths out the
natural ups and downs of the economic cycle, helping to avoid extreme
booms and busts, which can lead to instability and thus manages economic
stability.
2. Efficient Resource Allocation: Governments use fiscal policy to fund
essential services like infrastructure, education, and healthcare—areas
where private markets might underprovide due to low profitability. In cases
where the market fails to account for external costs or benefits (e.g.,
pollution or education), fiscal policy can step in. The government can impose
taxes (like a carbon tax) to discourage harmful activities or provide subsidies
(like for clean energy) to encourage positive ones.
3. Income Redistribution: Fiscal policy aims to reduce income
inequality with the help of progressive taxation (where higher earners
pay a larger percentage of their income in taxes) and social programs
(like welfare and unemployment benefits) help redistribute wealth from
the rich to the less fortunate, creating a more equitable society. Fiscal
policy finances safety nets such as pensions, disability benefits, and
healthcare for those in need, ensuring basic living standards.
4. Promoting Economic Growth: Government investment in projects like
roads, bridges, and schools boosts productivity, making the economy
more efficient in the long run. Through tax incentives and subsidies, the
government encourages private companies to invest, which helps
stimulate innovation and job creation.
5. Job Creation and Employment: By funding large-scale public works
projects, governments can directly create jobs and reduce
unemployment. When the government increases spending or cuts taxes,
it boosts overall demand, which leads to businesses hiring more workers
to meet that demand and thus stimulates private employment.
6. Managing Public Debt: Fiscal policy helps keep government debt
under control by ensuring that borrowing is balanced with the country’s
ability to repay, preventing excessive debt that could harm the economy.
During periods of economic growth, the government can run budget
surpluses (spending less than it collects in taxes) to reduce the national
debt.
7. Encouraging Long-term Stability: While fiscal policy can be used to
provide immediate relief during a crisis, it also focuses on fostering
long-term stability and growth by investing in education, technology, and
infrastructure and maintains a balance between the short-term and
long-term goals.
Components of Fiscal Policies:
1. Government Spending (Expenditure): This includes expenditures by the
government on goods and services that it buys from the private sector and
includes wages paid to government employees. This involves how the government
uses its budget to influence the economy. There are two main types:
▪ Capital Expenditure: This is long-term spending on infrastructure, such as
building roads, hospitals, schools, and other public projects. These investments
often increase the productive capacity of the economy and have long-lasting
effects on economic growth.
▪ Current Expenditure: This includes the day-to-day operating costs of the
government, such as salaries for public servants, maintenance of infrastructure,
subsidies, and welfare programs. These expenses are crucial for running the
government and providing essential services.
Examples:
▪ Infrastructure development (roads, bridges, etc.)
▪ Social services (healthcare, education, social security)
▪ Defense spending
▪ Subsidies and welfare programs (e.g., unemployment benefits)
2. Taxation (Revenue): Taxation is the method by which the government
raises revenue to fund its activities. It’s the primary source of revenue
and includes personal and corporate income taxes, sales taxes, property
taxes and other duties. It affects disposable income, consumption, and
investment. By adjusting the rates and structure of taxes, a government
can influence the economy by either increasing consumer spending
through tax cuts or controlling inflation through tax increases.
3. Borrowing: In cases where government spending exceeds its revenue,
the government may borrow funds. Borrowing can be through issuing
government bonds or borrowing from financial institutions. Public
borrowing can impact interest rates and credit availability for the private
sector. Borrowing is crucial for financing budget deficits but must be
managed to avoid unsustainable debt levels.
4. Transfer Payments: These are payments made by the government to
individuals through programs like unemployment benefits, pensions,
subsidies and welfare. Transfer payments aim to support vulnerable
groups and redistribute income to reduce inequality.