The government employs two broad classes of macroeconomic policies viz., demand side policies and supply side policies. The former are meant to influence the demand for goods and services and the latter the supply for goods and services. Traditionally, the focus was mostly on fiscal and monetary policies, the two major tools of demand side economies. From 1980s onward, however supply side economics has received a lot of attention.
Fiscal policy is concerned with the spending and tax initiatives of the government. It is perhaps the most direct tool to stimulate or dampen the economy. An increase in government spending stimulates the demand for goods and services, whereas a decrease deflates the demand for goods and services. By the same token, a decrease in tax rates increases the consumption of goods and services and an increase in tax rates decrease the consumption of goods and services.
Although fiscal policy has the most immediate impact on the economy, its formulation and implementation is often cumbersome and involved because of the prolonged legislative process that precedes it. Moreover, a significant portion of government spending such as interest on outstanding debt, defense expenditure and salaries of government employees is non discretionary. This may severely limit the flexibility in formulating fiscal policy.
The deficit or surplus in the governmental budget summaries the net effect of fiscal policy. A large deficit may stimulate the economy and large surplus may dampen the economy.
Monetary policy, which is concerned with the manipulation of money supply in the economy, is the other main plank of demand side economies. Monetary policy affects the economy mainly through its impact on interest rates. An expansionary monetary policy lowers short term, interest rates, thereby stimulating investment and consumptions demand. A contractionary monetary policy has the opposite effects. Most economists, however believe that a higher money supply only raise the price level without any enduring effect on economic activity. Hence, monetary authorities have to perform a difficult balancing act between stimulating the economy in the short run and inflating the economy in the long run.
Fiscal policy is cumbersome to formulate and implement but impacts the economy directly. Monetary policy, on the hand, is easy to formulate and implement but impacts the economy in a roundabout way.
Open market operation bank rate reserve requirements, and direct credit controls are the main tools of monetary policy. Open market operations involves buying or selling of government securities by the Reserve Bank of India (RBI), the central banking authority. When the RBI buys government bonds it issues cheques that augments money supply. Unlike others, the RBI can pay for its purchases without diminishing funds at a bank account. On the other hand, when the RBI sells government securities, it receives money which means that money supply diminishes. Open market operations may be employed by the RBI to fine-tune money supply.
The bank rate is the rate at which the RBI provides financial accommodation to schedule commercial and cooperative banks. It is essentially the rate at which the RBI buys or rediscounts bills of exchange and commercial paper. The bank rate presently is 6.00 percent. A reduction in bank rate signals an expansionary monetary policy and an increase in bank arte a contractionary monetary policy.
Reserve requirements in India are in the form of the cash reserve ratio and the statutory liquidity ratio. The cash reserve ratio (CRR) refers to the cash as a percentage of demand and time liabilities that banks maintain with the RBI. The statutory liquidity ratio (SLR) is the ratio of cash in hand (exclusive of cash balances under the CRR), balances in current account with public sector banks and the RBI, gold, and approved securities to the demand and time liabilities. Of course, approved securities (central and state government securities, securities of local bodies and government guaranteed securities) loom large in this list. From time to time the RBI stipulates the required CRR and SLR. A decrease in CRR and SLR signals an expansionary monetary policy and an increase a contractionary monetary policy.
The Reserve Bank of India may resort to direct credit controls like asking banks to lend a certain percentage of their funds to priority sectors. Whatever may be the merit of such controls, they tend to breed inefficiency and diminish competition.