Third Quarter Review of Monetary Policy 2009-10

What is Monetary Policy?

• Monetary policy is a tool used by the central bank to manage money supply in the economy in order to achieve a desirable growth. The central bank controls the money supply by increasing and decreasing the cost of money, the rate of interest.

What is Fiscal Policy? How is it different from Monetary Policy?

• The fiscal policy is used to monitor the economy. Two major tools of the fiscal policy are revenue spending and collection by government.

• So, while the monetary policy aims to stabilize the economy by controlling the money supply and interest rates, the fiscal policy uses government spending and taxation to achieve the same goal.

• A fiscal policy can be of three kinds — neutral, expansionary and contractionary.

When the revenue collection and spending of the government is equal it is called a neutral policy. An expansionary fiscal policy means higher government spending than tax collection, whereas, contractionary fiscal policy indicates lower spending than tax collections. While the former may lead to a budget deficit, the latter can result in budget surplus.

• During slowdown, the government uses expansionary fiscal policy and pumps in huge amount of money as stimulus packages and decreases the tax rates so that people have more money to spend. This is mainly to revive demand in the economy. On the contrary, when the economy becomes overheated and inflation goes up, the government increases the tax rates and decreases the spending to squeeze the money from the system.

• Central bank has two sets of tools - quantitative and qualitative - to signal easing or tight money conditions, depending on its policy objective.

While quantitative tools would include imposing cash reserve requirements (CRR) for banks, fixing the repo or reverse-repo rates, the bank rate and prescribing the level of statutory liquidity ratio (SLR) to signal the level of growth in the financial markets, pursuant with its growth objective for the economy.

Popular qualitative measures would include imposing margins on certain loans and moral suasion. However, RBI often tweaks only the repo or reverse-repo rates and CRR.

Changes in Third Quarter Review of Monetary Policy 2009-10:

• RBI has increased the cash reserve ratio (CRR) of scheduled banks by 75 basis points from 5.0 per cent to 5.75 per cent of their net demand and time liabilities.

• As a result of the increase in the CRR, about Rs. 36,000 crore of excess liquidity will be absorbed from the system.

• However key interest rates remain unchanged; Repo Rate (4.75%), Reverse Repo rate (3.25%), Bank Rate (6%).

Source: RBI, ET.