The Following Lessons to be written for CDE Students in Development Economics

Chapter 26: Role of Monetary & Fiscal Policies- Economic Development (Misra & Puri; Jhingon; Rana & Verma) Chapter 27: Trade Policies Development (Misra & Puri) Chapter 28: WTO Development (Taneja & Mier) Chapter 29: Institutions in Economic Development Education, Health, and Nutrition. Markets and States (Misra & Puri) Chapter 30: Population and Human Resource Development HDI, PQLI (Mier & Baldwin; HD Report; Todaro; Mier; UNDP Report)

Chapter 26
Role of Monetary & Fiscal Policies- Economic Development
Objectives:
After studying this lesson, you will be able to understand Meaning of Monetary policy Categories of Monetary policy Definition of fiscal policy Constituents of fiscal policy Difference between Growth and Development The importance of monetary and fiscal policies in economic development 26.1 26.2 26.3 Introduction Definition of Economic Development Definition of Monetary policy

26.3.1 Objectives of Monetary policy

26.3.2 Role of Monetary policy in economic development 26.3.3 Limitations of Monetary policy 26.4 Fiscal policy and its Meaning

26.4.1 Objectives of fiscal policy 26.4.2 Role of Fiscal policy in economic development 26.4.3 Limitations of Fiscal policy 26.5 26.6 26.7 26.8 26.9 Summary Check your Progress Key Concepts Self-Assessment Questions Answers to check your progress

26.10 Suggested Readings 26.1 Introduction: In this lesson, you learn about the meaning of Economic Development and also Monetary and Fiscal policies. Further, we learn the constituents of monetary and fiscal polices and importance of both the policies in attaining overall economic development in an economy. In General either monetary or fiscal policy is used to attain economic development of an undeveloped economies, because these economies are lagging behind due to several reasons and there exists either inflationary or deflationary conditions which are destabilize the system, therefore, there is a need of application of both the above stated policies not only to stabilize the economy but also to achieve overall economic development. Since Economic Depression, all most all economies compelled to think about the problems of economic development and interest shown by the states in the problems of undeveloped economies development. Economics of development is now considered as an important branch of economic theory. The study of economic development related to the causes of underdevelopment and its removal. Therefore, it is pertinent to examine the role of monetary and fiscal policies in economic development. Subsequent sections job is to concentrate on the terms of economic development, monetary and fiscal polices. And the role of these policies. 26.2.1. Definitions of Economic Development:

Economists have defined the term economic development in different ways. In general economic development implies not only a particular sector development but also the development of all sectors in an economy. Now let us look into the definitions given by the following economists; An Eminent development economist Mr. Gerald Mier has explained that Economic development is a process, whereby the real per capita income of country increases over a long period of time1. Bernard Okun and RW Richardson explained economic development in terms of material welfare. The definition runs as Economic development may be defined as a sustained secular improvement in well being, which may be considered to be reflected in an increasing flow of goods and services 2 Williamson and Buttrick have defined Economic development refers to the process, whereby the people of country or region come to utilize the resources available to bring about a sustained increase in per capita production of goods and services Kindle berger CP defined Economic development implies both more output and changes in the technical and institutional arrangement by which it is produced3 The definitions reviewed above reveal that development has been interpreted in terms of national output. Many objections crop up on above definitions, therefore, emphasis has shifted for measuring economic development later towards the Redistribution criterion. Of late, Amartya Sen. puts Economic growth cannot be sensibly treated as an end itself. Development has to be more concerned with enhancing the lives we lead and the freedoms we enjoy4 Development must, therefore, be conceived of as a multidimensional process involving major changes in social structures, popular attitudes and national institutions as well as the acceleration of economic growth, the reduction in inequality and the eradication of absolute poverty 5 We have discussed various definitions and these definitions provide measuring rods for economic development. The following methods are often used for measuring economic development: they are: Real National Income, Per Capita Income, Economic Welfare. At the outset, economic development aspect has occupied prime importance for the under developed countries development. Each section of society and every sector of economy are influenced by economic development. Therefore, it is must to study the role of overall economic policy in general and monetary policy and fiscal policy in particular. So let us look into the details of both the policies and their role in economic development. 26.2 Meaning of Monetary policy:

Having discussed the economic development and definitions, now let us define the monetary policy and describe its objectives. In General, monetary policy means the policy of credit control and the deliberate management of money supply. As there are different versions on meaning of economic development, here on monetary policy also various definitions drawn by different economists. Paul Eizing defines monetary policy

as The attitude of the political authority towards the monetary system of the community under its control. KP Kent has defined 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 CK Johri states Monetary policy comprises those decisions of Government and the Reserve Bank of India which affect the volume and composition of money supply, the size and distribution of credit the level and structure of interest rates and the effects of these variables upon the factors determining output and prices GK Shaw By Monetary policy we means any conscious action undertaken by the monetary authorities to change the quantity availability or cost of money We have various definitions, some of them are narrow and some are broad definitions of monetary policy. CK Johri and GK Shaw given broad definitions. In recent years, the use of monetary policy in its broad sense is getting popular, as it is more useful and practical. 26.3.1: Aims of Monetary Policy: The objectives of monetary policy have been varying from time to time depending upon the nature of problems facing the countries and the general economic policy pursued by them. The main objectives are: (a) Exchange Stability (b) Price Stability (c) Neutrality of Money (d) Full-Employment (e) Economic Growth (f) Balance of Payments equilibrium. Some times these objectives are mutually incompatible and the monetary authority has to make a choice on the basis of priorities. For instance, the objective of maintaining exchange rate stability may come in conflict with the objective of maintaining internal price stability; Similarly attainment of full employment may not go hand in hand with price stability and an accelerated rate of economic growth may but always be possible with stable exchange rates. Therefore, Radcliff Committee suggested the criterion of orderly life of the society; it implies that priorities have to be decided keeping in view the economic situation and social circumstances of country. In this connection Duesenbery says faced with a set of conflicting objectives, whose achievement is influenced by a variety of factors, the problem of monetary management is one of continuous a adaptation. 26.3.2 : Role of Monetary Policy in Economic Development: The role of monetary policy in economic development may be discussed under the following lines of approach: Appropriate Adjustment between Demand for and Supply of money Price Stability Credit Control Creation and Expansion of Financial Institutions Suitable Interest Rate Structure Debt Management

Monetary policy can play a vital role in the economic development of underdeveloped countries by minimizing fluctuations in prices and general economic activity by achieving an appropriate balance between the demand for money and supply of money. Because, economic development result in increase in more demand for money and it makes imperative for the monetary authority to increase the money supply but either more or less money supply than the requirement result in fluctuations in an economy. Therefore, the gist of the argument is that a proper control upon the supply of money will prevent economic fluctuations and pave the ground for rapid development of underdeveloped economies. In the process of economic development, it is unavoidable an increase in prices. Therefore it is imperative for the monetary authority for maintenance of stability in the domestic level of prices and exchange rates. The inflationary trend in price negatively affects the savings and diverts investment into unproductive channels. It is the duty to have a vigil by the monetary authority not only to regulate but also should keep constant check on the direction of money flow in turn to control price rise. The same inflationary trend will also adversely affect international trade and the foreign exchange earnings which otherwise could help in the development of the country. Thus, monetary policy should adopt such policy, which will check inflation and frequent devaluation of the currency. Monetary authority should also employ quantitative and qualitative credit control tools for the control of inflation, correction of adverse balance of payments and help the process of economic development. Not only that, with these instruments, it can influence and shape the character and pattern of investment and production, in particular selective credit control, unlike quantitative credit control, makes a discrimination between essential and non-essential uses of bank credit and help the funds to flow into desirable and uses without affecting the economy as a whole. This will quicken the pace of economic development. The process of economic development can speed up by establishing more and more financial institutions by developing financial system. These institutions are in less number in underdeveloped economies, therefore, it is difficult to mobilize the savings from the public effectively for economic development and consequently economic growth rate is very low. Monetary authority to extend the sphere of the monetary sector with the expansion of co-operative banking sector to meet the credit needs of ruralites and cut the tentacles of non-magnetized sector in rural areas. There are two subcomponents of monetary policy: cheap and dear money policy. Cheap money policy in other words availability of funds at lower rates of interest to stimulates investment both public and private. Thus, a policy of low interest rates serves as an incentive to investment for economic development. But there is a harm if these funds are diverted for hoarding and stockpiling and for other speculative purposes, thus monetary authority should be checked through selective credit controls and thereby directing investment into desirable channels. In contrary to low rates of interest policy, there are economists who suggest a policy of high interest rates to control inflationary conditions.

Further they stated that it would stimulate savings and thus increase the supply of invests able resources; it would secure the allocation of scarce resources into most productive uses. Therefore, keeping in view the conditions in an economy, countries should be more pragmatic in their approach and must evolve differentiated interest rate policy, which ensure rapid pace of economic development. To attain rapid progress in economic development, the monetary policy should aim at efficient management of public debt, which implies proper timing of the issuing of government bonds, stabilizing heir prices and minimizing he burden of debt. Because it is unavoidable to borrow on a large scale to implement the programs of economic development in undeveloped economies, hence as stated above, responsibility of managing public debt effectively and efficiently so as to serve the requirements of economic growth lies with the monetary authority. Limitations of Monetary Policy: The following factors may be limited the effectiveness of monetary policy. They are: o Existence of Vast Non-Magnetized Sector o Prevalence of Indigenous bankers o Weapons of Credit Control have limited application as people mostly rely on Currency in circulation o Lack of Banking habits of people o Undeveloped Security and Bill market o Unsound Practices of Banking sector o Accumulation of Black money by tax-evasion In spite of these limitations, there is no denying the fact that monetary policy can be used with advantage to economic growth by influencing the supply and uses of credit, combating inflation and maintaining the balance of payments equilibrium. However, no single policy can achieve the desired goal, hence monetary policy must be supplemented by fiscal policy, which influence economic activity. 26.4 Fiscal policy and its Meaning

Fiscal Policy is one more important component of overall economic policy. Monetary policy deals with the changes in demand for and supply of money where as fiscal policy is concerned with non-monetary instruments. Fiscal policy, by employing its instruments, secures the economic stabilization in developed economies and economic growth in underdeveloped countries. Its instruments broadly consists of (i) taxes (ii) Public Borrowing (iii) Public Expenditure. The importance of fiscal policy as an instrument of economic development was first envisaged by Keynes in his General Theory wherein he showed that the total national income was an index of economic activity and brought out the relation between economic activity and total spending. The direct and indirect effects of fiscal policy on aggregate

spending in the community were clearly established and as a result the budgetary policy of the government as a weapon of economic control and development came into prominence. But the Keynesian analysis of fiscal policy is, applicable to the advanced and industrialized countries and it has little relevance to underdeveloped countries. Let now look at definitions given by different economists. According to Arthur Smithies, fiscal policy means a policy under which the government uses its expenditure and revenue programs to produce desirable effects and to avoid undesirable effects on the national income, production and employment GK Shaw has defined fiscal policy in these words, We define fiscal policy to encompass any decision to change the level, composition or timing of government expenditure or to vary the burden, structure or frequency of the tax payment. A skilful management of fiscal policy instruments can go long way in maintaining economic stability and ensuring higher rates of economic growth. 26.4.1 Objectives of fiscal policy Objectives of fiscal policy are as follows (i) Securing the most efficient and rational allocation of economic resources (ii) Accelerating the rate of capital formation (iii) Controlling inflation (iv) Securing equitable distribution of income and wealth (v) Attaining and maintaining full employment As like in monetary policy objectives, fiscal policy objectives also mutually consistent but some times there are conflicts between them. Therefore, policy must decide its course of action in the light of the requirements of the situation prevailing in the country at the time. 26.4.2 Role of Fiscal policy in economic development K K Kurihara regards fiscal policy as a desiderate for underdeveloped countries lacking in private initiative, private voluntary saving and private innovation. He discusses the fiscal policy of government as an additional saver, an investor and an income redistributor. He observes as par as underdeveloped economy is concerned, budgetary surplus is the relevant position to be achieved and maintained. As an additional investor, government can increase the productive capacity of the economy and secure an accelerated rate of economic growth by changing the pattern of investment and laying emphasis on capacity creating rather than on income-generating aspects. As an innovator, the government should spend on research and experimentation and stimulate innovations and new techniques of production. As an income redistributor and for that fiscal measures can go a long way in reducing economic inequalities. In the words of Nurkse, fiscal policy assumes a new significance in he face of the problem of capital formation in underdeveloped countries

The fiscal policy should be construed as to secure full employment conditions and economic growth at rapid rate. The integration of the government budgets with the nations economy budgets can go a long way for the attainment of the objectives of rapid economic development and creation of full employment opportunities. We now proceed to discuss the role of fiscal policy instruments role in economic development. Taxation :Of the important sources of public revenue taxation is the most important. Through taxation, governments are collecting from 10- 30 percent levels to the national income in developed countries. Shortage of financial resources is the main obstacle in the way of economic development of the underdeveloped countries. There are certain forces operating in these countries, which increase consumption and reduce savings. The first among them is the population pressure. Besides, the high incomes groups spend much of their incomes on conspicuous consumption and their propensity to consume is further reinforced by the demonstration effect Still worse, a large part of the meager savings is dissipated in unproductive channels like real estate, hoarding, gold, jewellery, speculation, etc the taxation measures can be employed effectively to divert savings of the people into productive channels. In this connection, Report of the Taxation Enquiry Commission, Govt of India, observes, A tax system which on the whole, promotes capital formation in its two aspects of saving and investment fulfills an essential desideratum. Public Borrowing: There is a limit to which taxation can be resorted for resource mobilization. If the taxes are excessive, they will adversely affect peoples desire and ability to work, save and invest. This will obviously retard the paced of economic development. To avoid such a situation, public borrowing may cover the gap in resources required. It will not adversely affect peoples desire to work, save and invest as lending is voluntary n the lenders not only get back the amount lent but also earn interest on it. Further, public borrowing may add to the incentives of the people to save and invest more as he lure of earning more interest on lending is there. Public borrowing has its own limitations. The general masses are poor and their propensity to consume is high and hence they have no lending capacity. The rich generally do not like to lend to the government but instead divert their investive resources into speculative channels as they can earn more from there. Absence of organized money and capital markets are some of the other obstacles in the way of public borrowing program. However, government has to do efforts to compulsory borrowing for economic development. But it may be noted that no democratic government can rely on forced loans except for a short period and for certain specified projects. Ultimately, it is the voluntary lending by the people that matters and the government must be prepared to increase its domestic borrowing when the incomes and savings of the people increase as a result of economic and make public borrowing and important tool of resource mobilization. Public Expenditure: Pubic expenditure is one of the important weapons in the hands of the state to secure economic development of underdeveloped economies. Initially for economic

development, infrastructure facilities have to be provided. For which, government initiation is essential condition. Therefore, government has to spent huge amount on its development to pave the way to private entrepreneur to start key industries and also agrobased industries. Thus, a carefully and wisely planned public expenditure by creating social and economic overheads can go a long way in creating necessary environment for growth. But public expenditure can achieve its wider objective of development only if it conforms to certain well-defined principles of public expenditure. Further, care should be taken that public expenditure does not adversely affect peoples desire to work, save and invest and for that people should not be provided with direct money help but with goods and services in the form of free education, free medical facilities. Thus, the fiscal policy can affect the rate of economic development in a variety of ways such as by increasing the rate of saving and investment, affecting the allocation of resources, controlling inflation, promoting economic stability, securing equitable distribution of income and wealth and creating full employment policy in advance countries. 26.3.3 Limitations of Fiscal Policy: The effectiveness of fiscal policy will depend on the extent and depth of measures adopted and their right timing. Public spending on a large scale during depression poses the problem of finding out adequate sources of revenue. For instance, reliance placed on taxation to finance public investment during depression is not advisable. Thus, effectiveness of fiscal policy during depression is limited and conditioned by the availability of finance. Political and administrative delays have adverse effect in efficiency of fiscal measures. To cure unemployment through raising the aggregate demand in an economy, which suffers from disguised unemployment, cannot yield desired results.

A vigorous pursuit of fiscal measures for removing unemployment may lead to balance of payments difficulties. In recent years, economists have suggested control of private investment, in addition to fiscal and monetary measures, with a view to secure economic stabilization. This shows that fiscal policy alone cannot secure economic stabilization and full employment, though it is the most potent weapon to achieve the same. 26.5 Summary: Monetary or fiscal policies are important weapons in the hands of the government to secure rapid economic development. Monetary policy is nothing but the management of money supply for the purpose of attaining a set of objectives. Similarly, the means and instruments employed by the state to influence the general level of economic activity constitute the core of fiscal policy. However, it may be mentioned that the nature of economic problems facing the underdeveloped and developed economies is so complex that no single policy by itself can achieve the desired goal. Hence, one policy must be supplemented by other policy and other major policies of the government, which influence economic activity. 26.6 26.7 Check your Progress Key Concepts:

Demand for money Supply of Money Cheap money policy Dear money policy Exchange Stability Price Stability Neutrality of money Speculative motives Financial system Money Market Capital Market Bill Market Debt Management Deficit Financing External borrowing Internal borrowing Principles of Public Expenditure 26.8 Self-Assessment Questions

Essay Questions: 1. Explain the objectives of Monetary Policy in a developing economy? 2. Examine the effectiveness of monetary policy in India? 3. Explain the limitations of monetary policy in its working? 4. What is the important instrument of fiscal policy? 5. Examine the role of fiscal policy in under developed economies? Short Questions: 1. 2. 3. 4. 5. 26.9 26.9 1. 2. 3. 4. 5. 6. What is meant by cheap money policy? What is the instrument of monetary policy? Write note on lags of monetary policy? Write the different categories of taxation? Internal debt vs. external debt- elaborate Answers to check your progress Suggested Readings Ghatak, Subata: Monetary Economics in Developing Countries Meier, Gerald M., Leading Issues in Economic Development Gupta. SP Monetary Planning in India Chellaiah RJ Fiscal Policy in Underdeveloped countries Tyagi BP Public Finance Taneja & Myer Economics of Development & Planning