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Please note: What follows is a just a round-up on class discussions.

These notes are


to be combined with your own class notes, and finally with all the discussions that
we do in class to get a complete understanding on policy from an exam perspective.
All the best!

1. Fiscal and monetary policies are the two main policies through which demand and
growth can be increased and prices can be stabilized.

2. Fiscal policy (FP henceforth) is declared by the Ministry of Finance, Govt. of India
(MoF, GOI) whereas the monetary policy (MP henceforth) is under the control of the
Reserve Bank of India.

3. Whereas the immediate goals of FP connect to growth issues, the MP tries to achieve
a tightrope walk between supporting growth on one hand and controlling inflation on
the other.

4. The FP is basically declared through the Union Budget, which is typically presented
on two accounts. These are Revenue Account and the Capital Account.

5. Big ticket revenue account income items include taxes (only Union taxes) whereas
expense items are interest payments, salary bills and subsidies.

6. CENVAT, service tax, customs duties, income and wealth tax are some of the well
known Union taxes.

7. Taxes can be viewed as direct and indirect taxes.

8. Direct taxes are those in which the entity on whom the tax is levied is also the entity
that bears the burden of the tax. Indirect taxes can be pushed from the point of levy to
some other entity that bears the burden of the tax.

9. Indirect taxes cannot be avoided (they feed into the price of a product and so you
automatically pay taxes as you buy goods) and hence are big revenue earners for the
Government.

10. In terms of indirect taxes, CENVAT is the biggest earner. It is the new avatar of
excise duties, which were output based taxes

11. An excise is a tax on production. Every time the truck leaves the godowns with
goods, the goods are subjected to payment of excise.

12. An output comprises of inputs and value added. An output based tax hence is a tax on
input and VA. The more the input moves in the value chain, it gets taxed again and
again, which is unfair.
13. Output based taxes lead to tax cascadation. They are unfair since they cause
multiple taxation and also increase the price of the commodity higher than what it
could be.

14. Hence, India moved her systems to Value Added Taxes. VAT is the name of a
platform or system on which taxes are levied.

15. Service tax is also on a VAT system currently.

16. For payment of taxes, companies have to prove the value added by them by showing
input and output invoices. Hence, VAT framework has encouraged a movement
towards invoicing in India.

17. When companies buy inputs, they automatically pay taxes on the same. When they
sell output, they collect taxes from their client. Before depositing this with the
Government, they can claim a set off for their input taxes and hence land up
depositing only the net amount which is the tax on value added.

18. Currently, a seller of goods can only claim a set off against the taxes paid on goods
bought by him i.e. he cannot claim a set off against the taxes paid on services
purchased by him.

19. CENVAT rates are different from service tax rates as well.

20. Very soon, India will be on the Goods and Service Tax (GST) platform, on which it is
possible for a goods manufacturer to seamlessly claim a set off on goods tax collected
against service tax paid.

21. The chief 3 subsidy heads in India are food, fuel and fertilizers.

22. The biggest entry on the revenue account expenditure side is interest payments.

23. A deficit on the revenue account is treated to be bad news because it means that the
current income of the Government is not even enough to take care of current
expenses, let alone creating infrastructure from it.

24. The capital account income items include disinvestment proceeds and borrowings
from the RBI and the non-RBI sources.

25. The expense items on the capital account include spendings on infrastructure,
defense, R&D, health, education etc.

26. Ideally the flow should be from Revenue account to Capital account and not the other
way. The income items on the capital account should be used in creation of new
assets.
27. These proceedings should not be used to fund deficit on revenue account. With this
view the Infrastructure fund was created in 1997 to restrict the movement from
capital account to revenue account.

28. It is believed that in order to arrive at the overall fiscal deficit of the economy,
borrowings (from both RBI and non-RBI sources) should not be treated as income
and hence should not be clubbed together with tax receipts, disinvestment proceeds
etc.

29. Hence, fiscal deficit is the overall deficit as reflected in the budget, with the debt-
creating items on the capital account excluded from being counted as an income for
the GOI.

30. The fiscal deficit hence indicates the total borrowing requirements of the GOI.

31. To the extent that these borrowings are raised from the market i.e. non-RBI sources,
it implies that the funds move away from the private sector to the GOI.

32. Thus, market borrowings change the composition of debt, but not the total volume of
liquidity.

33. However increased market borrowings can also result in crowding out of private
investments.

34. On the other hand, to the extent that the GOI borrows directly from the RBI, the RBI
has to monetize this deficit by printing of money. This is referred to as deficit
financing.

35. Whilst deficit financing is important because GOI projects would not get completed
without it, it also can create inflationary stimuli in an economic system.

36. However, it is important to remember that creating more money is not always
harmful. Money finally creates demand and so, in a system, where demand is
lackluster, the Central Bank probably would want to support the fiscal programmes
through monetization, and not through market borrowing.

37. In a system with already high inflation (India 2010 is a case in point), monetization
however may land up worsening the inflation issue at hand.

38. The RBI thus has to carefully evaluate the current growth and inflation trends and
then advise the GOI on how much fiscal deficit will be tolerable for the economy and
most importantly, how this deficit is to be funded.
39. When the RBI creates money, it creates liabilities for itself, which have to be
supported by assets such as Govt. paper (T-Bills, G-secs), gold and FOREX reserves.

40. When the GOI runs into a deficit, it issues bonds called as Treasury Bills and
Government securities.

41. These bonds are subscribed to by the market and the RBI.

42. When the RBI subscribes to these bonds, the RBI is giving a loan to the GOI i.e. the
bonds held by the RBI as assets are used to create monetary liabilities i.e. money
supply.

43. Similarly, when more FOREX enters the country (this may happen because exports
are greater than imports or because of Foreign Direct Investment (FDI), Foreign
Institutional Investors (FII) or External Commercial Borrowings (ECB) inflows
received by Indian Govt. and non-Govt. entities), equivalent amount of rupees are
released into the system by the RBI. Thus, monetary liabilities are created against
FOREX asset backing.

44. This implies that while FOREX inflows are good, excessive inflows may affect the
inflation quotient in the economy.

45. If too much money supply is created, it can create too much demand and hence,
inflation. Hence the RBI uses certain tools of monetary policy (such as CRR, SLR and
OMOs) to control the inflation.

46. It is useful to remember that the RBI only uses demand management tools.

47. This means that whenever the RBI sees inflation, it tries to control demand and there
through control inflation.

48. Demand can be controlled if the interest rates offered by the banking system increase.
As the lending rates increase, it automatically becomes expensive for consumers to
buy cars or houses, thus softening the demand for these goods.

49. As lending rates shoot up, businesses too may keep expansion plans on hold. New
plans too may be unviable under higher costs of funds. All this implies that consumer
driven and business driven demand softens, thereby reigning in inflation.

50. Thus, the RBI tries to create high interest rate environments during inflation and soft
interest rate environments during recessions (when it wants to create demand).

51. How can the RBI influence the interest rate offered by banks?

52. Cash Reserve Ratio (CRR) are the cash reserves that commercial banks have to
maintain with the RBI. When the CRR is hiked up, more reserves are locked with the
RBI and hence the amount of liquidity that banks have with it is reduced. This
automatically means that the supply of funds with the banks dries up and so banks
increase interest rates.

53. During recessions, however, the CRR will be reduced.

54. The Statutory Liquidity Ratio (SLR) is the percent of bank deposits that bankers hold
in cash, current account balances with other commercial banks and eligible Govt.
bonds.

55. If SLR is hiked up, it again locks up bank funds in Govt. paper, leaving less for the
private sector, hence leading to interest rate hikes and control of demand and
inflation.

56. Thus, a hike in SLR does help to control inflation.

57. But at the same time, a hike in SLR, also changes the composition of bank debt away
from the private sector towards the GOI. Thus, on one hand, SLR is an inflation
control tool and on the other, it is a tool to create a ready market for Govt. bonds. This
implies that the market absorbs more of Govt. bonds, thereby reducing the pressure
on the RBI to monetize the deficit.

58. Open Market Operations (OMOs) by the RBI entail buying and selling of Govt.
bonds by the RBI. Under inflationary conditions, the RBI starts selling bonds, thereby
mopping up excess liquidity from the banks. Under recessionary trends, it buys
bonds, thereby easing liquidity into the banks and markets.

59. The RBI does the job of not only creating a debt market for the GOI, but nurturing the
market and smoothing liquidity conditions constantly.

60. Roles and functions of the RBI:

a. Sole authority of note issue


b. Banker to the GOI
c. Banker to the banks
d. Controller of credit and inflation through tools of monetary policy
e. Official custodian of FOREX reserves

61. When the RBI acts as a banker to the GOI, it advises the GOI on the demand
conditions in the market for Treasury Bills and G-secs. It auctions the T-Bills at a
discount. Govt. bonds are treated as liquid securities because the RBI stands ready
to buy these back from the FIs at all times. By declaring certain issues to be repo-
eligible or repoable securities, it creates a demand for these. When the bonds come
up for redemption, that too is handled by the RBI. If redemption is not possible, then
the RBI carries out bond market transactions such as a swap or a strip. A swap
happens when a short term bond is switched into a long term maturity instrument
thereby postponing redemption. A strip happens when a long term bond is converted
into several smaller face value bonds of shorter maturity.

62. In its capacity as a banker to banks, RBI is the lender of the last resort. It is
responsible for scrutiny and compliance related issues of the banks. It has created
frameworks such as the call money market, the Collateralized Borrowing and
Lending Obligations (CBLO) market and the repo market, wherein commercial banks
can place their funds for very short maturities. It itself is a player in all these markets.
Repo rate is the rate at which banks borrow from the RBI. Banks sell repoable G-secs
at a discount to the RBI with a promise to repurchase it back at the face value. By
changing the repo, the RBI can change the cost of funds for banks, thereby affecting
the day to day liquidity conditions in the markets.

63. CRR is pure credit control tool.

64. SLR is used for both credit control and liquidity management

65. SLR also acts as an indicator. An increase/decrease in SLR indicates whether RBI
wants to suck/infuse liquidity. A decrease in SLR also indicates that RBI wants to
prevent crowding out.

66. Reasons why banks subscribe to bonds:


a> Banks have to comply with statutory liquid requirements. As banks
receive incremental deposits their statutory liquid requirements also
increase. Hence, there is always a demand for fresh issue of bonds.
b> There exists a secondary market for G-secs and T-bills.
c> These bonds are risk free.
d> In a recessionary environment when private sector has low credit
requirement, banks have large exposure to GOI bonds.
e> Certain bonds are repoable. Banks need such bonds as collateral for repo
transaction.

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