MONETARY POLICY → ROLE OF RBI
FISCAL POLICY
PART 1: MONETARY POLICY (INDIA)
🔹 Meaning of Monetary Policy
Monetary policy refers to the policy used by the central bank of a country to regulate:
● Money supply (total money available in the economy)
● Interest rates (cost of borrowing)
👉 Objective:
● Maintain price stability
● Control inflation
● Ensure sustainable economic growth
In India, monetary policy is implemented by the Reserve Bank of India (RBI).
🔹 Objectives of Monetary Policy
1. Price Stability (Primary Objective)
● Price stability means controlling inflation.
● It avoids both excessive rise and fall in prices.
👉 Importance:
● Creates economic certainty
● Encourages investment
● Supports long-term growth
2. Economic Growth (Secondary Objective)
● RBI ensures availability of credit (loans) for growth.
● Maintains balance between inflation and growth.
🔹 Inflation Targeting in India
● India follows Flexible Inflation Targeting
● Target inflation: 4%
● Tolerance band: ±2%
● Range: 2% to 6%
👉 Set by Government of India in consultation with RBI (every 5 years)
🔹 Monetary Policy Committee (MPC)
Monetary Policy Committee (MPC) is a body formed in 2016 to take decisions related to
monetary policy in India.
MPC was established after amendment in the Reserve Bank of India Act, 1934.
It is provided under Section 45ZB of the Act.
The committee consists of 6 members:
● 3 members from RBI
● 3 members nominated by Government
The RBI Governor acts as the Chairperson (ex-officio).
🔹 Functions
The main role of MPC is to determine the policy interest rate (Repo Rate).
It ensures that inflation remains within the target range of 4% ± 2% (2% to 6%).
All monetary policy decisions are taken through a voting system, where decisions are based
on majority.
In case of a tie, the RBI Governor has a casting vote.
🔹 Meetings
The MPC meets at least 6 times in a year.
Additional meetings may be conducted during special or emergency situations.
🔹 Monetary Policy Tools
🟢 A. Quantitative Tools (Control volume of credit)
1. Bank Rate
● Rate at which RBI gives long-term loans to banks with No Agreement.
👉 Effect:
● Increase → borrowing costly → reduces inflation
● Decrease → borrowing cheaper → increases growth
2. Open Market Operations (OMO)
● Buying and selling of government securities by RBI
👉 During inflation:
● RBI sells securities → reduces money supply
👉 During recession:
● RBI buys securities → increases money supply
3. Cash Reserve Ratio (CRR)
● Percentage of deposits banks must keep with RBI in cash
👉 Effect:
● Increase → less lending → reduces inflation
● Decrease → more lending → increases liquidity
4. Liquidity Adjustment Facility (LAF)
Allows banks to borrow or deposit money with RBI on short-term basis.
(a) Repo Rate
● Rate at which RBI lends money to banks
● Injects liquidity
(b) Reverse Repo Rate
● Rate at which RBI borrows money from banks
● Absorbs liquidity
5. Marginal Standing Facility (MSF)
● Emergency borrowing facility for banks
● Higher rate than Repo Rate
6. Statutory Liquidity Ratio (SLR)
● Percentage of deposits banks must keep in:
○ Cash
○ Gold
○ Government securities
👉 Ensures liquidity and safety
7. Base Rate (Historical)
● Introduced in 2010
● Minimum rate below which banks cannot lend
8. MCLR
● Introduced in 2016
● Lending rate based on marginal cost of funds
9. External Benchmark System (2019)
● Loans linked to:
○ Repo rate
○ Treasury bill rates
○ Other benchmarks
🟡 B. Qualitative Tools (Control direction of credit)
● Margin requirements → controls loan amount
● Consumer credit regulation → controls instalments and down payment
● Moral suasion → RBI advice to banks
● Credit rationing → limits credit
● Publicity → RBI reports influence banks
● Directives → strict instructions
● Direct action → penalties for non-compliance
🟦 PART 2: ROLE OF RBI
🔹 Basic Information
● RBI is the central bank of India
● Established: 1 April 1935
● Under: RBI Act, 1934
● Nationalised: 1 January 1949
● Central office:
○ Initially: Calcutta
○ Shifted to Mumbai (1937)
🔹 Overall Role
RBI ensures:
● Financial stability
● Inflation control
● Economic growth
● Trust in currency
🔹 Functions of RBI
1. Issuer of Currency
● RBI issues all currency notes except ₹1 note and coins
● ₹1 note and coins issued by Government
👉 RBI manages distribution
2. Banker to Government
RBI acts as:
● Banker
● Agent
● Financial adviser
👉 Functions:
● Maintains accounts
● Receives and makes payments
● Manages public debt
3. Banker’s Bank
● Commercial banks keep accounts with RBI
● RBI provides loans and liquidity
4. Lender of Last Resort
● RBI provides emergency funds to banks
👉 Prevents:
● Bank failures
● Panic in economy
5. Clearing House Function
● Settles inter-bank payments
● Reduces need for physical cash
6. Controller of Credit
RBI controls credit using:
Quantitative tools:
● Bank Rate
● Repo Rate
● Reverse Repo Rate
● OMO
● CRR
● SLR
Qualitative tools:
● Selective credit control
● Moral suasion
● Credit rationing
7. Manager of Exchange Rate
● RBI manages exchange rate under managed float system
8. Custodian of Foreign Exchange Reserves
RBI holds:
● Foreign currency
● Gold
● SDRs
👉 Helps:
● Meet international payments
● Maintain stability
9. Collection and Publication of Data
RBI collects data on:
● Banking
● Inflation
● FDI and FPI
● Balance of Payments
● Exchange rates
👉 Publishes reports for:
● Policymakers
● Researchers
● Public
10. Regulator and Supervisor of Banks
RBI:
● Issues licences
● Inspects banks
● Controls operations
● Approves mergers
👉 Protects depositors
PART 3: FISCAL POLICY
Fiscal policy refers to the policy of the government related to:
● Public revenue (income of government)
● Public expenditure (spending by government)
● Public borrowing (loans taken by government)
The main purpose is to manage the economy and achieve macroeconomic goals like growth,
stability, and employment.
In India:
● Fiscal policy is made by the Ministry of Finance
● It is implemented through the Union Budget (annual financial plan of the government) &
Also called Budgetry policy
Fiscal policy means the use of:
● Taxes
● Government spending
● Borrowing
to influence economic activities such as production, consumption, and investment.
Objectives of Fiscal Policy
1. Economic Growth
Increase production and national income over time.
2. Price Stability
Control inflation (rise in prices) and deflation (fall in prices).
3. Full Employment
Ensure that maximum people get jobs.
4. Reduction of Income Inequality
Reduce gap between rich and poor using taxes and welfare spending.
5. Economic Stability
Avoid large fluctuations in the economy (booms and recessions).
6. Balanced Regional Development
Develop backward regions along with developed ones.
7. Resource Mobilisation
Collect funds through taxes and borrowing for development.
👉 Conclusion: Fiscal policy aims at growth + stability + equality.
Instruments of Fiscal Policy (Tools Used by Government)
A. Public Revenue (Government Income)
1. Tax Revenue
● Direct Taxes: Paid directly by individuals or companies
Example: Income tax, corporate tax
● Indirect Taxes: Collected indirectly through goods and services
Example: Goods and Services Tax, customs duty, excise duty
2. Non-Tax Revenue
● Fees, fines
● Dividends from public sector companies
● Profits of government enterprises
B. Public Expenditure (Government Spending)
● Developmental Expenditure
Spending on education, health, infrastructure (roads, railways)
→ Helps economic growth
● Non-Developmental Expenditure
Defence, interest payments, pensions
→ Necessary but does not directly create assets
C. Public Borrowing
Government takes loans:
● From inside the country (internal borrowing)
● From foreign sources (external borrowing)
D. Deficit Financing
When government spends more than its income, it finances the gap by:
● Borrowing
● Printing new money
⚠️ Excessive use leads to inflation.
Types of Fiscal Policy
1. Expansionary Fiscal Policy
Used during recession (low demand and unemployment)
Measures:
● Increase government spending
● Reduce taxes
Effect:
● Increases demand
● Creates jobs
⚠️ Risk: Can cause inflation if overused
2. Contractionary Fiscal Policy
Used during inflation (high prices)
Measures:
● Reduce government spending
● Increase taxes
Effect:
● Reduces demand
● Controls inflation
3. Counter-Cyclical Fiscal Policy
Policy that works opposite to business cycle:
● During recession → Expansionary policy
● During inflation → Contractionary policy
👉 Helps stabilize the economy.
Automatic vs Discretionary Fiscal Policy
Automatic Stabilisers
Work automatically without government action:
● Progressive tax system (higher income → higher tax)
● Welfare schemes (unemployment benefits)
👉 These reduce economic fluctuations naturally.
Discretionary Fiscal Policy
Government takes deliberate decisions:
● Changing tax rates
● Launching new schemes
PART II: BUDGET DEFICITS
Meaning of Budget Deficit
A budget deficit occurs when:
👉 Government expenditure > Government receipts in a financial year
Types of Budget Deficits
A. Revenue Deficit
Meaning:
Revenue expenditure is more than revenue receipts
Formula:
Revenue Deficit = Revenue Expenditure − Revenue Receipts
Explanation:
● Government is spending more on daily expenses than it earns
● Borrowing is used for consumption (not investment)
⚠️ Important Correction & Concept Clarity:
This is considered bad for the economy because it does not create assets.
B. Fiscal Deficit (Most Important for Exam)
Meaning:
Total borrowing requirement of government
Formula:
Fiscal Deficit = Total Expenditure − (Revenue Receipts + Non-Debt Capital Receipts)
Explanation:
● Shows how much money government needs to borrow
● Higher fiscal deficit → more debt
Effects:
● Can increase inflation
● Raises interest burden
● Increases public debt
C. Primary Deficit
Meaning:
Fiscal deficit excluding interest payments
Formula:
Primary Deficit = Fiscal Deficit − Interest Payments
Explanation:
● Shows current year’s borrowing (excluding past debt burden)
👉 If primary deficit = 0
→ Government is borrowing only to pay past interest
D. Capital Deficit
Meaning:
Capital expenditure exceeds capital receipts (excluding borrowing)
Explanation:
● Usually less harmful
● Because it leads to asset creation (like infrastructure)
9. Quality of Fiscal Deficit
● Borrowing for investment (roads, dams) → GOOD
● Borrowing for consumption → BAD
👉 Revenue deficit indicates poor fiscal quality.
10. Deficit Financing
Means government meets excess expenditure by:
● Borrowing from central bank
● Issuing treasury bills
● Creating new money
⚠️ Leads to demand-pull inflation if excessive.
Fiscal Responsibility and Budget
Management Law
This law was passed in the year 2003 and implemented from the year 2004-2005. It was
introduced to bring discipline in government finances.
➔ The main aim is to control excessive government borrowing and reduce fiscal deficits.
Objectives
1. Maintain fiscal discipline
2. Reduce fiscal deficit
3. Eliminate revenue deficit
4. Control public debt
5. Ensure transparency in government finances
Important Targets
1. Fiscal deficit should be around 3% of gross domestic product
2. Revenue deficit should be reduced to zero
3. Debt target is around 40% of gross domestic product for central government
4. Total government debt target is around 60%
➢ This law ensures fiscal discipline and prevents uncontrolled borrowing.
Ways and Means Advances
Ways and Means Advances are short term loans given by the central bank to the central and
state governments. To meet temporary shortage of funds or cash mismatch.
Features
1. Short term in nature
2. Interest is charged
3. Limit is fixed by the central bank
Types
1. Normal advances are given within a fixed limit
2. Special advances are given against government securities
Important Concept
If borrowing exceeds the limit, it becomes overdraft, which indicates poor financial
management.
Relation with Fiscal Responsibility Law
These advances are allowed, but long term borrowing from the central bank is not allowed.
❖ Ways and Means Advances provide temporary cash support and are not a
method of deficit financing.
MONETARY POLICY – LAST MINUTE REVISION
Core Idea
● Controls money supply + interest rates
● Done by Reserve Bank of India
● Goal → control inflation + support growth
Inflation Target
● 4 percent
● Range → 2 to 6 percent
● Flexible system
Monetary Policy Committee
● 6 members (3 Reserve Bank + 3 Government)
● Governor = head
● Decides repo rate
● Voting system (Governor has final vote)
● Meets at least 6 times
Reserve Bank – Key Roles
● Issues currency (except one-rupee note)
● Banker to Government
● Banker’s bank
● Lender of last resort
● Controls credit
● Regulates banks
● Manages foreign exchange
TOOLS (JUST REMEMBER LOGIC)
If inflation ↑ → reduce money
If recession → increase money
Quantitative Tools
● Bank Rate → long-term rate
● Repo Rate → lending to banks
● Reverse Repo → absorbs money
● Cash Reserve Ratio → cash with Reserve Bank
● Statutory Liquidity Ratio → liquid assets
● Open Market Operations → buy/sell securities
● Marginal Standing Facility → emergency loan (higher rate)
Qualitative Tools
● Margin → higher = less loan
● Moral suasion → advice
● Credit rationing → limit
● Direct action → penalty
5 SECOND RECALL
● Inflation control = main aim
● Repo rate = most important tool
● 4 percent inflation target
● Monetary Policy Committee decides rates
● Reserve Bank = controller of money and credit
FISCAL POLICY – QUICK REVISION NOTES
🔹 MEANING
➡️
Fiscal Policy = Government policy related to
➡️
Revenue (tax + non-tax)
➡️
Expenditure
👉
Borrowing
To control and guide the economy
In India → Made by Ministry of Finance, implemented via Union Budget
🔹 OBJECTIVES (REMEMBER: “G-P-F-I-S-R-B”)
• Growth
• Price stability (control inflation)
• Full employment
• Income equality
• Stability
• Resource mobilisation
• Balanced regional development
🔹 INSTRUMENTS
1. Public Revenue
• Direct Tax → Income tax, corporate tax
• Indirect Tax → GST, customs
• Non-tax → Fees, fines, PSU profits
2. Public Expenditure
• Developmental → Health, education, infra
• Non-developmental → Defence, interest
3. Public Borrowing
• Internal + External
4. Deficit Financing
• Borrowing + money creation
🔹 TYPES OF FISCAL POLICY
Expansionary (Recession)
• ↑ Govt spending
👉
• ↓ Taxes
Boost demand & employment
Contractionary (Inflation)
• ↓ Spending
👉
• ↑ Taxes
Control excess demand
Counter-Cyclical
👉 Opposite to business cycle (stabiliser)
🔹 AUTOMATIC vs DISCRETIONARY
Automatic
• Works automatically
• Example → Progressive tax, welfare schemes
Discretionary
• Govt decisions
• Example → Change tax rates
📊 BUDGET DEFICITS (VERY IMPORTANT)
🔹 Budget Deficit
👉 Govt Expenditure is more than Receipts
🔸 1. Revenue Deficit
Formula:
Revenue Exp – Revenue Receipts
👉 BAD → Dissaving, borrowing for consumption
🔸 2. Fiscal Deficit ⭐ (MOST IMPORTANT)
Formula:
Total Exp – (Revenue Receipts + Non-debt capital receipts)
👉 Shows total borrowing
👉 Leads to inflation + debt burden
🔸 3. Primary Deficit
Formula:
Fiscal Deficit – Interest
👉 Shows current fiscal condition
🔸 4. Capital Deficit
👉 Capital Exp > Capital Receipts
👉 LESS harmful (asset creation)
🔹 QUALITY OF DEFICIT
❌
✔ Borrowing for assets → GOOD
Borrowing for consumption → BAD
🔹 DEFICIT FINANCING
• Borrow from RBI
• Treasury bills
• Print money
👉 Causes inflation if excessive