This section has notes based on the working [paper](https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=13841Link) on relationship between monetary and fiscal policy. ## An Empirical Analysis of Monetary and Fiscal Policy Interaction in India. - 2011 Authors - Janak Raj, J. K. Khundrakpam & Dipika Das ## Conclusion 1. Fiscal dominance of monetary policy has moderated in India as a result of a series of fiscal and monetary policy reforms undertaken over the past two decades (1990-2010) 2. ==Specifically, the reaction of the two policies to shocks in inflation and output is mostly in the opposite direction.== 3. While monetary policy reacts in a counter-cyclical manner, fiscal policy reaction is primarily pro-cyclical in nature. 4. The positive impact of expansionary fiscal policy on output is highly short-lived, while there is a significant negative impact in the medium to long- term. ## Section 1: Introduction 1. Monetary and fiscal policies in any country are two macroeconomic stabilisation tools, but often been pursued in different countries in different directions. 2. Monetary policy is often pursued to achieve the objective of low inflation when there is output and price shocks. 3. Fiscal policy, on the other hand, is often biased towards high growth and employment even at the cost of higher inflation (Alesina and Tabelini, 1990; Aurbach, 2004). 4. For achieving an optimal mix of macroeconomic objectives of price stability and growth, it is necessary that the two policies complement each other. ==However, the form of complementarity will vary according to the stage of development of the country’s financial markets and institutions. 5. With increasing independence of central bank in the conduct of monetary policy from fiscal dominance during the last few decades, there has been a renewed interest in the issue of monetary and fiscal policy coordination (Melitz, 1997; Von Hagen et. al, 2001). 6. **Two events:** 1. Another development, which led to spawning a number of studies on this issue, was the Stability and Growth Pact (SGP) and formation of European Monetary Union (EMU). Under this arrangement, individual countries pursue independent fiscal policies within the SGP, but have a common monetary policy. Thus, this arrangement has underscored the importance of monetary and fiscal policy coordination (Muscatelli et. al, 2002). 2. Furthermore, the recent global financial crisis has once again demonstrated the importance of coordinated response of monetary and fiscal policies. Sovereign debt problem in many countries in the euro area, in particular, has also underlined the need for monetary and fiscal policies coordination. 7. **Developing economies:** In the context of developing economies, it is often viewed that there is complete fiscal dominance and the central bank is subservient to the fiscal authority (Fischer and Easterly, 1990; Calvo and Vegh, 1999). 1. Therefore, it is argued that the issue of coordination may not arise since the very concept of coordination arises only when the two institutions are independent. 2. Actual execution of the two policies could significantly differ from what could be expected from the institutional arrangements (Arby and Hanif, 2010). 3. ==Furthermore, irrespective of the dependence/independence of the two policies, there will be interaction between these two policies, and will be conditioned by the institutional framework. == 1. The institutional arrangements have been changing in many developing countries as they are moving towards making central banks more independent, implying time varying behaviour of the interaction between the two policies, which has important implications for the objectives of macroeconomic stabilisation. 2. ==Thus, from the macroeconomic policy point of view, it is important to empirically (by means of observation rather than theory) verify the nature of the interaction.== 8. **Indian context:** 1. Several changes have taken place in the monetary and fiscal policy frameworks, but these two have altered the basic nature of interactions between these two policies, particularly since the beginning of the 1990s. 1. These include complete phasing out of automatic monetisation of fiscal deficit through creation of ad hoc treasury bills (also called ad hocs) in 1997 2. Prohibiting RBI from buying government securities in the primary market from April 2006 under the Fiscal Responsibility and Budget Management (FRBM) Act, 2003. 2. ==However, the central government continues to incur large fiscal deficits, which has implications for the demand management by the Reserve Bank. == ## Section II - The Evolution of monetary and fiscal policies interface in India.  1. ==In terms of the Reserve Bank of India Act, 1934., the Reserve Bank manages the public debt of the Central and the State Governments and also acts as a banker to them. ==  2. In the pre-Independence days, the Colonial Government adopted a stance of fiscal neutrality.  3. However, requirements of the World War II necessitated primary accommodation to the Government from the Reserve Bank.  4. In the post-Independence period, the monetary-fiscal interface evolved in the context of the emerging role of the Reserve Bank. Given the low level of savings and investment in the economy, fiscal policy began to play a major role in the development process under successive Five-Year Plans beginning 1950-51. Fiscal policy was increasingly used to gain adequate command over the resources of the economy, which the monetary policy accommodated. Beginning the Second Plan, the Government began to resort to deficit financing to bridge the resource gap to finance plan outlays. Thus, the conduct of monetary policy came to be influenced by the size and mode of financing the fiscal deficit. Consequently, advances to the Government under the RBI Act, 1934 for cash management purposes, which are repayable not later than three months from the date of advance, in practice, became a permanent source of financing the Government budget deficit. Whenever government’s balances with the Reserve Bank fell below the minimum stipulation, they were replenished through automatic creation of ad hoc Treasury Bills. Though the ad hocs were meant to finance Government’s temporary needs, the maturing bills were automatically replaced by fresh creation of ad hoc Treasury Bills. Thus, monetisation of deficit of the Government became a permanent feature, leading to loss of control over base money creation by the Reserve Bank. In addition to creation of ad hocs, the Reserve Bank also subscribed to primary issuances of government securities. This was necessitated as the large government borrowings for plan financing could not be absorbed by the market. This, however, constrained the operation of monetary policy as it led to creation of primary liquidity in the system and entailed postponement of increases in the Bank Rate in order to control the cost of Government borrowings. The Reserve Bank Act, therefore, was amended in 1956 empowering the Reserve Bank to vary the cash reserve ratio (CRR) maintained by banks with it to enable control of credit boom in the private sector emanating from reserve money creation through deficit financing. .1 **SLR** The Statutory Liquidity Ratio ([[SLR - Statutory Liquidity Ratio|SLR - Statutory Liquidity Ratio]]) under the Banking Regulation Act, 1949 was originally conceived as a prudential requirement to ensure availability of sufficient liquid resources in relation to the liabilities by banks for meeting sudden drain on their resources. However, through a gradual hike the SLR became essentially an instrument to secure an increasing captive investor base for government securities to finance the increasing expansion in the government’s fiscal deficit, particularly after the nationalisation of banks in 1969. With the fiscal policy laying greater emphasis on social justice and alleviating poverty in the 1970s, monetary policy shifted from ‘physical planning’ in the financial sector to ‘credit planning’ in terms of direct lending and credit rationing. This altered the nature of relationship between the Reserve Bank and the Government, with the former playing a limited role in the structure of the financial system and use of the interest rate as a monetary policy instrument. The single most important factor influencing monetary policy in the 1970s and the 1980s was the phenomenal growth in reserve money due to Reserve Bank’s credit to the government. With little control over this variable, monetary policy focused on restricting overall liquidity by raising the CRR and the SLR to high levels. In pursuance of the recommendations of the Chakravarty Committee (1985), the monetary policy strategy shifted from the credit planning approach to a monetary targeting approach from 1986-87. This entailed clear assessment of primary liquidity creation consistent to achieve broad money supply (M3) - the target under the monetary targeting framework. The exercise of setting monetary targets was taken up immediately after the presentation of the Union Budget, which provided the magnitude of budget deficit and the level of market borrowing programme. The balance of payment crisis of 1991 recognised the fiscal deficit as the core problem. It, therefore, necessitated a strong and decisive coordinated response on the part of the Government and the Reserve Bank. Assigning due importance to monetary management, fiscal consolidation was emphasised and implemented in 1991-92. An important step taken during the 1990s with regard to monetary-fiscal interface was phasing out and eventual elimination of automatic monetisation through the issue of ad hoc Treasury Bills. Through Supplemental Agreements between the Reserve Bank and the Government of India, beginning September 1994, creation of ad hocs was completely phased out from April 1997. Thus, the recourse to monetisation was substantially lowered during 1990-91 to 1996-97. This enabled the Reserve Bank to bring down the CRR and the SLR, thereby freeing resources of the banking system for the commercial sector and set the stage for the Reserve Bank to reactivate its indirect instruments of monetary policy. The Reserve Bank used the Bank Rate as an instrument of monetary policy after a decade in 1992, reactivated OMO as an instrument of monetary management, introduced auctioned system for primary issuance of government securities and instituted a liquidity adjustment facility to manage day to day liquidity in the banking system. Although with phasing out of automatic monetisation through the ad hoc Treasury Bills reduced the fiscal dominance on monetary policy considerably, it did not eliminate the dominance altogether. In view of underdeveloped stage of the G-Sec market, for some years beginning the latter half of the 1990s, the Reserve Bank had to adopt a strategy of undertaking private placement/devolvement of government securities in the face of adverse market conditions and offloaded them through open market sales when conditions became more conducive. However, with the enactment of FRBM Act, 2003, the Reserve Bank has been prohibited from subscribing to government securities in the primary market from April 1, 2006. This provided the Reserve Bank provided with a greater flexibility in its conduct of monetary policy. Even though fiscal dominance through automatic monetisation of fiscal deficit has been done away with over the years in India, the influence of fiscal deficit on the outcome of monetary policy has continued to remain significant given its high level. High fiscal deficit, even if it is not monetised, can interfere with the monetary policy objective of price stability through its impact on aggregate demand and inflationary expectations.   [Section III](https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=13841#S3) contains a brief review of the literature. In [Section IV](https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=13841#S4), the theoretical and empirical framework, based on the literature, is laid out. [Section V](https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=13841#S5) presents the results. The final [section sums up](https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=13841#S6) the main findings. ## Resources 1. [[Fiscal-Monetary Co-ordination in India - An Assessment 2013 OPEN]] 2. [Monetary and Fiscal policy - 2011](https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=13841) 3.