Policy Responses To Ease Credit Crisis

JAIPURIA INSTITUTE OF MANAGEMENT LUCKNOW 2008-2009

A PROJECT REPORT ON

Policy Responses To Ease Credit Crisis

P.G.D.M. FIRST YEAR

UNDER THE SUPERVISION OF: PROF. MAHIMA SHARMA BUSINESS ENVIRONMENT

SUBMITTED BY: ADARSH AGRAWAL

(CFT08-004)

ACKNOWLEDGEMENT

Completion of any work or project depends upon the co-operation, coordination, efforts, and several resources of material, knowledge, energy & time. Now, we are very pleased to present our Project report successfully. We feel very fortunate to express our feelings about all the faculty members & all the friends who have contributed many suggestions for improvement. We are very thankful to our teacher Prof. MAHIMA SHARMA, she not only helped us to make this report come true but also gave us the valuable inspiration at every critical moment. We express our strong sense of gratitude to her, she helped us in every possible way beside the useful guidance & constructive inputs regarding final shaping up of this report on the topic Policy Responses To Ease Credit Crisis

Policy Responses To Ease Credit Crisis

The various policies adopted by government and central bank across the world to ease credit crisis could be summed under following heads:  Monetary Policy  Fiscal Policy Before discussing on how they can ease credit crisis, we need to know the following: What these policies are? And What are the effects of these on Economy? Policy works because it has artists pulling the strings.

Monetary Policy Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i)

the supply of money,

(ii)

availability of money, and

(iii)

cost of money or rate of interest.

Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in

a recession by

lowering

interest rates, while

contractionary policy involves raising interest rates in order to combat inflation. Monetary policy should be contrasted with fiscal policy, which refers to government borrowing, spending and taxation. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. The other primary means of conducting monetary policy include: (i)

Discount window lending (i.e. lender of last resort);

(ii)

Fractional

deposit

lending

(i.e.

changes

in

the

reserve

requirement); (iii)

Moral suasion (i.e. cajoling certain market players to achieve specified outcomes);

(iv)

"Open mouth operations" (i.e. talking monetary policy with the market).

Trends in central banking The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Recent attempts at liberalizing and reforming the financial markets (particularly the recapitalization of banks and other financial institutions in US elsewhere) are gradually providing the latitude required in order to implement monetary policy frameworks by the relevant central banks.

Monetary Policy: Inflation Targeting Price Targeting Monetary

Target

Market

Variable: Interest rate

overnight debt Level Interest rate

Long Term Objective:

on A given rate of change in the CPI on

A specific CPI number overnight debt The growth in money A given rate of change in the

Aggregates supply CPI Fixed Exchange The spot price of the The spot price of the currency Rate currency Low inflation as measured by Gold Standard The spot price of gold the gold price Usually unemployment + CPI Mixed Policy Usually interest rates change The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonised consumer price index).

Fiscal Policy Fiscal policy is an additional method to determine public revenue and public expenditure. In the recent years importance of fiscal policy has increased

due to economic fluctuations. Fiscal policy is an important instrument in the modern time. A fiscal policy is a policy under which government uses its expenditure and revenue programme to produce desirable effects and avoid undesirable effects on the national income, production and employment.

Objectives of fiscal policy: =p The objectives of fiscal policy may be regarded as follows;  To achieve desirable price level: The stability of general prices is

necessary for economic stability. The maintenance of a desirable price level has good effects on production, employment and national income. Fiscal policy should be used to remove; fluctuations in price level so that ideal level is maintained.  To achieve desirable consumption level: A desirable consumption

level is important for political, social and economic consideration. Consumption can be affected by expenditure and tax policies of the government. Fiscal policy should be used to increase welfare of the economy through consumption level.  To achieve desirable employment level: The efficient employment

level is most important in determining the living standard of the people. It is necessary for political stability and for maximization of production. Fiscal policy should achieve this level.  To achieve desirable income distribution: The distribution of income

determines the type of economic activities the amount of savings. In this way, it is related to prices, consumption and employment. Income

distribution should be equal to the most possible degree. Fiscal policy can achieve equality in distribution of income.  Increase in capital formation: In under-developed countries deficiency

of capital is the main reason for under-development. Large amounts are required for industry and economic development. Fiscal policy can divert resources and increase capital.  Degree of inflation: In under-developed countries, a degree of

inflation is required for economic development. After a limit, inflationary be used to get rid of this situation.

Instruments of Fiscal Policy: 1. Public expenditure 2. Taxes 3. Public debts The above mentioned instruments are used by the public authorities to achieve desirable level of production, consumption and National Income. During inflationary trend more and more taxes are levied on the community. In this way, purchasing power of the people can be decreased and desirable price level is achieved. During inflation public expenditure is decreased so that all in production may decrease high prices and increase the value of money. During deflationary period taxes are reduced and public expenditure is increased. In this way incentives to invest are increased and national income begins to rise. For economic development public debts are necessary. In under developed countries, due to insufficient resources

economic development is not possible. Public loans are drawn internally and externally. The above mentioned methods are called budgetary policy of the government. This policy can increase national income, production level and maintain full employment level. Fiscal policy, taking the scope of budgetary policy, refers to government policy that attempts to influence the direction of the economy through changes in government taxes, or through some spending (fiscal allowances). The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:  Aggregate demand and the level of economic activity

 The pattern of resource allocation  The distribution of income. Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:  A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.  An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through a rise in government spending or a fall in taxation revenue or a combination of the two. This will

lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.  Contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.

Methods of funding Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways: (i)

Taxation

(ii)

Seignorage, the benefit from printing money

(iii)

Borrowing money from the population, resulting in a fiscal deficit.

(iv)

Consumption of fiscal reserves.

(v)

Sale of assets (e.g., land).

ROLE OF FISCAL POLICY- ITS SIGNIFICANCE TO BUSINESS ECONOMY IN DEVELOPING COUNTRIES

 The main goal of the fiscal policy in developing countries is the promotion of the highest possible rate of capital formation. Underdeveloped economies are in the constant deficit of the capital in the economy and thus, in order to have balanced growth accelerated rate of capital formation is required. For this purpose the fiscal policy has to be designed in a way to raise the level of aggregate savings and to reduce the actual and potential consumption of people.  To divert existing resources from unproductive to productive and socially more desirable uses. Hence, fiscal policy must be blended with planning for development.  To create an equitable distribution of income and wealth in the society.  To protect the economy from the ills of inflation and unhealthy competition from foreign countries.  To maintain relative price stability through fiscal measures.  The approach to fiscal policy must be aggregate as well as segmental. the sectoral imbalances can be curbed by appropriate segmental fiscal measures.  The government expenditure on developmental planning projects must be increased. For this deficit financing can be used. It refers to creation of additional money supply either by creation of new money by printing by government or by borrowing from the central bank.  Public borrowing, loans from foreign nations etc can be used in the development of the resources for public sector.

 Fiscal policy in the developing economy has to operate within the framework of social, cultural and political conditions which inhibit formation and implementation of good economic policies.  In order to reduce inequalities of wealth and distribution, taxation must be progressive and government spending must be welfareoriented.  The hindrances in the effective implementation of fiscal policy in the developing countries are loopholes in taxation laws, corrupt tax administration, a high population growth, extravagant governmental spending on non-developmental items, an orthodox society etc.

Conclusion Considering the current scenario in respond to credit crisis following Monetary and Fiscal measures have been and could be taken: Monetary Measures 1. Decrease the CRR(Cash Reserve Ratio) 2. Decrease the Repo rate/Fed Rate

3. Increase Open Market Operations(i.e. purchasing bonds and marketable securities from market) 4. Decrease the Interest Rates 5. Issuing Bail Out Packages 6. Decrease Exchange Rates 7. Promotes foreign investments by increasing the minimum permeable

limit.(Regulatory Measures) 8. Encourage external commercial borrowing(Regulatory Measures) 9. Decrease PLR(Prime Lending Rate) Fiscal Measures 1. Increase Public Expenditure 2. Decrease Tax Rates 3. Issuing or Printing New Currency 4. Consumption of Fiscal Reserves/Surplus Budget

5. Purchase of Assets