Let us make in-depth study of the relation between monetary policy and fiscal policy of India.
Monetary policy in a planned economy of India cannot be framed independently of fiscal policy as achieving growth with price stability are the objectives of both these policies.
In India the Reserve Bank of India has often adopted accommodative monetary policy to Government’s fiscal policy.
Prior to 1991 when economic reforms were initiated the basic goal of monetary policy was to neutralize the impact of large fiscal deficits of the Government. To boost public sector investment for accelerating economic growth there was large increase in Government expenditure under various Five Year plans which was financed by borrowing by the Government and deficit financing (i.e., monetatisation of budget deficit).
Both Government borrowing from the market and deficit financing leads to the increase in aggregate demand and have therefore potential for causing inflation. Therefore, to ensure adequate funds to meet the borrowing requirements of the Government the statuary liquidity ratio (SLR) of the banks was raised to the maximum limit of 38.5 per cent. That is, banks were to buy government securities to this extent.
Besides, to check inflation, cash reserve ratio (CRR) of banks was raised to a high level of 15 per cent. The high cash reserve leaves less funds with the banks to lend to the private commercial sector. In this way large expansion of credit for private sector was prevented.
To quote C. Rangarajan the former Governor of the Reserve Bank of India, “Until the overall reforms process was initiated in 1991 the basic goal of monetary management took the form of compensatory increase in the cash reserve ratio (CRR) for banks, controls on the growth of commercial credit (mainly to the private enterprises sector) and adjustments of administered interest rates. The fixation of CRR and SLR at their maximum levels crowded out credit for the commercial sector. Thus, even when money supply was growing at a rapid rate, private sector could not get the needed credit for financing industry and trade”.
Explaining the monetary policy adopted prior to reform process of 1991, Dr. Y.V. Reddy, also a former Governor of the Reserve Bank of India writes, “given the command and controlled nature of the Indian economy, the RBI had to resort to direct instruments like interest rate regulation selective credit control and cash Reserve Ratio (CRR) as major policy instruments. These instruments were used to neutralize the monetary impact of the Government is budgetary operations”.
In the recent post-reform years, mainly, 2008-09 accommodative nature of monetary policy to the Government’s fiscal policy may be noted. In October 2008, a severe global financial crisis gripped the world economy following from the bankruptcy of Lehman’s brothers in the US.
This affected the growth of our exports and also led to the capital outflows from the Indian economy leading to the depreciation of the Indian economy and crash in Indian stock market. As a result, industrial and overall growth of the Indian economy started declining.
To check the economic slowdown the Government increased its expenditure, especially on infrastructure projects, and cut indirect taxes such as excise duty service tax to boost private sector investment and expenditure. To supplement and accommodate Government expansionary policy, the Reserve Bank reversed its earlier tight monetary policy in October 2008 and to boost private sector investment it reduced its repo rate from 9 per cent in July 2008 to 7.5 per cent in Oct. 2008 and further to 4.75 per cent in March 2009.
Similarly, RBI reduced cash reserve ratio (CRR) from 9 per cent in July 2008 to 6.5 per cent in Oct. 2008 and further to 5 per cent in March 2009 to make more funds available with banks to buy Government securities for financing sits borrowing and also to the private sector for expanding investment.
Thus, the RBI’s monetary policy has been accomodatory in the sense that it provided support to Government’s fiscal stimulus package to promote investment and growth. When in the later half of 2009-10 inflation rate again started rising the RBI began the process of withdrawing from the accommodative monetary policy stance in Oct. 2009 and started tightening its monetary policy to fight inflation.