Lecture

Public Systems & Policy
Course Contents
The invisible hand and market failures
Welfare economics principles
Income distribution issues
Public good, externalities and political economy
Cost-benefit analysis
Health, education, public distribution, environment
Institutions and policy making
Taxes and incentives, social security issues
Coverage
Overview
Public Finance Management
Government Expenditures
Government operations
Income distribution
Financing of Government Expenditures

Taxes
Debt
Public finance through state enterprise
Coverage (Contd.)
E- Governance
Definition
Scope
Objective
Advantages
Strategies
Coverage (Contd.)
Public Policy
Theoretical aspects of public policy
Implementation in India and in other
countries and effects thereof.
CONCEPTS , TOPICS
BUDGET, FISCAL DEFICIT, FISCAL CLIFF

IS-LM- KEYNESIAN MODEL
E-GOVERNANCE
CROWDING OUT EFFECT
PUBLIC PRIVATE PARTNERSHIPS (PPP)
INDUSTRIAL POLICY
FISCAL POLICY
MONETARY POLICY
PUBLIC POLICIES & ECO REFORMS INDIA, CHINA,
US
SECTORAL POLICIES- INDIA-TRANSPORT & ENERGY
Overview
Public Policy:
With the rejection of the exclusive regulatory stand after the 1990s
in favour of a developmental role of the state, the study of public
policy has become a significant discipline in recent times.
Theoretical aspects of public policy, its meaning, significance and
models for public policy analysis.
Emphasis on theory and conceptual premises alongside contextual
analysis of public policy
Analyse its implementation in India, the United States and in a
globalized world.
As the state has proved itself to be a catalyst of development, the
impact of the policy changes on areas such as public life, rural
development, anti-poverty programmes and decentralized planning
is to be analysed.
Overview
Public Finance is the study of
the role of the government in the
economy.
The purview of public finance is
considered to be governmental
effects on:
efficient allocation of resources
distribution of income
macroeconomic stabilization
Overview
The proper role of government provides a starting for the
analysis of public finance.
In theory, under certain circumstances, private markets will

allocate goods and services among individuals efficiently.
Market failure occurs when private markets do not allocate
goods or services efficiently. The existence of market failure
provides an efficiency-based rationale for collective or
governmental provision of goods and services.
Overview
Public sector programs should be designed to maximize
social benefits minus costs (cost-benefit analysis), and then
revenues needed to pay for those expenditures should be
raised through a taxation system that creates the fewest
efficiency losses.
Government can pay for spending by borrowing although
borrowing is a method of distributing tax burdens through
time rather than a replacement for taxes.
A deficit is the difference between government spending and
revenues. The accumulation of deficits over time is the total
public debt
Overview
Deficit finance allows governments to smooth
tax burdens over time, and gives governments
an important fiscal policy tool. Deficits can also
narrow the options of successor governments.
Public finance is closely connected to issues of
income distribution and social equity.
Governments can reallocate income through
transfer payments or by designing tax systems
that treat high-income and low-income
households differently.
Overview
Public policy doctrine concerns the body of
principles that strengthen the operation of legal
systems in each state. This addresses the social,
moral and economic values that tie a society
together: values that vary in different cultures
and change over time.
Overview
The fundamental principle in the operation
of a legal system is that ignorantia juris non
excusat (ignorance of the law is no excuse).
Strengthening most social, moral and religious
systems is the policy of sanctity of life.
Similarly, in many branches of law, the
Doctrine of Evasion prevents persons from
evading the application of obligations and
liabilities already attaching to them.
Resource Generation: Collection

of sufficient resources from the
economy in an appropriate
manner along with allocating
(Resource allocation)
Expenditure Management: Use
of these resources efficiently
Resource Utilization: Effectively
constitute good financial
management
Essential
components of a
Public Financial
Management
system:
Public Finance Management
Government purchases of goods and services

for current use are classed as government
consumption.
Government purchases of goods and services
intended to create future benefits- such as
infrastructure investment or research
spending are classed as government
investment.
Government expenditures that are not
purchases of goods and services, and instead
just represent transfers of money- such as
social security payments are called transfer
payments
Economists classify
government
expenditures into
three main types:
Government operations are those

activities involved in the running of a
state or a functional equivalent of a
state for the purpose of producing value
for the citizens.
Government operations have the power
to make, and the authority to enforce
rules and laws within a civil, corporate,
religious, academic, or other
organization or group.
In its broadest sense, "to govern" means
to rule over or supervise, whether over a
state, a set group of people, or a
collection of people
Governm
ent
Operatio
ns
Some forms of government

expenditure are specifically
intended to transfer income from
some groups to others.
Other forms of government
expenditure which represent
purchases of goods and services
also have an effect of changing
the income distribution
Income
Distribut
ion
Government Revenue:
Taxes
Non-tax revenue
Government borrowing
Printing of Money
Privatization
Government
expenditures are
financed in the
following ways:
Financing of Government
Expenditures
Taxation is the central part of modern public

finance.
The main objective of taxation is raising revenue
to meet its ever-growing expenditure on
administration and social services .
It is used as an instrument of attaining certain
social objectives i.e. as a means of redistribution
of wealth and thereby reducing inequalities.
It is used to reduce the inequalities of
income and wealth.
Taxation is also needed to draw away
money that would otherwise go into
consumption and cause infation to rise
Tax
es
Expenditures
Expenditures - Taxes
Direct Tax (which is proportional) , e.g.
Corporate income tax on corporations (incorporated entities)
Wealth tax
Personal income tax (may be levied on individuals, families such
as the Hindu Joint Family in India, unincorporated associations,
etc.)
Gift tax
Indirect tax (which is differential in nature):
Stamp duty, levied on documents

Excise tax (tax levied on production)
Sales tax (tax on business transactions, especially the sale of
goods and services)
Value added tax (VAT) is a type of sales tax
Services taxes on specific services
Duties (taxes on importation, levied at customs)
Road tax; Vehicle excise duty (UK), Registration Fee (USA), Regco
(Australia), Vehicle Licensing Fee (Brazil) etc.
Governments, like any other

legal entity, can take loans,
issue bonds and make
financial investments.
Government/Public/National
debt is money (or credit)
owed by any level of
government
(central/municipal or local
government)
Debt
Expenditures
Government debt can be categorized as

internal debt, owed to lenders within the
country, and external debt, owed to foreign
lenders.
Governments usually borrow by issuing
securities such as government bonds and
bills.
Less creditworthy countries sometimes
borrow directly from commercial banks or
international institutions such as the
International Monetary Fund or the World
Bank
Deb
t
Expenditures
Most government budgets are calculated on a cash

basis, meaning that revenues are recognized when
collected and outlays are recognized when paid.
Some consider all government liabilities, including
future pension payments and payments for goods
and services the government has contracted for
but not yet paid, as government debt. This
approach is called accrual accounting, meaning
obligations are recognized when they are acquired,
or accrued, rather than when they are paid
Deb
t
Expenditures
Is the net revenue derived from the

issuing of currency. It arises from
the difference between the face
value of a coin or bank note and the
cost of producing, distributing and
eventually retiring it from
circulation.
Is an important source of revenue
for some national banks, although it
provides a very small proportion of
revenue for advanced industrial
countries
Seignior
age
Expenditures
Public finance in centrally planned

economies has differed in fundamental
ways from that in market economies.
Some state-owned enterprises
generated profits that helped finance
government activities.
In market-oriented economies with
substantial state enterprise, (Venezuela),
the state-run oil company PSDVA
provides revenue for the government to
fund its operations and programs that
would otherwise be profit for private
owners
Public
Finance
through
State
Enterpris
e
Expenditures
In various mixed economies, the

revenue generated by state-run or
state-owned enterprises are used for
various state endeavours. Various
market socialist systems or proposals
utilize revenue generated by staterun enterprises to fund social
dividends, eliminating the need for
taxation altogether
Public
Finance
through
State
Enterprise
Expenditures
Measuring Govt.
Economic Operations
(Contd.)
The general government sector of a

nation includes all non-private sector
institutions, organisations and
activities. The general government
sector, by convention, includes all the
public corporations that are not able to
cover at least 50% of their costs by
sales, and, therefore, are considered
non-market producers.
Measuring Govt. Economic

Operations (Contd.)
Measuring Govt. Economic

Operations (Contd.)
Measuring Govt.
Economic Operations
The general government sector has three sub-sectors:
"Central government" consists of all administrative
departments of the state and other central agencies whose
responsibilities cover the whole economic territory of a
country, except for the administration of social security funds.
"State government" is defined as the separate institutional
units that exercise some government functions below those
units at central government level and above those units at
local government level, excluding the administration of social
security funds.
"Local government" consists of all types of public
administration whose responsibility covers only a local part of
the economic territory, apart from local agencies of social
security funds.
Measuring Govt.
Economic Operations
(Contd.)
Financial Accounting of Governments:

Governments produce a full set of
financial statements including the
statement of government operations
(akin to the income statement), the
balance sheet, and a
cash flow statement.
Measuring Govt.
Economic Operations
(Contd.)
The governments balance sheet presents the level

of the debt, i.e., the governments liabilities. Hence
it provides data to help estimate the resources a
government can potentially access to repay its debt.
The memorandum items of the balance sheet
provide additional information on the debt including
its maturity and whether it is owed to domestic or
external residents.
The balance sheet also presents a disaggregated
classification of financial and non-financial
assets.
Measuring Govt.
Economic Operations
The statement of operations (income
statement) contains the revenue and expense
accounts of the government.
The revenue accounts are divided into
subaccounts, including the different types of
taxes, social contributions, dividends from the
public sector, and royalties from natural
resources.
Finally, the interest expense account is one
of the necessary inputs to estimate the cost of
servicing the debt.
Public Policies, Health

Systems and Services
(Contd.)
Health is a critical contributor to the success of

social policies that enable the attainment of
national goals of social and economic
development.
Attaining those goals depends on effective
health policies.
Addressing health policy issues, which shape the
health system, poses problems because social
needs are multidimensional, adverse effects
can be cumulative, resources are finite, and,
frequently, solutions lie outside the health sector.
Public Policies, Health

Systems and Services
(Contd.)
Health policies are important because

they directly or indirectly affect all
aspects of daily life, actions,
behaviours, and decisions.
The Public Policy Action

Relationship
Most of the literature on the policy
process focuses on how policy is made.
There is a part concerned with the
relationship between policy and what
actually happens in the process of
delivery.

Relationship
By the time a policy is being rolled out, those at
the centre are already focusing on the next
problem or policy innovation and staff may have
moved on to an entirely different policy area. Yet,
clearly, implementation is crucial to the success of
any policy.
This unit is not concerned with technical questions
about policy instruments and levers, but with a
deeper question: how does change happen as a
result of new policies? The aim is to explore the
relationship between policy and action

Relationship
Models of Implementation
Policy delivery seems to be growing in importance.
- for example, the Blair governments in the UK were, from
the outset, preoccupied with delivery, delivery, delivery
as ministers and prime minister grew increasingly
frustrated with what was often viewed as the
intransigence of public service professionals.
- The constant cycle of change, in which new policies and
initiatives were introduced in rapid succession, producing
what critics described as policy overload or initiativitis,
can be understood in part as a result of prime ministerial
and ministerial frustration. This also produced an
explosion of new regulatory mechanisms
E- Governance
Definition
Scope
Objective
Advantages
Strategies
E- Governance
Definition:
The term E-government is misleading, as it implies an
electronic substitute for the physical government. Electronic
substitution of a government is not possible as Government
is a unit of people coming together to administer a
country.
A Government is a group of people responsible for the
administration and control of a Country/State. It involves
people like the Heads of States, Ministers, Government
Employees, etc. It also involves public participation. So
electronic substitution for a Government is not possible.
E- Governance
Definition:
Electronic Governance means using Information and
Communications Technology (ICT) to transform functioning
of the Government/ to run or carry on the business of the
Government of a Country.
It differs from E-Government as Governance is wider
than Governance. E-governance may refer to governance
of a Country, or the governance of an institution and also
governance of a Household by a housewife.
E-Governance in the popular parlance refers only to the
governing of a Country/State using ICT
E- Governance
Definition:
E-Governance therefore means the application of
ICT to transform the efficiency, effectiveness,
transparency and accountability of exchange
of information and transaction:
between Governments,
between Government agencies,
between Government and Citizens
between Government and businesses.
E-governance also aims to empower people
through giving them access to information.
E- Governance
Scope:
Governance is all about flow of information
between the Government and Citizens,
Government and Businesses and
Government and Government. E-Governance
also covers all these relationships as follows:
A. Government to Citizen
(G2C)
B. Citizen
to Government (C2G)
C. Government to Government (G2G)
D. Government to Business
(G2B)
E- Governance
Scope:
A.Government to Citizen (G2C):
In modern times, Government deals
with many aspects of the life of a
citizen. The relation of a citizen with
the Government starts with the birth
and ends with the death of the citizen.
E- Governance
Scope:
Government to Citizen (G2C):
The G2C relation will include the services provided by the
Government to the Citizens. These services include the
public utility services i.e. Telecommunication,
Transportation, Post, Medical facilities, Electricity,
Education and also some of the democratic services
relating to the citizenship such as Certification,
Registration, Licensing, Taxation, Passports, ID Cards etc.
Therefore E-Governance in G2C relationship will involve
facilitation of the services flowing from Government
towards Citizens with the use of Information and
Communications Technology (ICT).
E- Governance
Scope:
Therefore E-Governance in G2C relationship will involve
facilitation of the services flowing from Government
towards Citizens with the use of Information and
Communications Technology (ICT).
E-Citizenship
E-Registration
E-Transportation
E-Health
E-Help
E-Taxation
E- Governance
Scope:
E-Citizenship:
Includes the implementation of ICT for facilitation of Government Services
relating to citizenship of an individual. It involves online transactions
relating to issue and renewal of documents like Ration Cards, Passports,
Election Cards, Identity Cards, etc. It will require the Government to create a
virtual identity of every citizen so as to enable them to access the
Government services online. For the same, Government would need to
create a Citizen Database which is a huge task.
E-Registration:
E-Registration will cover the online registration of various contracts. An
individual enters into several contracts during his life. Many of these
contracts and transactions require registration for giving it legality and
enforceability. Such registration may also be made ICT enabled. Eregistration will help to reduce a significant amount of paperwork.
E- Governance
Scope:
E-Transportation:
E-Transportation services would include ICT enablement of
services of Government relating to Transport by Road, Rail, Water
or Air. This may involve online
booking and cancellation of tickets,
status of vehicles, railways, boats and flights,
issue and renewal of Driving Licences,
registration and renewal of vehicles,
transfer of vehicles,
payment of the fees of licences,
payment of fees and taxes for vehicle registration.
E- Governance
Scope:
E-Health:
E-Health services would be ICT enablement of the health services
of the Government. Under this interconnection of all hospitals may
take place. A patient database may be created. A local pharmacy
database may also be created. All this can be done.
E-Education - E-Education would cover the implementation of ICT
in imparting of education and conducting of Courses. Distant as
will as classroom education will be facilitated with the use of ICT.
Use of internet can reduce the communication time required in
Distance education; Internet may also help in conducting online
classes.
E- Governance
Scope:
E-Help:
E-Help refers to facilitation of disaster and crisis management
using ICT. It includes the use of technologies like internet, SMS,
etc. for the purpose of reducing the response time of the
Government agencies to the disasters. NGOs help Government in
providing help in situations of disasters. Online information relating
to disasters, warnings and calls for help can help the Government
and the NGOs coordinate their work and facilitate and speed up
the rescue work.
E-Taxation - E-Taxation will facilitate the taxing process by
implementing ICT in the taxing process. Online tax due alerts and
online payment of taxes would help transact faster.
E- Governance
Scope:
Citizen to Government (C2G):
Citizen to Government relationship will include the communication
of citizens with the Government arising in the Democratic process
like voting, campaigning, feedback, etc.
E-Democracy - The true concept of Democracy includes the
participation of the citizens in the democratic and governing
process. Today due to the increased population the active
participation of the citizens in governing process is not possible. The
ICT can help enable the true democratic process including voting,
public opinion, feedback and Government accountability.
E-Feedback includes the use of ICT for the purpose of giving
feedback to the Government. Lobbying is pursuing the Government
to take a certain decision. Use of ICT can enable online feedback to
the Government, online debates as to the Government services.
E- Governance
Scope:
Government to Government (G2G):
G2G relationship would include the relationships between Central
and State Government and also the relationship between two or
more Government departments.
E-administration - E-administration would include the
implementation of ICT in the functioning of the Government,
internally and externally. Implementation of ICT can reduce the
communication time between the Government Departments and
Governments. It can substantially reduce paperwork if properly
used. E-administration will also bring morality and transparency
to the administration of Government Departments.
E- Governance
Scope:
Government to Government (G2G):
E-police - The concept of E-police is little different from CyberPolice. Cyber Police require technology experts to curb the
electronic/cyber crimes. E-police refers to the use of ICT for the
purpose of facilitating the work of the Police department in
investigation and administration. The concept of E-police includes
databases of Police Officers, their performances, Criminal
databases wanted as well as in custody, the trends in crimes and
much more. ICT can help reduce the response time of the Police
department and also reduce cost by reducing paperwork.
3. E-courts - The concept of E-Court will include the ICT
enablement of the judicial process. Technology may help distant
hearing, online summons and warrants and online publication of
Judgments and Decrees.
E- Governance
Scope:
Government to Business (G2B):

E-Taxation : Corporate sector pays many taxes, duties and dues to the
Government. Payment of these taxes and duties will be made easier by ETaxation. Online taxing and online payment of taxes can help reduce cost and
time required for physical submission of taxes. ICT can also help crosscheck the
frauds and deficiencies in payment, further bringing accuracy and revenue to
the Government.
E-Licencing : Companies have to acquire various licences from the
Government, similarly the companies have to acquire various registrations. ICT
enablement of the licensing and registration can reduce time and cost.
E-Tendering : E-Tendering will include the facilities of online tendering and
procurement. It will online alerts as to new opportunities of business with the
Government and also online submission of tenders and online allotment of
work. It will reduce time and cost involved in the physical tendering system.
E- Governance
Objectives:
The object of E-Governance is to provide a SMARRT Government. The Acronym SMART refers to
Simple, Moral, Accountable, Responsive, Responsible and Transparent Government.
S - The use of ICT brings simplicity in governance through electronic documentation, online
submission, online service delivery, etc.
M - It brings Morality to governance as immoralities like bribing, red-tapism, etc. are eliminated.
A - It makes the Government accountable as all the data and information of Government is
available online for consideration of every citizen, the NGOs and the media.
R - Due to reduced paperwork and increased communication speeds and decreased
communication time, the Government agencies become responsive.
R - Technology can help convert an irresponsible Government Responsible. Increased access to
information makes more informed citizens. And these empowered citizens make a responsible
Government.
T - With increased morality, online availability of information and reduced red-tapism the
process of governance becomes transparent leaving no room for the Government to conceal any
information from the citizens.
These objects of E-Governance are achievable with the use of ICT and therefore the concept is
very alluring and desirable.
E- Governance
Objectives/Aims of E Governance :
To build an informed society: An informed society is an
empowered society. Only informed people can make a Government
responsible. So providing access to all to every piece of
information of the Government and of public importance is
one of the basic objective of E-Governance.
To increase Government and Citizen interaction: In the
physical world, the Government and Citizens hardly interact. The
amount of feedback from and to the citizens is very negligible. EGovernance to aims at build a feedback framework, to get
feedback from the people and make the Government aware
of people's problems.
E- Governance
To encourage citizen participation - True democracy requires participation
of each individual citizen. Increased population has led to representative
democracy, which is not democracy in the true sense. E-governance aims to
restore democracy to its true meaning by improving citizen participation in
the Governing process, by improving the feedback, access to information and
overall participation of the citizens in the decision making.
To bring transparency in the governing process - E-governance carries
an objective to make the Governing process transparent by making all the
Government data and information available to the people for access. It is to
make people know the decisions, and policies of the Government.
E- Governance
To make the Government accountable: Government is responsible and answerable for
every act decision taken by it. E-Governance aims and will help make the Government more
accountable than now by bringing transparency's and making the citizens more
informed.
To reduce the cost of Governance - E-Governance also aims to reduce cost of
governance by cutting down on expenditure on physical delivery of information and
services. It aims to do this by cutting down on stationary, which amounts to the most
of the government's expenditure. It also does away with the physical communication
thereby reducing the time required for communication while reducing cost.
To reduce the reaction time of the Government Normally due to red-tapism and
other reasons, the Government takes long to reply to people's queries and problems. EGovernance aims to reduce the reaction time of the Government to the people's
queries and problems,.
E- Governance
Advantages:
Speed: Technology makes communication
speedier. Internet, Phones, Cell Phones have
reduced the time taken in normal communication.
Cost Reduction: Most of the Government
expenditure is appropriated towards the cost of
stationary. Paper-based communication needs lots
of stationary, printers, computers, etc. which calls
for continuous heavy expenditure. Internet and
Phones makes communication cheaper saving
valuable money for the Government.
E- Governance
Advantages:
Transparency: Use of ICT makes governing profess transparent.
All the information of the Government would be made available
on the internet. The citizens can see the information whenever
they want to see. But this is only possible when every piece of
information of the Government is uploaded on the internet and is
available for the public to peruse. Current governing process
leaves many ways to conceal the information from all the people.
ICT helps make the information available online eliminating all the
possibilities of concealing of information.
Accountability : Once the governing process is made
transparent the Government is automatically made accountable.
Accountability is answerability of the Government to the people. It
is the answerability for the deeds of the Government. An
accountable Government is a responsible Government.
E- Governance
Strategies:
To build technical
infrastructure/framework across
India.
To build institutional capacity
To build legal infrastructure
To build judicial infrastructure
E- Governance
Strategies:
To make all information available
online
To popularise E-governance
Centre-State Partnership
To set standards
E-Governance
Example:
The Central Vigilance Commission (CVC) in India started an initiative
to create a website with the objective of reducing corruption and
increasing transparency by sharing a large amount of information
related to corruption with citizens. The CVC website communicates
directly with the public through messages and speeches to bolster
confidence in the institution, informs the public about its efforts in
fighting corruption, and makes public
the names of officers from the elite administrative and revenue
services against whom investigations have been ordered or penalties
imposed for corruption. Members of the public are highly encouraged
(mainly by rewards) to make their complaints and to provide
information against a public servant about taking of bribes in order
for the commission to undertake the necessary anticorruption actions
to eliminate bribery and to increase the transparency of rules,
procedures and service delivery.
E-Governance
Example:
In India, the Gyandoot project is a government-to-citizen intranet
project which offers numerous benefits to the region, to citizens and
to the community in general. The goal of the project has been to
establish community owned technologically innovative and
sustainable information kiosks in a poverty-stricken rural area of
Madhya Pradesh. The benefits assured by this intranet system have
increased the awareness of ICT importance and have spin off other
IT initiatives and programs, such as: the creation of new private ICT
training institutions; a high level of student enrolment about 60%;
parliament has allocated resources to set up other kiosks in schools
and to develop new models for e-education; Indira Gandhi National
Open University has opened a study center for undergraduate and
postgraduate courses on computer applications; the government
has instituted a cash award to motivate ICT projects.
Crowding Out Effect

Definition:
An economic concept where increased public sector spending
replaces, or drives down, private sector spending. Crowding
out refers to when government must finance its spending with
taxes and/or with deficit spending, leaving businesses with
less money andeffectively "crowding them out." One
explanation of why crowding out occurs is government
financing of projects with deficit spending through the use of
borrowed money. Because the government borrows such large
amounts of capital, its activities can increase interest rates.
Higher interest rates discourage individuals and businesses
from borrowing money, which reduces their spending and
investment activities.
Crowding Out Effect

Thus crowding out effect describes
the idea that large volumes of
government borrowing push up the
real interest rate, making it difficult or
close to impossible for individuals and
small companies to obtain loans.
Crowding Out Effect

For example, the higher taxes required for
government to fund social welfare programs
leaves less discretionary income for individuals
and businesses to make charitable donations.
Further, when government funds certain activities
there is little incentive for businesses and
individuals to spend on those same things.
Another example is increased government
spending on Medical aid, whichhas been linked to
decreased availability of private health insurance.
Crowding Out Effect

How It Works:
The theory behind the crowding out effect assumes that governmental borrowing uses up a
larger and larger proportion of the total supply of savings available for investment. Because
demand for savings increases while supply stays the same, the price of money (the interest
rate) goes up.
Crowding out begins to take effect when the interest rate level reaches a point at which only
the government can afford to borrow. Unable to compete for loans under such
circumstances, individuals and smaller-scale companies are forced (crowded) out of the
market.
Why It Matters:
Because crowding out leads to decreases in private sector consumption and, therefore,
slows economic growth, the crowding out effect should be a serious consideration for any
government that plans to get an increasing percentage of its funding through the
capital markets.
Crowding Out Effect

Crowding out effect occurs when governments
borrow funds from other countries to finance
government spending usually through expansionary
fiscal policies.
This is of concern because the government is
overspending i.e. revenue that is collected from
taxes and other relevant transactions is less than the
amount put forward in the budget and more recently,
large stimulus packages (e.g., what America had
done in the past few months of 2009).
Crowding Out Effect

When the government borrows from another country,
interest rate in that country goes up because an increase
in demand for loans, hence pushing up the prices. Because
the interest rate of the central bank subsequently
influences the interest rates of commercial or private
banks, this would in turn discourage private borrowing.
Using the Marginal Efficiency Capital Theory, firms with
planned investments will choose to postpone them and
consumers who have plans of buying large scale durable
goods will do likewise.
Crowding Out Effect

Increase in government spending crowd
outs some private borrowing. Again, the
severity of the effect is largely determined
by the magnitude of the crowding out
effect i.e. if the effect was significant,
fiscal policies undertaken by governments
would largely become ineffective.
Crowding Out Effect

Consider another source of crowding out effect through the FOREX
markets. The increase in borrowings of foreign funds raises the interest
rates of the central bank and commercial banks. Given that most
countries adopt a free capital movement policy, the rise in interest rate
makes it attractive for investors to save in that country's financial
market. This raises the demand for the country's currency causing it to
appreciate which would in turn make imports cheaper and exports more
expensive relative to the prices of foreign goods. This increases imports
and decreases exports causing net exports to decrease - this is actually a
decrease in aggregate demand (AD). Hence, the increase in
government spending to boost the economy fails to do so as
expected as it crowds out an increase in net exports, even
causing it to fall further.
Crowding Out Effect

Thus the crowding out effects of fiscal policy must be
minimised in order to maximise its effectiveness.
Crowding out effect is one of the adverse effects of
Keynesian policies; the other being chronic budget
deficits. In fact, many economic analysts are fearing
that President Obama's fiscal stimulus plan might cause
America to suffer huge budget deficits. The issue at
hand still remains largely controversial.
IS-LM MODEL AND CROWDING OUT

EFFECT
Definition of 'IS-LM Model'
A macroeconomic model that graphically represents two intersecting
curves, called the IS and LM curves.
The investment/saving (IS) curveis a variation of the incomeexpenditure model incorporating marketinterest rates (demand for this
model), while the liquidity preference/money supply equilibrium (LM)
curve represents the amount of money available for investing (supply
for this model).
The model attempts to explain the investing decisions made by
investors given the amount of money they have available and the
interest rate they will receive. Equilibrium occurs when the amount of
money invested equals the amount of money available for investing.
IS-LM MODEL
Since this is a non-dynamic model, there is a fixed
relationship between the nominal interest rate and the
real interest rate (the former equals the latter plus the expected
inflation rate which is exogenous in the short run); therefore
variables such as money demand which actually depend on the
nominal interest rate can equivalently be expressed as
depending on the real interest rate.
The point where these schedules intersect represents a shortrun equilibrium in the real and monetary sectors (though not
necessarily in other sectors, such as labor markets): both the
product market and the money market are in equilibrium. This
equilibrium yields a unique combination of the interest rate and
real GDP.
IS MODEL
The IS curve is defined by the equation:
Y = C(Y-T(Y))+ I(i)+G+(X-M(Y))
where Y represents income, C represents consumer spending as an
increasing function of disposable income (income, Y, minus taxes,
T(Y), which themselves depend positively on income), represents
investment as a decreasing function of the real interest rate, G
represents government spending, and X-M represents net exports
(exports minus imports) as a decreasing function of income
(decreasing because imports are an increasing function of income).
In this equation, the level of G (government spending) is presumed
to be exogenous, meaning that it is taken as a given.
IS MODEL
The IS curve is a locus of points of equilibrium in the "real" (non-financial)
economy. Given expectations about returns on fixed investment, every level
of the real interest rate (i) will generate a certain level of planned fixed
investment and other interest-sensitive spending: lower interest rates
encourage higher fixed investment and the like. Income is at the equilibrium
level for a given interest rate when the saving that consumers and other
economic participants choose to do out of this income equals investment .
The multiplier effect of an increase in fixed investment resulting from a lower
interest rate raises real GDP. This explains the downward slope of the IS
curve.
In summary, this line represents the causation from falling interest rates to
rising planned fixed investment (etc.) to rising national income and output.
LM MODEL
For the Liquidity preference and Money supply curve, the independent variable is
"income" and the dependent variable is "the interest rate." The LM curve shows the
combinations of interest rates and levels of real income for which the money
market is in equilibrium. It is an upward-sloping curve representing the role of
finance and money.
The LM function is the set of equilibrium points between the liquidity preference (or
Demand for Money) function and the money supply function (as determined by
banks and central banks).
Each point on the LM curve reflects a particular equilibrium situation in the money
market equilibrium diagram, based on a particular level of income. In the money
market equilibrium diagram, the liquidity preference function is simply the
willingness to hold cash balances instead of securities. For this function, the
nominal interest rate (on the vertical axis) is plotted against the quantity of cash
balances (or liquidity), on the horizontal. The liquidity preference function is
downward sloping. Two basic elements determine the quantity of cash balances
demanded (liquidity preference) and therefore the position and slope of the
function:
LM MODEL
DEMAND FOR MONEY:
- willingness to hold cash for everyday transactions and
- a precautionary measure (money demand in case of emergencies).
1) Transactions demand for money:
Transactions demand is positively related to real GDP (represented by Y,
Income). This is simply explained - as GDP increases, so does spending and
therefore transactions. As GDP is considered exogenous to the liquidity
preference function, changes in GDP shift the curve. For example, an
increase in the demand for money for transactions will increase interest rates
through the money market, and cause the LM curve to shift to up and to the
left.
2) Speculative demand for money:
- willingness to hold cash instead of securities as an asset for investment
purposes. Speculative demand is inversely related to the interest rate. As the
interest rate rises, the opportunity cost of holding cash increases - the
incentive will be to move into securities.
LM MODEL
Money supply is determined by the central bank decisions and willingness of commercial banks
to loan money. Though the money supply is related indirectly to interest rates in the very
short run, the money supply in effect is perfectly inelastic with respect to nominal interest rates
(assuming the central bank chooses to control the money supply rather than focusing directly
on the interest rate). Thus the money supply function is represented as a vertical line - money
supply is a constant, independent of the interest rate, GDP, and other factors.
Mathematically, the LM curve is defined by the equation:
Ms/P=Md(i, Y)
where the supply of money is represented as the real amount M/P (as opposed to the nominal
amount M), with P representing the price level, and L being the real demand for money, which
is some function of the interest rate i and the level Y of real income. The LM curve shows the
combinations of interest rates and levels of real income for which money supply equals
money demandthat is, for which the money market is in equilibrium.
For a given level of income, the intersection point between the liquidity preference and money
supply functions implies a single point on the LM curve: specifically, the point giving the level of
the interest rate which equilibrates the money market at the given level of income.
An increase in GDP shifts the liquidity preference function rightward and hence raises the
interest rate. Thus the LM function is positively sloped.
IS-LM and Crowding Out

effect
One hypothesis is that a government's deficit spending ("fiscal policy") has an

effect similar to that of a lower saving rate or increased private fixed investment,
increasing the amount of demand for goods at each individual interest rate. An
increased deficit by the national government shifts the IS curve to the right. This
raises the equilibrium interest rate (from i1 to i2) and national income (from Y1 to
Y2), as shown in the graph above. The equilibrium level of national income in the ISLM diagram is referred to as aggregate demand.
By the above hypothesis, the graph indicates one of the major criticisms of
deficit spending as a way to stimulate the economy: rising interest rates lead to
crowding out i.e., discouragement of private fixed investment, which in turn may
hurt long-term growth of the supply side (potential output).
Keynesians respond that deficit spending may actually "crowd in" (encourage)
private fixed investment via the accelerator effect, which helps long-term growth.
Further, if government deficits are spent on productive public investment (e.g.,
infrastructure or public health) that directly and eventually raises potential output,
although not necessarily more (or less) than the lost private investment might have.
The extent of any crowding out depends on the shape of the LM curve. A shift in the
IS curve along a relatively flat LM curve can increase output substantially with little
change in the interest rate. On the other hand, an upward shift in the IS curve along
a vertical LM curve will lead to higher interest rates, but no change in output.
IS-LM MODEL
IS-LM and Crowding Out

effect
Rightward shifts of the IS curve also result from exogenous increases in

investment spending (i.e., for reasons other than interest rates or income),
in consumer spending, and in export spending by people outside the
economy being modelled, as well as by exogenous decreases in spending
on imports. Thus these too raise both equilibrium income and the
equilibrium interest rate. Of course, changes in these variables in the
opposite direction shift the IS curve in the opposite direction.
The IS/LM model also allows for the role of monetary policy. If the money
supply is increased, that shifts the LM curve downward and to the right,
lowering interest rates and raising equilibrium national income. Further,
exogenous decreases in liquidity preference, perhaps due to improved
transactions technologies, lead to downward shifts of the LM curve and
thus increases in income and decreases in interest rates. Changes in these
variables in the opposite direction shift the LM curve in the opposite
direction.
Crowding Out Effect

The IS curve moves to the right, causing higher interest rates (i) and expansion in
the "real" economy (real GDP, or Y).
In economics, crowding out is a phenomenon occurring when expansionary
fiscal policy causes interest rates to rise, thereby reducing investment spending.
That means increase in government spending 'crowds out' investment spending.
Changes in fiscal policy shifts the IS curve, the curve which describes equilibrium in
the goods market. A Fiscal Expansion shifts IS curve to the right from IS1 to IS2. A
fiscal expansion increases equilibrium income from Y1 to Y2 and interest rates from
i1 to i2. At unchanged interest rates i1, the higher level of government spending
increase the level of Aggregate Demand. This increase in demand must be met by
rise in output. At each level of interest rate, equilibrium income must rise by the
multiplier times the increase in government spending.
Crowding Out Effect

If the interest rate stayed constant at i1, the goods market is in
equilibrium in that planned spending equals output, but the assets
market is no longer in equilibrium. Income has increased, and,
therefore, the quantity of money demanded is higher. Because there is
an excessive demand for real balances, the interest rate rises. Firms
planned spending declines at higher interest rates, thus the aggregate
demand falls. Therefore, the equilibrium is at higher interest rates. The
adjustment of interest rates and their impact on aggregate demand
dampen the expansionary effect of the increased government spending.
Crowding Out Effect

What factors determine how much crowding out takes place?
The extent to which interest rate adjustments dampen the output
expansion induced by increased government spending is determined by:
Income increases more, interest rates increase less, the flatter LM
(Liquidity preferenceMoney supply) curve.
Income increases less, interest rates increase less, the flatter IS
(InvestmentSaving) curve.
Income and interest rates increase more the larger the multiplier, thus,
the larger the horizontal shift in the IS curve.
In each case, the extent of crowding out is greater the more interest rate
increases when government spending rises.
Crowding Out Effect

Two extreme cases:
(I) Liquidity trap
If the economy is in the liquidity trap, the LM curve is horizontal, an increase in
government spending has its full multiplier effect on the equilibrium income. There is
no change in the interest associated with the change in government spending, thus
no investment spending cut off. Therefore no dampening of the effects of increased
government spending on income. If the demand for money is very sensitive to
interest rates, so that the LM curve is almost horizontal, fiscal policy changes have a
relatively large effect on output, while monetary policy changes have little effect on
the equilibrium output. So, if the LM curve is horizontal, monetary policy has no
impact on the equilibrium of the economy and the fiscal policy has a maximal effect.
Crowding Out Effect

(II)
The Classical Case and crowding out:
If the LM curve is vertical, then an increase in government spending has no effect on

the equilibrium income and only increases the interest rates. If the demand for money
is not related to the interest rate, as the vertical LM curve implies, then there is unique
level of income at which the money market is in equilibrium.
Thus, with vertical LM curve, an increase in government spending cannot change the
equilibrium income and only raises the equilibrium interest rates. But if government
spending is higher and the output is unchanged, there must be an offsetting reduction
in private spending. In this case, the increase in interest rates crowds out an amount of
private spending equal to increase in government spending. Thus, there is full
crowding out if LM is vertical.
Crowding Out Effect

Is Crowding Out Likely?
The question is how seriously we must take the possibility of crowding out?
This is discussed in three points given below:
(I) Consider an economy with given prices, in which the economy operates
below full employment. Under such conditions, when fiscal expansion
increases demand, firms can increase their output by hiring more workers.
But if the economy is at full employment level, crowding out becomes a
much more realistic possibility because firms cannot increase their output
through additional hiring. In this situation an increase in demand will lead to
an increase in price level rather than an increase in output.
Crowding Out Effect

(II) In an economy with unemployed resources full crowding
out will not occur because the LM curve is not vertical. A
fiscal expansion will raise interest rates, but income will
also rise depending on the slope of the LM curve.
Crowding out, if it occurs, is thus a matter of degree.
Crowding Out Effect

(III)Monetary authorities can accommodate a fiscal expansion by
increasing the money supply, thus dampening any rise in interest
rates. This monetary accommodation is referred to as "
monetizing the deficit", where the central bank prints money to buy
bonds issued by the government to pay for its expansionary deficit. In
this case, both IS and LM curves shift to right, resulting in increased
output at the same interest rate. Thus with an appropriate monetary
policy complementing fiscal policy, there need not be any crowding
out of private investment.
FISCAL POLICY AND

ECONOMIC REFORMS IN
INDIA
BACKGROUND:
Broadly, during the first 30 years of independence, between 1950 and 1980,
the
fiscal deficits of both the central and the state governments were not
excessive.
This was a period of revenue surplus in general. However, automatic
monetisation of government deficit by the RBI, which started as an exception
during the mid 1950s, became a regular practice thereafter.
Simultaneously, there was also a distinct shift in the management of the financial
sector with the nationalisation of major commercial banks in 1969 and
1980. These two developments had a significant bearing on the relationship
between the monetary authority (RBI) and the fiscal authority (Government).
There was a significant deterioration in the fiscal situation in the 1980s,
accompanied by large and automatic monetisation of government deficits.
FISCAL POLICY AND

ECONOMIC REFORMS IN
INDIA
The process involved issue of ad-hoc Treasury bills.
Since July 1974, the ad-hoc Treasury bills were offered at off-market discount
rate of 4.6 percent, which was less than half of the prevailing market rates.
There were two immediate consequences:
- When large government deficits were monetised, there was excess liquidity
in the system, which prompted the monetary authorities to increase the
cash reserve ratio (CRR) for banks at regular intervals with a view to mop
up the excess liquidity.
- To facilitate the central government to borrow comfortably, the monetary
authority, which is also the debt manager for the government, periodically
increased the statutory liquidity ratio (SLR) to be maintained by banks.
This process went on to an extent that CRR and SLR, together, pre-empted
more than 50 percent of banking sector liabilities, for a period.
FISCAL POLICY AND

ECONOMIC REFORMS IN
INDIA
The process involved issue of ad-hoc Treasury bills.
Since July 1974, the ad-hoc Treasury bills were offered at off-market discount rate of 4.6 percent,
which was less than half of the prevailing market rates.
There were two immediate consequences:
- When large government deficits were monetised, there was excess liquidity in the system, which
prompted the monetary authorities to increase the cash reserve ratio (CRR) for banks at regular
intervals with a view to mop up the excess liquidity.
- To facilitate the central government to borrow comfortably, the monetary authority, which is also
the debt manager for the government, periodically increased the statutory liquidity ratio (SLR)
to be maintained by banks.
This process went on to an extent that CRR and SLR, together, pre-empted more than 50 percent of
banking sector liabilities, for a period.
In other words, more than 50 percent of the resources of the banking sector were preempted
to primarily finance the budget deficits of the governments. Further, the deposit and
lending rates of banks were, for most part, administered. This situation impacted the health
of the banking system and the consequential adjustments during the banking sector
reform process were, naturally, somewhat complex.
The large fiscal deficit and its monetisation had some spill-over effect on the
FISCAL POLICY AND

ECONOMIC REFORMS IN
INDIA
In other words, more than 50 percent of the resources of the banking sector were pre-empted
to primarily finance the budget deficits of the governments.
Further, the deposit and lending rates of banks were, for most part, administered. This situation
impacted the health of the banking system and the consequential adjustments during the banking
sector reform process were, naturally, somewhat complex.
The large fiscal deficit and its monetisation had some spill-over effect on the external sector, which
reflected in the widening current account deficit in the late 1980s and early 1990s.
Triggered by the balance of payments crisis in the early 1990s, when our foreign currency assets
depleted rapidly to the extent that it could barely finance just two weeks of imports, we started the
reform process in 1991-92. A credible macroeconomic structural and stabilisation programme
encompassing trade, industry, foreign investment, exchange rate, public finance and financial
sector was put in place, which created an environment that was conducive for the expansion of
trade and
investment.
Simultaneously, several reform measures towards the marketisation of government borrowings
were initiated.
FISCAL POLICY AND

ECONOMIC REFORMS IN
INDIA
RBI entered into the first agreement with the government in 1994 to place a
limit on automatic monetisation.
The First Supplemental Agreement between the RBI and the Government of
India was signed in 1994 setting out a system of limits for creation of ad
hoc treasury bills during the three-year period ending 1996-97.
In 1997, RBI signed the second agreement with the government for the same.
In pursuance of this Second Supplemental Agreement between the RBI

and the Government of India on March 6, 1997, the ad hoc Treasury Bills
were completely phased out from April 1997, replaced by a scheme of Ways
and Means Advances, subject to limits.
In order to smoothen the transition, the Government of India was allowed to
incur also an overdraft, but at an interest rate higher than the rate applicable
for Ways and Means Advances (WMA). With effect from April 1, 1999 these
overdrafts were allowed only for a maximum of ten working days.
FISCAL POLICY AND

ECONOMIC REFORMS IN
INDIA
These features placed the Central Government on par with the State governments
which were brought under an Overdraft Regulation Scheme since 1985.
Furthermore, it was agreed that the RBI would trigger fresh floatation of
Government securities whenever 75 percent of the WMA limit was reached.
It was also agreed that the governments surplus cash balances with the RBI,
beyond an agreed level, would be invested by it in government securities.
While the transition to a full-fledged WMA and overdraft mechanism was gradual,
non-disruptive and consensual, the successful implementation of this mechanism
made it possible to incorporate some of these practices into a law the Fiscal
Responsibility and Budget Management Act (FRBM Act).
It is noteworthy that this law also practically prohibited RBI from participating in
primary issues of all government securities.
FISCAL POLICY AND

ECONOMIC REFORMS IN
INDIA
As a result of the concerted efforts to restore fiscal balance through tax reforms,
expenditure management, institutional reforms and financial sector reforms in the
first half of the 1990s, there was significant reduction in the magnitude of fiscal deficit
and the proportion of debt relative to GDP during the period 1991 to 1997.
However, during the period 1997 to 2003, there was a reversal in the trend of fiscal
consolidation, and the cumulative impact of industrial slowdown, fifth pay commission
award, and a lower than expected revenue buoyancy culminated in fiscal
deterioration.
This deterioration in the Indian fiscal position happened at an inopportune time
when there was fiscal improvement the world over and India was trying to
globalize. It is important to remember that Indias fiscal situation has been
significantly divergent from the global fiscal situation and continues to be so even
now.
This is the background we have to keep in view whenever we discuss the
pace and the content of economic reforms in India.
The coming into force of the FRBM Act, 2003 on July 5, 2004, which established a
framework for a rule based fiscal consolidation, should be viewed in this
background.
FISCAL POLICY AND

ECONOMIC REFORMS IN
INDIA
In the period subsequent to 2003, the central

governments fiscal position improved.
The states fiscal positions also improved significantly
during this period and their revenue deficits also were
close to being virtually eliminated.
ROLE OF RBI IN FISCAL

REFORMS
Given the institutional arrangement, the RBIs primary

objective is to maintain monetary stability.
The fiscal situation is decided and determined by the
Government. Once the fiscal situation is decided, it is the
Central Banks responsibility to ensure that monetary stability
is maintained and the governments borrowing programme is
managed with minimum disruptions in terms of stability.
FISCAL AND MONETARY

MANAGEMENT
With regard to operational issues relating to monetary policy, there is some

element of freedom but, in view of the fiscal dominance in the economy, the
overriding approach has been harmonization of monetary policy with fiscal policy for
ensuring stability. Within this framework, through mutual cooperation, several
reform measures have been undertaken by the government and the RBI.
A few illustrations of the links that exist between fiscal and monetary
management:
First, the Statutory Liquidity Ratio (SLR) was gradually reduced to the then
statutory minimum of 25%, effective October 21, 1997. Currently at 23%.
CRR has been reduced gradually, depending on the liquidity conditions, as a first
step, with the objective of ultimately reducing it to the statutory minimum of 3%.
In the meantime, RBIs commitment to the removal of the statutory prescriptions of
minimum reserve and liquidity requirements was demonstrated by its proposal to
the
Government for legislative amendments to remove the minima.
These legislations have since been passed. Now, there is no minimum statutory
stipulation for SLR and CRR.
FISCAL AND MONETARY

MANAGEMENT
The Reserve Bank of India (RBI) Act implicitly prescribed the CRR originally at a
minimum of 3 % of any banks net demand and time liabilities. This restriction
was removed by an amendment in 2006. While the RBI is now free to prescribe
this rate, and any CRR above 3% can still be viewed as a monetary tool to
contain expansion of money supply by influencing the money multiplier.
But the way in which the CRR was operated historically made it serve a much
wider role. During the 1990s, when there was infux of foreign funds through
non-resident Indian (NRI) deposits, a differential CRR was prescribed on such
deposits to restrict their inflows.
In the more recent period after 2004, when there was a huge influx of foreign
capital through varied forms of debt and non-debt flows, and the RBI ended up
accumulating large forex reserves, the CRR became an optional instrument to
sterilise the rupee resources released from such dollar purchases. This was
particularly enabled by not paying any interest on CRR balances
maintained by banks with the RBI. The other options of sterilisation was
through open market operations and the repo operations through the
liquidity adjustment window (LAF) which is a cost to the central bank, just as the
market stabilisation scheme cost the Government fiscally in terms of interest
payments.
FISCAL AND MONETARY

MANAGEMENT
Since 2004, the use of CRR as an instrument of sterilisation and also a

monetary tool has gained ground again.
Since CRR acts as a tax that increases their transaction costs, banks in
general would want its role to be restored to being a prudential minimum
requirement of not more than 3%.
Since quantitative easing has become a fashion of central banking across
the world, the RBI may well choose to bring the CRR further down gradually
to about 3% during the current easing phase, without losing sight of
monetary control in the face of inflation remaining high at around 7-8%.
Like CRR, SLR can also be viewed as a hybrid instrument of a different
variety. The SLR, according to some, is not a monetary tool and is only a
prudential requirement to serve as a cushion for safety of bank deposits.
The minimum prescription in this manner was 25% of banks demand and
time liabilities. But it was also more a way of finding a captive market for
government securities, particularly when they were bearing below market
interest rates. Not surprisingly, this ratio touched about 38 per cent around
1991.
FISCAL AND MONETARY

MANAGEMENT
Second: An issue that has come to the fore in the recent period pertains to higher
volatility in governments cash balances maintained with the RBI, which impacts
the liquidity conditions in the financial markets.
Volatility in Governments cash balances is not unique to the Indian situation and is
an issue even in other countries, but in our situation, it has become increasingly
prominent now.
It so happens that, at times, governments cash balances and the external situation
move in different directions and they create very little net impact on liquidity from
the perspective of overall monetary management.
However, there are occasions when they move in the same direction, in which case
the volatility in the liquidity conditions is much higher. This is one major current issue
in monetary management which could be linked to cash management in the
government.
The link becomes critical for maintaining orderly liquidity conditions in the money
market and effectively using short term overnight interest rates for monetary
operations.
FISCAL AND MONETARY

MANAGEMENT
Third, the magnitude of the combined fiscal
deficit of the centre and the states is
close to half of the households financial
savings, which is the largest component of
domestic savings. If fifty percent of households
financial savings are taken away by the
government sector, it has vital implications for
ensuring stability in the financial markets
because the demand for funds from the nongovernment productive sectors of the economy
has to be met simultaneously.
FISCAL AND MONETARY

MANAGEMENT
Fourth, India is still a bank-dominated system and about
70 percent of our banks (in terms of business) are owned
by the government. Thus, we could have a situation when
the objective of monetary policy and the objective of
broader public policy dealings with banking converge, in
which case the monetary policy could be very effective.
Sometimes, it could happen that the objective of monetary
policy and the objective of broader public policy may not
converge, in which case monetary policy may not be that
effective. In other words, the effectiveness of the monetary
policy depends not only on the actions of the monetary
authority, but also on other public policy postures. This
certainly complicates monetary management.
FISCAL AND MONETARY

MANAGEMENT
The issue of conflict of interest in public sector banking and government

ownership is yet another issue. The issue of conflict of interest in private
sector banks arises when the owner of the bank borrows from his own
bank. The single largest source of borrowing for the government being the
government-owned banks themselves, this conflict is rather apparent.
Fifth, one of the factors imparting rigidity to the interest rate structure in
India is the administered interest rates, particularly on small savings
instruments. In this context, administered interest rates fixed by the
Government on a number of small saving schemes and provident funds are
of special relevance as they have generally offered a rate different from
those on corresponding instruments available in the market, in some cases
along with tax incentives. The administered interest rates significantly
impact the level and allocation of savings. On the lending side also, there
are some administrative prescriptions for banks. Depending on how it is
calculated, on both the savings and the lending sides, the administered
structure of interest rate would apply to about 25 to 40 percent. In this
context, it is pertinent to note that the monetary policy mainly operates
through interest rates and interest rate signals, and constraints posed by
administered interest rates have to be duly recognized while dealing with
issues relating to monetary policy transmission mechanisms.
FISCAL AND MONETARY

MANAGEMENT
Sixth, theoretically it is well recognised that monetary policy is generally a

more effective counter-cyclical policy instrument than fiscal policy because
interest rate changes can be made and reversed quickly.
However, monetary policy adjustments may take longer than fiscal policy
adjustments to affect aggregate demand. It is also recognized that fiscal
policy contributes to broader based stabilization through the impact of
taxes and government spending on income sensitive (in addition to
interest-sensitive) components of aggregate demand.
When monetary policy is thus constrained in responding to output
variations, fiscal policy should normally take a more central role. Thus,
effective co-ordination between the fiscal policy and monetary policy is
important.
FISCAL AND MONETARY

MANAGEMENT
At a more aggregate level, in the context of our capacity to respond to

global developments, if we have a counter-cyclical policy approach, not
only the monetary policy but also the fiscal policy should be countercyclical. If the fiscal policy continues to be unidirectional, as we have in our
case, with persisting deficits, then the fiscal policy is not in a position to
produce a reasonable counter-cyclical impact. In these circumstances, the
monetary policy has a challenge in designing and implementing
appropriate countercyclical policies, that has the added burden of offsetting the impact of the fiscal policy. Well, despite these challenges, the
RBI has managed the situation reasonably well and we have the confidence
that we would be able to continue to manage. However, it is important to
recognize that, at times, unorthodox policies have assured the stability of
the Indian financial system despite fiscal stress, which is a desirable
outcome rather than achieving ritualistic compliance with pre-set rules.
RBIs Perspectives on Fiscal

Policy
The RBIs approach to fiscal reforms is that while we agree on the need to
eliminate the revenue deficit, and agree on a nominal limit for fiscal deficit,
what is even more important is the mode of financing the fiscal deficit and
the use that the resources so raised are put to.
Exclusive focus on fiscal deficit may tend to reduce the role of the
Government, and consequently, it will not be in a position to aid the
process of growth, in particular, inclusive growth. Re-prioritisation of
expenditure may be achieved through reduction or elimination of subsidies
and deployment of resources thus released to the more needy sectors.
Higher level of resources may also be available through reduction in tax
exemption.
In the light of financial turbulence across the world in the recent period, the
relevance of the fiscal in the management of the macro economy has
become even more important.
PUBLIC POLICY IN INDIA

Public Policy refers to an area of
government activity In which broader
interests of the people are linked in areas.
Like, education health, housing,
agriculture, energy, transport, even
foreign policy is referred as a public policy.
Thus any government activity having
wider ramifications for the people is
considered a Public Policy.
PUBLIC POLICY IN INDIA

Public Policy refers to an area of
government activity In which broader
interests of the people are linked in areas.
Like, education health, housing,
agriculture, energy, transport, even
foreign policy is referred as a public policy.
Thus any government activity having
wider ramifications for the people is
considered a public policy.
Industrial Policy in India

Industrialisation in India is considered
to be the engine of growth for the rest
of the economy.
The economic environment in India is
that of a mixed economy: i.e., coexistence of public and private sectors.
The present mixed economy has
evolved through a series of policy
formulations and legislations.

Goals of Industrial Policy:
Generate situations for maximum utilisation of raw
materials and human capital for industrialisation.
Suggest competitive advantages to investors,
including foreign investors.
Take advantage of govt.s incentives packages
Offer special attention to areas, like, export
oriented units.
To establish middle and large scale industries in
public, private and joint sectors to create industrial
base.

Industrial Policy Resolution of 1948:
Reflected the concept of a mixed economy
establishment of industries in both private
and public sectors will play a dynamic role.
Industries were divided into 4 broad
categories:
Industries involved in the manufacture of
arms, ammunitions, production and control
of atomic energy and the ownership and
management of railway transport.

(Contd.)
Industries such as, coal, iron and steel,
aircraft, ship building, manufacture of
telephones, telegraphs and wireless
apparatus.
Basic industries, like, automobiles, tractors,
fetilizers, sugar, paper, cement, cotton.
Leftover industries which were managed by
individual, priate and joint enterprises.

Industrial Policy Resolution of 1948 brought significant Industrial development during
the First 5 Yr Plan.
Industrial Policy Resolution of 1956 replaced this and aimed at implementation of a
socialistic pattern of society.
Industries were classified into 3 categories:
- Schedule A: Exclusively controlled by the State for establishing and developing
them (Defence, Heavy Inds, mining, transport and power)
- Schedule B: Controlled by both public and private sector ( mixed economy concept),
like, mining, aluminium, chemical, fertilizers, machine tools, etc.
- Schedule C: Remaining industries under private sector.
Encouraged establishment of small scale industries.
Discovering modern techniques of production.
Reducing regional inequalities in terms of development.
Improving living and working conditions of workers.
Securing participation of foreign capital so as to increase the pace of industrialisation.

Industrial Policy Statement of 1977:
Provisions of this Policy were: Emphasis on
Small scale industries (Inv upto Rs. 10 lacs), cottage
industries, ancillary inds.( Inv upto Rs. 15 lacs).
Basic industries for development of infrastructure, small
scale and village inds.
Capital goods and high technology industries which meet
requirements of agricultural and small scale inds.
Role of Public sector for encouragement of ancillary, small
scale & cottage inds.
Raising funds for revival of loss making small scale and sick
industries.

Industrial Policy Statement of 1980:
The Policy identified the inefficiencies of the
public sector and determined to improve the
efficiency of PSUs.
Most important Provisions were:
Limits of investments for small scale industries
were re-defined/raised ; handloom , handicrafts
were promoted.
Policy regularised unauthorised excess capacity in
private sector industries with important acts like
Monopolies Restriction & Trade Practices (MRTP) Act
and the Foreign Exchange Regulations Act (FERA).

Industrial Policy Statement of 1980 (Contd.):
The Policy liberalised the licensing capacity for
modernisation of industries.
The Govt de-licensed 23 industries.The companies
covered under MRTP and FERA were considered for
de-licensing after 1980.
In 1985, 25 broad groups of industries were delicensed ( like, industrial machinery, Iron and Steel
industry(before liberalisation)).
Limit for Cos. Under MRTP Act was raised from Rs. 20
Cr to Rs. 100 Cr.

Industrial Policy 1991:
Turning point for the Indian Economy. PM Mr
Narasimha Rao announced the New Economic Policy
with the following objectives:
To release industrial sector from unnecessary policy
restrictions.
Introduce liberalisation with a view to integrate the
Indian economy with the world economy.
To remove restrictions on Foreign Direct Investment.
To free domestic entrpreneurs from the restrictions of
MRTP Act.
To revive the sick enterprises under the public sector.

Industrial Policy 1991 (Contd.):
Govt. took up the Policy proposals in the
following areas:
Industrial Licensing Policy
Foreign Investment
Foreign Technology
Public Sector Policy
MRTP Act

Industrial Licensing Policy
Licensing abolished for all categories except
for industries related to security and
strategic concerns, social reasons, harmful
chemicals and environmentally hazardous.
In some industries licensing compulsory
like, coal & lignite, petroleum, alchoholic
drinks, industrial explosives, cigarettes, etc.

Foreign Investment:
To encourage foreign investment in high
priority sectors, those requiring huge
investments and advanced technology,
govt accorded approval for FDI upto 51%
equity.
Sanctions were given for forign technology
agreements in high priority industries.

Public sector policy:
The loss in public sector enterprises due to low
return on investment has burdened the govt. E.g.,
under this Policy, the govt decided to strengthen
those public enterprises which fall in the reserved
areas of operation and high priority areas.
Competition was induced in these areas by inviting
private sector participation. Sick industries were
referred to Board for Industrial and Financial
Reconstruction (BIFR) for rehabilitation schemes.
Government policy and reforms

in China
Chinas consumption story is driving
MNCsstrategy:
The Chinese governments drive to raise

incomes and shift growth towards domestic
consumption is likely to have a profound
impact on most companies. Among survey
respondents, 58% said that this policy is the
factor that will have the biggest impact on
their China strategy, while 56% said that
growth prospects for their industry was the
key driver of their China strategy.

in China
The Chinese government is eager to rebalance
economic growth drivers away from
investment and exports towards
consumption, and it is especially keen to raise
incomes of the less well-off. It plans to raise
minimum wages by at least 13% a year for the
five years covered by the governments 12th FiveYear Plan (FYP) for 2011-15. Market forces are
already driving up wages at an even quicker pace
in some areas: since 2010, 30 Chinese provinces
have raised their minimum wages, by an average
of 23%.

in China
In 2010 the minimum wage in Beijing went
up by over 45%, thanks largely to the galloping
economy and tightening labour supply.
While companies are in the short term
scrambling to find efficiencies to offset rising
wages, they are keenly aware of the
opportunity the creation of a new consumer
class represents. This class will not be limited to
the first-tier cities of Beijing and Shanghai, but
will emerge all across China and deep into
its poorer interior regions.

in China
In addition to wage rises, Chinas galloping
urbanisation will help push up consumption and
reduce the income gap. It will, in turn, further spur
economic growth and support consumption by existing
city dwellers and new migrants, as well as making it
easier to reach more consumers, creating huge
potential opportunities for the worlds industrial firms.
Forecast is that by 2025 around 70% of Chinas
population will live in cities. Between now and then 170
new mass transit systems and 40bn square metres of
floor space will be built. Chinas companies are not
likely to be able to manage all this on their own.

in China
The housing sector is driving growth in China. At current
rates of construction China can build a city the size of
Rome in only two weeks. This means China is underpinning
demand in global markets for many key commodities. It
also means that any downturn will quickly register on
Chinese GDP and global commodity markets.
In the decade leading up to 2010, China built the housing
equivalent of roughly two Spains or United Kingdoms, or
one Japan. In per capita terms, the average amount of floor
space enjoyed by urban Chinese has doubled over the
same period.
So what does the future hold? Is Chinas current housing
boom sustainable or is it heading for a Dubai-style bust?

in China
Healthcare reform, a key Chinese government
initiative, will be vital in unleashing the full potential of
the countrys consumption power. With no social safety
net, many Chinese households continue to save an
inordinate amount of their incomes against
medical emergency, or to fund their retirement.
Even relatively well-off city dwellers report that they save
more than 30% of their annual household income, in part
to cover medical emergencies. There is an urgent need
to overhaul Chinas patchy healthcare system to prepare
for the coming upsurge in the elderly population, and
also to bring a much-needed boost to the quality of life of
many of its citizens.

in China
Chinas rapid economic development has not translated
automatically into political development with many of its
institutions still in need of major reform. In the post MAO era
despite the decentralisation of local government with
significant administrative and fiscal authority, Chinas
government and policy making processes have retained much of the
inefficiency and corruption characteristics of the earlier period.
In OECD (Organisation of Economic Cooperation and Development)
countries, for instance it is believed that the authority of policy
making should be moved closer to the citizens so that the
decisions made are more suited to citizens needs.
The process of reform in China has been one of continuous
confict between the agenda of political elites in central
government, and the priorities of local leaders, with local
agents often distorting, delaying or ignoring the policies emanating
from the central government.

in China
Since the mid-1990s the central government has taken over
several important tax bases and substantially increased its tax
revenue at the expense of local governments.
The decentralisation since the early 1980s aimed at
motivating local leaders to develop the economy was a coping
strategy to deal with the problems caused by centralisation.
Centralisation in China since the mid 1990s, in turn was a
response to the decentralisation problems such as economy
overheat, decline in central governments capacity over
taxation and thriving corruption.
A usual approach of researching China is to understand the
theories and concepts generated from the Western liberal
democracies and then apply these theories and concepts to
the context of China. Without modification, these theories and
concepts are often inapplicable to China.

in China
The Chinese government has continually reformed its
government structure and policy making process to spur
sustainable development and enhance its legitimacy. The
reform of government and policy making in China follows
two intertwining trajectories: the first is to refine the
technical arrangements of various stages of policy process:
the second is more political, entailing power redistribution.
The global financial crisis has undeniably raised Chinas
stature in the world. Thanks to its ability to maintain near
double-digit annual GDP growth through the tumult of
2008-09, China overtook Japan as the worlds secondlargest economy in 2010. Before the global financial crisis
erupted, Goldman Sachs had expected China to surpass
the US as the worlds biggest economy around 2041.
EXPECTATIONS FROM INDIAS BUDGET :

2013-14
Background of Balancing the Budget 2013-14:
Some would say that the main suspense of the
Budget session of Parliament is already over. The
railway ministry announced its first hike in
passenger fares in 12 years in January, while the
finance ministry has floated a weather balloon
canvassing opinion on whether taxing the rich
more would help bridge the fiscal deficit.

2013-14
A widening fiscal deficit,
slower growth than previous years (the government has projected GDP
growth for fiscal year 2013-14 at 5%) and
Not enough headroom to spend (even on defence, which is going to face
spending cuts this year)
mean that the finance minister has less space than before for any
financial pyrotechnics.
This is a particularly problematic situation when presenting the last full
budget before a general election.
The session, therefore, will be packed with:
heavy-duty bills, contentious and political,
increasingly looking like a wish list
that should have been done and dusted over the past two years but
which now appears as governance in hindsight.

2013-14
High fiscal deficit would trim welfare spending:
There may not be a major increase in the allocation for social sector in the
forthcoming Budget due to the grim fiscal situation.
In the face of rating downgrade threats, Finance Minister had in October set a
fiscal deficit target of 4.8 per cent next fiscal. He had also said he would rein in
fiscal deficit at 5.3 per cent this fiscal yr.
The Government's flagship rural employment guarantee programme
MGNREGA (Mahatma Gandhi National Rural Employment Guarantee Act)
needs to be more "flexible" to regional sensitivities, especially in the central

India, where the Maoist insurgents are capitalising on the discontent spread by
lack of development.
This is the second time flaws have been found with MGNREGA. Earlier, the
programme had been termed as "paying wages for unproductive work" which
creates no real assets.

2013-14
Government may target Rs 40,000 crore from stake sales
in FY14:
The government is likely to target Rs 40,000 crore ($7.42
billion) in proceeds from stake sales in state-run companies in
the next fiscal year.
The revenue target from a partial privatisation of state-run
companies is higher than the Rs 30,000 crore government is
aiming for in the current fiscal year.
With less than two months to go before the year closes, the
government has managed to raise 70 percent of the targeted
amount, and officials in the government concede that the final
figures for this year could fall shy of the target.

2013-14
Salaried class employees want IT exemption limit
raised
Salaried class want Finance Minister to raise the
income tax exemption limit to at least Rs 3 lakh and
increase deductions like medical and educational
allowances in the Budget.
Over 89 per cent of respondents said the slab of tax free
income has not moved up in line with real inflation. The
current basic exemption limit of Rs two lakh should be
increased to at least Rs three lakh . This will increase the
purchasing power of individuals and stimulate demand.

2013-14
Barring education, the country's performance on the
other human development indicators like health has not
been good, even though the economic growth has been
strong, he said. He also pointed out a slew of paradoxes
like the human development index continuing to be poor in
spite of high per capita incomes in states like Gujarat,
Punjab and Haryana.
Similarly, richest states like Maharashtra, Andhra and
Karnataka, have districts or pockets having the worst
human development indicators.

2013-14
Raising tax exemption cap on interest payments on housing loans
Consultancy firm PwC today demanded increasing the cap on interest payments (up
to Rs 1.5 lakh are eligible for deduction on housing loans should be increased to Rs 3
lakh) and medical expenses for the purpose of tax benefits in the upcoming Budget.
He said the realty sector has been under pressure for quite some time now and the
government should incentivise investments into the sector, which will go a long way
in helping the economy.
On deductions for medical expenses, which currently stand at Rs 15,000 per annum,
an increase to Rs 50,000 is being demanded, more so considering that revision has
not happened in the past 14 years, but medical cost has surged manifold since then.
There is also a demand for the government to revisit standard deduction for the next
fiscal, which has been called off since 2006.

2013-14
Tax benefits for M&As (Mergers and Acquisitions) in all sectors
sought:
Industry body CII wants the government to extend tax benefits
pertaining to mergers and amalgamations (M&As) to all businesses
such as telecom, financial services, entertainment, sports, IT and
entertainment.
The move will help industry to reorganise and restructure operations in
sync with the rapidity of changes taking place in the business
environment as well as to deal with the emergence of new sectors and
segments.
Currently, M&A tax benefits are limited to industrial undertakings and
select services such as shipping, hotels, aircraft and banking.

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Public Systems & Policy

Financing of Government Expenditures

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In theory, under certain circumstances, private markets will

Resource Generation: Collection

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Some forms of government

Taxation is the central part of modern public

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Stamp duty, levied on documents

Governments, like any other

Government debt can be categorized as

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The general government sector of a

Measuring Govt. Economic

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Financial Accounting of Governments:

The governments balance sheet presents the level

Public Policies, Health

Health is a critical contributor to the success of

Public Policies, Health

Health policies are important because

The Public Policy Action

The Public Policy Action

The Public Policy Action

Government to Business (G2B):

Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

IS-LM MODEL AND CROWDING OUT

IS-LM and Crowding Out

One hypothesis is that a government's deficit spending ("fiscal policy") has an

IS-LM and Crowding Out

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Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

The Classical Case and crowding out:

If the LM curve is vertical, then an increase in government spending has no effect on

Crowding Out Effect

Crowding Out Effect

Crowding Out Effect

FISCAL POLICY AND

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FISCAL POLICY AND

In pursuance of this Second Supplemental Agreement between the RBI

FISCAL POLICY AND

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