In every economy, two powerful tools guide growth, stability, and prosperity — fiscal policy and monetary policy. While governments use fiscal policy through taxation and spending to influence demand, central banks rely on monetary policy to regulate money supply and interest rates. Together, these policies act like the steering wheel and brakes of an economy, balancing inflation deflation, unemployment, and growth.
In this blog, we’ll break down the basics, explore their differences, and see how they shape our daily lives in subtle but significant ways.
Table of Contents
FISCAL POLICY
Fiscal policy refers to revenue and expenditure policy of the government. It is also called Budegtary Policy of Government. Following mentioned are the measures taken by the government under fiscal policy to combat inflation and deflation in an economy.
GOVERNMENT EXPENDITURE
It is the principal component (or principal instrument) of fiscal policy. The government of a country incurs various types of expenditure, mainly:
(i) Expenditure on public works programmes such as the construction of roads, dams, bridges, etc.
(ii) Expenditure on education and public welfare programmes.
(iii) Expenditure on the defence of the country and the maintenance of law & order.
(iv) Expenditure on various types of subsidies to the producers with a view to encourage production.
During inflation, government expenditure is reduced, a cut in government expenditure acts like a ‘withdrawal’ from the circular flow of income in the economy. It is required when liquidity needs to be soaked to combat inflation.
During deflation, government expenditure is increased, A rise in government expenditure acts as an ‘injection’ into the circular flow of income in the economy. It is required when liquidity needs to be released to combat deflation.
TAXES
Taxes are a compulsory payment made to government by the household sector.
During inflation, government increase taxes, reducing the disposable income of the households.
During deflation, government reduce taxes, increasing the disposable income of the households.
PUBLIC BORROWING / DEBT
By issuing government securities, running small savings schemes, market loans and, treasury bills, the government of a country borrows money from the public.
During inflation, government try to increase its borrowings, soaking money from the economy.
During deflation, government try to decrease its borrowings so that people are left with greater liquidity.
BORROWING FROM CENTRAL BANK
Borrowing from the central bank means the government takes loans directly from the Reserve Bank of India (RBI) (or any country’s central bank). The RBI creates money and lends it to the government, often by purchasing government securities (like bonds) directly. This is called deficit financing, because the government covers its budget deficit through central bank credit.
During inflation, government reduce its borrowings from the central bank, reducing the supply of money.
During deflation, government increase its borrowings from the central bank in order to increase the supply of money.
MONETARY POLICY
The central bank (RBI in INDIA) adopts various measures to control the supply of money in the economy. Largely, these measures relate to credit supply by the commercial banks. These are broadly classified as:
(A) Quantitative Instruments, and
(B) Qualitative Instruments.
QUANTITATIVE INSTRUMENTS
Quantitative instruments are those instruments of credit control which focus on the overall supply of money in the economy. Supply of money is lowered to tackle inflation, and it is raised to tackle deflation.
Following is a brief description of these instruments:
Bank rate
Bank rate refers to the rate of interest at which the central bank lends money to the commercial banks. It relates to instant (immediate) loan requirement of the commercial banks.
During inflation, central bank increases the bank rate which leads to the increase in the market rate of interest and fall in borrowings.
During deflation, central bank decreases the bank rate encouraging borrowers to borrow at a low rate of interest.
REPO RATE / REPURCHASE RATE
Repo rate is the rate at which RBI (central bank of a country) lends short-term funds to banks against government securities.
During inflation, repo rate is increased making borrowing costlier.
During deflation, repo rate is decreased making borrowing cheaper.
REVERSE REPO RATE
It is the rate at which the central bank of a country borrows money from commercial banks, encouraging banks to park their money to the central bank.
During inflation, reverse repo is held higher encouraging banks to lend their money with the central bank than with the people.
During deflation, it is decreased to let the commercial banks lend money to the people, increasing money supply.
CASH RESERVE RATIO (CRR)
CRR is the percentage money that commercial banks must keep with the central bank.
During inflation, CRR is held higher, keeping less money for the banks to lend to decrease money supply.
During deflation, CRR is lowered letting the commercial banks lend more money to increase money supply in the economy.
STATUTORY LIQUIDITY RATIO (SLR)
SLR is the percentage of deposits that commercial banks must keep with the central bank in the form of liquid assets (gold, govt securities, etc.) before lending.
During inflation, SLR is kept higher, reducing the capacity of banks to lend.
During deflation, SLR is kept lower, increasing the capacity of banks to lend.
OPEN MARKET OPERATIONS (OMO)
Open market operations refer to the buying and selling of government securities by the central bank.
During inflation, the central bank of a country buys government securities in order to withdraw money from the economy.
During deflation, the central bank of a country sells government securities in order to inject money into the economy.
QUALITATIVE INSTRUMENTS
Qualitative instruments focus on how and where the credit is used (sector-specific), not just the total amount of money in the economy.
Following is a brief description of these instruments:
MARGIN REQUIREMENTS
Margin is the difference between the value of a loan and the value of the security offered. Central bank can raise margins to reduce borrowing for speculative purposes (like stock market) or lower margins to encourage credit flow.
CREDIT RATIONING
Central banks can limit the amount of credit a bank can give to certain sectors. For Example: restricting excessive lending to speculative trading, while ensuring priority sectors (like agriculture, MSMEs) get funds.
MORAL SUASION
Central bank persuades or advises banks to follow desired lending practices in the interest of the economy. For Example: urging banks to avoid speculative lending during inflation.
Above mentioned instruments/measures under the monetary policy of a country are used to ensure the economic stability of a country by combatting situations like inflation and deflation.
CONCLUSION
Fiscal and monetary policies are the twin pillars of economic management. While fiscal policy uses government spending and taxation to influence demand, monetary policy regulates money and credit to maintain stability. Together, they balance growth, control inflation, and safeguard the economy from crises. Understanding these tools not only helps us see how governments and central banks manage challenges but also makes us aware of how these decisions affect our everyday lives — from the prices we pay to the jobs we seek.
📌Author’s Note:
This blog is not just research — it’s a step in my journey toward working with global institutions like the IMF and World Bank.
Stay tuned and grow with me!
