An understanding into the Indian Financial System and Fiscal Policy

#macroeconomics #Indiangovernment #financialsystem #fiscalpolicy #bankdeposits #stockmarkets #bonds

Few days ago, a report stated that Bank deposits had fallen greatly.

“Data released by RBI showed the credit-deposit ratio at its highest in at least 20 years as loan off-take rose across categories including home loans and other loans for consumption,”.

“Customers are chasing high-return, equity linked-products,” Bhavik Hathi, managing director of consulting firm Alvarez and Marsal, told Livemint – and so left less money as deposits in banks.

https://thewire.in/banking/indian-banks-face-a-big-deposit-crunch-report

Infact the Sensex has reached record levels in spite of rising prices, war impact and climate crises. A lot of young Gen Z's are currently investing in the capital markets and plunging their small savings into the stock market in a wit to make quick money.

This news and market sentiment triggered me to pen down this article for my audience -

How our Financial system works and moreover how does the government decide making spends from their coffers to combat inflation or deflation, or even reduce tax burdens or inflate it.

One of the most important inventories and drivers of our economy, the Financial System functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. Meaning they mend a balance in the capital distribution of funds.

In simple terms it constitutes the Financial Stock markets, Regulators, Central banks, Financial Intermediaries and Payment Systems helping determine both the cost and the volume of credit.

Subsequently, this system is responsible for raising the price of acquiring funds or borrowings which impact everything right from the economy's consumption to production, employment, and growth.

Consequently, lowering the cost of credit can positively affect and enhance all the above factors.

• Savings Syndrome - Indians are habituated to save money for their future. This attitude helps the Financial System promise future income flows. Funds in the hands of the producers, results in better goods and services and an increase in society's living standards. However, when savings flow declines, investment and living standards growth begins to fall.?
• Liquidity Function - Money kept by way of deposits offers the least risk of all financial instruments. But its value is mainly eroded by inflation. Hence one always prefers to create an investment mix by storing funds in various financial instruments like stocks, bonds, debentures, etc. Although making such investments leads to a greater level of risk , and the degree of liquidity (i.e., conversion of the claims into money) is high. The financial markets provide the investor with the opportunity to liquidate their investments.?
• Payment Function - While offering convenience of using easy methods through modes of digital payments like UPI, Netbanking, Credit Cards etc. also drastically reduce the cost and time of transactions.
• Risk Function - The Financial System provides for protection by offering sale of life, health, and property insurance policies.They provide immense opportunities for the investor to hedge himself/herself against or reduce the possible risk involved in various instruments.?
• Policy Function - Most governments intervene in the financial system to influence macroeconomic variables like interest rates or inflation. Like RBI and Central bank indulges in several cuts in CRR and tries to decrease the interest rates and increase the availability of credit at cheaper rates to the corporations.?

Some basics on Fiscal Policy -

Fiscal policy refers to the use of government spending and taxation to influence the level of aggregate demand in the economy.?It is one of the main tools governments use to stabilize the economy and achieve their economic goals.

Two main components of fiscal policy are Government Spending and Taxation.

Governments can enhance or diminish their spending on various programs and services to stimulate or slow down economic activity. Similarly, they can adjust tax rates or change the types of taxes they collect to influence consumer and business behavior.

Fiscal policy can be used to address a range of economic issues, including unemployment, inflation, and economic growth. It can also be used to redistribute a society's income and wealth and fund important public goods and services.

So what are the basic functions of this policy and why does it prove to be integral towards economic development.

Five Basic Functions of the Fiscal Policy -

• Stabilization of the economy
• Redistribution of income
• Encouragement of economic growth
• Correction of imbalances
• Promotion of social goals

(Explaining each...)

1. Stabilization of the economy : Fiscal Policy can be used to stabilize the economy by adjusting government spending and taxation in response to changes in economic conditions.During a recession, the government implements an expansionary fiscal policy, which involves increasing government spending or decreasing taxes. This assists in stimulating economic activity and help create jobs, which can help improve the economy's overall health. While ,during times of economic expansion or high inflation, the government can implement a compressible fiscal policy, which involves reducing government spending or increasing taxes. This can help to reduce aggregate demand in the economy and slow down economic activity, which can help to stabilize prices and prevent an inflated economy.
2. Redistribution of Income : A robust Fiscal policy helps to redistribute income and wealth within a society. Governments can use various tools, including taxes and transfer programs, to redistribute income from high-income individuals and businesses to low-income individuals and families. One way governments can redistribute income is through progressive taxation, which involves charging higher tax rates on higher income levels. This can help to reduce income inequality by taking a larger share of income from those who can pay more and using the revenue to fund transfer programs or public goods and services that benefit society as a whole.In addition to progressive taxation, governments can use transfer programs, such as social security and unemployment benefits, to directly transfer income from one group to another. These programs help to proliferate a safety net for the most vulnerable in society and help reduce poverty and income inequality.

3. Encouragement of Economic growth : A Fiscal policy encourages economic growth by increasing aggregate demand in the economy. When the government increases spending or decreases taxes, it can stimulate economic activity and lead to an increase in output and employment. This can help increase economic growth and improve the economy's overall health.

However, it is important to note that the impact of fiscal policy on economic growth can vary depending on a range of factors, including the state of the economy, the effectiveness of the policy measures, and the broader economic and political context.

For example, an expansionary fiscal policy is more likely to boost economic growth during a recession when there is slack in the economy and businesses, and consumers have the capacity to increase spending. In contrast, expansionary fiscal policy may be less effective or even counterproductive during an economic expansion, as it could lead to inflated economic activity and inflation.

4. Correctness of Imbalances : Fiscal policy can correct economic imbalances, such as excessive inflation or deflation, or address persistent trade deficits or surpluses.

For example, if an economy is experiencing high inflation levels, the government may implement a compressible fiscal policy, which involves reducing government spending and increasing taxes. This can help to reduce aggregate demand in the economy, which can lead to a decrease in prices and help to stabilize the economy.

On the other hand, if the economy is in a recession and experiencing high levels of unemployment, the government may implement an expansionary fiscal policy, which involves increasing government spending and decreasing taxes. This can stimulate economic activity and help create jobs, which can help improve the economy's overall health.

Fiscal policy can also be used to address persistent trade imbalances, such as persistent trade deficits or surpluses. For example, the government may implement tariffs or other trade barriers to discourage imports and encourage exports, which can help to reduce trade deficits or increase surpluses.

5.Promotion of social goals : Fiscal policy can be used to promote social goals, such as reducing inequality, promoting social welfare, and improving access to education and healthcare.

For example, governments can use fiscal policy to redistribute income and wealth through progressive taxation and transfer programs, such as social security and unemployment benefits. This can help reduce income inequality and provide a safety net for those most vulnerable in society.

Fiscal policy can also fund important public goods and services that benefit society, such as education and healthcare. Governments can increase spending on these programs or offer tax incentives to encourage private investment in these areas.

In addition, fiscal policy can help to incentivize or discourage certain behaviors that have social implications. For example, governments may offer tax breaks or subsidies to encourage the development of renewable energy sources or impose taxes on products that are harmful to the environment.?

To conclude, every growing economy needs a strong fiscal policy to bring a balance in the socio-economic activity.

Most modern-day economies require vast sums of money to invest in capital assets (land, equipment, factory, etc.), which are then used to provide goods and services. The funds required are so huge that a single government/firm can't meet the requirement. However, various investors can quickly raise the required funds by selling financial claims like stocks, bonds, etc. While private firms/government issuing such a monetary claim hopes to return the borrowed funds from expected future inflows.

Indeed, we see that the financial markets within the financial system have made possible the exchange of current income for future income and the transformation of savings into investments so that production and revenue keep growing.

A Word of Caution: Investments are subject to market risks , please read the offer document before investing.?Be mindful about making investments in the right avenues so as to avoid risky propositions.