RBI’s Conundrum: Growth vs Inflation

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Though the dichotomous policy puzzle of growth versus inflation may not be new for the Reserve Bank of India, in the present pandemic times, the complexity to manoeuvre through this policy maze has amplified manifolds.

Covid-19 has adversely impacted the entire world with most economies and industries are under severe stress. India being no different. The GDP growth is expected to slip in the negative for the FY 2020-21, first time in the history of independent India, squashing our dream to be a $5 trillion economy by 2023.

To revive economic growth, there are two major policy tools – the fiscal policy and the monetary policy. Readers, lets take you through some basics of macroeconomics for you to better appreciate the dilemma of our policy makers.

The economic policy puzzle is best solved by having an optimal mix of the monetary policy and the fiscal policy. RBI spears ahead the monetary policy while the Government takes care of the action at the fiscal policy front.

The amalgamation of the two policy framework can be explained from the IS-LM framework (popularly know as Hicks-Hansen model). The IS-LM framework is the key for the economy to tide over the current growth-inflation stand-off. Both the IS and LM curve are drawn on the interest rate – output space.

The IS curve is the Investment Savings Curve for the economy representing the goods market that gets moved when the fiscal policy changes. An expansionary fiscal policy shifts the curve outward while a contractionary fiscal policy shifts the curve inwards.

Similarly, the LM curve or the Liquidity & Money Supply curve (representing in the money market) is the tool with the RBI to move the output and interest levels of the economy. An expansionary monetary policy such as reduction in interest rates shifts the LM curve to the right while a contractionary moneraty policy shifts the LM curve to the left.

Coming back to the current situation being faced by India. Already, prior to the pandemic, not all was hunky-dory with the economy. The economic growth was slipping and RBI had initiated gradual reduction in the key policy rates to revive growth. Since February 2019, the repo rate had been gradually reduced from 6.25% to 5.15% in October 2019. And then further from 5.15% to 4% post the advent of the pandemic. However, is it really translating into the economic growth revival? Only time will tell.

RBI Conundrum

Though RBI has managed to pump in liquidity in the system through its various measures, in the current economic scenario this may be necessary but not a sufficient action to revive growth keeping the inflation within the tolerable limits. An optimal stitching of the fiscal policy along with the monetary policy is what is required at this juncture.

Continuous reduction in interest rate is not desirable – this will lead to a surge in inflation if the economic production does keep pace, leading us into the vicious circle of stagflation. Since the monetary policy measures start showing results in the economy with a lag of a few quarters, it is prudent to hold on the rate cuts, let the decisions seep in the economic system, and let the fiscal policy measures be used to boost government spending and increase investment and consumption demand for the economy.

So readers, it is time to trust our experienced policy makers to make the right changes in the macroeconomic variables that would overhaul the entire cycle and bring India back on the desired growth trajectory.

Dr. Taunika Jain Agarwal Ph.D.

Alpha Research

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