UPSC MAINS 2019 : Fiscal wheels must also roll in order to make monetary policy effective

Fiscal wheels must also roll in order to make monetary policy effective

Topic : Fiscal wheels must also roll in order to make monetary policy effective

Topic in Syllabus: General Studies Paper 3: Indian Economy

 

Context :

Fiscal wheels must also roll in order to make monetary policy effective

Through four successive reductions in this calendar year, RBI has reduced the repo rate by 110 basis points to 5.4%.

 

Background:

Repo Rate

  • Repo rate is the rate at which the RBI lends money to commercial banks. 100 bps make a full percentage point.
  • As such, if the repo falls, all interest rates in the economy should fall. And that is why common people should be interested in RBI’s monetary policy.

Fiscal policy:

In economics fiscal policy is the use of government revenue collection (mainly taxes) and expenditure (spending) to monitor and influence a nation’s economy.

Monetary policy:

Monetary policy is the process by which the monetary authority of a country, typically the central bank or currency board, controls either the cost of very short-term borrowing or the money supply, often targeting inflation or the interest rate to ensure price stability and general trust in the currency.

 

Why economy has been slow to respond to incremental monetary stimuli?

  • Quarterly growth data show a continuing slowdown, mainly driven by sluggish demand, due to both external and domestic factors.
  • There is substantial excess capacity in the manufacturing sector.
  • With unutilized capacity, temporary and casual employees are being laid off and wage hikes are being postponed, reducing levels of aggregate disposable income, which is further reducing demand, particularly for consumer durables.
  • Unless capacity utilization improves, investment demand from the private sector is not likely to improve.
  • Repo rate reductions only provide enabling conditions to reduce the cost of borrowing. To be effective, adequate transmission needs to take place.

 

Effects of slowdown:

The sectors which are mainly affected are

  • Employment-intensive
  • Real estate
  • Automobile sectors.

 

Why fiscal side also important for effective monetary policy?

  • The central government’s capital expenditure to gross domestic product (GDP) has stagnated at 1.6% for 2018-19, and 2019-20 as budgeted. The state government’s capital expenditure to GDP has also been stagnating at close to 2% of GDP for some time. The public sector as a whole has an investment rate of close to 7%.
  • Demand for investment and consumer durables has to increase, which is a function of income, much more than the cost of borrowing.
  • To uplift investment sentiments, adequate momentum has to be generated at the fiscal side.
  • However, given revenue constraints and legislative limits on government borrowing, suitable countercyclical fiscal measures have not yet been taken.
  • Without a demand push from the public sector, monetary policy alone would not be effective.

 

What the government should do

  • The countercyclical policy is primarily the responsibility of the central government.
  • A one-year departure from the budgeted fiscal deficit of 3.3% of GDP for 2019-20 can be justified at the current juncture.
  • It should be ensured that the entire additional borrowing above the budgeted level is spent on capital expenditure.
  • It is established fact that increases in government capital expenditures have much larger multiplier effects, as compared to increases in government revenue expenditures.
  • State governments and the central and state public enterprises should come on board and undertake additional investment spending on infrastructure.
  • This will push investment from the private sector, uplifting the infrastructure and construction sectors, and later spreading out to other sectors.
  • Once a virtuous cycle is triggered with increased public sector investment, particularly focused on the employment-intensive infrastructure and construction sectors, private disposable incomes would increase, reversing the ongoing demand slow down.
  • As the magnitude of private borrowing grows, the transmission would improve.
  • In order to protect savings, particularly of small investors, some additional margin may continue to be provided to the depositors in small savings and other similar instruments.

 

Conclusion:

Together, the joint impact of the fiscal and monetary stimuli is expected to uplift the country’s growth from its present low level to levels comfortably above 7% and, eventually, closer to 8.5-9%. Sustaining growth at these levels is required if India were to become a $5-trillion economy by the end of FY25.

 

Sample Question

Together, the joint impact of the fiscal and monetary stimuli is expected to uplift the country’s growth from its present low level. Comment.

 


 

Fiscal wheels must also roll in order to make monetary policy effective infograph