The role of public policy for overall economic development has undergone a metamorphic transformation over the centuries.  In the ‘laissez-faire’ economy, government, as a public policy authority, was undertaking limited functions, such as defence (to protect sovereignty), offence (to maintain internal law and order) and public utilities (to provide public utility services) to the extent possible within the budget constraint.  It was believed that there was no conflict between individual interest and social interest.  Hence, individuals left to themselves could pursue professions that maximised the wellbeing of individuals as well as society. The individual interest and social interest may come in conflict with each other.  Nevertheless, classical economists continued to believe that the market mechanism works perfectly well with the limited role of the Government and therefore it should pursue annual balancing of the budget.

Adam Smith’s ‘invisible hands’ and J. B. Say’s market-clearing hypothesis in particular and classical economists’ views on the limited role of the Government, in general, came under severe criticism during the 1930s as the world economy went through a prolonged period of depression. Intellectual debate, spearheaded by John Maynard Keynes, abandoned the market-clearing hypothesis. The government assumed a bigger role in reviving the economy through the fiscal deficit.  The dominance of fiscal deficit as a public policy tool to stimulate the economy persisted for more than three decades. Instead of ‘pump-priming’ the economy through capital expenditure, the government more often misused the tool to meet its revenue expenditure. This together with a sharp increase in crude oil prices in the early 1970s pushed the global economy towards worldwide inflation in the mid-1970s.  Till such time, the central banks around the world were vested with the supplementary role of managing currency to facilitate transactions of goods and services.

Unfettered fiscal deficits and its financing by central banks contributed significantly to high inflation worldwide in the 1970s. Inflation was diagnosed as ‘always and everywhere a monetary phenomenon’ by monetarists, led by Milton Friedman. They argued that inflation arising out of supply shocks may be temporary unless supported by accommodative monetary policy. Since the mid-1970s, the central banks emerged as a major public policy authority, vis-a-vis the government, to control inflation.  For about a decade, monetary targeting was pursued by many central banks to achieve their objective of low inflation.  Since the 1980s, many central banks adopted inflation targeting as a formal framework of monetary policy. Fiscal discipline was necessary as a precondition to achieve price stability.  Many economists argued that ‘fiscal profligacy’ creates serious macro-economic imbalances in the economy. Inefficiency in the use of resources by the government was also argued. Nevertheless, fiscal dominance continued despite serious reservations put forward by economists about the adverse outcome of the sustained fiscal deficit. 

Table 1: Objectives of Public Policy

Objectives of Monetary Policy Objectives of Fiscal Policy
Price stability
Sustainable growth
External balance
Financial stability                
Full employment/growth
Reduction of inequality/poverty Macroeconomic balance
Financial stability
Money: Quantity and Price,Exchange Rate, Regulatory & Supervisory Tools.  
Tax, Expenditure, Public Debt, Openness, Convertibility.

There was a need for coordination between monetary policy and fiscal policy so that an optimum solution could be found in achieving public policy objectives. As can be seen from Table 1, there is a good deal of overlap as regards the objectives of monetary policy and fiscal policy.  If one major wing of public policy fails to achieve its objectives, it expects the other wing to do something for it to achieve the same. Can one wing of public policy be a good substitute for the other to achieve the common objective?  If not, what kind of coordination mechanism is put in place between public policy authorities so that the public policy objectives are achieved seamlessly?

Market forces, left to themselves may produce a real business cycle which may not be smooth.  Public policy has a role to play to reduce the amplitude of boom and bust so that a high rate of growth is achieved over a medium-term without high volatility.  One would, therefore, expect the public policy to be countercyclical.  So far as fiscal policy is concerned, revenue collections are generally buoyant in the boom while social sector expenditures are contained. This could be attributed, inter alia, to a low level of unemployment benefit required during the boom which helps prune government expenditures. Hence, the government is naturally in a better position to pursue a surplus budget during the boom. The reverse is true in case of recession.  Revenues are less while social sector expenditures are expected to rise which warrants deficit budget. Overall, a responsible government can achieve a cyclical balancing of the budget without much difficulty, given the nature of revenue buoyancy and expenditure pattern over a real business cycle. Violation of this golden rule may pose serious macroeconomic problems for an economy.

During the great moderation before the recent global financial crisis, both developed and developing countries pursued fiscal deficit leading to a phenomenal rise in debt-GDP ratio.  As a result, when the global economy was pushed to a recession, the government could not pursue an accommodative fiscal policy. Either there was a sovereign debt crisis (Europe) or unsustainable debt-GDP ratio forced governments to pursue fiscal consolidation during a period of recession.  When it was very much expected for the government to stimulate the economy, they were helpless due to imprudent policy pursued during the great moderation. Now the issue arises as to whether monetary authority can fill the gap and try to achieve the fiscal objective by pursuing an ultra-accommodative monetary policy. 

Real GDP growth is a function of real saving, real investment productivity, and technology.  While productivity and technology generally do not change in the short-run, growth is likely to hamper if real saving and real investment are not sustained.  In the long-run, real saving and real investment primarily depend on real income and profitability, respectively. In the short-run, possibly real interest rate can, to some extent, promote both real saving and real investment.  In fact, the real saving is more influenced by real income rather than the real interest rate.  In other words, the real interest rate is at best a weak determinant of real saving.  In developing countries, inflation rates are often higher than the deposit rate.  Hence, households do not get a real return from financial savings and hence prefer to save in physical assets such as gold and real estate. Similarly, the real interest rate is a weak determinate of gross domestic capital formation.  As interest cost as a proportion to total costs is generally low (3-4 per cent in India), it becomes difficult to stimulate the economy through interest rate policy unless wage cost, input cost, and other expenses are held in check.

In the post-crisis period, developed countries could pursue a low-interest rate policy (zero lower bound) to stimulate their economies. Since it was not sufficient, quantitative easing was pursued in several ways so that the economy could be quickly revived from the great recession.  It was generally observed that quantitative easing could not revive their economies.  In other words, monetary policy cannot be a good substitute for fiscal policy.  At least developed countries could pursue both low-interest-rate policy and quantitative easing as the inflation rate remained benign.  The developing countries were not in such an advantageous position as inflation expectations continued to remain elevated. At least, developed countries experimented for a considerable period of time with ultra-accommodative monetary policy as a substitute for fiscal policy.  This option was not available for developing countries due to different growth-inflation dynamics in such countries.

Another aspect of public policy is to maintain external sector balance which includes low external current account deficit as a proportion to GDP, low inflation differential between the major trading partners, and stable exchange rate.  Both monetary policy and fiscal policy have a definite role to play in this regard.  While fiscal consolidation reduces twin deficit, the prudent export-import policy of the government improves the trade balance.  Moreover, if a country has not achieved capital account convertibility, capital flows can be influenced by both monetary policy and fiscal policy. Maintaining a low rate of inflation by the central bank shall provide a congenial atmosphere to sustain export competitiveness.  In India, while the Foreign Exchange Management Act (FEMA) is enacted by the government, it is administered by the RBI. Capital account convertibility option lies with government although RBI can play a role in advising the government in this regard. 

We are living in an interconnected world.  There is a large cross-border movement of capital.  The exchange rates ought to be volatile in a globalised world.  Except for a few countries of the world which have adopted a fixed exchange rate regime, others pursue some form of the flexible exchange rate. The magnitude of volatility in the exchange rate shall be low if the medium-term fundamentals of the economy are strong.  Frictional factors, causing volatility in the exchange rate can be handled with limited interventions in the foreign exchange markets.

Inflation growth dynamics in India is complex. In the post-crisis period, growth collapsed around the world together with the softening of inflation.  In the emerging market economies like India, growth slowed down while inflation remained at an elevated level. The so-called ‘Phillips Curve’ type relationship was not observed in the case of India. Inflation control received priority over stimulating growth as option before the monetary authority was limited.

Empirical research in India shows that a low rate of inflation up to 6 per cent ‘greases the wheel of commerce’ while the same above 6 per cent ‘puts sand on the wheel of commerce’.  In fact, inflation beyond a threshold harms growth by adversely affecting financial savings as a proportion to GDP, creating uncertainty in the economy and more so, through the loss of competitiveness due to appreciation of real effective exchange rate. To ensure a reasonably high rate of growth on a medium-term basis, inflation needs to be kept at a low level. 

A historic agreement was signed between RBI and the Government on February 20, 2015, that empowers the RBI to pursue flexible inflation targeting to ensure price stability on a medium-term basis. The new framework of monetary policy has several innovative features.  First, there is a clear mandate for the RBI to achieve price stability, which would override other objectives if the inflation rate deviates from 4 ± 2 per cent from 2016-17. Second, the headline inflation measured in terms of new CPI shall be the nominal anchor in terms of which price stability shall be defined.  Third, the RBI shall be accountable if inflation deviates beyond the limit of 4 ± 2 per cent. The RBI has to explain the circumstances under which the inflation has deviated from the target, the action plan required to bring back inflation to the target level, and the timeline required to achieve this. The RBI has been reasonably successful in reducing the CPI inflation from 9.5 per cent in 2013-14 to 4.8 per cent in 2019-20.

Our understanding of public policy debate is still evolving. First of all, monetary policy and fiscal policy coordination is a must, notwithstanding areas of activities specified under statutory arrangements. Secondly, the burden of deviation from the prudent fiscal policy falls on monetary policy and vice versa.  Thirdly, the government is in a better position to stimulate growth by following countercyclical fiscal policy while the central bank is in a better position to achieve a low rate of inflation. Fourthly, achieving fiscal policy objectives with monetary policy and vice versa has not been very successful around the world as instruments in the hands of two public policy authorities are different.  Fifthly, the external sector balance of the economy is the joint responsibility of monetary policy and fiscal policy.

*The author is former Principal Adviser and Head of RBI’s Monetary Policy Department. Views are personal.


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