tight monetary policy versus economic growth
TRANSCRIPT
8/2/2019 Tight Monetary Policy Versus Economic Growth
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Tightmonetary policy Vs Economic growth
For an emerging and developing economy like India, it has always been a Hobson’s choice for
the central bank to select between the followings:
A: Economic-growth that is propped up by liberal monetary policy
OR
B: To rein in inflation through tight monetary policy.
Obviously, the ideal and sanguine scenario would be – Moderate inflation coupled with high
growth rate. However, esoteric market dynamics and panoply of macroeconomic variables
make it a difficult if not an unattainable target.
It is widely construed (and to some extent rightly so), that economic growth is inversely related
to the monetary policy. Many exhaustive literatures explaining the reasons behind the
aforesaid are available in the market. Some of the reasons (Rather major reasons) are
elucidated hereunder:
A: Economic growth increases the income of the people of the country and there is a demand
side pressure on the prices, which ultimately leads to inflation.
B: Liberal monetary policy in terms of low repo rate, reverse repo rate, CRR, SLR etc. makes the
money relatively cheaper and abundant in circulation and this leads to reduction in purchasing
power of the currency and hence inflation.
Proponents of economic growth suggest that for a poor country like India, economic growth
should take the precedence as there is no alternative of it. They stress upon the fact that even if
the growth rate is impeded because of the increasing the cost of money (through plethora of
monetary instruments viz. interest rate, CRR, SLR, repo rate, reverse repo rate etc., which are at
the disposal of the country’s central bank), the inflation will not come down instantaneously.
Reason being, inflation is not always a demand side pull. Instead, it is largely due to bottlenecks
in supply chain and inefficient distribution mechanisms and delivery systems, that the country
witnesses uncontrolled inflation. Indian subscribers of this view, put forward examples of 1970sand 1980s when the hyper inflation was due to supply constraints and not because of liberal
monetary policy. We had a stringent monetary policy at that point of time; still we had
witnessed one of the worst kinds of inflation.
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Scholars who represent the case of moderate inflation, present a different
perspectivealtogether. They emphasize on the fact that when inflation is high, the real rate of
interest goes down and people have got less or no incentive to deposit their money in bank and
this in turn restricts the funding of the infrastructure projects and other developmental
activities because of the dearth of available money. Hence it is imperative for any country(especially developing country like India) to have a firm grip on inflation before attention is
deviated towards growth consideration.
In India, monetary policy is a tool available to RBI to respond to the market stimuli. Moreover,
growth target is set by the planning commission, in consultation with the economic advisory
council. RBI and planning commission both have to work in tandem to create a financially
tenable and economically viable model of development for the country. Sustained journey in
the trajectory of growth target is indispensable for India if it has to improve and bolster its
stature as a formidable player in the global proscenium. But it is equally important for the
country to have a controlled inflation as well because it is the price rise that affects the poor
the most. With sustained inflation, many more people are thrown below poverty line because
their real purchasing power comes down. Moreover, it is to be understood that the effect of
economic growth takes time to percolate down to the masses and more often than not, the
benefits of economic growth in a country like India is enjoyed by a chunk of major players in the
markets and the benefits don’t even reach to the poor. But, in so far as inflation is concerned,
though the well-off section of the society may not feel the impact that much, the poor get the
pinch instantaneously.
So, it has always has been a difficult choice for RBI to tailor the monetary policy in a way tohave an optimum rate of inflation and growth. Whenever the country faces the downturn,
because of the turmoil in the external market, it decreases the rates so as to make rupee cheap,
to ensure that country continues to witness sustained growth. When persisting and intractable
inflation pesters the nation, the tightening of screw takes place.
The Inflation rate and various policy rates for past few years are given in the graph:
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Quite predictably, at the time of global recession during 2008-09, RBI eased monetary policy
rates to ensure adequate liquidity in the market. As soon as inflation started raising its head
and jumped outside the comfort zone of RBI, rates were increased to control the flow of
liquidity in the market. Recently in July, RBI increased the policy rates because of persistent and
intractable inflation.
However, for quite sometime, despite increasing the rate, inflation is not moderating and
questions are being asked about the efficacy of the monetary policy of the central bank. In this
regard, it must be understood that the monetary policy has got its own limitation and beyond a
certain point it can’t contain inflation. Inflation may have been catalyzed due to poor
harvesting, infrastructural lacunae, dilapidated delivery mechanism and global inflationary
pressure. Under those circumstances, the impact of tight monetary policy will be mediocre.
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It is imperative to mention here that monetary policy related instruments are time tested tools
in the hands of central banks but they are no substitute for prudent fiscal management,
capacity building, technological capabilities, proper market development and access and
efficacious supply chain. If India is to prosper, these issues have to be addressed from the
scratch and synchronization has to be established between fiscal policy and monetary policy toreap the full benefits of sound macroeconomic management policy. This sound macroeconomic
management policy coupled with immaculate supply chain management will be a giant leap
forward towards the attainment of the “developed nation status”.