Coordinated inequilibrium strategy between RBI and govt is most effective policy response in pandemic

The Indian Express

Dated 09.09.2020

Somya Kanti Ghose

Even as the pandemic continues to ravage India, there is renewed discussion in policy circles on kick-starting the economy, though there is a clear divide on when to unleash the second round of policy support. We don’t intend to get into a debate on its timing. Rather, we argue the importance of the year 1957 in India’s recovery and find that a coordinated inequilibrium strategy between the RBI and the government is the most effective policy response in the current pandemic. Most importantly, for such coordinated inequilibrium, a prerequisite, in the current circumstances, is effective communication from both RBI and government.

Coordination between monetary and fiscal authorities has been a thorny issue globally in recent years, particularly after the global financial crisis. India is no exception. Historically, if there is perfect coordination between the monetary and fiscal policy, then mathematically, there should be statistically significant negative correlation between the two. In the Indian context, for the 30-year period ended FY2020, plotting the scatter plot between the change in the consolidated fiscal deficit (as a crude indicator of the thrust of fiscal policy) on the horizontal axis and the change in the growth rate of broad money (as a crude indicator of monetary policy) on the vertical axis reveals no coordination, substantiating the dominance of fiscal over monetary policy. However, to be fair, the RBI did successfully stave off automatic monetisation and even the private placement of fresh issues with the FRBM Act in 2003. Non-coordination between the two in India is also constrained by several policy targets and fewer instruments.

Against this background, we show how policy coordination in India can result in a suitable, optimal combination of RBI/monetary and Ministry of Finance/fiscal strategy (based on “Issues in the Coordination of Monetary and Fiscal Policy” by Alan Blinder). Both the government and the RBI have two options between them — either a contraction or an expansion. Thus, we effectively have four policy options, and each of the options will have a particular benefit/payoff for the RBI and government. Our endeavour is to find out which policy option can result in a Nash Equilibrium. A Nash equilibrium occurs when neither the government nor the RBI can increase its payoff by unilaterally changing its action. There are four options — a fiscal policy expansion and a monetary policy contraction; a fiscal policy expansion and monetary policy expansion; a fiscal policy contraction and a monetary policy contraction; and a fiscal policy contraction and a monetary policy expansion.

The payoff scenarios are hypothesised as benefits accruing to the government and the RBI separately when they are deciding on either of the policy options: Contraction or expansion. Specifically, the government is assumed to favour an expansionary policy and gets maximum payoffs from a fiscal expansion, either with monetary expansion or contraction (the payoff is obviously maximum when the RBI also expands). Separately, the monetary authority ideally wants to contract the economy to fight inflation and gets maximum payoffs from a monetary contraction, either with a fiscal contraction or expansion (the payoff is obviously maximum when government also contracts).

In the current context, it is reasonable to assume that the government always prefers a tight fiscal policy for obvious reasons and expects the RBI to provide the necessary liquidity support through an expansionary monetary policy. This implies that the payoff matrix of fiscal contraction and monetary expansion would be the best optimal solution, at least from the government standpoint.

Reference

https://indianexpress.com/article/opinion/columns/rbi-government-indian-economy-pandemic-6588421/

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