Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

How to deal with the demand shock

Monetary policy can be a part of the overall responsebut it is perhaps the weakest policy lever available right now

The six members of the monetary policy committee of the Reserve Bank of India (RBI) will meet this week under extraordinary conditions. The currency reform is now a month old—and there continues to be intense debate about its implications over the long term.

However, there is little doubt the immediate impact will be a compression of aggregate demand, pushing down quarterly economic growth. Add to that the massive surplus liquidity because of the inflow of deposits into the banking sector, an inflow that has been enough to put immense strain on the reverse repo operations of the RBI. To add to the complications, the US Federal Reserve is also expected to increase interest rates this month. The dollar has rallied.

Most private-sector economists believe that the monetary policy committee will reduce interest rates by 25 basis points (one basis point is one-hundredth of a percentage point) in a bid to get economic activity back on track. The commentary from the Indian central bank too will be important. Governor Urjit Patel has been criticized for keeping silent during the ongoing monetary experiment. He told BloombergQuint in a rare interview that the RBI is studying the impact of the decision to replace old banknotes with new, and that the central bank will comment on the situation after the monetary policy is announced. The analytical comments from the RBI this week will be extremely important.

There would have been compelling reasons for a 25 basis point interest rate cut even if matters were more normal right now, especially since inflation is muted. The real issue is whether a rate cut can quickly deal with the impact of the shock to aggregate demand (and remember the economic impact is still uncertain despite the fiery rhetoric from all sides).

There are two concerns in this context. One, monetary policy works with a lag of about three quarters in India, so it may not be the best tool to stimulate demand right away. Two, lower interest rates are unlikely to lead to a rush to borrow for new projects. The demand for credit continues to be weak. And banks will be wary of using the short-term inflows into their coffers to make long-term loans, because of potential asset-liability mismatches.

Fiscal policy is likely to be a far more potent tool to deal with the problem. The government is working on a new fiscal law that will in all probability give it more room to spend in situations such as these. We had already commented in these columns soon after the currency reform was announced that a lot will ride on the ability of the government to quicken the pace of road building.

Construction activity has large multiplier effects in industries such as cement, steel and machinery. It also has the ability to create jobs quickly. This was seen in both the road building by the Atal Bihari Vajpayee government as well as the rural housing boom during the Manmohan Singh government.

Fiscal expansion can be done through either cutting taxes or increasing spending. The second is preferable right now because reversing tax cuts once the Indian economy makes up lost ground—perhaps after two quarters—will be very difficult. Spending on specific infrastructure programmes is far less sticky.

Some economists argue that the government could announce a special bonus when food procurement is being done, especially since wheat stocks are relatively low right now. But higher minimum support prices have important implications for overall inflation.

Prime Minister Narendra Modi seems to be flirting with another idea. He mentioned in a speech given over the weekend that his government would transfer money collected from tax evaders into Jan Dhan accounts. The Robin Hood narrative was straight out of the 1970s, but such a cash transfer to the poor would have the fastest impact on demand since the marginal propensity to consume is very high among those with low incomes. It is also not clear whether this should be interpreted as an election sop or a purely economic response to demand compression.

India is currently in uncharted waters, and too many people are talking with certainty about what is actually an outlier event. The temporary decline in economic growth needs to be countered with policy measures if negative multiplier effects are to be avoided, or a case where the initial decline in, say, the sales of motorcycles leads to job losses across the supply chain, and hence a next round of lower demand from the newly unemployed, leading to further job losses, and so on.

The upshot: Monetary policy can be a part of the overall response to the demand shock—but it is perhaps the weakest policy lever available right now.

Do you think a rate cut can quickly deal with the impact of the currency swap shock to aggregate demand? Tell us at
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