Tight Monetary Policy Versus Economic Growth

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.



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:



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.



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”.

Tight Monetary Policy Versus Economic Growth

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