The aggregate demand is defined by
the identity Y=C+I+G+(X-M). Implied is the aggregate demand is the sum of
consumption, investment, government expenditure and net exports. If the
government intends to create a trajectory for the AD, it can alter one or more
than one of these variables to meet its intended policy objectives. The government
itself is autonomous player and thus can influence the economy through
increased or decreased government spending G. Indirectly, the government can
influence the spending through two different instruments, the fiscal and the
monetary policy. The fiscal policy apart from the changes in government
expenditure would also comprise of changes in tax rates. The government can
increase or decrease tax rates thus influencing consumption, investment and net
exports. The second instrument, the government employs is the monetary policy. It
is through the instrument of interest rates, the government seeks to control the
money supply and thus influence aggregate demand. The monetary policy falls in
the domain of the Central Bank, in the context of India, the Reserve Bank of
India (RBI).
The RBI while nominally independent
usually functions in alignment with the government to achieve the intended
objectives. While there are conflicts between the central bank and the government,
usually, the government manages to have its way as evidence points towards from
across the world including the United States. The Central Bank can execute its
objectives through two mutually exclusive and conflicting ways. The Central
Bank can seek in stability in money supply or pursue stability in interest rates.
Yet it cannot pursue both simultaneously, since changes in one will impact the
other. A stability in money supply necessitates changes in interest rates to
keep money supply constant. On the other hand, a pursuit in keeping interest
rates constant would entail money supply to be frequently altered. The altering
of money supply in turn would influence the direction of inflation. As theory
suggests, there is a direct linkage between money supply and inflation given
the constancy in velocity of money and for a given level of real aggregate
demand.
In India, for a long time, the monetary
policy was a side show the fiscal dominance. The monetary policy was geared
towards an objective of ensuring adequate credit to trade, industry and
agriculture. It was aligned to the agricultural season rather than towards the
industrial and in general economic growth. Inflation targeting as policy
objective was more recent formulation. The RBI took over unofficially the role
of containing inflation around a decade or so back something that was formalized
in 2016. The RBI’s monetary policy committee (MPC) is entrusted with keeping
the inflation within the targeted band currently 4%+-2. The target is scheduled
to be up for review in March 2021. While there are serious questions on the
inflation targeting and its efficacy in times of crisis. In times of slump, the
counter cyclical measures need to be rooted in the governmental actions than in
the monetary policy. The monetary policy finds itself at odds given the
precedence of autonomous factors over induced factors in periods of
uncertainty. The Central Bank, in times of slump has to ensure credit provisions
to be available in adequacy to all sections including the most vulnerable. In a
way, the RBI’s role over the last year or so has more or less been to reinforce
its original role of as a facilitator of credit. The RBI has to act in
alignment with the government towards the policy objectives. In this context,
it is the inflation targeting through interest rate changes and keeping money
supply in line with the requirements of the economy. This would go in terms of
reinforcing the growth paradigms.
To the Central Bank, the commercial banks
are an essential medium of transmission of monetary policy to the grassroots. It
is the gaps in the trickle-down effect, the inability of the banks to pass on
the RBI policy benefits to the retail or the corporate borrowers that put
limits to the monetary policy. Implied is the ability of the commercial banks
in being the transmitting mechanism or the lack of the same is the rate
limiting step of the monetary policy. The banks essentially create money
through the fractional reserve system thus hindered by the RBI constraints on
borrowings mainly through the cash reserve ratio and statutory liquidity ratio.
The latter of course is more a readymade market for government securities.
Lower lending rates and lower
deposit rates encourage consumption. Since the opportunity cost of holding
money in a bank or related financial instrument would be high, there would be
tendency to go in for current consumption rather than postponing to some future
date. Similarly, the lower lending rates induce borrowers to front load their
borrowings and thus encourage both consumption and investment. On the contrary,
the higher deposit rates encourage the households to save and postpone the consumption
to some future date. Therefore, when the governmental objective is to create
conditions for increasing consumption or investment, the ideal way would be to
reduce both deposit and lending rates. On the other hand, when the economy is
overheating, the government wants to temper the economy. In this scenario, the
government would raise the borrowing rates to discourage lending. It will also
raise the deposit rates to ensure consumption is traded off in favor deposits
in financial instruments, bank and non-banking.
The monetary policy was believed to
be a market oriented way of governmental intervention rather than a direct
fiscal intervention through changes in G. The monetary policy has been the
favored instrument in the Western world especially both the United States and
the European Union. The creation of Euro zone was in effect a surrender of
monetary sovereignty to an authority in Brussels while gaining the advantage of
cheaper funds thanks to improve sovereign ratings collectively. This was
actually in quite a few ways the cause of the crisis in Greece, Ireland,
Portugal among other countries. The monetary sovereignty cannot be enforced
without a compromise on either currency convertibility terms or fluctuations in
exchange rates. This brings one to a deeper question of linkages between
monetary policy characteristics and the subsequent linkages with the external
sector. This has to be engaged separately at a later date.
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