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The demonetisation of 500 and 1000 rupee notes was announced by the Prime Minister on November 8, 2016; since then, there has been a growing interest in understanding fiscal-monetary policy linkages. This article revisits these compelling policy linkages. Increasingly, there is an alarming tendency of segregating the monetary and fiscal policy while assessing the impact of such announcements on macroeconomic activity. These debates around fiscal-monetary policy linkages find roots in the contemporary macroeconomic policy transition in India from “discretion” to “rules”, leave alone the “unanticipated demonetisation announcement”.


The fiscal policy institutions have moved away from discretionary fiscal stance towards FRBM (Fiscal Responsibility and Budget Management), the “fiscal rules” – which articulate the efficacy of fiscal authorities to keep the deficits within the numerical threshold level of deficits normalised to GDP. Recently, the monetary policy authorities too have begun following the “policy rules”, especially, of ‘inflation targeting’ and ‘central bank independence’ in India. The first MPC (Monetary Policy Committee) revised their projections of growth from 7.6 per cent to 7.1 per cent against the backdrop of demonetisation.
The Reserve Bank of India clarified that the downward revision in the growth projections is due to uncertainties resulting in “short-run disruptions in economic activity in cash-intensive sectors such as retail trade, hotels and restaurants and transportation, and in the unorganised sector” and “aggregate demand compression associated with adverse wealth effects”. However, it is a challenge for Indian policy makers to have ‘economic’ growth back on board with global turbulence of rising oil prices and Janet Yellen’s “hawkish” spirit of rising Fed rates.
Will demonetisation have only “intra-year” impacts and will remonetisation, bring ‘economic growth’ back on board? Economists are divided in their opinion here. The contemporary macroeconomic policy transition from discretion to rules raises one pertinent question in the minds of the researchers. “Does monetary rule require a fiscal rule?” If so, the FRBM Committee’s report is much awaited in India, after the release of the MPC Report by the RBI. The monetary-fiscal linkages are treated by examining the macroeconomic channels through which deficits affect monetary policy stance. Unfortunately, over the years, the coordination between fiscal and monetary policy has been weakening and the policy debates have confined to just numeric values of deficits – the ‘levels’ of deficit to 3 percent of GDP - in attempting such linkages, leave alone the financing pattern of fiscal deficits. There has been a widening acceptance that numeric fiscal rules are associated with greater fiscal discipline. It is after more than a decade of silence on these debates that, only last year, the Economic Survey has reopened these debates on fiscal and monetary policy linkages in India.
The significance of institutional linkages between fiscal and monetary authorities can be traced to ‘Unpleasant Monetary Arithmetic’, which reveals the situation of “fiscal dominance” where fiscal authority has the “first mover advantage”, while the monetary policy follows. Under this fiscal dominance, the attempts by the central bank to keep inflation low through inflation targeting cannot last and must ultimately yield to higher inflation in the longer run. So, “inflation today or inflation tomorrow” is the only plausible macro-fiscal policy option and obviously monetarist arithmetic  goes  “unpleasant” here.  From the perspective of financing deficits, if the bond financing of deficits, sooner or later, becomes unsustainable, the central bank has to step in and generate the monetary seigniorage revenues (print money) to remonetize eventually.
So, the moot question before the FRBM panel is that ‘is the macroeconomic scenario of unpleasant monetary arithmetic better for growth outcomes’? The other option is ‘Unpleasant Fiscal Arithmetic’ (central bank independence and inflation targeting with no fiscal policy dominance) that visualises to reverse the order of adjustment of “fiscal dominance” and transfer the first mover advantage from fiscal agencies to the central bank authorities. 
By introducing strict fiscal policy rules, it obligates the fiscal agencies to adjust to the anti-inflationary policy of the independent central bank and thus unpleasant monetary arithmetic turns into unpleasant fiscal arithmetic. These debates re-emerge as “fiscalists”, where the price level is independent of monetary policy but dependent strictly on fiscal policy; and these “fiscal policy of price determination” economists assumed that the price level indeterminacy problems can be solved by having the central bank peg the nominal interest rate at a level consistent with the central bank’s desired inflation rate, rather than by controlling the growth rate of the (base) money supply.
If we take recourse to these arguments for monetary-fiscal linkages, does FRBM panel visualise whether bond financing of deficits - the dominant mode of financing deficit in India - has an empirical upper bound? If so, do they visualise whether rate of interest on government bonds exceed the growth rate of the economy in recent years? The eventual monetisation of the deficits (through print money) appears far from reality as the present structure of financing the deficit has a negligible share of external financing of debt, and the composition of debt is more of long-term maturities. Still, the assumption that, the monetary regime has no influence on the conduct of fiscal policy needs a revisit, especially, when the economic growth rate (g) is plummeting and the real rates of interest (r) have shown no signs for a significant downward trend in recent years in India, leave alone the policy announcement on December 7, 2016 by RBI to keep policy rates at status quo.
All that I wish to flag here is not the concern of any straightjacket impending un-sustainability condition of r>g in India, but the recognition that monetary policy stance contains relevance for the “term structure of interest rates” and also has a catalytic role in promoting economic growth. Despite the concerted policy changes undertaken by the Government of India and the Central Bank to contain monetisation in India, the monetary seigniorage is not yet on the decline. Though the net RBI credit to the government has been controlled through policy coordination, the net FOREX reserve is on the rise. With demonetisation, and impending remonetisation, the component of “reserve money” or “high powered money” in India and its impact on growth should be taken up for research on an urgent basis.

1Urjit Patel Committee recommendations, Reserve Bank of India, 2014 and the ‘New Monetary Framework’, signed between the Government of India and the Reserve Bank of India, February 2015.

2According to “Bi-monthly Monetary Policy Statement, 2016-17 Resolution of the Monetary Policy Committee (MPC), Reserve Bank of India”.


The author is Associate Professor, NIPFP. Click here for detailed profile.
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