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1. The Context
The inflation targeting framework adopted in India in 2016 is coming up for review in 2021. Critiques of this framework have argued that there are a number of reasons why some aspects of this framework needs to be changed. These include the inappropriateness of the current measure used for inflation, the lack of adequate sensitivity to cyclical slowdowns, the ineffectiveness of the targeting framework as a result of weaknesses in the monetary transmission mechanism etc. I shall argue here that there is a deeper problem with the current inflation targeting framework that justifies a relook at this policy in conjunction with the FRBM framework that defines fiscal policy in India. Based on this critique, I suggest a policy option in the form of a fiscal-monetary coordination mechanism that is unconventional in nature1
2. The Growth Problem
It is well known that Indian growth rates have been falling consistently for the past couple of years. This has led to a lot of debate on whether this slowdown is cyclical or structural. However, even the staunchest proponents of cyclicality agree that compared to the pre-GFC period, growth rates of potential output2  have fallen significantly in India. A number of studies have also confirmed this3.   
The fall in potential growth rate in India has led to calls for structural reforms, as these are expected to increase private sector productivity by bringing down costs of factors of production including land, labour, electricity etc. However, even if these factors of production become cheaper, it is doubtful whether this would be enough to reinvigorate growth to our full potential. As many studies have shown, this is due to the fact that the availability of physical infrastructure, including roads, railways, airports, ports, etc. is woefully lacking in our country, and this hampers private sector competitiveness4. Clearly, large investments in these critical infrastructures would be as important as structural reforms, in order to increase our potential growth rates significantly.
The problem is of course with the financing of such expenditure. Historically in India, it has been the capital expenditure of the government that has financed such initiatives. Over the last few decades however, the government has gradually brought down its rates of capital expenditure, turning instead towards more private participation in this sector. However, in the last few years, this policy has been found to be disastrous, with some of these private infrastructure projects becoming the biggest Non-Performing Assets (NPA) with the banking sector. While other sources of private financing of infrastructure like pension or insurance funds are theoretically very promising, these will require major institutional reforms that will take time to give results. Clearly, even if such initiatives achieve some success over time, there still remains a strong case in favour of increasing the government’s capital expenditure on infrastructure projects.
3. The Macro Policy Conundrum
This however, is easier said than done. We have, in fact, moved in the opposite direction, with very low levels of capital expenditure to GDP ratio. This is the result of two distinct trends in the fiscal space. The first trend is that the government expenditure in India is increasingly being deployed to finance revenue rather than capital expenditure. The second trend is that the size of the government (in terms of expenditure) has itself shrunk as a result of our fiscal policy framework that has attempted to limit central government borrowing5. Clearly both these trends, acting together, have resulted in low capital expenditure ratios in India during the recent past.
What explains these two trends? The main factor behind the first trend is the political economy of growth following the market reforms in India. These reforms led to significantly higher growth rates in the Indian economy but for the most part, these growth rates were associated with low job creation and increasing inequality. This put political pressure on successive governments to increase revenue expenditures by funding government consumption and transfer payments, leading to what was termed as the ‘inclusive growth’ framework. This effectively brought down the share of capital expenditure in the government budgets. 
The second trend of limiting the size of the government is an outcome of the conceptual framework behind the reforms in India in the nineties, which envisaged the private sector as the principal engine of growth. In this framework, if supply-side constraints are removed through structural reforms, the animal spirits in the private sector would ensure high potential growth rates and put the Indian economy on a path to catch up with the more developed countries. The role of monetary and fiscal policy in such a framework was mainly to manage the business cycles that characterizes private sector led growth paths. Moreover, monetary policy was considered the more appropriate macroeconomic tool that could manage the business cycles effectively. Since higher government spending frequently resulted in larger market borrowings by the government, impeding the interest rate channel through which monetary policy works, it became imperative to put limits on fiscal deficits. This happened through the adoption of the FRBM act. 
4. A Possible Solution? 
The fall in potential growth rates has brought us to a crossroads, where we have to choose a new path. Can we redesign our macro policy framework so that it enables the government to boost its capital expenditure? In order to be effective, any attempt in this direction has to first address the two sets of factors described above that have kept capital expenditure low in recent times. This means, firstly, being able to avoid (at least to a large extent) the political pressures that force governments to increasingly budget for revenue expenditures, and secondly, maintaining the independence of monetary policy and the central bank. I propose a possible solution here that is institutionalised in terms of an unconventional fiscal-monetary coordination framework6.  As we shall see, this solution addresses adequately both sets of factors impeding capital expenditure currently. 
The basic institutional mechanism that I propose is an ‘Augmented Flexible Inflation Targeting’ framework, which specifically includes a standing fiscal facility provided by the central bank to be used conditionally for funding capital expenditure. It would be a permanent set-up but would only be activated if (i) the inflation forecast is within the range defined by a flexible inflation targeting framework (ii) the growth of potential output is below some well-defined long-run value and (iii) the underlying economic model predicts a higher growth of potential output if the government increases its capital expenditure. This would require the RBI to model potential output and its growth rate by using a production function approach (Bhoi and Behera, 2016), augmenting it with capital expenditure as an input into the production function. Theoretically, such a model of growth would be consistent with Barro (1990). Once the conditions of the standing facility are activated, there would be a mechanism to transfer the required funds to the government, to be spent as ‘additional’ capital expenditure over and above that which has been budgeted at the beginning of the fiscal year. A second critical part of the framework would be a clear exit strategy which would again be enforced by the central bank. This would be triggered by either (i) inflation forecasts moving outside the inflation targeting range or (ii) growth of potential output reaching the long-run values. 
How does this mechanism deal with the political pressures on the government to budget the additional funds for revenue expenditures? First and foremost, it does this by earmarking the fund specifically for capital expenditures. Here capital expenditure has to be well-defined, in broadly acceptable, capital-creating activities. Secondly, by keeping the activation of the facility and exit options completely in the hands of the central bank, the mechanism limits political pressure on the government. Finally, it can ensure that the money is spent on capital formation by conditioning the release of current tranches, on past tranches having been spent satisfactorily. While these mechanisms are still not airtight guarantees that the funds will be used for capital expenditures, it does make it difficult to channelize these funds to other uses. 
Of course, the availability of such a fund could drive governments to undertake less capital expenditure in the annual budget. However, given the various conditions that activate and discontinue the standing facility, this is an uncertain source of funds ex ante, so that it will be difficult for the government to know beforehand, just how much it can expect from this source. There may still be a tendency for the government to move to less capital expenditure. One way that this can be countered is if an additional condition is included for activating the facility that makes it a 'matching expenditure' contingent on the government's own budgeted capital expenditure. 
From a political economy perspective, governments and politicians do gain from higher growth rates but are unable to spend on public invest due to political pressures that demand immediate results. The mechanism described here enables the government to gain from increased capital expenditures without being directly responsible for that decision. This should make this mechanism politically cogent and hence add to its effectiveness .
How does this solution address the second set of factors, i.e., central bank independence? It does so, principally by sticking to the flexible inflation targeting mechanism that is currently in place. Secondly, central bank independence is also reserved by the fact that the size of this facility is determined solely by the central bank according to its modelling forecasts. Finally, since the standing facility bypasses the interest rate channel, the central bank ensures that standard monetary policy effectiveness is not impeded. 
One major adjustment that this solution needs however, is in the current fiscal framework, i.e., the FRBM act, which explicitly prevents the central bank from buying government bonds in the primary market, i.e., direct monetization. Since the standing facility effectively implies direct monetization of capital expenditure by the central bank, this solution is possible only if a revised fiscal framework allows such monetization under the conditions described above. Is such a significant adjustment in the FRBM act justified given our poor experience with such policies in the past? In my view there were three reasons why direct monetization in the past led to such poor outcomes. These were, first, the inflationary episodes from indiscriminate monetization, second, the fiscal profligacy or unproductive expenditure funded by such policies, and third, the size of the sovereign debt that resulted from such monetization. The framework proposed here addresses all three concerns. The concern about inflation is addressed through the inflation targeting mechanism. Fiscal profligacy is avoided by earmarking the facility specifically for capital expenditure.  Finally, the framework ensures the sustainability of the sovereign debt, not by focussing primarily on keeping down government expenditure, but by boosting the economy to a higher growth rate. These factors should ensure that this framework is completely different from the monetization episodes that we have experienced in the past. 
To be clear, this monetary policy support for capital formation, particularly in infrastructure, is not a substitute for either regular budgeted capital expenditure by the government or infrastructure funding that can come from long-term saving institutions like pension or insurance funds. After all, these two sources of funding are regular and stable and hence they are more appropriate for undertaking projects with long gestation periods. In comparison, the funding from the standing facility is uncertain by construct, as it is sensitive to inflationary episodes. So given this uncertainty, how can this fund be used for infrastructure creation? There are two ways in which this this can be done. The first is to consolidate the fund over a time period (say a year) over which the inflation targeting mechanism ensures that the inflation rate is within the acceptable range and hence the fund is available. Once the volume of the fund is determined (say for a year) by the central bank, it can be transferred any time that the economy is within the targeted range of inflation. The second way in which this facility can be used is to cover cost-overruns that large infrastructure projects frequently run into, with regular budgets not being able to support them in time. This in itself will help a lot of these projects complete on time, preventing further cost escalations. 
Clearly, the augmented flexible inflation targeting framework with a fiscal-monetary coordination mechanism that I have described here is a very unconventional policy tool in the Indian policy space. However, unconventional policy tools are becoming much more acceptable all over the world as conventional policies are finding it increasingly difficult to counter major economic shocks and structural changes. In the Indian context, the choice seems to be between adopting unconventional policies, or remaining stuck in low-growth traps, because that is where conventional macroeconomic policies have left us.

1. This note has benefitted greatly from discussions with Niranjan Rajadhyaksha and Andy Mukherjee.
2. Potential output refers to the level of output that is consistent with full capacity utilisation.
3. Bhoi and Behera (2016) provides details of these studies.
4. See Hulten et al. (2006) for an empirical analysis of this hypothesis for the Indian economy
5. See Roy (2019)
6. A similar fiscal-monetary coordination framework has been suggested by Stanley Fischer and associates (Barsch et. al, 2019) for developed countries. However, the objective there is augmenting demand management, since conventional monetary policy has become less effective. 


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Bartsch, Elga, Jean Boivin, Stanley Fischer, and Philipp Hildebrand. "Dealing with the next downturn: From unconventional monetary policy to unprecedented policy coordination." Macro and Market Perspectives (2019).
Bhoi, Barendra Kumar, and Harendra Kumar Behera. "India’s potential output revisited." Journal of Quantitative Economics 15, no. 1 (2017): 101-120.
Hulten, Charles R., Esra Bennathan, and Sylaja Srinivasan. "Infrastructure, externalities, and economic development: a study of the Indian manufacturing industry." The World Bank Economic Review 20, no. 2 (2006): 291-308.
Roy, Rathin, “Govt’s Shrinking Fiscal Space” in Business Standard, February 5, (2019).
Sabyasachi Kar, is Professor (RBI Chair), NIPFP, New Delhi.
The views expressed in the post are those of the authors only. No responsibility for them should be attributed to NIPFP. 
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