Policy changes to help revive economy also have trade-offs, says RBI paper

Reserve Bank of India (Representative image)

Measures such as demand management policy or flexible interest rates, which are aimed at reviving the economy and helping households may also adversely affect the latter, according to a working paper of the Reserve Bank of India.

Covid-19, described as a Black Swan event by the authors of the paper, imposed several challenges on the Indian economy. The authors attempted to assess the role and effectiveness of various public policy options and their trade-offs using a model that’s applicable to rare and extreme negative events.

The study suggested that supply-side measures taken during Covid-19 could lead to a decline in the government’s social expenditure, adversely affecting household welfare. On the other hand, managing demand to bring respite to households also can have adverse effects.

“Demand management policies are not completely free from trade-offs, as fiscal expansion via tax cuts or monetary expansion through an interest-easing cycle has inter-temporal welfare costs, as current tax cut may tighten future government spending, and lower interest rates may trigger inflation,” the authors wrote.

The paper concludes that demand revival policies may help only if they are fine-tuned with appropriate and calibrated supply-side reform measures to achieve an optimal policy mix to address the contemporary critical financial situation.

“In the face of a cyclical decline in interest income, consumers may be encouraged to invest in liquid assets that exhibit counter-cyclical returns like gold bonds,” they said in the paper.

The working paper also referred to growing concerns over unchanged low policy rates. The RBI has kept the repo rate at 4 percent and the reverse repo rate at 3.35 percent for quite a while. This has lowered the rate of interest on savings accounts and fixed deposits. A large proportion of the retired population depends on interest from deposits to supplement their finances.

“For households, it indicates that the utility declines more when the deposit rate is pegged to the policy rate by a mark-up condition, because a decrease in the policy rate will lead to a lower deposit rate. As the lower deposit rates are passed on to the households, their interest income falls,” the paper said.

While people who rely on deposits would like interest rates to go up, if the RBI tries to adjust policy rates based on the situation of households, it may create further complications.

A flexible deposit rate comes with an added cost as it erodes households’ interest income and results in a further decline in deposit rates, according to the paper’s authors, who are managers in the RBI’s Department of Economic and Policy Research.