Monetary policy for exceptional

Context: RBI and government should move forward with unconventional policy initiative of monetization of deficit, as it has low inflationary effect on the economy as oppose to the conventional belief.

The Significance of Unconventional Policy Initiatives (UPI): 

• Rise of Unconventional Monetary Policy : Global Financial Crisis influenced central bank’s initiatives in the form of asset purchase programs, forward guidance and quantitative easing (QE). 

• Proxy for conventional monetary easing: QE led to decrease in duration of risk and lower short-term policy rates expectations, leading to eased financial conditions.

• Unwarranted fears: due to criticism of large-scale QE distorting markets and stoking inflation. These fears are subdued due to the experience of last decade.

• UPI by RBI in recent times: This has led to higher liquidity.

• Long Term Repo Operations (LTRO)/ Targeted Long-Term Repo Operations (LTRO).
• Operation Twist
• Asymmetric cuts in Reverse Repo Rate.

• Deficit Monetization: could prove to be a proverbial dark horse. A case for deficit monetization can be made on following basis:

• Higher liquidity has not translated into credit creation: due to rising precautionary demand of money.

• Lowering of money multiplier: Huge inflows of deposits with high uncertainty in economic environment have restricted banks’ lending.

• False assumption about Velocity of money:

• Conventional Policies consider velocity of money to have one-to-one relationship with demand for money leading to inflation.

• Experience during financial crisis has shown that velocity of money is subject to volatile fluctuations in short term, driven by expectations of the economy.
• Thus, velocity of money is not a cause but an effect, and a sharp fall in it should be encountered by an increase in money creation.

• Monetization of deficit will not be inflationary:

• Monetizing fiscal deficit leads to RBI directly purchasing government debt rather than government borrowing from the market. 
• When the government uses these funds, it gets transferred to the central bank leading to increase in reserve money
• However, with low velocity of money, the reserve money would not lead to inflation.

• Enhanced credibility of central banks: if the monetization of deficit is cautioned with clear usage of funds and an ensured exit strategy.

• Need for UPI: due to various vulnerabilities of Indian market.

• As an emerging market, India is subjected to exogenous supply shocks impacting inflation.
• India has adaptive inflationary expectations and faces high deficit and debt ratios, subjected to scrutiny by foreign investors.

Conclusion: Tools like monetization could aid the current focus of the government and RBI towards easing financial conditions and lowering the cost of capital.