The Criticality of a Coordinated Policy Approach in Covid Times

Context: India’s move to a rules-based macroeconomic framework was based on the global thinking that central bank cares more for price stability and the government for growth.

Policy Coordination in times of COVID:

• Necessitated by supply constraints: The output shocks due to COVID have changed preferences of central bankers worldwide to give more weight to growth, leading to more coordination.

• Changes in the preference of Monetary Authority(MA) and the Fiscal Authority (FA): As the MA also values growth more, enforce coordination. 

Issues with the Monetary Fiscal Policy Coordination:

• Prisoner’s dilemma: While the monetary policy affects demand more, the fiscal policy affects supply-side costs and therefore, inflation.

• Since each is more effective in achieving the other’s objective, total independence leads to a prisoners’ dilemma type of non-co-operative strategic interaction. 
• As players follow their own interest, each is worse off in the outcome of higher inflation and lower growth. 
• If the Centre cuts back on expenditure that could reduce inflation, monetary policies are forced to keep interest rates high.

• Inflexible Rules: The Indian experience suggests a simple rule alone is not effective.

• It could be either interpreted too strictly, as inflation targeting was in the initial years, or it could be avoided, as fiscal responsibility was after the global financial crisis (GFC). 

• Impact of COVID: Loss of income, contagion and rising precautionary savings translates to depressed private investment and consumption. 

• Inefficacy of fiscal stimulus: The lockdown created serious supply chain disruptions, which has made the fiscal demand stimulus less effective.

• Gross domestic product estimates show that in April-June, supply-side contraction exceeded demand-side reduction. 

Way forward: 

• Making the rules more flexible: The flexible rulemaking reduces pay-offs from non-cooperation, making coordination (and not a prisoners’ dilemma) the self-enforcing outcome. 

• Since the Monetary Authority knows the Fiscal Authority will act on the supply side, it can lower interest rates. 

• Government has space and can create more asset and expenditure restructuring:

• The Fiscal Responsibility and Budget Management Act allows for monetary financing under a growth collapse. 
• Medical aid, preventing hunger and protecting livelihoods are priorities. 
• A moderate expansion in fiscal expenditure coinciding with the festival season and recovering supply chains could build private sector confidence and trigger spending. 

• Inject Surplus Liquidity: 

• • Surplus liquidity aids government borrowing and also reduces financial sector tensions and future non-performing assets requiring more government support. 
  • Equity cushions are available for banks.