Financial inclusion enhances the potency of interest-rate based monetary policy by causing an increasing number of people to become responsive to interest rate cycles, according to Reserve Bank of India Deputy Governor MD Patra.

“This, in turn, prompts appropriate smoothing behaviour. There is also some evidence to suggest that as interest rate sensitivity of the population increases, central banks need to move interest rates less to achieve their objectives,” Patra said.

Smoothing consumption

In his keynote address at the launch workshop of ‘Financial Inclusion for Rural Transformation’ organised by IIM Ahmedabad, the Deputy Governor said that although it is empirically observed that there is a two-way relationship between monetary policy and financial inclusion, it is unambiguous that financial inclusion is able to dampen inflation and output volatility.

Patra explained that this is “achieved by smoothing consumption by enabling people to draw down financial savings in difficult times for everyday needs. This makes people interest-sensitive.”

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Moreover, inflation-targeting monetary policy ensures that even those at the fringes of financial inclusion are secured from adverse income shocks that hit when prices rise unconscionably, he added.

Patra emphasised that financial inclusion fosters societal intolerance to inflation, a social preference for macroeconomic stability, and a sense of the long and variable lags with which monetary policy operates.

“This makes it possible for smaller monetary policy actions to achieve the same goals in a shorter period,” he said.

Financial literacy needed

The Deputy Governor noted that financially-included economic agents appear to be able to ride out interest-rate cycles pro-cyclically instead of being impacted counter-cyclically. Clearly, sustaining the thrust on financial inclusion will leave the RBI better off in achieving monetary policy transmission, he added.

“It is observed that financial literacy empowers people to choose more relevant information and to make better use of it. Closer assessment of future inflation helps inform choices on personal finance decisions, including opening of a bank account, taking a bank loan or even bargaining for wages,” Patra said.

The RBI Deputy Governor expects that an included and aware population will participate more in monetary policy formulation and implementation, develop more rational expectations and induce financial intermediaries to transmit policy impulses more swiftly and effectively across the financial system.

Access to formal finance

Patra explained that increasingly, monetary policy authorities realise that financial inclusion — or the equality of access to formal finance — impacts the conduct of monetary policy more fundamentally than they thought. The impact is felt in the choice of metric for measuring goal variables, in the choice of trade-off between their variances, and in the efficacy of monetary policy in reaching out to the broader economy.

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“In this context, central banks find themselves integrally involved in policy drives to expand financial inclusion because they have to take into account the true financial structures of the economies in which they conduct monetary policy,” he said.

Patra opined that as people get financially included, they can use their access to formal finance to deal with both good and bad times, and in more accurately assessing future inflation. And this has monetary policy implications.

“So, central banks do care about inequality. After all, social welfare — the mandate of institutions committed to the greater public good — hinges on it,” he said.

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