Almost all students of economics would have encountered a ‘must read’ book by Dornbusch and Fischer on macroeconomics, which was on the reading list for post-graduate courses. One of the authors, Stanley Fischer, who died recently, will be remembered as an academic who also worked with the multilateral lending agencies besides having a stint with Citi Bank. He topped it as Governor of Bank of Israel.

The fact that an academician was able to work across diverse organisations, including a central bank bears testimony to his contributions.

Fischer’s most well-known academic work was in monetary economics in the seventies. This was the time when the debate over Keynesian economics was revived. Keynes had said that when an economy was in a low equilibrium trap, a way out was to have a fiscal stimulus.

This meant spending more by increasing the size of the budget deficit and putting money in the hands of people by creating more jobs. This was followed by most countries till the beginning of the seventies.

Chicago school

The seventies also saw the resurgence of Freshwater economists from Chicago School led by Milton Friedman. It was the time when monetarism came to the fore especially after the first oil price shock. The oil shock shattered the belief that high inflation could not co-exist with high unemployment and low growth.

High crude oil prices led to supply side inflation and lower growth leading to a recession. Governments used fiscal expansion to get out of the recession, but this only added to inflation. This, said critics, was the failure of Keynesian economics; and monetarism took over. Friedman said that inflation almost always was a monetary phenomenon and expanding money supply to prop up the economy will only lead to higher inflation.

Rational expectations proponents such as Robert Lucas, Thomas Sargent and JF Muth expounded the famous hypothesis which assumed that once people are ‘rational’ and information is available to all then all policy consequences are anticipated in advance and decisions taken accordingly. As a corollary policies have little impact.

So to make policies effective, governments have to ‘fool the public’ by doing something different from the announced policies. In short, all policies are anticipated and would be ineffective.

It was in this context that Fischer became a leading proponent of the new Keynesian economics. Here it was argued that in such situations spending by government can spur economic activity and would not be inflationary, provided certain conditions are met. The reason for this shift was that wages did not react the way monetarists had hypothesized. Monetarism would argue that as money supply increased so would wages and prices.

Edmund Phelps also spoke of a natural rate of unemployment which an economy would always revert o. In Fischer’s words “because the money stock is changed by the monetary authority more frequently than labour contracts are renegotiated, and — given the assumed form of the labour contracts — monetary policy has the ability to affect the short-run behaviour of output, though it has no effects on long-run output behaviour”.

Time lags

So, there were time lags between stimulus and wage increases, and hence inflation was not an assumed outcome. Therefore, central banks could lower rates or follow an expansionary monetary policy to revive growth. Hence Fischer did, in a way, bring about a synthesis of monetarism and Keynes’ economics. This was a reconciliation of neoclassical economics under the assumptions of rational agents with an understanding that markets were not always competitive.

The crux of his hypothesis was that monetary policy can help balance out short-term fluctuations, but it cannot push the economy beyond its long-run potential. This is pertinent now even in our context, when there is a clarion call for a rate cut which is supposed to push up growth.

If Fischer were right, then the limits to stimulus through monetary policy will be restricted by the overall long run potential. Is potential growth 7-8 per cent is the question. The potential output given the capital structure and technology in the Indian economy is around 7 per cent which means there is still an output gap of around half percent. To this extent a case can be made for rate cut to achieve potential growth. The MPC can debate this issue.

If one were to stretch the Fischer argument further, it can be asked whether such rate cuts would be enough to push potential growth beyond the 7 per cent mark. The answer is probably not, because there are limits to which low interest rates can propel the economy. In fact, the monetarist view would come in once the potential is reached. If overall investment does not increase, then further monetary expansion would have inflationary potential which is not the case in the current situation.

Therefore, there is need for a calibrated approach to monetary policy as inflation, though low today due to food prices, can be provoked on the ‘core’ side if potential output does not increase in the face of monetary easing through repo cuts and liquidity infusion.

Fischer and his contribution to economics will stay forever.

The writer is Chief Economist, Bank of Baroda. Views expressed are personal

Published on June 11, 2025