Real truths about monetary tightening

AMARESH SAMANTARAYA | Updated on March 09, 2018



Runaway inflation in India in the recent period is not a sign of ineffective monetary policy.

With a view to counter rising prices in India, the RBI has been raising the repo rate under Liquidity Adjustment Facility (LAF) since early 2010, and the cumulative increase in repo rate has been 375 basis points.

Despite the continuous rate hikes, no visible impact has been produced in terms of inflation control. Inflation hovers above the 9 per cent level, much to the discomfort of policymakers and the general public. Questions have also been raised on the ability of monetary policy to fight inflation, thanks to this perceived dismal performance. However, before drawing any conclusion on the inability of monetary policy, there is a need to confirm the hypothesis.

Questioning the effectiveness of monetary policy based on rising nominal interest rates in the economy is somewhat erroneous in the current scenario. This is akin to the mistakes committed by many thinkers analysing the role of monetary policy during the Great Depression.

During Great Depression

Interest rates on US Treasury securities fell to extremely low levels during the Great Depression. Early Keynesians believed that despite expansionary monetary policy as characterised by low interest rates, the US economy witnessed its worst economic contraction and produced this as evidence of monetary policy impotency.

Under the leadership of Milton Friedman, the monetarists cleared the misperception by bringing to the board the distinction between real and nominal interest rates.

It was evident that although nominal interest rates were low, the real interest rates were high during the Great Depression due to very low inflation expectations.

The calculations revealed that real interest was as high as 8 to 10 per cent and at those levels, they were one of the highest in US history.

Thus, contrary to the perceptions of the early Keynesians, monetary policy was not expansionary, but extremely contractionary during the Great Depression, and played a role to exacerbate the economic downturn.

The same monetarist logic can be applied in the current Indian situation to argue that monetary policy is not that tight as perceived.

In the table, data on Call Money Rate and SBI Advance Rate (both nominal) in India is presented since 2004-05 along with the corresponding real rates to draw the correct perspective.

Real rates are obtained by adjusting for WPI inflation for corresponding periods.

More Accommodative

From the table, it is obvious that the real rates have been extremely low in recent years. The real rates, which matter for decision-making by agents, signify that monetary policy in India is accommodative, rather than tight as perceived. Thus, lack of control on inflation in India in the recent period should not be construed as lack of monetary policy effectiveness.

It is obvious that the interest charged by banks on housing loans and automobile loans actually does not discourage the decision to go in for a bank loan; rather, it is encouraging, for when the borrower pays back the loan, it is actually a lower amount in real terms. Moreover, a significant portion of such loan borrowers work in the formal sector. With increase in dearness allowance corresponding to rise in inflation, they are partly compensated for rising interest expenditure. Thus, rising EMI should not pinch them as much as is made out.

(The author is Reader, Department of Economics, Pondicherry University, Puducherry.)

Published on November 16, 2011

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