India may consider adopting well-targeted interest rate policy

Furthermore, we are not always aware that the prevailing interest rate policy includes a quasi-tax-subsidy scheme. In a recession, when the RBI lowers the interest rate, it gives a semi-subsidy to borrowers as well as a semi-tax on savers. Therefore, the policy is blunt, as it affects savers and not just borrowers. Savers include the middle class and retirees; They get a shock when interest rates come down.

Furthermore, changes in interest rates affect property prices. This, in turn, can affect banking stability (this is currently happening in the US and even Europe). So, the prevailing policy is again problematic.

Tampering with the prevailing policy from time to time will no longer work. We need an alternative policy. This also includes a tax-subsidy scheme, but the functioning and institutional set-up are very different. A simplified version of parts of the new policy solution is presented here in the case of a closed economy. It is based on a forthcoming book by this author, Macroeconomics and Asset Prices: Thinking Afresh on Policy.

Let’s start with the obvious. An interest rate is a relative value. This can be determined by the market forces of demand and supply. However, such an interest rate may not be correct. It is proposed that the Ministry of Finance (MoF) intervene and use a clear tax-subsidy scheme on the ‘advice’ of a new and independent advisory body. This is all instead of the central bank using a quasi-tax-subsidy scheme.

The policy proposed by the MoF would pave the way for the RBI to focus on one objective, which is to maintain low and stable (core) inflation. It can do this by using the money it issues, not the interest rate, as its principal policy tool; Basically, the interest rate should be left to the market and the MoF.

Under the proposed policy, the MOF influences the interest rate with the aim of maintaining real investment and aggregate output more generally, and the RBI uses the money it releases to take care of inflation. Now we have two objectives and two policy instruments!

Under the proposed policy, the RBI may be required to consider what the MoF does and vice versa, but in principle, there is no compromise in policy making. This is because the explicit tax-subsidy scheme is not merely a replacement for the quasi-tax-subsidy scheme; It is an additional and separate policy instrument.

We also need coordination between MoF and RBI in terms of prevailing policy; It is about the fiscal deficit and its likely impact on inflation. However, the coordination in the proposed policy is different; It is about clear tax-subsidy scheme that can affect interest rate and funding.

The proposed clear tax-subsidy scheme is for genuine investment. It is not for financial investment. And, it is for borrowers, not savers. So, it is well targeted and not blunt.

But what about the incident? Under the proposed policy, the finance ministry gives the subsidy. This increases the demand for money and hence the interest rate seen in the market tends to move towards normal levels, even as the effective interest rate for borrowers decreases in terms of actual investment. WHEREAS interest rates observed in the market are moving towards normal levels, asset prices and interest income, inter alia, are also moving towards normal levels; They are not unstable.

A similar analysis can be used to show the usefulness of a proposed interest rate policy in an economic boom.

Interest rate policy is not a panacea. And the point is not whether it should include subsidies or taxes. It is happening anyway. The point is to switch from a quasi-tax-subsidy scheme to an explicit tax-subsidy scheme that is effective and well-targeted. And, given that it’s well-aimed, it’s also relatively small in size. Although the proposed scheme may have some potential for abuse, note that the prevailing scheme by its very nature can be widely exploited.

We can say that the prevailing quasi-tax-subsidy scheme run by the Reserve Bank of India is self-financing; A quasi-tax on one group is used to indirectly finance a quasi-subsidy for another group within the same period. In contrast, the proposed explicit tax-subsidy scheme implies some increase in the fiscal deficit during recession and reduction in the fiscal deficit during boom, but all of this is desirable; This is in line with Keynesian fiscal policy.

The compromise between policy objectives is different from the trade-off between ‘guns and butter’. The latter is inevitable. The former is not if we use the proposed policy.

Some aspects of prevailing policy may be similar to parts of proposed policy (for example, changing the reserve currency after considering the currency multiplier and velocity of money). But overall the proposed policy is very different. This may be more useful.

The writer is visiting professor, Ashoka University