From UPSC perspective, the following things are important :
Prelims level : Monitory policy and fiscal policy
Mains level : Paper 3- Monetary and fiscal response.
The article analyses the relation between the response of fiscal authority and monetary authority to get the maximum payoff in the normal circumstance. But the pandemic would require different approach.
Coordination between monetary and fiscal authority in India
- Coordination between monetary and fiscal authorities has been a thorny issue globally in recent years.
- If there is perfect coordination between the monetary and fiscal policy then there should be statistically significant negative correlation between the two.
- In the Indian context, for the 30-year period till FY2020, relation between the change in the consolidated fiscal deficit and the change in the growth rate of broad money reveals no coordination, substantiating the dominance of fiscal over monetary policy.
- Non-coordination between the two in India is also constrained by several policy targets and fewer instruments.
Optimal combination of monetary and fiscal strategy
- Both the government and the RBI have two options between them — either a contraction or an expansion.
- Thus, we effectively have four policy options, and each of the options will have a particular benefit.
- Our endeavour is to find out which policy option can result in a Nash Equilibrium.
- A Nash equilibrium occurs when neither the government nor the RBI can increase its benefit by unilaterally changing its action.
- The payoff scenarios are hypothesised as benefits accruing to the government and the RBI separately when they are deciding on either of the policy options: Contraction or expansion.
- The government favour an expansionary policy and gets maximum payoffs from a fiscal expansion, either with monetary expansion or contraction.
- The monetary authority ideally wants to contract the economy to fight inflation and gets maximum payoffs from a monetary contraction.
So, what is optimal combination of fiscal and monetary strategy
- If the RBI opts for monetary expansion, the government also opts for expansion as the payoff is higher.
- But this will compel the RBI to then opt for contraction, since that gives it a higher payoff.
- Knowing this, the government’s best strategy will be then an expansion — so the outcome will always be a fiscal expansion with a simultaneous monetary contraction.
- This is the only Nash equilibrium for this game.
Responding to the pandemic
- The current pandemic is resulting in behavioural changes of individuals in terms of risk-taking.
- In the Indian context too, there are behavioural changes in terms of risk-taking.
- Many of the current companies were also born during the financial crisis, like Uber (2009), Microsoft (1975), Disney (1923), General Motors (1908) and General Electric (1890).
- Echoing such “procedural rationality” in the current unprecedented circumstances, we thus believe fiscal expansion and monetary expansion is the desirable outcome.
The RBI has been largely successful in communicating to the market about its intentions and we now expect the government to manage expectations with coordinated communication and leave matters of financing the fiscal deficit, through measures like monetisation, to the RBI.
Simply put, it is a situation where no player can increase his payoff by deviating alone (from the situation). That is,it is a situation where both players are involved in mutual best replies.