Understanding Fiscal Policy (1/3)

I wrote this last week on the basis of this write-up by Sajjid Chinoy. The sequel came out last week, so let’s read through it together.

First things first:

  1. During times of a crisis, such as the one we are going through, it may be helpful to think of the economy as a sick person. That would make us economists and policymakers the diagnosticians and doctors respectively.
  2. Us diagnosticians often like to think about why the person got sick. Was it because of some previously administered medicine? Was it because of some external factor? Maybe both? That is, we identify the disease, and the cause of the disease.
    In this case, the economy is struggling because of the lockdowns and the uncertainty about (at least) the near future. Those are the symptoms. The cause is, of course, the virus.
  3. The doctors – that is, the policymakers – will want to remove the cause behind the economy’s illness first. That is what Sajjid Chinoy means when he says: “With a health crisis at the genesis of the current situation, it’s tautological to say that ramping up vaccinations is the “first-best” solution to tackling the crisis.” That is the cause of the crisis, and removing the thing that causes the crisis is of paramount importance.
    The “how to do this best” question has troubled all of us, and continues to trouble us, and it is worth your time to keep tracking this issue. And it is a great way to learn about how to think about public policy.
  4. But treating the symptoms (and the manifestations) of the cause is equally important. Job losses, reduced investment, reverse migration, subdued demand, rising inequality, reduced incomes, the exacerbated lack of social safety nets are all symptoms and manifestations of the crisis. How to treat the symptoms? That is where Sajjid Chinoy’s second article comes into play.

There are two courses of treatments available to us diagnosticians and doctors: fiscal policy and monetary policy. Sajjid Chinoy argues (and in my opinion, does so convincingly) that monetary policy has done all the heavy lifting it could in 2020, and there’s not much left in the RBI’s arsenal.

Monetary policy was the prime mover last year and markets will inevitably clamour for that pedal to be pressed even harder. But quite apart from the fact that monetary conditions are already very accommodative and core inflation has averaged 5 per cent since the start of 2020, what’s less appreciated is the reduced efficacy of monetary policy in periods of elevated uncertainty. That’s because monetary policy ultimately relies on economic agents (households, businesses, banks) to act on the impulses it imparts. But when agents are faced with acute health, income and macroeconomic uncertainty, they often freeze into inaction (“the paradox of thrift”). So households don’t borrow, businesses don’t invest and banks don’t lend. This is evident in the evolution of bank credit over the last year in India. Despite negative real policy rates and falling real bank lending rates, credit growth has continued to slow all year long, likely reflecting these uncertainties.


Homework: What is core inflation? Where is this data to be gotten from? Where do we get data on the evolution of bank credit from? What are negative real policy rates? What are falling real bank lending rates? Where do we get that data from? What is credit growth? Where do we get that data from?1

Which means we must now think about how to best deploy fiscal policy.

The baton must, therefore, pass to fiscal policy. While fiscal policy cannot mitigate the health uncertainties it can help alleviate income and macroeconomic uncertainties. Stronger spending will not only boost activity but, in so doing, will reduce demand uncertainties for firms. Furthermore, income support (in cash or kind) along with public-investment-indu­ced-job-creation can alleviate income uncertainties for households and thereby help catalyse the private sector.


Sajjid Chinoy highlights two broad areas to think about in his article:

  1. Recalibrating To New Realities
  2. Making Space While The Sun Shines

There is much to agree with (and add to) in each of these cases, and I’ll do so in the next two blogposts.

But the bottomline across both articles, for students of macroeconomics, is this:

  1. Think of the economy as a human body. Like the human body, the economy is impossibly complex, and all of its underlying connections, mechanisms and responses aren’t entirely clear.
  2. Like a good diagnostician, it is important to keep tabs on a variety of different metrics on an ongoing basis. That’s what Sajjid Chinoy’s first article should mean to you – and therefore this blogpost is homework you really should do.
  3. Once you have enough data about the patient, a good doctor should be able to recommend potential cures. As with the human body, so with the economy: different doctors will recommend different treatments, and for many (mostly good) reasons. This is the part that gets really tricky.
  4. Sajjid Chinoy’s recommended course of treatment is his second article. As a student, you must try and understand why he recommends this course of treatment and no other, and ask yourself to what extent you agree with him. If you disagree with him (which is fine!), you should be able to tell yourself why – from a theoretical viewpoint.
  5. For example, you may disagree with him and say that India can still effectively deploy monetary policy. Maybe so, but you must have theoretically valid reasons for saying so.
  6. In fact, as a student, my advice to you would be to read an article willing yourself to disagree with the author. “How might this person be wrong?” is a great way to learn while reading. It is also a great way to keep yourself awake in class, trust me.
  1. Not all of the links will give you the exact answers, and that is deliberate. The last two questions being “unlinked” is also deliberate. If you are a student looking to work or study further in areas relating to macroeconomics, start building out a file with your answers to these questions (and many more!), and update the data on a regular basis.[]

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