Expansionary policies in a slowing economy

23 Jun 2025 GS 3 Economy
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  • The RBI has adopted an expansionary monetary policy, cutting the repo rate to 5.5% in two successive meetings (25 bps in April, 50 bps in June 2025).

  • This comes in the backdrop of expansionary fiscal policy, especially income tax cuts announced in February 2025.

Monetary-Fiscal Policy Coordination

  • Both policies impact aggregate demand and inflation, requiring careful coordination:

    • Monetary policy: Lower interest rates → higher investment

    • Fiscal policy: Tax cuts/increased spending → higher consumption

  • Poor coordination can cause policy neutralisation or macroeconomic instability.

    • Example: In the U.K. and U.S., tax cuts were offset by central banks refusing to reduce rates due to inflation fears.

    • In the 2008 crisis, when interest rates hit zero, only fiscal stimulus (government spending) could support demand.

Current Situation in India

  • GDP growth forecast: 6.5% in 2025–26

  • Inflation: Declined to a 6-year low of ~3% in June, aided by early monsoon and good harvest

  • Credit growth: Fell to a 3-year low of 9% in May 2025

  • Unemployment: Rose from 5.1% (April) to 5.6% (May)

  • Indicates weak aggregate demand despite expansionary policies.

Concerns with Policy Outcomes

  • Tax cuts were expected to increase household consumption, but growth remains muted.

  • Raises two key questions:

    1. Has the RBI underestimated future inflation risks?

    2. Have tax cuts failed to boost output, risking higher fiscal deficit?

Behavioural Assumptions in Question

  • One explanation is time lag in household consumption response—but this:

    • Contradicts the assumption that consumers are forward-looking (a core belief in inflation targeting models).

    • Suggests a future spike in inflation, if both investment and consumption pick up later.

Deficit and Equity Concerns

  • If growth doesn’t rise, tax revenue may fall, increasing the fiscal deficit.

  • Government may have to cut revenue spending to control the deficit:

    • This can disproportionately affect vulnerable populations dependent on subsidies/welfare.

  • Structural issue: Profit share rising, wages stagnating—market mechanisms alone may not ensure inclusive growth.

  • Recommends sustained government intervention to:

    • Raise wages and consumption power of the poor

    • Prevent inflationary pressures from falling disproportionately on the lower-income groups



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