INDIAN INSTITUTE OF MANAGEMENT ROHTAK

MACROECONOMICS AND ECONOMIC POLICY

Post-Graduate Programme – Term II (2019-20)

Group 8, Section ‘C’

Suyash Agrawal, Arun Choudhary, Abuzaid Ansari, Aishwarya Solanki, Sreelekshmi Madhu,
Pritha Barua

Topic: Monetary policy and the slowdown of the Indian economy

Contents:
S.No. Topic Page number

1 Executive Summary 2

2 Introduction 3

3 Research and Analysis (using Framework) 4

4 Recommendation and action plan 9

5 Bibliography 11

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Executive Summary:

Objective: We intend to study the usage of Monetary Policy, as a tool by the RBI, in the light of the
recent economic slowdown to keep the economy on track.

India touched the six-year low to the GDP growth moderated to 4.5% in Q2, FY 2019-20, extended a
sequential deceleration to the sixth consecutive quarter, which was the reason the most of the economists
raised eyebrows. So, to analyze the current situation, we looked upon the indications of this economic
slowdown.

Further, we observed key indicators of monetary policy changes according to which the focus of RBI
has been to stimulate consumption and investment and hence increasing aggregate demand. In the
analysis of monetary policy transmission, we found out a major flaw in transmission of rate cut by RBI
were not transferred to the financial system which in turn don’t added to the money supply and interest
rates remained higher so, RBI mandated banks to link their lending rates to an external benchmark such
as repo rate to ensure constant movement along with the policy rates.

Finally, In order to tackle the economic slowdown, we are recommending to increase the aggregate
demand through the changes in four elements of AD. Consumption could be increased by providing core
sectors incentives and lowering interest rates, Investment could be increased by cutting down the interest
rate as done by RBI, Government expenditure should be increased in core sectors as it would increase as
per expansionary policy to increase the aggregate demand and, Net exports are increased by attracting
more foreign capital investment in India and exporting more services than goods.

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Introduction:

What is an economic slowdown?

An economic slowdown happens when the pace of financial development eases back in an economy.
Nations as a rule measure financial development as the gross domestic product (GDP), which is the all-
out estimation of products and enterprises created in an economy during a particular time frame.

Observation of slowdown in the Indian Economy

After its concise stretch as the world's quickest developing economy, India's financial development has
been easing back to record-breaking lows. At first, the GDP development of India was gauged to be
6.9% in 2020, which at that point was changed to 6.3. This comes after the GDP development rate was
at its slowest in nearly 6 years. From this information, it shows that the Indian economy is right now
confronting an emergency because of a blend of variables, for example, expanded joblessness rate,
expanded, country trouble, liquidity crunch, and so forth.

Indications of slowdown

The slowdown of GDP is a major indicator of an economic slowdown.

Drop-in automobile sales

Drop-in fast-moving consumer goods sector

Performance drop of the core industrial segments

Rupee depreciation

Foreign Portfolio Investors pulling out of investments

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Research and Analysis: Understanding trends of Key Indicators of Monetary Policy changes

1) GDP Annual Growth Rate

As can be observed in the chart above, there has been a steep decline in the annual GDP growth rate of
the country. The downward trend can be attributed to multiple global and domestic issues like
geopolitical tensions, global economic slowdown, lack of demand, and NBFC crisis.

Moving on to the growth outlook, real GDP growth for Q2:2019 was projected to be between 6.1-5.3%,
but turned out to be significantly lower. Real GDP growth for 2019-20 is revised downwards from 6.1
per cent in the October policy to 5.0 per cent. While improved monetary transmission and a quick
resolution of global trade tensions are possible upsides to growth projections, a delay in revival of
domestic demand, a further slowdown in global economic activity and geo-political tensions are
downside risks.

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2) Repo rate and reverse repo rate

Repo rate and reverse repo rate has been revised five times in the year to bring it to a five year low. The
changes have been made in order to ultimately provide more disposable income for households and
firms in order to increase their consumption and investment. But this has not been able to be fully
implemented as there has been apprehensions from Banks end for lending in view of the recent loan
defaults and NBFC crisis.

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3) Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR)

The CRR has not been changed at all during the various monetary policy changes, but there has been a
slight change in the SLR, which has been reduced from 20% to 19%. This move could be interpreted as
an attempt by the government to make more cash available with the banks, which would result in more
loans and hopefully more consumption or investment.

4) Bank Rate or Discount Rate

In line with the trends of repo rate and reverse repo rate the Bank rate has been reduced over the period
from 6.75% to 5.65%. The decrease in the rate is to ensure it is easier for the banking system to take
loans from RBI, another move stimulate consumption.

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So in conclusion, the focus of the RBI has been to stimulate consumption and investment by decreasing
policy rates in order to increase aggregate demand, which would help in overcoming the existing
economic slowdown and get the economic growth back on track.

Analysis of monetary transmission

As discussed, the slowdown in the GDP growth rate (Growth recession) is attributed to the decreased
consumption (Private Final Consumption Expenditure) and decreased investments (Gross Fixed Capital
Formation). These are critical components of the Aggregate demand- which is a key determinant of
inflation and growth.

Monetary Policy is the tool in the hands of the Reserve Bank of India which helps in controlling the
money supply via changing the repo (repurchase) rates. The RBI lowers or increases the key policy rate
and these changes transmit through the money market to the entire financial system which, in turn,
influences the aggregate demand.

On the domestic front, the GDP is being pulled down by deacceleration in the GFCF. Also, there is a
reduction in the consumption expenditure receding as evident from the decreased sales of automobiles
and tractors which are indicators of the urban and rural consumption respectively.

These slumps in the economy may be caused by cyclical or structural factors. Cyclically caused slumps
require a counter-cyclical monetary action. However, when the slowdown is structural, structural
reforms would be required. RBI, in its recently released annual report, has concluded that “the recent
deceleration could be in the nature of a soft patch mutating into a cyclical downswing, rather than a
deep structural slowdown"2. This would justify further monetary easing this year. Thus, the RBI has
been continuously cutting its key policy rates in order to spur the investment demand and therefore the
aggregate demand. But the transmission of the same has been very slow and in adequate. RBI had
lowered its policy interest rate by a cumulative 110 basis points during the course of 2019, but banks
have cut their lending rates by a mere 29 basis points for loan customers.3 Thus, we see that there has
been a problem with the monetary policy transmission. Monetary policy transmission is the process by
which the policy rate cuts are transmitted in the financial system which eventually influences the
aggregate demand. Since the transmission has been very slow, the supply of money stock in the
economy has also been very slow.

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 This can be illustrated from the following graph:

i LM1
LM2
LM3

i1

i2

i3

IS

Y1 Y2 Y3 Y

Let LM1 and IS be the initial LM and IS curves in the economy. Now if the policy rates would have been
transmitted successfully and effectively, LM1 would have shifted to LM3 and the interest rate would have
been i3. But due to incomplete transmission of the policy rate cuts, LM1 shifts to the right to LM2 and the
interest rates come down to i2 from i1. Thus, we see that the interest rate remain higher.

The RBI has found the cause of this problem to be the whims of the banks in changing the lending rates.
And it has now mandated the banks to link their lending rates to an external benchmark (such as a repo
rate) in order to ensure their constant movement along with the policy rates. This will ensure that the
GFCF increase more rapidly as now the lending rates would be lesser and therefore there would be more
borrowing and therefore more aggregate demand.

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Recommendation and Action Plan:

We are recommending to increase the Aggregate Demand through the changes in four elements of it.

AD= C + I + G + NX

Consumption
The most potent factor through which we can revive the Indian Economy is increasing the consumption
of the country which would ultimately increase the aggregate demand of the country.
The consumption accounts for 59.3 percent of our GDP. India’s economic growth has stalled as far as 5
years ago. This is because of the fact that private investments had started increasing from that time itself
and secondly Exports, though had risen in 2013 but went back in a slowdown spiral since then. Some of
the factors that can be taken into consideration for boasting the economy be:
1) Provide core sectors’ incentives like in case of automobiles in order to clear out inventory and
increasing the aggregate demand of the country
2) A lower interest rate will result in an increase in investments, which will subsequently result in
an increase of aggregate demand, therefore this will give a boost to the income.
3) An increase in the income will leave more disposable income in the hands of the people, giving
rise to the consumption.

Investments
A general relation between interest and investment is that when interest rate is high, investment is going
to be low. In the ongoing recession the same doesn’t appear to happen because the low interest rate (due
to regular rate cuts by RBI) are not being passed on to the general public. The same can be reasoned by
the fact that banks are already ridden with a huge number of NPAs, therefore, they fear of passing the
cut interest rates to the general public. This is acting as blockage to Monetary Transmission.
A recommended step would be having stringent policy mandating the commercial bank to pass on the
rate cuts to the public at large.

Government expenditure

According to Keynesians, increasing government spending is the best way to stimulate aggregate
demand. When the government spending will increase as per the Expansionary policy then the aggregate
demand curve will shift rightward

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Now, coming to the practical aspects of the government spending to tackle the current economic
situation in India.
Government expenditure grew at 14.97% in FY 2017-18 and expected to grow at 8.87% this FY to
pump growth to various sectors like Infrastructure, automobile, food, fertilizers and Petroleum subsidies.

Net Exports
The figure for net exports for April to June 2019 stood at -$46 billion. This was almost similar to the net
exports for April to June 2018 at -$46.6 billion. This shows that is both exports and imports during the
period were at almost similar levels as the previous year.
Some recommendations to improve this state of affairs would be as follows:
1) An increase in overall trade-to-GDP ratio is an important entry point for any country before it
starts to build an ecosystem of forward and backward linkages in any industry. For example,
over the last many decades, as India has engaged in trades of crude and its refined products, it
has built an entire ecosystem that supports these industries. As time goes by, such industries
build scale on their own, or bring in other players as suppliers or customers domestically. This
will be a good way to attract more capital investment.
2) It is desirable for India to export more services than goods. From purely a financial perspective
of current account deficit, the distinction between goods and services does not matter, even
though service exports may not be as capital or labour intensive as manufacturing. Globally-
competitive services have been the forte of India and new segments can now be built out of
India, whether in payments, entertainment, or in technologically high-end segments, like
machine learning, artificial intelligence, gaming, etc.

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Bibliography:
1
https://www.rbi.org.in/scripts/FS_Overview.aspx?fn=2752
2
https://www.livemint.com/opinion/columns/opinion-the-slowdown-puzzle-and-rbi-s-monetary-policy-
bias-11570100660952.html
3
https://www.livemint.com/opinion/quick-edit/opinion-rbi-policy-efficacy-deficiency-
11570177966627.html
4
https://economictimes.indiatimes.com/news/economy/policy/quick-ways-out-of-slowdown-10-things-
government-can-do/articleshow/70934072.cms
5
https://www.rbi.org.in/Scripts/BS_ViewBulletin.aspx?Id=18638
6
https://www.livemint.com/news/india/15-ways-to-define-india-s-slowdown-1565715613762.html
7
http://tradingeconomics.com/
8
https://www.ibef.org/economy/union-budget-2019-20

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