Even as the Indian economy becomes increasingly open in the real and financial sectors -- a steady rise in the share of GDP originating in the traded goods sector and the financial markets integrating with global financial markets -- there is little awareness of the need for a complete economic policy revamp that should accompany this change.
Increased openness has implications both for traditional concerns such as the rates of inflation and growth, the distribution of income, the value of the rupee as well as for new areas of inquiry such as the state of the financial markets and links between financial and real sectors.
To deal with these issues we are yet to see the evolution of a new set of policy instruments or a redefinition of the old instruments that can deal with the challenges of economic management in an open economy. To be sure, these are very different from closed economy problems and call for a paradigm change in formulation of policy options.
Among the policy-making institutions, only the Reserve Bank of India has recognised these issues as it operates partially in its own sphere of action.
In the last currency and finance report, RBI did raise the issues as they relate to the management of the external sector. Now with openness becoming a politically backed process and globalisation an irreversible fact and indeed an agenda of all major political formations, an alternative policy framework has to be thought through.
This will have an impact right from differentiating as basic a concept as domestic demand from demand for domestic goods (which was more or less the same in the closed economy era) to the nature, causes and duration of domestic business cycles. The biggest change being that capital flows will now play a role in the cyclical growth process.
Historically all severe economic downturns have been associated with financial instability but in India the two have never operated in tandem earlier. Before that happens, which it will, there has to be effective policy instruments in place.
As the economy has been opening up, capital movements have rendered exchange rates more volatile and these variations have a strong pervasive impact on the domestic economy.
In the context of continued capital flows, seeking to sterilise (the limits to which are now obvious) is really a close economy mind set. An open economy policy would seek to enhance the absorptive capacity of the economy to use these capital flows.
The point is that the management of capital flows and their impact have to be now dealt with in a completely different context involving the rates of return in different markets, movements in currency, credit, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange. In other words, this amounts to changing the conduct of macro-monetary policy totally.
Similarly, the interaction between the real and financial sector in an open, developing economy will change rather dramatically; a passive monetary stance such as the one that we have been used to will lead to monetary policy tightening and a rise in interest rates.
The rate of inflation may fall, but there could be large fluctuations in interest rates and equity returns, which can harm the output in the medium term. These issues would not even arise in a closed economy let alone be of such an order as to constrain output.
At the same time, in an open economy, fiscal policy, which has been the driving force behind the management of a closed economic activity, will tend to be less effective now. And to be effective, it would need the support of a restrictive monetary policy. Recall, not so long ago, periods of restrictive fiscal policy have been complemented with expansionary/liberal monetary policy to reduce the output loss in the system. Such a blend will not work any more.
Similarly, on the expansionary side, the impact of an increase in government spending during recession to increase domestic demand and output will have vastly different effects on output and on the trade balance.
In an open economy, an increase in domestic demand has a smaller effect on output than in a closed economy, as well as an adverse effect on the trade opens the economy - the smaller the effect on output, larger is the adverse effect on the trade balance.
For these fiscal impulses to raise real activity monetary policy should not be too aggressively aimed at stabilising the economy. This is exactly the obverse of what was happening earlier. In the last three years, monetary policy has been actively engaged in short term stabilisation of the economy.
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