Coordination Between Fiscal and Monetary Policy

Why in the News?

1. The Reserve Bank of India (RBI) has reduced the repo rate by 25 basis points in April 2025 and again by 50 basis points in June 2025, bringing it to 5.5%.
2. This means that the RBI is practising expansionary monetary policy.
3. But the government is also following the same expansionary fiscal policy, as seen by the cut in income tax rates.
4. This raises concerns about the lack of coordination between fiscal and monetary policy, which may result in higher inflation or a widening fiscal deficit.

Repo Rate: Repo Rate is the interest rate at which the Reserve Bank of India (RBI) lends money to commercial banks for the short term, usually against government securities. If the RBI lowers the repo rate, loans become cheaper = more borrowing and spending. If the RBI raises the repo rate, loans become costlier = less borrowing and controlled inflation. Monetary Policy: Monetary Policy is the process by which the Reserve Bank of India (RBI) controls the money supply, interest rates, and availability of credit in the economy to ensure price stability and economic growth. Expansionary Monetary Policy: RBI increases money supply and lowers interest rates to boost economic growth. Contractionary Monetary Policy: RBI reduces money supply and raises interest rates to control inflation. Fiscal Policy: Fiscal policy refers to the government's use of spending and taxation to influence the economy’s growth, employment, and inflation levels. Expansionary Fiscal Policy: The government increases spending or cuts taxes to boost economic growth. Contractionary Fiscal Policy: The government reduces spending or raises taxes to control inflation and reduce fiscal deficit. Inflation: Inflation is the rate at which prices of goods and services rise over time, reducing the purchasing power of money. Fiscal Deficit: Fiscal deficit is the gap between the government’s total spending and its total income (excluding borrowings) in a financial year.

Key Highlights:

1. India's Economy is Slowing Down
   1. People are losing jobs (as seen by rising unemployment rates from 5.1% in April, 2025 to 5.6% in May, 2025), prices are stable (low inflation), and businesses are under stress.
   2. The RBI started cutting interest rates to encourage borrowing and spending.
2. What the Government Can Also Do
   1. The government can reduce taxes or increase spending (like a reduction of income tax).
   2. This puts more money into people’s hands and boosts demand and job creation.
3. If there is no policy coordination:
   1. If the RBI cuts rates but the government tightens its spending, the impact cancels out.
   2. Similarly, if the government gives tax cuts but the RBI raises interest rates, people still hesitate to spend.
   3. This makes the policies ineffective.
4. Examples from Other Countries
   1. In the UK and the US, when the government gave tax cuts, the central bank did not reduce the interest rates.
   2. Instead, it increased the interest rates, hindering people’s spending and reducing the impact of expansionary fiscal policy.
5. Why Just Giving Money Doesn’t Work
   1. People might save the money instead of spending it, especially if they’re unsure about the future.
   2. Tax cuts and rate cuts may not always translate into higher demand due to weak consumer sentiment.
6. What We Need is Confidence
   1. People spend more when they feel secure (steady jobs, stable prices, and clear direction).
   2. RBI and the government must send a unified signal to encourage spending and investment.
7. About the Government's Budget
   1. Spending more increases the fiscal deficit.
   2. But during slowdowns, it’s acceptable to borrow more if it helps revive the economy.
   3. However, excessive borrowing without productive outcomes can hamper long-term fiscal sustainability.
8. India’s Situation Right Now:
   1. Although expansionary fiscal and monetary policies are being followed, the growth rate remains steady at 6.5%.
   2. This is because households are not spending much despite the increase in their disposable income.
   3. One reason behind this can be that these policy signals will take time to convert into outcomes.
   4. But this violates the basic assumption of modern inflation targeting that consumers are forward-looking and adjust current spending based on future expectations.
   5. Also, even if they are not forward-looking and will increase their consumption in the future, it can imply a sudden increase in future inflation, which would require a sharp reaction for future monetary policy.
   6. Also, if the output does not rise significantly, it would lead to lower tax collections for the government, leading to a rise in fiscal deficit.
   7. For maintaining the deficit, the government will need to cut its expenditure.
   8. If it cuts its revenue spending, then it will impact the vulnerable population who is dependent on this spending.
   1. If it cuts its capital expenditure, it may hamper the overall growth of the economy.
   10. A coordination is therefore required to be maintained in current monetary and fiscal policies, keeping in mind both the short-term and long-term implications of the action.

Inflation Targeting: Inflation targeting is a monetary policy strategy where the central bank aims to keep inflation within a specific range (in India, 4% ± 2%). It helps maintain price stability, which is essential for economic growth and investor confidence. In India, the RBI uses tools like repo rate changes to achieve this target under the Monetary Policy Framework Agreement.

Challenges and Way Forward:

Challenges	Way Forward
Poor Policy Coordination: Fiscal and monetary policies may send mixed signals	Ensure tight coordination between RBI and Finance Ministry on timing and strategy
Low Consumer Spending: People are saving instead of spending	Increase confidence through job security, stable prices, and targeted transfers
Rising Fiscal Deficit: Tax cuts and spending raise government borrowing	Focus on productive spending (infra, health, education) to create future growth
Muted Growth Despite Stimulus: Growth remains low despite rate cuts	Use a combined fiscal-monetary push targeted at the middle class and small businesses
Inflation Risks: Expansionary steps can increase price levels	Monitor inflation closely, and be ready with timely policy adjustments

Conclusion:

Right now, both the RBI and the government are using expansionary policies to support the slowing economy. But if these policies are not well coordinated, their effects may become weak or even cancel each other out. People are not spending enough despite tax cuts and lower interest rates, which shows that confidence is still low. At the same time, rising fiscal deficit and future inflation risks are concerns. To ensure that these policies help in improving growth, the RBI and the government must send a clear and united signal. A balanced and well-coordinated approach is needed, one that supports both short-term recovery and long-term stability.

Ensure IAS Mains Question Q. In the context of India’s current macroeconomic situation, discuss the importance of coordination between fiscal and monetary policy. What are the possible risks of poor coordination? (250 words)

 

Ensure IAS Prelims Question Q. With reference to India's economic policy in 2025, consider the following statements: The RBI is following an expansionary monetary policy by cutting the repo rate. The government has adopted a contractionary fiscal policy by increasing taxes. Poor coordination between fiscal and monetary policy may reduce the effectiveness of economic stimulus. Which of the statements given above is/are correct? 1 and 2 only 1 and 3 only 2 and 3 only 1, 2 and 3 Answer: b Explanation: Statement 1 is correct: The RBI reduced the repo rate by 25 basis points in April and 50 basis points in June 2025, which is an expansionary move to increase liquidity and support growth. Statement 2 is incorrect: The government reduced income tax rates, which is an expansionary fiscal policy. Contractionary policy would involve increasing taxes or cutting spending. Statement 3 is correct: When fiscal and monetary policies are not aligned, like tax cuts with high interest rates, their effects can cancel out, reducing the overall impact on growth and demand.

 

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