Lack of policy reforms and high interest rate environment has endangered the India growth story. And in order to revive growth, expansionary policies on both fiscal and monetary front are the need of the hour. But what exactly is meant by an expansionary policy? In simple terms, a policy that promotes growth is deemed expansionary. For instance, lowering interest rates is an example of expansionary monetary policy. Likewise, increasing government spend is an example of expansionary fiscal policy. But India cannot afford expansionary policies. Persistently high inflation means that interest rates cannot be lowered. Further, rising fiscal deficit leaves no room for further increase in government spending. In that case, how can we bring growth back on track?
The most feasible solution is to reduce the deficit. Empirical evidence has suggested that reduction in deficit by curtailing expenditure can stimulate growth in the next 3-5 years. Now, one might wonder how that is possible. Reduction in expenditure will enable the government to follow a loose monetary policy which promotes growth. Here, we explain how.
Reduction in expenditure will lower the deficit. This will bring down inflation as government borrowings will reduce. It may be noted that government majorly finances its fiscal deficit through borrowings. And as borrowings reduce the money stock in the economy reduces. This brings down inflation. As a result, interest rates will also come down. This can bring growth back on track.
Nonetheless, it may be noted that there are two ways to reduce the fiscal deficit. One is to reduce the expenditure (as explained above) and second is to increase taxes. However, increase in taxes does not have the desired impact on the economy. That is because increase in taxes negatively impacts consumption and private investment. And this hurts growth.
Thus, it appears that if the earlier growth levels are to be re-stored, India will first have to take steps to curb its fiscal deficit by cutting back on spending.