India Faces Challenges from Expansionary Policy Shift

Source: The post India Faces Challenges from Expansionary Policy Shift has been created, based on the article “Expansionary policies in a slowing economy” published in “The Hindu” on 23rd June 2025

UPSC Syllabus Topic: GS Paper3-Indian Economy and issues relating to planning, mobilisation, of resources, growth, development and employment.

Context: The Reserve Bank of India has recently cut repo rates twice, following earlier income tax reductions. This double expansionary approach—fiscal and monetary—has raised concerns about inflation, policy coordination, and economic outcomes amid signs of slowing growth and weak demand.

Monetary and Fiscal Shift

1. Recent Monetary Policy Actions: The RBI has lowered the repo rate by 75 basis points since April 2025. The rate now stands at 5.5%, indicating a strong expansionary stance. These cuts were possible due to a significant fall in inflation to 3%, the lowest in six years.
2. Fiscal Expansion via Tax Cuts: In February 2025, the government introduced income tax cuts aimed at boosting household consumption and economic activity. This was expected to support aggregate demand through higher disposable incomes.
3. Growth and Inflation Outlook: The RBI forecasts 6.5% GDP growth for 2025–26 and inflation within its target band of 4% ±2%, providing justification for monetary easing. However, concerns remain regarding whether both policies working simultaneously will overheat the economy.

Need for Policy Coordination

1. Interaction of Demand-Side Policies: Both monetary and fiscal policies influence aggregate demand. While lower interest rates boost investment, tax cuts increase consumption. Without coordination, their combined effects may risk rising inflation or fiscal slippages.
2. International Precedents: In the U.S. and U.K., tax cuts were offset by tight monetary policy due to inflation concerns. Conversely, in 2008, when interest rates were ineffective, government spending was used to restore demand.
3. Current Scenario in India: India’s situation reflects simultaneous expansion, raising questions about policy alignment. The muted response from households may suggest that tax cuts have not translated into immediate demand, highlighting possible issues in coordination.

Signs of Economic Weakness

1. Falling Credit Growth and Rising Unemployment: Credit growth dropped to a three-year low of 9%, and unemployment rose to 5.6% in May 2025. These indicators point to weak aggregate demand despite policy stimulus.
2. Ineffective Consumption Boost: Households were expected to increase spending post-tax cuts. However, actual consumption has remained low, raising concerns about the effectiveness of fiscal policy in stimulating immediate growth.
3. Delayed Policy Impact: Some argue that tax windfalls take time to influence behaviour. But this challenges the assumption of forward-looking households, a key principle in inflation targeting frameworks. If delayed, future demand surges may require sharp policy responses.

Inflation and Deficit Concerns

1. Inflation Risks: If both investment and consumption pick up suddenly, it could result in a future inflation spike, pressuring the RBI to react sharply with rate hikes, disrupting economic stability.
2. Rising Fiscal Deficit Fears: If output doesn’t rise, tax revenues may fall, widening the fiscal deficit. The government may be forced to reduce spending, potentially harming vulnerable sections of society.
3. Need for Inclusive Measures: Given rising profits and weak wage growth, the article suggests targeted government spending to raise wages and consumption power among the poor as a more sustainable path to growth.

Question for practice:

Examine how simultaneous expansionary fiscal and monetary policies in India could impact inflation, growth, and fiscal sustainability.