The Tobin funnel and post-covid stimulus withdrawal dilemmas

News: The Government has recently signaled that India will exit its extraordinary fiscal and monetary policies of pandemic times, gradually.

Why there is a need to exit the pandemic-induced extraordinary policy?

The pandemic has affected all the economies and made the governments spend more. The central banks also injected extra liquidity into financial systems. Such coordinated action was necessary during a crisis. But now, since normal life is returning and the economic impact of the pandemic is receding, policymakers have to figure out how to reverse the decisions taken.

India decided to exit gradually because the economy needs policy support till private-sector demand becomes stronger, but it has disturbed the local bond market.

What are the policy challenges existing for India?

First challenge is to withdraw the macroeconomic stimulus before economic imbalances build up. Because if the economy failed to get out in time, it can lead to excess inflation or balance-of-payments pressures (or both). But it is tricky because the recovery is uneven across various sectors.

Second challenge is to figure out the different speeds at which the monetary and fiscal stimuli are withdrawn. James Tobin, who won the Nobel Prize for economics in 1981 has provided a model for such coordination.

What is Tobin Funnel model?

As per this model, a nation-state has control over two taps; one for net government spending and another for money supply. The water rushes through a common funnel into a tank below. The moment the tank below the funnel gets full, it overflows in the form of inflation. The volume of the tank depends on the supply side of the economy.

So, the underlying assumption in the Tobin funnel is that fiscal and monetary policy can sometimes be used alone and sometimes in combination for policy coordination.

But the issue is that it assumes that fiscal and monetary policies have the same effect. Hence, the question arises whether it is applicable in case of supply shock like pandemic. Also, another question is whether the law has created separate zones of intervention for the government and the central bank, then how the interventions can be made.

How Tobin model creates policy dilemma?

The extra government borrowing creates huge public debt. For example, in the case of India, the bond market believes that the Centre’s borrowing program in the next fiscal year is too high. Along with this, there is inflation and RBI is the inflation manager of the economy as well as debt manager.

Now the dilemma is whether RBI should raise interest rates to tackle inflation or keep them low to support the government budget.

What is the way forward?

The economic scenario depends on the pace at which the stimulus is withdrawn and on the relative role played by fiscal and monetary policies. The finance ministry has laid out a clear path of fiscal consolidation, but the monetary policy signals have been confusing. That is why there is a need for clear signals which are important as the actual actions.

Source: This post is based on the article “The Tobin funnel and post-covid stimulus withdrawal dilemmas” published in Livemint on 23^rd Feb 2022.