Covid-19, and the way to avoid a blunt interest rate policy

  • Blog Post Date 16 June, 2020
  • Perspectives
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Given the looming recession due to Covid-19, the Reserve Bank of India has reduced interest rates to encourage economic activity in the country. In this post, Gurbachan Singh contends that the prevailing interest rate policy is non-transparent and complex, in addition to being blunt. He proposes an alternative policy that is transparent, simple, and well-targeted.


“... [there is] confusion between what might be called the “monetary” effects of monetary policy - the effects on the stock of money - and the “credit” effects - the effects on recorded rates of interest and other conditions in the credit market." (Friedman, 1959, p. 43)

We are in a big humanitarian, medical, and economic crisis at present due to Covid-19. These are indeed very extraordinary times. And, extraordinary times require extraordinary measures. However, there can be a choice within the category of extraordinary measures. And that choice needs to be made carefully. This post is about making such a choice.

The extraordinary macroeconomic policy that is usually suggested is, very briefly, as follows. The Government of India (GOI) should incur a larger fiscal deficit; if required, the additional debt should be monetised (see, for example, Sen 2020). This (fiscal cum monetary) policy is indeed warranted, provided there is no alternative. But that is not true. I have argued primarily for a different fiscal policy in earlier I4I posts. Here, I will focus on a different monetary policy. But before I spell out the new monetary policy, it may help to motivate the same.

The motivation

First, reserve money, currency in circulation with the public, and net Reserve Bank of India (RBI) credit to GOI have expanded at annualised rates of 21%, 43%, and 117% from 31 March to 29 May 2020. Even the minimum of these figures is very high – more so when there is a serious economic slowdown in the same period. And, the maximum figure of 117% is very high – more so when it is very likely that in the rest of the year, the RBI credit to GOI will continue to increase. These figures are bothersome also because these are for a period that is preceded by a period in which the average retail price inflation had already gone well above the 4% target; the figures are 4.62%, 5.54%, 7.35%, 7.59%, 6.58%, and 5.84% for the months from October to March 2020. The inflation rate may jump up a lot more, given the recent data on money and continuation of the trend.

Second, given the looming recession due to Covid-19, the RBI has reduced interest rates to encourage economic activity in India. RBI’s repo rate is now at 4% and the reverse repo rate is 3.35%. With effect from 31 May 2020, the interest rates for fixed deposits at the State Bank of India (SBI) vary between 3.3% and 5.7%. Given the inflation rates (as seen above), the current real interest rates are very low, likely negative. This is, of course, good news for the borrowers, and this is indeed what the public authorities have intended. However, RBI’s interest rate policy adversely affects those who depend on interest income – the retirees, pensioners, widows, middle class people with hard earned money, charitable trusts, resident welfare associations (RWAs), local public bodies, non-governmental organisations (NGOs), and the endowment funds in educational/research institutions (hereafter, all these will be referred to as savers).1 So, the policy is blunt. And, it has, as we will see, other adverse side effects as well.2

What we need is a well-targeted policy. This is indeed possible (Singh 2014, 2015; Feldstein 2016). But let us first better understand the prevailing policy.

Understanding the prevailing policy

For simplicity, let us focus on the basic elements of the prevailing interest rate policy. Given the reduction of interest rates by the RBI in a recession, there is a fall in the interest cost for borrowers and in the interest incomes. It is as if a subsidy is being given to borrowers and a tax is being imposed on interest income in a recession! We may call it a quasi-tax-subsidy scheme in a recession. On the other hand, in a boom, the RBI raises the interest rate to discourage investment; this increases the interest cost for borrowers, and raises the interest incomes. Now, again, it is as if we have a tax-subsidy scheme at work in a boom though it is the opposite of the scheme in a recession. In a boom, we have a quasi-tax on borrowers and a quasi-subsidy for savers.

It is true that though the savers stand to lose in a recession, they gain in a boom as a result of the prevailing interest rate policy. However, the utility of money can be far higher in a recession than it is in a boom. So, overall, the savers do lose as a result of the prevailing interest rate policy – more so if the RBI is, for various reasons – quite keen to lower interest rates in a recession but it takes action on raising interest rates in a boom, which is, in practice, more often than not, too little and too late. So, the prevailing policy is indeed problematic. But what is the alternative?

A well-targeted interest rate policy

Under the policy I propose, the RBI is not involved in varying interest costs to stabilise investment; instead, it is the GOI that looks after this issue. The RBI is involved elsewhere (more on this below).

The GOI can give a (clear) subsidy on the interest cost for borrowing entities in a recession; this will encourage investment. Similarly, in a boom, the GOI can impose a (clear) tax on interest cost for borrowing entities; this will discourage investment. So, that is how interest costs are varied to stabilise investment over the economic cycle. And that is where the proposed clear tax-subsidy scheme ends.

What about the savers? Under the proposed policy, there is no need for a tax (or quasi-tax) on interest income in a recession. Similarly, under the proposed policy, there is no need for subsidy (or quasi-subsidy) on top of the interest income for the savers in a boom. So, the proposed policy does not have any adverse effect on the savers; it is directed at borrowers only (more on this below). That feature of the policy makes it well-targeted.

The proposed policy is well-targeted in one more way. Observe that under the prevailing policy, if the interest rate is lowered by the RBI, it applies to borrowings for any purpose whether these borrowings are for real investment or financial investment (people can borrow at low rates of interest to invest in, say, stocks; a prominent example of this is what investors like Warren Buffet did in the West). This, however, is not the intention of the policy3. The latter is intended for pushing up real investment alone. So, we have another side-effect of the prevailing policy. What about the proposed policy?

Recall that under the proposed policy, a tax-subsidy scheme is used to change the interest cost for borrowers. Now, the public authorities can choose the borrowers to whom the tax-subsidy scheme will apply. The mandate can be that the subsidy in recession and tax in boom are for (verifiable) real investment and not financial investment. So, the proposed policy is well-targeted in this way as well.4

There is yet another way in which the prevailing policy is blunt, and the proposed policy is well-targeted. Under the prevailing policy, the RBI is able to push the interest rates down only if it issues additional base money, which is what is used to meet the additional demand for funds – the demand that can arise due to the lower interest rate. Such expansion of base money can have its own difficulties in one way or another, sooner or later. In contrast, there is no need for any additional issue of base money under the proposed policy; it just involves a tax-subsidy scheme. So, there are no complications or side-effects of the proposed policy.5

How come the proposed policy is so well-targeted and the prevailing policy is not?

Interest rate and interest cost

In this section, I will consider the case of recession only; it is easy to see that the case of boom is just the opposite. Under the prevailing policy, the idea, as we know, is to change the interest rate; the result is, of course, that the interest costs (and the interest incomes) are affected. In contrast, under the proposed policy, the public authorities are not changing the interest rate per se; they use a subsidy scheme to lower the interest cost for borrowers in recession. It is interesting that though the public authorities do not change the interest rate directly under the proposed policy, there is an indirect effect on the interest rate. In a recession, thanks to the subsidy on interest cost, the demand (curve) for funds shifts out. This can push up the equilibrium (after-subsidy) interest rate and the quantum of borrowings.

It is interesting that though the subsidy is paid to the borrowers, the incidence of the subsidy is on savers as well. In a recession, their interest income is higher after the subsidy is paid to borrowers compared to what it would be in a free market (wherein no subsidy is paid), which is, in turn, higher than the interest income under the prevailing policy (wherein the interest rate is reduced by the RBI below what it would be in a free market). Of course, even the after-subsidy equilibrium interest rate in a recession may be lower than the equilibrium interest rate in a normal period. So, the savers can be still less well-off in a recession even under the proposed policy.

The institutional arrangement

Under the prevailing interest rate policy, it is only natural that the RBI should be in charge, given that the issue of additional base money is involved. However, in case of the proposed policy, the present institutional arrangement is not suitable as a tax-subsidy scheme is involved. So, what can the new arrangement be?

Let us think of a separate and independent department that decides on the quantum of the tax-subsidy under the proposed policy. For lack of a better term, let us call it the RST Office, where RST stands for rate (of interest), subsidy, and tax.6 The reason for having such an office is to minimise possible political interference. The RST Office can provide a somewhat binding advice on the relevant specific tax/subsidy rates.7 It may be argued that the proposed interest rate policy is fiscal policy and that the latter works slower than monetary policy. This is indeed true under the prevailing macroeconomic policy regime. However, under the proposed fiscal policy, it is different.

It is envisaged that the RST Office under the proposed policy will be an ongoing/ regular/ ‘standing’ office. The conception is that this office or institution announces and periodically revises subsidy or tax rates (depending on whether it is recession or boom) based on its independent assessment. So, there is hardly any delay in decision-making insofar as the proposed tax-subsidy scheme is concerned. The actual collection of the tax or the actual payment of the subsidy can be done by the GOI as part of its usual implementation of its taxes/subsidies. The borrowers can include the new tax/subsidy in the tax returns that they file anyway.

Note that there is hardly any inter-temporal (over several years) imbalance in the budget related to the proposed policy, given the tax and subsidy scheme over the economic cycle. It is nevertheless true that there is still an issue as the subsidy needs to be paid now. How can this be done? We have in this context: (1) re-allocative fiscal policy (cutting down on low priority expenditure and increasing spending elsewhere), (2) re-distributive fiscal policy with minimal effect on aggregate demand (Singh 2020a), (3) Keynesian fiscal policy with fiscal deficit, and (4) Keynesian fiscal policy with some reduction of assets like shares in public sector undertakings (PSUs), excess public land, and excess forex reserves (Singh 2020b). Note that it is only in the third case that a fiscal deficit is involved; there is scope for financing the subsidy on interest cost under the proposed policy as a part of the fiscal policy of the kinds that are covered in the other three cases.

It is important to note that though the tax-subsidy scheme considered here may be viewed as fiscal policy, it is completely different from Keynesian fiscal policy. The former is specifically about varying interest costs for the borrowers over the economic cycle whereas Keynesian fiscal policy is about varying aggregate government spending (or aggregate taxes) over the economic cycle.

In all this analysis so far, what is the role of the RBI under the proposed policy, and what about the initial issue of trade-off between low inflation and high output? I can now address these questions.

Output and inflation

As seen already, under the proposed policy, the GOI affects the interest cost for the borrowing entities through its tax-subsidy scheme. Note that this intervention obviates the need for the RBI to use interest rate as an instrument to bring about changes in interest rates for the purpose of dealing with a recession/boom. Now this has an interesting implication. The RBI can, given the proposed policy of the GOI to vary interest costs over the economic cycle, focus on using its interest rate policy for the purpose of inflation targeting. That is a big step forward. Let me elaborate.

Under the prevailing policy, considering the simple textbook story, we have one instrument with the Central Bank (the interest rate) but two objectives (maintaining low inflation and high output level). So, there is a trade-off (Tinbergen 1952; RBI, 2014). However, under the proposed policy, we have two instruments – interest rate with the RBI, and tax-subsidy scheme with the GOI (Singh 2014, 2015). So, it is possible to take care of two objectives now.


The prevailing interest rate policy is non-transparent, complex, and blunt. In contrast, the proposed policy is transparent, simple, and well-targeted (it is just unfamiliar). Equally important, if not more important, this post has also shown how it is possible to maintain low and stable inflation even as there is a need to reduce the interest costs for the borrowers and thereby encourage economic activity.


  1. It may be argued that in a recession, savings anyway need to be discouraged, given the ‘paradox of thrift’, that is, individual savings can worsen a recession by reducing the aggregate demand. However, the right lesson is not that it is individually irrational to save; instead, collectively the GOI should spend more.
  2. The problem of a blunt interest rate policy is not unique to India. We know that there is a pensions crisis that has been building up in many developed countries (Authers and Wigglesworth 2016). Indeed, the reasons for this include, inter alia, the prevailing interest rate policy.
  3. It may be argued that borrowings at low rates to invest in stocks can be useful in a recession. This is because stock prices can rise and accordingly consumption can rise through the ‘wealth effect’. However, empirically, the wealth effect is weak; this is particularly true in India. In any case, consumption can be pushed up in a different way in a recession through a (temporary) reduction in consumption taxes.
  4. Some fraud may arise. However, what is fraud under the proposed policy is what is legal and legitimate under the prevailing policy. So, even if there is some ‘fraud’, the proposed policy is superior to the prevailing policy.
  5. It is true that a tax-subsidy scheme can have other adverse effects like distortionary effects. However, that argument is about efficient allocation of resources, given full employment. Here, the context is different.
  6. Though not necessary, let me cite a related precedent. Public debt was earlier managed by the Central Bank. However, there was a difficulty. So, a separate and independent Public Debt Office was created (outside of the Central Bank and the government) in many countries. We can, mutatis mutandis, draw lessons to set up the RST Office.
  7. It may help to consider an analogy. The Finance Commission in India provides a somewhat binding advice on the GOI and state governments in matters of revenue sharing in India. Similarly, the RST Office can, mutatis mutandis, provide a somewhat binding advice.

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