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Monetary policy’s impact on inequality

GS Paper 3

 Syllabus: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment

 

Source: IE

 Context: Over the course of the next four days, the Monetary Policy Committee (MPC) of RBI will deliberate whether interest rates should be hiked further or not.

Background: Since May last year, RBI has been raising the repo rate (the rate at which the RBI lends to the banking system) → banks/other financial institutions charge higher interest rates → existing EMIs for home/car/business loans have been going up.

 

The pros and cons of raising interest rates:

Pros Cons
Contain inflation: Higher EMI would dissuade enough people from borrowing money to fund future economic activity → slowdown in demand for money → bring down inflation → “too much money chasing too few goods”.

 

●       Hike per se cannot improve the supply of those goods and services

●       Prevent the “second-order effects” of high inflation → refer to a spike in people’s expectation of future inflation

●       Limit India’s economic expansion and make unemployment worse

●       A contractionary/tighter monetary policy (higher interest rates) increases inequality in an economy

Does bringing interest rates down reduce inequalities?

  • From the 2008 Global Financial Crisis until the war between Russia and Ukraine, most central banks practised an expansionary/loose monetary policy → low-interest rates → flooding the economy with additional money → spurring economic activity.
  • But, there was growing criticism that low-interest rates were leading to higher wealth inequalities.
  • Here’s how: When interest rates are low → savers barely get any rewards (save-you-lose) → most of the wealth creation happens in the stock markets → stocks are mostly owned by the rich (invest-you-win).

 

What should be done given the harmful effects of both (contractionary/expansionary) monetary policies on inequality?

  • Widening inequalities is a very long-term trend, which depends on deep structural changes in any economy such as globalisation, technological progress, demographic trends etc.
  • A properly managed monetary policy promotes greater economic stability and prosperity for the economy as a whole, by
    • Mitigating the effects of recessions on the labour market and
    • Keeping inflation low and stable.
  • There is the need to rely on fiscal policy (taxes and government spending programs) and policies aimed at improving workers’ skills to address distributional concerns.

 

Insta Links:

RBI Monetary Policy

 

Mains Links:

Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons in support of your arguments. (UPSC 2019)