Our public discourse should be informed by economic theory that is free of obfuscations
For some time now there has been a debate in the country that is as esoteric as it is misleading, namely whether the Reserve Bank of India’s reserves should be drawn down by the government to finance its expenditure.
On the one side, the argument is that if the government has to undertake extra expenditure, then, other things remaining unchanged, it would increase the fiscal deficit, while financing expenditure by running down the RBI’s reserves entails no such increase in fiscal deficit; since an increase in fiscal deficit is supposed to be bad for the economy, it follows that financing larger expenditure by running down the RBI’s reserves, which are in any case very high relative to its assets, higher than in many other countries, is socially desirable.
The argument advanced against this does not question this proposition at a theoretical level. It asserts instead that the government should not be undermining the autonomy of the RBI, using it as a tool for appeasing the electorate through larger spending in an election year.
In fact, however, the argument for running down the RBI’s reserves is theoretically erroneous for two reasons: one, there is no difference whatsoever in terms of macroeconomic impact between increasing the fiscal deficit and running down the RBI’s reserves; a proper definition of the fiscal deficit should actually include the running down of the RBI’s reserves as well. Two, an increase in government expenditure financed by a larger fiscal deficit is not always a bad thing; indeed, in many situations, like India today, a deficit-financed increase in expenditure is better than no increase in expenditure, though of course it is worse than a tax-financed increase in government expenditure.
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