In the dictionary of central banking, there is the well known conflict; between economic growth and price stability. This conflict says that inflation can be checked by reducing economic growth. The primary objective for the RBI is to ensure price stability (no inflation) and financial stability (enough liquidity).
High economic growth means high velocity of circulation of money as well as demand for money. The best way to avoid inflation is restricting people to use money for consumption and investment purposes. This can be ensured if high interest rate is imposed on bank loans. If high interest rate is adopted, people will avoid loans for the purpose of consumption and investors avoid loans for financing their investment activities. Hence, high interest rate is an ideal platform for the RBI to pursue on other targets like financial stability.
But when consumption and investments are restricted, employment and economic growth are also restricted and this is not a concern for a text book following central bank like the RBI. If inflation occurs the blame will be on central bank, on the other hand, if growth falls, the blame will be on the government. For the RBI, it is better to avoid blame on it.
The relationship between the government and the central bank changed considerably after the 2008 crisis in favor of the RBI. The RBI was able to get more power in the wake of turbulent global markets. RBI became an important institution, and the only entity to sophisticatedly judge financial stability risk like the global financial crisis. Financial stability acquired the pivotal position. The RBI used the occasion to be comfortable at the operational level and obtained a veto power for using a high interest rate continuously to cool inflation. Government on the other side was on a weaker side because it was perpetually depended on the RBI to mobilize funds to finance its high fiscal deficit. Thus, at the policy formulation level the RBI got upper hand over the ministry of finance.
In the pretext of ensuring financial stability, the central bank is continuously working on liquidity adjustment facility after the fall of Lehman brothers. But when tremendous money is released through repo to ensure financial stability, inflation may go up. The RBI here can’t ensure financial stability and price stability simultaneously. So, the RBI is leaving the responsibility to ensure price stability to interest rate. Because, if a high interest rate is pursued continuously, automatically investment and consumption will come down, thus restricting inflation. RBI can concentrate safely on other objectives if high interest rate is kept. Thus, the RBI has emerged more as a growth killer along being a financial stabilizer after 2008.
So, the conduct of monetary policy, in India after 2008 was using CRR and repo operations to provide liquidity to the financial sector. Additionally, keeping high interest rate to discourage the use of money for consumption and investment to avoid inflation has emerged as a big trend. This practice has resulted in low economic growth in the country despite the exuberant feature of being an emerging market economy.
