Financial inclusion empowers monetary policy

Michael Patra of RBI in this recent speech links financial inclusion to monetary policy.  This is interesting as usually we have not linked the two fields.

In my remarks today, I would like to contribute to this growing interest in the symbiosis between financial inclusion and monetary policy by (a) assimilating the received wisdom and empirical evidence that has been accumulated so far on the subject; and (b) drawing applicable lessons therefrom for India. This assumes relevance in the context of the pandemic during which the loss of life and livelihood impacted the financially disadvantaged and vulnerable households and businesses the most. Drawing upon its experience with financial inclusion, the RBI crafted a pandemic response that reached out in the form of unconventional measures to those afflicted sections of society, keeping finance flowing, and financial institutions and markets functional, especially when personal incomes were lost and the future was highly uncertain.

Monetary policy maximises human welfare by minimising the deviations of output from its potential and inflation from the target. Although it is empirically observed that there is a two-way relationship between monetary policy and financial inclusion, it is unambiguous that financial inclusion is able to dampen inflation and output volatility. This is achieved by smoothing consumption by enabling people to draw down financial savings in difficult times for everyday needs. In the process, it makes people interest-sensitive. Moreover, inflation targeting monetary policy ensures that even those at the fringe of financial inclusion are secured from adverse income shocks that hit them when prices rise unconscionably.

At the cost of being slightly technical, therefore, the rest of my remarks will address four issues that sit at the heart of this confluence: first, the choice of the appropriate price index as the population gets progressively included financially; second, the impact of financial inclusion on output and inflation variability and the trade-off between them – the dilemma that is central to the conduct of monetary policy; third, the transmission of monetary policy impulses through the economy; and fourth, the impact of financial awareness on expectations and hence on the credibility of monetary policy.

On choice of headline vs core inflation:

Which measure of inflation should monetary policy target to maximise welfare? Financial inclusion appears to be the lowest in rural, agriculture-dependent areas where food is the main source of income. Recent work in the tradition of dualistic models shows that in the presence of financial frictions – in this case, financially excluded or credit-constrained consumers existing alongside those that have full access to formal finance – flexibly determined food prices have a critical role to play in influencing the real wages and incomes of the excluded and hence their aggregate demand. Interest rate change don’t matter so much.

When food prices rise, the extra income earned by the financially excluded is not saved but instead consumption is increased, leading to higher aggregate demand. In this kind of a situation, the efficacy of monetary policy in achieving its stabilisation objective increases by targeting a measure of prices that includes food prices rather than one that excludes them such as core inflation.

The lower the level of financial inclusion, therefore, the stronger is the case for price stability being defined in terms of headline inflation rather than any measure of core inflation that strips out food and fuel.

In India, food accounts for 46 per cent of the CPI, among the highest shares anywhere in the world. Furthermore, the CPI combines a rural index and an urban index, with the share of food being even higher in the rural index at 54.2 per cent. In the urban index too, the share of food at 36.3 per cent is also sizable in a cross-country perspective. Consequently, aggregate demand is highly influenced by the behaviour of food prices and farm output, rather than interest rate changes to which the urban index could be sensitive. It is in this context that the monetary policy framework overhaul in 2016 to usher in a flexible inflation targeting regime wisely chose the headline CPI as its metric for measuring the inflation target rather than any measure of core inflation, despite persuasive arguments for the latter that are made even today.  

Impact of financial inclusion on output and inflation variability:

As I mentioned earlier, the responsibility assigned to monetary policy is to keep output close to or at its potential and inflation aligned to its target. Financially included consumers are able to smooth consumption in the face of shocks because of their access to savings (deposits) and credit from the formal financial system in the event of income losses. On the other hand, financially excluded consumers are not able to do so and hence they are vulnerable to higher volatility in consumption spending and output. An economy with all consumers financially included would expect to experience less output volatility due to lower consumption volatility. In an economy with financially excluded consumers, monetary policy has to assign a greater weight to stabilising output.

Overarchingly, however, it is inflation volatility that affects all consumers, whether included or excluded. Therefore, minimising inflation volatility should be the predominant objective of monetary policy in its welfare maximising role. It follows that the larger the share of financially excluded people in an economy, the more the central bank has to pay attention to output stabilisation at the cost of focusing on inflation stabilisation. As financial inclusion rises, monetary policy can hone its ability to stabilise inflation and reap welfare gains for society at large.

In India, the issue of financial inclusion and its role in shaping the monetary policy reaction function was recognised from the very outset while instituting the flexible inflation targeting framework. Accordingly, price stability was assigned primacy among the goals of monetary policy, with output being a secondary objective to turn to only after price stability as defined numerically in terms of 4 per cent with a tolerance band of +/-2 per cent around it has been achieved.

 

One Response to “Financial inclusion empowers monetary policy”

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