Expansionary Policies in a Slowing Economy

Syllabus: GS3/Economy

Context

• India is currently witnessing a rare phase where both fiscal and monetary policies are expansionary.
  • While this approach aims to revive aggregate demand in a slowing economy, it also brings the risk of inflation, policy misalignment, and fiscal stress.

Key Policies Adopted Recently

• In Union Budget 2025–26, ₹11.21 lakh crore earmarked for infrastructure, agriculture, MSMEs, and digital connectivity (strong emphasis on capital expenditure).
• Income Tax cuts announced were intended to boost consumption during a slowdown.
• RBI cut the repo rate to 5.5% to encourage borrowing and investment amid slowing growth.
• The RBI’s dual mandate — price stability and growth — has led to:
  • Rate cuts to encourage borrowing.
  • Inflation targeting, with retail inflation falling to 4.6% in 2024–25.
  • Liquidity support for financial institutions and NBFCs.

Issues & Challenges

• Lack of Policy Coordination: If both policies work together without coordination, it might overheat the economy causing inflation.
  • Despite these policies, growth is still slow, credit growth is weak, and unemployment is rising.
• Muted Demand Response: People are not spending much, even with tax cuts. This challenges the Rational Expectations Theory (core to inflation targeting)
• Widening Fiscal Deficit Risk: If growth doesn’t rise, tax revenue will fall, leading to a fiscal deficit. To plug the gap, the government may have to cut welfare spending, hurting vulnerable groups.
• Rising Inequality and Weak Wages: Corporate profits rising, but real wages stagnant. Expansion policies may benefit capital more than labour.

Instances of Expansionary Policies Adopted in Past

• The New Deal (1930s): By the United States, in response to the Great Depression.
• Post-2008 Global Financial Crisis: By Central Banks and US Federal Reserve; Slashed interest rates to near zero and introduced quantitative easing — buying government securities to inject liquidity into the economy.
  • In India, RBI slashed the repo rate from 9% in 2008 to 4.75% by April 2009.
• Japan’s Abenomics (2012–2020): Three-pronged strategy:
  • Monetary easing by the Bank of Japan;
  • Fiscal stimulus through government spending; and
  • Structural reforms to revive Japan’s stagnant economy.
• COVID-19 Pandemic Response (2020–2021):
  • Massive fiscal stimulus packages — direct cash transfers, unemployment benefits, and business loans — while central banks cut interest rates and expanded asset purchases to cushion the economic blow.
  • India rolled out the Aatmanirbhar Bharat Abhiyan, a ₹20 lakh crore package
  • Other steps:
    • Repo rate cuts to a historic low of 4%.
    • Loan moratoriums and liquidity support for NBFCs and housing finance companies.

Benefits of Expansionary Policies in India

• Boosts Aggregate Demand: Expansionary fiscal policies like tax cuts and increased public spending raise disposable incomes and consumption.
  • Similarly, lower interest rates encourage borrowing and investment, helping revive demand across sectors.
• Supports Employment: Government-funded infrastructure projects and MSME support schemes can generate jobs, especially in rural and informal sectors, reducing unemployment during downturns.
• Encourages Private Investment: Lower borrowing costs and improved consumer sentiment can incentivize businesses to invest in capacity expansion, innovation, and hiring.
• Stabilizes Financial Markets: Liquidity injections by the RBI and credit guarantees for NBFCs and banks help maintain financial stability and prevent credit crunches.
• Short-Term Economic Relief: During emergencies like the COVID-19 pandemic, direct cash transfers and food security measures provided immediate relief to vulnerable populations.

Way Forward 

• Strengthen Policy Coordination Mechanism: Institutionalised dialogue between RBI and Ministry of Finance.
• Prioritise Targeted Transfers: Increase DBTs and wage support schemes to boost bottom-up demand.
• Revise Tax Structures Holistically: Combine income tax relief with indirect tax (GST) rationalisation.
• Monitor Inflation Proactively: Pre-emptively tighten monetary policy if demand-pull inflation rises.

Conclusion

• Expansionary policies have played a vital role in India’s economic management, especially during crises. However, their success depends on timing, targeting, and coordination.
• Policymakers need to balance short-term stimulus with long-term fiscal prudence and structural reforms to ensure sustainable growth.

Source: TH