India’s monetary policy is by design financially inclusive, the evidence of which is still coalescing, and increased inclusion will over time enhance policy effectiveness by fostering societal intolerance to inflation, said Reserve Bank of India (RBI) Deputy Governor Michael D. Patra.
“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,” he said, addressing a meet on financial inclusion on Friday.
“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,” Dr. Patra added.
Observing that financial inclusion appeared to have increased, with the level of the RBI’s financial inclusion index rising from 49.9 in March 2019, to 53.1 in March 2020, and further to 53.9 in March 2021, he said: “The evidence is still forming and strong conclusions from its analysis may be premature, but India’s monetary policy is by design” inclusive.
Financial inclusion appeared to be the lowest in rural, agriculture-dependent areas where food was 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,” he said.
“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,” he said.
Price stability target
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, Dr. Patra noted.
In India, food accounts for 46% of the CPI, among the highest shares globally.
“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,” the RBI Deputy Governor emphasised.