The macroeconomic framework that can guide our policy choices

Indian policymakers have faced a delicate situation over the past few months to maintain support for the economy while being careful not to stoke inflation further. The result was a gradual exit from the stimulus put in place after the pandemic hit in early 2020. The one area of ​​comfort through it all was India’s balance of payments. International capital flows were greater than we needed to fill the current account deficit. The Reserve Bank of India (RBI) could absorb these excess dollars into its burgeoning foreign exchange pool, especially as domestic private sector investment was low.

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The Swan Diagram

The situation became more complicated after the arrival of Russian tanks in Ukraine. International crude oil prices have risen sharply. Brent crude surged toward $140 a barrel on Monday and has only fallen slightly since. It is important to remember that the RBI inflation forecast as well as the Union Government budget calculations were made assuming crude prices at $75 a barrel. The prices of other industrial raw materials also increased in line with energy prices. All of this is bound to hit a commodity importer like India. Neelkanth Mishra, equity strategist at Credit Suisse India, estimates that energy imports, oil and non-oil, could rise by $100 billion if current prices continue for an extended period. The rising energy import bill, partly offset by our petroleum product exports, will put pressure on the balance of payments, especially if portfolio investment in Indian equities declines due to currency aversion. risk. The increase in the oil bill will also influence overall inflation as well as the government budget, depending on the extent to which the government will pass on higher oil prices to consumers and what it will absorb through the through reductions in excise duties on gasoline or an increase in fertilizer subsidies. India is far from unmanageable in its balance of payments, as a comparison with 2013 will show. Yet policy choices must be made in response to this rapidly changing situation.

A useful way to define the challenge is to look at two types of macroeconomic equilibrium: internal and external. They have been defined in various ways. An economy can be said to have internal equilibrium when there is full employment or economic growth is at its potential or when inflation is not accelerating. An economy with an external balance does not have a large current account deficit or surplus. The idea of ​​internal and external balance, and the interaction between them, is most closely identified with the work of international economists such as James Meade and Harry Johnson. JP Morgan’s Chief Indian Economist, Sajjid Chinoy, previously used this framework in an article for Mint in July 2018 ( as well as in a few recent research reports.

Australian economist Trevor Swan has given a very good framework for understanding how a country should react to various combinations of internal and external imbalances in its economy. Take a look at the attached table. The two policy levers at play are changes in the real exchange rate (on the Y axis) and changes in monetary and fiscal policies to manage domestic demand (on the X axis). The first affects the composition of demand between imported goods and domestically produced goods in an economy, or the redirection of expenditures. The latter affects the size of domestic demand, or the control of spending.

There are now four stylized macroeconomic possibilities:

1) A current account deficit with growth below its potential.

2) A current account deficit with rising inflation.

3) A current account surplus with rising inflation.

4) A current account surplus with growth below its potential.

Any country seeking to maintain internal and external balance at the same time will need to move closer to the happy point where the two lines intersect, maintaining the levels of real exchange rate and domestic demand needed to get the job done. Swan’s framework provides clues that are still relevant today, depending on a country’s position in the macroeconomic space shown here. However, factors such as productivity growth, trade shocks, or capital controls can alter the equilibrium point.

The general rule is that the real exchange rate must depreciate to reduce the current account deficit or appreciate to reduce a current account surplus. Meanwhile, interest rates and net government spending must be calibrated to manage domestic demand, based on the combination of economic growth and inflation that a government seeks to target. The Swan diagram can help think about the policy task conceptually, rather than giving exact estimates of the adjustments needed.

India will therefore need to adjust its mix of fiscal, monetary and exchange rate policies to maintain a balance in the event that the global turmoil persists for an extended period, to ensure that neither internal nor external imbalances spiral out of control. Much also depends on whether the government sees the uneven recovery or inflation as the greater risk; how the burden of internal adjustment is shared between fiscal policy and monetary policy; and whether RBI chooses to let the rupee depreciate or use its foreign exchange reserves to defend the currency. These are as much politico-economic calls as technical ones.

Niranjan Rajadhyaksha is CEO and Principal Researcher at Artha India Research Advisors, and a member of the Academic Advisory Board of the Meghnad Desai Academy of Economics.

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