Answer to Question #118657 in Macroeconomics for Karan Bhanot

Question

Prime minister of india promised a more aggressive fiscal policy with large increase in spending and significant tax cuts leafing to much larger budget deficit. The Indian economy was near the full employment rate ( in India unemployment rate was below 5%), what would India's central bank response in terms of changes to the cash rate? Explain

Answer 1

When government spending changes it will have an effect on fiscal policy not forgetting the aggregate demand.

The increase in government spending as well as tax cuts evidences expansionary measures that have employed by the Indian government. Expansionary measures seek to accelerate economic growth by increasing the economic transactions through affecting the monetary supply; this is achieved by increasing government expenditure and reducing tax rates. The complimentary monetary policy should be reducing the cash rate, which, will serve to increase the supply of money within the economy thus spur growth. The concerting of reduced cash rates, tax cuts, and increased government spending will accelerate economic growth in the Indian economy.

The central bank of India can therefore reduce the cash rate so as to make funds affordable for these activities in the economy.