Raghuram Rajan clears the air on how to finance the stimulus



the coronavirus the crisis has paralyzed the economy and there are few options for the government, but provide greater stimulus to revive demand. Many have argued that while India’s blockade has been the toughest, its stimulus package is one of the smallest, so far. To finance a larger public spending program, the government can either ask the RBI to print more money (monetize the deficit) or it can issue new bonds to be underwritten by banks (raise money through loans). in a LinkedIn put, former RBI governor Raghuram Rajan He explained how the two paths work and why “monetization” is a good option in the short term and within reasonable limits.

So is this a free lunch for the government?
“RBI direct financing is sometimes called money printing and is thought to be free,” but Rajan says this is “misleading.” The reason is because the government finances itself from RBI, while RBI finances itself from banks at a reverse repo rate of 3.75%.
This represents a loss to the government in two ways: first, a reduction in the annual dividend that RBI pays the government. Second, banks get 3.75% instead of the 6% they could get by buying government bonds directly. And since the government owns 70% of the banking sector, its dividends from public sector banks also decrease proportionally.
Will it fuel inflation?
Such direct financing “is not inflationary per se”, as long as banks are reluctant to lend more to companies or consumers. However, Rajan points out that as normal times return, RBI will have to pay a higher rate for excess reserves, or sell its government bond holdings and extinguish excess reserves, otherwise it will risk excessive credit expansion and inflation.
Rajan says that if the fiscal deficit and public debt growth are deemed unsustainable, “investors and rating agencies will be scared.” Therefore, he calls for measures that guarantee “we will return to fiscal health in the medium term.”

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