Fiscal Dominance of Monetary Policy: Global and Indian Experience

Fiscal dominance refers to a phenomenon whereby the government’s fiscal profligacy is accommodated by the central bank’s monetary policy thereby compromising its objectives of maintaining price and financial stability. Drawing from historical experience, countries have instituted several measures—most notably, fiscal rules to keep government borrowing within limits and inflation targeting to clearly define the mandate of the central bank—in order to restrain fiscal dominance. The interplay between monetary and fiscal policies has played out in the real world several times over the last decade, most recently in managing the economic fallout of the COVID-19 pandemic that has engulfed both rich and poor countries alike. Confronted with secular stagnation, the issue of fiscal dominance has become less potent for rich county central banks as their challenge has turned from restraining inflation to igniting inflation. The situation with emerging market central banks is however different. They still have to contend with inflation, rather than disinflation, pressures. They also have to contend with fragile and immature governance institutions. The case for combating fiscal dominance of monetary policy in emerging markets therefore remains strong. That case is possibly the strongest for India.