By Rohan Chinchwadkar
The Reserve Bank of India had a unique opportunity to gain insights into the impact of the black economy on monetary policy transmission and inflation by cutting interest rates in its policy announcement on December 7, 2016.
Arriving at conclusions
To claim that it has found a cure for cancer, a pharmaceutical company has to conduct clinical trials to test the drug. A clinical trial involves selecting a random sample of people based on pre-decided criteria. Later, they are divided into two groups: treatment group (which will receive the actual drug) and control group (which will receive a placebo). This allows the company to provide comparative data about the safety and effectiveness of the new drug. And, the drug is then licensed for general use if multiple rounds of clinical trials show consistent and positive results.
The economists’ real-time laboratory
Economists, however, do not enjoy that luxury. The Governor of the Reserve Bank of India cannot test the safety and effectiveness of an interest rate cut by doing a clinical trial involving a random sample of people. Economists, thus rely on something called a ‘natural experiment’: empirical studies in which groups of individuals are exposed to treatment and control conditions determined by nature or factors outside the control of the scientists. If the treatment is unexpected and the impact is instantaneous, the natural experiment is more reliable.
Demonetisation is a perfect event for a natural experiment. The announcement was indeed surprising and the impact was immediate. Demonetisation has impacted multiple aspects of people’s lives – employment, healthcare, nutrition, education, marriage, and much more. This attracted scientists from different fields such as psychology, sociology, politics and economics to study the implications of this event using the framework of natural experiments. However, financial economists faced a problem.
An uncoupled cause and effect
It so happened that on the day demonetisation was announced, Donald Trump was elected the President of United States of America. It was, of course, an unexpected political upset. Trump’s election is what we call, a confounding event. An event which happens along with the main event and impacts the same variables.
On November 9, stock market returns, volatility, exchange rates, market-based interest rates and foreign capital inflows were affected by two events: demonetisation in India and Trump’s election in the USA. Most argue that the impact of Trump’s election on the Indian economy is much less than that of demonetisation. Yet, there is no denying that there is an influence and that, it is impossible to separate the two. Thus, natural experiments conducted around demonetisation suffered from confounding effects from the election of the Trump Sarkaar.
An opportunity lay in the hands of the RBI to conduct a reliable natural experiment around demonetisation. Market-based interest rates adjusted to demonetisation on November 9. However, central bank interest rates have still not adjusted.
One of the most under-studied questions in monetary policy is the influence of the black economy on monetary policy transmission and inflation. For decades, RBI has been operating under the assumption that the black economy does not influence the effect of an interest rate cut on transmission and inflation.
This December, RBI had the golden opportunity to gain insight into the less-understood relationship. On December 7, there was no black cash economy to interfere with the mainstream channels of monetary policy transmission.
In fact, for the first time in decades, the value of the black cash economy in India stands close to zero.
And, this is likely to remain until the end of the year.
By comparing the impact of the December rate cut on transmission and inflation with historical trends, the RBI had an opportunity to understand how monetary policy affects the economy in the absence of a black cash market.
Given that the RBI reduced their GDP growth estimate by 50 basis points, a rate cut of 25 basis points would have easily been absorbed by the economy without substantial upside risk of inflation. Of course, Governor Urjit Patel has more important things on his plate right now, but the researcher in him must have definitely been tempted to grab this rare scientific opportunity.