1 The old world
For many decades, macro-policy in India was conducted in an environment with five key
elements:
a Agricultural shocks rather than a conventional business cycle In the old India, there was no
‘business cycle’ in the conventional sense of the term. GDP growth was repeatedly thrown
off trend by monsoon shocks. In a sheltered environment where competition from imports
and from new entrants was blocked by the government, the behaviour of firms was not
dominated by a forward-looking quest for profitable investment opportunities. The cyclical
behaviour of profits, inventories, investment and prices, which is the essence of the ‘business
cycle’ that is found in market economies, did not exist.
• A closed economy The old India was a closed economy with steep barriers against trade
in goods, services and capital flows. As a consequence, the useful mental models of the
macroeconomy were those that were rooted in a closed economy.
• Deeply distortionary tax policy coupled with a fiscal crisis The central gross fiscal deficit
escalated from 3.3% in 1970-71 to 8.3% in 1986-87. The first task of macroeconomic policy
was that of wrestling down the fiscal deficit, and averting a fiscal crisis. This process was
complicated by the need to simultaneously shift away from a distortionary framework of
tax policy towards efficient tax policy. This involved sometimes worsening the fiscal deficit
in the quest for efficiency - as was the case with the phasing out of customs duties.1
• Financial markets that lacked speculative price discovery Financial markets were prohibited,
or dominated by government owned financial firms, or were vitiated by rules imposed by the
government. Hence, key markets were afflicted with illiquidity and lacked forward-looking
speculative price discovery. The role played by finance in a mature market economy -
of converting expectations about the future into information used for decision-making by
economic agents, and of driving the allocation of capital - was not being performed.
• A monetary policy which was shaped by deficit financing Fiscal deficits were partly funded
through financial repression: by forcing financial firms to buy government bonds at below-
market interest rates. In addition, deficit financing was done on a substantial scale. Mone-
tary policy was, then, conducted in a closed-economy setting, with artificial interest rates,
and a substantial scale of monetisation of deficits.
In this article, we argue that India has changed beyond recognition on all these five
elements. We argue that these changes have far-reaching consequences for the conduct
of macroeconomic policy. The tried and true policy reflexes which worked well in the
1980s and 1990s are increasingly out of touch with the new realities. India is now a
more conventional market economy, and there is a much bigger role for the great themes
of macroeconomics - as it is practised elsewhere in the world - in shaping Indian macro
policy.
1 As an example of the tensions of undertaking a fiscal consolidation while simultaneously removing
distortions, see Ra jaraman (2004).