Real GDP, Interest & Exchange rates in a Dual Economy

In listening to US Ivy league trained economists, it strikes me that they have either forgotten what they learnt in college and preached on Wall street for 20 years or have been so traumatized by the Global Financial crisis, that they have forgotten that real economy is about real interest rates and real exchange rates!

Some analysis to remind them: Indian real interest rates have risen sharply during 2014-15. This has had a negative impact on interest sensitive sectors like real estate & housing and Motor vehicles. 

   By increasing the interest differential with the World, this (incentivizes &) leads to short run capital inflows. This has led to an exchange rate appreciation of 10% in 2014-15, despite the fact that part of inflows has added to exchange reserves and despite a fall in inflation which would normally result in real depreciation. The real appreciation has had a strong negative effect on the tradeable sectors of the economy, particularly the globalized corporates sector, which has slowed recovery from a cyclical trough.  Though this sector’s growth recovery is affected by the speed of Global recovery(ie of globalized sectors world wide), misplaced Indian policy has nipped the incipient recovery in the bud.  

  Meanwhile fiscal policy has moved in a mildly positive direction, with a slightly lower deficit and a slightly higher ratio of investment to consumption. With the exception of one serious error on the taxation issue (MAT), reform policies have seen moderate to good progress.  One has therefore to attribute most of the above effects to a hardening/tightening of (real) monetary policy during 2014-15 (by about 2% points). It follows that at a minimum, the (real) monetary tightening must be reversed in 2015-16 and a greater effort made to reduce government consumption (leakages) so more can be spent on infrastructure investment. This will stimulate growth without affecting inflation.

 Purely Indigenous analysts (as against ivy league ones), seem on the other hand to have forgotten that the organized part of the economy is not the whole economy, but just a fraction of it.  Till a decade ago they talked about the dual nature of the economy and how monetary and credit policy actions of the central bank affected only the formal organized part of the economy.  Even though the globalized part of the economy and the formal financial system has gradually increased since 1990, the economic and financial dualism hasn’t suddenly disappeared or become irrelevant. Thus monetary and credit policies affect mostly the formal economy.  Growth of the informal economy can be faster or slower than the formal and its relationship to monetary policy is obscure at best.  

  Because the 1990s reforms unshackled the formal, organized part of the economy, it invested more and grew faster than the informal part of the economy. Post-financial crisis, global trade and GDP growth collapsed. Consequently, except for 2009, when there was a world wide injection of fiscal and monetary stimulus, we should not be surprised to see the formal, globalized part of the economy growing slower than the informal.   In fact the continuation of the Indian stimulus in 2010 made the subsequent downturn worse.  

An interpretation based on a pure dualistic, segmented financial market model of the Indian economy would suggest that monetary policy tightening has reduced demand and capacity utilization in the formal sector and pushed it towards deflation (as indicated by the IIP and WPI respectively), while the informal sector has recovered gradually despite changes in monetary and fiscal policy.   The actual picture is undoubtedly a little more complex than either the Wall street-Chicago model or the Dual economy model can capture. That is why good macro-economic practice, requires a mixture of theory, empiricism and intuition.