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Why we get a compromised deal
Have you ever wondered why the government and the RBI work in cross-purposes? Here’s a possible explanation that has its origin in game theory.
IN MANAGING THE economy, there are two factors: one, fiscal policy and two, monetary policy. The former is about taxes and government spending; the latter is about interest rates. In India, the government is responsible for fiscal policy while the Reserve Bank is responsible for monetary policy. 
The government, through its fiscal policy, can either have a balanced budget or a deficit budget. The RBI, through its monetary policy, can either set low or set high interest rates. Let’s assume that the government and the RBI act independently and without knowledge of what the other has chosen to do.

Deficits and inflation

You and I want lower taxes. We also want the government to spend on defence, education, health care and subsidies! So the government is under constant pressure to lower taxes and increase spending. This leads to a deficit budget, which in turn leads to higher inflation.

The RBI’s main job is to curb inflation. Households and industry want low interest rates. This leads to a higher demand for automobiles, housing and for capital investment; all of which are inflationary. On a different note, there is less threat of inflation when the government has a balanced budget.  

So, low taxes (people’s choice) leads to deficit budget  which leads to inflation. Low interest rates (people’s choice) leads to inflation. Yet no one wants inflation. What a nice conundrum!

What the government and the RBI like and dislike 

With this backdrop, let’s construct a payoff matrix to appreciate the consequences. There are now four outcomes. Budget deficit with low interest rates; budget deficit with high interest rates; balanced budget with low interest rate and balanced budget with high interest rates.  

The government best prefers (let’s say payoff is 4) a budget deficit with low interest rates. This pleases its every constituency! The government hates most (say payoff is 1) a balanced budget with high interest rates. Of the other two outcomes it prefers (payoff 3) a balanced budget with low interest rate because it keeps the middle class happy. A deficit budget with high interest rate is rated with a payoff of 2.

Look at the RBI’s likes and dislikes. It loves most (payoff is 4) a balanced budget with low interest rates. That’s because this can sustain economic activity without much inflation. It hates most (say payoff is 1) a deficit budget with low interest rates because it is highly inflationary. Of the other two outcomes with high interest rates it prefers (payoff 3) a balanced budget because that’s less inflationary. Finally, a deficit budget with high interest rate is rated with a pay off of 2.

See how the parties act

If the government believes that the RBI will go for a low interest rate regime, the government will prefer a deficit budget (note payoff for deficit is 4 while for surplus is 3). And if it believes that the RBI will choose high interest rate the government will again prefer a deficit budget (note payoff is 2 against 1). Thus in either case the government will choose a deficit budget. 

Now the RBI reads through this point that the government, come what may, will choose a deficit budget. Under the circumstance the RBI will choose high interest rate over low interest rate (payoff is 2 as against 1). Thus the country gets a deficit budget with high interest rate.  

Notice that this is so notwithstanding the fact that both the government and RBI will best gain by going for quadrant 1 [Balanced budget with low interest rate], which at 3,4 is superior to the choice it has thrust on itself 2,2!

On such niceties are national policies drawn. 
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