Liquidity Trap and Its Impact on Indian Economy
Recent economic trends in India indicate the presence of a liquidity trap. Despite the Reserve Bank of India (RBI) lowering interest rates by 100 basis points since February 2025, credit growth remains modest and demand for borrowing is subdued. This situation mirrors the classical liquidity trap concept introduced by John Maynard Keynes during the 1930s Great Depression. The current environment demands a nuanced understanding of monetary and fiscal policies to stimulate growth effectively.
Concept of Liquidity Trap
A liquidity trap occurs when interest rates approach zero but credit demand remains stagnant. People prefer holding cash over borrowing or investing despite cheap money. This was seen during the Covid-19 pandemic and is now evident in India. Lowering interest rates alone fails to boost economic activity when businesses face weak demand and excess capacity.
Credit Growth and Demand Dynamics
In India, credit growth is around 10% in the first five months of 2025, which is stable but not robust. The transmission of rate cuts to deposit rates is almost complete, but lending rates have only partially adjusted. Borrowing is primarily for working capital, reducing costs but not increasing investment. Surplus capacity and slow demand discourage fresh borrowing for expansion.
Role of Government Capex
To counter the liquidity trap, the government is leading investment through capital expenditure (capex). The planned ₹11 lakh crore outlay for FY26 aims to drive infrastructure and other sectors. Private investment remains limited, mostly confined to infrastructure linked to government spending. Consumer goods industries face challenges due to surplus capacity and GST-related inventory adjustments.
Tax Concessions as Demand Stimulus
The government’s tax relief measures include ₹1 lakh crore in income tax concessions and GST rate reductions on many consumer goods. These steps increase disposable income and encourage spending. However, benefits accruing to higher-income groups may not translate fully into consumption due to lower marginal propensity to consume. Some savings might shift to financial markets rather than immediate consumption.
Monetary and Fiscal Policy Coordination
Given the limited impact of rate cuts alone, monetary policy must be complemented by fiscal measures. The government’s direct spending programmes like PM Kisan and MGNREGS, combined with capex and tax incentives, provide a Keynesian stimulus. This coordination between RBI and the government is critical to navigate the liquidity trap and encourage sustainable growth.
Risks of Excessive Rate Cuts
Continuous lowering of interest rates risks mispricing capital and inflationary pressures if excess borrowing occurs without real demand growth. The RBI’s cautious stance and the government’s fiscal push together help balance growth and inflation concerns. A status quo in monetary policy appears prudent under current conditions.
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