Evolving digital revolution

Policy and regulation will need consistent adaptation

The Reserve Bank of India’s (RBI’s) latest Report on Currency and Finance, published this week, focused on the implications of the global digital revolution, with emphasis on its impact on India. The digital economy in India currently represents about 10 per cent of gross domestic product and is projected to grow to 20 per cent by 2026. With one of the world’s largest digitally connected populations, the report provided timely insights into the wide-ranging effects of digitisation on sectors such as banking, innovation, e-commerce, fintech, and digital trade in India. One significant aspect is the digitisation of the payments system. As the report noted, India leads globally in real-time payment volumes, with digital payments increasing at a compound annual growth rate of 50 per cent and 10 per cent in volumes and value terms, respectively, over the past seven years.

However, the extensive adoption of digital payment platforms can significantly influence the money circulation in the economy, with implications for liquidity and monetary policy. Digitisation enhances monetary-policy effectiveness through financial inclusion, real-time data availability, increased transparency, and expanded credit channels. However, a shift to less regulated entities can affect policy transmission because they tend to operate outside conventional systems. Monetary policy transmission is examined by how deposit and lending rates respond to the RBI’s policy repo-rate changes. For instance, if the RBI reduces the repo rate, banks typically lower lending rates to encourage borrowing and investment. However, if significant transactions move to unregulated entities, the response to the RBI’s policy changes may weaken, reducing effectiveness.

Further, as the report highlighted, digitisation can diminish the effectiveness of monetary policy by reducing price stickiness. Digital technology lowers menu and information costs, thereby enhancing short-run price flexibility. Consequently, prices quickly adjust to balance supply and demand, nullifying the impact of monetary policy. Further, on the one hand, substantial initial investment in digital technology and firms’ digital collusion can increase market concentration, leading to monopolies that exert upward pressure on inflation to gain higher markups and profits. However, on the other hand, the advent of e-commerce can broaden the domestic market, enhancing competition and potentially lowering inflation. Thus, digitisation through potential increase in price flexibility, increased market concentration, and enhanced market competition in different sectors can affect the New Keynesian Phillips Curve (NKPC), a central tool of central banks in assessing the inflation dynamics and policy evaluation. If increased price flexibility outweighs the stabilising effect of more product varieties, inflation volatility may rise. Conversely, more product varieties can mitigate the impact of market concentration and lower markups. Technological shocks can frequently affect markups and marginal costs, potentially destabilising inflation expectations and the stability of the NKPC.

Thus, digitisation can impact macroeconomic stability through previously uncommon channels. While digital technology enhances administrative capacity, it also brings significant new challenges. One is the operation of monetary policy because of the impact of digitisation on prices. Further, with increased digital transactions and with banking services being available practically round the clock, banks can face liquidity issues in times of stress. As was witnessed during the recent banking crisis in the US, stress in bank balance sheets can quickly exacerbate and pose financial stability risks.  Thus, the RBI will need to progressively adapt to the changes in the economy and the banking system because of increasing digitisation to fulfil its mandate of price and financial stability.