Critically examine whether monetary policy built on individual-optimisation models is enough to manage business-cycle instability in an emerging economy like India.

Micro-founded (DSGE) models build the economy up from the choices of optimising households and firms. They link consumption to interest rates and expected future income. They make monetary policy rigorous, but on their own they cannot manage business cycles in an emerging economy like India.

Strengths of individual-optimisation models

• Internal consistency: every result traces back to an explicit behavioural assumption. This makes policy trade-offs transparent and comparable.
• Rate channel works: lending rates on outstanding rupee loans fell 55 bps and fresh term-deposit rates fell 106 bps during February–August 2025 [6]. RBI judged transmission "robust, albeit with some frictions" [5].
• Adaptability: after 2008, IMF staff added a banking sector to the DSGE method (MAPMOD) instead of abandoning it [3].

Limitations

• Fallacy of composition: under the Paradox of Thrift, higher individual saving can lower aggregate income and total savings. This happens because equilibrium income depends on aggregate demand [2].
• Investment runs on expectations: RBI linked corporate investment to 75.2% capacity utilisation in Q4 2025-26, above the 74.0% long-term average. It also warned that heightened uncertainty could dampen investor sentiment [7]. Cheaper credit alone cannot fix sentiment.
• Blind to crises: the models are solved around a normal steady state, so they suit small shocks, not crashes. They also assumed banks lend only out of prior savings [3] and under-modelled liquidity and contagion risk [4].
• Emerging-economy shocks: supply shocks such as West Asian energy prices and El Niño risk to the monsoon [5] lie outside the demand channel that interest rates act on.

Way forward

• Counter-cyclical fiscal policy: government spending (G) can fill demand gaps when private investment (I) falls [1].
• Macroprudential tools: build Basel III elements and credit-cycle risks into macro-financial models [4].
• Expectation tracking: use surveys such as OBICUS alongside rate models to read investment intentions [7].

Micro-founded models therefore explain how rate signals travel, but not why firms invest or why crises erupt. India needs a mixed toolkit to deliver stable, job-rich growth (SDG 8). Flexible inflation targeting should anchor rate policy, backed by FRBM-consistent fiscal space, macroprudential buffers and close tracking of business expectations.