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Inflation has been a thorn in the side of the government for quite a while a while now. The rising prices of essential commodities especially food commodities, has affected the common man especially the poor. Knowing the fact that 32% of the total population still lives below poverty line in the country, makes this a graver problem. The paper tries to do analysis of monetary factors affecting the rate of inflation. It tries to explore various options in front of Reserve Bank of India as the central monetary authority. The paper also tries to arrive at best solution from various options and gives out their supportive and opposing arguments. The paper also provides suggestions in tackling the problem in a similar scenario in the future.
Table of Contents
Table of Content
Purpose of Study
Review of Literature
Inflation- Emperor of Economic maladies
Causes of Inflation
Reserve Bank of India (RBI)
Inflation and Monetary Policies
Rate of Inflation in India
Measure of Inflation in India
Inflation is one of the most prominent and misinterpreted economic phenomenon. It is a sustained increase in prices of all goods across the board. Due to this reason, it erodes the cost purchasing power in the economy and raises the cost of living. It is a phenomenon that has been faced by countries all over the world and is constantly evolving over the course of history. Central Banks, financial institutions, and analysts track the level of inflation due to its criticality in day to day life of every person. More importantly, the poor are the most vulnerable to inflation in the society. As, JM Keynes said, “Inflation is the form of taxation which the public find hardest to evade”; it has received a wide attention from media recently.
India’s growth story depends critically on inflation in the country. India has faced two periods i.e. 2006-08 and 2009-11 of severe inflationary pressures. These periods have caused a severe burden on the purchasing power of a normal citizen in the country. RBI has tried to tackle this situation by increasing the increasing the repo rate and reverse repo rates nine time by 25 basis points (bps) from April 2010 to May 2011; whereas in May 2011, the hike of both rates was by 50 bps. This has severely affected the growth of the economy and India’s GDP results have taken a beating. But in order to maintain a sustainable level of inflationary rate, growth in the short run needs to be compromised. Hence maintaining the balance between an optimal inflation rate and persistent growth is a very delicate policy.
To study and analyse the impact of various monetary policy options available to the Reserve Bank of India to contain the inflationary trends in India.
Purpose of the Study
India’s identity as an emerging economic giant depends largely on the manner in which it tackles the inflation in the country. In the short term, growth may be compromised to get out of this quagmire but there is a need to minimise this period of slowdown in growth. This study looks to gives solutions and suggestions to combat the situation and helps me in understanding the circulation of money and its efficacy in fighting inflation.
The research project shall two stages. In the first stage, secondary data will be collected associated with the research. The secondary data in this research will be the recent rates of inflation and policy measures undertaken by the Reserve Bank of India (RBI) and other numbers from other statistical databanks.
Further, the research will also study the various research papers that have explained the successful implementation of different monetary methods in other countries and try to draw up on their findings.
Inflation- Emperor of Economic Malaise
Whenever demand for a good is more than the supply for the good the price for that good increases. But if prices of commodities across all sectors increase then this situation is called inflation. In this situation there is very little that a government or a central bank can do because of its huge scope.
Inflation is a phenomenon of persistent rise in prices of commodities and factors of production. It is not the increase in price of a single good but a significant and a sustained rise in general price levels. Inflation however is not the increase in prices of all commodities rather it is a rise in prices of certain goods and services in such a way the overall prices increases.
Inflation reduces the valuation of money where a certain amount of money would now buy smaller amount of a good than it did before the phenomenon.
Macro-economically speaking Inflation arises due to a gap in aggregate demand and aggregate supply.
Kaushik Basu (2011) has said that Inflation has been ancient phenomenon by stating that it has been experienced by humankind since the time of the end of barter system and the use of mediums of exchange like paper money, precious metals or any other source of exchange.
Causes of Inflation
There are two major causes of inflation
Demand Pull Inflation: When price levels increase due to excess of spending i.e. aggregate demand. This means that people have too much money to spend for a few amounts of good. It occurs when the economy spends beyond the production capability and hence aggregate demand increases which causes rise in prices of various products.
Cost-Push Inflation: Cost-push inflation arises due to increase in cost of production at each price level. This is majorly contributed to increase in direct costs of production which reduces the aggregate supply. A decrease in aggregate supply as compared to a constant aggregate demand usually leads not only to higher price level. This situation can be compounded by fall in total level of output also and is termed as stagflation.
Prasanna and Gopakumar (2011) state the importance of control of inflationary pressures by saying that macroeconomic stability and necessary infrastructure are prerequisites of continual growth. Macroeconomic stability can hence be achieved through affective control of inflation. A study of results of various countries proves that there exists an inverse relationship between inflation and long-term growth. Countries with high inflation rates have performed much inferior as compared to countries with low or moderate rates of inflation.
Kaushik Basu (2011) in his paper Understanding Inflation and controlling it explains the enormity of the problem of Inflation and says that aggregate demand in the economy is affected by various agents and each agent can undo the actions of the other. He also names Inflation as the “Emperor of Economic Maladies”
He also mentions that the current situation which the country is facing is not the worst that India has faced. And says that the country faced it worst situation of inflation during the period of November 1973 to December 1974 where inflation rate never dropped below 20% and was above 30% from June-Sep 1974.
Amol Agrawal (2011) does a comparative analysis of the two recent inflationary periods suffered by the country and mentions that factors influencing inflation in 2009-11 are different than the factors influencing 2006-08, where in the former it is a combination of supply and demand shocks whereas the latter was due to the slowdown caused by the global financial crisis.
Reserve Bank of India (RBI)
The Reserve Bank of India (RBI) was established on April 1, 1935 in accordance with the the Reserve Bank of India Act, 1934. The Central Office was shifted to Mumbai from Kolkata in 1937 where it is currently located.
RBI is responsible for several functions as a central bank and has evolved and gained autonomy gradually through adaptations and changes.
Along with the basic functions of a central bank i.e. the sole authority of issuing bank notes of all denominations it has functions of managing exchange rates, regulating financial system and the banker of other banks. It is also the main policy maker of monetary policies in India. In 1998, the RBI formally adopted objectives of monetary policies which are stated as:
To maintain a stable inflation.
To support appropriate liquidity to support higher economic growth.
To ensure smooth relations with exchange market.
To maintain stable interest rates.
However there is no directive about the price stability. This it can be attributed to the fact that the monetary policy of RBI has evolved over time and has tried to maintain a balance between price stability and growth through adequate credit facility.
Inflation and Monetary Policies
Frederic Mishkin (2010) outlines nine basic principles of the science of monetary policy which are:
Inflation is always a monetary phenomenon: Various researches conducted by monetarist like Friedman and others have categorically proved that money supply is a key determinant of macro-economic activity particularly inflation. It has been agreed that an overly expansive monetary policy is the fundamental source of inflation.
Price stability has important benefits: High inflation reduces the value of money as a medium of exchange. This leads to uncertainty about current and future price levels making it difficult to make proper decisions. This situation leads to volatility in the economy and high costs of inflation causes to increase in the improper deployment of resources in the country.
No long-run trade-off between unemployment and inflation: Phillips Curve suggests that in short term there is a definitive inverse relation between the rate of unemployment and the rate of inflation in an economy. But in the long-run there is no such trade-off. In the long-run the economy gravitated towards a natural and a stable rate of unemployment without any correlation with rate of inflation.
The Crucial Role of Expectations: In the long run the expectation of the inflation plays a crucial role. The rationale behind its importance is that economic activities depend a lot on the future monetary policies and market conditions hence actions of policymakers play a crucial role in overall market sentiments and consequently to the setting the policies.
Patra and Ray (2010) as a part of IMF working paper mention that correct inflation expectation can also play a central role in setting and conducting the monetary policy for the country. Over a fixed time period, if inflation expectation remains anchored the effectiveness of the monetary policy increases over the time and its accuracy also reflects the credibility of the monetary authority.
Taylor Principle: Taylor principle implies that nominal short-term interest rates should be set in such a way that it responds to deviation of actual inflation rates from target inflation rates and of actual GDP from potential GDP. This means that inflation will only remain under control of real interest rates rise in response to the hike in inflation.
The time-inconsistency problem: If the policies are based on short-term goals i.e. decisions are made based on day-by-day basis or discretionary basis than it can lead to even worse situation. Monetary Policy makers may find it difficult to maintain their strategy over an optimal period of time; this would make it time-inconsistent.
Independence of central bank: This is the most fundamental aspect for a central bank in any country. A central bank is the best placed institution to tackle the technical issue of inflation. By allowing the central banks to operate independently allows them to implement their aims without being concerned about the short term pressures and other external pressures. Bank of England’s independence in setting monetary policies in 1997 and resultant decline of breakeven inflation is a striking example at best.
Strong nominal anchor: A long run commitment to price stability through setting up a nominal anchor helps in coping with the problem of time-inconsistencies. It shows the clear focus of the central bank for its near future and helps it to desist from the temptation of short-term expansionary gains. It also makes the government much more responsible and promotes price stability and the likelihood of inflation scares.
Financial frictions and the Business Cycle: Financial disruptions due to business cycle of boom and depression could be very damaging to the economy and this view was further consolidated after the depression of 2007-09. The most severe business cycle downturns are typically the outcomes of financial instability hence shocks to financial system adversely affects financial stability and hence inflation.
Rate of Inflation in India
Kaushik Basu (2012) illustrates the recent trends of inflation rate throw a challenging dilemma to the policy makers. The all commodity inflation rate has hovered around 10% whereas the food inflation has even crossed the 20% mark for Dec-09 and Feb-10. (Refer to the Table 1 in Appendices)
With still 32% of the population living below the poverty line this steep increase is unacceptable for the country.
Source: The Rise of the Indian Economy: Fiscal, Monetary and other Policy Challenges by Kaushik Basu (2012)
Measure of Inflation in India
There can be various measures for measurement of inflation in a country.
In most countries CPI (Consumer Price index) is the most widely used measure of inflation. The overall CPI represents the cost of a representative basket of goods and services consumed by a rural/urban household.
In some countries, PPI (Producer Price Index) is also used as a measure of inflation. The uniqueness of PPI is that it calculate price rise from the perspective of the producer or the seller. The difference between PPI and CPI may arise due to government subsidies, sales and excise taxes, and distribution costs.
Ila Patnaik (2011) et al mentions in their article that India is one of the few countries in the world where the WPI is considered as the headline inflation measure by the central bank. This can be attributed to three reasons:
Holistic coverage of the country
Timeliness of release
Availability in disaggregated format
They argue that WPI even though being a valuable source of data, should be de-emphasized in the inflation measurement, because essentially it is not calculating the price that a customer is paying for the good.
Deepak Mohanty (2010) mention that India currently has five different primary measures of inflation:
The Wholesale Price Index (WPI)
The Consumer Price Index for Industrial Workers (CPI-IW)
The CPI for Agricultural Labourers (CPI-AL)
The CPI for Rural Labourers (CPI-RL)
The CPI for Urban non-manual employees (CPI-UNME)
D Subbarao (2010) in his lecture mentioned that the multiplicity of inflation indices is a problem and on-going efforts have been made to reduce the number of consumer price index, which shall give a much more wholesome view of the inflation rates. Also this system does not consider the service sector which now currently contributes majority of the country’s GDP.
Deepak Mohanty (2010) pitches for a more inclusive CPI in the country. He says that CPI measures the level of expenditure that the consumers spend on buying selected goods and services at retail prices, hence a broad based CPI for the country as a whole which includes both the manufacturing and services sector and provides greater relevance to future monetary policy formulation.
He mentions that RBI is currently considering the use of CPI (Urban) and CPI (Rural) indices that would give a more wholesome result.
He also suggests the use of GDP deflator to measure inflation accurately in the country. GDP deflator is a broader measurement as compared to CPI and WPI. It is calculated from national accounts as the ratio of the estimates at the current prices to the estimates at constant prices. It is seldom used because of delay in publication of national accounts which are available on a quarterly basis with a lag of around two months.
Cristadoro and Giovanni Veronese (2011) give a more critical assessment of RBI’s policies and say that major difference between RBI’s strategy and other emerging economies is insistence on various objectives without a formal statement concerning their ordering.
They attribute the current problem of inflation in the country to the lack of clear objective for the monetary policy by the RBI and its insistence to adapt anti-inflationary steps according to the prevailing economic conditions. They call for a more emphatic strategy from the RBI recognizing its commitment to price stability as a priority which is independent from the evolution of the economy. This will not only set a perfect guideline for future course of action but will also help in an accurate Taylor Rule calculation.
Cristadoro also give a calibrated Taylor Rule for India and other emerging economies to deal with price shocks through the monetary policies. It has the advantage of being simpler and less complex than calculating from the normal Taylor rule.
Vineeth Mohandas (2012) observes that Reserve Bank of India has been ‘recession averse’ i.e. its strategies are focused on averting the situation of economic slowdown rather than inflation which is natural for an emerging economy like India.
Masson et al (1997) pitched for Inflation targeting as a suitable monetary policy to reduce inflation and say that countries like New Zealand, Canada, the United Kingdom, Finland, Sweden, Australia, and Spain have implemented monetary policies focusing on reducing inflation as the primary motive and have been able to reduce the rate of inflation in their respective countries.
Rakesh Mohan (2008) points out that inflation targeting may not be the best solution for India as while achieving low inflation as a central aim of monetary policy and also maintain the high and continual growth is sometimes counterproductive to each other. Apart from the legitimate concern for maintaining high growth as the vital objective for a growing economy, inflation targeting is not the most suitable solution for India.
Abbas et al (2012) also come to a conclusion that Inflation targeting is not a big success in emerging economies including India because of variety of reasons. These factors range from lack of any pre-conditions and weak relationship between the variables and the their adverse shock to the important variables in the Taylor equation i.e. Real GDP, Inflation, Exchange Rate, short term interest rates.
The study of previous literature on Inflation and the subsequent monetary policies shows that each method has its merits and demerits. A single method in itself will not give the desired results. The RBI has done a commendable job till now in controlling the inflationary pressure in the country, but it needs to evolve continuously to sustain a persistent growth of the economy.
RBI first of all needs to shift from the multiple indices of measuring inflation to lesser or if possible single measure of Inflation measurement.
RBI also needs to set a fixed nominal anchor within whose range it will formulate its monetary policies.
RBI also needs to formally state its objective of staying close to a certain inflation number to reinstate its commitment to financial and price stability.
RBI is the prima facie authority (along with the Government of India), plays a crucial role in formulating the monetary policies. It can shape the future of the economic stability of the nation and propel the country towards a flourishing phase it is destined to.
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