The first question that comes to our mind is what is inflation, well it means a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. For Example, If price of potatoes rises to Rs 15/ KG from Rs 12/KG due to inflation, then it means the capacity to purchase potato decreases ( as consumers will have to pay more money for a KG of potato).
Inflation affects the Economy in a big way. It affects both the poor’s as well as the affluent masses. When inflation affects an economy, to maintain the same level of living standards we would have to pay more. For Example: To enjoy the same level of potato i.e. 1 KG, consumers have to pay Rs. 15/- instead of Rs. 12/-. That is we would have to pay more for same amount of goods and services you had used prior to inflation. Our income may not increase at the same rate as inflation, which creates the problem.
At the time of inflation, financial planning becomes difficult. The reason being the value of money decreases with inflation. It would affect the pensioners more than the ones who are currently employed.
To combat the dreadful effects of inflation, government frequently uses to methods which are Monetary Policy and Fiscal Policy. Monetary Policy is the policy in which monetary authority of a country (Reserve Bank Of India for India) controls the supply of money. There are various tools which RBI uses under Monetary Policy.
Open Market Operation
At the time of inflation RBI sells the Govt bonds to people such that extra money can be pulled out of Economy and at the time of deflation RBI purchases Govt Bonds to insert money in Economy.
Reserve Ratio
Reserves
can be of two types Cash Reserve Ratio
(The Cash Reserve Ratio (CRR) refers to this liquid
cash that banks have to maintain with the Reserve Bank of India (RBI) as a
certain percentage of their demand and time liabilities. For example if the CRR
is 10% then a bank with net demand and time deposits of Rs 1,00,000 will have
to deposit Rs 10,000 with the RBI as liquid cash). The other one is Statutory Liquidity Ratio (It’s
the percentage of Demand and Time Maturities that banks need to
have in any or combination of the following forms
i) Cash
ii) Gold valued at a price not exceeding the current market price,
iii) Unencumbered approved securities (G Secs or Gifts) valued at a price as
specified by the RBI from time to time.
The maximum limit of SLR is 40% and
minimum limit of SLR is 24%. It’s 24% now). Well at the time of inflation, RBI rises the
Reserve Rates such that commercial banks needs to keep more amount with RBI,
thus there loan giving capacity will reduce and the excess money from the
economy can be churned out. During deflation, the rates are reduced to flush
more money in economy.
Discount Rate
The rate at which commercial bank can borrow from RBI is known as discount rate. At the time of inflation RBI increases the discount rate such that the borrowing becomes costly and the excess money in the Economy can be slowed down and at the deflation RBI curtails the discount rate to put more money in Economy.
Fiscal Policy
Fiscal Policy means a policy in which Govt adjusts its level of income and spending to control inflation. There are various tools of Fiscal Policy, such asTax Rates
During inflation, charges more tax to reduce the excess level of money in the economy and during deflation they reduces the tax burden.Government Expenditure
Spending more for Economy means creating employment opportunities which will increase the money supply. For Example: Spending more on infrastructure will give job opportunities to many workers. Thus during inflation curtails expenditure and during deflation spends more and more.
Well, The inflation genie
is out of the bottle and policy makers are busy taming it. The initial
response to high inflation had come from
a plethora of fiscal measures (which are determined by the GOI) announced in
early 2010 to control food price inflation. Monetary policy was on a much
static, wait and watch mode at that point of time. Despite optimism that food
price inflation would moderate quickly, it was quite still and only recently it
started to fall appreciably as the monsoon and cropping outlook are improving.
The opposite upward sloping curve for non-food inflation means that the onus of
controlling has now shifted to monetary policy (which falls under the
department of RBI, the central bank of our nation).
In theory, monetary policy can check cyclical demand size pressures. So
before implementing large doses of monetary measures, we must be convinced that
demand is the primary culpibable factor.
So the next issue, becomes the coveted journey from textbook to reality.
The gigantic question that strikes our mind at this point of time is, - “How
effective is monetary policy in controlling inflation, particularly in a
country like India?”
To start with, I support RBI’s move to have a mid-quarter review of
monetary policy. In a fast changing and quite unpredictable macroeconomic
environemnt, there is a need for continuous assesment and policy action. By
reviewing the monetary policy every six weeks, RBI can provide a more realistic
and faster response to developemnts.
Coming now to inflation, if we look at the index, we see that inflation
has been at double-digit level since Feb’2010. Latest figures show that in
June’2010, inflation stood at 10.6%. The inflation in primary articles has
remained at elevated levels for an extended period, with inflation crossing the
15% mark in recent months, the price rise phenomenon is now spreading to other
segments aswell. Data also reveals that non-food manufacturing inflation has
seen a rapid build up, rising from near zero in Nov’2009 to 7.3% in June’2010.
This increase in price of manufactured goods is mainly due to the following
factors: 1) Increase in prices of raw materials and industrial inputs.
2) Upward
revision in wages and salaries, with several companies renegotiating their
compensation contracts to match the higher cost of living (i.e. wage-price
spiral).
3) The most
important factor is the recovery in economic situation with some segments of
industry now facing huge constraints to meet the constant rising demand.
Our Central Bank is understandably worried about this increasingly
generalised nature of inflation. It has made its concern public and to bring
down inflation, it has introduced a series of quick and successive policy rate
hikes. Even Subir Gokarn, RBI’s deputy governor states that, “Inflation stays
RBI’s prime focus”. The authenticity of his statement was rightly visible when
on July 2,2010, the repo and reserve repo rates were hiked by 25 bps and
further on July 27, 2010, RBI repeated the act, but this time, the reserve repo
was hiked by 50 bps. The billion dollar question is whether these moves will
help in cooling down price and bringing inflation back to the more acceptable
5% level.
The other problem
that can be pin pointed at this point is whatever happens to manufacturing
inflation alone doesnot determine the overall inflation situation in the
economy. This is because we also have a more volatile component of primary
articles inflation. And this doesnot respond to monetary policy alone.
Controlling primary inflation, particularly food inflation, requires an
altogether differnet strategy and unfortunately RBI has negligible role in
that. Today, we are betting on a good monsoon that will give us a favourable
output. And once the new crop comes into the market, food prices should settle
down. However, this is not a solution to food inflation. We cannot keep chasing
the monsoon every year to keep food prices under control. We have to realise
that with high growth, rising incomes and aggressive development work being
undertaken in rural areas, food demand is rising rapidly. And the only way to
maintain price line here is to have a sustainable policy for the farm sector.
In case of fruit and vegetables, we need to minimise the wastage ratio that can
be as high as 40%. Here, government must encourage private sector participation
in building the required storage and transportation infrastructure. Even with
sufficient buffer stock of rice and wheat, the problem here lies with the
failed public distribution system. We need to develop an alternate mechanism to
Public Distribution System.
By deploying monetary policy, we cannot hope to achieve medium or long
term price stability. The right action to control inflation has to be in the
form of acceleration of farm sector growth and ensuring comprehensive and
timely distribution of agricultural produce. Also, focus must go back to
economic reforms, which will ease supply-side constraints and bottlenecks.
Monetary policy alone will never be able to tame inflation in a country like
India where most of the inflation related factors lies beyond the scope of RBI.
So its really a high time and we seriously need to ponder over this vital topic
or else the genie will keep roaming around and soon we all will start dancing
to its tune.
This article is written by Abhinav Saha. I am not responsible for his views and opinions.
