inflation

December 28, 2017 | Author: Nilay Agarwal | Category: Inflation, Aggregate Demand, Money Supply, Banks, Money
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Introduction Inflation is a global phenomenon in present day times. There is hardly any country in the capitalist world today which is not afflicted by the spectre of inflation. It is on account of this that the phenomenon of inflation has widely attracted the attention of the economists all over the world but despite that there is no generally accepted definition of the term “inflation” as it is a highly controversial term which has undergone many modifications. A common man understands that there is inflation when he buys his usual list of commodities from the market. If there is an appreciable increase in prices, there is indeed inflation and the media is already full of such bad news. A simple definition of inflation is an increase in prices and or decline in purchasing power. However over the years, the definition of inflation has undergone a change. According to the Webster's New Universal Unabridged Dictionary published in 1983 the second definition of 'inflation' after 'the act of inflating or the condition of being inflated' is: "An increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet the demand." So this broader definition focuses on money supply. If there is more money supply, it causes an increase. So inflation is a cause rather than effect. The American Heritage Dictionary of the English Language, 2000 (4th Edition) defines it more broadly: a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services. In this definition, inflation would appear to be the consequence or result (rising prices) rather than the cause. Different economists have offered different definitions of inflation. In fact there is a plethora of definitions of inflation. The layman however understands by the term “Inflation” sizeable and a rapid increase in the general price level. Inflation in the

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popular mind is generally associated with rapidly rising prices which cause a decline in the purchasing power of money.

Different Definitions of Inflation Prof. Crowther has defined inflation as a state in which the value of money is falling because prices are rising. “But this definition of Prof. Crowther is defective and does not offer a complete picture of the phenomenon of inflation. This definition has been criticized on two grounds: (i)

According to Crowther every increase in the price level is inflationary and has harmful effects on the economy. On the contrary it serves as a stimulant for the revival of economy.

(ii)

Prof. Crowther’s definition emphasizes the symptoms rather than the cause of the disease. The rise in the price level is a symptom rather than the cause of inflation. This definition fails to explain why the price level increases from time to time.

Prof. Kemmerer has defined inflation as “Too much currency in relation to the physical volume of business being done.” Even this definition is not satisfactory. Obviously this definition involves a comparison between the two quantities – the volume of currency on the one side and the volume of physical goods and services on the other side. The difficulty with this definition is that it suffers from vagueness. It is not possible to determine accurately the demand for money. There is no dependable technique whereby the physical volume of goods and services can be accurately the demand for money. There is no dependable technique whereby the physical volume of goods and services can be accurately converted into the demand for money. As such Kemmerer’s definition cannot be looked upon as satisfactory definition.

Prof. Coulborn has also emphasized the same point as has been done by Prof. Kemmerer in the above definition. He says “inflation is too much money chasing too few goods. “ Coulbourne definition also involves a comparison between the quantity of money on one side and the supply of goods and services on the other side. This definition is subject to the same limitations as Kemmerer’s definition.

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Prof. Golde offers a similar definition which reads as follows : “ Inflation occurs when the volume of money actually buying goods and services increases faster than the available supply of goods .” This definition also emphasizes the same point namely that the value of money increases at a faster rate then the supply of goods and services. Modern economics do not agree that money supply alone is the cause of inflation. As pointed out by Hicks, “Our present troubles are not of a monetary character.” Johnson defines inflation as a sustained rise.”

Brooman defines inflation as a continuing increase in the general price level. “Shapiro also defines inflation “as a persistent and appreciable rise in the general level of prices.

The above definitions given by Kemmerer Coulbourne Goldenweinser belong to the same category. They seek to establish cause and affect relationship between supply of money and the price level. . According to these definitions the rise in price level is caused by an increase in the supply of money. The increase in the supply of money is the cause; the rise in the price level is the effect.

But the above cause and effect relationship between supply of money and the price level was reversed in Germany in the post-war period. In other words the hyperinflation which took place in Germany in the post world war period could not be explained by the normal cause and effect relationship between supply of money and the price level as pointed out in the above definitions. It was rise in price which caused the expansion of money supply over business requirements pushes up the price level. Price inflation is the second stage of inflation when the rising price level necessitates a rapid expansion of the supply of money. During the price inflation the prices rise with such rapidity that even the money supply cannot keep pace with them. This stage of inflation is referred to as hyper inflation. To our mind Prof. Einzing’s definition of inflation “Inflation is that state of disequilibrium in which an expansion of purchasing power tends to cause or is the effect of an increase of the price level.” An analysis of this definition reveals the fact that the rise in the price level is not only the result but also cause of money supply. According to Webster's New Universal Unabridged Dictionary published in 1983 the second definition of "inflation" after "the act of inflating or the condition of being inflated" is: 3

"An increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet the demand.” This definition includes some of the basic economics of inflation and would seem to indicate that inflation is not defined as the increase in prices but as the increase in the supply of money that causes the increase in prices i.e. inflation is a cause rather than an effect. So between 1983 and 2000 the definition appears to have shifted from the cause to the result. Also note that the cause could be either an increase in money supply or a decrease in available goods and services.

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Types of Inflation There are several types of inflation observable in an economy. These can be classified as under… 1. Creeping, Walking, Running and Galloping Inflation: This classification is made on the basis of the ‘speed’ with which the prices increase in the economy. Creeping Inflation- When the price rise is very slow like the pace of a snail or creeper, it is called creeping inflation. It is the mildest type of inflation. Under this , the price rise slowly; industry and trade receive stimulus and the country slowly and gradually develops economically. It is on account of its stimulating effect that some economists welcome it for the economic development of a backward economy. • Walking or Trotting Inflation- When prices rise moderately and the annual inflation is a single digit, it is called Walking or Trotting Inflation. • Running Inflation- When the prices rise rapidly like the running of a horse at a rate of speed 10-20% per annum, it is called a running inflation. In case, the government fails to curb running inflation in time, it may easily develop into Galloping Inflation. • Galloping or Hyper inflation- When prices rise very fast at double or triple digit rates from more than 20-100% per annum or even more, it is called hyper or galloping inflation. There are two classic examples of galloping inflation i. The great inflation of Germany after the First World War. ii. The great Chinese inflation after the second world war •

2. Comprehensive and Sporadic Inflation: The former type of inflation occurs when the prices of all commodities register a rise in the economy. The prices of almost all the commodities show an upward trend during a period of inflationary spiral. 5

Sporadic inflation, on the other hand, is sectoral inflation under this type of inflation, only the prices of a few commodities show an upward trend. The price of a few commodities may rise upwards on account of central physical bottlenecks which may impede any attempt to increase their production.

3. Open and repressed Inflation: • Open Inflation- An inflation is said to be open when the government takes no steps to check the rise in the price level. Open inflation is allowed to continue unchecked without any attempt on the part of the government to hold the price line. Under open inflation, the market mechanism is allowed to work itself out fully without restriction being imposed by the government. • Repressed inflation- An inflation is said to be repressed inflation when the government actively intervenes to check the rise in the price level. The government may check the rising trend in the price level by resorting to rationing of scarce items or resorting to price control. 4. Full and Partial Inflation: According to Professor Pigou, the price level consequent upon the expansion of money supply in the pre full employment stage is referred to as partial inflation. But the increase in the supply of money after the point of unemployment does not increase output and employment because there already is present the full employment of resources in the economy which consequently leads to a sharp uninterrupted rise in the price level. Such situation is referred to as Full Inflation. 5. Peace Time , War Time and Post War Inflation: Peace Time Inflation- This type of inflation is very often as a result of increased governmental expenditure on ambitious developmental project in the economy. • War Time Inflation- During war time, the increase in the output of the goods and services doesn’t keep pace with the expansion of money supply. An inflationary graph inevitably emerges which results in a rise in price level. • Post War Inflation- It takes place immediately after the sessation of hostilities when the pent-up demand finds open expression on the relaxation of price in physical control by the government. •

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6. Currency and Credit Inflation: Currency Inflation- This is the classic type of inflation marked by an excess supply of money in relation to the available out of goods and services. It inevitably results in an inflationary rise in the price level. • Credit Inflation- Sometimes the government encourages an expansion of credit without expanding the supply of money in circulation. This is known as credit inflation. The main objectives of credit inflation are: i. To lighten the burden of indebtedness of the farmers. ii. To expand production to mobilize financial resources for developmental plans. •

7. Induced Inflation: • Profit Induced Inflation- Sometimes the production cost starts declining and consequently, the prices show a declining trend. But the government doesn’t allow the prices to fall down by resorting to artificial means. This situation results in an increase in the profit margins of the producers, thus leads to profit induced inflation. • Deficit Induced Inflation- When the government is not able to cover the deficits; it is forced to resort to the printing press for issuing new currency. Under these circumstances, it may result in the rising price level and thus leads to the deficit induced inflation. • Wage Induced Inflation- When the workers organize themselves into powerful trade unions and force the employers to increase the wages, this inevitably pushes the production cost and thus leads to wage induced inflation. * There are certain other types of inflation like Mark-Up Inflation, Ratchet Inflation, Stagflation, Sectoral Inflation and Imported Inflation.

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Causes of Inflation The root cause of inflation is the imbalance between the total demand and total supply of goods and services in the economy which causes excess demand. The emergence of excess demand in the economy can be attributed to two main factors:1. Increase in demand for goods and services 2. Decrease in the supply of goods and services

Factors Causing Increase in Demand Following are the factors which cause an increase in demand:1. Increase in public and private expenditure- An increase in public expenditure

consequent upon the outbreak of war or developmental planning invariably causes an increase in the demand for goods and services in the economy. An increase in private expenditure (primarily in investment activities)gives rise to increase in demand for factors of production which results in an increase in the factor prices .when factor income increases ,there is more and more of expenditure on consumption goods .

2. Increase in exports- An increase in the foreign demand for the country’s

products reduces the stock of commodities available for home consumption. It creates a situation of shortage of goods and services in the economy, giving rise to inflationary pressures.

3. Reduction in taxation- When the government reduces taxes ,it results in an

increase in the purchasing power of consumers which they use for buying goods and services for consumption purposes. This naturally leads to an increase in the aggregate demand in the economy.

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4. Repayment of past internal debts- When the government pays its past debts to

the public it results in the increase in the purchasing power of the consumers and thus increases demand.

5. Rapid growth of population- A rapidly growing population has the effect of

raising up the level of aggregate demand for goods and services in a country. This acts as an inflationary force and tends to raise the prices to higher levels.

6. Black money- The existence of huge amount of black money in the economy is

also responsible for increase in demand .people spend such unearthed money on buildings, marriages ,luxuries etc thereby raising demand.

7. Deficit Financing- In order to meet its meet its mounting expenses, the

government resorts to deficit financing by borrowing from the public and printing notes in the huge quantity. This raises aggregate demand in relation to aggregate supply.

8. Increase in consumer landing- The demand of goods and services increases

when the consumer spending increases. It may be due to easy availability of credit etc it increases the demand for goods and services.

Factors Causing Decrease in Supply Following are the factors which causes decrease in supply:1. Shortages of supplies of factors of production- Occasionally, the economy of a

country may be confronted with shortages such factors as labor, capital, raw materials etc. these shortages are bound to reduce the production of goods and services for consumption purposes.

2. Industrial disputes- In countries where trade unions are strong, they help in

curtailing inflation. Trade unions resort to strikes and if they happen to be unreasonable from employer’s point of view and are unreasonably prolonged, they force the employers to declare lockouts. In both cases industrial production falls, thereby reducing supply of goods in the country.

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3. Natural calamities- Natural calamities like floods, droughts etc. adversely

affects the supplies of agricultural products. The latter, in turn, create shortage of food products and raw materials, thereby helping inflationary pressures.

4. Operation of law of diminishing returns- In countries where industries use old

and obsolete machines and outdated methods of production, the law of diminishing returns operates. This raises cost per unit of production, thereby raising the prices of products leading to inflation.

5. Lopsided production- If the stress is placed on the production of comfort and

luxury goods, thereby neglecting essential and consumer goods in a country, it creates shortages of goods in the country, it creates shortages of goods in the market and hence causes inflation.

6. Hoarding by consumers and traders- Hoarding by consumers and hoarding is

one of the causes which may affect the supply side. Hoarding by suppliers is done to exploit the consumers by reducing the supply at particular point of time and then raising prices after the demand exceeds. Sometimes consumers also tend to purchase commodities with the expectation that the prices will rise in the near future. This also creates a deficiency in the supply of the goods and services.

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Demand Pull & Cost Push Inflation

Demand Pull Inflation Demand-pull inflation arises when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as "too much money chasing too few goods". More accurately, it should be described as involving "too much money spent chasing too few goods", since only money that is spent on goods and services can cause inflation. This would not be expected to persist over time due to increases in supply, unless the economy is already at a full employment level. The term demand-pull inflation is mostly associated with Keynesian economics According to Keynesian theory, the more firms will employ people, the more people are employed, and the higher aggregate demand will become. This greater demand will make firms employ more people in order to output more. Due to capacity constraints, this increase in output will eventually become so small that the price of the good will rise. At first, unemployment will go down, shifting AD1 to AD2, which increases Y by (Y2 - Y1). This increase in demand means more workers are needed, and then AD will be shifted from AD2 to AD3, but this time much less is produced than in the previous shift, but the price level has risen from P2 to P3, a much higher increase in price than in the previous shift. This increase in price is called inflation

Cost Push Inflation Cost-push inflation is a type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available. A situation that has been often cited of this was the oil crisis of the 1970s, which some economists see as a major cause of the inflation experienced in the Western world in that decade. It is argued that this inflation resulted from increases in the cost of petroleum imposed by the member states of OPEC. Since petroleum is so important to industrialized economies, a large increase in its price can lead to the increase in the price of most products, raising the inflation rate. This can raise the normal or built-in inflation rate,

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reflecting adaptive expectations and the price/wage spiral, so that a supply shock can have persistent effects.

Austrian school economists such as Murray N. Rothbard and monetary economists such as Milton Friedman argue against the concept of cost-push inflation because increases in the cost of goods and services do not lead to inflation without the government and its central bank cooperating in increasing the money supply. The argument is that if the money supply is constant, increases in the cost of a good or service will decrease the money available for other goods and services, and therefore the price of some those goods will fall and offset the rise in price of those goods whose prices have increased. One consequence of this is that monetarist economists do not believe that the rise in the cost of oil was a direct cause of the inflation of the 1970s. They argue that although the price of oil went back down in the 1980s, there was no corresponding deflation. Keynesians argue that in a modern industrial economy, many prices are sticky downward or downward inflexible, so that instead of prices falling in this story, a supply shock would cause a recession, i.e., rising unemployment and falling gross domestic product. It is the costs of such a recession that likely cause governments and central banks to allow a supply shock to result in inflation. They also note that though there was no deflation in the 1980s, there was a definite fall in the inflation rate during this period. Actual deflation was prevented because supply shocks are not the only cause of inflation; in terms of the modern triangle model of inflation, supply-driven deflation was counteracted by demand pull inflation and built-in inflation resulting from adaptive expectations and the price/wage spiral

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Calculation of Inflation Rate Mathematically, inflation or inflation rate is calculated as the percentage rate of change of a certain price index. The price indices widely used for this are Consumer Price Index (adopted by countries such as USA, UK, Japan and China) and Wholesale Price Index (adopted by countries such as India). Thus inflation rate, generally, is derived from CPI or WPI. Both methods have advantages and disadvantages. Since India uses WPI method for inflation calculation, let’s go in to the details of WPI based inflation calculation.

How is WPI (Wholesale Price Index) Calculated? In this method, a set of 435 commodities and their price changes are used for the calculation. The selected commodities are supposed to represent various strata of the economy and are supposed to give a comprehensive WPI value for the economy. WPI is calculated on a base year and WPI for the base year is assumed to be 100. To show the calculation, let’s assume the base year to be 1970. The data of wholesale prices of all the 435 commodities in the base year and the time for which WPI is to be calculated is gathered. Example: WPI for the year 1980 for a particular commodity, say wheat. Assume that the price of a kilogram of wheat in 1970 = Rs. 5.75 and in 1980 = Rs. 6.10 The WPI of wheat for the year 1980 is,(Price of Wheat in 1980 – Price of Wheat in 1970)/ Price of Wheat in 1970 x 100 i.e. (6.10 – 5.75)/5.75 x 100 = 6.09 Since WPI for the base year is assumed as 100, WPI for 1980 will become 100 + 6.09 = 106.09. In this way individual WPI values for the remaining 434 commodities are calculated and then the weighted average of individual WPI figures are found out to arrive at the

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overall Wholesale Price Index. Commodities are given weight-age depending upon its influence in the economy.

How is Inflation Rate Calculated? If we have the WPI values of two time zones, say, beginning and end of year, the inflation rate for the year will be, (WPI of end of year – WPI of beginning of year)/WPI of beginning of year x 100 For example, WPI on Jan 1st 1980 is 106.09 and WPI of Jan 1st 1981 is 109.72 then inflation rate for the year 1981 is, (109.72 – 106.09)/106.09 x 100 = 3.42% and we say the inflation rate for the year 1981 is 3.42%. Since WPI figures are available every week, inflation for a particular week is calculated based on the above method using WPI on the later week and WPI on the previous week. This is how we get weekly inflation rates in India.

Characteristics of WPI Following are the few characteristics of Wholesale Price Index 1>WPI uses a sample set of 435 commodities for inflation calculation 2>the price from wholesale market is taken for the calculation 3>WPI is available for every week 4>It has a time lag of two weeks, which means WPI of the week two weeks back will be available now

WPI in India There have been discussions going on whether to use WPI as a measure to check on inflation.basically WPI has some loopholes:-

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WPI as the name suggests is at the whole sale level and so, it does not measure the exact price rise which the end-consumer end up paying.

The second major problem with WPI calculation that more than 100 out of 435 items have lost their significance from consumption point of view. e.g., the commodities like coarse grains which is generally used for cattle feed thereby having no significance continue to be there in the list which is used to measure inflation. Also, the services which have a lot of importance in our economy is not there in the list. Besides this, the list of commodities was last reviewed in 1993-1994 and today most of the commodities have become redundant in their use. WPI gives us the essence of the business which we are taking as the nerve of the consumers while calculating price rise. So, there is a high time need that India should shift from WPI to CPI for measuring inflation. In India, we have four CPI indices • • • •

CPI UNME (Urban Non Manual Employees) CPI AL (Agricultural Labour) CPI RL (Rural Labour) CPI IW (industrial Workers)

So, decision to choose which CPI index will be risky and unwieldy. Second, important reason for which we are not using CPI is reported on monthly basis with a huge time lag whereas WPI is published weekly basis

Consumer Price Index CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. CPI is a fixed quantity price index and considered by some a cost of living index. Under CPI, an index is scaled so that it is equal to 100 at a chosen point in time, so that all other values of the index are a percentage relative to this one.

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Stages of Inflation Inflation passes through three stages. In the first stage the rise in price is slow and gradual. In this stage it is easier to check the inflationary rise in the price of goods and services. But if it is not effectively checked in the first stage then it enters the second stage. In second stage inflation becomes a serious headache for the government. The prices of goods and services start rising much more rapidly then before. It not possible to eliminate inflation completely but if the government takes effective steps, it may be possible to prevent a further rise in price level. In the third stage, prices of goods and services now start rising almost every minute and it becomes impossible for the government to check them. These can be illustrated by an example , in first stage price rise in a proportion is less than the supply of money. If the supply of money increases by 10%, the price rise by 5% or even less than that . In the second stage, the prices rise exactly in the same proportion in which the supply of money increases. In other words, if the supply of money is increased by 10% the price rise also goes by 10%. In the third stage, the price rise in a much greater proportion than the increase in the supply of money. In other words, if the supply of money is 10% price level may rise by 15% or even more. The above three stages are described below: • Pre-full Employment Stage: The rise in price level in the first stage is less than proportionate to the increase in the supply of money. Let us suppose the supply of money increases by 10%. As, a result, there will be immediate rise in the price level. Consequently, the production of goods and services receive stimulus. As a result of increase in output of goods and services, the price level will come down. But if the supply of money is again increased by 10%, the price level will rise up, giving encouragement to the production of goods and services in the economy. In this way if there is continuous increase in the supply of money, a stage will come when the output of goods and services may not increase in the same proportion in which the supply of money increases. The reason being that

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with the expansion of production, the supply of the factors of production goes on declining.

• Full Employment Stage: If the supply of money continues to increase without any interruption, then after some time production will cease to increase, or in other words, production will become stagnant .The reason being that all productive resources are already fully employed. Extra resources are not available for a further expansion of production. Hence, the further expansion of production comes to an end. Since production becomes constant, the price level now starts increasing in the same proportion in which the supply of money increases. •

Post-full Employment Stage:

If the supply of money continues to increase even after the time of full employment, then for some time the price level will increase in the same proportion in which supply of money increases. But after that the supply of money increases so much that the public loses confidence in it and the increase in the price level is much more than the increase in supply of money. For example, if the supply of money is 10%, then the price level increases by 20%, 30% or even 40%. In such a situation, it becomes difficult, to check the rise in the price level. This is the final stage of inflation. In this stage, the prices rise so high that money exchange comes to be replaced by commodity exchange in due course of time

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Effects of Inflation Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as hit man. A period of prolonged, persistent and continuous inflation results in the economic and social and moral disruption of society. The effects of inflation can be discussed under two subheadsa) Effects on production b) Effect on distribution The general perception is that inflation is harmful for the economy. This leads us to the question as to whether inflation is always detrimental to productive activities. Mild inflation may actually be good for the economy, particularly when there are unemployed productive resources in the country. Mild inflation will cause an expansion of money supply in an under developed country which will result in a slow and gradual rise in the prices. The profit margins of businessmen will continue to increase as the production cost will not rise in the same proportion. Encouraged by the favorable conditioned the businessmen will increase their investment in production activities generating more income and employment in the economy. This process of increased investments and increasing employment continues till the point of full employment is reached. But after the point of full employment of productive resources, any expansion of money supply is bound to result in hyper inflation. Thus, an expansion of money supply after the point of full employment may not be harmful for the economy. In fact, mild inflation may serve as a tonic for the economy of the country. But any expansion of money supply after the point of full employment will degenerate into runaway or hyper inflation. And hyperinflation as already pointed out above, is very harmful for the economy. It creates business uncertainty which is inimical to production. It is this hyperinflation which has harmful consequences for the economy. In fact, hyperinflation disrupts the smooth 19

functioning of the economy. This type of inflation has the following adverse effects on the productive activities of the country: 1) Since hyperinflation results in a serious depreciation of the value of money, it discourages saving on the part of the public. With reduced savings, the process of capital accumulation suffers a serious set back. 2) If the value of money undergoes considerable depreciation, this may even drive out the foreign capital already invested in the country. 3) With the reduced capital accumulation the investment will suffer a serious set back which may have an adverse effect on the volume of production in the country. 4) The volume of production with not only decline on account of the slowing down on capital accumulation, it may also decline on account of business uncertainty which may discourage entrepreneurs and businessmen from taking business risk and production. 5) The pattern of production in the economy may also undergo changes under the impact of run away inflation. This type of inflation may result in the diversion of productive resources from the essential goods industries to the luxury goods industries creating further shortages of consumer goods for the common man. 6) Since run away inflation in a seller’s market, it may lead to a serious deterioration in the quality of goods produced in the economy. 7) Inflation also leads to hoarding of essential goods both by the traders as well as the consumers. The traders hoard stocks of essential commodities with a view to making higher profits or with a view to selling scarce items in the black market. The consumers also resort to hoarding of essential goods for fear of pain higher prices in the future. The may also hoard essential goods with a view to ensuring continuous an uninterrupted supply for themselves. 8) The worst part of inflation is that it gives stimulus to speculative activities on account of the uncertainty generated by a continuously rising price level. Instead of earning increased profits out of increased production, the businessmen find it easier to increase their profits through speculative activities. 9) The more effect of inflation that it disrupts the smooth working of the price mechanism, their by creating an all-round confusion in the economy. 10)The economy system looses it flexibly under the impact of inflationary forces which have been knack of reducing the mobility of productive resources in the economy. 11)The worse effect of hyper inflation is that in due course of time it results in a flight from domestic currency on account of it’s constantly diminishing value. Ina n advanced stage of hyper inflation; the people loose confidence in their home currency and rush to by foreign currencies of stabler value to safeguard their assets. /in fact, there is a scramble on the part of the people to exchange home currency for foreign currency in the foreign exchange market. Nevertheless, as pointed out above a mid dose of inflation serves as a stimulant by energizing an activating ideal resource in the economy. It induces movement of real resources to the expanding sectors of the economy. It encourages 20

entrepreneurs to make investments in new enterprises which lead to in productive capacity, ultimately, in the volume of production. Price stability need not be interpreted as price rigidity. Economic stability, in fact, is quiet consistent with an annual increase to 3 to 4 percent in the general price level. This produces salutary effect on the economy as a whole.

Effects on Distribution Inflation produces a deep impact on the distribution of income and wealth in society. A prolonged period of persistent inflation results in redistribution of income and wealth in favour of the already richer and more affluent classes of society. The distributive share accruing to the business classes increases much more than that of wage-earning or rentier classes. Businessmen, traders, merchants and speculators reap rich harvests on account of windfall profits accruing to them as a result of the inflationary rise in prices. Prices under the pressure of inflation rise much more than the production cost. There is always a time lag between the rise in production cost and rise in the price level. This time brings rich profits to the business classes. Moreover, the stocks and inventories of business man invariably go up in value because of the constantly rising price level under the impact of inflation. The business classes thus, make all round gains during a period of inflation. The fact of the matter is that the flexible income groups, such as , businessmen, merchants and traders are always the gainers in period of inflation while the fixed income groups, such as, workers, salaried employees, teachers, pensioners, etc are always the losers on the account of the inflationary rise in prices. Inflation is always unjust. It is a like a steeply regressive tax. Inflation throws the economic burden on the shoulders of those sections of the community who are the least able to bear it. The concrete effects of inflation on various groups of society are as follows: 1) Debtors and creditors. During inflation, debtors are generally the gainers while the creditors are the losers. The reason is that the debtors had borrowed when the purchasing power of money was high and now return the loans when the purchasing power of money is low due to rise in prices. In other words the debtors while repaying their debts return less purchasing power to the creditors than what they have actually burrowed. Since the creditors receive less in real terms, they are the losers during inflation. 2) Wage and salary earners. Wage and salary earners mostly suffer during inflation because wages and salaries generally do not rise in the same proportion in which the cost of living rises. Then there is the time lag between the rise in the cost of living and the rise in the wages and salaries. If the workers and salaries earners are well organized into powerful trade unions, they may not suffer much during inflation, but if they are unorganized or ill-organized, as they generally are, they may suffer much as their wages and salaries may not increase at all or may increase in the proportion in which the cost of living increases. 21

3) Fixed-income groups. The fixed-income groups are the hardest hit during inflation because their incomes being fixed do not bear any relation ship with the rising cost of living. Persons who live on the past savings, pensioners, interest and rent receivers suffer most during inflation as their incomes remain fixed while the prices sole high. Inflation, it is said, is also a killer of older, retired people who with the advent of winter, find their pensions inadequate to buy their fuels with their existing fixed pensions. 4) Entrepreneurs. Inflation is the boon to the entrepreneurs whether they are manufactures, traders, merchants or businessmen, because it serves as a tonic for business enterprise. They experience windfall gains as the prices of their inventories (stocks) suddenly go up. They also gain because their costs do not go up as rapidly as the prices of their products. The costs of labour, raw materials and equipment, etc. do not catch up with the rise in prices of products. Inflation converts the entrepreneurs into ‘profiteers’ who put the community to ransom to their profiteering and hoarding their activities. 5) Investors. Investors re generally of two types: (i) investors in equities (shares) and (ii) investors in fixed interest-yielding bonds and debentures. Inflation bestows favours on the former and is rather harsh on the latter. Dividends on equities increase with the increase in prices and corporate earning and as such the investors in equities are favourably affected. Incomes from bonds and debentures, however, remain fixed and as such, investors in them are adversely affected. The small middle-class investors generally invest in fixed interestyielding bonds and equities and therefore, have much to lose during inflation. Frequently they find their saving largely, if not completely, wiped out as a result of the deprecation in the value of money. The rich-class investors. On the other hand invest in equities on which the dividends go up during on inflation and are thus beneficially affected.

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Measures to Control Inflation The causes of inflation, its effects and its harmful consequences have emphasized the need for adopting a prompt and effective anti-inflationary policy on the part of the government. There are three major lines of action to check and control an inflation boom. • Monetary measures • Fiscal measures • Realistic measures Monetary Measures One method to control the inflation is to reduce the flow of cash in the economy, which helps to reduce an inflation pressure. This is done through the following monetary measures. i.

Increased Rediscount Rate: Rediscount Rate is the rate at which the central bank lends loan to its member banks. An increase in rediscount rate leads to an increase in bank rates (i.e., the interest rates charged by commercial banks), because there is a definite relationship between the two. Also the cost of borrowing funds for business and consumer spending increases and thus discourage excessive activity based on borrowed funds. This results in a fall in the intensity of inflationary pressures in the economy. Limitations: • If bank rates do not rise pari passu with the rise in rediscount rates, then there will be no decline in the business and customer borrowing, and hence, the inflationary pressures will continue even though the rediscount rates have been raised. • This doesn’t work if the commercial banks have an easy access to additional reserves. For example, the commercial banks which are in possession of large amount of short-term government securities to the central bank or by converting the maturing securities into cash. Instead of borrowing from the central bank at higher discount rates, the commercial banks might prefer to sell their low yield securities during inflation. 23

• If non-bank holders of government securities were to convert their holdings into cash would have the effect of increasing the velocity of money consequent upon increased cash balances. At a time of raising prices and falling value of money, there is a strong temptation on the part of holders of fixed income yielding assets to convert them into cash. ii.

Sale of Government Securities in the Open Market: In this method to check the inflationary boom the Government resorts to sales of government securities to the public by central bank. As the buying public purchases and pays for those government securities, the commercial banks’ reserves with the central bank are correspondingly reduced and they are obliged to adopt a restrictions credit policy in relation to business requirements. This process helps in creating tight money conditions in the market, and thus arresting the further growth of the inflationary bloom. Limitations: • When commercial banks are able to increase their reserves by selling their stocks of government securities to the central bank this policy becomes ineffective. • When the non-bank holders of government securities may also, in the absence of other buyers, sell them to the central bank and deposit the proceeds with the commercial banks, again the reserves with the commercial banks increases and there is no effect on inflation boom. • The policy may also be offset by increased borrowings from or by increased sales of treasury bills to the central bank by the commercial banks.

iii.

Higher Reserve Requirements: It is necessary for all the member banks to have some percentage of its cash with the central bank. This is known as Cash Reserve Ratio (CRR). The raise in this reserve ratio absorbs the excess reserves of the banking system and thus prevents them from forming a basis for further credit expansion. Limitations: • When the commercial banks happens to have very large excess reserves, even the raising of reserve requirements may not significantly curtail their power to create credit. • The ability of commercial banks to increase or replenish their reserves through sale of government securities may render higher reserve requirements ineffective to check credit expansion.

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• A large inflow of gold on account of the existence of an export surplus will also, by increasing the member-banks’ reserves, offset the anti-inflationary effect of higher reserve requirements. iv.

Consumer Credit Control: This device is introduced to curb excessive spending on the part of consumers. Recently installment purchase has increased to a large extent and this has increased the consumer spending. Most of consumer goods, such as, radios, television sets, washing machines, etc. are purchased by the consumers on installment credit. During inflation this credit purchase are reduced to the minimum to curtail excessive spending on the part of consumers. This is done by • Raising the minimum initial payment on specified goods • By extending the application of consumer credit control to a large number of goods • By decreasing the length of the payment period

v.

Higher Margin Requirements: This is another method of selective credit control like consumer credit control policy. The central bank in its pursuance of an anti-inflation policy may raise the margin requirements to higher levels. As is well known, every commercial bank before giving loans against collateral security keeps a certain specified margin say 20% or 30%. So when a businessman offers a security for Rs. 10,000 and the bank keeps a margin of 20%, then it means that it will not advance more than Rs. 8,000 to the businessman. This margin is necessitated by the possibility of a fall in the value of the security. Thus, higher margin requirements have the effect of checking undue monetary expansion.

Fiscal Measures Fiscal policy is now recognized as an important instrument to tackle an inflationary situation. By this method the spending capacity of the public is reduced by grabbing the excess money from the public. This will check the increase in prices of essential commodities and helps in reducing the inflation boom. This is done through the following methods. 1. Government Expenditure:

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During inflation, as is well known, effective demand increases far too much due to unregulated private spending. The increased private expenditure presses heavily against the limited supply of goods and services available in the market. To counteract increased private spending, the government should, at such a time, reduce its own expenditure to the minimum extent possible to help limit the aggregate demand. Limitations: • The decrease in government expenditure particularly in the war period will lead to decrease in military expenditure which is not possible. • Any drastic cut in government expenditure to cure inflation may sometimes actually land the economy in a slum. • This policy of a cut in government expenditure may actually come into clash with a long-range public investment program. 2. Taxation:

The main issue during inflation is to reduce the size of disposable income in the hands of the general public in view of the limited supply of goods and service in the market. It is therefore, necessary to take away the excess purchasing power from the public in the form of taxes. The rates of existing taxes should be steeply increased while new taxes should be imposed on commodities and services so as to leave less money supply with the public to spend. The best anti-inflation tax is personal tax with steep rates and high surcharges. This would reduce the spendable income in the hands of the public, and thus help anti-inflation measures must aim at reducing current incomes in the hands of those sections which, if not taxed, would contribute to raising the price level. The tariffs on imports should be lowered down as much as possible to encourage increased imports to set up the supply of goods at home to absorb the increased money supply in the economic system. The tariffs on necessities of life particularly reduced so as to contain inflationary pressures in the economic system by increasing the supply of goods and services. While increasing the taxation to curb inflationary pressures, money incomes are not so much deflated as to provoke a recession in the economy. 3. Public Borrowing:

The object of public borrowing is to take away from the public excess purchasing power which, if left free, would surely exert a limited upward pressure on the price level in view of the limited supplies of goods and services 26

in the economy. This can be voluntary or compulsory. Ordinarily, the public borrowing is voluntary, left free to the free will of the individuals. But voluntary borrowing has one disadvantage, and that is, it does not bring to the government sufficient amounts to have really effective impact on the inflationary pressures. It thus becomes essential in due course of time to resort to compulsory savings or compulsory borrowings from the public (also known as deferred pay). By this plan a certain percentage of the wages or salaries are compulsorily deducted in exchange for savings bonds which become redeemable after a few years. This has an added advantage of releasing blocked purchasing power at the first symptom of a recession in business activity. It was adopted by India in 1963 to check inflation, though under public compulsion it had to be withdrawn by the Government of India. Limitations: • It involves the use of compulsion which is generally unpalatable to the public. • It results in discontent if applied to those sections of the community which are not in a position to contribute to this scheme in view od their limited pay packets. 4. Debt Management:

The existing public debt should be managed in such a manner as to reduce the existing money supply and prevent further credit expansion. Anti-inflation debt management usually requires the retirement or repayment of bank-held debt out of a budgetary surplus. The idea is that the government securities held by commercial banks should be retired by the government out of a budgetary surplus. This would check the power of commercial banks to encash their securities and add to their reserves for the purpose of credit expansion. There is, however, one snag here. At the time of inflation, despite its best efforts, the government may not succeed in having a budgetary surplus. Due to the excessive increase in expenditure, the government may actually be faced with deficit budget. In that case, the government can adopt another method to retire the bank-held debt. It can retire this debt by sale of bank-ineligible bonds to nonbank investors like insurance companies, savings banks, individuals, etc. This will have the effect of taking away the spendable money from the public and, thus, contribute to a lessening of pressure on the limited stocks of goods and services available in the market. Limitations: It would be rendered ineffective if the nonbank investors were unwilling to give up spendable money in exchange for government bonds. It would also prove futile 27

if the nonbank investors utilized, for purchasing government bonds, idle funds which would not have been spent at all.

5. Overvaluation:

An overvaluation of domestic currency in terms of foreign currencies will also serve as an anti-inflationary measure in three ways. • It will discourage exports and thereby result in an increased availability of goods and services in the domestic market. • By encouraging imports from abroad, it will add to the domestic stock of goods and services, and, thus absorb the excessive purchasing power in the economy. • By cheapening the prices of those foreign materials which enter domestic production, it will help in checking an upward cost-price spiral. Limitations: If other countries are also suffering from inflation, then the country concerned shall have to overvalue its currency considerably to neutralize the inflationary effect of the raising cost of imports. Realistic Measures These realistic measures can be used to supplement the monetary-fiscal measures undertaken to contain inflationary pressures. 1. Expansion of Output:

Increased production is the best antidote to inflation because, as pointed out above, at the time inflationary gap arises partly due to the inadequacy of output. This can be done in the following ways. • In time of inflation it becomes difficult to increase output because of the full utilization of resources. The productive resources are already fully employed. The steps should be taken to increase the output of those goods which seems to be extremely sensitive to inflationary pressures by shifting productive resources from less inflation-sensitive goods. In other words reallocation of productive resources is suggested to step up the output of inflation-sensitive goods, such as, food, clothing, housing and other essential consumer goods. • The output should be increased by making the workers work for longer hours in factories. They should be accompanied by “overtime allowances”. These overtime wages should either be taxed or taken away by the government in form of loans so as to prevent from spending this additional income.

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• The other feasible method is to increase the output through technical innovations in industry. It is also essential at time of inflation to maintain peace, because during inflation the workers are generally discontented and their grievances mount with the rising cost of living. Attempts should be made to devise some labor management machinery, attend the workers grievances to avoid work stoppages which are bound to inhibit production at a critical time. • Government may adopt a liberal import policy to offset the domestic import policy to offset the domestic shortage of goods. As a matter of policy, the government can also import inflation-sensitive and essential goods in exchange for export of non-essential and inflation-insensitive goods. 2. Wage Policy:

During an inflationary boom, wages cannot be left free to chase the prices upward. They have to be controlled so as to contain inflationary pressures in the economy. Wage increases may be allowed to workers only if their productivity, i.e. output per worker, increases. But if the wages in a particular industry are already sub-standard, they may be got raised without increasing the prices of goods produced, i.e., by reducing the profit margins of the producers. It is important for the government at such a time to keep down the cost of living through its antiinflation program, for if it fails to do so, the workers’ unions would be perfectly justified in asking for higher wages from their employers, and the government should let them do so. Even the government can tax away or borrow a part of money wages as a part of its anti-inflation program. But complete wage freeze is rather difficult to achieve during peacetime inflation, because trade unionism is a powerful force now in advanced economies. This is rendered still more difficult by the fact that wages are not only costs to employers but also incomes to the workers, and any step taken in the direction of a wage freeze may give rise to uncontrollable deflationary movements in future. 3. Price control and Rationing:

This was done in fairly wide scale in various countries of the world to fight inflation during and after the Second World War. The object of price control is to lay down the upper limit beyond which the price of a particular commodity would not be allowed to rise. Anyone selling the concerned commodity would not be allowed to rise. Anyone selling above the upper limit would be in risk. To ensure the successful functioning of price control, the following conditions have to be satisfied. • The government should have under its control adequate stock of the commodity concerned. This will fail if doesn’t have adequate stock of its own.

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• The demand for the concerned commodity should be controlled through rationing, failing which, taking advantage of the fixed price the richer sections shall be able to buy a major portion of the available stocks. 4. Population planning:

Control on population by adopting different measures of family will reduce the demand and finally prices will be controlled. 5. Economic Planning:

Effective economic planning is necessary to control the inflation in the country.

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The Current Scenario Inflation around the World The Indian people and the government are both quaking with fear with inflation hovering at around 8%. The people can barely make two ends meet with prices soaring, and the government knows that if prices don't fall, the government will. But India is not the only nation grappling with rising inflation. The entire world is facing the problem. Considering inflation, the top 10 nations falling in the list of countries affected by highest rates of inflation are1. Zimbabwe: 355,000% The inflation in Zimbabwe for the month of March 2008 rose to 355,000%! Yes, 355,000 per cent! It more than doubled from the February figure of 165,000%. Economists say that it is a miracle that the Zimbabwean economy is still surviving and prices have been rising to unprecedented proportions. Inflation surged between February and March following the sudden rise in money supply that flooded the economy to finance the 2008 elections. Apart from this food and non-alcoholic beverages continued to drive up inflation. Almost 80% of the nation is unemployed. The Zimbabwean central bank has introduced $500 million bearer cheques (or currency notes) for the public, and $5 billion, $25 billion, $50 billion agro-cheques for farmers. Just last fortnight the nation had introduced $250 million bearer cheques. A sausage sandwich sells for Zimbabwean $50 million. A 15-kg bag of potatoes cost Zimbabwean $260 million. But then, Zimbabwean $50 million is roughly equal to US$ 1!

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A Zimbabwean man holds up a new $500-million note on May 16, 2008 in Harare. | Photograph: Desmond Kwande/AFP/Getty Images

2. 3. 4. 5. 6. 7. 8.

Iraq: 53.2% Guinea: 30.9% San Tome and Principe: 23.1% Yemen: 20.8% Myanmar: 20% Uzbekistan: 19.8% Democratic Republic of Congo: 18.2%

A train carrying Congolese people in Kinshasa: The terrain and climate of the Congo Basin present serious barriers to road and rail construction

9. Afghanistan: 17% 10. Serbia: 15.5%

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Inflation in India The beginning of 2008 has seen a dramatic rise in the price of rice and other basic food stuffs. There has also been a no-less alarming rise in the price of oil and gas. When coupled with rises in the price of the majority of commodities, higher inflation was the only likely outcome. By July 2008, the key Indian Inflation Rate, the Wholesale Price Index, has risen above 11%, its highest rate in 13 years. This is more than 6% higher than a year earlier and almost three times the RBI’s target of 4.1%. Inflation has climbed steadily during the year, reaching 8.75% at the end of May. There was an alarming increase in June, when the figure jumped to 11%. This was driven in part by a reduction in government fuel subsidies, which have lifted gasoline prices by an average 10%. The Indian method for calculating inflation, the Wholesale Price Index, is different to the rest of world. Each week, the wholesale price of a set of 435 goods is calculated by the Indian Government. Since these are wholesale prices, the actual prices paid by consumers are far higher. In times of rising inflation this also means that cost of living increases are much higher for the populace. Cooking gas prices, for example, have increased by around 20% in 2008. With most of India’s vast population living close to – or below – the poverty line, inflation acts as a ‘Poor Man’s Tax’. This effect is amplified when food prices rise, since food represents more than half of the expenditure of this group. The dramatic increase in inflation will have both economic and political implications for the government, with an election due within the year. The hike in crude oil prices in one of the most important factor contributing to the high rate of inflation in India with the current price touching around $ 105 per barrel of oil. Speculation amid the weakening U.S. dollar and concession fears in the aftermath of the U.S. sub-prime mortgage crisis were clearly one of the vital players behind the skyrocketing oil prices. OPEC Secretary-General Abdullah al-Badri said on May 23 the cartel could do nothing to curb the hike in oil prices as speculation and the weak U.S. dollar, rather than insufficient output, should be held responsible. "When we see there is a shortage of supply, we will act," he said. But in the present situation, "even if we increase output tomorrow, the prices will not come down because of speculation and because of a weak dollar." The fluctuation of crude oil prices is closely related to the global financial market. Rising oil prices should be put into the context of the global financial market, which could be affected by a wide range of factors such as the change of exchange rates, geopolitics, political instability and natural disasters. All these may be reasons for speculation, and from this way of thinking, an answer to the current record high oil price could be found. Analysts said there are several causes for rising oil market speculation. The outbreak of the sub33

prime mortgage crisis in the United States last summer and the resulting turbulence in the world financial market channeled huge capitals into the oil market. Speculation not only pushed up oil prices, but also increased fluctuation on the world oil market. It is estimated that speculators control 1 billion barrels of crude oil in future contracts involving a total of 100 billion U.S. dollars. They buy or sell oil futures based on market information, which increased the market uncertainty. Such speculation could boost oil prices to one record high after another, or cause acute market turbulence as the price bubble finally bursts, analysts said. While speculators may have benefited from the current round of price surges at the cost of common consumers' interests, uncontrollable rises in fuel prices will exert a negative impact on the global economy by causing sluggish consumption, increasing business costs and pushing up inflation, they added. The price of oil has been slowly coming down but not before the governments of the world interfered in some way. For starters, they realized that there were two ways to deal with the problem. 1. To use the OPEC meetings as a means to persuade oil producers to produce more oil in an effort to match supply with demand for oil. 2. To strictly monitor the oil markets to make sure that the speculation over the price of oil does not set in hence leading to inconsistent buying and selling frenzies. These two primary steps have brought down the level of oil to where it is today. But it has made amply clear that the World is consuming a lot more oil than even a year ago and that this is a long term situation that needs to be immediately dealt with.

The Inflation Rates this Year 34

- 2008 Aug 23 - 2008 Aug 16 - 2008 Aug 09 - 2008 Aug 02 - 2008 Jul 26 - 2008 Jul 19 - 2008 Jul 12 - 2008 Jul 05 - 2008 Jun 28 - 2008 Jun 21 - 2008 Jun 14 - 2008 Jun 07 - 2008 May 31 - 2008 May 24 - 2008 May 17

12.34% 12.40% 12.63% 12.44% 12.01% 11.98% 11.89% 11.91% 11.89% 11.63% 11.42% 11.05% 8.75% 8.24% 8.1%

- 2008 May 10 - 2008 May 03 - 2008 Apr 26 - 2008 Apr 19 - 2008 Apr 12 - 2008 Apr 05 - 2008 Mar 29 - 2008 Mar 22

7.82% 7.83% 7.61% 7.57% 7.33% 7.14% 7.41% 7.0%

- 2008 Mar 15 - 2008 Mar 08 - 2008 Mar 01 - 2008 Feb 23 - 2008 Feb 16 - 2008 Feb 09 - 2008 Feb 02 - 2008 Jan 26 - 2008 Jan 19 - 2008 Jan 12

6.68% 5.92% 5.11% 5.02% 4.89% 4.35% 4.07% 4.11% 3.93% 3.83%

- 2008 Jan 05

3.79%

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The WPI Inflation Chart showing the hike in inflation from January 2008 to August 2008

Controlling Inflation India continues to pay the price for not undertaking fundamental monetary policy reform. Merely raising rates will not solve the problem. The way forward lies in breaking the INR/USD peg, as was done in early 2007, and having a 10% rupee appreciation. When inflation spikes, the single focus of the government becomes controlling inflation. This is not how mature market economies work. In all mature market economies, the task of controlling inflation - and only the task of controlling inflation - is placed with the central bank. In mature market economies, inflation crises do not arise, because the full power of monetary policy is devoted to this one task. In their depths of anguish from dealing with this inflation crisis, the Prime Minister and the Finance Minister should channel their attention to RBI reforms. We are suffering from these problems because of the blunders of monetary policy. The possibility of such blunders needs to be eliminated by rewriting the RBI Act. The text of this Act is completely wrong in the light of the monetary economics that we know today. With a sound monetary policy framework, inflation would be stabilised, inflation crises like this would not periodically hijack the government, and distortionary short-sighted initiatives such as banning exports of certain goods would not arise. 36

India is in a big mess on monetary policy. The attempt that is underway consists of pegging the rupee to the dollar at a time when the dollar has dropped sharply. Dollar prices of many commodities have risen since producers do not like being shortchanged with the same number of dollars. Holding Rs.40 a dollar intact, the global increase in commodity prices has been imported into India. With increasing de facto convertibility, pegging the exchange rate to the US dollar leads to pressure to adopt the monetary policy of the US. The US has cut rates sharply. A massive interest rate differential has built up, and inspired a flourishing "dollar carry trade" involving borrowing in the US and bringing money into India. RBI has been swamped with capital flows owing to this interest rate differential. In fighting to implement the pegged exchange rate, RBI has done market manipulation on a massive and unprecedented scale on both the spot and forward markets. The fiscal costs of this are rapidly building up. In a grim dogfight with the private sector, RBI artificially engineered a rupee depreciation, from Rs.39.12 on 1 Feb to Rs.40.46 on 17 March, in trying to break expectations of a one-way bet on the rupee. This is one of the factors which has helped to drive up inflation. Raising interest rates while leaving the exchange rate regime intact is a poor answer for three reasons: 1. The US 90-day rate is 1.28% and the Indian 90-day rate is 7%. With this massive interest rate differential, RBI's currency trading in January alone was over $20 billion! If this is done for a year, we will add $240 billion to reserves and start suffering an interest cost on MSS of over 2% of GDP. The bigger the interest rate differential, the bigger the pressure of capital inflows will be. 2. Further, a perceptible slowdown in the world economy is visible. To a smaller extent, a slowdown is visible in India also. This is not a good time to raise rates. 3. Finally, the impact of interest rates on inflation is slow and remote. Owing to policy blunders, we lack the bond-currency-derivatives nexus, the system of financial markets through which interest rate decisions by a central bank at the short-term rate are propagated into all interest rates in the economy. RBI's strategy of preventing sophisticated finance wherever it can has yielded ineffectiveness of RBI. The existing stance of monetary policy is ultimately inconsistent because it engenders inflation that Parliament will not tolerate. The key element of the policy that has to break is the rupee-dollar pegs at Rs.40 per dollar.

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The right combination of policy for the short-term involves: 1. An appreciation to Rs.36 per dollar with 2. A reduction in the short rate to 4%. This would simultaneously hit at all the problems that we face today. A 10% rupee appreciation would yield a nice dent on inflation, as happened in March 2007. By reducing the mispricing of the rupee, it would reduce pressure from capital flows. In addition, a 300 bps reduction in interest rates would reduce the flow of money coming into the country seeking interest rate arbitrage. To the small extent that the monetary transmission does work, this rate cut would help bolster the economy in what appears to be shaping up as a difficult time. This combination of policies - a stronger rupee, lower rates, and lower inflation would restore the balance of a consistent monetary policy framework. Who would gain and who would lose? The broad population would benefit from lower inflation. Exporters would suffer owing to a stronger rupee. But as we saw in 2007, the impact of the exchange rate on the WPI is sharp and visible. Exports were unaffected despite a slowing world economy: Gross earnings on the current account grew by 19% in the June quarter, 23% in the September quarter and 33% in the December quarter. Compare these against the values of 27%, 29% and 24% for the three quarters before the rupee appreciation and the world economic slowdown. The political economy of an exchange rate appreciation is much like that of cutting customs duties. The beneficiaries of cutting customs duties are diffused and widespread. The losers are focused and engage in lobbying. Just as India found the political resources to cut customs duties despite this lobbying, the same must now be done with rupee appreciation. Such political contests are, of course, highly distressing. The long-term answer lies in depoliticising the rupee-dollar market by focusing the central bank on inflation and getting it out of currency manipulation. An immature market economy is one where the exchange rate is stable, and where inflation and GDP growth are unstable. A

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mature market economy is one where inflation and GDP growth are stable, and the exchange rate is unstable. Getting there requires rewriting the RBI Act.

Recent Measures by the Government to Control Inflation in India In order to contain inflationary pressures, the monetary measures undertaken by the Reserve Bank were supplemented by a number of fiscal and supply augmenting measures undertaken by the Government. These include: (i) Measures relating to Imports Pulses: Customs duty on import of pulses was reduced to zero on June 8, 2006 and the period of validity of import of pulses at zero duty, which was initially available up to March 2007, was first extended to August 2007 and further to March 2009. Wheat: Import of wheat at zero duty, which was available up to end-December 2006, was extended further to end-December 2007. Edible oils: Customs duty on palm oils was reduced by 10 percentage points across the board in April 2007 and import duty on various edible oils was reduced in a range of 5-10 percentage points in July 2007. The 4 per cent additional countervailing duty on all edible oils was also withdrawn. Customs duties on crude and refined edible oil were reduced from a range of 40-75 per cent to 20.0-27.5 er cent in March 2008. Import of crude form of edible oil at zero duty and refined form of edible oil at a duty of 7.5 per cent was allowed. Rice: In March 2008, the customs duty on semi-milled or wholly-milled rice was reduced from 70 per cent to zero per cent up to March 2009. Maize: Customs duty on maize imported under a Tariff Rate Quota of five lakh metric tonnes was also decreased from 15 per cent to Nil in April 2008. Milk: In order to ensure adequate availability of milk in lean summer months, basic customs duty on skimmed milk powder was proposed to be reduced from 15 per cent to 5 per cent for a Tariff Rate Quota of 10,000 metric tonnes per annum in April 2008. Similarly, on butter oil, which is used for reconstituting liquid milk, customs duty was reduced from 40 per cent to 30 per cent. Cement: On April 3, 2007, import of portland cement other than white cement was exempted from countervailing duty (CVD) and special additional customs duty; it

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was earlier exempted from basic customs duty in January 2007. Exports of cement were prohibited with effect from April 11, 2008. Iron & Steel: In order to augment the domestic availability of steel products as well as to soften prices, the following measures were announced: a) Reduction in the basic customs duty on pig iron and mild steel products viz., sponge iron, granules and powders; ingots, billets, semi-finished products, hot rolled coils, cold rolled coils, coated coils/sheets, bars and rods, angle shapes and sections and wires from 5 per cent to Nil; b) Full exemption of the import of TMT bars and structurals from CVD, which is currently at 14 per cent; c) Reduction in the basic customs duty on three critical inputs for manufacture of steel, i.e. metallurgical coke, ferro alloys and zinc from 5 per cent to Nil. Cotton: The 10 per cent customs duty on cotton imports along with 4 per cent special additional duty was abolished with effect from July 8, 2008. Crude Oil & Petroleum products: Customs duty on crude oil was reduced from 5 per cent to ‘nil’ as well as on diesel and petrol from 7.5 per cent to 2.5 per cent each, and on other petroleum products from 10.0 per cent to 5.0 per cent. Excise duty on petrol and diesel was reduced by Re. 1 per Litre. (ii) Measures relating to Exports Pulses: A ban was imposed on export of pulses with effect from June 22, 2006 and the period of validity of prohibition on exports of pulses, which was initially applied up to end-March 2007, was further extended first up to end-March 2008 and then for one more year beginning April 1, 2008. Onion: The minimum export price (MEP) was increased by the National Agricultural Cooperative Marketing Federation of India Ltd. (NAFED) by US $ 100 per tonne for all destinations from August 20, 2007 and by another US $ 50 per tonne with effect from October 2007 for restricting exports and augmenting availability in the domestic market. Edible Oils: The export of all edible oils was prohibited with immediate effect from April 1, 2008.

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Rice: On April 1, 2008, export of non-basmati rice was banned and the minimum export price (MEP) was raised to US $ 1,200 per tonne in respect of basmati rice. On April 29, 2008, an export duty of Rs.8,000 per tonne was imposed on basmati rice along with a commensurate reduction in its minimum export price and thereby re-fixed the MEP at US$ 1,000 per tonne. Iron & Steel: On April 29, 2008, export duty was imposed on steel items at the following three different rates: • 15 per cent on specified primary forms and semi-finished products, and hot rolled coils/sheet, • 10 per cent on specified rolled products including cold-rolled coils/sheets and pipes and tubes, • 5 per cent on galvanized steel in coil/sheet form. For this purpose, a uniform statutory rate of 20 per cent has been incorporated in the Export Schedule. These measures are expected to disincentivise the export of steel and augment domestic supply. Cotton: One per cent drawback benefits (refund of local taxes) on exports of raw cotton was withdrawn with effect from July 8, 2008. (iii) Other Measures a) The minimum support price (MSP) for paddy was raised by Rs. 125 per tonne for 2007-08 and for wheat by Rs. 150 for 2007-08 and further by Rs. 150 for 200809. b) Issuance of oil bonds to State-run oil marketing companies.

New Monthly Inflation Rate India plans to release wholesale price inflation data on a monthly basis from endOctober or mid-November, and says the new reading will include a larger number of items and better reflect prices. A senior official at the Commerce and Industry Ministry involved in developing the new data series said on Tuesday the current weekly wholesale price index (WPI) would be discontinued.

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"The (new) series is going towards finalisation. When we switch over to monthly data, there will be no need for the weekly data," he said. The new index would be based on 2004/05 prices. The official said the government would also release weekly price data for primary articles, which includes food, non-food products and minerals, after it switches over to a monthly reading. Indian inflation jumped to a 13-year high in June after a 10 per cent increase in local fuel prices and in mid-August was ruling just below an annual 12.5 per cent. The widely watched wholesale price index rose 12.40 per cent in the 12 months to Aug. 16, below the previous week's annual rise of 12.63 per cent. But there has been criticism that the data underestimates price pressures in Asia's third-largest economy. Policy makers say monthly WPI data in tandem with weekly numbers for primary articles would help the central bank better calibrate its monetary policy decisions. The sharp increase in the inflation rate in the past few months has forced the government and the central bank to raise rates, tighten liquidity and cut taxes to rein in soaring prices to avoid voter anger during state and federal polls. India is also hoping to bring out a new urban consumer price index (CPI) in April or May next year to give a more accurate and harmonised picture of prices in towns and cities. With the policies being followed by India, the government puts forth the estimation that the inflation rate could be controlled to 10% by the end of the year 2008.

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