Management of Inflation in India

“INFLATION MANAGEMENT IN INDIA” {A PROJECT REPORT SUBMITTED IN PARTIAL FULFILLMENT OF THE MASTER OF FINANCE AND CONTROL}

Prepared by: Tapas Kumar Parida Roll No: 43706V074008

SESSION: 2007-09 Under the guidance of: Dr. Kshiti Bhusan Das Reader, Master of Finance & control Utkal University

MASTER OF FINANCE AND CONTROL (MFC) P.G. DEPARTMENT OF COMMERCE, UTKAL UNIVERSITY, BHUBANESWAR-751004 APRIL - 2009

MASTER OF FINANCE AND CONTROL (MFC) P.G. DEPARTMENT OF COMMERCE, UTKAL UNIVERSITY BHUBANESWAR - 751004 Dr. KSHITI BHUSAN DAS Reader, Master of Finance and Control (MFC) P.G.Department of Commerce, Utkal University, Vanivihar, Bhubaneswar-751004

CERTIFICATE This is to certify that this project entitled “Inflation Management in India” is a bonafide work of Mr. Tapas Kumar Parida. He has carried out the research work under my guidance and supervision for the preparation of the project. This piece of research is their genuine work and has not been published any where at any time to the best of my knowledge. The project is an evidence of his undivided commitment and sincerity.

I wish all the success in his life.

Place: Bhubaneswar

(Dr. Kshiti Bhusan Das)

Date:

Research Supervisor

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DECLARATION

I do hereby declare that the project entitled “Inflation Management in India” is an authentic piece of work done by me under the guidance of Dr. Kshiti Bhusan Das, Reader, Master of Finance and Control (MFC), Utkal University, for the partial fulfillment of the requirement for the degree of Mater of Finance and Control (MFC), Utkal University, Bhubaneswar. This piece of research is my genuine work and has not been published any where at any time to the best of my knowledge.

Place: Bhubaneswar Date:

(TAPAS KUMAR PARIDA)

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ACKNOWLEDGEMENT

I Praise the God for Blessing me with grace and showing mercy on me to complete the task. I expressed my deep sense of gratitude to My Supervisor Dr. Kshiti Bhusan Das, Reader, Master of Finance and Control, P.G. Department of Commerce, Utkal University, for instilling confidence in me through their inspirational words and providing invaluable comments on many issues and understanding me during the preparation of the project. The report has been prepared on the basis of materials available on the subject in different Journals, RBI Bulletin etc. No word of gratitude is sufficient to appreciate the encouragement and help I have been receiving from time to time from my friends, my seniors (Specially Subrat Kumar Maity, Pinaki Prasad Nanda & Jyoti Prakash & my juniors. I am giving special thanks to my elder brother SRINIBASH and my Special friend (SHREYA), who helped me enough to prepare this project. Finally, I express my indebtedness to my parents and family, for being ever inspiring, loving and supportive. I again thank all the people who are directly or indirectly involved in helping me to prepare this project.

Tapas Kumar Parida

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ABSTRACT The Indian economy has been registering a mammoth GDP growth during postliberalization period. The opening up of the Indian economy after the 1990s increased India's industrial output, which in turn raised the inflation India rate significantly. The stupendous growth rate of industrial output and employment created an enormous pressure in the market mechanism consequently resulted in inflation rate, which pushed it further. The Reserve Bank of India (the Central Bank) and the Ministry of Finance, Government of India are concerned about the crisis and justifiably putting initiates to bring economic stability in the economy. In July 2008, the key Indian Inflation Rate, i.e., the Wholesale Price Index, has risen beyond 12.6 %, the highest rate of inflation in 13 years. This is more than 7% higher than what it was a year earlier and it is almost three times, the RBI’s target inflation rate of 4.1%. The US Sub Prime crisis, followed by economic recession engulfed the entire globe and India also a victim to this trend. Resultantly the GDP growth rate of the country fell significantly from 9.6% in 2007-08 to 5.3% in quarter-4 of 2008-09. Now, the Indian Economy is in a very critical situation. On the one hand there is heavy volatility in the capital market, leading to large scale loss employment leave aside further creation of employment in the country; on the other hand both the Inflation rate &the GDP growth rate are showing down turn. The country’s inflation rate is falling to 0.18% for the week ended April 15th, 2009 & it is continuous fall over three weeks period. The Central Bank’s monetary policy reducing the key rates (Repo, Reverse Repo etc) to restore liquidity in the market, has helped the economy in reviving and moving on the growth path. But ironically the banks are not yet ready for giving loan especially at this critical situation. Then finally, it is apprehended that India may go to the stage of recession in very near future. The relationship between money supply, inflation and interest rates is a highly debated issue in economics literature. Neoclassical theory states that inflation can either be controlled by increasing short-term interest rates or by reducing money supply. In order to determine the relationships between money supply, inflation and interest rates v

and in an attempt to discover the actual instrument used to control inflation, here the researcher has used monthly data from 1998-2008 from the Handbook of Statistics on the Indian economy by the Reserve Bank of India to find the causal relationship between them. The variables used were Wholesale Price Index, interest rates, M1 and M3. The Wholesale Price Index is the ‘headline inflation index’ for the Indian economy. M1 is a narrow measure of money supply including the total money in circulation and M3 is a broader measure which includes everything present in M1 plus all the items which act as perfect substitutes for M1. Findings: I found that interest rates and money supply share a positive causal relationship and that changes in interest rates influence money supply, while money supply variations do not lead to changes in interest rates. Changes in interest rates are related not only to money stock but also to changes in real income, price level and inflation. In addition, the causation links also proved to be weak. Thus, the effect of money supply on interest rates could be eliminated. Based on the results of the regression models, and ruling out relationships that are not statistically significant and those that are not causally possible, only three relationships remain: Ø interest rates on money supply Ø money supply on inflation Ø inflation on money supply Finally, the findings of this research conclude that interest rates do not increase or decrease the inflation directly. The rise or fall in rates affects the inflation level through the impact that these have on money supply. Conclusion: As the theory suggests, it was revealed that there exist a negative effect of the rate of interest on inflation. However, the interest rates operate through the money supply. It is said that the growth of money supply can be constrained by increasing the interest rates, thus stating a negative relationship between the two. But if we look at this relationship from a different perspective, it could also be possible that an increase in interest rates helps to increase the growth of demand deposits. When the rate of interest vi

is high, people are tempted to deposit their surplus income into the bank in order to generate interest, thereby putting their money for a better use. Therefore, if we look at it from this angle, then the interest rates and the money supply share a positive relationship. Also, money supply shares a negative relationship with inflation. A reduction in money supply helps to bring the inflation level down. Thus, in this way the interest rates can be used to control the inflation, but not at the desired level that we expect them to. Thus, there are very close & integral causal relationship between inflation, money supply & interest rate. But at the current recessionary situation, the Central Bank instead focusing on the growth rate rather should focus on recession and find ways, how to tackle it? If given an option between the devil and the deep sea this researcher would prefer inflation of 10% rather than to have recession. It is postulated on the basis of economic fundamentals that during recession the economy collapses to such an extent that, it becomes very difficult to come out of the economic disaster. Neither Inflation is good for the economy; equilibrium has to be maintained. Both the situations have evil effects and the present crisis must be cured with very effective policy options and market measures.

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CONTENTS

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CHAPTERS

TOPICS

PAGES

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Certificate Declaration Acknowledgement Abstract CHAPTER-I

GENERAL INTRODUCTION

CHAPTER-II

CHAPTER-III

1.1

Introduction

1.2

Objectives of the Study

1.3

Inflation is inevitable

1.4

Inflation is menance or blessing

1.5

Methodology

1.6

Limitations of the Study

REVIEW OF LITERATURE 2.1

Introduction

2.2

Literature Review

2.3

Conclusion

INFLATION IN INDIA 3.1

Introduction

3.2

Recent Causes of Inflation

3.3

How inflation measured in India???

3.4

Global Price Scenario

01 – 07

08 – 13

14 - 27

3.4.1 Global Inflation 3.5

Inflation in India

3.6

Conclusion

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CONTENTS **************************************************************************

CHAPTERS

TOPICS

PAGES

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CHAPTER-IV

CAUSALITY & CAUSATION BETWEEN M3, INTEREST RATE & INFLATION

CHAPTER-V

CHAPTER-V I

4.1

Introduction

4.2

Different Theories

4.3

Conclusion

28 – 31

EMPIRICAL RESULTS 5.1

Data & Empirical Results

5.2

Regression Analysis – I

5.3

Regression Analysis – II

5.4

Conclusion

CONCLUSION 6.1

Introduction

6.2

Findings

6.3

Conclusion

32 - 37

38 - 40

BIBLIOGRAPHY

………………………………………….

41 - 44

APPENDIX

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45 - 52

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CHAPTER – I INTRODUCTION

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1.1 Introduction “Inflation is bringing us true democracy. For the first time in history, luxuries and necessities are selling at the same price” - Robert Orben W

hen one describes inflation, it hardly makes any difference whether one refers to it as an ‘episode’ or a ‘disaster’. However, most of the central bankers, who are

having a tenacious battle of preventing an episode from turning into a disaster, express different views regarding inflation. Inflation is often described by economists as the general and persistent increase in prices across an economy over a period of time. The rise in prices affects the wages, real income, production, unemployment and so on. For economies that are persistently fighting high rates of inflation, the rise in prices brings no smiles. Inflation hits the dinner table of both the rich and the poor, only the degree varies. While the government considers a rise in prices as a signal of economic growth, central bankers’ have often treated inflation as their ‘first enemy’. Inflation is like a ‘syndrome’, which is always talked about, but only a few are aware of its intricacies. The main focus of central banks is to control inflation, which has often been perceived as a ‘mission impossible’. However, inflation is not a supernatural phenomenon which we do not have control over. The existence of inflation is man-made and potentially, we can not only overcome inflation, but also prevent its occurrence in the first place.1 According to the finance and economic literature, the key instrument used by central banks to restrict inflation is the short-term interest rate. It is presumed that an increase in interest rates leads to a fall in inflation. However, with reference to the Indian economy, can interest rates be used for the purpose of reducing inflation?

1. See

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For more than two decades, controlling inflation has been the main goal for policymakers. Empirical research confirms that inflation has a deleterious impact on economic growth as it creates distortions related to savings and investments. Central banks deploy an appropriate monetary policy as the key instrument to maintain the desired level of inflation. In order to be effective, the monetary policy must be preemptive and proactive to contain inflation. Since the causes of inflation vary from country to country, the central bank must be react speedily and intelligently and employ appropriate country-specific monetary policy instruments such as the interest rate. The monetary policy must be flexible enough to act according to changing scenarios. An effective option normally used is an inflation targeting framework. 1.2 Objectives of the Study The main objectives of this study are: Ø To analyze the causal link between money supply, inflation & interest rate in India, Ø To analyze the effect of rate of interest on inflation in India, Ø To see how inflation is calculated in India, Ø To see how India controls Inflation & rationale behind the control measures, and Ø To see the relationship between Inflation & GDP growth rate. 1.3 Inflation is inevitable but what really determines inflation? Inflation is difficult to predict as it is aggravated by several non-monetary factors such as frequent supply shocks. These shocks have the ability to create distortions in the monetary transmission mechanism by paying insufficient attention to the role of demand side factors in the inflation process. Furthermore, central banks experience difficulty in discerning the exact impact of these factors on the price level due to their uncontrollable nature and the unavailability of information, thereby making the formulation of monetary policy complex. (Mohanty and Klau, 2004) In the short run, non-monetary factors influence inflation whereas in the long-run they get replaced by monetary variables. -3-

Empirical research has been incapable of determining the precise causes of inflation, leaving the debate in this issue unresolved. High inflation has been attributed to factors like monetization of excessive fiscal deficits which are caused by indexation of wages and prices, repeated devaluation of the exchange rate, output gap, food prices and excess money supply. Agricultural shocks and unanticipated movements in the exchange rate influence inflation weaken the significance of the demand management policy and complicate the conduct of monetary policy. Movements in the exchange rate directly affect inflation by changing the domestic prices of imports. When inflation is driven by demand factors and when changes in demand can be accurately estimated by the output gap or monetary growth, the transparency and accountability of the monetary policy enhances. Research suggests that if authorities opt for a fixed exchange rate regime, the exchange rate has no impact on inflation. However, while empirical evidence has been ambiguous as to whether a fixed or flexible rate reduces inflation, some cross-sectional studies propose that a pegged exchange rate regime lowers inflation although this depends on the credibility of the regime. (Edwards, 1993 and Ghosh et al, 1995) Irrespective of the regime, experiences have proved that the exchange rate is an important determinant of inflation. The role of relative prices has attracted considerable attention as a factor triggering inflation. Firms adjust prices after reacting to large shocks and tend to ignore small shocks. Therefore, the impact of a price shock on inflation depends largely on its distribution: the more it is skewed to either side reflects the effect on overall inflation. Major Price changes arising mainly from supply shocks have major macroeconomic implications. (Fischer, 1981) 1.4

Inflation is a Menance or Blessing??? The perceptions of people regarding inflation are varied. While some actually

think of it as no real threat in peace time, others refer to it as a necessary price of continuing economic growth. It is probably more difficult to arouse the people to the evils of inflation than it is to the hazardous effects of depression and recession. It has often been called the most spiteful of all taxes, which affect everyone and especially -4-

those with meager incomes. In contrast to this view, people whose incomes rise faster than prices actually find advantages in inflationary booms and call it a blessing in disguise. Others feel that inflation is an illusion and that in the recent years, prices have stabilized. Some contend that for economic growth and social progress, the price level must rise. To any average individual, inflation is related to a higher cost of living which in other words is a money problem. Consumers might not succeed in understanding that their purchasing power must eventually be restricted by the production and supply of goods and services and the demand for them. Their cure for inflation might either be to increase the accessibility of money in some way or to ‘cheapen’ the money by boosting prices. Thus, one view is that inflation is a phenomenon of prosperity and boom. We all want a higher growth rate, even is it is attainable at the expense of instability and unemployment in the economy. (Buehler, 1959) On the other hand, if one is to judge by the recent outpouring of articles, books, government reports and other literature on inflation, then inflation does seem like a potential menace. In order to solve the problem of mass unemployment and to assure economic stability, the excess expenditure by consumers and the government must be increased. As a result, wages must increase. Thus, the existence of some inconsistency between the goals of price stability and economic growth cannot be denied. An absolutely stable economy will face stagnation whereas a dynamic and growing economy is bound to be associated with unemployment of resources, some imbalances and some local depressions. General ups and downs, with the risk of at least temporary inflation, are unavoidable in an economy. Furthermore, the anticipation of future inflation affects savings and speculative activities and breeds further inflation. “Hedges against inflation are commonly sought in common stocks, real estate and other various commodities.” (Buehler, 1959) A decent growth rate and reasonable stability must be the only expectation. Various explanations for the causes of inflation have been offered, but the bottom line still remains that the “consumer bears the brunt of it and it unequally affects population”. “Inflation indirectly means an insidious, cancerous inflammation of prices and the attrition of the purchasing power of peoples’ incomes and savings”. (Buehler, 1959) If a high rate of inflation persists without any intention to control it, the -5-

monetary system may crumple, government and other debts may be repudiated and private and public insolvency may emerge. Inflation results from the super-abundance of currency in relation to the existing supply of goods and services. With higher demand, a limited supply and a higher inflow of purchasing power, the upsurge in prices is inevitable. Too many rupees are said to be purchasing too few goods. This is the socalled demand-pull inflation. On the other hand, cost-push inflation occurs when higher costs lead to higher prices. The blame often goes to big business firms for high profits and administered prices and to labour unions which instigate workers to demand wages higher than the gains in productivity. In the controversy over profits and wages, each sides holds the other responsible for the price increase and both try to obtain the largest possible share of the income of the undertaking. If we look at it from this perspective, then the increase in profits and wages may actually be a symptom of inflation rather than a cause of it. The attempts to control wage increases have been rather vain in the face of inflationary pressures. With the different standards of living of people, size of families, age of the population and various other factors, fluctuations in demand arise. Due to this, the price and cost of living indexes suffer from various limitations even after adjusting for changing conditions in supply and demand. 1.5

Methodology The relationships between money supply growth, inflation and interest

rates is a highly debated issue in literature. Neoclassical theory states that inflation can either be controlled by increasing short-term interest rates or by reducing money supply growth a) Sample Data Used & Sources: In order to determine the relationships between money supply, inflation and interest rates and in an attempt to discover the actual instrument used to control inflation, I used monthly data from 1998-2008 from the Handbook of Statistics on the Indian Economy by the Reserve Bank of India(RBI). The variables used were Wholesale Price Index, interest rates, M1 and M3. The Wholesale Price Index is the ‘headline inflation index’ for the Indian economy. (Virmani, 2003) M1 is a narrow measure of money supply including the total money in -6-

circulation, traveller’s checks, checking account balances, Negotiable Order of Withdrawal (NOW) accounts, automatic transfer service accounts and balances in Credit Unions. It includes currency plus all the items which can be treated like currency in the Banking System. M2 is a broader measure which includes everything present in M1 plus all the items which act as perfect substitutes for M1 such as certificates of deposit, savings deposits and money market funds held by individuals. (Stiglitz and Walsh, 2006) M3 is the broadest measure of money which includes everything in M1 and M2, that is, large denomination savings accounts, large time deposits, repos of maturity greater than one day at commercial banks and institutional money market mutual funds3. b) Analytical Tools: I analyzed the different relationships by conducting two separate regressions: Ø Inflation, M1 and interest rates with inflation being my dependent variable Ø Inflation, M3 and interest rates using inflation as my regressand 1.6

LIMITATIONS OF THE STUDY The study based on the secondary data provided by Reserve Bank of India (RBI)

and due to lack of time, researcher could not take a long time series data for the analysis purposes, which may give a better result for the interrelationship between money supply, interest rate & inflation. ****END****

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CHAPTER – II REVIEW OF LITERATURE

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2.1 INFLATION: Reducing the Purchasing Power of Money in the Economy Empirical evidence suggests that the main instrument in monetary policy to control inflation should be the short-term interest rate and reducing the interest rate is followed by a decline in inflation. (Alvarez, Lucas, Jr., Weber, 2001) A mass of evidence has been found linking money growth, interest rates and inflation: an increase in the average growth rate of money supply leads to an increase in interest rates which ultimately reduces the inflation rate. Increasing short-term interest rates is an indirect, effective way to reduce the money supply in the economy. The government sells bonds in open market operations and takes the money out of the system. Open market operations initially raise the interest rate in response to a velocity increase, then reduce it to below the target level and then bring it back to the target. Also, the formulation of an appropriate interest-rate policy can help to improve the short-run behaviour of interest rates and prices. The short-run connections between money supply, interest rates and inflation have been found to be highly unreliable. An examination of the bond market equilibrium is an essential requirement for the study of interest rate behaviour. In this market, the real interest rate depends on the present and expected future consumption of traders only. 2.2 Literature Review A recent discussion on monetary policy revolves around a class of policies known as ‘Taylor rules’. Under these rules, an interest rate is set by the central bank as an increasing function of the inflation rate or the forecasted rate of inflation. (Taylor, 1993) The ‘Taylor rules’ can be studied within a Keynesian framework. An important assumption under this framework is that markets are segmented or ‘incomplete’ in such a way that is consistent with the liquidity effect. The greater the liquidity effect, the more significant is the role played by interest rates in stabilizing inflation rates to the set target. It proposes that interest rates can only reflect expected inflation and open market operations can only influence interest rates through the information derived from the inflation premium.

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A segmented market model adapted from Alvarez et al. (2001) shows that a policy of increasing short-term interest rates to contain inflation can be rationalized with quantity theoretic models of monetary equilibrium. A policy at any date is set in advance of the realization of the velocity shock in that particular period. The introduction of shocks to velocity leads to instability in the empirical relationship between money supply and prices. A temporary increase in velocity raises the price level which reduces the interest rates and inflation. The variability of these shocks can be seen either in money supply, interest rates or inflation and this is determined solely by the monetary policy. If the change is reflected in money supply, then the response is a reduction in the growth of money supply initially, followed by an increase in the next period and back to the expected target thereafter. This helps to smoothen the inflationary impact of the increase in velocity. However, if we take inflation targeting into consideration, then committing to a Taylor rule results in loss of independence for monetary authorities and limits their effectiveness. Thus, to rationalize the use of any interest rate rules requires the use of an objective besides the attainment of an inflation target. Fama and Gibbons (1982) have attempted to explain the negative association between inflation and real interest rates. Koreisha and Partch (1985) used a vector autoregressive-moving average (VARMA) model to examine the causal links between money supply, interest rates and inflation which was supported by Geske and Roll (1983). Interest rates explain a substantial fraction of the variation in inflation. However, Mehra (1978) and Sims (1980b) point out that the causal relations obtained from a bivariate causal test are not robust enough when other variables are introduced in the vector autoregressive (VAR) system. In this respect, Koreisha and Partch’s causality test based on the VARMA model which uses the first difference in interest rates as a proxy for a change in expected inflation is more appropriate than others even though a separate role for interest rates is not allowed for. However, the monetary base growth rate is highly correlated with interest rates and the rate of inflation to an extent which is almost redundant. (Lee, 1992)

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On the other hand, inflation and nominal interest rates are negatively associated with subsequent growth in industrial production. When nominal interest rates increase because of inflationary expectations, industrial production tends to decline. Real interest rates, however, are positively related with growth in industrial production. In empirical work on India, there has been some confusion regarding interest rates: whether they should be nominal or real rates. Nominal rates fail to show sufficient variability and their co-efficients are usually insignificant in the money demand functions. The real rate is preferred as the better explanatory variable as it shows greater variation due to the large variation in the inflation rate. (Rao and Singh, 2003) Some investigators are of the view that since the dependent variable (inflation) is measured in real magnitudes, the independent variable (interest rate) should also be in real terms. The inclusion of the real interest rate implies that the demand for real balances rises with the expected rate of inflation. However, if there are high inflation periods in the data, using the nominal as well as the real interest rate is appropriate. Nominal interest rates have aimed popularity as indicators of inflation expectations. For instance, Svensson (1993) uses forward rates to explain inflation expectations with the help of simple assumptions about the real interest rate. The relationship between inflation expectations and nominal interest rates may change over time if there is a change in monetary policy or the occurrence of shocks in the economy. Central banks are interested in accurate predictions of inflation and interest rates are reasonably good indicators. Interest rates are quickly and easily available for many different forecasting horizons. Also, they are market prices, hence they react to new information and changing circumstances. Thus, the public invests confidence in them. (Soderlind, 1998) The relationship between nominal interest rates and inflation is of particular interest to monetary economists due to the profound implications it might have on monetary policy. (Holmes and Kwast, 1979) After the seminal contribution made by Irving Fisher in 1930 regarding the relationship between inflation and interest rates, substantial attention and controversies have emerged in the macroeconomic and finance literature. (Leiderman, 1979) In line

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with Fisher’s work, the universal finding that there is no relationship between the interest rates at a point in time and the subsequently observed inflation rates. Irving Fisher was the first economist to hypothesize a difference between real and nominal interest rates and that interest rates contain market forecasts for the future inflation rate. His theory asserts that a rise in the public’s inflation expectations leads to an equivalent increase in the nominal interest rates, keeping the real interest rate constant. Fama (1977) tested this informational aspect in a strict, rational expectations and constant expected real rate version of Fisher’s theory. He tested US data on one to six month treasury bills and inflation rates from 1953-1971 and found that interest rates are not only good predictors of inflation but they represent significant information about future inflation rates beyond that enclosed in past inflation rates. The role of interest rates is enhanced in countries which experience high and volatile inflation. According to Fama (1977), past inflation rates carry ‘non-trivial’ information about future inflation rates. The addition of lagged inflation variables in the prediction of the inflation rate may lead to systematic measurement errors and these errors are often ignored by the market while setting the appropriate interest rate. A well functioning market is said to be ‘efficient’ only when it correctly uses all the information in forecasting the inflation rate. According to this theory, variations in the expected inflation rate are reflected in the variations in the nominal interest rate. However, when the employment to population (E/P) ratio was taken into consideration, it was found that this variable makes a greater contribution in providing information than that incorporated in the interest rate. Despite this contribution, the interest rate remains the single best predictor of the inflation rate. None of the other variables succeeded in making a significant contribution in the estimation of inflation rates. Economists like Nelson and Schwert (1977) contradicted Fama’s theory by assuming that expected inflation is a function of lagged inflation rates and the role of interest rates as efficient predictors is exaggerated. Mundell (1963) and Tobin (1965) on the other hand suggested that there is a negative relationship between inflation and interest rates and past inflation rates are more reliable predictors of future inflation. - 12 -

Fisher pointed out that in well functioning capital markets, the one-period nominal interest rate is the real return plus the anticipated inflation rate. However, in a world where uncertainty plays a dominant role and where foresight is imperfect, the nominal interest rate is defined as the equilibrium expected real return plus the market’s assessment of the future inflation rate. (Fama, 1975) Thus, Fisher (1930) concludes, “We have found evidence, general and specific, that price changes do, generally and perceptibly, affect the interest rate in the direction indicated by a priori theory. But since forethought is imperfect, the effects are smaller than the theory requires and lag behind price movements, in some periods, very greatly.” If the inflation rate is predictable to a certain extent, and if the expected real return does not change so as to offset the expected changes in the inflation rate, then a relationship between interest rates and inflation will exist in an ‘efficient’ market. If a relationship ceases to exist, the market is ‘inefficient’, such that it overlooks important information about future inflation while setting nominal interest rates. Nominal interest rates are said to summarize all the relevant information about expected inflation that is in time-series with past inflation rates. If the market ignores the information derived from so obvious a source as past inflation, its efficiency is seriously questionable. Charles R. Nelson and G. William Schwert (1977) examined the time-series properties of inflation rates calculated from the Consumer Price Index (CPI) and found that past inflation rates do not reveal sufficient information regarding future inflation rates, thereby suggesting that the regression tests conducted by Fama were not powerful enough. The time-series properties were used to enhance the power of the regressions and to obtain an optimal predictor of inflation based on the history of past inflation rates. 2.3 Conclusion Though there are numerous reasons to choose interest rates as an explanatory variable for inflation, the questions still arises: How precise are they? Are they biased? If Central banks use methods like macroeconomic models to surveys, then why should they rely on prediction rules as accurate measures of inflation? ****END**** - 13 -

CHAPTER – III INFLATION IN INDIA

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3.1 INTRODUCTION During World War II, you could buy a loaf of bread for $0.15, a new car for less than $1,000 and an average house for around $5,000. In the twenty-first century, bread, cars, houses and just about everything else cost more. A lot more. Clearly, we've experienced a significant amount of inflation over the last 60 years. When inflation surged to double-digit levels in the mid- to late-1970s, Americans declared it public enemy No.1. Since then, public anxiety has abated along with inflation, but people remain fearful of inflation, even at the minimal levels we've seen over the past few years. Although it's common knowledge that prices go up over time, the general population doesn't understand the forces behind inflation. What causes inflation? How does it affect your standard of living? From the previous chapters, it is clear that, Inflation is nothing but substantial increase in the general price level over a period of time, say a year, a week, a month. 3.2 RECENT CAUSES OF INFLATION The Indian economy has been registering a mammoth GDP growth postliberalization. The opening up of the Indian economy after the 1990s increased India's industrial output, which in turn raised the inflation India rate significantly. The stupendous growth rate of industrial output and employment created an enormous pressure on the inflation rate and pushed it further. The present rise of inflation India rate could be detrimental to the projected growth and aims of the Indian economy. The main cause of rise in the inflation rate in India is the pricing disparity of agricultural products between the producer and consumers in the Indian market. Moreover, the skyrocketing of prices of food products, manufacturing products, and essential commodities have also catapulted the inflation rate in India. Furthermore, the unstable international crude oil prices have worsened the situation. Generally, the recent causes of inflation are: Ø High demand for primary articles Ø Surging global oil price hike Ø Global Economic Fluctuations Ø Future Trading of necessity goods - 15 -

Ø Strikes by Lorry Owners Ø Rising Imported raw materials Ø A depreciation in the Exchange rate Ø Rapid growth of Money Supply Ø Increasing the rate of growth of real estate prices Thus, from the above, it is clear that there are so many reasons for the hike in general price level of our country. 3.3 How Inflation Measured in India??? Inflation measurement is the process through which changes in the prices of individual goods and services are combined to yield a measure of general price change. So how does India calculate inflation? And how is it calculated in developed countries? India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy. Most developed countries use the Consumer Price Index (CPI) to calculate inflation. Ø Wholesale Price Index (WPI) WPI was first published in 1902, and was one of the more economic indicators available to policy makers until it was replaced by most developed countries by the Consumer Price Index in the 1970s. WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. It is also the price index which is available on a weekly basis with the shortest possible time lag only two weeks. The Indian government has taken WPI as an indicator of the rate of inflation in the economy. Ø Consumer Price Index (CPI) 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

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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. Economists Shunmugam and Prasad say it is high time that India abandoned WPI and adopted CPI to calculate inflation. India is the only major country that uses a wholesale index to measure inflation. Most countries use the CPI as a measure of inflation, as this actually measures the increase in price that a consumer will ultimately have to pay for. "CPI is the official barometer of inflation in many countries such as the United States, the United Kingdom, Japan, France, Canada, Singapore and China. The governments there review the commodity basket of CPI every 4-5 years to factor in changes in consumption pattern," says their research paper. It pointed out that WPI does not properly measure the exact price rise an end-consumer will experience because, as the same suggests, it is at the wholesale level. The paper says the main problem with WPI calculation is that more than 100 out of the 435 commodities included in the Index have ceased to be important from the consumption point of view. Take, for example, a commodity like coarse grains that go into making of livestock feed. This commodity is insignificant, but continues to be considered while measuring inflation. India constituted the last WPI series of commodities in 1993-94; but has not updated it till now that economists argue the Index has lost relevance and can not be the barometer to calculate inflation. Shunmugam says WPI is supposed to measure impact of prices on business. "But we use it to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index. And it does not factor in services which have assumed so much importance in the economy," he pointed out. But why is India not switching over to the CPI method of calculating inflation? Finance ministry officials point out that there are many intricate problems from shifting from WPI to CPI model. Ø First of all, they say, in India, there are four different types of CPI indices, and that makes switching over to the Index from WPI fairly 'risky and unwieldy.' The four CPI series are: CPI Industrial Workers; CPI Urban Non-Manual Employees; CPI Agricultural labourers; and CPI Rural labour. - 17 -

Ø Secondly, officials say the CPI cannot be used in India because there is too much of a lag in reporting CPI numbers. In fact, as of May 21, the latest CPI number reported is for March 2006. Ø The WPI is published on a weekly basis and the CPI, on a monthly basis. And in India, inflation is calculated on a weekly basis. 3.4 Global Price Scenario: Inflation or Deflation??? After reaching an intra-year peak of 12.9 per cent on August 02, 2008, inflation, as measured by year-on-year variations in WPI, fell sharply to 0.3 per cent on March 28, 2009. This large order of volatility in the inflation outcome in just one year is unprecedented. The sharp volatility in international commodity prices contributed significantly to the spiralling inflation in the first half, and then to the subsequent decline from a higher base at fast pace in the second half. When external and supply side factors condition the inflation trend along with demand pressures, demand management policy measures have to be employed in a calibrated manner. The surge that was witnessed in oil, food and commodity prices in the first half of 2008 had created testing conditions for the conduct of monetary policy. The sharp fall in inflation in the second half, however, has facilitated aggressive monetary easing, which aim at arresting the economic slowdown. Unlike the WPI based inflation, CPI based inflation in India, however, remains high, with recent evidence of very modest moderation, and the transmission process of lower inflation at the wholesale level to inflation at the retail level has emerged as an important issue in the conduct of Reserve Bank’s monetary policy. During the first half of 2008-09, headline inflation increased in major economies, reflecting the combined impact of higher food and fuel prices as well as strong demand conditions, especially in emerging markets. Subsequently, inflation decelerated sharply as international energy and commodity prices declined substantially and demand pressures eased following the impact of global financial crisis. The monetary policy stance pursued by most central banks in advanced economies during 2008-09 was largely expansionary, aimed at mitigating the adverse implications of the financial crisis. The central banks in emerging market economies were engaged in preemptive monetary tightening till September 2008 to contain inflation and inflationary expectations. Subsequently, they reversed their policy stance and reduced their policy - 18 -

rates as the spillover of the US subprime crisis turned out to be much wider and deeper, severely affecting growth prospects. In India, inflation as measured by year-on-year variations in the wholesale price index (WPI), increased sharply from 7.7 per cent at end-March 2008 to an intrayear peak of 12.9 per cent on August 2, 2008, reflecting the impact of some passthrough of higher international crude oil prices to domestic prices as well as continued increase in the prices of metals, chemicals, machinery and machinery tools, oilseeds/edible oils/oil cakes and raw cotton. Subsequently, WPI inflation declined sharply to 0.3 per cent as on March 28, 2009, led by the reductions in the administered prices of petroleum products and electricity as well as decline in the prices of freely priced petroleum products, oilseeds/edible oils/oil cakes, raw cotton, cotton textiles and iron & steel. The decline in prices of most of these commodities was in line with the decline in international commodity prices since July 2008. Consumer price inflation as reflected in various consumer price indices continued to remain high in the range of 9.6-10.8 per cent during January/February 2009 as compared with 7.3-8.8 per cent in June 2008 and 5.2-6.4 per cent in February 2008. 3.4.1 Global Inflation Headline inflation in major advanced economies firmed up till the second quarter of 2008-09 on account of higher energy and food prices and declined subsequently. Consumer price index (CPI) inflation in OECD countries increased from 3.6 per cent in March 2008 to 4.9 per cent in July 2008 but declined sharply to 1.3 per cent by February 2009. The recent decline in inflation in OECD countries was led by a decline in inflation of energy and food articles. Amongst major economies, headline inflation in the US declined to (-) 0.4 per cent in March 2009 from 5.6 per cent in July 2008. In the UK, inflation declined to 3.2 per cent in February 2009 from 5.2 per cent in September 2008. In the Euro area, inflation came down to 0.6 per cent in March 2009 from 4.0 per cent in July 2008. Core inflation also moderated, though modestly in major economies. In OECD countries, inflation, excluding food and energy, came down to 1.9 per cent in February 2009 from 2.4 per cent in September 2008 (2.1 per cent at March 2008). Producer price - 19 -

index (PPI) inflation also moderated in both advanced and emerging market economies (EMEs). PPI inflation in the OECD countries, which firmed up from 6.3 per cent in March 2008 to 9.8 per cent in July 2008 declined sharply to (-)1.0 per cent in February 2009. According to the latest assessment of the US Federal Open Market Committee (FOMC) on March 18, 2009, in the light of increasing economic slackness in domestic and world economy, it was expected that inflation would remain subdued. Moreover, the Committee saw some risk that inflation rates could persist for a time below the levels that best foster economic growth and price stability in the longer term. However, the economy continued to contract. Furthermore, job losses, declining equity and housing wealth, and tight credit conditions weighed on consumer sentiment and spending. Against this backdrop, as the weak economic conditions warranted for exceptionally low levels of the federal funds rate (US policy rate), the FOMC kept the policy rate unchanged at a target range of 0.0-0.25 per cent since December 16, 2008. During 2008-09, the policy rate was reduced by a total of 200 basis points. According to the latest assessment of Monetary Policy Committee of the Bank of England, inflation is likely to fall below the 2 per cent target by the second half of 2009, reflecting diminishing contributions from retail energy and food prices and the impact of the temporary reduction in Value Added Tax. The committee viewed that there remains a substantial risk of undershooting the 2 per cent CPI inflation target in the medium term and that a further easing in monetary policy was warranted. Accordingly, the policy rate was reduced by 50 basis points to 0.5 per cent on March 5, 2009, taking the cumulative reduction to 475 basis points during 2008-09. According to the Governing Council of the ECB, inflation rates have decreased significantly and are expected to remain well below 2 per cent over 2009 and 2010 reflecting ongoing sluggish demand in Euro area and other countries. Accordingly, the ECB reduced the policy rate by 25 basis points to 1.25 per cent, effective April 8, 2009. Earlier, the ECB had cut the policy rate thrice by a total of 275 basis points since October 2008 to 1.50 per cent after raising it by 25 basis points in July 2008. The above all can be seen from the following table:

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Table – 3.1 : Global Inflation Indicators CPI Inflation PPI Inflation Country Mar-09 Feb-09 Developed Economies Australia 3.7 6.4 Canada 1.4 1.6 Euro Area 0.6 -1.8 Japan -0.1 -1.1 UK 3.2 3.1 US -0.4 -1.3 Developing Economies Brazil 5.6 7.4 India 9.6 0.3 China -1.6 -4.5 Indonesia 7.9 7.9 Israel 3.6 -4.5 Korea 3.9 5.2 Russia 14 -8.2 South Africa 8.6 7.3 Source: Macroeconomic & Monetary Developments in 2008-09, RBI Amongst the key macroeconomic indicators in select EMEs, consumer price inflation was in the range of (-)1.6 per cent to 14.0 per cent in February/March 2009. Real policy rates ranged between (-)4.6 and 6.9 per cent in March 2009 (Table 62). The real effective exchange rate (REER) for the select EMEs, barring the currency of China, underwent real depreciation, on a year-on-year basis, in March 2009.

Table – 3. 2: Key Macroeconomic Indicators: Emerging Markets Real GDP Growth CPI Inflation Country Rate Mar-08 Mar-09 2007 2008 Brazil 4.7 5.6 5.7 5.8 China 8.7 -1.6 13 9 India 5.5 9.6 9 7.1 Indonesia 6.3 7.9 6.3 6.1 Israel 3.7 3.6 5.4 4.3 Korea 3.9 3.9 5 4.1 Phillipines 6.4 6.4 7.2 4.4 Russia 13.3 14 8.1 6.2 South Africa 9.8 8.6 5.1 3.1 Thailand 5.3 -0.2 4.8 4.7 Source: Macroeconomic & Monetary Developments in 2008-09, RBI - 21 -

3.5 INFLATION CONDITIONS IN INDIA The Annual Policy Statement for 2008-09 (April 2008) of the Reserve Bank was announced on the background of elevated inflation levels, and the Policy Statement reaffirmed its resolve to bring down inflation to around 5.5 per cent in 2008-09 with a preference for bringing it as close to 5.0 per cent as soon as possible, recognizing the evolving complexities in globally transmitted inflation. As the potential inflationary pressures from international food and energy prices had amplified, the policy focused on conditioning perceptions for inflation in the range of 4.0-4.5 per cent so that an inflation rate of around 3.0 per cent became a medium-term objective consistent with India’s broader integration into the global economy and with the goal of maintaining self- accelerating growth over the medium-term. Inflation hardened during the first quarter of 2008-09 on account of strong demand and significant international commodity price pressures. Therefore, it was recognised that an adjustment of overall aggregate demand on an economywide basis was warranted to ensure that generalised instability did not develop and erode the hardearned gains in terms of both outcomes of and positive sentiments on India’s growth momentum. The priority for monetary policy was identified to be eschewing any further intensification of inflationary pressures and to firmly anchor inflation expectations. Accordingly, the Reserve Bank increased the cash reserve ratio (CRR) by a total of 100 basis points between May and July 2008 to 8.75 per cent. Furthermore, the repo rate under the Liquidity Adjustment Facility (LAF) was increased by a total of 75 basis points to 8.50 per cent in June 2008. The First Quarter Review of the Annual Statement on Monetary Policy for 2008-09 expected that inflation would moderate from then prevailing high levels in the months to come. In view of the prevailing macroeconomic, liquidity and overall monetary conditions, the First Quarter Review announced an increase in the fixed repo rate under the LAF by 50 basis points from 8.5 per cent to 9.0 per cent with effect from July 30, 2008 and an increase in the CRR by 25 basis points to 9.0 per cent with effect from August 30, 2008, which can be seen from the following table:

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Table – 3.3 :Movement in Key Policy Rates in India Reverse Repo Repo WPI Effective Since CRR Rate Rate Inflation 6th jan-2006 5.75 6.75 5 4.9 25th July-2006 6 7 5 4.7 31st Oct-2006 6 7.25 5 5.4 23rd Dec-2006 6 7.25 5.25 5.8 6trh Jan-2007 6 7.25 5.5 6.4 31st Jan-2007 6 7.5 5.5 6.7 17th Feb-2007 6 7.5 5.75 6 3rd March-2007 6 7.5 6 6.5 31st March-2007 6 7.75 6 5.9 14th April-2007 6 7.75 6.25 6.3 28th April-2007 6 7.75 6.5 6 4th Aug-2007 6 7.75 7 4.4 10th Nov-2007 6 7.75 7.5 3.2 26th April-2008 6 7.75 7.75 8.3 10th May-2008 6 7.75 8 8.6 24th May-2008 6 7.75 8.25 8.9 12th June-2008 6 8 8.25 11.7 25th June-2008 6 8.5 8.25 11.9 5th July-2008 6 8.5 8.5 12.2 19th July-2008 6 8.5 8.75 12.5 30th July-2008 6 9 8.75 12.5 30th Aug-2008 6 9 9 12.4 11th Oct-2008 6 9 6.5 11.3 20th Oct-2008 6 8 6.5 10.8 25th Oct-2008 6 8 6 8.7 3rd Nov-2008 6 7.5 6 8.7 8th Dec-2008 5 6.5 5.5 6.6 5th Jan-2009 4 5.5 5.5 5.3 17th Jan-2009 4 5.5 5.5 4.9 4th March-2009 3.5 5 5 2.4 20th April-2009 3.25 4.75 5 0.18 Source: Macroeconomic & Monetary Developments in 2008-09, RBI

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CPI Inflation 7.7 6.7 7.3 6.9 6.7 6.7 7.6 6.7 6.7 6.7 6.7 7.3 5.5 7.8 7.8 7.8 7.7 7.7 8.3 8.3 8.3 9 10.4 10.4 10.4 10.4 10.4 9.7 10.4 10.4 10.2

WPI inflation started to decline since August 2008, mainly on account of decline in prices of freely priced petroleum products, edible oils and textiles. The Mid- Term Review of Annual Policy for the Year 2008-09 observed that in the absence of further shocks, generalised inflation could not be sustained, especially with money supply contained at the average rate of 2003-08, a period when inflation was low and stable. The Review also noted that the effect of softening international commodity prices on inflation in India could be muted just as the elevation of international commodity prices was not fully passed on to domestic prices. The challenge for the setting of monetary policy was identified to be balancing the costs of lowering inflation in terms of output volatility (particularly in the context of the moderation in industrial and services sector activity) against the risk of then prevailing levels of inflation persisting and getting embedded in inflation expectations. The review highlighted the importance of remaining focused on ringing inflation down to levels that are compatible with a strong but stable momentum of

growth in the economy and financial stability while

recognising that there existed high level of uncertainty with this judgment. Since September 2008, the Reserve Bank adjusted its policy stance from demand management to arresting the moderation in growth, as India’s growth trajectory has been impacted both by the financial crisis and the global economic downturn. Accordingly, between September 2008 and January 2009, the Reserve Bank reduced the repo rate under the LAF from 9.0 per cent to 5.5 per cent, the reverse repo rate under the LAF from 6.0 per cent to 4.0 per cent and the CRR from 9.0 per cent to 5.0 per cent. The aim of these measures was to augment domestic liquidity and to ensure that credit continues to flow to productive sectors of the economy. The Third Quarter Review of the Annual Statement on Monetary Policy for 2008-09 assessed that the inflation rate was expected to moderate further in the last quarter of 2008-09. Keeping in view the global trend in commodity prices and the domestic demand-supply balance, WPI inflation was projected to decelerate to below 3.0 per cent by end-March 2009 from then prevailing level of 5.6 per cent. The review also noted that the consumer price inflation was yet to moderate and the decline in inflation expectations had not been commensurate with the sharp fall in WPI inflation. It recognised that the headline WPI inflation could fall below 3 per cent in the short-run partly because of statistical reason of high base since early 2008 mainly caused by exceptionally high global oil and commodity prices. It affirmed that with the policy endeavour of ensuring price stability - 24 -

with well-anchored inflation expectations, the Reserve Bank would take into account the behaviour of all the price indices and their components.

As the global financial and economic conditions further deteriorated since the Third Quarter Review and the impact on India’s growth trajectory has turned out to be deeper and wider than anticipated earlier, the Reserve Bank further announced monetary stimulus measures in terms of reduction in the repo rate under the LAF from 5.5 per cent to 5.0 per cent, the reverse repo rate under the LAF from 4.0 per cent to 3.5 per cent on March 4, 2009.

Wholesale Price Inflation During 2008-09, inflation in India, based on the wholesale price index (WPI) firmed up to an intra-year peak of 12.9 per cent on August 2, 2008 from 7.7 per cent at end-March 2008. The increase in inflation during March-August 2008 was mainly on account of some pass-through f high international crude oil prices to domestic prices as well as elevated levels of prices of iron and steel, basic heavy inorganic chemicals, machinery and machine tools, oilseeds/oil cakes, raw cotton and textiles. The increase in inflation during this period reflected strong demand pressures as well as international commodity price pressures.

WPI inflation exhibited strong downward trend since August 2008 and reached 0.3 per cent as on March 28, 2009. Between August 2, 2008 and March 28, 2009, WPI declined by 5.8 per cent driven by the reduction in the administered prices of petroleum products and electricity as well as decline in prices of freely priced minerals oil items, iron and steel, oilseeds, edible oils, oil cakes and raw cotton. The wholesale price inflation in India can be seen from the following table:

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Table: 3.4: Wholesale Price Inflation in India 2007-08(Mar2008Commodity Weight 29) 09(March-28) Inflation WC Inflation WC All Commodities

100

7.7

100

0.3

100

1. Primary Articles Food Articles i. Rice ii. Wheat iii. Pulses iv. Vegetables v. Fruits vi. Milk vii. Egg, Fish & Meat Nom-food Articles i. Raw Cotton ii. Oil Seeds iii. Sugarcane Minerals 2. Fuel, Power, Light & Lubricants

22 15.4 2.4 1.4 0.6 1.5 1.5 4.4 2.2 6.1 1.4 2.7 1.3 0.5

9.7 6.5 9.1 5.1 -1.9 14.2 4.1 8.7 2.4 11.4 14 20.3 -0.4 49.9

28.2 13.2 2.5 1 -0.2 2.3 1 4.7 0.8 8.8 2 6.7 -0.1 6.2

3.5 6.3 12.8 5.2 8.3 -4 8.1 6.1 3.1 -0.1 2.5 -2.3 0 -12.5

14.2

6.8

18.9

-6.1

7 5.5 1.8

9.3 1.5 9.8

15.1 1.4 2.5

-8.7 -2.6 -1

301 369.7 104.9 28.1 20.7 -20.7 53.7 97.5 27.2 -2 11.1 -24.4 0 -65.4 495.5 422.9 -66.7 -7.6

63.8

7.3

52.8

1.4

297.3

i. Mineral Oils ii. Electricity iii. Coal Mining 3. Manufactured Products

WC: Weighted Contribution, Source: Macroeconomic & Monetary Developments in 2008-09, RBI Consumer Price Inflation Inflation, based on y-o-y variation in consumer price indices (CPIs), increased since June 2008 mainly due to increase in the prices of food, fuel and services (represented by the ‘miscellaneous’ group). Various measures of consumer price inflation, though started declining, still remained high in the range of 9.6-10.8 per cent during January/ February 2009 as compared with 7.3-8.8 per cent in June 2008 and 5.2-6.4 per cent in February 2008 (Table 69). The higher level of consumer price inflation as compared to WPI inflation in recent months could be attributed to higher prices of food articles which have higher weight in CPIs. Which can also seen from the following table: - 26 -

Table – 3.5 : Consumer Price Inflation: Major Groups Mar-

Mar-

Mar-

Feb-

CPI Measure

06

07

08

09

CPI Industrial Worker

4.9

6.7

7.9

9.6

5

7.6

6

-

CPI - Agricultural Laborers

5.3

9.5

7.9

10.8

CPI - Rural Laborers

5.3

9.2

7.6

10.8

WPI Inflation

4.1

5.9

7.7

2.4

GDP Deflator based Inflation

4.9

5.5

4.9

-

CPI - Urban Non-manual Employees

Source: Macroeconomic & Monetary Developments in 2008-09, RBI 3.6 CONCLUSION An important challenge in the macroeconomic and monetary policymaking during 2008-09 has been to manage the volatility emerging in respect of several key economic indicators of the Indian economy. During the course of the year, while overall growth moderated from its high growth momentum, headline WPI inflation declined sharply from a double digit level to near zero per cent by the end of the year. India's financial sector activity confronted a sudden shift from a phase of high to that of sharply receding capital inflows. This was manifested in reversal of the appreciating trend in the exchange rate during the year.

****END****

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CHAPTER – IV RELATIONSHIP BETWEEN MONEY SUPPLY, INTEREST RATE & INFLATION

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4.1 Introduction

The effect of money supply announcements on interest rates has attracted considerable attention in both the academic literature and the financial press in the recent years. The effect of money supply on interest rates has had an everlasting and controversial history in economics. The mercantilists were under the impression that any increase in the growth of money supply would be supplemented by a fall in interest rates. (Carr and Smith, 1972)

MONEY SUPPLY

INFLATION

INTEREST RATE

4.2 Different Theories A number of theories have been formulated in order to get a better understanding of the relationship between money supply, interest rates and inflation: Ø Fisher’s theory According to Fisher’s theory (1930), money supply announcements influence interest rates by creating changes in the information set and thereby changing inflationary expectations. This indeed is the only way by which announcements affect interest rates as they have an insignificant impact on the actual money stock. - 29 -

Ø Inflation expectations theory According to Fama’s (1975) hypothesis, an unexpected jump in money supply leads to higher inflationary expectations followed by an increase in short-term interest rates, while the announcement of a drop has the reverse effect. However, an essential prerequisite is that prices must respond quickly to changes in money supply. If prices react slowly then rational agents do not amend their short-run inflation forecasts after an announcement. The impact on long-term rates depends on the agents’ interpretation of the money supply announcements. If their expectations regarding future money growth and inflation continue to change, then the impact on long-term rates will be larger than that on short-term rates.

Ø Keynesian hypothesis The existence of a liquidity effect is prominent when prices do not react instantaneously to money supply shocks. A sudden rise in nominal money supply leads to a rise in real money balances, the reason being that prices are sluggish. In order to clear the money market, the interest rates must decline to offset the increase in demand for money. This in turn raises the rate of inflation. However, since the liquidity effect is a short-run phenomenon, the interest rate rises when prices change and come back to their starting point once the price adjustment is complete. (Keynes, 1964) Thus, the Keynesian theory predicts that when unanticipated announcements in money supply are made, short-term interest rates rise and long-term either fall or remain unchanged depending on whether the period of monetary restraint is permanent or shortlived.

Ø The Real Activity hypothesis The real activity hypothesis alleges that money supply announcements provide the market with information about future output, and thereby future money demand. An unexpected jump in the money stock signals higher output and greater money demand. In response to a sudden increase in money supply, short-term interest rates go up and long-term interest rates also rise but lesser than short-term rates unless there is a permanent change in output. (Cornell, 1983)

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Ø The Risk premium hypothesis The risk premium hypothesis states that money stock announcements alter the required real return on financial assets by providing the market with information about aggregate risk preferences and beliefs. The risk-aversion hypothesis predicts that in response to announcement of an unexpected increase in money, short-term interest rates may rise or fall. However, the greater the maturity of the security, the more likely it is that its yield will increase. Empirical tests show that money supply announcements have an impact on the real rate, but they do not permit us to conclude that monetary shocks affect the real rate. This apparent paradox arises because the announcements also function as signals which reveal information about real variables such as risk preferences and expected future output.

4.3 Conclusion The relationship between interest rates and money supply announcements continues to remain a puzzle. Alternate views by economists such as Fama and Gibbons (1982) claim that the interest rate changes which occur are due to the inducement of equilibrium shifts of resources between investment and consumption. This throws light on the fact that if the liquidity effect does not influence interest rates, then the policy anticipations effect cannot hold true because it is premised on the mere existence of the liquidity effect.

****END****

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CHAPTER – V EMPIRICAL RESULTS

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5.1 Data & Empirical Results The relationships between money supply growth, inflation and interest rates is a highly debated issue in literature. Neoclassical theory states that inflation can either be controlled by increasing short-term interest rates or by reducing money supply growth. In order to determine the relationships between money supply, inflation and interest rates and in an attempt to discover the actual instrument used to control inflation, I used monthly data from 1998-2008 from the Handbook of Statistics on the India economy by the Reserve Bank of India. The variables used were Wholesale Price Index, interest rates, M1 and M3. The Wholesale Price Index is the ‘headline inflation index’ for the Indian economy. (Virmani, 2003) M1 is a narrow measure of money supply including the total money in circulation, traveler’s cheque, checking account balances, Negotiable Order of Withdrawal (NOW) accounts, automatic transfer service accounts and balances in Credit Unions. It includes currency plus all the items which can be treated like currency in the banking system. M2 is a broader measure which includes everything present in M1 plus all the items which act as perfect substitutes for M1 such as certificates of deposit, savings deposits and money market funds held by individuals. (Stiglitz and Walsh, 2006). M3 is the broadest

measure of money which includes everything in M1 and M2, that is, large denomination savings accounts, large time deposits, repos of maturity greater than one day at commercial banks and institutional money market mutual funds. I analyzed the different relationships by conducting six separate regressions: a) Inflation, M1 and interest rates with inflation being my dependent variable b) Inflation, M3 and interest rates using inflation as my regressand c) M1, interest rates and inflation with M1 as my dependent variable d) M3, interest rates and inflation using M3 as the dependent variable e) Interest rates, M1 and inflation with interest rates as my dependent variable f) Interest rates, M3 and inflation using interest rates as my dependent variable

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In the following we will analyze all this in a briefly manner: 5.2

Inflation, M1 and interest rates with inflation being my dependent variable: INFLATION

INTEREST RATE

M1 With inflation as my dependent variable and interest rates and M1 as my explanatory variables, I received the following results: T (P) = 0.571 + 0.016 T (R) – 0.247 T (M1) (0.000)

(0.699)

(0.000)

R² = 0.321 It appears that inflation increases by 0.016 units for every one unit increase in interest rates, which contradicts the commonly held view that short-term interest rates are the nominal anchors for reducing inflation. However, this effect was significant only at the 0.699 level. Although there appears to be an effect of the interest rate on inflation, if we state that there is in fact such an effect there is a 69.9% probability of committing a Type I error. On the other hand, M1 proved to have shared an inverse relationship with inflation. The result showed that inflation reduces by 0.247 units for every one unit increase in M1. With a p value of 0.000, this effect is highly significant.

When I replaced inflation by M1 as my dependent variable, the resulting equation was:

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T (M1) = 0.631 + 0.489 T (R) – 0.516 T (P) (0.000)

(0.000)

(0.000)

R² = 0.773 This indicates that M1 increases by 0.489 units for every one unit increase in interest rates and reduces by 0.516 units for every one unit increase in inflation. Both effects are highly significant. 5.3

Inflation, M3 and interest rates using inflation as my regressand: INFLATION

INTEREST RATE

M3

The tests using inflation as my regressand and interest rates and M3 as my regressors, illustrated similar results: T (P) = 0.516 – 0.020 T (R) – 0.216 T (M3) (0.000 )

(0.618)

(0.004)

R² = 0.279 The outcome was that inflation appeared to decrease by 0.020 units for every one unit rise in interest rates, but this is significant only at the 0.618 level so it is not significant. On the other hand, inflation goes down by 0.247 units for every one unit rise in M3 and this effect is significant. Taking M3 as my dependent variable, I found the following result: T (M3) = 0.345 + 0.425 T (R) – 0.341 T (P) (0.000)

(0.000)

R² = 0.749 - 35 -

(0.004)

In the case of M3, money supply increased by 0.425 units for every unit increase in interest rates, confirming a positive relationship. On the other hand, M3 fell by 0.341 units for every one unit rise in inflation, stating their negative relationship. Both effects are significant. Fitting these regression results into our diagram we have the following: INFLATION

__

+

INTEREST RATE

__

M3, M1 Since the significance level for the effect of interest rates on inflation was 0.618 and that for the effect of inflation on interest rates was 0.699, it was concluded that there was no statistical evidence for any connection between interest rates and inflation. Therefore, this particular relationship could be eliminated from the analysis. Based on tests of causality and causation, the effect of money supply (M1 and M3) on interest rates showed very high figures in terms of causality indicating that such causal probabilities are impossible.

I found that interest rates and money supply share a positive causal relationship and that interest rates changes influence money supply, while money supply variations do not lead to changes in interest rates. Changes in interest rates are related not only to money stock but also to changes in real income, price level and inflation. In addition, the causation links also proved to be weak. Thus, the effect of money supply on interest rates could be eliminated. Based on the results of the regression models, and ruling out relationships that are not statistically significant and those that are not causally possible, only three relationships remain:

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Ø interest rates on money supply Ø money supply on inflation Ø inflation on money supply Also, I conclude that interest rates do not increase or decrease inflation directly. The rise or fall in rates affect the inflation level through the impact they have on money supply. When interest rates rise, the demand for deposits increase, thereby increasing M1 and M3. Money supply, in turn, shares a negative relationship with inflation. Thus, based on the results found above, interest rates have an impact on money supply, which in turn have an impact on inflation.

INTEREST RATE

MONEY SUPPLY

INFLATION The regression model has been a guiding principle in providing information on the connection between inflation, interest rates and money supply and has been instrumental in directing me towards my goal. 5.4

Conclusion The discussion above also suggests that an theoretical statistical procedure might

prove to be superior to economic theory for explaining the relationship between inflation, interest rates and money supply. Furthermore, because theory is less useful a guide in evaluating such relationships, it is more important to check for the significance of statistical methods. There are various aspects of past literature which will raise questions regarding the validity of my conclusion. This is an empirical issue which cannot be settled on theoretical grounds as the results prove otherwise and cannot be resolved without further research. (Mishkin, 1981) In conclusion, even if interest rates are said to cause inflation, does this necessarily mean that they are the only useful instruments to control inflation? ****END**** - 37 -

CHAPTER – VI CONCLUSION

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6.1 Introduction Neoclassical theory suggests that the key instrument used to control inflation is the short-term interest rate. When inflation is high, central banks increase the interest rates to bring inflation down. In this sense, interest rates are said to have a negative relationship with inflation.

6.2 Findings & Conclusion As theory suggests, I found a negative effect of the rate of interest on inflation. However, interest rates operate through money supply. It is said that money supply growth can be constrained by increasing the interest rates, thus stating a negative relationship between the two. But if we look at this relationship from a different perspective, it could also be possible that an increase in interest rates helps to increase the growth of demand deposits. When the rate of interest is high, people are tempted to deposit their surplus income into the bank in order to generate interest, thereby putting their money to better use. Thus, if we look at it in this light, then interest rates and money supply share a positive relationship. Also, money supply shares a negative relationship with inflation. A reduction in money supply helps to bring the inflation level down. Thus, in this way interest rates can be used to control inflation, but not in the standard way we expect them to.

Returning to the original research question, my conclusion us that interest rates can be used to control inflation. However, there are two serious caveats to this. The first is that the causal chain from the interest rate to inflation passes through the stock of money. The econometric results indicate strongly that what is involved is the stock of money as determined by individuals rather than money supply which the monetary authorities might seek to determine. In other words, the behaviour of individuals rather than monetary authorities is a vital part of the control mechanism.

Secondly, the control depends on the connection by way of causality rather than causation. The causal chain from the rate of interest to inflation consists largely of

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connections in the form of causality but by no means exclusively so. This limits the confidence we can have in using the rate of interest to reduce inflation. 6.3 Conclusion Perhaps the greatest importance of these two caveats is that they make it clear that we must think in terms of causing. If the interest rate is to be an instrument for controlling inflation, it must exert a causal influence on inflation and that causal influence must have the form of causality rather than causation. The fundamental requirement is not merely connection but causality.

“Inflation is unjust and deflation is inexpedient . . . , both are evils to be shunned.

_ J. M. Keynes

****END****

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APPENDIX

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