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Inflation in India, Monetary and Fiscal Policy

ByVaibhav ChoudhryBFIA 1B75057


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When prices rise, each rupee buys less goods and

services than it had been before.

Erodes purchasing power of money

It is measured through inflation rate- the annualizedpercentage change in a general price index(ConsumerPrice Index andWholesale Price Index) overtime.

INFLATION


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HOW IS IT MEASURED?

Consumer Price Index

Wholesale Price Index


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WPI is the index that is used to measure the change inthe average price level of goods traded in wholesalemarket.

Limitation :-

WPI is supposed to measure impact of prices on business. But we use it to measurethe impact on consumers. Many commodities not consumed by consumers get

calculated in the index.

Wholesale Price Index (435 commodities)


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Estimates average price of consumer goods and servicespurchased by households.

Considers basket of goods and services from one period to

the next within the same area.

Definition : It is a price index determined by measuring the

price of a standard group of goods meant to represent the

typical market basket of a typical urban consumer. Thepercent change in the CPI is a measure estimating inflation.

Consumer Price Index


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PI for a certain year - PI for a comparative year X 100PI for a comparative year

Simple formula of Inflation Rate


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1. Add uncertainty and make it difficult for companies to budgetor plan long-term.

2. Uncertainty about the future purchasing power of money

discourages investment and saving.

3. There can also be negative impacts to trade from an increasedinstability in currency exchange prices.

4. The above further leads to Imbalance in BOP.

5. Higher income tax rates.

Consequences of Inflation


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India food inflationdeclinesto 13.07 percenton February 10, 2011

India food inflationrose at 17.05 percenton February 3, 2011

India food inflationrose at 15.57 percenton January 27, 2011

India's food inflationrateeasesto 15.52% on January 20, 2011

India's food inflationrateeasesto 16.91% on January 13, 2011


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HOW

TO CONTROL INFLATION

1. MONETARY POLICY

2. FISCAL POLICY


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` The term monetary policy refers to actions taken bycentral banks to affect monetary magnitudes orother financial conditions.

` variables such as money supply, interest rates andavailability of credit.

` affects liquidity

` By affecting liquidity affects credit,

` it affects total demand in the economy.


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Price Stability: The DominantPrice Stability: The Dominant

ObjectiveObjective

` There is convergence of views in developed anddeveloping economies, that price stability is the

dominant objective of monetary policy.` Price stability does not mean complete year-to-year

price stability which is difficult to attain.

` Price stability refers to the long run average stability

of prices.` Price stability involves avoidance of both

inflationary and deflationary pressures.


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1. This is the rate at which central bank (RBI) lends money to other banksor financial institutions.

2. If the bank rate goes up, long-term interest rates also tend to move up,

and vice-versa.

3. Thus, it can said that in case bank rate is hiked, in all likelihood bankswill hikes their own lending rates to ensure and they continue to make aprofit.

What is Bank Rate ?

Bank Rate

6.00%

(w.e.f.29/04/20

03)


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Repo is the rate at which banks borrow from RBI

Reverse Repo is the rate at which banks deploy their surplus funds with RBI.

Both usedfor overnight lending and borrowing purposes.

An increase in these policy rates imply borrowing and lending costs for banks would

increase and this should lead to overall increase in interest rates like credit, deposit etc.The higher interest rates will in turn lead to lower demand and thereby lower inflation.The move was in line with market expectations

Reverse Repo Rate

5.50%

(w.e.f.

25/01/2011)

Increased from 5.25%

which was continuing

since 02/11/2010

Repo Rate6.50% (w.e.f.

25/01/2011)

Increased from 6.25%


since 02/11/2010


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When banks raise demand and time deposits, they are required to keep a certainpercent with RBI. This percent is called CRR.

1. An increase in CRR implies banks would be required to keep higher percentage of

fresh deposits with RBI.2. This will lead to lower liquidity in the system.

3. Higher liquidity leads to asset price inflation and also leads to build up ofinflationary expectations.

BY increasing the rate by 25 bps, RBI has signalled that though it wants to tightenliquidity it also wants to keep ample liquidity to meet the outflows.

Cash Reserve Ratio (

CRR)

6.00% (w.e.f.

24/04/2010)

Increased from 5.00% to

5.50% wef 13/02/2010;

and then again to 5.75%wef 27/02/2010; and now

to 6.00% wef 24/04/2010


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What is SLR ? This term is used by bankers and indicates the minimumpercentage of deposits that the bank has to maintain in form of gold,

cash or other approved securities.

Thus, we can say that it is ratio of cash and some other approved to

liabilities (deposits) It regulates the credit growth in India.

Statutory Liquidity Ratio (SLR)24%(w.e.f.

18/12/2010)

Decreased from 25%


since 07/11/2009


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Demonetization of Currency.

However, one of the monetary measures is to

demonetize currency of higher denominations.Such a measure is usually adoptedwhen there is abundance of black money in the country.

Issue of New Currency. The most extreme monetary measure is the issue of newcurrency in place of the old currency. Under this system, one new note is exchanged

for a number of notes of the old currency. The value of bank deposits is also fixedaccordingly.Such a measure is adopted when there is an excessive issue of notes and

there is hyperinflation in the country. It is very effective measure. But is inequitable

forits hurts the small depositors the most.


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NEWDELHI: Attributing rising inflation partly to stimulus and increasing global commodity prices ,

Finance Minister Pranab Mukherjee today said the government was committed to take all steps to

moderate price rise .

"We have to take all the necessary steps to keep inflation at moderate levels", he said while speaking at

the 9th Pravasi Bhartiya Divas here.

The government had already taken tough action against hoarding to check rising prices, especially ofonions.

To help the economy combat the impact of global financial crisis in 2008, the Reserve Bank as well as

the government had provided several stimulus packages.

These measures mainly included increasing money supply, lowering tax rates and hiking public

expenditure.

While asking the Indian diaspora to invest and contribute to country's growth and prosperity,

Mukherjee said the government was making efforts to achieve double-digit growth rate.

"These policy measures are directed towards two major objectives. The first is to grow the economicpie in a sustained manner and boost GDP growth to a long-term path of over ten per cent per annum.

"The second is to take concrete steps in order to ensure equitable and inclusive distribution of the fruits

from this growth process", he added.


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FISCAL POLICY

Monetary policy alone is incapable of

controlling inflation. It should, therefore,

besupplemented by fiscal measures. Fiscalmeasures are highly effective forcontrollinggovernment expenditure, personalconsumption expenditure, and private andpublicinvestment. The principal fiscal

measures are the following:


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(a) Reduction in UnnecessaryExpenditure.The government should reduceunnecessary expenditure on non-developmentactivities in order to curb inflation. This will

also put a check on private expenditure which

is dependent upon government demand forgoods and services. But it is not easy to cutgovernment expenditure. Though economymeasures are always welcome but it becomesdifficult to distinguish between essential and

non-essential expenditure. Therefore, this

measure should besupplemented by taxation


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b) Increase in Taxes.To cut personalconsumption expenditure, the rates of

personal, corporate and commodity taxesshould be raised and even new taxes should be

levied, but the rates of taxes should not be sohigh as to discourage saving, investment

and production. Rather, the tax system shouldprovide larger incentives to those whosave, invest and produce more. Further, tobring more revenue into the tax-net, the

government should penalize the tax evadersby imposing heavy fines. Such measures are

bound to be effective in controlling inflation.To increase the supply of goods within thecountry, the government should reduceimport duties and increase export duties.


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c) Increase in Savings. Another measure is toincrease savings on the part of the people.

This will tend to reduce disposable income

with the people, and hence personalconsumptionexpenditure. But due to the risingcost of living, people are not in a position tosave muchvoluntarily. Keynes, therefore,advocated compulsory savings or what he

called deferredpayment' where the saver getshis money back after some years. For this

purpose, thegovernment should float publicloans carrying high rates of interest, start

saving schemeswith prize money, or lotteryfor long periods, etc. It should also introduce

compulsoryprovident fund, provident fund-cum-pension schemes, etc. compulsorily. All

such measuresto increase savings are likely tobe effective in controlling inflation


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d) Surplus Budgets. An important measure isto adopt anti-inflationary budgetary policy.

For this purpose, the government should giveup deficit financing and instead have surplus

budgets. It means collecting more in revenuesand spending less.

(e) Public Debt. At the same time, it shouldstop repayment of public debt and postpone it

to some future date till inflationary pressuresare controlled within the economy. Instead,

thegovernment should borrow more to reduce

money supply with the public


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