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SAHIL GULATI
BBA-2nd
SEMESTER
ROLL NO- 06580301712
BUSINESS ECONOMICS-II
RESEARCH ASSINGNMENT
SUBJECT CODE- BBA 104
INSTUCTOR- DR.NIDHI GUPTA
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ASSINGMENT -1
Inflation rate in India
touched 12% in July 2008.
What was the dilemma
faced by the RBI & the
government in adopting
strong measures for
controlling inflation.
Explain in detail?
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INFLATION IN INDIA: TRENDS,POLICY AND ITS CAUSES
inflation is a sustained rise in the general level of prices of goods and services over a period of
one year.In other words, it indicates the percentage rise in the general prices today compared to a
year ago.The rise (fall) in inflation means that purchasing power of money declines (increases).
This measure is very useful in understanding the trends in cost of living and also in comparing
the trends in major macroeconomic variables. From the policy point of view, particularly for the
monetary authorities, tracking of inflation is quite essential in formulating necessary growth
policies.
In the recent period, India has been witnessing very high inflation rates and this has become a
serious policy concern as it could have adverse impact on both growth and welfare of the
country. The recent data shows that the headline inflation in May 2010 is at 10.16%, against the
RBIs comfortable level of around 5%, as stated in the April 2010 Annual Credit Policy
statement. In this context, here we look into the recent trends in the inflation rates (both
headlines and also the subcomponents) and the main drives of these high rates. In the end, some
discussion on the policy options that might help in containing inflation would be specified.
RECENT TRENDS
Before we look into the recent trends in the inflation rates, we need to understand the existing
measures of inflation. As in any economy, India also has two broad estimates that cover the
prices in whole sale market (which is called Wholesale Price Index (WPI)) and the retail market
(Consumer Price Index (CPI)). Within CPI there are three sub indices that cover three groups
namely industrial workers, urban non-manual employees and agricultural laborers. But there is
no consolidated CPI for the whole economy. In the case of WPI, the index covers only the prices
of goods and not the services, thus, making difficult for the policy makers and researchers in
choosing the appropriate price index for target and also for research. However, WPI is the one
that is tracked by the analysts and policy makers as the information flow is faster with WPIcompared to CPI, which comes with a lag of two months.
It is also generally assumed that any changes in the prices in wholesale market would eventually
transmit (or pass-through) to the retail market. Hence, WPI might be a better indicator for
tracking the general price level in the economy. However, a look at the graph below shows that
the convergence between WPI and CPI inflation is quite weak, particularly during the high
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inflationary periods, and also takes a long lag. Thus, this divergence in price indices also results
in divergence in the policy impacts as well.
The recent trends in the inflation numbers show that India is experiencing high inflation situation
since the end of 2009 and currently it is at an uncomfortable level of 10.16% in May 2010 and
there are expectations that this would increase further. At the disaggregated level, one may notethat the prices of both food and non-food and the fuel group are increasing sharply since the
middle of 2009, while the inflation rate in the manufacturing sector was almost subdued at
around 6% for a long time. As minimum rise in the inflation rate acts as an important incentive
for the production activity, this could have adverse impact on the consumption and could
particularly affect the poor who are largely not indexed in India. Based on this, our own studies
in the past have shown that the threshold (or the optimal or tolerant) inflation for India is at
around 4 to 4.5%. Policy makers (particularly the monetary authorities) would try to contain the
inflation at around this range. Although India does not follow the inflation targeting regime
(where the inflation rate should be controlled at a level fixed by the legislation.
For instance, UK has fixed the inflation target at 2%), it is generally clear from the policy
statements (such as manual Credit policy) that the Central Bank would try to control the inflation
once it crosses the comfortable level.
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CAUSES OF HIGH INFLATION
As discussed above, currently, in May 2010, the WPI inflation is above 10%. Monetarists, led
by Nobel Laureate Milton Friedman of Chicago School, across the globe believe that in the
long-run, inflation is always and everywhere a monetary phenomenon. This means that the
money supply growth is the major determinant of inflation and in the long run higher inflation
rate can be controlled only through tight monetary policy. But there are other competing
schools, such as Keynesians, that say that money is not so important rather than the aggregate
demand caused by private and government spending that determines inflation.
Hence, Keynesians suggest that money is not the one determinant of inflation. Money has a role
only when its growth is higher than the economys capacity to absorb. There is also a view that
explains cost-push version of inflation, which is largely due to supply-shock that results in fall
in aggregate supply. Overall, while there are many theories that explain the causes of inflation,
based on enumerable empirical studies, relying on one school of thought might not be wise. In
India also there were many studies on inflation determinants and their conclusions are quite
diverse.
As the behavior of inflation is very dynamic the theoretical explanations of this behavior could
also be dynamic. Hence, this needs to be examined on a regular basis.
INFLATION AND GROWTH CONCERNS IN INDIA
Two sets of recently released figures on the economy - the Index of Industrial Production (IIP)
and inflation - have set off an interesting debate about the direction of our monetary policy. The
RBI has become caught between the never ending debate about making a trade-off between
inflation and growth.
Recently released CSO data on the IIP indicates that industrial growth decelerated in January
2008 to 5.3%, compared to 11.6% for January 2007. The biggest hit was taken by the two critical
engines of industrial and consequently economic growth - consumer durables and capital goods.
While the former fell 3.1% ( a rise of 5.3% in Jan 2007), the later rose a mere 2.1% (16.3% in
Jan 2007) for the month of January 2008. However, Fast Moving Consumer Goods (FMCG,
consumer non durables), exhibited a 10.1% growth in January, compared to 9.1% last year. Food
products, beverages, tobacco etc showed double digit growth. The growth rate of the core
infrastructure industries group - crude petroleum, petroleum refinery products, coal, cement,
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electricity and steel - which has a 26.7% weight age in the overall IIP fell from 4.2%in January,
compared to 8.3% in January 2007.
Wholesale Price Index (WPI) had already begun to breach the self-imposed year-on-year 5%
tolerance level in the third week of February and continues to rise. WPI based inflation rate
breached the critical 5% mark to close at 5.11% for the week ended March 1, 2008, the highestin over nine months. It further rose to 5.92% when the latest figures were released for the week
ended March 8, 2008, to reach the highest figure since May 7, 2007. The prices for cereals
increased 6.28%, for milk 9.71%, vegetables 9.79%, dairy products 9.31%, cement 5.13%, iron
and steel 20.87%, and edible oils 17.52%.
There are many reasons to doubt that the drop in capital goods is not part of any long term trend.
For a start, statistically 2006-07 was an year of extraordinary industrial growth, with the final
quarter growth being 12.5%. Sustaining this was not realistic and maybe not even desirable,
given the strains it would place on an already stretched out economy. Investments in the main
consumers of capital goods like infrastructure have been growing and shows no signs of
slackening. The order books of the main capital goods manufacturers remain buoyant and their
sales numbers have shown robust growth. In fact, the key listed capital goods companies grew by
about 33 per cent in the last quarter of 2007, in comparison to the same period last year.
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The already committed investments in these sectors may be enough to sustain the present capital
goods growth trends in the near future. The projected expenditures in these non tradable services
like ports, airports, highways, power, urban infrastructure, telecommunications etc is massive,
are by themselves capable of sustaining very high growth rates. The Government's own flagshipprograms like the Golden Quadrilateral and other National Highway projects, PMGSY,
JNNURM, and the programs to promote PPP in core infrastructure, should provide more than
adequate demand side stimulus to sustain high rates of growth for sectors like capital goods. The
demand for both residential and commercial real estate is both massive and ever growing, and
has not shown any signs of slackening. The critical inputs to infrastructure sector like steel and
cement, after a blip in January, exhibited robust growth in February.
The construction sector, which encompasses all these infrastructure investments, exhibited one
of the lowest sectoral ICORs in the Tenth Plan period at a very low 1.2. It has also been shown
that construction sector generates one of the highest employment rates for every rupee
investment. All this will ensure that the economic multiplier will be significant from these
committed and projected investments. So any talk of a major slowdown may be not based on any
logical foundations.
The recent budget cut CENVAT on all goods from 16% to 14%, excise duties on automobiles
from 16% to 12%, excise duties on drugs and diagnostic equipments, and some packaged food
items from 16% to 8%. These rates were cut with the objective of lowering prices and thereby
spurring consumption and boosting industrial and business activity. The consumer durables
sector, especially two-wheelers and automobiles, is expected to be one of the largest
beneficiaries of this. The Sixth Pay Commission is expected to put nearly Rs 350 billion in the
hands of consumers, thereby providing a major fillip to manufacturing demand. These are all
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strong stimulus measures that are expected to keep aggregate demand high, and thereby keep the
corporate investment climate healthy.
MEASURE STEPS TO CONTOL
The Government have responded to the rising food and commodity prices by piecemeal and
stop-gap measures like price controls, freeing imports, banning exports (on edible oils), lowering
customs duties (on rice and edible oils), imposing export duties (on steel), and prohibiting futures
trading (on food grains). These efforts are based on the wishful but futile assumption that it is
possible to insulate the Indian economy from the global trend of rising food and commodity
prices. This attempt at importing deflation by freeing up the external sector has severe
limitations, given the small quantities involved in such trade and the high prices prevalent in the
global markets.
The rising global commodity prices, both food and non-food, has pushed up import prices.
Addressing this inflation with monetary policy levers may not only not yield results, but may
backfire badly, especially at a time when growth itself is slowing down. That the inflation is not
driven by demand side pressures is also clear from the fact that growth in money with the public
has declined form a very permissible 17% to an even less 14% in February, 2008. The RBI
figures show that money supply which has been growing at 22.2% annually, is slowing down to
an estimated 21.2%. It is clear that while the demand side is robust, the supply side appears
constrained. The rise in inflation is therefore more due to cost push factors than demand pull
ones.
The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The
major domestic supply side bottle necks that have been driving prices up include stagnating
agricultural production, declining private capital investments in manufacturing, and over-
stretched infrastructure, especially power and transport logistics.
The domestic supply side factors that are driving inflation need to addressed through someimmediate policy interventions. Infrastructure bottlenecks are an immediate priority that will
continue to strangle any economic growth. It is impossible for India to grow at double digit
growth rates, by maintaining low inflation, without massive investments in its creaking
infrastructure. Agriculture investments, both physical and those aimed at improving productivity,
have been declining and this is manifested in the stagnating production, thereby forcing imports.
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This needs to be addressed immediately on the highest priority, especially given the large share
of population dependent on agriculture.
The external sector has also been a significant determinant on price increases. Since 2004, import
prices of oil have soared from $34 to $110, palm oil from $471 to $1177, and Thailand rice from
$225 per tones to $510 per tones. Our import basket has taken an enormous hit, and naturallyinflationary pressures have been building up. Commodity prices worldwide - food grains, cash
crops, energy and metals - have been growing at an alarming rate. Over the six years to February
2008, the Goldman Sachs broad commodity index jumped by 288 per cent, the energy price
index by 358 per cent, the non-energy index by 178 per cent, the industrial metals index by 263
per cent and the agricultural index by 220 per cent.
All this will also reduce the demand for oil and other energy supplies. Economic growth in the
merging economies too will drop, though not sharply, thereby further reducing domestic demand
in these markets. All this is likely to result in lower commodity prices, which will benefit large
domestic market and commodity import dependent economies like India and China.
What should the Government do at such times?
Such times are a strong reminder of the continuing need to maintain a robust and effective Public
Distribution System (PDS), which would help insulate at least the poorest of the poor from
global economic volatility. It is also a reiteration of the importance of food security, and the need
to make investments in agriculture with the objective of increasing productivity and thereby
expanding production. There is very little Governments can do to control the rising commodity
and energy prices, apart from cosmetic exercises that play to the galleries, but will achieve
precious little. Aggressive promotion of investments in infrastructure will be important for
easing the constraints faced in a sector vital for promotion of overall economic growth.
These times also highlight the immense complexity involved in aggressively interventionist
market controlling approaches like price controls and duty hikes. Therefore, in suchcircumstances, if the Government decides to assist a category of consumers with some subsidy, it
is more appropriate that such subsidies be transferred as direct cash transfers than by meddling
with the price mechanism. Such measures are better able to co-ordinate with the market and
deliver the full bang for the buck. Besides, it will also prevent market distortions that have
consequences that often go much beyond the duration of the crisis itself.
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What should the RBI do to ward off inflationary pressures or
CONCLUSION?
It appears that the RBI's dilemma can be resolved if not by easing the monetary policy, but atleast by holding on to it, so as to address growth concerns. Any tightening of monetary policy
would have serious implications at a time when the investment climate is not at the pink of
health. Further, in a cost push inflation scenario, any monetary tightening will be ineffective.
It also a timely reminder about the need to keep a low interest rate cushion when the economy is
doing well, so that it gives the Government a sufficient enough interest rate buffer that it can
exercise and increase rates when inflation rears its head. In fact, we should have lowered the
interest rates late last December itself, in anticipation of such a reality, given the storm clouds
that were then gathering around the US economy.
For the foreseeable future ahead, Indian economy will have inflationary pressures stoked up due
to factors that are cost-push than demand-pull. Inflation is more likely to arise out of the
economy's inability to provide the critical inputs necessary to sustain the fast pace of growth. In
such circumstances, monetary policy will be more critical in lowering the cost of capital and
encouraging growth, and will have only a minimal role in controlling inflation.
In the final analysis, a 7-7.5% GDP growth rate is by any yardstick a very good deal, especially
at a time of such tumult in the global economy. Given the fact that the robust 9% plus growth of
the past few years, was taking its toll on an over-stretched economy and supply side constraints
were becoming increasingly evident, a relative cooling off should even be welcomed.
Given all our supply side constraints and infrastructure bottlenecks, sustaining a 9% growth
without stoking off inflation was an impossibility. A slowdown in growth to 7-7.5% should suit
us, in so far as it would help prevent over-heating and consequent build up of inflationary
pressures, all of which have the potential of squeezing medium-term growth itself.
ACKNOWLEDGEMENT
Iexpress my sincere gratitude and thanks to DR.NIDHI GUPTA for his valuable and unmatchedguidance and sincere efforts in trying to make us not just familiar but well equipped with the
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fundamentals and building stones of the research work. The efforts put up by us during the
development of this project would not have been fruitful, if it were not the people around us,
who encouraged us at all times. Taking this opportunity, further we would like to thank the staff
and the faculty members of the institution for being there whenever we need their help.
We are also grateful to Prof. Col. Mahander Singh Director General, RDIAS for his expertguidance and cooperation in making our project learning and worthwhile experience.
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