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ROLL NUMBER: PC/AEC/O908
REGISTRATION NUMBER:
O19462 of SESSION 2005-2006
THE ROLE OF THE
RESERVE BANK OF INDIAIN USING MONETARY
POLICY
TO COMBAT INFLATION
IN INDIA
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INTRODUCTION
Inflation is the condition of apersistently rising price level.
Price stability does not mean zeroinflation.
For an emerging market economylike India, an inflation rate of 4%per annum is tolerable.
Study of inflation is important as
costs of inflation are significant.
Social Costs
Inflation erodes the purchasingpower of money.
There is diminution of real valueof savings as real interest ratesturn negative.
Persistently high inflation altersinflationary expectations.
High inflation aggravatesinequality.
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MEANING
OFINFLATION
According to Milton Friedman-
Inflation is always and everywhere a monetary phenomenon
Long run inflation cannot occur without a persistent increase in the moneysupply.
In the short term or medium term inflation can take place due to a negative
supply shock or expansionary fiscal policy.
Inflation can be Cost PushorDemand Pullby nature. Both result from
an activist stabilization policy to promote high employment.
A budget deficit can be the source of a sustained inflation only if it is
persistent and if the government finances it by creating money rather than
by issuing bonds to the public.
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ANTI-INFLATIONARY
POLICIES Contractionary fiscal policy is a measure to control inflation only in the
short run.
Long-run inflation can be checked only by decreasing the money supply.
Another method to check inflation is to freeze wages (an anti-trade unionpolicy) and prices (an anti-trust or anti-monopoly policy).
Inflation Targeting has been adopted by many countries to achieve price
stability. But in a country like India with recurrent supply shocks this
policy is not viable.
Hyperinflation is defined as an extremely rapid increase in the price level.
Its obvious cause is the excessive growth in the money supply, mainly due
to huge government budget deficits.
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EXPERIENCE OF INFLATION
IN INDIA
2004-2005
It was characterized by a steepincrease in fuel prices.
The roots of this inflation were
traced to international supply
shocks rather than domestic
overheating.
TheWPI inflation was 6.5%,
fuel price inflation was 10.1%
while inflation of primary
articles was 3.6%.
2006-2007
Inflation was demand-driven.
Rise in prices of primary productsdue to adverse (sectoral) supply
shock.
Inflation in other prices was due
to booming aggregate demand.
By the end of the yearWPI
inflation subsided to 5.7% but
inflation for primary and
manufactured products was high
at 10.7% and 5.8% respectively.
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RBIs ANTI-INFLATIONARY
POLICIES (2004-2005)
Restrictive monetary measures
The Cash Reserve Ratio (CRR)was raised from 4.5% by 0.25percentage point both in
September & October 2004 by thesame magnitude.
There was a hike in the reverserepo rate to 4.75%.
Sectoral Measures
Urea prices were left unchanged.
The extent of hike in theadministered prices of coal &
mineral oil was less than their
price increases abroad.
Excise & custom duties on
petroleum products were cutsubstantially.
Cuts in tariffs on vegetable oil.
Increase in the quantum of free-
sale sugar.
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RBIs ANTI-INFLATIONARY POLICIES
(2006-2007)
Measures to curb inflation in pricesof primary articles
Imports of wheat, pulses, oilseeds,
maize and sugar was permitted.
Ban on export of wheat, pulses
and skimmed milk powder. Increased supply of wheat under
FCIs public distribution system.
A hundred rupee hike in the
minimum support price for wheat.
Imposition of bans on futuresmarket trading in wheat, tur and
urad.
Measures to curb inflation in pricesof non-agricultural commodities
Custom duties on inorganic
chemicals, non-ferrous metals and
cement was reduced.
Custom duties on petrol anddiesel were reduced from 10% to
7.5% and their prices were raised
by Rs 2 & Re 1 respectively.
Restrictive Monetary Measures
Hike in the reverse repo rate from5.25% to 6%
Hike in repo rate by 150 basis
points to 7.75%.
Hike in CRR from 5% to 6.50%.
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EXPERIENCE OF INFLATION IN INDIA
2008-2009
External supply side shocks werethe key drivers of inflation duringthis period.
Inflation was triggered largely bya sharp increase in the prices ofbasic metals and mineral oils.
The headline inflation deceleratedfrom a peak of 12.91% on August2, 2008 to 0.84% at end- March2009.
2009-2010
During July 2009, y-o-y WPIinflation was (-) 1.17% onaccount of high base last year.
Major contributors to annualinflation were food items i.e.inflation emanated from domestic
sources. There was a decline in the prices
of mineral oil, iron & steel, edibleoils etc.
India witnessed a sharp increaseinWPI inflation from a negative
terrain during June-August 2009to 9.9% by February 2010.
The increase in CPI is even higherin the range of 14.9%- 16.9%.
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RBIs POLICIES (2008-2009)
Measures adopted during the crisis period
The repo rate was reduced by 425 basis points to 4.75%.
The reverse repo rate was reduced by 275 basis points to 3.25%.
The CRR was reduced by a cumulative 400 basis points to 5%.
Institution of several sector-specific liquidity facilities.
Establishment of a forex swap facility.
RBI also allowed restructuring of stressed assets by banks in order toincrease the flow of credit for productive purposes.
Reduction in the Statutory Liquidity Ratio (SLR) from 25% to 24% of
NDTL (Net Demand and Time Liabilities).
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RBIs ANTI-INFLATIONARY
POLICIES (2009-2010)
Policy stance of the RBI
Policy stance was shifted from
managing the crisisto managing
the recovery.
The stance of monetary policy was: To anchor inflation expectations.
Actively manage liquidity.
To ensure that credit demand ofproductive sector was adequatelymet.
In view of the rising food inflation RBI
announced the first phase of exit from
expansionary monetary policy in
October 2009.
Policy measures adopted by the RBI
during the recovery period
CRR of banks was raised to 5.75%from 5% of NDTL.
Increase in policy reverse repo and
repo rates by 25 basis points each in
March 2010.
SLR was restored to 25% of NDTL.Note: 2009-10 inflation is more
challenging and serious as it is
owing to the rise in food prices.
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ECONOMETRIC
ANALYSISCHOICE OF VARIABLES
As per the theoretical discussion, the main determinants of the overall inflationin the economy are: Government budget deficit, M1 (currency + current a/cdeposits), Agricultural(foodgrain) production, GDP & WPI of fuel, power, light& lubricant (viz,WPI of fuel).
The question I want to address:Which of these variables have significantlyaffected the overall inflation in the Indian economy over the past 10 years,i.e. for the period 1999-2009.
In order to avoid Spurious Regression, time series properties of each variablemust match.
The dependent variable being WPI inflation, y-o-y & log values of eachvariable is subject to unit root analysis.
For feasibility of solution, monthly data on each variable has been considered(the variables GDP and foodgrain production have been ignored as monthlydata is unavailable on them).
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RESULTS OF UNIT ROOT TESTRESULTS OF UNIT ROOT TEST
(AT FIRST DIFFERENCE)(AT FIRST DIFFERENCE)
LOGARITHMIC MODELLOGARITHMIC MODEL
VARIABLES
Log (WPI-AllCommodities)
[is stationary at first
difference.
i.e. I (1) ]
Log (M1)
[is stationary at first
difference.
i.e. I (1) ]
Log (WPI of Fuel)
[is stationary at first
difference.
i.e. I (1) ]
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APPLICATION OF OLS TO THE
STATIONARY LOG MODEL
Estimated dlog (WPI-All Commodities) =
0.001026 () 0.002961 dlogM1 + 0.281012 dlog (WPI of fuel)
(0.000449) (0.039707) (0.049119)
[2.288623] [-0.074580] [5.721007]
( )- standard error; [ ]- t statistic
dlogM1 is statistically insignificant. dlog (WPI of Fuel) is statisticallysignificant.
No multicollinearity problem.
No autocorrelation problem. Therefore the estimated coefficients are
efficient. Goodness of fit [i.e. correlation coefficient between actual and estimated
values of dlog (WPI-All Commodities)] is 0.451 which is quite good.
Note: For the given sample nature of inflation is cost push
(in the short run).
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COINTEGRATION TEST
2- Step Engle Granger Test has been used to test for the presence of longrun relationship amongst the variables.
Suppose that y(t) ~I (1) and x(t) ~I(1). Then y(t) and x(t) are said to be
cointegrated if there exists a such that y(t) x(t) is I (0) i.e., estimated
u(t) must be I (0). This is denoted by saying y(t) and x(t) are CI (1, 1).
A cointegrating (long- run) relationship is present only between log (WPI-
All Commodities) and log (M1).
This is in conformity with the classical view that in the long run overall
WPI inflation is determined by the money supply alone.
In other words in the absence of monetary accommodation non-monetary
forces have only a transitory affect on the prices.
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Why should price increases (following, say, a one-off
increase in crude prices) which reflect adjustment to a
new equilibrium situation and are not of a continuing
nature be regarded as inflation? Do such price increasesrequire any policy response?
Does not the analysis or diagnosis of inflation in terms of the
behaviour of prices of particular commodities or product
groups go against the fundamental approach of theeconomic theory? Is it not necessary for this purpose to use
a macroeconomic framework?
What is the economic rationale of freezing some
prices or trying to curb their increase for
purposes of controlling inflation?
When inflation is due to some sectoral cost push, but
there is evidence of excess capacity or demanddeficiency elsewhere in the economy should the
central bank take recourse to monetary tightening
at all?
When the administered prices of petroleum or other products
are below their international levels, should the governmentraise them when the overall inflation is low, but keep them
unchanged or lower them if the general price level exhibits
a strong upward trend due to sectoral or macroeconomic
factors?
Since a major reason adduced by the central bank formonetary tightening irrespective of the sources of
inflation is the need for containing inflation
expectations, it is important to ascertain the
determinants of such expectations.
CRITICAL ANALYSIS
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IsWPI superior to other price
indices for purposes ofinitiating anti-inflationary
fiscal or monetary measures?
RBI primarily acts as an ENABLER- the measures
taken by the RBI during the crisis period (2008-
2009) only enable/allow credit expansion. This
however does not imply that there was actualcredit expansion.
In the context of the Indian economy, empirical analysis shows
a high degree of persistence of inflation, especially in the
case of food and edible oil groups. There is an urgent need
to address the issue of structural supply constraints,particularly in agriculture, so that these do not become a
binding constraint in the long run, making the task of
inflation-management more difficult.
RBI states conflicting objectives- it wants the banks to
be profitable and at the same time instructs them toadvance credit to the priority sectors of the
economy. Both these objectives cannot be achieved
simultaneously.
RBI in its policy stance states that it aims to maintain a
balance between growth and inflation. This is again
a self-conflicting objective. In order to achieve
long run growth the economy may have to suffersome amount of inflation in the short run.
Lastly, monetary tools have proved to be more
effective in economies with greater financial
inclusion.
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SUGGESTIONS
NEED FOR A NEW INDEX TO
MEASURE INFLATION
Divergence betweenWPI and CPI
has accentuated since early 2008
This underscores the need for a
representative measure of
inflation for better articulation of
monetary policy.
A broad based CPI for the country
as a whole, including both
services and manufacturing
products, has greater relevance for
monetary policy formulation.
CASE FOR INFLATION-INDEXEDBONDS
Nominal interest rate depends on theexpected real return of investors,expected inflation rate and the
inflation risk premium. One way of mitigating the inflation
risk premium is to issue Inflation
Indexed Bonds with an assured
real return in the range of 2-3%.
Such bonds if properly structuredwould provide a complete hedge
against inflation & protect the long-
time savers & investors from the
inflation risk.
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CONCLUSION
Right now, the RBI seems to be concentrating only on the demand-end ofinflation; as a result the entire perspective of supply is completely ignored.
Inflation may also be curtailed if the supply is bolstered to meet the demands ofthe people.
It is sufficiently clear that the reason that the inflation occurs is because the
economic status and mindsets of the people of India are advancing. Why should this rise in demand be considered as a disadvantage?
The problem here is that the countrys infrastructure is not capable of meetingthese requirements.
But surprisingly, instead of giving any attention to the supply factors, the RBI isstifling the requirements of the consumers and is attempting to create an illusion
that there is no demand for the products. The situation is perfectly described by the following statement:
The greatest trick the devil ever pulled was
convincing the world that evil did not exist
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