IMPACT OF MONETARY POLICY, EXCHANGE RATE ON INFLATION

ECONOMICS PROJECT
BARUN KAFLEY (SEAT 26)

SEMESTER II

SEC-F
VARUN SHA (SEAT 22)

IMAN GUHA (SEAT 20)

2012

With an open economy and large capital inflows, management of the exchange rate becomes an independent concern. The domestic currency can begin to appreciate (because of nominal appreciation) even with domestic price stability, if there are large capital inflows.Studies suggest that exchange rates are more volatile than can be explained by the macroeconomic fundamentals and moreover this excess volatility has in some cases inhibited international trade -Dr. C. Rangarajan

INTRODUCTION
Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. An increase in the money supply, or currency in circulation, leads to a decrease in the value associated with the currency, a persistent decrease in the purchasing power of money. This decrease in the value increases the prices of goods and services, i.e., more of the currency is required to buy the same goods and services as compared to the prior year. As it is rightly said, inflation occurs when too much money chases too few goods. Factors Affecting Inflation The reasons for the changes are many folds. The most important of these being the rising demand for goods and services owing to the fast growing economy leading to a systematic inflation, rise in global inflation levels due to a shortfall in supply to meet the demand of growing economies, growing money supply due to increase in government spending and the pressure to meet deficit financing, increase in wages and tax rates leading to increase in overall prices for goods and services, among others. Some of the factors affecting inflation are: Monetary Policies-It is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The monetary policy tools are Repo Rate, Reverse Repo Rate, Open Market Operations, Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). Repo Rate - The rate at which the RBI lends money to commercial banks is called repo rate. Two types of repo rate, quoted repo rate and unquoted repo rate. Fiscal Policy It is the use of government expenditure and revenue collection (taxation) to influence the economy. Exchange Rate -Exchange rate between two currencies is the rate at which one currency will be exchanged for another. Global Crude Oil Prices

Measures of Inflation: Inflation is usually estimated by calculating the inflation rate of a price index i.e. Consumer Price Index (CPI) and Wholesale Price Index (WPI). WPI is used in India to calculate inflation. The CPI, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price.[11] While comparing inflation measures for various periods one has to take into consideration the base effect as well. The WPI is based on the wholesale price of a few relevant commodities. The commodities chosen for the calculation are based on their importance in the region and the point of time the WPI is employed. For example in India about 435 items were used for calculating the WPI in base year 1993-94 while the advanced base year 2004-05 uses 676 items. The indicator tracks the price movement of each commodity individually. Based on this individual movement, the WPI is determined through the averaging principle. Why WPI in India? In India, inflation is calculated on a weekly basis. The WPI is published on a weekly basis and the CPI, on a monthly basis. WPI in India is used extensively for short term policy intervention because it is the only index that is available on a weekly basis with a two weeks lag. Most of the major countries like US, UK, Euro zone, China and Japan follow CPI. WPI measures the change in the prices of the good from the perspective of the producers while CPI measures the price changes for the basket of good which are more consumer-centric. Limitations of WPI The WPI in its role as a guide to policy formulation has several critical limitations. The important limitations relate to Non-inclusion of services Following a fixed weighting scheme while the economy is undergoing major structural changes Use of gross transactions data rather than data on final purchases.

RATIONALE BEHIND THE PROJECT

Our purpose of study is that every country faces the problem of inflation whether developed, underdeveloped or developing. We have used the repo rate as a proxy for the monetary policies and the exchange rate to see the trend in inflation i.e., the affect of the changes in these two factors on inflation for the period of 2006-2010. An increase in repo rate means other banks has to borrow money from RBI at a higher interest rate which implies that they will tend to borrow less money during that time and so money supply will go down , resulting in an decrease in inflation and vice versa. As the currency appreciates imports become less costly. This causes imports to increase while there is a decrease in exports. So the supply of goods increase and inflation falls. On the other hand when the currency depreciates, exports become attractive and imports get costly. The suppliers tend to export more and import less. Therefore there is a shortage of goods which causes an increase in inflation. As inflation affects the entire economy and there are various factors affecting the level of inflation, therefore our purpose of study is to develop a deeper insight on how the two factors that we have taken into consideration, the repo rate and the exchange rate affect inflation.

Data and Methodology

Source of Data: WPI: Office of Economic Advisor, Govt. of India http://eaindustry.nic.in/Download_Data_9394.html Repo rate: Reserve Bank of India http://www.rbi.org.in/scripts/PublicationsView.aspx?id=13634 Exchange rate data: Economic Research, Federal Bank of St. Louis http://research.stlouisfed.org/fred2/categories/272 Government expenditure: Planning Commission of India http://planningcommission.nic.in/data/datatable/index.php?data=datatab Period of study: January 2006- December 2011 (6 years) Frequency: Monthly data on Wholesale Price Index (WPI), Repo rate (monetary policy parameter) and Exchange rate (currency). In addition, Government spending data (annual) has been used to explain the impact of a major fiscal policy parameter.

Methodology
A multiple regression technique has been used to fit the data and explain the impact of the said variables on WPI. Regression calculations done in SPSS 13.0 The data has been transformed to the natural logarithm (ln) values using MS-Excel and then fed into the model as the input variables. The purpose of this transformation is two-folda. To bring the data under normal distribution in case some outliers hinder it from being so b. The ln values are of better use in explaining % changes in the dependent variable with respect to % changes in the independent variables (elasticity) which is in fact the case here as changes in WPI are under our purview. The SPSS model has been run with ln(WPI) as the dependent variable and ln(Repo rate) and ln(Currency) as the independent variables. The output has been checked for multi collinearity, autocorrelation in the dependent variable before proceeding towards analysis.

Results: Statistical Interpretations

Model fit: R20.168 (a low value is admissible for time series data) Level of significance: Significant at 1% level (Using ANOVA) Autocorrelation: Durbin-Watson test0.036: negligible autocorrelation in dependent variable. Multi collinearity: Variable Influence Factor (VIF) 2.157 indicates that there is some amount of correlation between the two independent variables, Repo rate and Currency which is logical given the dependence of monetary policy and exchange rate. Standardized coefficient for ln(Repo rate) (0.110) is less than the critical value (0.382) which implies that the effect of this variable on the WPI is insignificant. Standardized coefficient for ln(Currency) is 0.450 > critical value (0.001). Thus, a change in currency has a significant impact on WPI over the said period. The value of un-standardized coefficient is 0.063 (repo rate) and 0.747 (currency) which indicates that for every unit change in ln(Repo rate), ln(WPI) changes by 6.3% whereas for same change in Currency, it changes by 74.7%. This is in corroboration of the significance tests on the standardized coefficients.

DISCUSSIONS:

WPI and EXCHANGE RATE

60 55 50 180 170 160 150 140 WPI 130 120 35 30 200 6 200 7 200 8 200 9 201 0 201 1 110 100 Exchange Rate WPI

Exchange Rate 45
40

Timeline

One of the major factors affecting Inflation is Currency Exchange rate. When Exchange Rate in an economy appreciates, then its exports become more costly while imports become cheap. So there is an incentive for the sellers to sell in the domestic market rather than exporting, thereby increasing the supply in the domestic markets. As a result, there is a downward pressure on the Inflation. Moreover if Currency Exchange Rate depreciates, then exports become more attractive while imports become more costly. Thus there is an incentive to sell more abroad, thereby reducing the supply in the domestic economy. As a result, there is an upward pressure on the Inflation. Thus we see that, keeping all other things constant, there is a direct relationship between Inflation and Currency Exchange Rate. Moreover there is a time lag of 4-5 months from where the impact of currency on inflation can be felt. This is evident from the graph.

In 2006, till September inflation was increasing as a result of increase in currency rate. But as the currency started to appreciate with respect to US Dollar, the rate of increase in inflation cooled down. The inflation was increasing only because of the Government spending. During 2007 and 1st half of 2008, the currency went on consolidating and so the inflation rate also fell during that time. But after August 2008, the currency suddenly depreciated a great deal due to the US subprime crisis. During that time the Government also raised its expenditure by around 38% (SEE EXHIBIT III). Thus Government expenditure coupled with heavy depreciation of Indian currency and rising crude oil prices had an inflationary impact in the economy. Thus inflation continued to rise. Though the currency stabilized in the range of Rs 44-46/$ during 2010 and early part of 2011, but the inflation continued to rise. Though RBI raised the Repo rates 13 times during 15 months in 2010-11, still the inflation did not cool off much. The inability of the monetary policies in curbing the inflation demonstrates that the inflation was due to supply side bottlenecks. Hence the Government had to resort to greater spending so as to address supply side problems. Thus in 2011, the Government budgeted to spend around 36% more than 2010 levels. Moreover hoarding and other speculative acts also contributed to the rising inflation. Seeing the inefficiency of the monetary policy in tackling the inflation in India in recent times, we understand that the structure of the economy also plays a key issue. In the past 4-5 years, the monetary policy wasnt effective in curbing inflation much while the same monetary policies were able to better manage inflation earlier. This is because the monetary policies have an impact on the price of manufactured goods rather than agricultural goods. Moreover RBI need not raise their rates every time to control inflation since raising the key rates have an adverse impact on the growth of the economy.

WAY FORWARD:
Since the inflation was due to supply side constraints, the Government should look to improve agricultural productivity as well as encourage manufacturers to produce more. If the key monetary policy rates remain high, this will discourage private investment in the economy as their cost of borrowings will be high. Hence a low interest rate policy should be followed so as to encourage more private investment which would lead to capacity creation. Moreover the Government should also look to improve warehousing and transportation facilities as many perishable food items are destroyed because of these. Hence cold storage facilities need to be developed. The Government should also give emphasis on Supply Chain Management to eliminate the impact of hoarding and speculative buying.

EXHIBIT I MODEL OUTPUT

Descriptive Statistics Mean 4.8478254 6574521 1.8891545 7839496 3.8062502 0311575 Std. Deviation .11517443327 4734 .19899425404 7871 .06935979569 6033 N 72 72 72

ln(WPI) ln(REPO) ln(CURR)

Rsq 0.168

Adjusted Rsq 0.144

Std error 0.1065

F 6.981

DOF 1 2

DOF 2 69

Sig.F 0.002

Durbin Watson 0.036

Parameters ln (Repo) ln (Currency)

Unstandardized coeff(B) 0.063 0.747

Std error 0.072 0.207

Standardized coefficient () 0.11 0.45

Sig. 0.382 0.001

VIF 2.157 2.157

EXHIBIT II DATA SET

Column1

Column2 MONTHS

Column3 REPO RATE

Column4 CURRENCY RATES 44.2324 44.2284 44.3378 44.8245 45.2226 45.8886 46.3675 46.4461 46.0281 45.3582 44.7209 44.4781 44.2117 44.012 43.7936 42.0176 40.5561 40.5905 40.28 40.6791 40.1735 39.3661 39.3168 39.3752 39.2704 39.6724 40.1452 39.9668 41.8814 42.7633 42.723 42.9248 45.4264 48.6196 48.7905 48.4804

Column5 WPI

2006

JANUARY FEBRUARY MARCH APRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER

6.5 6.5 6.5 6.5 6.5 6.75 7 7 7 7.25 7.25 7.25 7.25 7.5 7.5 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 8.5 8.5 9 9 8 7.5 6.5

105.4 105.6 105.7 107.8 108.7 109.9 110.8 111.5 112.2 112.7 112.6 112.2 112.4 112.6 112.8 114.5 114.7 114.8 115.7 116.0 116.0 116.3 116.8 116.7 117.5 119.0 121.5 123.5 124.1 127.3 128.6 128.9 128.5 128.7 126.9 124.5

2007

JANUARY FEBRUARY MARCH APRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER

2008

JANUARY FEBRUARY MARCH APRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER

2009

JANUARY FEBRUARY MARCH APRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER

5.5 5.5 5 4.75 4.75 4.75 4.75 4.75 4.75 4.75 4.75 4.75 4.75 4.75 5 5.25 5.25 5.25 5.5 5.75 5.75 6 6.25 6.25 6.5 6.5 6.75 6.75 7.25 7.5 8 8 8.25 8.5 8.5 8.5

48.7326 49.1914 51.2062 50.0596 48.5497 47.7459 48.4358 48.3314 48.3606 46.7192 46.5619 46.5987 45.9216 46.3472 45.4982 44.4714 45.8716 46.5758 46.8363 46.5791 45.9904 44.425 44.9986 45.1192 45.3975 45.423 44.9699 44.3954 44.9377 44.8426 44.4151 45.365 47.6585 49.2856 50.7911 52.5228

124.4 123.3 123.5 125.0 125.9 126.8 128.2 129.6 130.3 131.0 132.9 133.4 135.2 135.2 136.3 138.6 139.1 139.8 141.0 141.1 142.0 142.9 143.8 146.0 148.0 148.1 149.5 152.1 152.4 153.1 154.2 144.9 156.2 157.0 156.9 156.9

2010

JANUARY FEBRUARY MARCH APRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER

2011

JANUARY FEBRUARY MARCH APRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER

EXHIBIT III Government Expenditure

Year 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 Expenditure(Cr) 72466 80526 105737 124342 143468 198100 218901 298612 335521 % Change 11.12 31.31 17.60 15.38 38.08 10.50 36.41 12.36

REFERENCES
1. http://www.simpletaxindia.net/2008/11/what-is-crrrepo-rateslr-how-it-effects.html 2. http://www.want2rich.com/2011/05/indian-economy/reasoning-the-recent-hike-of-repo-rates-by-the-reserve-bank-ofindia/ 3. http://www.freeonlineresearchpapers.com/factors-of-inflation 4. http://rbi.org.in/scripts/notificationuser.aspx?id=5602&mode=0

5. http://india-reports.in/future-growth-global-transitions/economy-in-transition/reasons-behind-inflation-in-india/

6. Office of Economic Advisor, Govt. of India; http://eaindustry.nic.in/Download_Data_9394.html

7. Reserve Bank of India; http://www.rbi.org.in/scripts/PublicationsView.aspx?id=13634

8. Economic Research, Federal Bank of St. Louis; http://research.stlouisfed.org/fred2/categories/272

9. Planning Commission of India; http://planningcommission.nic.in/data/datatable/index.php?data=datatab

10. Ila Patnaik and D.K.Joshi. Inflation, investment and growth in India: The role of macroeconomic policy. In Inflation, Growth and Development. Economic Development Management for Asia and the Pacific, Joint Policy Studies, UNDP, Canberra, 1998