ECONOMICS HL

Commentary number 2

Title of extract:
Indias central bank faces tricky balancing act

Source of extract: The Sydney Morning Herald

http://www.smh.com.au/business/world-business/indias-central-bank-faces-tricky-balancing-act20090921-fx0q.html

Date of extract: 03/11/2009 Date the commentary was written: 11/11/2009 Word count: 741 words. Sections of the syllabus to which the commentary relates: Macroeconomics

Candidate name: Juan Martn Sanguinetti Candidate number: 2623-039

The main theme of the article is Indias worrying about a fall in its annual GDP1 growth rate from 9% to 6%, and also about a risk of a high rise in inflation. In this commentary we are going to talk about how Indias central bank is planning to fight inflation 2 and keep the economic recovery on track. To start with the analysis we can use evidence in the article to identify that inflation is affected mainly by cost-push factors. Although the increase is minimal and is a good parameter for an economy, India is concerned about the possibility that inflation continues to rise and become harmful for their country. So here is where Indias central banks dilemma starts. Because if inflation is of a cost-push nature, the deflationary demand side policies3 may bring down the price level, but they will result in lower national output and are likely to cause unemployment4 to rise, and this goes against Indias objective of increasing GDP growth rate. This situation can be observed in the following diagram which shows in theory what will happen with the level of unemployment if inflation decreases:

In the diagram we can see how a decrease in inflation from inf1 to inf2 will affect the unemployment, increasing it from U1 to U2.

1 2

Gross domestic product is the total value of all final goods and services produced in an economy in a year. Inflation is defined as a persistent increase in the average price level in the economy. 3 Deflationary demand side policies objective is to reduce aggregate demand using deflationary fiscal policies or deflationary monetary policies. 4 Unemployment is defined as people of working age who are without work, available for work and actively seeking employment according to the International Labour Organization.

To continue the commentary I will explain why Indias central bank has this trade-off between inflation and unemployment. According with the New Zealand-born economist Alban Williams Phillips studies, other economist have reached the conclusion that several countries in the past has experience the dilemma of having to decide between contrary politics in anti inflationary policies or unemployment. Like other central banks across the world, the Reserve Bank of India has cut interest rates many times in the last year in order of facing the world financial crisis and maintaining a high GDP growth rate. By cutting progressively the interest rate, households and firms were benefitted because they started borrowing loans at lower interest rates, producing an increase in investments. As investment is a component of the aggregate demand5, it also increased and inflation started rising. In the following diagram we can see the results of this measure.

The aggregate demand increased and curve has shifted to the right, producing both an increase in output from y1 to y2 and price level from p1 to p2. The resurfacing inflation [] has confronted the central bank with the dilemma about when to take the first steps to tighten monetary policy to keep a lid on prices. This is why the central bank is thinking in raising the percentage of cash commercial banks must keep in reserve6. In this way, the central bank will fight inflation decreasing the amount of money that the central bank lends to the

5 6

Aggregate demand is defined as the total spending on goods and services in a period of time at a given price level. This is known as cash reserve ratio.

banks. As the article explains, this would have the effect of cooling credit expansion and hence inflation.

However, as we can observe in the following diagram, which shows the relationship between quantity of loanable funds and interest rate, this measure will decrease the supply of loanable funds.

If supply of loanable funds falls, interest rate will increase. Therefore we will have a situation where the higher interest rate might cause interest-sensitive private investment to fall, thus reducing aggregate demand. If aggregate demand starts falling the situation may be the opposite to that shown in diagram B and Indias objective of going back to annual growth rates of nine-per-cent-plus will be threaten. We can say that India is facing a complicated dilemma in its attempt to recover the 9% annual growth. However, the actual 6% annual growth is still very high and even enviable for many countries. This raises a debate because Indias governments great ambition brings many measures which are constantly affecting households and firms in positive and negative ways. This happens because India is trying to achieve their objectives in short terms, when it would be better to plan a little-be-little recovery in the long term which would affect less drastically households and firms.