4.

THE INDIAN ECONOMY: DEALING WITH INFLATION

a. What, in your opinion, were the factors, both domestic and global, that led to the inflation
trend in India in early 2007?

Inflation is the rise in prices which occurs when the demand for goods and services exceeds their
available supply. In simpler terms, inflation is a situation where too much money chases too few
goods. In India, the wholesale price index (WPI), which was the main measure of the inflation
rate, consisted of three main components - primary articles, which included food articles,
constituting 22% of the index; fuel, constituting 14% of the index; and manufactured goods,
which accounted for the remaining 64% of the index. Food inflation was a serious issue for any
economy and some possible causes were discussed below.

The main reason was that with the high growth rate of the economy and rising incomes, demand
for food had been gone up over time. This resulted in a mismatch between the supply and
demand for food grains and increase in the prices of food grains. The average annual GDP
growth in the 2000s was about 6% and during the second quarter (July-September) of fiscal
2006-2007, the growth rate was as high as 9.2%. All this growth was bound to lead to higher
demand for goods. However, the growth in the supply of goods, especially food articles such as
wheat and pulses, did not keep pace with the growth in demand. As a result, the prices of food
articles increased.

Though the agriculture growth rate increased in India since independence, but in the last few
years it has decreased in India due to reduced soil quality and inaccessibility of new technology
and investment. Inadequate distribution links, poor storage and processing capacity have led to a
huge amount of food grains getting wasted. Agriculture contributed to 21-22% of GDP but
accounted for just 5.7% of the total investment as of 2004. Also the supply side constraints and
inadequate support systems caused less growth in agriculture. So, after the Green Revolution, the
agriculture sector was totally ignored.

Along with the above reason there are several factors responsible for this. The lower supply from
the rest of the world had led to a sharp increase in agricultural prices and prices of manufactured
products, due to severe shortfall in world output. The surge in international prices of farm
products coincided with an adverse domestic supply situation in markets for wheat, pulses,
oilseeds and other agricultural goods, and much more importantly, with the emergence of
aggregate demand pressure in the economy.

The adding of money to the domestic monetary base reflected an abrupt change in policy by the
RBI. The large amounts of dollars, RBI were forced to buy, were fuelling excessive growth in
the money supply and hence also contributed to the inflation.

Conclusion

Considering the above factors, this was obvious that, agricultural sector in India suffers from
structural problems which must be addressed by the government and policy makers.

b. Critically analyze the measures taken by the Indian Government and the RBI to control
inflation. What impact does the tackling of inflation through monitory means have on economic
growth?

Food articles had contributed significantly to inflation during 2006-07. The government had
experienced that prices were rising because supplies had not kept pace with demand in a fast
growing economy.

The steps taken by the RBI to tackle inflation included a rise in repo rates (the rates at which
banks borrowed from the RBI), a rise in Cash Reserve Ratio and a reduction in rate of interest on
cash deposited by banks with RBI. The signals were intended to force banks to raise lending
rates and to reduce the amount of credit disbursed. The RBI's measures were expected to draw
out a substantial sum from the banks. This step was expected to remove some amount of money
from the economy and to induce firms and individuals to reduce expenditure. In effect, while the
economy was booming and the credit needed to grow, the central bank was tightening the
availability of credit. The RBI had also indirectly strengthen the rupee to make imports cheaper
in order to increase the supply of goods and bring the prices of goods down but it might decline
exports and affect employment in export-related units.

The Government had taken a number of short term and medium term measures to improve
domestic availability of essential commodities and to control inflation. GOI had taken following
measures to procure more food articles and to stabilize the price rise.

(i) Reducing import duties for rice, wheat, pulses, cooking oils and cement and other
products to make imports more flexible to ensure timely supply.

(ii) Banning future trade of wheat, rice and pulses to ensure an adequate supply for the
domestic market.

(iii) Raising taxes on all products covered under excise, customs and service tax including
education cess and income tax and increasing spending on the social sector such as health and
education to manipulate demand by curtailing money supply.

(iv) Reducing import duties on non-agricultural products to see where the supply gaps were
coming from.

(v) Introducing incentives for using cheaper alternatives in the production of cement and
assuring long term coal supplies to cement manufacturers in an effort to control their costs.

(vi) Setting up monitoring cell to review the price situation periodically.

(vii) Forming an expert group to study a forward trading in commodities and its impact on
prices.

(viii) Revising the WPI to include over 1200 items so as to more accurately measure the rate of
inflation and to incorporate best practices from other countries.

However, the cut in petrol and diesel prices could be described as a "belated cut" that was
unlikely to curb inflation to any appreciable extent. Also Government should check hoarding,
concentrate more on the development of the agriculture sector and strengthen the public
distribution system.

Impact of the tackling of inflation through monitory means on economic growth

RBI had used variety of tools to manage inflation. It is very difficult to specify which monetary
measure had been more effective to manage inflation as usually a mix of measures was taken.
However, the following analysis had been done to understand the impact of monetary measures
on inflation.

The combined effect of the monetary measures, CRR hike and the REPO rate hike, were meant
to increase the cost of funds for banks, make loans dearer and temper the demand for credit. The
prime lending rate of the banks were increased which affected the SMEs to get working capital
loan and harmed the employment, competitiveness in export business and growth. The high
interest rates had attracted the foreign funds which, in turn was rapidly appreciating the domestic
currency, and giving foreign institutional investors and their beneficiaries a double bonus; first
through returns on their investment and then on the appreciating exchange rate. The firms who
had to produce goods and services were getting badly hampered by high interest rates.

CRR had the impact on reducing the money supply in the economy and played some role in the
fight against inflation. But the impact of the CRR hike would result in increase of the lending
rates, both for production and consumption. The RBI could address only the demand side
through such an approach. The need of the hour was to curb only consumption credit and not
production. On the other hand there was urgent need to increase supplies of food products and
manufactured goods, for which credit flow to the farm sector and industry must increase.

Conclusion

However, the monetary policy took some time to lower the inflation but it was hard to pinpoint a
particular measure as there were a series of measures.