Amity International Business School

Assignment on

Methods to Control Inflation

Submitted ByKuhoo Chauhan Form No-1170621 MBA- IB

1.

Foreign Direct Investment

Making a case for opening up multi-brand retail to FDI, a Prime Minister appointed panel on inflation has called for allowing global players in the sector at the earliest to check price rise. "The IMG (Inter-ministerial Group) deems that it is time for India to allow FDI in multi product retail and proposes that the Government consider this at the earliest... (it) believes that reform in this sector can be an effective inflation busting measure," a working paper of the panel said. It has cautioned, however, against the risk of corporations in the sector becoming monopolistic and hiking prices, calling for watchful regulation. The IMG, headed by Chief Economic Advisor Kaushik Basu, was constituted by Prime Minister Manmohan Singh in February to suggest ways to check inflation. Inflation, hovering over 9 per cent, is a cause of concern for both the Government and the Reserve Bank. RBI, even at the cost of economic growth, has been hiking interest rates since March 2010 to tame inflation. The paper said that Because of the dated technology and managerial methods used in moving products, there is excessive value erosion all the way. This, in turn, raises the price that consumers have to pay," it said, adding that there is scope for change and modernization on this front, especially in the case of fruits and vegetables. In India, the gap between farm gate price and retail price is exceedingly high. The share of organized retail in India is just over 4 per cent. The sector, employing millions of people, is dominated by small, local shops. For government to try to achieve modernization in retail through "hands-on intervention at every stage and for every product is to court failure". However, it is important to allow the entry of FDI into this sector in a properly regulated fashion, the paper added. "We must guard against the risk of these new corporations becoming monopolistic and charging high prices," paper said. Promoting competition at the local level and prevent cartelisation action needs to be taken on multiple fronts.

2. Monetary Policy
A sharp rise in interest rates has severe consequences. We saw the collapse in industry following such a rise in the late 1990s and in July 2008. Policy should rather follow a path of gradual rise in interest rates conditional on inflation. The knowledge of future rise will reduce inflationary expectations, if combined with action to reduce costs. A short-term nominal exchange rate appreciation reduces costs. This can be very useful to contain a temporary spike in oil or food prices and will become more effective as petrol prices are free and food prices reflect border prices. The current depreciation runs counter to the attempt to reduce inflation. Changing one exchange rate prevents thousands of nominal price changes that then become sticky and persist, requiring painful prolonged adjustment. Small steps give the freedom to respond to evolving circumstances. But to walk with baby steps one must start early and coordinate action over several fronts. FiscalConsolidation The government now seems to be trying a better combination: Imposing fiscal consolidation so monetary policy can be more accommodative. Lower debt, deficits and interest rates are useful attributes for a more open economy to have. But rather than raise tax rates that push up prices and costs, a better approach to fiscal consolidation is to reduce wasteful government expenditure. Plugging leakages and cutting allocations in areas where budgets have not been spent would create better incentives to spend. The government has a poor record in spending effectively. Tax revenues have started rising again with growth, but this boom should not be squandered like the last one. The contribution of economic growth was 55 per cent and of spending cuts was 35 per cent to Canadas successful deficit reduction in the 1990s.

3. Supply Response
The supply response is especially important since India is in a catch-up growth phase. Investment is occurring to relieve specific bottlenecks. Data from Indias Central Statistical Organization (CSO) shows that fixed investment has remained above pre-crisis levels of 32 per cent of GDP. There is a sharp rise in the production of capital goods. Continuing high investment implies there cannot be a large excess of demand over capacity. Good growth and sales help spread manufacturing costs. If

productivity rises, the price-line can be held. A good monsoon after a bad one should see a sharp jump in agricultural production and softening of food prices. Inflation in primary articles will fall from this month onwards because of the base effect and manufactured goods inflation from November. But wages and commodity prices are pushing up costs. Sustained high food price inflation raises wages, since food is still above 50 per cent of the average consumer basket. That procurement prices have held steady this year, after excessive hikes in the past few years, will provide some relief. But over the longer term, structural measures, such as better infrastructure and empowering more private initiatives, are required to improve agricultural supply response. That the National Rural Employment Guarantee Scheme (NREGA) has raised rural wages is a good thing, but the emphasis has been on employment and not productivity, although it has the potential to raise both. A wage rise exceeding that in agricultural productivity raises food prices. Or else rupee appreciation is required to let wages rise without inflation. Prices normally are sticky downwards. So, with monetary accommodation, a relative price change raises the general price level. What goes up doesnt readily come down except for commodities. But in India administered prices impart an upward bias even for food and fuel. The petrol price decontrol was required prices will now be free to fall as well as rise. But the timing of the price rise, when inflation is dangerously high, is unfortunate. Past oil price hikes have not led to sustained inflation because they either followed or led to severe monetary tightening. The attempt to conserve the macroeconomic stimulus can be consistent with falling inflation only if it enables a supply response. Post-reform India has had loose fiscal and tight monetary policy. Direct subsidies created hidden indirect costs and raised debt. But inflation harms electoral prospects, so instead of inflating debt away, a severe monetary tightening would be imposed. There would be a large sacrifice of output, but little reduction in chronic cost-driven inflation.

4. Wage and Price Control

Wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is over-consumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term. Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed

Articles & News on Inflation

Articles:

May Inflation Surges to 3.2% in OECD Countries

[July 6, 2011] The Organization for Economic Co-operation and Development (OECD) has finished aggregating the May inflation data provided by its member countries and has released the results. Energy prices were up a whopping 14.2% for the 12 months ending in May while food prices were up by 3.9%. The overall average for all products in all the OECD countries was 3.2% in May. This was up from the 2.9% reported in April. The major components of this increase were mainly a sharp acceleration of inflation in Canada (to 3.7% in May, up from 3.3% in April) and the United States (to 3.6%, up from 3.2%) with high food and energy prices being the main drivers. The following chart breaks the components down by color so we can see how the food and energy components affect the total.

In other major OECD economies inflation remained either stable (United Kingdom, 4.5%, Italy, 2.6% Japan, 0.3%) or slowed (2.3% in Germany down from 2.4% and 2.0% in France down from 2.1%). Euro area annual inflation (HICP) also slowed to 2.7% in May, down from 2.8%.

Its Weight in Gold: The Real Prices of Things

June21,2011 By Charles Vollum, Casey Research Fiat currencies the world over are being manipulated by central banks, which is distorting asset and commodity prices. Successful investing requires that investors have a good idea of what things cost and what they are really worth and using the worlds oldest and most stable form of money, gold, to compare prices is one way to get that insight. To that end, below is a sampling of current prices measured in grams or milligrams of gold. Price comparisons are against prices as of June 10. Currency Watch: Change from: Week ago Year ago 0.7% -20.4% -15.7% -3.9% -9.4%

Price in Gold US 20.3 mg D CA 20.8 mg 0.7% D EU 29.7 mg 1.9% R JP 0.254 mg 1.7% Y

The month of May was rough for all the currencies, with the EUR and JPY making new alltime lows on the 24th and 25th, respectively, while the USD made a new all-time low on June 6th. Since then, they have all been struggling to regain the lost ground. Last week, the muchbeleaguered euro made the most headway, followed by the JPY. All of the currencies are down significantly from their year-ago levels, but the USD has fared much worse than the others, down 20%. Commodity Watch: Change from: Price in Week ago Year Gold ago Crude 2.02 g/bbl -0.2% 4.7% Oil Silver 0.760 g/oz 7.0% 65.5% Coppe 82.6 mg/lb 0.0% 13.3% r Coffee 53.9 mg/lb 2.1% 54.0% Cotton 30.5 mg/lb -6.5% 44.8%

Silver has been strong, not just in dollars but in gold as well. On February 18, it closed convincingly above its long-term resistance level at 0.7 grams of gold. This was followed by a fast run-up to the 1.0-gram level, last seen in the early 1980s, and then a quick drop back to the 0.7 level.

Ways to Shelter Your Cash from Inflation

By Terry Coxon, The Casey Report The high rate of inflation most of us believe is waiting not too far down the road will be an earthquake for investment markets. The likely winners (gold, silver, precious metals stocks) and the likely losers (long-term bonds and most stocks) arent too hard to identify. But separating the sheep from the goats is only one element for financial success in an environment of rapidly rising consumer prices. Higher rates of price inflation will bring greater volatility to all financial markets. The higher you expect inflation and hence gold to go, the more volatility you should expect to see for assets of every type. Even if in fact the dollar is on the road to perdition, there will be detours and backtracking along the way. Inflation doesnt operate smoothly; it is a disruptor for both the economy and for the political system. From time to time over the next five to ten years, the Federal Reserve will come to see inflation as its most urgent problem. And every time that happens, the Fed will slow the creation of fresh dollars or even put up a big INTERMISSION sign and stop printing altogether for a while. Such seizures of monetary virtue wont last long, but while they do last, they will hammer most investment markets, including the market for the yellow stuff and for stocks of companies that produce or look for it. You could be absolutely correct about where the dollar is headed in the long run and still have a scary ride. 2008 was just a preview of the downdrafts you will need to survive. There will be even uglier smash-ups, and you dont want to be among the hard-money investors who get carried off on a stretcher. To avoid being one of them, youll need to include cash as a constant, permanent element of your portfolio. Cash is a courage booster. Having a substantial cash reserve makes it easier to hold on to your other investments when they are getting battered and you are tempted to bail out. And cash gives you the wherewithal to buy on dips and on the big dumps.

News Reports

1. Growth conundrum: high rates hit industry, but prices out

of control
HT Correspondent, Hindustan Times New Delhi, July 10, 2011 The Reserve Bank of India's (RBI) next move on policy rates hinges largely on two sets of data that will be released this week - industrial output growth for May, and the consolidated monthly inflation for June. Policy-makers face a harsh dilemma, as a slew of fiscal and monetary measures to curb inflation have not yet tamed runaway prices, and have instead hurt economic growth. The galloping inflation rate - it was 9.06% in May - is likely to breach 11% next month, when the data starts reflecting the recent fuel price hike. The government last month raised diesel, kerosene prices and cooking gas prices by Rs 3 a litre, Rs 2 a litre and Rs 50 a cylinder. This will have a cascading effect on most expenses, ranging from transport to food. The hike in diesel prices alone will add 0.30 percentage points to the overall inflation rate, besides knocking up prices of most goods. Fuel, power and lighting carry a weight of 14.91% in the wholesale price index (WPI), India's most followed inflation index.

2. Food inflation at 7-week low; fuel price reason of concern: FM

Press Trust Of India New Delhi, July 07, 2011 Cheaper pulses and vegetables brought down food inflation to a seven-week low of 7.61 % for the week ended June 25 though finance minister Pranab Mukherjee said inflationary pressure is likely to continue following the recent increase in rates of petroleum products. While the inflation or non-food primary articles fell during the period under review, a rise

was noticed in the fuel and power index on account of hike in prices of diesel, cooking gas and kerosene announced last month. Food inflation, as measured by the Wholesale Price Index (WPI), stood at 7.78 % during the previous week. It was almost 20 % during the comparable period of June, 2010.

During the week under review, pulses became over 9 % cheaper year-on-year, while prices of vegetables and potatoes also went down by 8.74 % and 2.13 %, respectively. "There is inflationary pressure in the system and these weekly variations (in food inflation numbers) are mainly because of base effect," Mukherjee said. He further said the overall inflation in June could see some upward movement, from 9.06 % recorded in May. It would be mainly on account of the fuel price hike announced on June 24, he added. The latest numbers on price rise of food items are the lowest since the week ended May 7, when food inflation stood at 7.47 %.Meanwhile, inflation in overall primary articles stood at 11.56 % for the week ended June 25, down from 11.84 % in the previous week. Primary articles have a share of over 20 % in the WPI basket.Inflation of non-food items stood at 17.69 %, down from 17.91 % in the previous week. Prices of LPG went up by 14.58 % on an annual basis. The inflation index for LPG was 11.31 % during last few weeks. On a weekly basis the index on fuel and power rose to 166.3 points from 160.2 points in the previous week. Overall fuel and power inflation stood at 12.67 %.

India to see stable growth, inflation to ease: UBS

3. Press Trust Of India New Delhi, July 05, 2011 India is expected to see better data on inflation as prices are likely to come down and growth is likely to "slow and stabilize" in the summer months, Swiss banking major UBS said in a research note. Inflation is expected to "more meaningfully come off and growth is likely to slow and stabilize in the summer months", according to UBS's Asia Equity Strategy report. "... We think the world has slowed down, Asia with it, and that in Asia, especially for China and India, inflation is very close to peaking in the coming months," the report said, adding this would result in the "potential for policy tightening to temporarily come to an end."

However, the need to raise policy rates one more time still exists, with UBS India Economist Philip Wyatt predicting one last rate hike at the RBI's July 26 meeting, since inflationary pressures still loom large. Indian inflation has been stubbornly high since mid-last year and despite repeated rate hikes by the RBI, has not yet really stabilized, the report said.

Controlling Inflation
1. Monetary policy

Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum. A low positive inflation is usually targeted, as deflationary conditions are seen as dangerous for the health of the economy. There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.

2.

Fixed exchange rates

Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-avis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

3.

Gold standard

The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver. Economies based on the gold standard rarely

experience inflation above 2 percent annually.[51] Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output.