Inflation is a general rise in prices across

the economy.
If the price of one item - say a particular
model of car - increases because demand
for it is high, we do not think of this as
inflation.
Inflation occurs when most prices are
rising by some degree across the whole
economy.
the inflation rate is a measure of the
change in prices over a specified
period

deflationis a decrease in the

generalprice levelof goods and services
Deflation occurs when theinflationrate
falls below 0% (a negativeinflation rate).
disinflation, a slow-down in the inflation
rate (i.e. when inflation declines to lower
levels)
Inflation reduces the real value
ofmoneyover time; conversely, deflation
increases the real value of money

Core Inflation is also known as underlying

inflation, is a measure of inflation which
excludes items that face volatile price
movement, notably food and energy.
In other words, Core Inflation is nothing
but Headline Inflation minus inflation that
is contributed by food and energy
commodities.

stagflationis a situation in which theinflation

rateis high and theeconomic growthrate slows
down and unemployment remains steadily high.
thePhillips curveis a historical inverse
relationship between the rate
ofunemploymentand the rate ofinflationin an
economy.
Stated simply, the lower the unemployment in
an economy, the higher the rate ofinflation.
While it has been observed that there is a
stable short run tradeoff between
unemployment and inflation, this has not been
observed in the long run.

External Sector:
Higher inflation and the resultant higher
inflation differential relative to the inflation
in rest of the world could cause the real effective
exchange rate (REER) to appreciate, which in
turn could weaken export growth.
Moreover, domestic firms may find it difficult to
pass on the rising input costs to consumers in
the face of competition from cheaper imports,
which may increase pressure on margins.
Margin pressures could alter investment plans
as well as cost of financing for firms.

The most significant adverse impact of inflation

could be on private investment and even productivity
of investment.
First, firms have to spend time and money to understand
and manage the effects of inflation on their business.
Second,higher noise in the information embodied in
prices could lead to over investment in some sectors and
underinvestment in others.
Third, inflation could cause misallocation of financial
resources - from productive investment to speculative
activities.
Fourth, it may discourage domestic savings. Borrowers
benefit at the expense of creditors in a rising inflation
scenario.
Fifth, inflation could discourage capital inflows.

Even if inflation is seen as a tax, fiscal imbalances may

actually increase in a high inflation environment.
First, because of specific fiscal measures taken to
contain inflation (such as tax cuts and higher
subsidies), which in turn could delay fiscal
consolidation. In the case of India, suppressed inflation
could be significant, going by the magnitude of food,
fertilizer and petroleum products subsidies.
Second, expenditure growth at times may match
inflation, given the indexation of wages and expected
demands for compensation matching the rate of
inflation. Revenue collection, however, may lag
behind, due to lags in pricing of public utilities as well
as incentives to underreport income to escape the
inflation tax.
Fiscal imbalance is a risk to both inflation and growth
in the medium-run.

Stock markets may react adversely

to high inflation, leading to negative
wealth and income effects, as well as
higher cost of funds, both of which could
adversely impact growth.
At times, however, asset price bubbles
and associated positive wealth effect
could become a source of inflationary
pressures.

When supply shocks increase input costs,

that automatically raises headline inflation
while simultaneously reducing growth.
Supply shocks by their very nature lead to large
relative price changes, which in turn may
depress demand on the one hand while raising
input costs on the other. The overall impact
becomes visible in terms of low growth and high
inflation.
Stagflationary possibilities could yield a growthinflation relationship contrary to what the
conventional Phillips Curve relationship
suggests.

demand... how much money is being spent.

But inflation is not just about demand in
isolation
the amount of money people are spending
relative to what can be produced.
Inflation tends to rise when, at the current price
level, demand for goods and services in the
economy is greater than the economy's ability
to produce goods and services - its output.
One of the original descriptions of inflation
remains valid - that 'too much money chases too
few goods.
inflation is usually generated by an excess
of demand over supply

if people expect inflation, their

behaviour can lead to inflation
People have to believe that there will be
low inflation before they stop building
expectations of high inflation into their
decisions.
The authorities have to demonstrate that
they will not allow inflation to rise - that
they will act to ensure demand does not
rise too much ahead of output.

Price stability means that changes in the

general level of prices across the
economy are relatively small and gradual

prices do not rise by much from month to

month and from year to year.
In practice, price stability equates to low
and stable inflation.
the broad aim of monetary policy is to
achieve price stability

the value of money

Ensuring that prices are fairly stable amounts to
trying to maintain the value of money, ie ensuring
that what 1 buys today will be roughly the same
as what it will buy tomorrow or next month.
If people expect the value of their money to fall,
this undermines the role of money as a measuring
rod for the value of goods and services in the
economy.
It no longer acts as a standard and stable measure
of value, because its own value is falling and
uncertain.
At worst, when confidence in a currency
deteriorates completely, money can stop being
used as a means of exchange.

the role of prices

Uncertainty about the value of money - the future prices
of goods and services - can be damaging to the proper
functioning of the economy.
Prices are at the core of a market-based economic
system. They help to determine what goods and services
are demanded and what is supplied.
When prices across the economy are fairly stable, specific
changes in the prices of individual goods and services
allow firms and individuals to make decisions about how
much to consume, how much to produce and invest, and
how much to save or borrow.
But when the prices of most goods and services are rising,
it is more difficult to know which items are rising in price
relative to others.
For example, if the demand for organic vegetables is high
and prices are rising, this should be a signal to other
companies to increase supply to this market.
But if prices in general are rising, it might not be clear
whether the higher price is part of this general increase or
specific to an individual product.

when demand rose much faster than output

and inflation increased, sharp increases in
interest rates were necessary to bring demand
back into line.
This often resulted in large falls in output - ie
a recession - as the imbalance in the economy
was abruptly corrected.
One of the costs of unsustainably high output
growth - an economic boom - and the resultant
upward pressure on costs and prices, has been
large falls in output and employment.
These falls were probably greater than would
have been the case had demand and output
grown in a steadier and more balanced way.

Monetary policy aims to influence the overall

level of monetary demand in the economy
so that it grows broadly in line with the
economy's ability to produce goods and
services.
This stops output rising too quickly or slowly.
Interest rates are increased to moderate
demand and inflation and they are reduced
to stimulate demand.
If rates are set too low, this may encourage
the build-up of inflationary pressure; if they
are set too high, demand will be lower than
necessary to control inflation.

Monetary policy operates by influencing

the price at which money is lent, ie the
cost of borrowing and the income from
saving.
Bank rate -the whole range of interest
rates set by commercial banks,

Spending and saving decisions

A change in the cost of borrowing affects spending
decisions.
Interest rates will affect the attractiveness of
spending today relative to spending tomorrow.
An increase in interest rates will make saving
more attractive and borrowing less so.
This will tend to reduce current spending, by both
consumers and firms.
That includes spending by consumers in the shops
and spending by firms on new equipment, ie
investment.
Conversely, a reduction in interest rates will tend
to increase spending by consumers and firms.

A change in interest rates will affect consumers' and

firms' cash flow, ie the amount of cash they have
available.
For savers, a rise in interest rates will increase the
money received from interest-bearing bank and
building society deposits.
But it will also mean higher interest payments for
people and firms with loans - debtors - who are being
charged variable interest rates (as opposed to fixed
rates which do not change).
These include many households with mortgages on
their homes.
These fluctuations in cash flow are likely to affect
spending.
Lower interest rates will have the opposite effects
on savers and borrowers.

A change in interest rates affects the value of

certain assets, such as house and share
prices.
Higher interest rates increase the return on
savings in banks and building societies.
This might encourage savers to invest less of
their money in alternatives, such as property
and company shares.
Any fall in demand for these assets is likely to
reduce their prices.
This reduces the wealth of individuals holding
these assets, which, in turn, might influence
their willingness to spend.
Again, lower interest rates have the opposite
effect, ie they tend to increase asset prices.

A particular influence on prices comes

through the exchange rate.
A rise in interest rates relative to those in
other countries will tend to result in an
increase in the amount of funds flowing into
the country as investors are attracted to the
higher rates of interest.
This will tend to result in an appreciation of
the exchange rate against other currencies.
In practice, the exchange rate will be
influenced both by expectations about
future interest rates and any unexpected
changes in interest rates.

1). Monetary measures and

2). Fiscal measures

price stability
growth and
financial stability
Financial stability describes the condition
where the financial intermediation
process functions smoothly and there is
confidence in the operation of key
financial institutions and markets within
the economy.

(i) defining an operational target, generally

an interest rate;
(ii) setting a policy rate which could
influence the operational target;
(iii) setting the width of corridor for shortterm market interest rates;
(iv) conducting liquidity operations to keep
the operational target interest rate stable
within the corridor; and
(v) signalling of policy intentions.
The operating target, however, is only an
intermediate objective of monetary policy.

First, in the formative years during 1935-1950, the

focus of monetary policy was to regulate the supply
of and demand for credit in the economy through the
Bank Rate, reserve requirements and OMO.
Second, during the development phase during 19511970, the need to support plan financing through
accommodation of government deficit financing by
the RBI began to significantly influence the conduct
of monetary policy.
This led to introduction of several quantitative control
measures to contain the consequent inflationary
pressures while ensuring credit to preferred sectors.
These measures included selective credit control,
credit authorisation scheme (CAS) and social control
measures to enhance the flow of credit to priority
sectors. The Bank Rate was raised more frequently
during this period.

Third, during 1971-90, the focus of monetary

policy was on credit planning.
However, the dominance of fiscal policy over
monetary policy accentuated and continued
through the 1980s.
To raise resources for the government from
banks, the statutory liquidity ratio (SLR) was
progressively increased from the statutory
minimum of 25 per cent of banks net
demand and time liabilities (NDTL) in 1970 to
38.5 per cent by 1990.
And to neutralise the inflationary impact of
deficit financing, the cash reserve ratio (CRR)
was gradually raised from its statutory
minimum of 3 per cent to 15 per cent of NDTL
during the period.

Fourth, the 1980s saw the adoption of monetary

targeting framework based on the recommendations of
Chakravarty Committee (1985).
Under this framework, reserve money was used as
operating target and broad money (M3) as an
intermediate target.
A number of money market instruments such as interbank participation certificates (IBPCs), certificates of
deposit (CDs) and Commercial Paper (CP) were
introduced based on the recommendations of Vaghul
Committee (1987).
Fifth, structural reforms and financial liberalisation in
the 1990s led to a shift in the financing paradigm for
the government and commercial sectors with
increasingly market-determined interest rates and
exchange rate.
By the second half of the 1990s, in its liquidity
management operations, the RBI was able to move
away from direct instruments to indirect market-based
instruments.
The CRR and SLR were brought down to 9.5 per cent
and 25 per cent of NDTL of banks by 1997.

Sixth, the monetary policy operating procedure also underwent a

change following the recommendation of Narasimham Committee
II (1998).
The RBI introduced the Interim Liquidity Adjustment Facility (ILAF)
in April 1999, under which liquidity injection was done at the Bank
Rate and liquidity absorption was through fixed reverse repo rate.
The ILAF gradually transited into a full-fledged liquidity
adjustment facility (LAF) with periodic modifications based on
experience and development of financial markets and the payment
system.
The LAF was operated through overnight fixed rate repo and
reverse repo from November 2004.
The LAF helped to develop interest rate as an instrument of
monetary transmission. In the process, two major weaknesses
came to the fore. First was the lack of a single policy rate.
The operating policy rate alternated between repo and reverse
repo rates depending upon the prevailing liquidity condition. In a
surplus liquidity condition, the operating policy rate was the
reverse repo rate, while in a deficit liquidity situation it was the
repo rate.
Second was the lack of a firm corridor. The effective overnight
interest rates dipped below the reverse repo rate in surplus
conditions and rose above the repo rate in deficit conditions.
Moreover, overnight call rates became unbounded under
occasional liquidity stress. Thus, more often the overnight interest
rate remained outside the corridor.

First, the weighted average overnight call money

rate was explicitly recognised as the operating
target of monetary policy.
Second, the repo rate was made the only one
independently varying policy rate.
Third, a new Marginal Standing Facility (MSF) was
instituted under which scheduled commercial
banks (SCBs) could borrow overnight at their
discretion up to one per cent of their respective
NDTL at 100 basis points above the repo rate.
Fourth, the revised corridor was defined with a
fixed width of 200 basis points. The repo rate was
placed in the middle of the corridor, with the
reverse repo rate 100 basis points below it and
the MSF rate 100 basis points above it.

Cash reserve Ratio (CRR)istheamountoffundsthatthebankshavetokeep

withtheRBI.IfthecentralbankdecidestoincreasetheCRR,theavailable
amountwiththebankscomesdown.TheRBIusestheCRRtodrainout
excessivemoneyfromthesystem.
Reverse Repo rateistherateatwhichtheRBIborrowsmoneyfrom
commercialbanks.BanksarealwayshappytolendmoneytotheRBIsince
theirmoneyareinsafehandswithagoodinterest.

Anincreaseinreversereporatecanpromptbankstoparkmorefundswiththe
RBItoearnhigherreturnsonidlecash.Itisalsoatoolwhichcanbeusedby
theRBItodrainexcessmoneyoutofthebankingsystem.
Repo Rate?
TherateatwhichtheRBIlendsmoneytocommercialbanksiscalledrepo
rate.Itisaninstrumentofmonetary policy.Wheneverbankshaveany
shortageoffundstheycanborrowfromtheRBI.

Areductioninthereporatehelpsbanksgetmoneyatacheaperrateandvice
versa.ThereporateinIndiaissimilartothediscountrateinthe US.

BankRate:6.0%
RepoRate:8.50%
ReverseRepoRate:7.50%
MarginalStandingFacilityRate:9.50%
CRR:6.0%
SLR:24.0%

Repo rate- in a deficient liquidity scenario, it lends to the

market at the repo rate

Reverse repo rate- In times of surplus liquidity, the RBI

borrows from the market at the reverse repo rate

RR<R

in case, RBI wants to make it more expensive for the banks

to borrow money, it increases the repo rate; similarly, if it
wants to make it cheaper for banks to borrow money, it
reduces the repo rate

An increase in the reverse repo rate means that the RBI

will borrow money from the banks at a higher rate of
interest. As a result, banks would prefer to keep their
money with the RBI

Repo Rate signifies the rate at which liquidity is injected in

the banking system by RBI, whereas Reverse repo rate
signifies the rate at which the central bank absorbs liquidity
from the banks.

The difference between the two rates, which was 50 basis

points (bps) at the time they evolved into policy rates was
relentlessly widened to 150 bps.

676 commodities
available on a weekly
basis
time lag of two weeks
The base year of the
WPI series is 2004- 05
Services do not get
reflected in the WPI
series
Manufactured products
gets 64.972 %
weightage

260 items
CPI (IW) is
constructed on a
monthly basis
The base year for CPI
(IW) is
CPI (IW) series is
more sensitive to
changes in food
prices. food gets 57
% weightage