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¢ Inflation is the condition of a
persistently rising price level.
¢ Price stability does not mean zero
inflation.
¢ For an emerging market economy
like India, an inflation rate of 4%
per annum is tolerable.
¢ Study of inflation is important as
costs of inflation are significant.

¢ Inflation erodes the purchasing
power of money.
¢ There is diminution of real value
of savings as real interest rates
turn negative.
¢ Persistently high inflation alters
inflationary expectations.
¢ High inflation aggravates
inequality.
 






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¢ ccording to Milton Friedman-
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¢ pong run inflation cannot occur without a persistent increase in the money
supply.
¢ In the short term or medium term inflation can take place due to a negative
supply shock or expansionary fiscal policy.
¢ Inflation can be V   or V

 by nature. Both result from
an activist stabilization policy to promote high employment.
¢  budget deficit can be the source of a sustained inflation only if it is
persistent and if the government finances it by creating money rather than
by issuing bonds to the public.

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¢ ontractionary fiscal policy is a measure to control inflation only in the
short run.
¢ pong-run inflation can be checked only by decreasing the money supply.
¢ nother method to check inflation is to freeze wages (an anti-trade union
policy) and prices (an anti-trust or anti-monopoly policy).
¢ Inflation Targeting has been adopted by many countries to achieve price
stability. But in a country like India with recurrent supply shocks this
policy is not viable.
¢ Hyperinflation is defined as an extremely rapid increase in the price level.
Its obvious cause is the excessive growth in the money supply, mainly due
to huge government budget deficits.
 




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]PI is the headline inflation measure
due to high frequency of data availability.
Divergence between PI & ]PI:
¢ Food prices have a higher weightage
(46-49%) in the PI measures than in
]PI (22-26%).
¢ Prices of services are included in PI ] 
(wt: 12-24%), not ]PI.
¢ Metal prices are included in ]PI, not
|

PI.
¢ Differences in the actual price for


similar commodities at wholesale and
retail levels often prevails.
]
Inspite of the divergence among
inflation indices they follow a similar

path over long time spans.







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¢ It was characterized by a steep
increase in fuel prices.
¢ The roots of this inflation were
traced to international supply
shocks rather than domestic
overheating.
¢ The ]PI inflation was 6.5%,
"
¢ Inflation was demand-driven.
¢ Rise in prices of primary products
due to adverse (sectoral) supply
shock.
¢ Inflation in other prices was due
to booming aggregate demand.
¢ By the end of the year ]PI
inflation subsided to 5.7% [
fuel price inflation was 10.1% 







 

 
 


   
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¢ The ash Reserve Ratio (RR)
was raised from 4.5% by 0.25
percentage point both in
September & October 2004 by the
same magnitude.
¢ There was a hike in the reverse
repo rate to 4.75%.
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¢ mrea prices were left unchanged.
¢ The extent of hike in the
administered prices of coal &
mineral oil was less than their
price increases abroad.
¢ Excise & custom duties on
petroleum products were cut
substantially.
¢ uts in tariffs on vegetable oil.
¢ Increase in the quantum of free-
sale sugar.
 

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¢ Imports of wheat, pulses, oilseeds, ¢ ustom duties on inorganic

maize and sugar was permitted. chemicals, non-ferrous metals and

¢ Ban on export of wheat, pulses
cement was reduced.
and skimmed milk powder. ¢ ustom duties on petrol and

¢ Increased supply of wheat under

FI¶s public distribution system.
¢  hundred rupee hike in the
minimum support price for wheat.
¢ Imposition of bans on futures
market trading in wheat, tur and
urad.
diesel were reduced from 10% to
7.5% and their prices were raised
by Rs 2 & Re 1 respectively.
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¢ Hike in the reverse repo rate from
5.25% to 6%
¢ Hike in repo rate by 150 basis
points to 7.75%.
¢ Hike in RR from 5% to 6.50%.







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¢ External supply side shocks were
the key drivers of inflation during
this period.
¢ Inflation was triggered largely by
a sharp increase in the prices of
basic metals and mineral oils.
¢ The headline inflation decelerated
from a peak of 12.91% on ugust
2, 2008 to 0.84% at end- March
2009.
¢ During July 2009, y-o-y ]PI
inflation was (-) 1.17% on
account of high base last year.
¢ Major contributors to annual
inflation were food items i.e.
inflation emanated from domestic
sources.
¢ There was a decline in the prices
of mineral oil, iron & steel, edible
oils etc.
¢ India witnessed a sharp increase
in ]PI inflation from a negative
terrain during June-ugust 2009
to 9.9% by February 2010.
¢ The increase in PI is even higher
in the range of 14.9%- 16.9%.
 



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¢ The repo rate was reduced by 425 basis points to 4.75%.
¢ The reverse repo rate was reduced by 275 basis points to 3.25%.
¢ The RR was reduced by a cumulative 400 basis points to 5%.
¢ Institution of several sector-specific liquidity facilities.
¢ Establishment of a forex swap facility.
¢ RBI also allowed restructuring of stressed assets by banks in order to
increase the flow of credit for productive purposes.
¢ Reduction in the Statutory piquidity Ratio (SpR) from 25% to 24% of
NDTp (Net Demand and Time piabilities).
  
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Policy stance was shifted from
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The stance of monetary policy was: ¢ RR of banks was raised to 5.75%
¢ To anchor inflation expectations. from 5% of NDTp.
¢ ctively manage liquidity. ¢ Increase in policy reverse repo and
¢ To ensure that credit demand of repo rates by 25 basis points each in
productive sector was adequately March 2010.
met.
¢ SpR was restored to 25% of NDTp.
In view of the rising food inflation RBI
announced the first phase of exit from V #$%&

  
expansionary monetary policy in 


    
October 2009. 

  
 


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¢ s per the theoretical discussion, the main determinants of the overall inflation
in the economy are: Government budget deficit, M1 (currency + current a/c
deposits), gricultural(foodgrain) production, GDP & ]PI of fuel, power, light
& lubricant (viz,]PI of fuel).
¢ The question I want to address: ] [   


    


 

 
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¢ In order to avoid µSpurious Regression¶, time series properties of each variable
must match.
¢ The dependent variable being ]PI inflation, y-o-y & log values of each
variable is subject to unit root analysis.
¢ For feasibility of solution, monthly data on each variable has been considered
(the variables GDP and foodgrain production have been ignored as monthly
data is unavailable on them).
 
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Estimated dlog (]PI-ll ommodities) =
0.001026 (±) 0.002961 dlogM1 + 0.281012 dlog (]PI of fuel)
(0.000449) (0.039707) (0.049119)
X2.288623] X-0.074580] X5.721007]

( )- standard error; X ]- t statistic

¢ dlogM1 is statistically insignificant. dlog (]PI of Fuel) is statistically
significant.
¢ No multicollinearity problem.
¢ No autocorrelation problem. Therefore the estimated coefficients are
efficient.
¢ Goodness of fit Xi.e. correlation coefficient between actual and estimated
values of dlog (]PI-ll ommodities)] is 0.451 which is quite good.
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¢ 2- Step Engle Granger Test has been used to test for the presence of long
run relationship amongst the variables.
¢ Suppose that y(t) ~I (1) and x(t) ~I(1). Then y(t) and x(t) are said to be
cointegrated if there exists a ȕ such that y(t) ± ȕ x(t) is I (0) i.e., estimated
u(t) must be I (0). This is denoted by saying y(t) and x(t) are I (1, 1).
¢  cointegrating (long- run) relationship is present only between log (]PI-
ll ommodities) and log (M1).
¢ This is in conformity with the classical view that in the long run overall
]PI inflation is determined by the money supply alone.
¢ In other words in the absence of monetary accommodation non-monetary
forces have only a transitory affect on the prices.
 
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RBI states conflicting objectives- it wants the banks to
be profitable and at the same time instructs them to
RBI in its policycredit
advance stancetostates
the that it aims
priority to maintain
sectors of the a
pastly, monetary tools have proved to be more
balance
economy. between
Both growth
these and inflation.
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be is again
achieved
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a self-conflicting objective. In order to achieve
simultaneously.
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In RBI primarily
the context acts as an ENBpER- theanalysis
some amount of inflation in the short run.shows
of the Indian economy, empirical measures
ataken by theofRBI
high degree duringofthe
persistence crisis period
inflation, (2008-
especially in the
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case onlyand
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edible oil groups. to other
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fiscal or monetary measures?
inflation-management more difficult.
 
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1 |1
 232
 2
21 |]23 
|1
 
ù Divergence between ]PI and PI
has accentuated since early 2008
¢ This underscores the need for a
representative measure of
ù Nominal interest rate depends on the
expected real return of investors,
expected inflation rate and the
inflation risk premium.
ù One way of mitigating the inflation
risk premium is to issue µ


inflation for better articulation of

+
,
 ¶ with an assured
monetary policy.
¢  broad based PI for the country
as a whole, including both
services and manufacturing
products, has greater relevance for
monetary policy formulation.
real return in the range of 2-3%.
ù Such bonds if properly structured
would provide a complete hedge
against inflation & protect the long-
time savers & investors from the
inflation risk.
 


¢ Right now, the RBI seems to be concentrating only on the demand-end of

inflation; as a result the entire perspective of supply is completely ignored.
¢ Inflation may also be curtailed if the supply is bolstered to meet the demands of
the people.
¢ It is sufficiently clear that the reason that the inflation occurs is because the
economic status and mindsets of the people of India are advancing.
¢ ]hy should this rise in demand be considered as a disadvantage?
¢ The problem here is that the country¶s infrastructure is not capable of meeting
these requirements.
¢ But surprisingly, instead of giving any attention to the supply factors, the RBI is
stifling the requirements of the consumers and is attempting to create an illusion
that there is no demand for the products.
¢ The situation is perfectly described by the following statement:
V-   .     




 
 
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