Economics Sahil

7/28/2019 Economics Sahil

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SAHIL GULATI

BBA-2nd

SEMESTER

ROLL NO- 06580301712

BUSINESS ECONOMICS-II

RESEARCH ASSINGNMENT

SUBJECT CODE- BBA 104

INSTUCTOR- DR.NIDHI GUPTA


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ASSINGMENT -1

Inflation rate in India

touched 12% in July 2008.

What was the dilemma

faced by the RBI & the

government in adopting

strong measures for

controlling inflation.

Explain in detail?


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INFLATION IN INDIA: TRENDS,POLICY AND ITS CAUSES

inflation is a sustained rise in the general level of prices of goods and services over a period of

one year.In other words, it indicates the percentage rise in the general prices today compared to a

year ago.The rise (fall) in inflation means that purchasing power of money declines (increases).

This measure is very useful in understanding the trends in cost of living and also in comparing

the trends in major macroeconomic variables. From the policy point of view, particularly for the

monetary authorities, tracking of inflation is quite essential in formulating necessary growth

policies.

In the recent period, India has been witnessing very high inflation rates and this has become a

serious policy concern as it could have adverse impact on both growth and welfare of the

country. The recent data shows that the headline inflation in May 2010 is at 10.16%, against the

RBIs comfortable level of around 5%, as stated in the April 2010 Annual Credit Policy

statement. In this context, here we look into the recent trends in the inflation rates (both

headlines and also the subcomponents) and the main drives of these high rates. In the end, some

discussion on the policy options that might help in containing inflation would be specified.

RECENT TRENDS

Before we look into the recent trends in the inflation rates, we need to understand the existing

measures of inflation. As in any economy, India also has two broad estimates that cover the

prices in whole sale market (which is called Wholesale Price Index (WPI)) and the retail market

(Consumer Price Index (CPI)). Within CPI there are three sub indices that cover three groups

namely industrial workers, urban non-manual employees and agricultural laborers. But there is

no consolidated CPI for the whole economy. In the case of WPI, the index covers only the prices

of goods and not the services, thus, making difficult for the policy makers and researchers in

choosing the appropriate price index for target and also for research. However, WPI is the one

that is tracked by the analysts and policy makers as the information flow is faster with WPIcompared to CPI, which comes with a lag of two months.

It is also generally assumed that any changes in the prices in wholesale market would eventually

transmit (or pass-through) to the retail market. Hence, WPI might be a better indicator for

tracking the general price level in the economy. However, a look at the graph below shows that

the convergence between WPI and CPI inflation is quite weak, particularly during the high


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inflationary periods, and also takes a long lag. Thus, this divergence in price indices also results

in divergence in the policy impacts as well.

The recent trends in the inflation numbers show that India is experiencing high inflation situation

since the end of 2009 and currently it is at an uncomfortable level of 10.16% in May 2010 and

there are expectations that this would increase further. At the disaggregated level, one may notethat the prices of both food and non-food and the fuel group are increasing sharply since the

middle of 2009, while the inflation rate in the manufacturing sector was almost subdued at

around 6% for a long time. As minimum rise in the inflation rate acts as an important incentive

for the production activity, this could have adverse impact on the consumption and could

particularly affect the poor who are largely not indexed in India. Based on this, our own studies

in the past have shown that the threshold (or the optimal or tolerant) inflation for India is at

around 4 to 4.5%. Policy makers (particularly the monetary authorities) would try to contain the

inflation at around this range. Although India does not follow the inflation targeting regime

(where the inflation rate should be controlled at a level fixed by the legislation.

For instance, UK has fixed the inflation target at 2%), it is generally clear from the policy

statements (such as manual Credit policy) that the Central Bank would try to control the inflation

once it crosses the comfortable level.


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CAUSES OF HIGH INFLATION

As discussed above, currently, in May 2010, the WPI inflation is above 10%. Monetarists, led

by Nobel Laureate Milton Friedman of Chicago School, across the globe believe that in the

long-run, inflation is always and everywhere a monetary phenomenon. This means that the

money supply growth is the major determinant of inflation and in the long run higher inflation

rate can be controlled only through tight monetary policy. But there are other competing

schools, such as Keynesians, that say that money is not so important rather than the aggregate

demand caused by private and government spending that determines inflation.

Hence, Keynesians suggest that money is not the one determinant of inflation. Money has a role

only when its growth is higher than the economys capacity to absorb. There is also a view that

explains cost-push version of inflation, which is largely due to supply-shock that results in fall

in aggregate supply. Overall, while there are many theories that explain the causes of inflation,

based on enumerable empirical studies, relying on one school of thought might not be wise. In

India also there were many studies on inflation determinants and their conclusions are quite

diverse.

As the behavior of inflation is very dynamic the theoretical explanations of this behavior could

also be dynamic. Hence, this needs to be examined on a regular basis.

INFLATION AND GROWTH CONCERNS IN INDIA

Two sets of recently released figures on the economy - the Index of Industrial Production (IIP)

and inflation - have set off an interesting debate about the direction of our monetary policy. The

RBI has become caught between the never ending debate about making a trade-off between

inflation and growth.

Recently released CSO data on the IIP indicates that industrial growth decelerated in January

2008 to 5.3%, compared to 11.6% for January 2007. The biggest hit was taken by the two critical

engines of industrial and consequently economic growth - consumer durables and capital goods.

While the former fell 3.1% ( a rise of 5.3% in Jan 2007), the later rose a mere 2.1% (16.3% in

Jan 2007) for the month of January 2008. However, Fast Moving Consumer Goods (FMCG,

consumer non durables), exhibited a 10.1% growth in January, compared to 9.1% last year. Food

products, beverages, tobacco etc showed double digit growth. The growth rate of the core

infrastructure industries group - crude petroleum, petroleum refinery products, coal, cement,


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electricity and steel - which has a 26.7% weight age in the overall IIP fell from 4.2%in January,

compared to 8.3% in January 2007.

Wholesale Price Index (WPI) had already begun to breach the self-imposed year-on-year 5%

tolerance level in the third week of February and continues to rise. WPI based inflation rate

breached the critical 5% mark to close at 5.11% for the week ended March 1, 2008, the highestin over nine months. It further rose to 5.92% when the latest figures were released for the week

ended March 8, 2008, to reach the highest figure since May 7, 2007. The prices for cereals

increased 6.28%, for milk 9.71%, vegetables 9.79%, dairy products 9.31%, cement 5.13%, iron

and steel 20.87%, and edible oils 17.52%.

There are many reasons to doubt that the drop in capital goods is not part of any long term trend.

For a start, statistically 2006-07 was an year of extraordinary industrial growth, with the final

quarter growth being 12.5%. Sustaining this was not realistic and maybe not even desirable,

given the strains it would place on an already stretched out economy. Investments in the main

consumers of capital goods like infrastructure have been growing and shows no signs of

slackening. The order books of the main capital goods manufacturers remain buoyant and their

sales numbers have shown robust growth. In fact, the key listed capital goods companies grew by

about 33 per cent in the last quarter of 2007, in comparison to the same period last year.


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The already committed investments in these sectors may be enough to sustain the present capital

goods growth trends in the near future. The projected expenditures in these non tradable services

like ports, airports, highways, power, urban infrastructure, telecommunications etc is massive,

are by themselves capable of sustaining very high growth rates. The Government's own flagshipprograms like the Golden Quadrilateral and other National Highway projects, PMGSY,

JNNURM, and the programs to promote PPP in core infrastructure, should provide more than

adequate demand side stimulus to sustain high rates of growth for sectors like capital goods. The

demand for both residential and commercial real estate is both massive and ever growing, and

has not shown any signs of slackening. The critical inputs to infrastructure sector like steel and

cement, after a blip in January, exhibited robust growth in February.

The construction sector, which encompasses all these infrastructure investments, exhibited one

of the lowest sectoral ICORs in the Tenth Plan period at a very low 1.2. It has also been shown

that construction sector generates one of the highest employment rates for every rupee

investment. All this will ensure that the economic multiplier will be significant from these

committed and projected investments. So any talk of a major slowdown may be not based on any

logical foundations.

The recent budget cut CENVAT on all goods from 16% to 14%, excise duties on automobiles

from 16% to 12%, excise duties on drugs and diagnostic equipments, and some packaged food

items from 16% to 8%. These rates were cut with the objective of lowering prices and thereby

spurring consumption and boosting industrial and business activity. The consumer durables

sector, especially two-wheelers and automobiles, is expected to be one of the largest

beneficiaries of this. The Sixth Pay Commission is expected to put nearly Rs 350 billion in the

hands of consumers, thereby providing a major fillip to manufacturing demand. These are all


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strong stimulus measures that are expected to keep aggregate demand high, and thereby keep the

corporate investment climate healthy.

MEASURE STEPS TO CONTOL

The Government have responded to the rising food and commodity prices by piecemeal and

stop-gap measures like price controls, freeing imports, banning exports (on edible oils), lowering

customs duties (on rice and edible oils), imposing export duties (on steel), and prohibiting futures

trading (on food grains). These efforts are based on the wishful but futile assumption that it is

possible to insulate the Indian economy from the global trend of rising food and commodity

prices. This attempt at importing deflation by freeing up the external sector has severe

limitations, given the small quantities involved in such trade and the high prices prevalent in the

global markets.

The rising global commodity prices, both food and non-food, has pushed up import prices.

Addressing this inflation with monetary policy levers may not only not yield results, but may

backfire badly, especially at a time when growth itself is slowing down. That the inflation is not

driven by demand side pressures is also clear from the fact that growth in money with the public

has declined form a very permissible 17% to an even less 14% in February, 2008. The RBI

figures show that money supply which has been growing at 22.2% annually, is slowing down to

an estimated 21.2%. It is clear that while the demand side is robust, the supply side appears

constrained. The rise in inflation is therefore more due to cost push factors than demand pull

ones.

The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The

major domestic supply side bottle necks that have been driving prices up include stagnating

agricultural production, declining private capital investments in manufacturing, and over-

stretched infrastructure, especially power and transport logistics.

The domestic supply side factors that are driving inflation need to addressed through someimmediate policy interventions. Infrastructure bottlenecks are an immediate priority that will

continue to strangle any economic growth. It is impossible for India to grow at double digit

growth rates, by maintaining low inflation, without massive investments in its creaking

infrastructure. Agriculture investments, both physical and those aimed at improving productivity,

have been declining and this is manifested in the stagnating production, thereby forcing imports.


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This needs to be addressed immediately on the highest priority, especially given the large share

of population dependent on agriculture.

The external sector has also been a significant determinant on price increases. Since 2004, import

prices of oil have soared from $34 to $110, palm oil from $471 to $1177, and Thailand rice from

$225 per tones to $510 per tones. Our import basket has taken an enormous hit, and naturallyinflationary pressures have been building up. Commodity prices worldwide - food grains, cash

crops, energy and metals - have been growing at an alarming rate. Over the six years to February

2008, the Goldman Sachs broad commodity index jumped by 288 per cent, the energy price

index by 358 per cent, the non-energy index by 178 per cent, the industrial metals index by 263

per cent and the agricultural index by 220 per cent.

All this will also reduce the demand for oil and other energy supplies. Economic growth in the

merging economies too will drop, though not sharply, thereby further reducing domestic demand

in these markets. All this is likely to result in lower commodity prices, which will benefit large

domestic market and commodity import dependent economies like India and China.

What should the Government do at such times?

Such times are a strong reminder of the continuing need to maintain a robust and effective Public

Distribution System (PDS), which would help insulate at least the poorest of the poor from

global economic volatility. It is also a reiteration of the importance of food security, and the need

to make investments in agriculture with the objective of increasing productivity and thereby

expanding production. There is very little Governments can do to control the rising commodity

and energy prices, apart from cosmetic exercises that play to the galleries, but will achieve

precious little. Aggressive promotion of investments in infrastructure will be important for

easing the constraints faced in a sector vital for promotion of overall economic growth.

These times also highlight the immense complexity involved in aggressively interventionist

market controlling approaches like price controls and duty hikes. Therefore, in suchcircumstances, if the Government decides to assist a category of consumers with some subsidy, it

is more appropriate that such subsidies be transferred as direct cash transfers than by meddling

with the price mechanism. Such measures are better able to co-ordinate with the market and

deliver the full bang for the buck. Besides, it will also prevent market distortions that have

consequences that often go much beyond the duration of the crisis itself.


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What should the RBI do to ward off inflationary pressures or

CONCLUSION?

It appears that the RBI's dilemma can be resolved if not by easing the monetary policy, but atleast by holding on to it, so as to address growth concerns. Any tightening of monetary policy

would have serious implications at a time when the investment climate is not at the pink of

health. Further, in a cost push inflation scenario, any monetary tightening will be ineffective.

It also a timely reminder about the need to keep a low interest rate cushion when the economy is

doing well, so that it gives the Government a sufficient enough interest rate buffer that it can

exercise and increase rates when inflation rears its head. In fact, we should have lowered the

interest rates late last December itself, in anticipation of such a reality, given the storm clouds

that were then gathering around the US economy.

For the foreseeable future ahead, Indian economy will have inflationary pressures stoked up due

to factors that are cost-push than demand-pull. Inflation is more likely to arise out of the

economy's inability to provide the critical inputs necessary to sustain the fast pace of growth. In

such circumstances, monetary policy will be more critical in lowering the cost of capital and

encouraging growth, and will have only a minimal role in controlling inflation.

In the final analysis, a 7-7.5% GDP growth rate is by any yardstick a very good deal, especially

at a time of such tumult in the global economy. Given the fact that the robust 9% plus growth of

the past few years, was taking its toll on an over-stretched economy and supply side constraints

were becoming increasingly evident, a relative cooling off should even be welcomed.

Given all our supply side constraints and infrastructure bottlenecks, sustaining a 9% growth

without stoking off inflation was an impossibility. A slowdown in growth to 7-7.5% should suit

us, in so far as it would help prevent over-heating and consequent build up of inflationary

pressures, all of which have the potential of squeezing medium-term growth itself.

ACKNOWLEDGEMENT

Iexpress my sincere gratitude and thanks to DR.NIDHI GUPTA for his valuable and unmatchedguidance and sincere efforts in trying to make us not just familiar but well equipped with the


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fundamentals and building stones of the research work. The efforts put up by us during the

development of this project would not have been fruitful, if it were not the people around us,

who encouraged us at all times. Taking this opportunity, further we would like to thank the staff

and the faculty members of the institution for being there whenever we need their help.

We are also grateful to Prof. Col. Mahander Singh Director General, RDIAS for his expertguidance and cooperation in making our project learning and worthwhile experience.


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Economics Sahil

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