Inflation Control Measures… A Paradox!

Why Inflation!

In simple terms, it is Inflation if the prices of most goods go up. Such rate of increases in prices may be both slow & rapid and it’s difficult to define in an unambiguous sense.

Causes of Inflation are many and varied. One of the most popular types of Inflation is DPI (Demand Pull Inflation) which states that an increase in AD (Aggregate Demand) over the available output leads to a rise in the price level.

Classicists attribute this rise in AD to Money supply while Keynesian hold a different argument.

According to them, there can be an autonomous increase in AD, such as a rise in consumption demand or investment or govt. spending or a tax cut or a net increase in exports with no increase in money supply. This would prompt upward adjustment in price.

So DPI is caused by both Classical adjustment and Keynesian argument.

Today, Inflation has been a highly debated issue in the economic world. One of the goals of modern Government is to control inflation and ensures Price Stability in economy (Keynes opined for Government intervention – like fiscal instruments to check the inflation while Classicists opined for a small and low budget by the government).

According to Classicists Inflation fallacy, when inflation occurs, the buyers of goods and services pay more for what they buy, but at the same time sellers of goods and services receive more for what they sell.

Thus, according to this view, on account of inflation, people lose with one hand, but gains with the other. As a result, there is no net loss due to inflation.

People earn their income by selling their services, physical or mental. In course of inflation, prices of services also rise to some extent along with the rise in prices of goods.

Thus Inflation does not reduce the real income of the people. Conversely Keynes argued that buyers and sellers are two different classes of the society and as such this fallacy does not hold true.

So, far social cost of Inflation is concerned, Fisher suggested that, high rates of Inflation lead to low rate of sustained economic growth. Some American Economists believe that there are no or little social costs of inflation.

In the United States, where prices of services may increase in response to anticipated inflation, nominal incomes from services keep pace with the rising prices of goods; there is no adverse effect of inflation on real incomes of the people. But what is true for America is not true for India.

In India, prices of services do not adjust partially and therefore rising prices of goods erode the purchasing power of their nominal incomes and therefore adversely affect the living standards of the people.

A large part of the country is unorganized where people do not automatically raise the prices of their services. Even in organized sector, rise in money wages lag much behind the rise in price level.

Landless agricultural workers, casual labor in both the rural and urban areas (petty wage earner) fail to change their wages over years even there is rapid inflation in the economy.

Inflation, therefore rightly considered as an enemy no 1 of the poor people. Basically, these arguments for inflation lead to DMP (Demand Management policy) which may be broadly grouped into:

  •       Fiscal Policy
  •       Monetary Policy

As an Inflation control measure, Fiscal Policy may be defined in one word “Reducing Budget Deficit”.

When there is overall budget deficit (Both Capital & revenue Budget) of the Govt, the only technical way of creating new money is to borrow money from the Federal Reserve i.e. RBI, against its own securities. This is so because the Government has to pay neither the rate of interest nor the original amount of that case.

Thus the excess expenditure by the Government (Budget Deficit) financed by newly created money lead to the rise in income of the people.

This causes the AD of the country to rise to a greater extent than the amount of deficit financing undertaken through the operation of what Keynes called “Income Multiplier”.

In the opinion of many economists the injection of money supply caused by deficit financing leads to expansion of AD in the economy AS (Aggregate Supply) of output is inelastic in nature.

An important factor responsible for current inflation in the Indian Economy is that the supply of essential consumer goods such as food grains, cloths etc are highly volatile, which ultimately generate DPI.

On the other hand, in controlling inflation, the network of monetary policy is squeezing credit. As a demand management instrument, monetary policy works in two ways:

  • Influence Cost of Credit
  • Influence the credit availability to private business firms

So far Cost Of Credit is concern, the higher the rate of interest, the greater the cost of borrowing from the banks by the business firms (may cause Crowding Out Effect) and also to provide incentives for saving more.

In the fifties and early sixties, the cheap credit policy (i.e. lower interest rates) was recommended on the ground that lower rate of interest will promote more private investment which is an important factor determining economic growth.

The cheap money policy was adopted in India up to 1964, which did not prove effective because private investment demand has been empirically found to be interest inelastic.

ROLE OF THE RBI TO CONTROL INFLATION

While RBI ACT,1934 has given full power to RBI to use all traditional instruments of credit control, on the other hand Banking regulation Act has given some additional power to use some direct methods of credit control.

Formal methods of credit control comprises of Bank rate, OMOs, Refinance policy,Variable Reserve ratios(CRR,SLR), Selective Credit Control Methods like Credit planning, Rationing of credit, Differential interest rates, Control of Consumer Credit, Credit Authorization Scheme, Fixation of Margin Requirement etc.

Informal method consists of Moral Suasion, Direct orders etc. The monetarists today, emphasizes that it is the chance in credit availability rather than cost of credit( i.e, interest rate), is a more effective instrument of regulating Aggregate Demand. For example, OMOs is a effective to reduce credit availability.

Under OMOs, the Central bank sells Government securities. Commercial banks, buy these securities will make payment for them in terms of cash reserves.

As a result, the banks capacity to lend money to the business firms will be curtailed and less loanable funds reduce investment demand by the business firms.

However, in India OMOs do not play a significant role as an instrument of credit control to fight against  inflationary situations. As the market for Government securities is narrow as well as captive.

Compulsion by law(i.e.,purchase of such securities) directs Commercial banks, LIC,GIC and Provident funds to invest a certain proportion of their funds in buying Government securities.

Thus in the context of captive market for Government securities OMOs cannot be use fully for checking inflation.

In India, it is the CRR(cash reserve ratio) which can be raised to curb inflation. In recent years to squeeze credit for checking inflation, CRR( max 15%, min 3%) has been raised from time to time.

Another instrument for affecting credit availability is the SLR ( statutory liquidity ratio, max 40%).

According to SLR, in addition to CRR, banks have to keep a certain minimum proportion of their deposits in the form of specified liquid assets, and for this purpose is government securities.

However, Narasimham Committee did not favor a high SLR. In its opinion, the SLR had become an instrument in the hands of the Government to mobilize resources in support of the central and state budget.

Further a significant increase in SLR does not mean that monetary policy was quite restrictive during 1963 to 1990.

An increase in SLR does not restrain total expenditure on the other hand is likely to increase.  Therefore, SLR is not a technique o0f monetary control.

SELECTIVE AND DIRECT CREDIT CONTROLS

In India, the SCCs are being used by the RBI to prevent speculative hoarding of commodities so as to check the rise in prices of these commodities.

The SCCs in India are being used in case of food grains, oilseed,vegetable oils, cotton, sugar, gur and khandi sari.

Generally RBI uses three kinds of Selective Credit Controls:

A) minimum margins for lending against specific securities.

B) ceiling on the amounts of credit for certain purposes; and

C) discriminatory rate of interest charged on certain types of advances.

The success of the SCCs also depends upon the extent to which the funds from non-bank sources is available to the businessman.

When the bank credit for a particular purpose is reduced, the businessman can use their own funds to borrow from non-regulated money markets for speculative holding of inventories.

In India, today the businessman have large quantities of black money with them which they generally use for speculative hoarding of inventories of sensitive commodities and in this way succeed in defeating the purpose of selective controls.

SUPPLY MANAGEMENT THROUGH IMPORTS

In some cases, to correct excess demand relative to aggregate supply, AS can also be raised by importing goods in short supply. When inflation is of the type of supply- side inflation, imports are increased to augment the domestic supply of goods.

To increase imports of goods in short supply the Government can reduce custom duties on them so that their imports become cheaper and therefore their imports help in containing inflation.

This is also a good controlling measure against hoarding of goods by a section of businessman for speculative purposes. The attempt by the Government to import goods in short supply would compel the hoarders to release their hoarded stocks.

However, when international prices of commodities are high, their imports cannot be very helpful for tackling domestic inflation.

INCOME POLICY : FREEZING WAGES

One popular anti-inflationary measure which has often been suggested is the avoidance of wages increases which are unrelated to productivity.

This requires exercising control over wage-income. some economists are of the opinion that it is through wage-price spiral that inflation inflation gets momentum.

When cost of living rises due to initial rise in prices, workers demand higher wages to compensate for the rise in cost of living. When their wage demand are conceded to, it gives rise to cost-push inflation.

This generates inflationary expectations which add fuel to the fire. However, if wages are raised equal to the increase in the productivity of labor, then it will have no inflationary effect.

However, freezing wages and linking it with productivity only irrespective of what happens to the cost of living has been strongly opposed by trade unions to ensure social justice.

 

INFLATION RATE AND FOOD ARTICLES PRICE CRISIS

In its report on Macro-Economic and Monetary Developments in 2011-12, The RBI claimed that ” the inflation ate is likely to remain sticky at about current levels” ( Inflation stood at 6.95 per cent in February, 2012).

Even though inflation declined marginally to 6.89 per cent in march,2012, but the prices of food articles rose sharply to 9.94 per cent.

The Finance Minister of India describes it as a ” disturbing factor “. Food articles have a 14.3 per cent share in the WPI.

Vegetable prices increased to 30.57 per cent from 1.57 per cent in February 2012. Milk become expensive by 15.29 per cent, While rice and cereals turned costlier by 4.73 per cent respectively.

price pressures persist with considerable suppressed inflation in crude oil, electricity and fertilizers and as a result BOP is under significant stress.

Finally there is steep fall in industrial growth.  In the light of above, the RBI unveils the annual monetary policy in April 2012.