1.4 Monetary Policy

Monetary Policy

Macroeconomic tool to manage money supply to achieve specific goals such as: constraining inflation maintaining appropriate exchange rate generating jobs economic growth balancing savings and investments

Tools available: Bank rate Reserve ratios (CRR, SLR, etc.) OMO Intervention in the FOREX markets Moral suasion

Bank Rate 9%

Rate at which RBI lends to commercial banks; used to manage money supply and credit; Revision in bank rate is a signal by RBI to banks to revise deposit rates and PLR.

It is usually not changed unless demand is extraordinary

Statutory Liquidity Ratio (SLR)

23%

Banks are required to maintain liquid assets in form of gold, cash and approved securities

Reduction of SLR provides banks with greater money thus enabling them to lend money at lower interest rates

SLR’s primary function is to ensure govt. funding No floor on SLR (RBI Amendment 2006)

Cash Reserve Ratio (CRR)

4.5%

It is a portion of the bank deposits that the bank should keep with the RBI in cash form No interest is earned on CRR No ceiling and floor rate (RBI Amendment 2006) CRR’s primary function is inflation management It is used only when there is a serious need to manage credit and inflation (Great

Recession), otherwise Repo and Reverse Repo Rates (policy rates) are used

Repo Rate 8%

Rate at which RBI lends money to commercial banks and financial institutions on short term basis against govt. securities.

Banks undertake to repurchase the security at a later date – overnight or few days at a pre-determined price

Reverse Repo Rate 7%

Rate at which RBI borrows money from commercial banks and financial institutions on short term basis against govt. securities

Open Market Operations (OMO)

“Outright” purchase and sale of govt. securities in the open market by RBI in order to influence the volume of money and credit in the economy

It doesn’t change the total stock of govt. securities but change the proportion held by RBI, commercial and cooperative banks

It does not involve re-purchase operation

Liquidity adjustment facility (LAF)

Objective: Funds under LAF are used by the banks for their day-to-day mismatches in liquidity Banks use this facility at repo and reverse repo rates

Discretion of RBI: Under the revised Scheme, RBI will continue to have the discretion to conduct

overnight reverse repo or longer term reverse repo auctions at fixed rate or at variable rates depending on market conditions and other relevant factors

RBI will also have the discretion to change the spread between the repo rate and the reverse repo rate as and when appropriate

Marginal Standing It was introduced in 2011-12 by the RBI

Facility

Under this, banks have been allowed to borrow overnight at their discretion, up to 1% of their respective net demand and time liabilities (NDTL), at 1% more than the repo rate.

What is the difference b/w LAF-repo rate and MSF? Under LAF-repo rate, banks have to borrow by pledging government securities over and

above the statutory liquidity requirement of 24%. But in case of borrowing from MSF, banks can borrow funds within the statutory liquidity ratio of 24%.

Selective Credit Controls

On the orders of RBI for a specific sector, either: Credit can be rationed Interest rate can be hiked

This effectively controls the money available to that sector thus discouraging activities like hoarding and black marketing

Total quantum of credit does not change and the general line of interest remains the same

Moral Suasion

A persuasion measure used by RBI to influence and pressure but not force banks into adhering to policy. Measures used are:- Closed door meetings with Directors Increased severity of inspections Discussions, appeal to communicative spirit

Exchange Rate ‘Management’

through Monetary Policy

Although in India, we have free floating exchange rates, but sometimes RBI steps in to prevent excess volatility, so in effect India has managed float

Say, the economy is being flooded by excess dollars (extraordinarily excess FIIs or FDIs or QE done by another country), these dollars need to be mopped up RBI needs FOREX Regulate the appreciation of Rupee. (Exports Affected)

RBI prints rupees and buys these excess dollars This printed money is called base money or reserve money or high powered money

This excessive liquidity needs to be mopped up due to inflationary concerns and is done by a mixture of: Hike in interest rates Increase in CRR Selling Market Stabilization bonds (MSBs)

Market Stabilization Bonds (MSB)

In extraordinary times, the trade of existing securities through OMO and LAF is not sufficient to reduce liquidity in the market (See – Exchange Rate ‘Management’)

In that case, Govt. has to generate and sell MSBs These new securities create an additional burden on the govt. as it has to pay coupon

rates on the bonds leading to ‘Quasi Fiscal Burden.’ This is a costly process.

Liquidity Trap

To combat recession, central bank tries to increase liquidity by cutting interest rates. Once, interest rates reach zero or near zero, central bank can do no more. However, the excess liquidity may be trapped in the banks, where in banks do not want

to lend as credit may turn into bad asset, and businesses do not want to borrow as demand has slumped.

Japanese economy in the late 90s and more recently US and Europe during the recession where interest rates are nearly zero.

Way out of Liquidity Trap: QE or Aggressive Fiscal Policy (Might lead to sizeable FD)Quantitative Easing

(QE) Extreme form of monetary easing used to stimulate an economy where interest rates

are either at or close to zero and have failed to revive the economy Central bank purchases financial assets including treasury and bonds from financial

institutions using the money it has printed

QE I & II = $700 billion each

Floating Rate of Interest rate offered by the bank floats in relation to the rate of govt. security

Interest instrument of similar maturity period

Inflation targeting Policy approach adopted by govt. & RBI in conjunction, to keep inflation in particular

range Proper coordination of fiscal and monetary policy is must, but India does not follow it

Fiscal v/s Monetary Policies

Monetary Policy is very dynamic as it is not only a tool to fight inflation and recession (although limited efficacy), it also takes into account such diverse factors: Signals to the economy by way of rate and reserve adjustment Exchange rates Credit quality International capital flows of money on large scales

M1, M2, M3, M4 M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + ‘Other’

deposits with the RBI) M2: M1 + Savings deposits with Post office savings banks M3: M1+ Time deposits with the banking system (this is also called broad money) M4: M3 + All deposits with post office savings banks (excluding NSC)Recent Trends

Interaction b/w Monetary and Fiscal Policy

Recession

Monetary

Limited Usage. Reduced Rates may not help. Liquidity Trap

Unconvenional Measures like QE

Fiscal

Makes more sense. Unless fiscal stimulus not used judiciously.

Sovereign debt crisis in Europe

Inflation

Monetary

If inflation is demand driven, i.e due to excess money supply, monetary

policy will work.

If it is supply driven, not much use. Eg- Rise in price of onions due to

hoarding

Fiscal

Unpopulist measures like reduced spending and raising taxes. Govt.

though will not spend money. May not be the best thing for a

democratic govt.

(Have to Understand This)

Monetary and fiscal policies in any country are two macroeconomic stabilization tools. However, these two policies have often been pursued in different countries in different directions. Monetary policy is often pursued to achieve the objective of low inflation to stabilize the economy from output and price shocks. On the other hand, fiscal policy is often biased towards high growth and employment even at the cost of higher inflation (Alesina and Tabelini, 1990; Aurbach, 2004). For achieving an optimal mix of macroeconomic objectives of growth and price stability, it is necessary that the two policies complement each other. However, the form of complementarity will vary according to the stage of development of the country’s financial markets and institutions.

Furthermore, the recent global financial crisis has once again demonstrated the importance of coordinated response of monetary and fiscal policies. Sovereign debt problem in many countries in the euro area, in particular, has also underlined the need for monetary and fiscal policies coordination.

In the context of developing economies, it is often viewed that there is complete fiscal dominance and the central bank is subservient to the fiscal authority (Fischer and Easterly, 1990; Calvo and Vegh, 1999). Therefore, it is argued that the issue of coordination may not arise since the very concept of coordination arises only when the two institutions are independent. However, it is argued that actual execution of the two policies could significantly differ from what could be expected from the institutional arrangements (Arby and Hanif, 2010). Furthermore, irrespective of the dependence/independence of the two policies, there will be interaction between these two policies. The nature of the interaction, however, will be conditioned by the institutional framework. The institutional arrangements have been changing in many developing countries as they are moving towards making central banks more independent, implying time varying behaviour of the interaction between the two policies, which has important implications for the objectives of macroeconomic stabilisation. Thus, from the macroeconomic policy point of view, it is important to empirically verify the nature of the interaction.

In India also, several changes have taken place in the monetary and fiscal policy frameworks, particularly since the beginning of the 1990s. These include complete phasing out of automatic monetisation of fiscal deficit through creation of ad hoc treasury bills (also called ad hocs) in 1997 and prohibiting RBI from buying government securities in the primary market from April 2006 under the Fiscal Responsibility and Budget Management (FRBM) Act, 2003. These changes are quite significant and have altered the basic nature of the interaction between monetary and fiscal policies. However, the central government continues to incur large fiscal deficits, which has implications for the demand management by the Reserve Bank. In this backdrop, the paper empirically examines the interaction between monetary and fiscal policies in India in the recent period. In particular, the focus is on examining the monetary and fiscal policy responses to shocks in output and inflation.

Evolution of Monetary and Fiscal Policy Interface in India The framework for monetary and fiscal policy interface in India stems from the provisions of the Reserve Bank of

India Act, 1934. In terms of the Act, the Reserve Bank manages the public debt of the Central and the State Governments and also acts as a banker to them. The interface between these two policies, however, has been continuously evolving. In the pre-Independence days, the Colonial Government adopted a stance of fiscal neutrality. However, requirements of the World War II necessitated primary accommodation to the Government from the Reserve Bank.

In the post-Independence period, the monetary-fiscal interface evolved in the context of the emerging role of the Reserve Bank. Given the low level of savings and investment in the economy, fiscal policy began to play a major role in the development process under successive Five-Year Plans beginning 1950-51. Fiscal policy was increasingly used to gain adequate command over the resources of the economy, which the monetary policy accommodated. Beginning the Second Plan, the Government began to resort to deficit financing to bridge the resource gap to finance plan outlays. Thus, the conduct of monetary policy came to be influenced by the size and mode of financing the fiscal deficit. Consequently, advances to the Government under the RBI Act, 1934 for cash management purposes, which are repayable not later than three months from the date of advance, in practice,

became a permanent source of financing the Government budget deficit. Whenever government’s balances with the Reserve Bank fell below the minimum stipulation, they were replenished through automatic creation of ad hoc Treasury Bills. Though the ad hocs were meant to finance Government’s temporary needs, the maturing bills were automatically replaced by fresh creation of ad hoc Treasury Bills. Thus, monetisation of deficit of the Government became a permanent feature, leading to loss of control over base money creation by the Reserve Bank.

In addition to creation of ad hocs, the Reserve Bank also subscribed to primary issuances of government securities. This was necessitated as the large government borrowings for plan financing could not be absorbed by the market. This, however, constrained the operation of monetary policy as it led to creation of primary liquidity in the system and entailed postponement of increases in the Bank Rate in order to control the cost of Government borrowings. The Reserve Bank Act, therefore, was amended in 1956 empowering the Reserve Bank to vary the cash reserve ratio (CRR) maintained by banks with it to enable control of credit boom in the private sector emanating from reserve money creation through deficit financing.

The Statutory Liquidity Ratio (SLR) under the Banking Regulation Act, 1949 was originally conceived as a prudential requirement to ensure availability of sufficient liquid resources in relation to the liabilities by banks for meeting sudden drain on their resources. However, through a gradual hike the SLR became essentially an instrument to secure an increasing captive investor base for government securities to finance the increasing expansion in the government’s fiscal deficit, particularly after the nationalisation of banks in 1969.

With the fiscal policy laying greater emphasis on social justice and alleviating poverty in the 1970s, monetary policy shifted from ‘physical planning’ in the financial sector to ‘credit planning’ in terms of direct lending and credit rationing. This altered the nature of relationship between the Reserve Bank and the Government, with the former playing a limited role in the structure of the financial system and use of the interest rate as a monetary policy instrument. The single most important factor influencing monetary policy in the 1970s and the 1980s was the phenomenal growth in reserve money due to Reserve Bank’s credit to the government. With little control over this variable, monetary policy focused on restricting overall liquidity by raising the CRR and the SLR to high levels.

In pursuance of the recommendations of the Chakravarty Committee (1985), the monetary policy strategy shifted from the credit planning approach to a monetary targeting approach from 1986-87. This entailed clear assessment of primary liquidity creation consistent to achieve broad money supply (M3) - the target under the monetary targeting framework. The exercise of setting monetary targets was taken up immediately after the presentation of the Union Budget, which provided the magnitude of budget deficit and the level of market borrowing programme.

The balance of payment crisis of 1991 recognised the fiscal deficit as the core problem. It, therefore, necessitated a strong and decisive coordinated response on the part of the Government and the Reserve Bank. Assigning due importance to monetary management, fiscal consolidation was emphasised and implemented in 1991-92. An important step taken during the 1990s with regard to monetary-fiscal interface was phasing out and eventual elimination of automatic monetisation through the issue of ad hoc Treasury Bills. Through Supplemental Agreements between the Reserve Bank and the Government of India, beginning September 1994, creation of ad hocs was completely phased out from April 1997. Thus, the recourse to monetisation was substantially lowered during 1990-91 to 1996-97. This enabled the Reserve Bank to bring down the CRR and the SLR, thereby freeing resources of the banking system for the commercial sector and set the stage for the Reserve Bank to reactivate its indirect instruments of monetary policy. The Reserve Bank used the Bank Rate as an instrument of monetary policy after a decade in 1992, reactivated OMO as an instrument of monetary management, introduced auctioned system for primary issuance of government securities and instituted a liquidity adjustment facility to manage day to day liquidity in the banking system.

Although with phasing out of automatic monetisation through the ad hoc Treasury Bills reduced the fiscal dominance on monetary policy considerably, it did not eliminate the dominance altogether. In view of underdeveloped stage of the G-Sec market, for some years beginning the latter half of the 1990s, the Reserve Bank had to adopt a strategy of undertaking private placement/devolvement of government securities in the

face of adverse market conditions and offloaded them through open market sales when conditions became more conducive. However, with the enactment of FRBM Act, 2003, the Reserve Bank has been prohibited from subscribing to government securities in the primary market from April 1, 2006. This provided the Reserve Bank provided with a greater flexibility in its conduct of monetary policy.

Even though fiscal dominance through automatic monetisation of fiscal deficit has been done away with over the years in India, the influence of fiscal deficit on the outcome of monetary policy has continued to remain significant given its high level. High fiscal deficit, even if it is not monetised, can interfere with the monetary policy objective of price stability through its impact on aggregate demand and inflationary expectations.

VI. Summary and Concluding Remarks This study analyzed the behavior of interaction between fiscal and monetary policies in India using quarterly

data for 2000Q2 to 2010Q1. The choice of period of the study was influenced by the operating procedure of monetary policy in India which underwent a paradigm shift in the early 2000 with the introduction of liquidity adjustment facility and the interest rate channel becoming the main monetary policy signaling instrument. The complete phasing out of automatic monetization of fiscal deficit by april 1997, the fiscal dominance over monetary policy had also eased substantially. Furthermore, the FRBM Act, 2003 prohibited the Reserve Bank from buying government securities in the primary market from April 2006.

Granger causality tests indicate that fiscal policy continues to unilaterally influence monetary policy even after the elimination of automatic monetization of fiscal deficit and prohibition of RBI from buying government securities from the primary market. The impulse response functions from VAR analysis showed that monetary policy is highly sensitive to shocks in inflation and it responds swiftly in a counter-cyclical manner. However, the response of fiscal policy shows a pro-cyclical tendency to both inflation and output shocks, which perhaps explains as to why monetary policy responds strongly than otherwise it would have.

The study also suggests that expansionary fiscal policy is effective in raising the level of output over the potential level only in the short run. In the medium to longer term, however, fiscal expansion leads to economic slowdown. It seems fiscal deficit leads to decline in savings and investment in the economy over the medium term, besides crowding-out more efficient private sector investment by government consumption.

1.6 Inflation

ConceptInflation: Concepts, facts and policy

Inflation

Definition: Persistent rise in prices of goods and services

Classification of InflationCreeping 1 to 5%; manageable (good for economy)Trotting 5 to 10%; Galloping 10 to 20%Runaway More than 20%

HyperinflationPrice increases rapidly may lead to monetary collapse – currency loses its value

Types of inflation

Demand pull inflation Increase in demand due to increased private and govt. spending Expansionary RBI Monetary policy Excess FDI/FII investment in the country Consequences:

Real GDP rises and unemployment falls If supply is augmented to adjust to demand prices come down again so may be referred

to as growth inflation

Cost push inflation (supply shock inflation) By reduced supplies due to increased cost of production or due to increase in money-wages

at speedier rate than that of the rise in the productivity of labor which results in further increase in prices.

Structural inflation It is a kind of persistent inflation Caused by deficiencies in certain conditions of the economy such as backward agricultural

sector, inefficient distribution, and inadequate storage facilities. Change in consumption pattern due to rise in income and inability of the economy to adjust

accordingly

Other causes of inflation include Speculation, Cartelization and Hoarding practices

Headline Inflation

It is a measure of the total inflation within an economy and is affected by areas of the market which may experience sudden inflationary spikes such as food or energy. As a result, headline inflation may not present an accurate picture of the current state of the economy.

This differs from core inflation or underlying inflation, which excludes factors such as food and energy costs.

Headline inflation is more useful for the typical household because it reflects changes in the cost of living, while core inflation is used by central banks because core inflation is less volatile and shows the effects of supply and demand on GDP better.

WPI is usually considered as the headline inflation indicator in India Trends for 2012-13 (Economic Survey 2012-13):

Headline WPI inflation remained relatively sticky around 7 to 8% in 2012-13 and moderated to a three-year low of 7.18% in Dec 2012. The decline is mainly due to moderation in non-food manufacturing inflation (or core inflation)

Major contributory factors to headline inflation during 2011-12: higher primary articles prices driven by vegetables, eggs, meat, and fish due to changing dietary

pattern of consumers increasing global commodity prices especially metal and chemical prices which ultimately led to

higher domestic manufactured prices persistently high international (Brent) crude petroleum prices in the last two years averaging

around $ 111 per barrel (/bbl) in 2011 as compared to $ 80/bbl in 2010

Core or Underlying

Inflation

Measures the long term trend in the general price level Changes in the price of fuel, food and other volatile items are excluded Prices are not within the control of monetary policy in as much as these are supply shock Since March 2010, RBI has been using non-food manufacturing inflation (NFMI) as a core

inflation measure for India. NFMI is computed by excluding the prices of primary articles, fuel group and processed food from the WPI.

Trends for 2012-13: Core inflation declined to 4.24% in Dec 2012 from its peak of 8.35% in Nov 2011.

Apart from monetary measures taken b y the RBI, softening of international and domestic prices of metals, chemicals, and textiles products also contributed to its moderation.

Collection of Statistics,

2008

To bring in new rules for improving data collection within time and with accuracy Penalty of Rs. 1000/- for first default (14-days notice); and Rs. 5000/- per day thereafter Act also makes willful manipulation and omission of data a criminal offence punishable by

prison term upto 6 months It prevents or obstructs any employee from collecting data It gives powers to the govt. to classify any statistic as core statistics and also determine the

method to collect and disseminate the same.

Philips Curve

Given by Arthur W Phillips in 1958 It shows the relationship between the rate of

unemployment and the rate of inflation Lower the unemployment in an economy, the

higher the rate of inflation Concept has been proven empirically and some

govt. policies are directly influenced by it

Engel Law

Engel's law is an observation in economics stating that as income rises, the proportion of income spent on food falls, even if actual expenditure on food rises. In other words, the income elasticity of demand of food is between 0 and 1.

As indicated by NSSO surveys, and consistent with worldwide experience, there has been a structural (Engel's law) shift in the consumption pattern of consumers as they become richer, with an increase in consumption of protein-rich commodities like fish, meat, eggs, and milk, an ongoing long-term process.

NAIRU Non-Accelerating Inflation Rate of Unemployment It is the rate of unemployment at which inflation will remain stable In terms of output, NAIRU corresponds to highest level of real GDP that can be sustained

Deflation

Deflation is a prolonged and widespread decline in prices that causes consumers and businesses to curb spending as they wait for prices to fall further.

It occurs when economy's headline inflation indicator typically CPI enters negative territoryNegative Impacts if left unchecked it can lead to disinflationary spiral it makes more expensive to service existing debts this is especially true for governments who

have borrowed trillions of dollars globally as that becomes more expensive to pay off, the risk of default and bankruptcy rises too,

making banks more wary of lending this reduces demand and further exacerbate the deflationary problem

Remedy: Tax cuts to boost demand from consumers and businesses lowering central bank interest rates to encourage economic activity printing more currency to boost money supply capital injections into the banking system increase government spending on projects that boost the return on private investment

The three IndicesWPI

Indicator designed to measure the changes in the price level of commodities that flow in to the wholesale

trade Vital guide to economic analysis and policy formulation Not intended to capture the effects of price rise on the consumer, though it generally and broadly indicates it Compiled on weekly basis with a time lag of 2 weeks and this provisional weekly index is made final after 8 weeks

WPI published weekly by Economic Advisor, in the Min of Commerce and Industry

Abhijet Sen Committee Report 2008 (implemented in Sep 2010) Change base year to 2004-05 Alter the weight attached to each commodity group

New WPI Base year 2004-05 Total Items – 676. Manufactured – 555, Primary – 102, Fuel and Power - 19 241 new items added to reflect changes in India’s price line and new consumption pattern Consumer items

such as ice cream, flowers, mineral water, readymade food, computer stationary, VCD’s, etc. Almost 200 items dropped from old WPI such as Video Cassette Recorder, Typewriter, etc. Weight of Manufactured Items and Fuels increased, but primary articles decreased

Calculations Point to Point Basis. Week On Week Seasonal commodities – Weight gets transferred to other seasonal commodity or to existing ones

Advantages Covers lot of goods. Available with a short time lag of fortnight Convenient to Compile All India Character. The wholesale prices remain more or less same throughout the country. In contrast CPI,

the retail prices vary due to consumer preferences, Rural or Urban, Purchasing Power, Sales tax levied by state.

Disadvantages (even the new Index of 2010) Services not included. Transport, Healthcare, Rails, Postal, Banking. New Indices Expected – one for Financial

Services and the other on Trade and Transport Unorganized sector not included. 35 % of manufactured goods in unorganized sectors. Therefore not broad

based.Index of

Industrial Production

(IIP)

IIP measures factory output growth i.e. conveys the status of production in the industrial sector in a given period of time, in comparison with a fixed reference point in the past.

IIP estimate for a given month is always released within 6 weeks from that month. The data for the IIP estimate is supplied by 15 source agencies which include DIPP, Indian Bureau of Mines, CSO and Central Electricity Authority, among others. Compiled by CSO

The scope of IIP in India is confined to Mining, Manufacturing and Electricity sectors only. Gas production is also included in the Manufacturing sector

Old IIP Base year 1993-94 Highly volatile and unrepresentative of current market

New IIP Base year 2004-05 Criticized because of the volatility as in previous indicator

IIP figures are generally seen as an important but short-term indicator of whether industrial

activity in a country has risen or dipped, till more detailed studies or surveys are available. Investors can use the IPI of various industries to examine the growth in the respective

industry. If the IPI is growing month-over-month for a particular industry, this is a sign that the companies in the industry are performing well.

(for trends in IIP, refer to Key indicators towards the end of the file)Consumer Price Index

(CPI)CPI-IW

Industrial WorkersCPI-UNME

Urban Non-Manual EmployeesCPI-AL

Agricultural Labor 370 commodities (broad based) Base year 2001 Services included Compiled by Min of Labor

180 commodities Base year 1984-85 Services included/ Discontinued from 2008 Compiled by MOSPI

160 commodities Base year 1986-87 No Services NREGA wages from 2011 Compiled by Min of Labor

CPI-AL & UNME Main purpose – measuring the impact of price rise on rural and urban poverty Not considered as robust national inflation measures as they are highly specific After using CPI-AL for NREGS, max wages – Andaman and min wages - Meghalaya

CPI-IW & UNME Certain services included such as education, recreation, transport & communication But other big services such as trade, hotels, financing, insurance, real estate and business services do not find a

mention (refer Service Price Index)

Govt. released data for the new CPI. The figures for Jan 2012 (by CSO) are: CPI-Rural – 7.38% CPI-Urban – 8.25% CPI-National – 7.65% (CPI-N)

National Consumer Price Index (CPI-N) will be used for 7th Pay Commission The gap between the WPI and CPIs had widened in 2009-10 due to higher food inflation, as food items have a

much larger weight in the CPI vis-à-vis the WPI.

Service Price Index

SPI is being proposed by an expert committee headed by Prof. CP Chandrasekhar supported by Min of Commerce & Industry Services comprise 55% of the GDP

Producer Price Index

Mooted by RBI Guv in Jul 2012 Prices of goods as they are sold by the producers to the wholesalers Difference b/w PPI and WPI may be due to subsidies, excise, transport and distribution costs It will give an account of the economy's efficiency in transferring goods and services from the

producer to the consumer

GDP Deflator (National Income

Deflator)

Widest scope – encompasses the entire spectrum of economic activities including services Compiled by CSO using National Accounts Data Available only annually with a lag of 1 year Limited use for conduct of policy

Factors WPI CPI

Food Weightage Food 27%Larger weight in CPI ranging from 46% in CPI-IW to 69% in CPI-ALTherefore more sensitive to changes in prices of food items

Fuel Weightage 14.2%; More sensitive 5.5-8.4%Services Not covered Included to different degrees -

Need for an all-India average

No real need as wholesale prices are almost same throughout the country

Information collected from different centres and all-India average declared because consumer prices vary across regions and also across cities according to consumer preferences and purchasing power

IssuesProblems due to high inflation

Inflation discourages exports as the domestic sales can be more attractive Inflation may erode the external competitiveness of domestic products if it leads to higher production costs,

wage increases, higher interest rate and currency depreciationLogic: Export competitiveness depends upon two things – exchange rate and cost of production. Inflation will depreciate the currency making exports attractive (cheaper) but the increased cost of production (cost-push inflation) may increase the price of good and thereby creating unfavorable condition for exports. Inflation can drag down growth as the interest rates may increase (2 routes – RBI increasing CRR, etc or

increase in demand of loans in the domestic market) It will redistribute income from those with fixed incomes and shift to those who withdraw from inflation-

linked incomes or businesses. Savings in cash will not be preferred because of declining value of currency Strikes can take place for higher wages which can cause a wage spiral

Is small amount of inflation good for the economy? If it is a result of innovation Small price rise is necessary for wages to go up It helps economy to keep off deflation which can otherwise set off a recession Inflation at a moderate level is an incentive to the producer Ideal level of inflation – 4% according to Chakravarty Committee (1985) and 5.5% according to RBI

Growth vs. Inflation Trade Off in the short term inflation may be synonymous with growth but it has to be controlled because it affects the

poor disproportionately In the long term – Inflation will lead to a retarded growth due to reduced savings and investments