Introduction

Inflation is a global phenomenon in present day times. There is hardly any

country in the capitalist world today which is not afflicted by the spectre of inflation.
It is on account of this that the phenomenon of inflation has widely attracted the
attention of the economists all over the world but despite that there is no generally
accepted definition of the term “inflation” as it is a highly controversial term which
has undergone many modifications.

A common man understands that there is inflation when he buys his usual list of
commodities from the market. If there is an appreciable increase in prices, there is
indeed inflation and the media is already full of such bad news.

A simple definition of inflation is an increase in prices and or decline in

purchasing power. However over the years, the definition of inflation has
undergone a change.

According to the Webster's New Universal Unabridged Dictionary published in 1983

the second definition of 'inflation' after 'the act of inflating or the condition of being
inflated' is:

"An increase in the amount of currency in circulation, resulting in a relatively

sharp and sudden fall in its value and rise in prices: it may be caused by an
increase in the volume of paper money issued or of gold mined, or a relative
increase in expenditures as when the supply of goods fails to meet the demand."

So this broader definition focuses on money supply. If there is more money supply, it
causes an increase. So inflation is a cause rather than effect.

The American Heritage Dictionary of the English Language, 2000 (4th Edition)
defines it more broadly: a persistent increase in the level of consumer prices or a
persistent decline in the purchasing power of money, caused by an increase in
available currency and credit beyond the proportion of available goods and services.

In this definition, inflation would appear to be the consequence or result (rising prices)
rather than the cause.

Different economists have offered different definitions of inflation. In fact there is a

plethora of definitions of inflation. The layman however understands by the term
“Inflation” sizeable and a rapid increase in the general price level. Inflation in the

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popular mind is generally associated with rapidly rising prices which cause a decline
in the purchasing power of money.

Different Definitions of Inflation

Prof. Crowther has defined inflation as a state in which the value of money is falling
because prices are rising. “But this definition of Prof. Crowther is defective and does
not offer a complete picture of the phenomenon of inflation. This definition has been
criticized on two grounds:

(i) According to Crowther every increase in the price level is inflationary

and has harmful effects on the economy. On the contrary it serves as a
stimulant for the revival of economy.

(ii) Prof. Crowther’s definition emphasizes the symptoms rather than the
cause of the disease. The rise in the price level is a symptom rather than
the cause of inflation. This definition fails to explain why the price level
increases from time to time.

Prof. Kemmerer has defined inflation as “Too much currency in relation to the
physical volume of business being done.” Even this definition is not satisfactory.
Obviously this definition involves a comparison between the two quantities – the
volume of currency on the one side and the volume of physical goods and services on
the other side. The difficulty with this definition is that it suffers from vagueness. It is
not possible to determine accurately the demand for money. There is no dependable
technique whereby the physical volume of goods and services can be accurately the
demand for money. There is no dependable technique whereby the physical volume of
goods and services can be accurately converted into the demand for money. As such
Kemmerer’s definition cannot be looked upon as satisfactory definition.

Prof. Coulborn has also emphasized the same point as has been done by Prof.
Kemmerer in the above definition. He says “inflation is too much money chasing too
few goods. “ Coulbourne definition also involves a comparison between the quantity
of money on one side and the supply of goods and services on the other side. This
definition is subject to the same limitations as Kemmerer’s definition.

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Prof. Golde offers a similar definition which reads as follows : “ Inflation occurs
when the volume of money actually buying goods and services increases faster than
the available supply of goods .” This definition also emphasizes the same point
namely that the value of money increases at a faster rate then the supply of goods and
services.

Modern economics do not agree that money supply alone is the cause of inflation. As
pointed out by Hicks, “Our present troubles are not of a monetary character.” Johnson
defines inflation as a sustained rise.”

Brooman defines inflation as a continuing increase in the general price level. “Shapiro
also defines inflation “as a persistent and appreciable rise in the general level of
prices.

The above definitions given by Kemmerer Coulbourne Goldenweinser belong to the

same category. They seek to establish cause and affect relationship between supply of
money and the price level. . According to these definitions the rise in price level is
caused by an increase in the supply of money. The increase in the supply of money is
the cause; the rise in the price level is the effect.

But the above cause and effect relationship between supply of money and the price
level was reversed in Germany in the post-war period. In other words the
hyperinflation which took place in Germany in the post world war period could not be
explained by the normal cause and effect relationship between supply of money and
the price level as pointed out in the above definitions. It was rise in price which
caused the expansion of money supply over business requirements pushes up the price
level. Price inflation is the second stage of inflation when the rising price level
necessitates a rapid expansion of the supply of money. During the price inflation the
prices rise with such rapidity that even the money supply cannot keep pace with them.
This stage of inflation is referred to as hyper inflation. To our mind Prof. Einzing’s
definition of inflation “Inflation is that state of disequilibrium in which an expansion
of purchasing power tends to cause or is the effect of an increase of the price level.”
An analysis of this definition reveals the fact that the rise in the price level is not only
the result but also cause of money supply.

According to Webster's New Universal Unabridged Dictionary published in 1983 the

second definition of "inflation" after "the act of inflating or the condition of being
inflated" is:

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 "An increase in the amount of currency in circulation, resulting in a relatively
sharp and sudden fall in its value and rise in prices: it may be caused by an
increase in the volume of paper money issued or of gold mined, or a relative
increase in expenditures as when the supply of goods fails to meet the demand.”

This definition includes some of the basic economics of inflation and would seem to
indicate that inflation is not defined as the increase in prices but as the increase in the
supply of money that causes the increase in prices i.e. inflation is a cause rather than
an effect.

So between 1983 and 2000 the definition appears to have shifted from the cause to the
result. Also note that the cause could be either an increase in money supply or a
decrease in available goods and services.

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 Types of Inflation

There are several types of inflation observable in an economy. These can be classified
as under…

1. Creeping, Walking, Running and Galloping Inflation:

This classification is made on the basis of the ‘speed’ with which the prices
increase in the economy.

• Creeping Inflation- When the price rise is very slow like the pace of a
snail or creeper, it is called creeping inflation. It is the mildest type of
inflation. Under this , the price rise slowly; industry and trade receive
stimulus and the country slowly and gradually develops economically. It is
on account of its stimulating effect that some economists welcome it for the
economic development of a backward economy.
• Walking or Trotting Inflation- When prices rise moderately and the
annual inflation is a single digit, it is called Walking or Trotting Inflation.
• Running Inflation- When the prices rise rapidly like the running of a
horse at a rate of speed 10-20% per annum, it is called a running inflation.
In case, the government fails to curb running inflation in time, it may easily
develop into Galloping Inflation.
• Galloping or Hyper inflation- When prices rise very fast at double or
triple digit rates from more than 20-100% per annum or even more, it is
called hyper or galloping inflation. There are two classic examples of
galloping inflation
i. The great inflation of Germany after the First World War.
ii. The great Chinese inflation after the second world war

2. Comprehensive and Sporadic Inflation:

The former type of inflation occurs when the prices of all commodities register
a rise in the economy. The prices of almost all the commodities show an
upward trend during a period of inflationary spiral.

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 Sporadic inflation, on the other hand, is sectoral inflation under this type of
inflation, only the prices of a few commodities show an upward trend. The
price of a few commodities may rise upwards on account of central physical
bottlenecks which may impede any attempt to increase their production.

3. Open and repressed Inflation:

• Open Inflation- An inflation is said to be open when the government

takes no steps to check the rise in the price level. Open inflation is allowed
to continue unchecked without any attempt on the part of the government to
hold the price line. Under open inflation, the market mechanism is allowed
to work itself out fully without restriction being imposed by the
government.
• Repressed inflation- An inflation is said to be repressed inflation when
the government actively intervenes to check the rise in the price level. The
government may check the rising trend in the price level by resorting to
rationing of scarce items or resorting to price control.

4. Full and Partial Inflation:

According to Professor Pigou, the price level consequent upon the expansion of
money supply in the pre full employment stage is referred to as partial
inflation.

But the increase in the supply of money after the point of unemployment does
not increase output and employment because there already is present the full
employment of resources in the economy which consequently leads to a sharp
uninterrupted rise in the price level. Such situation is referred to as Full
Inflation.

5. Peace Time , War Time and Post War Inflation:

• Peace Time Inflation- This type of inflation is very often as a result of

increased governmental expenditure on ambitious developmental project in
the economy.
• War Time Inflation- During war time, the increase in the output of the
goods and services doesn’t keep pace with the expansion of money supply.
An inflationary graph inevitably emerges which results in a rise in price
level.
• Post War Inflation- It takes place immediately after the sessation of
hostilities when the pent-up demand finds open expression on the relaxation
of price in physical control by the government.

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6. Currency and Credit Inflation:

• Currency Inflation- This is the classic type of inflation marked by an

excess supply of money in relation to the available out of goods and
services. It inevitably results in an inflationary rise in the price level.
• Credit Inflation- Sometimes the government encourages an expansion of
credit without expanding the supply of money in circulation. This is known
as credit inflation. The main objectives of credit inflation are:
i. To lighten the burden of indebtedness of the farmers.
ii. To expand production to mobilize financial resources for
developmental plans.

7. Induced Inflation:

• Profit Induced Inflation- Sometimes the production cost starts declining

and consequently, the prices show a declining trend. But the government
doesn’t allow the prices to fall down by resorting to artificial means. This
situation results in an increase in the profit margins of the producers, thus
leads to profit induced inflation.
• Deficit Induced Inflation- When the government is not able to cover the
deficits; it is forced to resort to the printing press for issuing new currency.
Under these circumstances, it may result in the rising price level and thus
leads to the deficit induced inflation.
• Wage Induced Inflation- When the workers organize themselves into
powerful trade unions and force the employers to increase the wages, this
inevitably pushes the production cost and thus leads to wage induced
inflation.

* There are certain other types of inflation like Mark-Up Inflation,

Ratchet Inflation, Stagflation, Sectoral Inflation and Imported
Inflation.

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 Causes of Inflation

The root cause of inflation is the imbalance between the total demand and total supply
of goods and services in the economy which causes excess demand. The emergence of
excess demand in the economy can be attributed to two main factors:-

1. Increase in demand for goods and services

2. Decrease in the supply of goods and services

Factors Causing Increase in Demand

Following are the factors which cause an increase in demand:-
1. Increase in public and private expenditure- An increase in public expenditure
consequent upon the outbreak of war or developmental planning invariably
causes an increase in the demand for goods and services in the economy.
An increase in private expenditure (primarily in investment activities)gives rise
to increase in demand for factors of production which results in an increase in
the factor prices .when factor income increases ,there is more and more of
expenditure on consumption goods .

2. Increase in exports- An increase in the foreign demand for the country’s

products reduces the stock of commodities available for home consumption. It
creates a situation of shortage of goods and services in the economy, giving rise
to inflationary pressures.

3. Reduction in taxation- When the government reduces taxes ,it results in an

increase in the purchasing power of consumers which they use for buying
goods and services for consumption purposes. This naturally leads to an
increase in the aggregate demand in the economy.

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 4. Repayment of past internal debts- When the government pays its past debts to
the public it results in the increase in the purchasing power of the consumers
and thus increases demand.

5. Rapid growth of population- A rapidly growing population has the effect of

raising up the level of aggregate demand for goods and services in a country.
This acts as an inflationary force and tends to raise the prices to higher levels.

6. Black money- The existence of huge amount of black money in the economy is
also responsible for increase in demand .people spend such unearthed money
on buildings, marriages ,luxuries etc thereby raising demand.

7. Deficit Financing- In order to meet its meet its mounting expenses, the
government resorts to deficit financing by borrowing from the public and
printing notes in the huge quantity. This raises aggregate demand in relation to
aggregate supply.

8. Increase in consumer landing- The demand of goods and services increases

when the consumer spending increases. It may be due to easy availability of
credit etc it increases the demand for goods and services.

Factors Causing Decrease in Supply

Following are the factors which causes decrease in supply:-

1. Shortages of supplies of factors of production- Occasionally, the economy of a

country may be confronted with shortages such factors as labor, capital, raw
materials etc. these shortages are bound to reduce the production of goods and
services for consumption purposes.

2. Industrial disputes- In countries where trade unions are strong, they help in
curtailing inflation. Trade unions resort to strikes and if they happen to be
unreasonable from employer’s point of view and are unreasonably prolonged,
they force the employers to declare lockouts. In both cases industrial
production falls, thereby reducing supply of goods in the country.

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3. Natural calamities- Natural calamities like floods, droughts etc. adversely
affects the supplies of agricultural products. The latter, in turn, create shortage
of food products and raw materials, thereby helping inflationary pressures.

4. Operation of law of diminishing returns- In countries where industries use old

and obsolete machines and outdated methods of production, the law of
diminishing returns operates. This raises cost per unit of production, thereby
raising the prices of products leading to inflation.

5. Lopsided production- If the stress is placed on the production of comfort and

luxury goods, thereby neglecting essential and consumer goods in a country, it
creates shortages of goods in the country, it creates shortages of goods in the
market and hence causes inflation.

6. Hoarding by consumers and traders- Hoarding by consumers and hoarding is

one of the causes which may affect the supply side. Hoarding by suppliers is
done to exploit the consumers by reducing the supply at particular point of time
and then raising prices after the demand exceeds. Sometimes consumers also
tend to purchase commodities with the expectation that the prices will rise in
the near future. This also creates a deficiency in the supply of the goods and
services.

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11
 Demand Pull & Cost Push Inflation

Demand Pull Inflation

Demand-pull inflation arises when aggregate demand in an economy outpaces
aggregate supply. It involves inflation rising as real gross domestic product rises and
unemployment falls, as the economy moves along the Phillips curve. This is
commonly described as "too much money chasing too few goods". More accurately, it
should be described as involving "too much money spent chasing too few goods",
since only money that is spent on goods and services can cause inflation. This would
not be expected to persist over time due to increases in supply, unless the economy is
already at a full employment level.

The term demand-pull inflation is mostly associated with Keynesian economics

According to Keynesian theory, the more firms will employ people, the more people
are employed, and the higher aggregate demand will become. This greater demand
will make firms employ more people in order to output more. Due to capacity
constraints, this increase in output will eventually become so small that the price of
the good will rise. At first, unemployment will go down, shifting AD1 to AD2, which
increases Y by (Y2 - Y1). This increase in demand means more workers are needed,
and then AD will be shifted from AD2 to AD3, but this time much less is produced
than in the previous shift, but the price level has risen from P2 to P3, a much higher
increase in price than in the previous shift. This increase in price is called inflation

Cost Push Inflation

Cost-push inflation is a type of inflation caused by substantial increases in the cost of
important goods or services where no suitable alternative is available. A situation that
has been often cited of this was the oil crisis of the 1970s, which some economists see
as a major cause of the inflation experienced in the Western world in that decade. It is
argued that this inflation resulted from increases in the cost of petroleum imposed by
the member states of OPEC. Since petroleum is so important to industrialized
economies, a large increase in its price can lead to the increase in the price of most
products, raising the inflation rate. This can raise the normal or built-in inflation rate,

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reflecting adaptive expectations and the price/wage spiral, so that a supply shock can
have persistent effects.

Austrian school economists such as Murray N. Rothbard and monetary economists

such as Milton Friedman argue against the concept of cost-push inflation because
increases in the cost of goods and services do not lead to inflation without the
government and its central bank cooperating in increasing the money supply. The
argument is that if the money supply is constant, increases in the cost of a good or
service will decrease the money available for other goods and services, and therefore
the price of some those goods will fall and offset the rise in price of those goods
whose prices have increased. One consequence of this is that monetarist economists
do not believe that the rise in the cost of oil was a direct cause of the inflation of the
1970s. They argue that although the price of oil went back down in the 1980s, there
was no corresponding deflation.

Keynesians argue that in a modern industrial economy, many prices are sticky
downward or downward inflexible, so that instead of prices falling in this story, a
supply shock would cause a recession, i.e., rising unemployment and falling gross
domestic product. It is the costs of such a recession that likely cause governments and
central banks to allow a supply shock to result in inflation. They also note that though
there was no deflation in the 1980s, there was a definite fall in the inflation rate during
this period. Actual deflation was prevented because supply shocks are not the only
cause of inflation; in terms of the modern triangle model of inflation, supply-driven
deflation was counteracted by demand pull inflation and built-in inflation resulting
from adaptive expectations and the price/wage spiral

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 Calculation of Inflation Rate

Mathematically, inflation or inflation rate is calculated as the percentage rate of

change of a certain price index. The price indices widely used for this are Consumer
Price Index (adopted by countries such as USA, UK, Japan and China) and Wholesale
Price Index (adopted by countries such as India). Thus inflation rate, generally, is
derived from CPI or WPI. Both methods have advantages and disadvantages. Since
India uses WPI method for inflation calculation, let’s go in to the details of WPI based
inflation calculation.

How is WPI (Wholesale Price Index) Calculated?

In this method, a set of 435 commodities and their price changes are used for the
calculation. The selected commodities are supposed to represent various strata of the
economy and are supposed to give a comprehensive WPI value for the economy.

WPI is calculated on a base year and WPI for the base year is assumed to be 100. To
show the calculation, let’s assume the base year to be 1970. The data of wholesale
prices of all the 435 commodities in the base year and the time for which WPI is to be
calculated is gathered.

Example: WPI for the year 1980 for a particular commodity, say wheat. Assume that
the price of a kilogram of wheat in 1970 = Rs. 5.75 and in 1980 = Rs. 6.10

The WPI of wheat for the year 1980 is,(Price of Wheat in 1980 – Price of Wheat in
1970)/ Price of Wheat in 1970 x 100

i.e. (6.10 – 5.75)/5.75 x 100 = 6.09

Since WPI for the base year is assumed as 100, WPI for 1980 will become 100 + 6.09
= 106.09.

In this way individual WPI values for the remaining 434 commodities are calculated
and then the weighted average of individual WPI figures are found out to arrive at the

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overall Wholesale Price Index. Commodities are given weight-age depending upon its
influence in the economy.

How is Inflation Rate Calculated?

If we have the WPI values of two time zones, say, beginning and end of year, the
inflation rate for the year will be,

(WPI of end of year – WPI of beginning of year)/WPI of beginning of year x 100

For example, WPI on Jan 1st 1980 is 106.09 and WPI of Jan 1st 1981 is 109.72 then
inflation rate for the year 1981 is,

(109.72 – 106.09)/106.09 x 100 = 3.42% and we say the inflation rate for the year
1981 is 3.42%.

Since WPI figures are available every week, inflation for a particular week is
calculated based on the above method using WPI on the later week and WPI on the
previous week. This is how we get weekly inflation rates in India.

Characteristics of WPI
Following are the few characteristics of Wholesale Price Index

1>WPI uses a sample set of 435 commodities for inflation calculation

2>the price from wholesale market is taken for the calculation

3>WPI is available for every week

4>It has a time lag of two weeks, which means WPI of the week two weeks back will
be available now

WPI in India
There have been discussions going on whether to use WPI as a measure to
check on inflation.basically WPI has some loopholes:-

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WPI as the name suggests is at the whole sale level and so, it does not measure
the exact price rise which the end-consumer end up paying.

The second major problem with WPI calculation that more than 100 out of
435 items have lost their significance from consumption point of view.

e.g., the commodities like coarse grains which is generally used for cattle feed
thereby having no significance continue to be there in the list which is used to
measure inflation. Also, the services which have a lot of importance in our
economy is not there in the list. Besides this, the list of commodities was last
reviewed in 1993-1994 and today most of the commodities have become
redundant in their use.

WPI gives us the essence of the business which we are taking as the nerve of
the consumers while calculating price rise. So, there is a high time need that
India should shift from WPI to CPI for measuring inflation.

In India, we have four CPI indices

• CPI UNME (Urban Non Manual Employees)

• CPI AL (Agricultural Labour)
• CPI RL (Rural Labour)
• CPI IW (industrial Workers)

So, decision to choose which CPI index will be risky and unwieldy.

Second, important reason for which we are not using CPI is reported on
monthly basis with a huge time lag whereas WPI is published weekly basis

Consumer Price Index

CPI is a statistical time-series measure of a weighted average of prices of a
specified set of goods and services purchased by consumers. It is a price index
that tracks the prices of a specified basket of consumer goods and services,
providing a measure of inflation.

CPI is a fixed quantity price index and considered by some a cost of living
index. Under CPI, an index is scaled so that it is equal to 100 at a chosen point
in time, so that all other values of the index are a percentage relative to this
one.

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 Stages of Inflation

Inflation passes through three stages. In the first stage the rise in price is slow and
gradual. In this stage it is easier to check the inflationary rise in the price of goods and
services. But if it is not effectively checked in the first stage then it enters the second
stage. In second stage inflation becomes a serious headache for the government. The
prices of goods and services start rising much more rapidly then before. It not possible
to eliminate inflation completely but if the government takes effective steps, it may be
possible to prevent a further rise in price level. In the third stage, prices of goods and
services now start rising almost every minute and it becomes impossible for the
government to check them.

These can be illustrated by an example , in first stage price rise in a proportion is less
than the supply of money. If the supply of money increases by 10%, the price rise by
5% or even less than that . In the second stage, the prices rise exactly in the same
proportion in which the supply of money increases. In other words, if the supply of
money is increased by 10% the price rise also goes by 10%. In the third stage, the
price rise in a much greater proportion than the increase in the supply of money. In
other words, if the supply of money is 10% price level may rise by 15% or even more.

The above three stages are described below:

• Pre-full Employment Stage:

The rise in price level in the first stage is less than proportionate to the increase in the
supply of money. Let us suppose the supply of money increases by 10%. As, a result,
there will be immediate rise in the price level. Consequently, the production of goods
and services receive stimulus. As a result of increase in output of goods and services,
the price level will come down. But if the supply of money is again increased by 10%,
the price level will rise up, giving encouragement to the production of goods and
services in the economy. In this way if there is continuous increase in the supply of
money, a stage will come when the output of goods and services may not increase in
the same proportion in which the supply of money increases. The reason being that

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with the expansion of production, the supply of the factors of production goes on
declining.

• Full Employment Stage:

If the supply of money continues to increase without any interruption, then after some
time production will cease to increase, or in other words, production will become
stagnant .The reason being that all productive resources are already fully employed.
Extra resources are not available for a further expansion of production. Hence, the
further expansion of production comes to an end. Since production becomes constant,
the price level now starts increasing in the same proportion in which the supply of
money increases.

• Post-full Employment Stage:

If the supply of money continues to increase even after the time of full employment,
then for some time the price level will increase in the same proportion in which supply
of money increases. But after that the supply of money increases so much that the
public loses confidence in it and the increase in the price level is much more than the
increase in supply of money. For example, if the supply of money is 10%, then the
price level increases by 20%, 30% or even 40%. In such a situation, it becomes
difficult, to check the rise in the price level. This is the final stage of inflation. In this
stage, the prices rise so high that money exchange comes to be replaced by
commodity exchange in due course of time

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 Effects of Inflation

Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as

hit man. A period of prolonged, persistent and continuous inflation results in the
economic and social and moral disruption of society.

The effects of inflation can be discussed under two subheads-

a) Effects on production
b) Effect on distribution

The general perception is that inflation is harmful for the economy. This leads us to
the question as to whether inflation is always detrimental to productive activities.

Mild inflation may actually be good for the economy, particularly when there are
unemployed productive resources in the country. Mild inflation will cause an
expansion of money supply in an under developed country which will result in a slow
and gradual rise in the prices. The profit margins of businessmen will continue to
increase as the production cost will not rise in the same proportion.

Encouraged by the favorable conditioned the businessmen will increase their

investment in production activities generating more income and employment in the
economy.

This process of increased investments and increasing employment continues till the
point of full employment is reached. But after the point of full employment of
productive resources, any expansion of money supply is bound to result in hyper
inflation. Thus, an expansion of money supply after the point of full employment may
not be harmful for the economy. In fact, mild inflation may serve as a tonic for the
economy of the country. But any expansion of money supply after the point of full
employment will degenerate into runaway or hyper inflation. And hyperinflation as
already pointed out above, is very harmful for the economy. It creates business
uncertainty which is inimical to production. It is this hyperinflation which has
harmful consequences for the economy. In fact, hyperinflation disrupts the smooth

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functioning of the economy. This type of inflation has the following adverse effects
on the productive activities of the country:

1) Since hyperinflation results in a serious depreciation of the value of money, it

discourages saving on the part of the public. With reduced savings, the process of
capital accumulation suffers a serious set back.
2) If the value of money undergoes considerable depreciation, this may even drive
out the foreign capital already invested in the country.
3) With the reduced capital accumulation the investment will suffer a serious set
back which may have an adverse effect on the volume of production in the
country.
4) The volume of production with not only decline on account of the slowing down
on capital accumulation, it may also decline on account of business uncertainty
which may discourage entrepreneurs and businessmen from taking business risk
and production.
5) The pattern of production in the economy may also undergo changes under the
impact of run away inflation. This type of inflation may result in the diversion of
productive resources from the essential goods industries to the luxury goods
industries creating further shortages of consumer goods for the common man.
6) Since run away inflation in a seller’s market, it may lead to a serious deterioration
in the quality of goods produced in the economy.
7) Inflation also leads to hoarding of essential goods both by the traders as well as
the consumers. The traders hoard stocks of essential commodities with a view to
making higher profits or with a view to selling scarce items in the black market.
The consumers also resort to hoarding of essential goods for fear of pain higher
prices in the future. The may also hoard essential goods with a view to ensuring
continuous an uninterrupted supply for themselves.
8) The worst part of inflation is that it gives stimulus to speculative activities on
account of the uncertainty generated by a continuously rising price level. Instead
of earning increased profits out of increased production, the businessmen find it
easier to increase their profits through speculative activities.
9) The more effect of inflation that it disrupts the smooth working of the price
mechanism, their by creating an all-round confusion in the economy.
10)The economy system looses it flexibly under the impact of inflationary forces
which have been knack of reducing the mobility of productive resources in the
economy.
11)The worse effect of hyper inflation is that in due course of time it results in a
flight from domestic currency on account of it’s constantly diminishing value. Ina
n advanced stage of hyper inflation; the people loose confidence in their home
currency and rush to by foreign currencies of stabler value to safeguard their
assets. /in fact, there is a scramble on the part of the people to exchange home
currency for foreign currency in the foreign exchange market.

Nevertheless, as pointed out above a mid dose of inflation serves as a stimulant by

energizing an activating ideal resource in the economy. It induces movement of
real resources to the expanding sectors of the economy. It encourages

20
 entrepreneurs to make investments in new enterprises which lead to in productive
capacity, ultimately, in the volume of production. Price stability need not be
interpreted as price rigidity. Economic stability, in fact, is quiet consistent with an
annual increase to 3 to 4 percent in the general price level. This produces salutary
effect on the economy as a whole.

Effects on Distribution
Inflation produces a deep impact on the distribution of income and wealth in society.
A prolonged period of persistent inflation results in redistribution of income and
wealth in favour of the already richer and more affluent classes of society. The
distributive share accruing to the business classes increases much more than that of
wage-earning or rentier classes. Businessmen, traders, merchants and speculators reap
rich harvests on account of windfall profits accruing to them as a result of the
inflationary rise in prices. Prices under the pressure of inflation rise much more than
the production cost. There is always a time lag between the rise in production cost and
rise in the price level. This time brings rich profits to the business classes. Moreover,
the stocks and inventories of business man invariably go up in value because of the
constantly rising price level under the impact of inflation. The business classes thus,
make all round gains during a period of inflation. The fact of the matter is that the
flexible income groups, such as , businessmen, merchants and traders are always the
gainers in period of inflation while the fixed income groups, such as, workers, salaried
employees, teachers, pensioners, etc are always the losers on the account of the
inflationary rise in prices. Inflation is always unjust. It is a like a steeply regressive
tax. Inflation throws the economic burden on the shoulders of those sections of the
community who are the least able to bear it.

The concrete effects of inflation on various groups of society are as follows:

1) Debtors and creditors. During inflation, debtors are generally the gainers while
the creditors are the losers. The reason is that the debtors had borrowed when the
purchasing power of money was high and now return the loans when the
purchasing power of money is low due to rise in prices. In other words the
debtors while repaying their debts return less purchasing power to the creditors
than what they have actually burrowed. Since the creditors receive less in real
terms, they are the losers during inflation.
2) Wage and salary earners. Wage and salary earners mostly suffer during inflation
because wages and salaries generally do not rise in the same proportion in which
the cost of living rises. Then there is the time lag between the rise in the cost of
living and the rise in the wages and salaries. If the workers and salaries earners
are well organized into powerful trade unions, they may not suffer much during
inflation, but if they are unorganized or ill-organized, as they generally are, they
may suffer much as their wages and salaries may not increase at all or may
increase in the proportion in which the cost of living increases.

21
3) Fixed-income groups. The fixed-income groups are the hardest hit during
inflation because their incomes being fixed do not bear any relation ship with the
rising cost of living. Persons who live on the past savings, pensioners, interest
and rent receivers suffer most during inflation as their incomes remain fixed
while the prices sole high. Inflation, it is said, is also a killer of older, retired
people who with the advent of winter, find their pensions inadequate to buy their
fuels with their existing fixed pensions.
4) Entrepreneurs. Inflation is the boon to the entrepreneurs whether they are
manufactures, traders, merchants or businessmen, because it serves as a tonic for
business enterprise. They experience windfall gains as the prices of their
inventories (stocks) suddenly go up. They also gain because their costs do not go
up as rapidly as the prices of their products. The costs of labour, raw materials
and equipment, etc. do not catch up with the rise in prices of products. Inflation
converts the entrepreneurs into ‘profiteers’ who put the community to ransom to
their profiteering and hoarding their activities.
5) Investors. Investors re generally of two types: (i) investors in equities (shares)
and (ii) investors in fixed interest-yielding bonds and debentures. Inflation
bestows favours on the former and is rather harsh on the latter. Dividends on
equities increase with the increase in prices and corporate earning and as such the
investors in equities are favourably affected. Incomes from bonds and
debentures, however, remain fixed and as such, investors in them are adversely
affected. The small middle-class investors generally invest in fixed interest-
yielding bonds and equities and therefore, have much to lose during inflation.
Frequently they find their saving largely, if not completely, wiped out as a result
of the deprecation in the value of money. The rich-class investors. On the other
hand invest in equities on which the dividends go up during on inflation and are
thus beneficially affected.

22
 Measures to Control Inflation

The causes of inflation, its effects and its harmful consequences have emphasized the
need for adopting a prompt and effective anti-inflationary policy on the part of the
government. There are three major lines of action to check and control an inflation
boom.

• Monetary measures
• Fiscal measures
• Realistic measures

Monetary Measures

One method to control the inflation is to reduce the flow of cash in the
economy, which helps to reduce an inflation pressure. This is done through the
following monetary measures.

i. Increased Rediscount Rate:

Rediscount Rate is the rate at which the central bank lends loan to its member
banks. An increase in rediscount rate leads to an increase in bank rates (i.e., the
interest rates charged by commercial banks), because there is a definite
relationship between the two. Also the cost of borrowing funds for business
and consumer spending increases and thus discourage excessive activity based
on borrowed funds. This results in a fall in the intensity of inflationary
pressures in the economy.

Limitations:

• If bank rates do not rise pari passu with the rise in rediscount rates, then there
will be no decline in the business and customer borrowing, and hence, the
inflationary pressures will continue even though the rediscount rates have been
raised.
• This doesn’t work if the commercial banks have an easy access to additional
reserves. For example, the commercial banks which are in possession of large
amount of short-term government securities to the central bank or by
converting the maturing securities into cash. Instead of borrowing from the
central bank at higher discount rates, the commercial banks might prefer to sell
their low yield securities during inflation.

23
 • If non-bank holders of government securities were to convert their holdings
into cash would have the effect of increasing the velocity of money consequent
upon increased cash balances. At a time of raising prices and falling value of
money, there is a strong temptation on the part of holders of fixed income
yielding assets to convert them into cash.

ii. Sale of Government Securities in the Open Market:

In this method to check the inflationary boom the Government resorts to
sales of government securities to the public by central bank. As the buying
public purchases and pays for those government securities, the commercial
banks’ reserves with the central bank are correspondingly reduced and they are
obliged to adopt a restrictions credit policy in relation to business requirements.
This process helps in creating tight money conditions in the market, and thus
arresting the further growth of the inflationary bloom.

Limitations:

• When commercial banks are able to increase their reserves by selling their
stocks of government securities to the central bank this policy becomes
ineffective.
• When the non-bank holders of government securities may also, in the absence
of other buyers, sell them to the central bank and deposit the proceeds with the
commercial banks, again the reserves with the commercial banks increases and
there is no effect on inflation boom.
• The policy may also be offset by increased borrowings from or by increased
sales of treasury bills to the central bank by the commercial banks.

iii. Higher Reserve Requirements:

It is necessary for all the member banks to have some percentage of its cash
with the central bank. This is known as Cash Reserve Ratio (CRR). The raise in
this reserve ratio absorbs the excess reserves of the banking system and thus
prevents them from forming a basis for further credit expansion.

Limitations:

• When the commercial banks happens to have very large excess reserves, even
the raising of reserve requirements may not significantly curtail their power to
create credit.
• The ability of commercial banks to increase or replenish their reserves through
sale of government securities may render higher reserve requirements
ineffective to check credit expansion.

24
 • A large inflow of gold on account of the existence of an export surplus will
also, by increasing the member-banks’ reserves, offset the anti-inflationary
effect of higher reserve requirements.

iv. Consumer Credit Control:

This device is introduced to curb excessive spending on the part of consumers.
Recently installment purchase has increased to a large extent and this has
increased the consumer spending. Most of consumer goods, such as, radios,
television sets, washing machines, etc. are purchased by the consumers on
installment credit. During inflation this credit purchase are reduced to the
minimum to curtail excessive spending on the part of consumers. This is done
by

• Raising the minimum initial payment on specified goods

• By extending the application of consumer credit control to a large
number of goods
• By decreasing the length of the payment period

v. Higher Margin Requirements:

This is another method of selective credit control like consumer credit control
policy. The central bank in its pursuance of an anti-inflation policy may raise
the margin requirements to higher levels. As is well known, every commercial
bank before giving loans against collateral security keeps a certain specified
margin say 20% or 30%. So when a businessman offers a security for Rs.
10,000 and the bank keeps a margin of 20%, then it means that it will not
advance more than Rs. 8,000 to the businessman. This margin is necessitated
by the possibility of a fall in the value of the security. Thus, higher margin
requirements have the effect of checking undue monetary expansion.

Fiscal Measures

Fiscal policy is now recognized as an important instrument to tackle an

inflationary situation. By this method the spending capacity of the public is
reduced by grabbing the excess money from the public. This will check the
increase in prices of essential commodities and helps in reducing the inflation
boom. This is done through the following methods.

1. Government Expenditure:

25
 During inflation, as is well known, effective demand increases far too much
due to unregulated private spending. The increased private expenditure presses
heavily against the limited supply of goods and services available in the
market. To counteract increased private spending, the government should, at
such a time, reduce its own expenditure to the minimum extent possible to help
limit the aggregate demand.

Limitations:

• The decrease in government expenditure particularly in the war period will lead
to decrease in military expenditure which is not possible.
• Any drastic cut in government expenditure to cure inflation may sometimes
actually land the economy in a slum.
• This policy of a cut in government expenditure may actually come into clash
with a long-range public investment program.

2. Taxation:

The main issue during inflation is to reduce the size of disposable income in the
hands of the general public in view of the limited supply of goods and service
in the market. It is therefore, necessary to take away the excess purchasing
power from the public in the form of taxes. The rates of existing taxes should
be steeply increased while new taxes should be imposed on commodities and
services so as to leave less money supply with the public to spend. The best
anti-inflation tax is personal tax with steep rates and high surcharges. This
would reduce the spendable income in the hands of the public, and thus help
anti-inflation measures must aim at reducing current incomes in the hands of
those sections which, if not taxed, would contribute to raising the price level.

The tariffs on imports should be lowered down as much as possible to

encourage increased imports to set up the supply of goods at home to absorb
the increased money supply in the economic system. The tariffs on necessities
of life particularly reduced so as to contain inflationary pressures in the
economic system by increasing the supply of goods and services.

While increasing the taxation to curb inflationary pressures, money incomes

are not so much deflated as to provoke a recession in the economy.

3. Public Borrowing:

The object of public borrowing is to take away from the public excess
purchasing power which, if left free, would surely exert a limited upward
pressure on the price level in view of the limited supplies of goods and services

26
 in the economy. This can be voluntary or compulsory. Ordinarily, the public
borrowing is voluntary, left free to the free will of the individuals. But
voluntary borrowing has one disadvantage, and that is, it does not bring to the
government sufficient amounts to have really effective impact on the
inflationary pressures. It thus becomes essential in due course of time to resort
to compulsory savings or compulsory borrowings from the public (also known
as deferred pay). By this plan a certain percentage of the wages or salaries are
compulsorily deducted in exchange for savings bonds which become
redeemable after a few years. This has an added advantage of releasing blocked
purchasing power at the first symptom of a recession in business activity. It
was adopted by India in 1963 to check inflation, though under public
compulsion it had to be withdrawn by the Government of India.

Limitations:

• It involves the use of compulsion which is generally unpalatable to the public.

• It results in discontent if applied to those sections of the community which are
not in a position to contribute to this scheme in view od their limited pay
packets.

4. Debt Management:

The existing public debt should be managed in such a manner as to reduce the
existing money supply and prevent further credit expansion. Anti-inflation debt
management usually requires the retirement or repayment of bank-held debt out of
a budgetary surplus. The idea is that the government securities held by commercial
banks should be retired by the government out of a budgetary surplus. This would
check the power of commercial banks to encash their securities and add to their
reserves for the purpose of credit expansion. There is, however, one snag here. At
the time of inflation, despite its best efforts, the government may not succeed in
having a budgetary surplus. Due to the excessive increase in expenditure, the
government may actually be faced with deficit budget. In that case, the
government can adopt another method to retire the bank-held debt. It can retire this
debt by sale of bank-ineligible bonds to nonbank investors like insurance
companies, savings banks, individuals, etc. This will have the effect of taking
away the spendable money from the public and, thus, contribute to a lessening of
pressure on the limited stocks of goods and services available in the market.

Limitations:

It would be rendered ineffective if the nonbank investors were unwilling to give

up spendable money in exchange for government bonds. It would also prove futile

27
if the nonbank investors utilized, for purchasing government bonds, idle funds
which would not have been spent at all.

5. Overvaluation:

An overvaluation of domestic currency in terms of foreign currencies will also

serve as an anti-inflationary measure in three ways.

• It will discourage exports and thereby result in an increased availability of

goods and services in the domestic market.
• By encouraging imports from abroad, it will add to the domestic stock of goods
and services, and, thus absorb the excessive purchasing power in the economy.
• By cheapening the prices of those foreign materials which enter domestic
production, it will help in checking an upward cost-price spiral.

Limitations:

If other countries are also suffering from inflation, then the country concerned
shall have to overvalue its currency considerably to neutralize the inflationary
effect of the raising cost of imports.

Realistic Measures

These realistic measures can be used to supplement the monetary-fiscal measures

undertaken to contain inflationary pressures.

1. Expansion of Output:

Increased production is the best antidote to inflation because, as pointed out

above, at the time inflationary gap arises partly due to the inadequacy of
output. This can be done in the following ways.

• In time of inflation it becomes difficult to increase output because of the full

utilization of resources. The productive resources are already fully employed.
The steps should be taken to increase the output of those goods which seems to
be extremely sensitive to inflationary pressures by shifting productive
resources from less inflation-sensitive goods. In other words reallocation of
productive resources is suggested to step up the output of inflation-sensitive
goods, such as, food, clothing, housing and other essential consumer goods.
• The output should be increased by making the workers work for longer hours
in factories. They should be accompanied by “overtime allowances”. These
overtime wages should either be taxed or taken away by the government in
form of loans so as to prevent from spending this additional income.

28
• The other feasible method is to increase the output through technical
innovations in industry. It is also essential at time of inflation to maintain
peace, because during inflation the workers are generally discontented and their
grievances mount with the rising cost of living. Attempts should be made to
devise some labor management machinery, attend the workers grievances to
avoid work stoppages which are bound to inhibit production at a critical time.
• Government may adopt a liberal import policy to offset the domestic import
policy to offset the domestic shortage of goods. As a matter of policy, the
government can also import inflation-sensitive and essential goods in exchange
for export of non-essential and inflation-insensitive goods.

2. Wage Policy:

During an inflationary boom, wages cannot be left free to chase the prices
upward. They have to be controlled so as to contain inflationary pressures in the
economy. Wage increases may be allowed to workers only if their productivity, i.e.
output per worker, increases. But if the wages in a particular industry are already
sub-standard, they may be got raised without increasing the prices of goods
produced, i.e., by reducing the profit margins of the producers. It is important for
the government at such a time to keep down the cost of living through its anti-
inflation program, for if it fails to do so, the workers’ unions would be perfectly
justified in asking for higher wages from their employers, and the government
should let them do so. Even the government can tax away or borrow a part of
money wages as a part of its anti-inflation program. But complete wage freeze is
rather difficult to achieve during peacetime inflation, because trade unionism is a
powerful force now in advanced economies. This is rendered still more difficult by
the fact that wages are not only costs to employers but also incomes to the
workers, and any step taken in the direction of a wage freeze may give rise to
uncontrollable deflationary movements in future.

3. Price control and Rationing:

This was done in fairly wide scale in various countries of the world to fight
inflation during and after the Second World War. The object of price control is
to lay down the upper limit beyond which the price of a particular commodity
would not be allowed to rise. Anyone selling the concerned commodity would
not be allowed to rise. Anyone selling above the upper limit would be in risk.
To ensure the successful functioning of price control, the following conditions
have to be satisfied.

• The government should have under its control adequate stock of the
commodity concerned. This will fail if doesn’t have adequate stock of its own.

29
• The demand for the concerned commodity should be controlled through
rationing, failing which, taking advantage of the fixed price the richer sections
shall be able to buy a major portion of the available stocks.

4. Population planning:

Control on population by adopting different measures of family will reduce the

demand and finally prices will be controlled.

5. Economic Planning:

Effective economic planning is necessary to control the inflation in the country.

30
 The Current Scenario

Inflation around the World

The Indian people and the government are both quaking with fear with inflation
hovering at around 8%. The people can barely make two ends meet with prices
soaring, and the government knows that if prices don't fall, the government will.

But India is not the only nation grappling with rising inflation. The entire world is
facing the problem. Considering inflation, the top 10 nations falling in the list of
countries affected by highest rates of inflation are-

1. Zimbabwe: 355,000%

The inflation in Zimbabwe for the month of March 2008 rose to 355,000%! Yes,
355,000 per cent! It more than doubled from the February figure of 165,000%.

Economists say that it is a miracle that the Zimbabwean economy is still surviving and
prices have been rising to unprecedented proportions. Inflation surged between
February and March following the sudden rise in money supply that flooded the
economy to finance the 2008 elections. Apart from this food and non-alcoholic
beverages continued to drive up inflation.

Almost 80% of the nation is unemployed. The Zimbabwean central bank has
introduced $500 million bearer cheques (or currency notes) for the public, and $5
billion, $25 billion, $50 billion agro-cheques for farmers. Just last fortnight the nation
had introduced $250 million bearer cheques.

A sausage sandwich sells for Zimbabwean $50 million. A 15-kg bag of potatoes cost
Zimbabwean $260 million. But then, Zimbabwean $50 million is roughly equal to
US$ 1!

31
 A Zimbabwean man holds up a new $500-million note on May 16, 2008 in Harare. | Photograph:
Desmond Kwande/AFP/Getty Images

2. Iraq: 53.2%
3. Guinea: 30.9%
4. San Tome and Principe: 23.1%
5. Yemen: 20.8%
6. Myanmar: 20%
7. Uzbekistan: 19.8%
8. Democratic Republic of Congo: 18.2%

A train carrying Congolese people in Kinshasa: The terrain and climate of the Congo Basin present
serious barriers to road and rail construction

9. Afghanistan: 17%
10. Serbia: 15.5%

32
Inflation in India
The beginning of 2008 has seen a dramatic rise in the price of rice and other basic
food stuffs. There has also been a no-less alarming rise in the price of oil and gas.
When coupled with rises in the price of the majority of commodities, higher inflation
was the only likely outcome.

By July 2008, the key Indian Inflation Rate, the Wholesale Price Index, has risen
above 11%, its highest rate in 13 years. This is more than 6% higher than a year
earlier and almost three times the RBI’s target of 4.1%.

Inflation has climbed steadily during the year, reaching 8.75% at the end of May.
There was an alarming increase in June, when the figure jumped to 11%. This was
driven in part by a reduction in government fuel subsidies, which have lifted gasoline
prices by an average 10%. The Indian method for calculating inflation, the Wholesale
Price Index, is different to the rest of world. Each week, the wholesale price of a set of
435 goods is calculated by the Indian Government. Since these are wholesale prices,
the actual prices paid by consumers are far higher.

In times of rising inflation this also means that cost of living increases are much
higher for the populace. Cooking gas prices, for example, have increased by around
20% in 2008. With most of India’s vast population living close to – or below – the
poverty line, inflation acts as a ‘Poor Man’s Tax’. This effect is amplified when food
prices rise, since food represents more than half of the expenditure of this group. The
dramatic increase in inflation will have both economic and political implications for
the government, with an election due within the year.

The hike in crude oil prices in one of the most important factor contributing to the
high rate of inflation in India with the current price touching around $ 105 per barrel
of oil. Speculation amid the weakening U.S. dollar and concession fears in the
aftermath of the U.S. sub-prime mortgage crisis were clearly one of the vital players
behind the skyrocketing oil prices. OPEC Secretary-General Abdullah al-Badri said
on May 23 the cartel could do nothing to curb the hike in oil prices as speculation and
the weak U.S. dollar, rather than insufficient output, should be held
responsible. "When we see there is a shortage of supply, we will act," he said. But in
the present situation, "even if we increase output tomorrow, the prices will not come
down because of speculation and because of a weak dollar." The fluctuation of crude
oil prices is closely related to the global financial market. Rising oil prices should be
put into the context of the global financial market, which could be affected by a wide
range of factors such as the change of exchange rates, geopolitics, political instability
and natural disasters. All these may be reasons for speculation, and from this way of
thinking, an answer to the current record high oil price could be found. Analysts said
there are several causes for rising oil market speculation. The outbreak of the sub-

33
prime mortgage crisis in the United States last summer and the resulting turbulence in
the world financial market channeled huge capitals into the oil market. Speculation
not only pushed up oil prices, but also increased fluctuation on the world oil market. It
is estimated that speculators control 1 billion barrels of crude oil in future contracts
involving a total of 100 billion U.S. dollars. They buy or sell oil futures based on
market information, which increased the market uncertainty. Such speculation could
boost oil prices to one record high after another, or cause acute market turbulence as
the price bubble finally bursts, analysts said. While speculators may have benefited
from the current round of price surges at the cost of common consumers' interests,
uncontrollable rises in fuel prices will exert a negative impact on the global economy
by causing sluggish consumption, increasing business costs and pushing up inflation,
they added.

The price of oil has been slowly coming down but not before the governments of the
world interfered in some way. For starters, they realized that there were two ways to
deal with the problem.

1. To use the OPEC meetings as a means to persuade oil producers to produce

more oil in an effort to match supply with demand for oil.
2. To strictly monitor the oil markets to make sure that the speculation over the
price of oil does not set in hence leading to inconsistent buying and selling
frenzies.

These two primary steps have brought down the level of oil to where it is today.

But it has made amply clear that the World is consuming a lot more oil than even a
year ago and that this is a long term situation that needs to be immediately dealt with.

The Inflation Rates this Year

34
- 2008 Aug 23 12.34%
- 2008 Aug 16 12.40%
- 2008 Aug 09 12.63%
- 2008 Aug 02 12.44%
- 2008 Jul 26 12.01%
- 2008 Jul 19 11.98%
- 2008 Jul 12 11.89%
- 2008 Jul 05 11.91%
- 2008 Jun 28 11.89%
- 2008 Jun 21 11.63%
- 2008 Jun 14 11.42%
- 2008 Jun 07 11.05%
- 2008 May 31 8.75%
- 2008 May 24 8.24%
- 2008 May 17 8.1%

- 2008 May 10 7.82%

- 2008 May 03 7.83%
- 2008 Apr 26 7.61%
- 2008 Apr 19 7.57%
- 2008 Apr 12 7.33%
- 2008 Apr 05 7.14%
- 2008 Mar 29 7.41%
- 2008 Mar 22 7.0%

- 2008 Mar 15 6.68%

- 2008 Mar 08 5.92%
- 2008 Mar 01 5.11%
- 2008 Feb 23 5.02%
- 2008 Feb 16 4.89%
- 2008 Feb 09 4.35%
- 2008 Feb 02 4.07%
- 2008 Jan 26 4.11%
- 2008 Jan 19 3.93%
- 2008 Jan 12 3.83%

- 2008 Jan 05 3.79%

35
 The WPI Inflation Chart showing the hike in inflation from January 2008 to August 2008

Controlling Inflation

India continues to pay the price for not undertaking fundamental monetary policy
reform. Merely raising rates will not solve the problem. The way forward lies in
breaking the INR/USD peg, as was done in early 2007, and having a 10% rupee
appreciation.

When inflation spikes, the single focus of the government becomes controlling
inflation. This is not how mature market economies work. In all mature market
economies, the task of controlling inflation - and only the task of controlling inflation
- is placed with the central bank. In mature market economies, inflation crises do not
arise, because the full power of monetary policy is devoted to this one task.

In their depths of anguish from dealing with this inflation crisis, the Prime Minister
and the Finance Minister should channel their attention to RBI reforms. We are
suffering from these problems because of the blunders of monetary policy. The
possibility of such blunders needs to be eliminated by rewriting the RBI Act. The text
of this Act is completely wrong in the light of the monetary economics that we know
today. With a sound monetary policy framework, inflation would be stabilised,
inflation crises like this would not periodically hijack the government, and
distortionary short-sighted initiatives such as banning exports of certain goods would
not arise.

36
India is in a big mess on monetary policy. The attempt that is underway consists of
pegging the rupee to the dollar at a time when the dollar has dropped sharply. Dollar
prices of many commodities have risen since producers do not like being short-
changed with the same number of dollars. Holding Rs.40 a dollar intact, the global
increase in commodity prices has been imported into India.

With increasing de facto convertibility, pegging the exchange rate to the US dollar
leads to pressure to adopt the monetary policy of the US. The US has cut rates sharply.
A massive interest rate differential has built up, and inspired a flourishing "dollar
carry trade" involving borrowing in the US and bringing money into India. RBI has
been swamped with capital flows owing to this interest rate differential.

In fighting to implement the pegged exchange rate, RBI has done market manipulation
on a massive and unprecedented scale on both the spot and forward markets. The
fiscal costs of this are rapidly building up. In a grim dogfight with the private sector,
RBI artificially engineered a rupee depreciation, from Rs.39.12 on 1 Feb to Rs.40.46
on 17 March, in trying to break expectations of a one-way bet on the rupee. This is
one of the factors which has helped to drive up inflation. Raising interest rates while
leaving the exchange rate regime intact is a poor answer for three reasons:

1. The US 90-day rate is 1.28% and the Indian 90-day rate is 7%. With this
massive interest rate differential, RBI's currency trading in January alone was
over $20 billion! If this is done for a year, we will add $240 billion to reserves
and start suffering an interest cost on MSS of over 2% of GDP. The bigger the
interest rate differential, the bigger the pressure of capital inflows will be.
2. Further, a perceptible slowdown in the world economy is visible. To a smaller
extent, a slowdown is visible in India also. This is not a good time to raise
rates.
3. Finally, the impact of interest rates on inflation is slow and remote. Owing to
policy blunders, we lack the bond-currency-derivatives nexus, the system of
financial markets through which interest rate decisions by a central bank at the
short-term rate are propagated into all interest rates in the economy. RBI's
strategy of preventing sophisticated finance wherever it can has yielded
ineffectiveness of RBI.

The existing stance of monetary policy is ultimately inconsistent because it engenders

inflation that Parliament will not tolerate. The key element of the policy that has to
break is the rupee-dollar pegs at Rs.40 per dollar.

37
The right combination of policy for the short-term involves:

1. An appreciation to Rs.36 per dollar with

2. A reduction in the short rate to 4%.

This would simultaneously hit at all the problems that we face today. A 10% rupee
appreciation would yield a nice dent on inflation, as happened in March 2007. By
reducing the mispricing of the rupee, it would reduce pressure from capital flows. In
addition, a 300 bps reduction in interest rates would reduce the flow of money coming
into the country seeking interest rate arbitrage. To the small extent that the monetary
transmission does work, this rate cut would help bolster the economy in what appears
to be shaping up as a difficult time.

This combination of policies - a stronger rupee, lower rates, and lower inflation -
would restore the balance of a consistent monetary policy framework.

Who would gain and who would lose? The broad population would benefit from
lower inflation. Exporters would suffer owing to a stronger rupee. But as we saw in
2007, the impact of the exchange rate on the WPI is sharp and visible. Exports were
unaffected despite a slowing world economy: Gross earnings on the current account
grew by 19% in the June quarter, 23% in the September quarter and 33% in the
December quarter. Compare these against the values of 27%, 29% and 24% for the
three quarters before the rupee appreciation and the world economic slowdown.

The political economy of an exchange rate appreciation is much like that of cutting
customs duties. The beneficiaries of cutting customs duties are diffused and
widespread. The losers are focused and engage in lobbying. Just as India found the
political resources to cut customs duties despite this lobbying, the same must now be
done with rupee appreciation.

Such political contests are, of course, highly distressing. The long-term answer lies in
depoliticising the rupee-dollar market by focusing the central bank on inflation and
getting it out of currency manipulation. An immature market economy is one where
the exchange rate is stable, and where inflation and GDP growth are unstable. A

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mature market economy is one where inflation and GDP growth are stable, and the
exchange rate is unstable. Getting there requires rewriting the RBI Act.

Recent Measures by the Government to Control Inflation in India

In order to contain inflationary pressures, the monetary measures undertaken by the

Reserve Bank were supplemented by a number of fiscal and supply augmenting
measures undertaken by the Government. These include:

(i) Measures relating to Imports

Pulses: Customs duty on import of pulses was reduced to zero on June 8, 2006 and
the period of validity of import of pulses at zero duty, which was initially available
up to March 2007, was first extended to August 2007 and further to March 2009.

Wheat: Import of wheat at zero duty, which was available up to end-December

2006, was extended further to end-December 2007.

Edible oils: Customs duty on palm oils was reduced by 10 percentage points across
the board in April 2007 and import duty on various edible oils was reduced in a
range of 5-10 percentage points in July 2007. The 4 per cent additional
countervailing duty on all edible oils was also withdrawn. Customs duties on crude
and refined edible oil were reduced from a range of 40-75 per cent to 20.0-27.5 er
cent in March 2008. Import of crude form of edible oil at zero duty and refined form
of edible oil at a duty of 7.5 per cent was allowed.

Rice: In March 2008, the customs duty on semi-milled or wholly-milled rice was
reduced from 70 per cent to zero per cent up to March 2009.

Maize: Customs duty on maize imported under a Tariff Rate Quota of five lakh
metric tonnes was also decreased from 15 per cent to Nil in April 2008.

Milk: In order to ensure adequate availability of milk in lean summer months, basic
customs duty on skimmed milk powder was proposed to be reduced from 15 per
cent to 5 per cent for a Tariff Rate Quota of 10,000 metric tonnes per annum in
April 2008. Similarly, on butter oil, which is used for reconstituting liquid milk,
customs duty was reduced from 40 per cent to 30 per cent.

Cement: On April 3, 2007, import of portland cement other than white cement was
exempted from countervailing duty (CVD) and special additional customs duty; it

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was earlier exempted from basic customs duty in January 2007. Exports of cement
were prohibited with effect from April 11, 2008.

Iron & Steel: In order to augment the domestic availability of steel products as well
as to soften prices, the following measures were announced:

a) Reduction in the basic customs duty on pig iron and mild steel products
viz., sponge iron, granules and powders; ingots, billets, semi-finished products, hot
rolled coils, cold rolled coils, coated coils/sheets, bars and rods, angle shapes and
sections and wires from 5 per cent to Nil;

b) Full exemption of the import of TMT bars and structurals from CVD,
which is currently at 14 per cent;

c) Reduction in the basic customs duty on three critical inputs for manufacture
of steel, i.e. metallurgical coke, ferro alloys and zinc from 5 per cent to Nil.

Cotton: The 10 per cent customs duty on cotton imports along with 4 per cent
special additional duty was abolished with effect from July 8, 2008.

Crude Oil & Petroleum products: Customs duty on crude oil was reduced from 5
per cent to ‘nil’ as well as on diesel and petrol from 7.5 per cent to 2.5 per cent
each, and on other petroleum products from 10.0 per cent to 5.0 per cent. Excise
duty on petrol and diesel was reduced by Re. 1 per Litre.

(ii) Measures relating to Exports

Pulses: A ban was imposed on export of pulses with effect from June 22, 2006 and
the period of validity of prohibition on exports of pulses, which was initially applied
up to end-March 2007, was further extended first up to end-March 2008 and then
for one more year beginning April 1, 2008.

Onion: The minimum export price (MEP) was increased by the National
Agricultural Cooperative Marketing Federation of India Ltd. (NAFED) by US $ 100
per tonne for all destinations from August 20, 2007 and by another US $ 50 per
tonne with effect from October 2007 for restricting exports and augmenting
availability in the domestic market.

Edible Oils: The export of all edible oils was prohibited with immediate effect from
April 1, 2008.

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 Rice: On April 1, 2008, export of non-basmati rice was banned and the minimum
export price (MEP) was raised to US $ 1,200 per tonne in respect of basmati rice.
On April 29, 2008, an export duty of Rs.8,000 per tonne was imposed on basmati
rice along with a commensurate reduction in its minimum export price and thereby
re-fixed the MEP at US$ 1,000 per tonne.

Iron & Steel: On April 29, 2008, export duty was imposed on steel items at the
following three different rates:

• 15 per cent on specified primary forms and semi-finished products, and hot
rolled coils/sheet,
• 10 per cent on specified rolled products including cold-rolled coils/sheets
and pipes and tubes,
• 5 per cent on galvanized steel in coil/sheet form.

For this purpose, a uniform statutory rate of 20 per cent has been incorporated in the
Export Schedule. These measures are expected to disincentivise the export of steel
and augment domestic supply.

Cotton: One per cent drawback benefits (refund of local taxes) on exports of raw
cotton was withdrawn with effect from July 8, 2008.

(iii) Other Measures

a) The minimum support price (MSP) for paddy was raised by Rs. 125 per tonne
for 2007-08 and for wheat by Rs. 150 for 2007-08 and further by Rs. 150 for 2008-
09.

b) Issuance of oil bonds to State-run oil marketing companies.

New Monthly Inflation Rate

India plans to release wholesale price inflation data on a monthly basis from end-
October or mid-November, and says the new reading will include a larger number of
items and better reflect prices.

A senior official at the Commerce and Industry Ministry involved in developing the
new data series said on Tuesday the current weekly wholesale price index (WPI)
would be discontinued.

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"The (new) series is going towards finalisation. When we switch over to monthly data,
there will be no need for the weekly data," he said. The new index would be based on
2004/05 prices.

The official said the government would also release weekly price data for primary
articles, which includes food, non-food products and minerals, after it switches over to
a monthly reading.

Indian inflation jumped to a 13-year high in June after a 10 per cent increase in local
fuel prices and in mid-August was ruling just below an annual 12.5 per cent.

The widely watched wholesale price index rose 12.40 per cent in the 12 months to
Aug. 16, below the previous week's annual rise of 12.63 per cent.

But there has been criticism that the data underestimates price pressures in Asia's
third-largest economy.

Policy makers say monthly WPI data in tandem with weekly numbers for primary
articles would help the central bank better calibrate its monetary policy decisions.

The sharp increase in the inflation rate in the past few months has forced the
government and the central bank to raise rates, tighten liquidity and cut taxes to rein in
soaring prices to avoid voter anger during state and federal polls.

India is also hoping to bring out a new urban consumer price index (CPI) in April or
May next year to give a more accurate and harmonised picture of prices in towns and
cities.

With the policies being followed by India, the government puts forth the estimation
that the inflation rate could be controlled to 10% by the end of the year 2008.

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