INTRODUCTION OF INFLATION

1.1 DEFINITION

According to Crowther, “Inflation is a state in which the value of money is falling i.e. prices
are rising.”

1.2 HOW TO MEASURE INFLATION?

If the price level in the current year is ‘P1’ & in the previous year is ‘Po’, then inflation for
the current year is

1.3 FEATURES OF INFLATION:

1. Inflation leads to persistent remarkable and continuous rise in general price level.
2. Inflation is a scarcity oriented.
3. Inflation is a dynamic phenomenon. It is not a state of high prices, but a process of rising
prices.
4. Inflation is a state of disequilibria. It involves an imbalance between aggregate demand and
aggregate supply.
5. Inflation is a pure monetary phenomenon.
6. Real inflation takes place only after full employment.
7. Inflation is a longer period phenomenon.

1.4 TYPES OF INFLATION:

Inflation is often classified on three different criteria. Firstly, one might distinguish between
various types of inflation on the basis of speed at which the general price level rises.
Secondly, one way distinguishes between open and suppressed inflation. Finally, as we find
in the modern macroeconomic theory, inflation is classified on the basis of the factors, which
induce it.
On the criterion of the rate at which the general price level rises, we have the following types
of inflation:
1. Creeping Inflation
2. Walking Inflation
3. Running Inflation
4. Galloping or Hyper-Inflation
5. Cost-Push Inflation
6. Demand-pull Inflation
7. Built-in Inflation
8. Chronic Inflation
9. Core Inflation
10. Headline inflation
11. Stealth Inflation
12. Assets inflation

1. Creeping Inflation
An extremely mild form of inflation is often characterized as creeping inflation. In this case
prices rise at a rate of around 2 percent per annum. In case the rate of inflation does not
register further increase, those a mild does of inflation may not have any adverse effects on
the economy.
Creeping inflation sometimes provides necessary inducement to investors. The debatable
question about the creeping inflation however, is whether it would not eventually gather
momentum and thereby creates distortions in the economy. The world has witnessed both
types of situations. Certain countries have lived with mild inflation’s over long periods and
their economies in these periods have registered rapid economic growth. In other countries,
creeping inflation eventually accelerated and caused the collapse of the economy.

2. Walking Inflation
The walking inflation in terms of degree of prices rise is an intermediate situation between the creeping and
running inflation’s. The rate of inflation in this case is distinctly higher than that in the case of the creeping
Inflation. Since the walking inflation does not invite widespread protests, the monetary
authorities do often not take it seriously and they don’t undertake timely corrective measures.
It also sometimes leads to balance of payments problems because on the one hand it induces
imports and, on the other discourages exports.
3. Running Inflation
The running inflation is considered to be a stage between walking inflation and
hyperinflation. Since the hyperinflation is often defined as a situation in which prices rise at a
rate of at least 40 percent per month.
When prices rise at a rate exceeding 4-5 percent per month the situation becomes alarming.
This inflation redistributes income to the disadvantages of the fixed income groups such as
workers, pensioners and salary earners, it is considered to be highly unjust. Further a running
inflation also creates conditions of uncertainty. If prices rises from 10-12 percent than the
economy will be collapsed and there will be no monetary measures to prove effective.

4. Hyper Inflation
The hyper-inflation refers to a situation in which prices rise at an alarming rate of 40 percent
per month or even more. The most notable examples of hyper-inflation are to be found in the
economic histories of Germany, Austria, Russia, Poland, Greece, Hungary and China. In
hyperinflation money loses its importance as a store of value as no one holds it for
precautionary and speculative purposes. In fact, a hyper-inflation invariably
leads to a monetary collapse and national catastrophe. However, it is important to recognize
the fact that hyper-inflation does not arise abruptly. It is always a result of wrong policies of
the government. Whenever in some country the government indulges recklessly in
unproductive expenditures, which are largely financed by borrowing from the Central Bank
of the Country, a process of inflation begins which often culminates in hyper-inflation.
5. Cost-Push Inflation
Aggregate supply is the total volume of goods and services produced by an economy at a
given price level. When there is a decrease in the aggregate supply of goods and services
stemming from an increase in the cost of production, we have cost-push inflation. Cost-push
inflation basically means that prices have been “pushed up” by increases in costs of any of
the four factors of production (labour, capital, land or entrepreneurship) when companies are
already running at full production capacity. With higher production costs and productivity
maximized, companies cannot maintain profit margins by producing the same amounts of
goods and services. As a result, the increased costs are passed on to consumers, causing a rise
in the general price level (inflation).
Management Practice under Cost-Push Inflation:
To understand better their effect on inflation, let’s take a look into how and why production
costs can change. A company may need to increases wages if labourers demand
higher salaries (due to increasing prices and thus cost of living) or if labour becomes
more specialized. If the cost of labour, a factor of production, increases, the company has to
allocate more resources to pay for the creation of its goods or services. To continue to
maintain (or increase) profit margins, the company passes the increased costs of production
on to the consumer, making retail prices higher. Along with increasing sales, increasing
prices is a way for companies to constantly increase their bottom lines and essentially grow.
Another factor that can cause increases in production costs is a rise in the price of raw
materials. This could occur because of scarcity of raw materials, an increase in the cost of
labour and/or an increase in the cost of importing raw materials and labour (if the they are
overseas), which is caused by a depreciation in their home currency. The government may
also increase taxes to cover higher fuel and energy costs, forcing companies to allocate more
resources to paying taxes.

To visualize how cost-push inflation works, we can use a simple price-quantity graph
showing what happens to shifts in aggregate supply. The graph below shows the level of
output that can be achieved at each price level. As production costs increase, aggregate
supply decreases from AS1 to AS2 (given production is at full capacity), causing an increase
in the price level from P1 to P2. The rationale behind this increase is that, for companies to
maintain (or increase) profit margins, they will need to raise the retail price paid by
consumers, thereby causing inflation.

6. Demand-Pull Inflation
Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by
the four sections of the macro economy households, businesses, governments and foreign
buyers. When these four sectors concurrently want to purchase more output than the economy
can produce, they compete to purchase limited amounts of goods and services. Buyers in
essence “bid prices up”, again, are causing inflation. This excessive demand, also referred to
as “too much money chasing too few goods”, usually occurs in
an expanding economy.
Management Practice under Demand-Pull Inflation:
The increase in aggregate demand that causes demand-pull inflation can be the result of
various economic dynamics. For example, an increase in government purchases can increase
aggregate demand, thus pulling up prices.

Another factor can be the depreciation of local exchange rates, which raises the price of
imports and, for foreigners, reduces the price of exports. As a result, the purchasing of
imports decreases while the buying of exports by foreigners increases, thereby raising the
overall level of aggregate demand (we are assuming aggregate supply cannot keep up with
aggregate demand as a result of full employment in the economy). Rapid overseas growth can
also ignite an increase in demand as more exports are consumed by foreigners. Finally, if
government reduces taxes, households are left with more disposable income in their pockets.
This in turn leads to increased consumer spending, thus increasing aggregate demand and
eventually causing demand-pull inflation. The results of reduced taxes can lead also to
growing consumer confidence in the local economy, which further increases aggregate
demand.

Demand-pull inflation is a product of an increase in aggregate demand that is faster than the
corresponding increase in aggregate supply. When aggregate demand increases without a
change in aggregate supply, the ‘quantity supplied’ will increase (given production is not at
full capacity). Looking again at the price-quantity graph, we can see the relationship between
aggregate supply and demand. If aggregate demand increases from AD1 to AD2, in the short
run, this will not change (shift) aggregate supply, but cause a change in the quantity supplied
as represented by a movement along the AS curve. The rationale behind this lack of shift in
aggregate supply is that aggregate demand tends to react faster to changes in economic
conditions than aggregate supply.

As companies increase production due to increased demand, the cost to produce each
additional output increases, as represented by the change from P1 to P2. The rationale behind
this change is that companies would need to pay workers more money (e.g. overtime) and/or
invest in additional equipment to keep up with demand, thereby increasing the cost of
production. Just like cost-push inflation, demand-pull inflation can occur as companies, to
maintain profit levels, pass on the higher cost of production to consumer’s prices.
 INDIAN SCENARIO

Inflation is no stranger to the Indian economy. In fact, till the early nineties Indians were used
to double-digit inflation and its attendant consequences. But, since the mid-nineties
controlling inflation has become a priority for policy framers.

The natural fallout of this has been that we, as a nation, have become virtually intolerant to
inflation. While inflation till the early nineties was primarily caused by domestic factors
(supply usually was unable to meet demand, resulting in the classical definition of inflation of
too much money chasing too few goods), today the situation has changed significantly.

Inflation today is caused more by global rather than by domestic factors. Naturally, as the
Indian economy undergoes structural changes, the causes of domestic inflation too have
undergone tectonic changes.

Needless to emphasize, causes of today's inflation are complicated. However, it is indeed

intriguing that the policy response even to this day unfortunately has been fixated on the
traditional anti-inflation instruments of the pre-liberalization era.

Reasons for inflation in India

1) Increase in Demand and fall in supply causes rise in prices.
2) A Growing Economy has to pass through Inflation.
3) Lack of Competition and Advanced Technology (increases cost of production and rise in
price)
4) Defective Monetary and Fiscal Policy (In India its fine)
5) Hoarding (when traders hoard goods with intention to sell later at high prices)
6) Weak Public Distribution System
INFLATION PRESSURE OVER THE LAST FEW MONTHS
INFLATION IN INDIA AND OTHER DEVELOPED COUNTRIES
 INFLATION DURING 1980’s AND 1990’s

WPI inflation was relatively stable between 1983 and 1990, averaging 6 ¾ percent, recording
a low of 3 percent in early 1986, and a high of a little over 10 percent in 1988. In the 1990s,
inflation has, on average, been higher at 8 ¾ percent, and considerably more variable.
Inflation rose sharply in the early 1990s, reaching a peak of a little over 16 percent in late
1991, as primary product prices rose sharply and the balance of payment crisis resulted in a
sharp depreciation of the rupee and upward pressure on the price of industrial inputs.
However, as the agricultural sector rebounded, industrial activity slowed, and financial
stability was restored, inflation declined to 7 percent by mid 1993 but then again accelerated
to over 10 percent during 1994 and 1995 as economic activity recovered strongly. In
response, the RBI moved to tighten monetary policy, and inflation was brought down
gradually, reaching a low of 3 ¾ percent in mid 1997.However, more recently, inflation again
accelerated in the second half of 1998as adverse supply conditions in key commodity markets
put upward pressure on food price. As these conditions have eased, inflation has again fallen
sharply.

Within the three sub-component of WPI, prices in the manufacturing sector have been
lowered and more stable, ranging from 2-13 percent. Inflation in both primary products and
fuel and energy categories has been considerably high in1990s than in the 1980s. Both
indices have also volatile. Within the fuel and energy category, the sharp rise in prices in the
recent year is partly due to government moving more towards market based prices, although
given the administered nature of these prices such adjustment have tended to occur at
irregular intervals leading to sharp movements in the index.
 INFLATION OF INDIA (WPI)

The Wholesale Price Index (WPI) is the most widely used price index in India. It is the only
general index capturing price movements in a comprehensive way. WPI was first published
in 1902, and was one of the more economic indicators available to policy makers until it was
replaced by most developed countries by the Consumer Price Index in the 1970s.It is an
indicator of movement in prices of commodities in all trade and transactions. It is also the
price index in India, which is available on a weekly basis with the shortest possible time lag
of two weeks. It is due to these attributes that it is widely used in business and industry
circles and in Government and is generally taken as an indicator of the rate of inflation in the
economy.

The current series of Index Number of Wholesale Prices in India with 1981- 82 as base year
came into existence from July 1989. With a view to reflecting adequately the changes that
have taken place in the economy since 1981-82, the Government appointed a Working Group
to revise the existing WPI series and to examine the commodity coverage, selection of the
base year, weighting diagram and other related issues. WPI is the index that is used to
measure the change in the average price level of goods traded in wholesale market. The new
series with 1993-94 as the base has as many as 435 items in the Commodity basket. To reflect
the structural changes in the economy that have taken place over a decade, a large number of
commodities have been added and a few with diminished importance have been dropped. In
the revised series, “Primary Articles” contribute 98 items, “Fuel, Power, Light and
Lubricants” 19 items, and “Manufactured Products” provide 318 items. The number of price
quotations in the revised series is spread out to as many as 1918 quotations. In all, there are
136 new items in the revised series. Out of that, Primary Articles account for 13, Fuel Group
contributes 1 and Manufactured Products have 122 new commodities. The revised weights of
the three major groups are given below. Figures in the parentheses are the weights of the
respective groups in the 1981-82 series.
 Primary Articles
 Fuel, Power, Light & Lubricants
 Manufactured Products
India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in
the economy. Most developed countries use the Consumer Price Index (CPI) to calculate
inflation.

Annual rates of change in the WPI calculated using both the existing and the new series are
given below. It is seen that the new series starts at a higher level than the old series
accounting for a relatively higher annual rate of change, but thereafter the two series virtually
move in cycle.

Main constituents of WPI

1. Primary articles
2. Fuel, power
3. Manufactured products
4. Food articles
5. Vegetables
6. Food products
7. Edible oils
8. Cement

Criteria for Selection of Wholesale Price Outlets

The following criteria were used to determine the wholesale price outlets
1. Popularity of an establishment along the line of goods to be priced
2. Consistency of the stock
3. Permanency of the outlet
4. Cooperativeness of the price informant
5. Location

Measures of inflation in India

Three different price indices are available in India
1. Wholesale price index
2. Consumer price index [calculated for 3 different types of workers]
3. GDP deflator
Availability
1. The WPI is available weekly [for a lag of 2 weeks]
2. The CPI is available monthly [for a log of 1 month]
3. The GDP deflator is available annually
In many countries, the main focus is placed on CPI for assessing inflationary trends, because

1. It is the index most statistical resources are placed

2. It is most closely related to the cost of living

In India however the main focus is placed on WPI because it has a broader coverage and is
published on a more frequent and timely basis than the CPI.

However, the CPI remains important because it is used for indexation purposes for many
wage and salary earners.
 RESERVE BANK OF INDIA

The central bank of the country is the Reserve Bank of India (RBI). It was established in
April 1935 with a share capital of Rs. 5 crores on the basis of the recommendations of the
Hilton Young Commission. The share capital was divided into shares of Rs. 100 each fully
paid which was entirely owned by private shareholders in the beginning. The Government
held shares of nominal value of Rs. 2, 20,000.

Reserve Bank of India was nationalized in the year 1949. The general superintendence and
direction of the Bank is entrusted to Central Board of Directors of 20 members, the Governor
and four Deputy Governors, one Government official from the Ministry of Finance, ten
nominated Directors by the Government to give representation to important elements in the
economic life of the country, and four nominated Directors by the Central Government to
represent the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New
Delhi. Local Boards consist of five members each Central Government appointed for a term
of four years to represent territorial and economic interests and the interests of co-operative
and indigenous banks.
The Reserve Bank of India Act, 1934 was commenced on April 1, 1935. The Act, 1934 (II of
1934) provides the statutory basis of the functioning of the bank.
The Bank was constituted for the need of following
 To regulate the issue of bank notes
 To maintain reserves with a view to securing monetary stability and
 To operate the credit and currency system of the country to its advantage.

Functions of Reserve Bank of India:

 To maintain monetary stability so that the business and economic life can deliver welfare
gains of a properly functioning mixed economy.
 To maintain financial stability and ensure sound financial institution so that monetary
stability can be safely pursued and economic units can conduct their business with
confidence.
 To maintain stable payments system so that financial transactions can be safely and
efficiently executed.
 To promote the development of financial infrastructure of markets and systems, and to
enable it to operate efficiently i.e., to play a leading role in developing a sound financial
system so that it can discharge its regulatory function efficiently.
 To ensure that credit allocation by the financial system broadly reflects the national
economic priorities and societal concerns.

ROLE OF RBI

The Reserve Bank of India Act of 1934 entrust all the important functions of a central bank
the Reserve Bank of India.

1. Bank of Issue
Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to issue bank
notes of all denominations. The distribution of one rupee notes and coins and small coins all
over the country is undertaken by the Reserve Bank as agent of the Government. The Reserve
Bank has a separate Issue Department which is entrusted with the issue of currency notes.
The assets and liabilities of the Issue Department are kept separate from those of the Banking
Department. Originally, the assets of the Issue Department were to consist of not less than
two-fifths of gold coin, gold bullion or sterling securities provided the amount of gold was
not less than Rs. 40 crores in value. The remaining three-fifths of the assets might be held in
rupee coins, Government of India rupee securities, eligible bills of exchange and promissory
notes payable in India. Due to the exigencies of the Second World War and the post-war
period, these provisions were considerably modified. Since 1957, the Reserve Bank of India
is required to maintain gold and foreign exchange reserves of Ra. 200 crores, of which at
least Rs. 115 crores should be in gold. The system as it exists today is known as the minimum
reserve system.

2. Banker to Government
The second important function of the Reserve Bank of India is to act as Government banker,
agent and adviser. The Reserve Bank is agent of Central Government and of all State
Governments in India excepting that of Jammu and Kashmir. The Reserve Bank has the
obligation to transact Government business, via. to keep the cash balances as deposits free of
interest, to receive and to make payments on behalf of the Government and to carry out their
exchange remittances and other banking operations. The Reserve Bank of India helps the
Government - both the Union and the States to float new loans and to manage public debt.
The Bank makes ways and means advances to the Governments for 90 days. It makes loans
and advances to the States and local authorities. It acts as adviser to the Government on all
monetary and banking matters.
3. Bankers' Bank and Lender of the Last Resort
The Reserve Bank of India acts as the bankers' bank. According to the provisions of the
Banking Companies Act of 1949, every scheduled bank was required to maintain with the
Reserve Bank a cash balance equivalent to 5% of its demand liabilities and 2 per cent of its
time liabilities in India. By an amendment of 1962, the distinction between demand and time
liabilities was abolished and banks have been asked to keep cash reserves equal to 3 per cent
of their aggregate deposit liabilities. The minimum cash requirements can be changed by the
Reserve Bank of India.

The scheduled banks can borrow from the Reserve Bank of India on the basis of eligible
securities or get financial accommodation in times of need or stringency by rediscounting
bills of exchange. Since commercial banks can always expect the Reserve Bank of India to
come to their help in times of banking crisis the Reserve Bank becomes not only the banker's
bank but also the lender of the last resort.

4. Controller of Credit
The Reserve Bank of India is the controller of credit i.e. it has the power to influence the
volume of credit created by banks in India. It can do so through changing the Bank rate or
through open market operations. According to the Banking Regulation Act of 1949, the
Reserve Bank of India can ask any particular bank or the whole banking system not to lend to
particular groups or persons on the basis of certain types of securities. Since 1956, selective
controls of credit are increasingly being used by the Reserve Bank.

The Reserve Bank of India is armed with many more powers to control the Indian money
market. Every bank has to get a license from the Reserve Bank of India to do banking
business within India, the license can be cancelled by the Reserve Bank of certain stipulated
conditions are not fulfilled. Every bank will have to get the permission of the Reserve Bank
before it can open a new branch. Each scheduled bank must send a weekly return to the
Reserve Bank showing, in detail, its assets and liabilities. This power of the Bank to call for
information is also intended to give it effective control of the credit system.
The Reserve Bank has also the power to inspect the accounts of any commercial bank.
As supreme banking authority in the country, the Reserve Bank of India, therefore, has the
following powers
(a) It holds the cash reserves of all the scheduled banks.
(b) It controls the credit operations of banks through quantitative and qualitative controls.
(c) It controls the banking system through the system of licensing, inspection and calling for
information.
(d) It acts as the lender of the last resort by providing rediscount facilities to scheduled banks.

5. Custodian of Foreign Reserves

The Reserve Bank of India has the responsibility to maintain the official rate of exchange.
According to the Reserve Bank of India Act of 1934, the Bank was required to buy and sell at
fixed rates any amount of sterling in lots of not less than Rs. 10,000. The rate of exchange
fixed was Re. 1 = sh. 6d. Since 1935 the Bank was able to maintain the exchange rate fixed at
lsh.6d. though there were periods of extreme pressure in favour of or against the rupee. After
India became a member of the International Monetary Fund in 1946, the Reserve Bank has
the responsibility of maintaining fixed exchange rates with all other member countries of the
I.M.F.

Besides maintaining the rate of exchange of the rupee, the Reserve Bank has to act as the
custodian of India's reserve of international currencies. The vast sterling balances were
acquired and managed by the Bank. Further, the RBI has the responsibility of administering
the exchange controls of the country.

6. Supervisory functions
In addition to its traditional central banking functions, the Reserve bank has certain non-
monetary functions of the nature of supervision of banks and promotion of sound banking in
India. The Reserve Bank Act, 1934, and the Banking Regulation Act, 1949 have given the
RBI wide powers of supervision and control over commercial and co-operative banks,
relating to licensing and establishments, branch expansion, liquidity of their assets,
management and methods of working, amalgamation, reconstruction, and liquidation.
The RBI is authorized to carry out periodical inspections of the banks and to call for returns
and necessary information from them. The nationalization of 14 major Indian scheduled
banks in July 1969 has imposed new responsibilities on the RBI for directing the growth of
banking and credit policies towards more rapid development of the economy and realization
of certain desired social objectives. The supervisory functions of the RBI have helped a great
deal in improving the standard of banking in India to develop on sound lines and to improve
the methods of their operation.

7. Promotional functions
With economic growth assuming a new urgency since Independence, the range of the
Reserve Bank's functions has steadily widened. The Bank now performs a variety of
developmental and promotional functions, which, at one time, were regarded as outside the
normal scope of central banking. The Reserve Bank was asked to promote banking habit,
extend banking facilities to rural and semi-urban areas, and establish and promote new
specialized financing agencies. Accordingly, the Reserve Bank has helped in the setting up of
the IFCI and the SFC; it set up the Deposit Insurance Corporation in 1962, the Unit Trust of
India in 1964, the Industrial Development Bank of India also in 1964, the Agricultural
Refinance Corporation of India in 1963 and the Industrial Reconstruction Corporation of
India in 1972. These institutions were set up directly or indirectly by the Reserve Bank to
promote saving habit and to mobilize savings, and to provide industrial finance as well as
agricultural finance. As far back as 1935, the Reserve Bank of India set up the Agricultural
Credit Department to provide agricultural credit. But only since 1951 the Bank's role in this
field has become extremely important. The Bank has developed the co-operative credit
movement to encourage saving, to eliminate moneylenders from the villages and to route its
short term credit to agriculture. The RBI has set up the Agricultural Refinance and
Development Corporation to provide long-term finance to farmers.

CONTROL MEASURES OF RBI

RBI actually has four chief weapons in its arsenal to control the inflation. They
are
1. Open Market Operations (OMO)
2. Reserve Requirements (CRR and SLR)
3. Bank Rate or Discount rate
4. Repo rate

1. Open Market Operations (OMO)

In this case RBI sells or buys government securities in open market transaction depending
upon whether it wants to increase the liquidity or reduce it. So when RBI sells government
securities in secondary market it sucks out the liquidity (stock of money) in the economy. So
overall it reduces the money supply available with banks in effect the capital available with
banks for lending purpose becomes scarce hence interest rates move in upward direction.
Exactly opposite happens when RBI buys securities from open market. The transaction
increases the money supply available with banks so the cost of money (interest rate) moves in
downward direction and business activities like new investments, capacity expansion gets
boost. In a nutshell RBI buys securities when the economy is sluggish and demand is not
picking up and sells securities when the economy is overheated and needs to cool down.

OMO is also used in curbing the artificial liquidity created to avoid strengthening of rupee
against dollar in order to remain competitive in exports.

2. Reserve Requirements
This mainly constitute of Cash to Reserve Ratio (CRR) and Statutory Liquidity ratio (SLR).
CRR is the portion of deposits (as cash) which banks have to keep/maintain with the RBI.
This serves two purposes firstly, it ensures that a portion of bank deposits is totally risk-free
and secondly it enables that RBI control liquidity in the system, and thereby, inflation.
Whereas SLR is the portion of their deposits banks are required to invest in government
securities. So due to CRR and SLR obligation towards RBI financial institutions will be able
to lend only the part of money available with them although this effect is small when
transaction is between just two entities and constitute one layer.

But when money flows through series of players and layers very less money will be left with
the institutions present at the bottom of pyramid. So higher is the CRR less is the money
available in the economy. So interest rates will move in upward direction and opposite
happens when CRR is reduced. Recently RBI raised CRR from 4.5% to 5% in two stages
which enabled to transfer about 8000 Crore rupees from money in supply to RBI’s coffers.
CRR has actually been reduced to this level of 5% from 15% in 1981.
3. Bank Rate or Discount rate
This is the rate at which the RBI makes very short term loans to banks. Banks borrow from
the RBI to meet any shortfall in their reserves. An increase in the discount rate means the RBI
wants to slow the pace of growth to reduce inflation. A cut means that the RBI wants the
economy to grow and take up new ventures. Indian bank rate is at 6 per cent down from 10
per cent in 1981 and 12 per cent in 1991

4. Repo rate
It is the rate at which the RBI borrows short term money from the market. After economic
reforms RBI started borrowing at market prevailing rates. So it makes more sense to banks to
lend money to RBI at competitive rate with no risk at all. Although the repo rate transactions
are for very short duration the everyday quantum of operations is approximately Rs 40,000
crore everyday. Thus, large amount of capital is not available for circulation. With increase in
repo rate banks tend to invest more in repo transactions.

Open market operations have limitations due to amount of government securities with RBI is
limited and close to Rs 60,000 Crore and out of that only Rs 45,000 Crore is in form of
marketable securities. Considering Bank Rate which is untouched in current scenario RBI is
left with only 2 major measures viz. CRR and Repo Rate in its armory to guard against the
onslaught of inflation.

Since large part of inflation is attributed to large increase in international oil and metal prices,
the cooling price trend in them comes as a great relief to RBI and Indian economy as a whole
and along with RBI measures has helped stabilize inflation.
 MONETARY POLICY

The Reserve bank of India, being primarily concerned with money matters, so organize
currency and credit that it subs serves the broad economic objectives of the country. In the
performance of this task, it formulates and executes a monetary policy with clear cut goals
and tools to be used for this.

Meaning and objectives

Monetary policy, also described as money and credit policy, itself with the supply of money
as also credit to the economy. This is a statement, announced twice in a year. With decline in
the share of agricultural credit, and a rise in that of a industrial credit, the RBI has started
making an annual policy statement in April with a review of the same in October Beginning
with 1999-2000 The RBI has decided that the policy announcement will be an annual affair.

The policy statement gives an overview of the working of the economy. In the light it
specifies the measures that the RBI intends to take an influence such key factors of money
supply, interest rate and inflation so as to ensure price stability. It also lays down norms for
financial institutions (like banks, finance companies etc.) governed by the RBI. There pertain
to such matters as cash reserves ratio, capital adequacy etc. in short, it is a sort of blue-print
containing a description of aims and means.

Two set of objective have been pursued for long. One is controlled expansion of money. It
sought to achieve the twin objectives of meeting in the full needs of production and trade,
and at the same time moderating the growth of money supply to contain the inflationary
pressure in the economy.

Second is sect oral deployment of the funds depending upon the priorities lay down in the
plant, the RBI as determined the allocation of funds also the interest rate among the different
sector. The sector which have received special attention are; core industries (coal, iron, steel
and engineering etc); food grains (rice, wheat); priority sector (agriculture, small scale
industries etc); and weaker section of population.
During the 1990s, and since then, while the growth of the economy remains the primary aim,
the control of inflation as become more urgent concern of the policy the thrust of the policy
as been restrictive in nature so as to reduce the fast growing money supply. The aim as been
to bring down the high double-digit inflation aimed at achieving the trend rate of inflation at
about 5%. The stipulated growth in money supply was put at an average of 11% to 12% per
annum. And the projected growth the rate of the economy was set at 5% to 6%. The ninth
plan as envisaged an average inflation rate in the region of 7% per annum .The growth of
money supply at 16 % the growth rate of economy is 6.5% other important concern of the
policy as been deployment of funds as among sectors such as procurement of food grains by
the government, priority sectors and export. The monetary policy, with its various aims, is to
supplement the process of macro-stabilization and structural adjustment intimated in the
middle of 1991.

Monetary Policy of RBI

Reserve Bank of India focuses on the following main six basic goals of monetary policy
 High employment
 Economic growth
 Price stability
 Interest-rate stability
 Stability of financial markets
 Stability in foreign exchange markets

Limitation of Monetary Policy

While examining the working of the monetary policy. It is important remember that there are
some limitations on its successful application. These limitations on its successful application.
These limitation mostly arise from the under developed character of the economy, as also
from certain shortcomings of the economic situation obtaining in the country.
1. Restricted scope of policy
The first thing to be aware of is that the policy relating to money is not all that is needed to
combat every evil, not even every monetary problem.

Every economic problem has diagnosed and tackled from all the angles including the
monetary side if the situation so demands. For example the price situation prevailing in the
country is not solely or the case of inflationary rise in price, where money seems to be a
major factor it needs to be stressed that monetary policy can at best influence the demand for
goods. For an effective use of the policy to flight inflation much larger policy profile is
necessary.

Correctly I.G.Patel states “… the role of monetary policy in combating inflation in any
country is strictly limited and that monetary policy can be effective only if it is a part of an
overall frame work of policy which includes not only fiscal and foreign exchange policy but
also what is described as income policy”

2. Predominance of currency
In the context of Indian conditioned a limitation on the effective use of currency in the total
money supply. The fact inhibits the credit-creating capacity of the banking system. And since
the reserve bank operates on money supply via credit to the public, its capacity to do so is
accordingly limited. With currency forming a large proportion of money supply, banks have
to face the problem of large outgo of currency every time they create credit. By habit and
custom associated with the paucity and backwardness of appropriate institution people prefer
to make use of cash rather than cheques. This means that a major portion of the cash
generally percolates in the economy without returning to the banking system in the form of
deposits. This reduces the capacity of the banking system to create fresh credits on the basis
of an increase in its reserves.

However it needs also to be noted that in recent years. The effectiveness of the monetary
policy is on its increase. This is largely because of the larger use of credit and the consequent
relative decline of currency in the total money supply, resulting from the increase in the
diversification of the economy and growth investment and organized money markets. The
last being aided by the reserve bank.

3. Underdeveloped money market

Another inhibiting factor in the Indian situation is the weak money market. This market
essentially dealing in short-term funds, is in fact cut into two with not much communication
between them and therefore with divergence in the structure of interest rates. One part where
the monetary policy is more effective is the organized one consisting of Reserve bank, the
state bank foreign banks, the Indian joint-stock banks etc the other part, which is unorganized
and less amenable to the operation of reserve bank consist of heterogeneous agencies, known
as “indigenous bank” these and other non-banking institutions provide a considerable
proportion of total credit and worse, the linkage between the two sectors are not so well
developed.

In this regard, too, things are improving with the further expansion of organized market and a
large number of indigenous bankers associating with modern institutions including reserve
bank uniform ally over a large part is being witnessed.

4. Existence of black money

A serious obstacle in the efficient working of monetary policy circulation of large amount in
the bank market. The transactions i.e. borrowers and lenders keep their transaction secret. As
such these are not reported the result is that supply and demand of money does not remain as
desired RBI. This means that a significant part of money economy remains outside the orbit
of RBI’s monetary policy it is rightly regarded “as a threat to the ability of the official
monetary-credit policy mechanism to manage demand and price in several sectors of the
economy.

5. Government policies
The scope of monetary policy is further restricted because the RBI could not pursue
independent line in money affairs the expansion of money supply has for example not always
need in the response of genuine needs of the economy .the creation of new money to meet the
government deficits is one such case it has been one powerful factor causing inflationary
pressures in the economy again in the development of credit among different use for example
purchase of government securities through the instrument of Statutory Liquidity Ratio (SLR)
and Cash Reserve Ratio (CRR) further a considerable proportion of as much as 40 percent of
bank credit is required to be extended to the activities specified under the scheme of priority
sectors. So is to case of interest rates which have been influenced more by the government
policy rather than the RBI’s wishes. The rate of interest in respect of specified loans. In fact it
leads to a distortion of interest –structure as the banks tried to make up for this by charging
higher rates from the borrowers.

The enumeration of the main limitation on the monetary policy in India should be enough for
us to realize that this policy, even within its restricted sphere, is not the effective remedy for
problems essentially monetary in character. With in development and diversification of the
economy as also with the furtherance of banking habits things are bound to improve.

However, in the meantime and alongside there is a need to modernize the money market,
which can be the basis for an effective monetary policy.
 MONETARY & CREDIT POLICY

Monetary and Credit policy has direct impact on prices of commodities, inflation and
prevailing interest rates, hence, the growth of overall Indian economy. After the economic
reforms started in early nineties, although the interest rate determination is market based,
credit policy of RBI determines the direction of movement of interest rates. Thus help RBI
control the inflation.

Apart from this it also contains norms for the banking and financial sector and the institutions
which are governed by RBI like Banks, financial institutions, non-banking financial
institutions, primary dealers (money markets) and dealers in the foreign exchange (forex)
market. It also contains an economic overview and presents future forecasts. The objective of
the policy is to maintain price stability and ensure adequate flow of credit to the productive
sectors of the economy. Stability for the national currency and growth in employment and
income are also considered.

Credit policy of RBI

Annual Credit Policy RBI keeps all rates intact. In its credit policy for 2007-08, the Reserve
Bank of India has kept all the interest rates unchanged to sustain the investment boom.

The RBI has lowered its growth forecast to 8.5 per cent from 8.5-9 per cent as it expects
global GDP to decline in 2007. Inflation targets have also been revised downward to 5 per
cent from last year's targets of 5-5.5 per cent and RBI's medium term inflationary target is
now 4-4.5 per cent.

The RBI has also announced important operational tools for moving towards capital account
convertibility. Among them Indian companies can invest in foreign companies’ up to 300 per
cent of their net worth, hedging for individuals and remittances up to $100,000 v/s. USD
50,000 earlier.

Domestic producers and users will also be allowed to hedge their price risk on international
commodity exchanges for copper, aluminum, zinc, and even aviation turbine fuel. Indian
companies will also be allowed to rebook and cancel their forward contracts.
Highlights RBI Monetary and Credit Policy
Following are the highlights of the Monetary and Credit Policy that the
Reserve Bank of India
 RBI hikes CRR by 0.25 per cent from May 24;
 Repo, Reverse Repo, Bank Rates unchanged.
 RBI projects economy to grow by 8-8.5 per cent in 2008-09;
 Inflation to be brought down to around 5.5 per cent in 2008-09 with a preference for
bringing it close to 5.0 per cent as soon as possible. Going forward, the resolve is to
condition policy and perceptions for inflation in the range of 4.0-4.5 per cent so that an
inflation rate of around 3.0 per cent becomes a medium-term objective.
 High priority to price stability, well-anchored inflation expectations and orderly
conditions in financial markets while sustaining the growth momentum.
 Swift response on a continuous basis to evolving adverse international and domestic
developments through both conventional and unconventional measures.
 Emphasis on credit quality and credit delivery while pursuing financial inclusion.
 Scheduled banks required to maintain CRR of 8.25 per cent with effect from the fortnight
beginning May 24, 2008.
 M3 expansion to be moderated in the range of 16.5-17.0 per cent during 2008-09.
 Deposits projected to increase by around 17.0 per cent or Rs 5, 50,000 crore (Rs 5,500
billion) during 2008-09.
 Adjusted non-food credit projected to increase by around 20.0 per cent during 2008-09.
 Introduction of STRIPS in Government securities by the end of 2008- 09.
 A clearing and settlement arrangement for OTC rupee derivatives proposed.
 Domestic crude oil refining companies would be permitted to hedge their commodity
price risk on overseas exchanges/markets on domestic purchase of crude oil and sale of
petroleum products based on underlying contract.
 Currency futures to be introduced in eligible exchanges in consultation with the SEBI;
broad framework to be finalized by May 2008.
 Indian companies to be allowed to invest overseas in energy and natural resources sectors.
 Reserve Bank can be approached for capitalization of export proceeds beyond the
prescribed period of realization.
 Loans granted to RRBs for on lending to agriculture and allied activities to be classified
as indirect finance to agriculture.
 The shortfall in lending to weaker sections would be taken into account for contribution
to RIDF with effect from April 2009.
 RRBs allowed selling loan assets to other banks in excess of their prescribed priority
sector exposure.
 The Reserve Bank to disseminate details of various charges levied by banks.
 Asset classification norms for credit to infrastructure projects relaxed.
 The prudential guidelines for specific off-balance sheet exposures of banks to be
reviewed.
 Reserve Bank to carry out supervisory review of banks' exposure to the commodity
sector.
 The limit of bank loans to individuals for housing having lower risk weight of 50 per cent
enhanced from Rs. 20 lakh to Rs. 30 lakh.
 Consolidated supervision of financial conglomerates proposed.
 Working Group to be set up for a supervisory framework for SPVs/Trusts.
 Inter-departmental Group to review the existing regulatory and supervisory framework
for overseas operations of Indian banks.
 All transactions of Rs. one crore and above made mandatory to be routed through the
electronic payment mechanism.
 Dispense with the extant eligibility norms for opening on-site ATMs for well-managed
and financially sound UCBs.
 Regulations in respect of capital adequacy, liquidity and disclosure norms for
systemically important NBFCs to be reviewed

RBI Credit Policy Refocusing on Inflation

The RBI has raised both the repo and the reverse repo rates by 25 basis points and most
analysts expect further hikes over the next year. Does this mean that the era of benign interest
rates are over? Central banks all over the world are generally fixated on controlling inflation,
even at the cost of economic growth. The US Fed is famous (or notorious, depending which
side you are on), for its obsession with inflation control and has often been accused of
pushing the economy to phases of lower growth through its hawkish interest rate policies.
The RBI, as befitting the central bank of a developing country starved of economic growth,
has traditionally given more importance to growth.

The latest credit policy review came after some optimistic statements from the finance
ministry on inflation and the need to keep interest rates low for sustaining the growth
momentum. The finance minister was less convinced about the need for a rate hike as he
stated publicly that inflation was within manageable limits. The finance ministry was of the
opinion that the effect of high oil prices had more or less been absorbed.

Going by the language of the mid-term review announced, the RBI clearly differs with the
government on both inflation and the impact of oil price. The central bank believes that
higher oil prices, considered a temporary phenomenon in early reports, have become a more
permanent component in inflation management. The RBI is also of opinion that the pass-
through effect of higher oil prices are not fully reflected in the prices of intermediate and final
goods. Hence, the central bank seems to have decided to focus more on inflation rather than
growth.

The RBI clearly admits that it would be difficult to keep year end inflation at the targeted 5 to
5.5 per cent without necessary policy responses. Hence, it has decided to act ahead of the
problem. As a deputy governor of the bank put it, inflation is like toothpaste – once you let it
ooze out, it is very difficult to push back.

As expected, the RBI raised the reverse repo rate, the rate at which it borrows money from
the system, by 25 basis points taking it to 5.25 per cent. The repo rate, the rate at which the
RBI lends money to the system, has also been raised by a matching margin to 6.25 per cent.
The second move was not as widely expected as the first and is being seen as a sign of this
new found aggressiveness. To prevent the market from reading too much into the hikes in
repo and reverse repo rates, the RBI has left both the bank rate and cash reserve ratio (CRR)
unchanged. The bank rate, currently at 6 per cent, is a token or signaling rate which does not
have any operational significance. However, it has some psychological significance as it is
used as a reference rate indicating the medium term interest outlook of the central bank. By
keeping the bank rate stable, the RBI is allowing itself the flexibility to roll back if economic
growth is affected in future.
 IMPACT ON INFLATION

The 15 per cent rise in national and per capita income and a buoyant 9.4 per cent GDP
growth notwithstanding, the common man is still reeling under the massive burden of rising
prices.

In fact, excepting for just sugar, the rates of as many as 7-8 essential commodities have shot
up by over 25 per cent between January and May as against the same period last year.

While the prices of wheat, pulses, spices and condiments, edible oil, meat & meat products,
milk products and fruits & vegetables – on an average – increased by over 25 per cent in this
period, forcing the aim admit to question the authenticity of the much promised inclusive
growth.

The price rises come at a time when India has witnessed a growth of 15.8 per cent in 2006-07
in its national income from Rs 28,46,762 crore in 2005-06 to Rs 32,96,639 crore in 2006-07.

The primary reason for their vegetables price rise is the entry of retailers in organised market
which has been sourcing supplies directly from the farmers to retail warehouses.
 EFFECTS OF INFLATION

2.1 ECONOMIC EFFECTS OF INFLATION

Inflation is a very unpopular happening in an economy. Inflation is the most important

concern of the people as it badly affects their standard of living. Some America presidential
candidates called ‘Inflation As Enemy Number One’ High rate inflation makes the file of the
poor very miserable. It is therefore described as anti-poor. Inflation not only disrupts the
economy but also prepares ground for social and political upheavals.
The effects/consequences of inflation are as followers –

2.1.1. EFFECTS ON PRODUCTION

The condition or fact of being operative or in force on production can be divided into two
categories the stimulating or effect and the disastrous effect.

(A) Stimulating or Favorable Effect

Because of the effects on production it has been observed that mild inflation or gently rising
prices have a stimulating or a tonic effect on the economy. When price rise profits increases,
investment increases that generates income and creates employment as a results output
expands. This process continues up to the point of full employment

(B) Disastrous or Unfavourable Effects

If money supply increases beyond the point of full employment, it would lead to a galloping
or hyperinflation and results in disastrous effects on the economy.
[a] Uncontrolled inflation leads to discouragement in savings due to falling value of money.
[b] Energies of business community are diverted to speculation and making quick profits
rather than genuine production i.e. encourages speculation.
[c] Inflation encourages the hoarding and black marketing
[d] Inflation also affects Misallocation of Resources
[e] Flight of capital is encouraged due to fall in money the investors prefer to invest abroad.
[f] Consumers suffers as seller’s market will be developed if price of all type of goods rise of
any quality.
2.1.2. EFFECTS OF INFLATION ON INCOME DISTRIBUTION
Inflation is socially undesirable. It redistributes wealth in favor of the rich at the cost of poor
it makes the rich richer and poor poorer. The people whose real incomes erode during
inflation are the victims of inflation.
[a] As the value of money falls the burdens of debt is reduced and debtors gain creditor suffer
because in real sense they receive less during inflation.
[b] Fixed income groups like salaried class and pensioners are hit hard during inflation.
[c] Business community welcomes inflation as they earn super normal profits.
[d] Investors in shares benefit during inflation small savers, small investors and class lose
during inflation.
[e] Farmers gain in inflation by prices of agriculture prices commodities rise and costs paid
them lag behind prices.

2.1.3. EFFECT OF INFLATION ON CONSUMPTION AND WELFARE

Inflation reduces the economic welfare of the fixed income groups as the price raises the
purchasing power of money falls hence the people get a smaller amount of goods services or
low quality for the same amount of money. As a result their consumption would fall and the
standard of living. Hence galloping inflation is the ‘Cruelest tax of all’.

2.1.4. EFFECTS OF INFLATION ON FOREIGN TRADE

Inflation affects adversely the Country’s balance of payments situation when prices are
raising foreign demand for our goods will fall and exports declined due to high prices
domestic consumers buy foreign goods and imports rise hence unfavourable balance of
payments.

2.1.5. SOCIAL AND POLITICAL EFFECTS

[a] The antisocial elements get rewarded and the masses suffer during inflation.
[b] Inflation disrupts social life by favouring rich and black market.
[c] The standard of business morality go down during inflation.
[d] People lose faith in democratic government due to inflation.

2.1.6. EFFECTS ON MANUFACTURERS

Inflation is harmful to trade. Manufacturers generally sell goods on credit. When they seek
repayment they find that the money they receive is less than they expected? They therefore
become reluctant to trade.
 MEASURES OF INFLATION

Inflation is measured by calculating the percentage rate of change of a price index, which is
called the inflation rate. This rate can be calculated for many different price indices, including
Consumer price indices (CPIs) which measure the price of a selection of goods purchased by
a "typical consumer." In the UK, an alternative index called the Retail Price Index (RPI) uses
a slightly different market basket.

Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust
fixed incomes and contractual incomes to maintain the real value of those incomes.

Wholesale price index The Wholesale Price Index (WPI) is the most widely used price index
in India. It is the only general index capturing price movements in a comprehensive way.
WPI was first published in 1902, and was one of the more economic indicators available to
policy makers until it was replaced by most developed countries by the Consumer Price Index
in the 1970s.It is an indicator of movement in prices of commodities in all trade and
transactions.
Producer price indices (PPIs) which measure the prices received by producers. This differs
from the CPI in that price subsidization, profits, and taxes may cause the amount received by
the producer to differ from what the consumer paid. There is also typically a delay between
an increase in the PPI and any resulting increase in the CPI. Producer price inflation measures
the pressure being put on producers by the costs of their raw materials. This could be" passed
on" as consumer inflation, or it could be absorbed by profits, or offset by increasing
productivity. In India and the United States, an earlier version of the PPI was called the
Wholesale Price Index.

Commodity price indices, which measure the price of a selection of commodities. In the
present commodity price indices are weighted by the relative importance of the components
to the "all in" cost of an employee.

The GDP Deflator is a measure of the price of all the goods and services included in Gross
Domestic Product (GDP). The US Commerce Department publishes a deflator series for US
GDP, defined as its nominal GDP measure divided by its real GDP measure.
Capital goods price Index, although so far no attempt at building such an index has been
made, several economists have recently pointed out the necessity of measuring capital goods
inflation (inflation in the price of stocks, real estate, and other assets) separately.[citation
needed] Indeed a given increase in the supply of money can lead to a rise in inflation
(consumption goods inflation) and or to a rise in capital goods price inflation. The growth in
money supply has remained fairly constant through since the 1970's however consumption
goods price inflation has been reduced because most of the inflation has happened in the
capital goods prices.

Regional Inflation
The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of
the US.

Historical Inflation
Before collecting consistent econometric data became standard for governments, and for the
purpose of comparing absolute, rather than relative standards of living, various economists
have calculated imputed inflation figures. Most inflation data before the early 20th century is
imputed based on the known costs of goods, rather than compiled at the time. It is also used
to adjust for the differences in real standard of living for the presence of technology. This is
equivalent to not adjusting the composition of baskets over time.
 MEASURES TO CONTROL INFLATION

These are the following actions taken to control inflation

1) Monetary Measures
2) Fiscal Measures
3) Other Non-monetary Measures

(1) MONETARY MEASURES

(A) Quantitative Methods
1. Raising the Bank Rate
To control inflation the central bank increases the bank rate. With this the cost of borrowing
of commercial banks from central bank will increase so the commercial banks will charge
higher rate of interest on loans. This discourages borrowings and thereby helps to reduce the
money in circulation.

2. Open Market Operations

During inflation, the central bank sells the bills and securities. These cash reserves of
commercial banks will decrease as they pay central bank for purchasing these securities. Thus
the loan able funds with commercial banks decrease which leads to credit contraction.

3. Variable Reserve Ratio

The commercial banks have to keep certain percentage of their deposits with the central bank
in the form of cash reserve. During inflation, the central bank increases this cash reserve ratio
this will reduce the lending capacity of the banks.

(B) The Qualitative Methods

1. Fixation of Margin Requirements
Commercial banks have to maintain certain fixed margins while granting loans. In inflation
central bank raises the margin to contract credits and reduces the price level.

2. Regulation of Consumer Credit

For purchase of durable consumer goods on installment basis rules regarding payments are
fixed. During inflation and initial payment is increased and the number of installments are
reduced. These results in credit contraction and fall in prices.

3. Control through Directives

Certain directives are issued by central bank to commercial banks and they are asked to
follow them while lending. This keeps in check the volume of money.

4. Rationing of Credit
The central bank regulates the amount and purpose for which credit is granted by commercial
banks.

5. Moral Suasion
This refers to request made by central bank to commercial banks to follow its general
monetary policy.

6. Direct Action
Direct action is taken by central bank against commercial banks if they do not follow the
monetary policy laid by it.

7. Publicity
The central bank undertakes publicity to educate commercial bank and public about the
trends in money market. By undertaking these measures the central bank can control the
money supply and help to curb inflation.
 TRACKING INFLATION

Many people think it is ok to tolerate some inflation if, in return, it is possible to sustain
higher growth rates. Nothing matters as much for peace, prosperity and poverty alleviation as
high GDP growth. However, the link between inflation and growth is complex. High inflation
does not give high growth. The growth miracles of Asia, where above 7% growth was
sustained over a 25-year period, were not associated with high inflation. In fact, countries
with high inflation have tended to have low growth.

In the business cycle, an acceleration of inflation can support a temporary acceleration of

growth. In India, expected inflation has gone up from roughly 3% in 2004 to roughly 7%
today--a rise of 4 percentage points.

Interest rates have risen by less than 4 percentage points. As a consequence, real interest rates
have actually gone down. Borrowing has become cheaper; we have a credit boom; and this is
giving heightened GDP growth.

If inflation now stands still at 7%, this boost to GDP growth will fade away. Episodes where
inflation went up are associated with a brief acceleration of GDP growth. A government can
jolt an economy by raising the inflation rate. This heightened growth is not sustained.
Conversely, achieving high sustained GDP growth is about fundamental issues of economic
reform, and does not concomitantly require high inflation.

One of the great strengths of India is that the political system just does not accept high
inflation. This is one area where politicians have been ahead of the intellectuals. Inflation of
3% is politically acceptable, and inflation above 5% sets off alarm bells.

The government that can jolt an economy by raising the inflation rate then has to go through
the costly process of wringing out the inflation, to get back to 3%. Since there is no trade-off
between inflation and GDP growth, Parliament is right in demanding low inflation and high
GDP growth.
Currently, in India, we go through boom-and-bust cycles; sometimes GDP growth rates are
very high and sometimes GDP growth rates drop sharply. This boom-and-bust cycle is
unpleasant for every household. There is a powerful international consensus that stabilizing
inflation reduces this boom and- bust cycle of GDP growth.

The ideal combination, which has been achieved in all mature market economies, is one
involving low inflation, which is also predictable and nonvolatile. Low inflation volatility
induces low volatility of GDP growth.

Low and predictable inflation also reduces the number of mistakes made by entrepreneurs in
formulating investment plans. What India does not have is an institutional capacity for
delivering predictable, non-volatile inflation of 3%. In socialist India, the way to deal with an
outbreak of inflation was to do government interference in commodity markets.

A few commodities that "cause" inflation are identified, and the government swings into
action banning exports, giving out import licenses, banning futures trading, sending the
police to unearth "hoarding", etc.

This is deeply distortionary. Milk exports were banned, and milk prices fell. But why should
milk farmers pay for a macroeconomic problem of inflation? The cost of bringing down
inflation needs to be dispersed all across the economy.

If milk prices had been allowed to rise, then more labour and capital would shift from
unproductive cereals to high-value milk production. India has the potential to be the world's
biggest exporter of milk. But this requires a sophisticated web of producers, supply chain,
exporters, factories, etc.

This sophisticated ecosystem will not flourish when the government meddles in the milk
industry. A meddlesome government will go through the whiplash of doing an MSP one day
because milk prices are low and banning exports another day because milk prices are high.

There is something profoundly wrong about a government that interferes in what can be
imported and what can be exported. If the export of ball bearings were sometimes banned by
the government, you can be sure there would be fewer factories to build ball bearings.
India is evolving from a socialist past into a mature market economy. How can predictable,
non-volatile inflation of 3% be achieved? The recipe that has been developed worldwide is to
devote the entire power of monetary policy to this one task. In India, the RBI has a complex
mandate spanning over many contradictory roles. This has led to failures on inflation control.

In a mature market economy, a modern central bank watches expected inflation with great
interest. Active trading takes place on the spot and derivatives markets, for both ordinary
bonds and inflation-indexed bonds.

Using these prices, a modern central bank is able to infer expected inflation. When the short-
term interest rate is raised or lowered, in order to respond to changes in expected inflation,
there is a slow impact on the economy, possibly spread over two to three years. A modern
central bank has the economic knowledge required to watch out for expected inflation deep in
the future, and respond to it ahead of time, so as to deliver inflation that is on target.

In India's case, the RBI Act of 1934 predates modern monetary economics. In other countries,
fundamental reforms have been undertaken in order to refashion monetary institutions in the
light of modern knowledge. As an example, in the late 1990s, when Tony Blair and Gordon
Brown won the election, they refashioned the Bank of England as a focused central bank
which has three core values

The bad drafting of the RBI Act of 1934 is the ultimate cause of the distress of milk
producers today. These linkages are not immediately visible, but they are very real. It is
because India does not have a proper institutional foundation for monetary policy that we are
reduced to distortionary mechanisms for inflation control.
 ISSUES IN MEASURING INFLATION

Measuring inflation requires finding objective ways of separating out changes in nominal
prices from other influences related to real activity. In the simplest possible case, if the price
of a 10 kgs of corn changes from 90 to 100 over the course of a year, with no change in
quality, then this price change represents inflation. But we are usually more interested in
knowing how the overall cost of living changes, and therefore instead of looking at the
change in price of one good, we want to know how the price of a large 'basket' of goods and
services changes. This is the purpose of looking at a price index, which is a weighted average
of many prices. The weights in the Consumer Price Index, for example, represent the fraction
of spending that typical consumers spend on each type of goods (using data collected by
surveying households).

Inflation measures are often modified over time, either for the relative weight of goods in the
basket, or in the way in which goods from the present are compared with goods from the past.
This includes hedonic adjustments and “reweighing” as well as using chained measures of
inflation. As with many economic numbers, inflation numbers are often seasonally adjusted
in order to differentiate expected cyclical cost increases, versus changes in the economy.

Inflation numbers are averaged or otherwise subjected to statistical techniques in order to

remove statistical noise and volatility of individual prices. Finally, when looking at inflation,
economic institutions sometimes only look at subsets or special indices. One common set is
inflation excluding food and energy, which is often called “core inflation”.
 AN EXAMPLE OF HOW INFLATION CAN BE DANGEROUS

Hazards of inflation [How Zimbabwe was affected by inflation] have you heard of a country
which is dotted with malls filled with goods, but no customers? It is Zimbabwe, the land of
Mugabe.

Zimbabwe is a classic case of how inflation can make life hell for people. Experts say it all
started with Mugabe’s regime. Whatever may be the reason, the basic flaw in Zimbabwe’s
economy is that Zimbabwe lost its ability to feed itself.

So, if you don’t have enough agriculture commodities the prices are bound to go up. This is
one lesson India can learn from Zimbabwe. India’s wheat, rice, pulses and edible oil
production is not enough to keep pace with the growth the country is witnessing. That is why
Indian government is worrying about the rising inflation rates.

However, it is not anywhere near Zimbabwe. Zimbabwe’s skyrocketing inflation – now the
world’s highest, running at more than 100,000 per cent a year – keeps the cost of living
rising.

In 1979, when Mugabe’s nationalist rebels overthrew the white dominated government of
Rhodesia, and changed the name of the country to Zimbabwe, thousands of commercial
farms managed to grow enough food to export throughout the region.

At present, more than a decade of mismanagement and neglect has dropped agricultural
production to pre-colonial levels. This year, Zimbabwe’s shortfall in maize is 360,000 tones,
and its shortfall in wheat is 255,000 tones.

Streets of Zimbabwe are dotted with shopping mall. That shows that there is food on the
shelves, but all of it highly priced. Massive department stores, built for a time when farmers
from miles around would come to do their weekend shopping, are full of clothes, but without
customers.

With cash almost a worthless possession, people have started investing in something
different. They stack bags of maize meal in their homes.
The situation in Zimbabwe has hit several Indians badly. Many of the Indian businessmen in
Zimbabwe, especially Guajarati’s, are finding it tough to do trade there.

Because, a sausage sandwich sells for 30 million Zimbabwe dollars, or about US $1.25. A
30-pound bag of potatoes cost 90 million in the first week of March. Now that same bag costs
160 million.

So, Zimbabwe is an example for the world how inflation can ruin a country, which does not
produce enough food for itself.
 CONCLUSION

Inflation is not simply a matter of rising prices. There are endemic and perhaps
diverse reasons at the root of inflation. Cost-push inflation is a result of decreased
aggregate supply as well as increased costs of production, itself a result of different
factors. The increase in aggregate supply causing demand-pull inflation can be the
result of many factors, including increases in government spending and depreciation
of the local exchange rate. If an economy identifies what type of inflation is occurring
(cost-push or demand pull), then the economy may be better able to rectify (if
necessary) rising prices and the loss of purchasing power.

Inflation is just like a man whose behaviour cannot be predicted and one can say that
as man has two faces, similarly Inflation can also be said to have Positive and
Negative faces on Indian Economy.