Lecture Note

Course, H 101: Introduction to Economics

Instructor: Dr Amarendra Das1

Inflation

Definition: Persistent and perceptible rise in general price is known as inflation.

The words that need emphasis in this definition are persistent, perceptible and
general price. That means to be called inflation price should rise continuously
and significantly. By general price we mean the weighted average price of all
commodities. Suppose in the market there are 100 commodities and the price
of 50 commodities have fallen and price of 50 commodities have risen. The
weighted average price rise could be zero. In this case it may not be called
inflation.

In the common parlance, inflation is measured from the Whole Sale Price Index
or Consumer Price Index. The Wholesale Price Index (WPI) is the price of a
representative basket of wholesale goods. A consumer price index (CPI)
measures changes in the price level of market basket of consumer goods and
services purchased by households. The CPI is a statistical estimate constructed
using the prices of a sample of representative items whose prices are collected
periodically. The computation of CPI takes into account price changes and the
actual inflation that affects the end
consumer. CPI is thus a reflection of
changes in the retail prices of specified
goods and services over a time period
which is traded by particular consumer
group.

Types of Inflation Based on Factors

responsible

1. Demand Pull Inflation and

2. Cost push Inflation

Figure 1: Demand Pull inflation

1
Assistant Professor in Economics, School of Humanities and Social Sciences, NISER, Bhubaneswar. Email
[email protected]

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Demand Pull Inflation: When demand is greater than supply, commodity price
rises. The rise in demand could be due to rise in the general income level of the
people, changes in the taste and preferences etc. In figure 1 we see that there is
a shift in the demand curve to the right side resulting in a shift in equilibrium
from point A to point B. This leads to a rise in price from OP* to OP1. Keynes
argued that demand pull inflation could be a full employment phenomenon
only. In figure 2 we show a Keynesian long run aggregate supply curve (LRAS)
which bends upward at full employment level of output Y3. In case of
underemployment equilibrium due to rise in demand, supply could also
increase to meet the excess demand and keep the price at same level or price
would rise moderately. For example when demand curve shifts from AD1 to
AD2 and up to AD3 supply also rises from Y1 to Y2 and Y3. Due to rise in
demand quantity supply also increases. However, after Y3 quantity of supply if
demand rises further to AD4 quantity supply cannot increase further and it
leads to only rise in price from P3 to P4. However, it is observed that even in
case of underemployment situation there could be demand pull inflation due to
market imperfection and
other structural
constraints. For example
in case of India the food
inflation remained at a
very high level between
2011 and 2014. This was
due to draught and low
agricultural output
compared to the rise in
demand. In such a
situation government
becomes helpless to
control price in spite of its
best efforts.

Figure 2: Inflation before and at full employment

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Cost Push Inflation

Price of a product could rise due to

rise in the cost of production. When
the cost of production rises due to
rise in wages, raw material cost, fuel
costs, etc. Due to rise in the cost of
inputs the supply curve shifts to left
side. In the figure 3 equilibrium
changes from E1 to E2 due to rise in
cost of inputs and shift in supply
curve left ward. Resultantly
equilibrium price rises from P1 to P2.

In India for example, due to rise in Figure 3 Cost Push Inflation

crude oil prices in the international
market, petrol and diesel prices rise. This leads to rise in the transportation
cost and fuel cost of production. Finally this leads to a rise in the general
prices.

Types of Inflation (Based on Rates)

Creeping Inflation: Creeping or mild inflation is when prices rise 3% a year or

less. Such inflations are not harmful for the economy. As a matter of fact
creeping or mild inflation is good for economy as its gives a positive business
sentiment. In Indian case RBI has kept the inflation target of 4% ±2%.
Therefore inflation between 2 to 6% is acceptable and could be considered as
creeping inflation. This rate would vary across countries keeping in view the
growth rate of economy. In India the nominal growth rate of GDP remains more
than 12% and real GDP growth hovers around 7%. In such a case an inflation
rate of 4-6% is manageable. However, in case of advanced economies like US
and EU, UK where GDP growth rates remains below 2-3% an inflation of more
than 3% could be considered as a matter of concern.

Walking Inflation: This type of strong, or pernicious, inflation is between 6-

10% a year. It is harmful to the economy because it heats up economic
growth too fast. People start to buy more than they need, just to avoid
tomorrow's much higher prices. This drives demand even further, so that
suppliers can't keep up. As a result, common goods and services are priced out
of the reach of most people.

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Galloping inflation: When inflation rises to ten percent or greater, it wreaks
absolute havoc on the economy. Money loses value so fast that business and

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employee income can't keep up with costs and prices. Foreign investors avoid
the country, depriving it of needed capital. The economy becomes unstable,
and government leaders lose credibility. Galloping inflation must be prevented.
India experienced

Hyper Inflation: Hyperinflation is when the prices skyrocket more than 50% a
month. It is fortunately very rare. In fact, most examples of hyperinflation have
occurred when the government printed money recklessly to pay for war.
Examples of hyperinflation include Germany in the 1920s, Zimbabwe in the
2000s, and during the American Civil War. Indian has never experienced hyper
inflation.

Core Inflation: This is the inflation rate that excludes temporary ‘volatile’
factors, such as energy and food prices.

Effects of Inflation:

Positive Impact on Traders. Traders make a huge amount of profit during

hyper inflation.

Negative impact on fixed salaried class and E1 wage earners. If the nominal
income remains same and inflation goes up, then them real income of the wage
earners goes down. For example with a monthly income of Rs 1000, the
consumer used to purchase 20 kg of dal at price Rs 50 per kg. But now with
the same wage if dal price goes up to 100 the consumer can purchase only 10
KG dal.

If the input prices rises producer may incur higher cost of production. This will
further lead to rise in price, fall in demand and reduction in profit margin.

Deflation:

Persistent and perceptible fall in price.

Compared to inflation, deflation is bad for the economy. Steady fall in price
would create a pessimist business environment.

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 Measures to Control Inflation

Broadly two sets of policies are used to control inflation.

1. Monetary Policy
2. Fiscal Policy

Monetary policy refers to use of monetary instruments under the control of

central bank to regulate magnitudes such as interest rate, money supply,
availability of credit with a view to achieving the ultimate objective of economic
policy.

The goal(s) of monetary policy

 The primary objective of monetary policy is to maintain price stability while keeping in mind
the objective of growth. Price stability is a necessary precondition to sustainable growth.

 In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory
basis for the implementation of the flexible inflation targeting framework.

 The amended RBI Act also provides for the inflation target to be set by the Government of
India, in consultation with the Reserve Bank, once in every five years. Accordingly, the
Central Government has notified in the Official Gazette 4 per cent Consumer Price Index
(CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the
upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.

 The Central Government notified the following as factors that constitute failure to achieve the
inflation target:(a) the average inflation is more than the upper tolerance level of the inflation
target for any three consecutive quarters; or (b) the average inflation is less than the lower
tolerance level for any three consecutive quarters.

 Prior to the amendment in the RBI Act in May 2016, the flexible inflation targeting framework
was governed by an Agreement on Monetary Policy Framework between the Government and
the Reserve Bank of India of February 20, 2015.

The Monetary Policy Framework

 The amended RBI Act explicitly provides the legislative mandate to the Reserve Bank to
operate the monetary policy framework of the country.

 The framework aims at setting the policy (repo) rate based on an assessment of the current and
evolving macroeconomic situation; and modulation of liquidity conditions to anchor money
market rates at or around the repo rate. Repo rate changes transmit through the money market
to the entire the financial system, which, in turn, influences aggregate demand – a key
determinant of inflation and growth.

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 Once the repo rate is announced, the operating framework designed by the Reserve Bank
envisages liquidity management on a day-to-day basis through appropriate actions, which aim
at anchoring the operating target – the weighted average call rate (WACR) – around the repo
rate.

 The operating framework is fine-tuned and revised depending on the evolving financial market
and monetary conditions, while ensuring consistency with the monetary policy stance. The
liquidity management framework was last revised significantly in April 2016.

The Monetary Policy Process

 Section 45ZB of the amended RBI Act, 1934 also provides for an empowered six-member
monetary policy committee (MPC) to be constituted by the Central Government by
notification in the Official Gazette. Accordingly, the Central Government in September 2016
constituted the MPC as under:

1. Governor of the Reserve Bank of India – Chairperson, ex officio;

2. Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy – Member, ex
officio;

3. One officer of the Reserve Bank of India to be nominated by the Central Board – Member, ex
officio;

4. Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) – Member;

5. Professor Pami Dua, Director, Delhi School of Economics – Member; and

6. Dr. Ravindra H. Dholakia, Professor, Indian Institute of Management, Ahmedabad – Member.

(Members referred to at 4 to 6 above, will hold office for a period of four years or until further
orders, whichever is earlier.)

 The MPC determines the policy interest rate required to achieve the inflation target. The first
meeting of the MPC was held on October 3 and 4, 2016 in the run up to the Fourth Bi-monthly
Monetary Policy Statement, 2016-17.

 The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the
monetary policy. Views of key stakeholders in the economy, and analytical work of the
Reserve Bank contribute to the process for arriving at the decision on the policy repo rate.

 The Financial Markets Operations Department (FMOD) operationalises the monetary policy,
mainly through day-to-day liquidity management operations. The Financial Markets
Committee (FMC) meets daily to review the liquidity conditions so as to ensure that the
operating target of monetary policy (weighted average lending rate) is kept close to the policy
repo rate.

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 Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary
policy with experts from monetary economics, central banking, financial markets and public
finance advised the Reserve Bank on the stance of monetary policy. However, its role was
only advisory in nature. With the formation of MPC, the TAC on Monetary Policy ceased to
exist.

Instruments of Monetary Policy

There are several direct and indirect instruments that are used for implementing monetary policy.

 Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to
banks against the collateral of government and other approved securities under the liquidity
adjustment facility (LAF).

 Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on
an overnight basis, from banks against the collateral of eligible government securities under
the LAF.

 Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo
auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected
under fine-tuning variable rate repo auctions of range of tenors. The aim of term repo is to help
develop the inter-bank term money market, which in turn can set market based benchmarks for
pricing of loans and deposits, and hence improve transmission of monetary policy. The
Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated under
the market conditions.

 Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can
borrow additional amount of overnight money from the Reserve Bank by dipping into their
Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides
a safety valve against unanticipated liquidity shocks to the banking system.

 Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in
the weighted average call money rate.

 Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of
exchange or other commercial papers. The Bank Rate is published under Section 49 of the
Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore,
changes automatically as and when the MSF rate changes alongside policy repo rate changes.

 Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with
the Reserve Bank as a share of such per cent of its Net demand and time liabilities (NDTL)
that the Reserve Bank may notify from time to time in the Gazette of India.

 Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in safe
and liquid assets, such as, unencumbered government securities, cash and gold. Changes in

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 SLR often influence the availability of resources in the banking system for lending to the
private sector.

 Open Market Operations (OMOs): These include both, outright purchase and sale of
government securities, for injection and absorption of durable liquidity, respectively.

 Market Stabilisation Scheme (MSS): This instrument for monetary management was
introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital
inflows is absorbed through sale of short-dated government securities and treasury bills. The
cash so mobilised is held in a separate government account with the Reserve Bank.

For current operative policy rates, please see "Current Rates" section on the home page.

Open and Transparent Monetary Policy Making

 Under the amended RBI Act, the monetary policy making is as under:

 The MPC is required to meet at least four times in a year.

 The quorum for the meeting of the MPC is four members.

 Each member of the MPC has one vote, and in the event of an equality of votes, the Governor
has a second or casting vote.

 The resolution adopted by the MPC is published after conclusion of every meeting of the MPC
in accordance with the provisions of Chapter III F of the Reserve Bank of India Act, 1934.

 On the 14th day, the minutes of the proceedings of the MPC are published which include:

a. a. the resolution adopted by the MPC;

b. b. the vote of each member on the resolution, ascribed to such member; and

c. c. the statement of each member on the resolution adopted.

 Once in every six months, the Reserve Bank is required to publish a document called the
Monetary Policy Report to explain:

a. a. the sources of inflation; and

b. b. the forecast of inflation for 6-18 months ahead.

Fiscal Policy

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The term fiscal is derived from Roman word Fisc which means treasury.
Therefore, fiscal policy refers to the policy of treasury. Fiscal policy has two
components: Expenditure and taxation.

Contractionary Fiscal Policy: Contractionary fiscal policy refers to the policy of

treasury in which expenditure is slashed and tax rate is increased. Reduction
in government expenditure reduces the income of people and thus aggregate
demand. Similarly, increase in tax rates reduces the disposable income with
the people and thus reduces the incentive to invest for the producers and
expenditure of the consumer. Overall result is shrink in aggregate demand.

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