Swati - Presentation

8/8/2019 Swati - Presentation

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ROLL NUMBER: PC/AEC/O908

REGISTRATION NUMBER:

O19462 of SESSION 2005-2006

THE ROLE OF THE

RESERVE BANK OF INDIAIN USING MONETARY

POLICY

TO COMBAT INFLATION

IN INDIA


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INTRODUCTION

Inflation is the condition of apersistently rising price level.

Price stability does not mean zeroinflation.

For an emerging market economylike India, an inflation rate of 4%per annum is tolerable.

Study of inflation is important as

costs of inflation are significant.

Social Costs

Inflation erodes the purchasingpower of money.

There is diminution of real valueof savings as real interest ratesturn negative.

Persistently high inflation altersinflationary expectations.

High inflation aggravatesinequality.


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MEANING

OFINFLATION

According to Milton Friedman-

Inflation is always and everywhere a monetary phenomenon

Long run inflation cannot occur without a persistent increase in the moneysupply.

In the short term or medium term inflation can take place due to a negative

supply shock or expansionary fiscal policy.

Inflation can be Cost PushorDemand Pullby nature. Both result from

an activist stabilization policy to promote high employment.

A budget deficit can be the source of a sustained inflation only if it is

persistent and if the government finances it by creating money rather than

by issuing bonds to the public.


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ANTI-INFLATIONARY

POLICIES Contractionary fiscal policy is a measure to control inflation only in the

short run.

Long-run inflation can be checked only by decreasing the money supply.

Another method to check inflation is to freeze wages (an anti-trade unionpolicy) and prices (an anti-trust or anti-monopoly policy).

Inflation Targeting has been adopted by many countries to achieve price

stability. But in a country like India with recurrent supply shocks this

policy is not viable.

Hyperinflation is defined as an extremely rapid increase in the price level.

Its obvious cause is the excessive growth in the money supply, mainly due

to huge government budget deficits.


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EXPERIENCE OF INFLATION

IN INDIA

2004-2005

It was characterized by a steepincrease in fuel prices.

The roots of this inflation were

traced to international supply

shocks rather than domestic

overheating.

TheWPI inflation was 6.5%,

fuel price inflation was 10.1%

while inflation of primary

articles was 3.6%.

2006-2007

Inflation was demand-driven.

Rise in prices of primary productsdue to adverse (sectoral) supply

shock.

Inflation in other prices was due

to booming aggregate demand.

By the end of the yearWPI

inflation subsided to 5.7% but

inflation for primary and

manufactured products was high

at 10.7% and 5.8% respectively.


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RBIs ANTI-INFLATIONARY

POLICIES (2004-2005)

Restrictive monetary measures

The Cash Reserve Ratio (CRR)was raised from 4.5% by 0.25percentage point both in

September & October 2004 by thesame magnitude.

There was a hike in the reverserepo rate to 4.75%.

Sectoral Measures

Urea prices were left unchanged.

The extent of hike in theadministered prices of coal &

mineral oil was less than their

price increases abroad.

Excise & custom duties on

petroleum products were cutsubstantially.

Cuts in tariffs on vegetable oil.

Increase in the quantum of free-

sale sugar.


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RBIs ANTI-INFLATIONARY POLICIES

(2006-2007)

Measures to curb inflation in pricesof primary articles

Imports of wheat, pulses, oilseeds,

maize and sugar was permitted.

Ban on export of wheat, pulses

and skimmed milk powder. Increased supply of wheat under

FCIs public distribution system.

A hundred rupee hike in the

minimum support price for wheat.

Imposition of bans on futuresmarket trading in wheat, tur and

urad.

Measures to curb inflation in pricesof non-agricultural commodities

Custom duties on inorganic

chemicals, non-ferrous metals and

cement was reduced.

Custom duties on petrol anddiesel were reduced from 10% to

7.5% and their prices were raised

by Rs 2 & Re 1 respectively.

Restrictive Monetary Measures

Hike in the reverse repo rate from5.25% to 6%

Hike in repo rate by 150 basis

points to 7.75%.

Hike in CRR from 5% to 6.50%.


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EXPERIENCE OF INFLATION IN INDIA

2008-2009

External supply side shocks werethe key drivers of inflation duringthis period.

Inflation was triggered largely bya sharp increase in the prices ofbasic metals and mineral oils.

The headline inflation deceleratedfrom a peak of 12.91% on August2, 2008 to 0.84% at end- March2009.

2009-2010

During July 2009, y-o-y WPIinflation was (-) 1.17% onaccount of high base last year.

Major contributors to annualinflation were food items i.e.inflation emanated from domestic

sources. There was a decline in the prices

of mineral oil, iron & steel, edibleoils etc.

India witnessed a sharp increaseinWPI inflation from a negative

terrain during June-August 2009to 9.9% by February 2010.

The increase in CPI is even higherin the range of 14.9%- 16.9%.


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RBIs POLICIES (2008-2009)

Measures adopted during the crisis period

The repo rate was reduced by 425 basis points to 4.75%.

The reverse repo rate was reduced by 275 basis points to 3.25%.

The CRR was reduced by a cumulative 400 basis points to 5%.

Institution of several sector-specific liquidity facilities.

Establishment of a forex swap facility.

RBI also allowed restructuring of stressed assets by banks in order toincrease the flow of credit for productive purposes.

Reduction in the Statutory Liquidity Ratio (SLR) from 25% to 24% of

NDTL (Net Demand and Time Liabilities).


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RBIs ANTI-INFLATIONARY

POLICIES (2009-2010)

Policy stance of the RBI

Policy stance was shifted from

managing the crisisto managing

the recovery.

The stance of monetary policy was: To anchor inflation expectations.

Actively manage liquidity.

To ensure that credit demand ofproductive sector was adequatelymet.

In view of the rising food inflation RBI

announced the first phase of exit from

expansionary monetary policy in

October 2009.

Policy measures adopted by the RBI

during the recovery period

CRR of banks was raised to 5.75%from 5% of NDTL.

Increase in policy reverse repo and

repo rates by 25 basis points each in

March 2010.

SLR was restored to 25% of NDTL.Note: 2009-10 inflation is more

challenging and serious as it is

owing to the rise in food prices.


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ECONOMETRIC

ANALYSISCHOICE OF VARIABLES

As per the theoretical discussion, the main determinants of the overall inflationin the economy are: Government budget deficit, M1 (currency + current a/cdeposits), Agricultural(foodgrain) production, GDP & WPI of fuel, power, light& lubricant (viz,WPI of fuel).

The question I want to address:Which of these variables have significantlyaffected the overall inflation in the Indian economy over the past 10 years,i.e. for the period 1999-2009.

In order to avoid Spurious Regression, time series properties of each variablemust match.

The dependent variable being WPI inflation, y-o-y & log values of eachvariable is subject to unit root analysis.

For feasibility of solution, monthly data on each variable has been considered(the variables GDP and foodgrain production have been ignored as monthlydata is unavailable on them).


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RESULTS OF UNIT ROOT TESTRESULTS OF UNIT ROOT TEST

(AT FIRST DIFFERENCE)(AT FIRST DIFFERENCE)

LOGARITHMIC MODELLOGARITHMIC MODEL

VARIABLES

Log (WPI-AllCommodities)

[is stationary at first

difference.

i.e. I (1) ]

Log (M1)


difference.

i.e. I (1) ]

Log (WPI of Fuel)


difference.

i.e. I (1) ]


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APPLICATION OF OLS TO THE

STATIONARY LOG MODEL

Estimated dlog (WPI-All Commodities) =

0.001026 () 0.002961 dlogM1 + 0.281012 dlog (WPI of fuel)

(0.000449) (0.039707) (0.049119)

[2.288623] [-0.074580] [5.721007]

( )- standard error; [ ]- t statistic

dlogM1 is statistically insignificant. dlog (WPI of Fuel) is statisticallysignificant.

No multicollinearity problem.

No autocorrelation problem. Therefore the estimated coefficients are

efficient. Goodness of fit [i.e. correlation coefficient between actual and estimated

values of dlog (WPI-All Commodities)] is 0.451 which is quite good.

Note: For the given sample nature of inflation is cost push

(in the short run).


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COINTEGRATION TEST

2- Step Engle Granger Test has been used to test for the presence of longrun relationship amongst the variables.

Suppose that y(t) ~I (1) and x(t) ~I(1). Then y(t) and x(t) are said to be

cointegrated if there exists a such that y(t) x(t) is I (0) i.e., estimated

u(t) must be I (0). This is denoted by saying y(t) and x(t) are CI (1, 1).

A cointegrating (longrun) relationship is present only between log (WPI-

All Commodities) and log (M1).

This is in conformity with the classical view that in the long run overall

WPI inflation is determined by the money supply alone.

In other words in the absence of monetary accommodation non-monetary

forces have only a transitory affect on the prices.


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Why should price increases (following, say, a one-off

increase in crude prices) which reflect adjustment to a

new equilibrium situation and are not of a continuing

nature be regarded as inflation? Do such price increasesrequire any policy response?

Does not the analysis or diagnosis of inflation in terms of the

behaviour of prices of particular commodities or product

groups go against the fundamental approach of theeconomic theory? Is it not necessary for this purpose to use

a macroeconomic framework?

What is the economic rationale of freezing some

prices or trying to curb their increase for

purposes of controlling inflation?

When inflation is due to some sectoral cost push, but

there is evidence of excess capacity or demanddeficiency elsewhere in the economy should the

central bank take recourse to monetary tightening

at all?

When the administered prices of petroleum or other products

are below their international levels, should the governmentraise them when the overall inflation is low, but keep them

unchanged or lower them if the general price level exhibits

a strong upward trend due to sectoral or macroeconomic

factors?

Since a major reason adduced by the central bank formonetary tightening irrespective of the sources of

inflation is the need for containing inflation

expectations, it is important to ascertain the

determinants of such expectations.

CRITICAL ANALYSIS


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IsWPI superior to other price

indices for purposes ofinitiating anti-inflationary

fiscal or monetary measures?

RBI primarily acts as an ENABLER- the measures

taken by the RBI during the crisis period (2008-

2009) only enable/allow credit expansion. This

however does not imply that there was actualcredit expansion.

In the context of the Indian economy, empirical analysis shows

a high degree of persistence of inflation, especially in the

case of food and edible oil groups. There is an urgent need

to address the issue of structural supply constraints,particularly in agriculture, so that these do not become a

binding constraint in the long run, making the task of

inflation-management more difficult.

RBI states conflicting objectives- it wants the banks to

be profitable and at the same time instructs them toadvance credit to the priority sectors of the

economy. Both these objectives cannot be achieved

simultaneously.

RBI in its policy stance states that it aims to maintain a

balance between growth and inflation. This is again

a self-conflicting objective. In order to achieve

long run growth the economy may have to suffersome amount of inflation in the short run.

Lastly, monetary tools have proved to be more

effective in economies with greater financial

inclusion.


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SUGGESTIONS

NEED FOR A NEW INDEX TO

MEASURE INFLATION

Divergence betweenWPI and CPI

has accentuated since early 2008

This underscores the need for a

representative measure of

inflation for better articulation of

monetary policy.

A broad based CPI for the country

as a whole, including both

services and manufacturing

products, has greater relevance for

monetary policy formulation.

CASE FOR INFLATION-INDEXEDBONDS

Nominal interest rate depends on theexpected real return of investors,expected inflation rate and the

inflation risk premium. One way of mitigating the inflation

risk premium is to issue Inflation

Indexed Bonds with an assured

real return in the range of 2-3%.

Such bonds if properly structuredwould provide a complete hedge

against inflation & protect the long-

time savers & investors from the

inflation risk.


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CONCLUSION

Right now, the RBI seems to be concentrating only on the demand-end ofinflation; as a result the entire perspective of supply is completely ignored.

Inflation may also be curtailed if the supply is bolstered to meet the demands ofthe people.

It is sufficiently clear that the reason that the inflation occurs is because the

economic status and mindsets of the people of India are advancing. Why should this rise in demand be considered as a disadvantage?

The problem here is that the countrys infrastructure is not capable of meetingthese requirements.

But surprisingly, instead of giving any attention to the supply factors, the RBI isstifling the requirements of the consumers and is attempting to create an illusion

that there is no demand for the products. The situation is perfectly described by the following statement:

The greatest trick the devil ever pulled was

convincing the world that evil did not exist


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