Case study 1 : Inflation of India

What causes Inflation?

In India, the wholesale price index (WPI), which was the main measure of the inflation rate, consisted of three main components - primary articles, which included food articles, constituting22% of the index; fuel, constituting 14% of the index; and manufactured goods, which accounted for the remaining 64% of the index.

For purposes of analysis and to measure more accurately the price levels for different sections of society and for different regions, the RBI also kept track of consumer price indices. The average annual GDP growth in the 2000s was about 6% and during the second quarter (July-September) of fiscal 2006-2007, the growth rate was as high as 9.2%. All this growth was bound to lead to higher demand for goods. However, the growth in the supply of goods, especially food articles such as wheat and pulses, did not keep pace with the growth in demand. As a result, the prices of food articles increased. According to Subir Gokarn, Executive Director and Chief Economist, "The inflationary pressures have been particularly acute this time due to supply side constraints of food articles which are a combination of temporary and structural factors."

Measures Taken

In late 2006 and early 2007, the RBI announced some measures to control inflation. These measures included increasing repo rates, the Cash Reserve Ratio (CRR) and reducing the rate of interest on cash deposited by banks with the RBI. With the increase in the repo rates and bank rates, banks had to pay a higher interest rate for the money they borrowed from the RBI. Consequently, the banks increased the rate at which they lent to their customers. The increase in the CRR reduced the money supply in the system because banks now had to keep more money as reserves. On December 08, 2006, the RBI again increased the CRR by 50 basis points to 5.5%. On January 31, 2007, the RBI increased the repo rate by 25 basis points to 7.5%.

Outlook

Several analysts were of the view that the RBI could have handled the 2006-07 inflation without tinkering with the interest rates, which according to them could slow down economic growth. Others believed that high inflation was often seen by investors as a sign of economic mismanagement and sustained high inflation would affect investor confidence in the economy. However, the inflation rate in emerging economies was usually higher than developed economies.



However, by looking at the inflation rate of 2006-2007, we will find the contractionary monetary policy taken by India government did not cure the inflationary growth. In long run, supply-side policy which increases the productive capacity of India should be taken instead.