Wednesday, May 18, 2011

Identify the major factors that have been responsible for inflation and what policy measures have been taken by the government to tackle this problem?

Identify the major factors that have been responsible for inflation and
what policy measures have been taken by the government to tackle this

Answer. Inflation is the expansion of the monetary base usually effected through
a central bank's borrowing or printing of currency. Inflation results in a persistent
rise in the general price level as measured against a standard level of purchasing
power. There are many varying measures of inflation in use because different
prices affect different people. The most widely known indices are the Consumer
Price Index (CPI) which measures the change in nominal consumer prices and
the GDP deflator which measures inflation in new products and services created.
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
Types of Inflation
Demand-pull inflation: This is basically when the aggregate demand in an
economy exceeds the aggregate supply. It is also defined as `too much money
chasing too few goods'. Bare-boned, it means that a country is capable of
producing only 100 items but the demand is for 105 items.
It's a very simple demand-supply issue. The more demand there is, the costlier it
becomes. Much the same as the way real estate in the country is rising.
Cost-push inflation: This is caused when there is a supply shock. The best
example to describe cost-push inflation is the oil shock in the 1970s. When
OPEC was formed, it squeezed the supply of oil and this caused oil prices to rise,
contributing to higher inflation. This is similar to what has happened recently
when the oil price hike increased inflation in many a country.
Inflation in India: How to tackle it
Global imbalance the cause for global liquidity
To understand the text of the present bout of inflation, let us at the outset
understand the context: the functioning of the global economy, which is in a state
of extreme imbalance. This is simply because developed western economies,
particularly the United States, are consuming on a massive scale leading to
gargantuan trade deficits.
Crucially their extreme levels of consumption and imports are matched by the
proclivity, nay fetish, of the developing countries in having an export-driven
economic model. Thus while a set of developing countries produces, exports and
also saves the proceeds by investing their forex reserves back in these countries,
developed countries are consuming both the production and investment
originating from the developing countries.
In effect, developing countries are building their foreign exchange reserves while
the developed countries are accumulating the corresponding debt. After all, it
takes two to a tango.
For instance, the US current account deficit is estimated to be 7 per cent of GDP
in 2006 and stood at approximately $900 billion. Obviously, the current account
deficit of the US becomes the current account surplus of other exporting
countries, viz. China, Japan and other oil producing and exporting countries.
The reason for this imbalance in the global economy is the fact that after the
Asian currency crisis; many countries found the virtues of a weak currency and
engaged in 'competitive devaluation.'
Under this scenario, many countries simply leveraged their weak currency vis-avis
the US dollar to gain to the global markets. This mercantilist policy to maintain
their competitiveness is achieved when their central banks intervenes in the
currency markets leading to accumulation of foreign exchange, notably the US
dollar, against their own currency.
Implicitly it means that the developing world is subsidizing the rich developed
world. Put more bluntly, it would mean that the US has outsourced even
defending the dollar to these countries, as a collapse of the US currency would
hurt these countries holding more dollars in reserves than perhaps the US itself!
Rather than demand pushing the value of commodities higher in the past 18
months, it has been the (impending) dollar's devaluation against commodities
that has pushed commodity prices to record highs."
Naturally, as the players fear a fall in the value of the dollar and reach out to
various assets and commodities, the prices of these commodities and assets too
will rise.
The psychological dimension
But as the imbalance shows no sign of correcting, players seek to shift to
commodities and assets across continents to hedge against the impending fall in
the US dollar. Thus, it is a fight between central banks and the psychology of
market players across continents.
As a corrective measure, economists are coming to the conclusion that most of
the currencies across the globe are highly undervalued vis-a-vis the dollar,
which, in turn, requires a significant dose of devaluation. For instance, a
consensus exists amongst economists and currency traders that the Yen is one
of the most highly undervalued currencies (estimated at around 60%) along with
the Chinese Yuan (estimated at 50%) followed by other countries in Asia.
This artificial undervaluation of currencies is another fundamental cause for
increasing global liquidity.
What has further compounded the problem is the near-zero interest rate regime
in Japan. With almost $905 billion forex reserves, it makes sense to borrow in
Japan at such low rates and invest elsewhere for higher returns. Obviously,
some of this money -- estimated by experts to be approximately $200 billion --
has undoubtedly found its way into the asset markets of other countries.
Most of it has been parked in alternative investments such as commodities,
stocks, real estates and other markets across continents, leveraged many times
over. Needless to reiterate, the excessive dollar supply too has fuelled the
property and commodity boom across markets and continents.
The twin causes -- excessive liquidity due to undervaluation of various currencies
(technical) and fear of the US dollar collapse leading to increased purchase of
various commodities to hedge against a fall in US dollar (psychological) -- needs
to be tackled upfront if inflation has to be confronted globally.
Higher international farm prices impact Indian farm prices
What actually compounds the problem for India is the fact that lower harvest
worldwide, specifically in Australia and Brazil, and the overall strength of demand
vis-a-vis supply and low stock positions world over, global wheat prices have
continued to rise.
Wheat demand is expected to rise, while world production is expected to decline
further in the coming months, as a result of which global stocks, already at
historically low levels, may fall further by 20 per cent. These global trends have
put upward pressure on domestic prices of wheat and are expected to continue
to do so during the course of this year.
No wonder, despite the government lowering the import tariffs on wheat to zero,
there has been no significant quantity of wheat imports as the international prices
of wheat are higher than the domestic prices.
Growth and forex flows
Another cause for the increase in the prices of these commodities has been due
to the fact that both India and China have been recording excellent growth in
recent years. It has to be noted that China and India have a combined population
of 2.5 billion people.
Given this size of population even a modest $100 increase in the per capita
income of these two countries would translate into approximately $250 billion in
additional demand for commodities. This has put an extraordinary highly demand
on various commodities. Surely growth will come at a cost.
The excessive global liquidity as explained above has facilitated buoyant growth
of money and credit in 2005-06 and 2006-07. For instance, the net accretion to
the foreign exchange reserves aggregates to in excess of $50 billion (about Rs
225,000 crore) in 2006-07. Crucially, this incremental flow of foreign exchange
into the country has resulted in increased credit flow by our banks. Naturally this
is another fuel for growth and crucially, inflation.
This Reserve Bank of India's strategy of dealing with excessive liquidity through
the Market Stabilization Scheme (MSS) has its own limitations. Similarly, the
increase in repo rates (ostensibly to make credit overextension costly) and
increase in CRR rates (to restrict excessive money supply) are policy
interventions with serious limitations in the Indian context with such huge forex
How about the revaluation of the Indian Rupee?
The current bout of inflation is caused by a multiplicity of factors, mostly global
and is structural. Monetary as well as trade policy responses, as has been
attempted till date, would be inadequate to deal with the extant issue effectively.
Crucially, a stock market boom, a real estate boom and a benign inflation in the
foodgrains market is an economic impossibility.
It has to be noted that the Indian market is structurally suited for leveraging
shortages rather effectively. Added to this is the information asymmetry among
various class of consumers as well as between consumers, on the one hand, and
producers and consumers, on the other.
Further, the sustained flow of foreign money, thanks to the excessive global
liquidity in the world, has fuelled the rise of the stock markets and real estate
prices in India to unprecedented levels.
This boom has naturally led to corresponding booms in various related markets
as much as the increased credit flow has in a way resulted in overall inflation.
Measures taken by RBI
The Indian Central Bank has taken measures designed to curb inflation in one of
the world’s fastest growing economies.
The central bank has increased the cash reserve ration, attempting to reduce the
overall amount of money loaned from banks.
The monetary measures to tackle inflation are meant to increase the cost of
funds for banks, make loans dearer and temper the demand for credit. But for
inflation targeting to be uniformly effective, due emphasis has to be placed on the
supply-side constraints as well, even while making banking inclusive.
The increasing cost of funds and rising interest rates are of little consequence in
the economic life of a financially excluded population. The impact will be critical
on smaller segments and will take awhile to yield results for the economy.

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