Trend of inflation in India

ACKNOWLEDGMENT

I am thankful to Ms Palwinder Kaur for providing me the chance to work on the topic of "Study the trend of inflation for the last 5 year and critically evaluate the steps taken by RBI". The term paper tested my patience at every step of the preparation but the courage provided me by the teachers helped me to swim against the tide.

First of all I thank to ALMIGHTY GOD for giving me power to pen down the term paper in its present shape. I thank the entire teaching staff especially Miss Palwinder Kaur for sharing his valuable knowledge with us & for providing his able guidance and support. I also thank to my classmate or senior/roommate who every time helped me out and encouraged me for carrying out the task.

I am also thankful to all my friends and well-wisher who help me in completing my project timely by providing their suggestions.

INFLATION

Inflation has been different in different dictionaries over the ages. Dictionaries have given different versions of definition regarding inflation. Inflation is an economic condition wherein the price of the goods and services increase steadily measured against standard level of purchasing power, whereas the supply of the goods and services decline along with the devaluation of money.

When the economy of a country faces inflation it brings bad news for the people because the supply of goods decreases and this scarcity causes a predicament for the people. The definition of inflation has undergone lot of changes since 1983 when it appeared in the dictionary for the first time. At that time inflation was thought of as a cause but as time passed by the definition and its significance changed. Economists from different schools differ in their opinion regarding the genesis of inflation. However, it is agreed that inflation occurs due to an unexpected rise in the supply of money which causes devaluation or a decrease in the supply of goods and services.

Again, the inflation rate decreases with the increase in the production of goods and with the decrease in the supply of money in the market.

The purview of inflation has narrowed in the present day since only the phenomenon of increase in the price level is termed as inflation these days. Previously, the devaluation of money was also considered to be a condition of inflation. In the present day this phenomenon is known as a monetary inflation.

The inflation in price is measured against the purchasing power of the consumers and is done by the Bureau of Labor Statistics in United States of America.

Factors Leading to Inflation-

There are several factors, which lead to inflationary circumstances in an economy. These factors enable the demand to increase without maintaining any balance with the supply. The factors are:

  • Increase in the supply of money
  • Price Control
  • Expenditure of monetary reserves

Inflation affects the whole of the economy squarely including the taxes and import tariffs. They decrease the efficiency of the economy that produces goods and services.

Types of Inflation-

There are four main types ofinflation. The various types of inflation are briefed below.

Wage Inflation:

Wage inflation is also called as demand-pull or excess demand inflation. This type of inflation occurs when total demand for goods and services in an economy exceeds the supply of the same. When the supply is less, the prices of these goods and services would rise, leading to a situation called as demand-pull inflation. This type of inflation affects the market economy adversely during the wartime.

Cost-push Inflation:

As the name suggests, if there is increase in the cost of production of goods and services, there is likely to be a forceful increase in the prices of finished goods and services. For instance, a rise in the wages of laborers would raise the unit costs of production and this would lead to rise in prices for the related end product. This type of inflation may or may not occur in conjunction with demand-pull inflation.

Pricing Power Inflation:

Pricing g power inflation is more often called as administered price inflation. This type of respective goods and services to increase their profit margins. A point noteworthy is pricing power inflation does not occur at the time offinancial crisis and economic depression, or when there is a downturn in the economy. This type of inflation is also called as oligopolistic inflation because oligopolies have the power ofpricingtheir goods and services.Inflation occurs when the business houses and industries decide to increase the price of there.

Sectoral Inflation:

This is the fourth major type of inflation. The sectoral inflation takes place when there is an increase in the price of the goods and services produced by a certain sector of industries. For instance, an increase in the cost of crude oil would directly affect all the other sectors, which are directly related to the oil industry. Thus, the ever-increasing price of fuel has become an important issue related to the economy all over the world. Take the example of aviation industry. When the price of oil increases, the ticket fares would also go up. This would lead to a widespread inflation throughout the economy, even though it had originated in one basic sector. If this situation occurs when there is arecessionin the economy, there would be layoffs and it would adversely affect the work force and the economy in turn.

Other Types of Inflation

Fiscal Inflation:

Fiscal Inflation occurs when there is excess government spending. This occurs when there is a deficit budget. For instance, Fiscal inflation originated in the US in 1960s at the time President Lydon Baines Johnson. America is also facing fiscal type of inflation under the president ship of George W. Bush due to excess spending in the defense sector.

Hyper Inflation:

Hyper inflation is also known as runaway inflation or galloping inflation. This type of inflation occurs during or soon after a war. This can usually lead to the complete breakdown of a country's monetary system. However, this type of inflation is short-lived. In 1923, in Germany, inflation rate touched approximately 322 percent per month with October being the month of highest inflation

CAUSES OF INFLATION:

There are a few different reasons that can account for the inflation in our goods and services; let's review a few of them.

  • Demand-pull inflation:
  • Refers to the idea that the economy actual demands more goods and services than available. This shortage of supply enables sellers to raise prices until equilibrium is put in place between supply and demand.

  • Cost-push theory:
  • Also known as "supply shock inflation", suggests that shortages or shocks to the available supply of a certain good or product will cause a ripple effect through the economy by raising prices through the supply chain from the producer to the consumer. You can readily see this in oil markets. WhenOPECreduces oil supply, prices are artificially driven up and result in higher prices at the pump.

    Money supply:

    Plays a large role in inflationary pressure as well. Monetarist economists believe that if theFederal Reservedoes not control the money supply adequately, it may actually grow at a rate faster than that of the potential output in the economy, or real GDP. The belief is that this will drive up prices and hence, inflation. Low interest rates correspond with high levels of money supply and allow for more investment in big business and new ideas, which eventually leads to unsustainable levels of inflation, as cheap money is available. Thecredit crisis of 2007is a very good example of this at work.

    EFFECTS OF INFLATION:

    The most immediate effects of inflation are the decreased purchasing power of the dollar and its depreciation. Depreciation is especially hard on retired people with fixedincomesbecause their money buys a little less each month. Those not on fixed incomes are more able to cope because they can simply increase their fees. A second destabilizing effect is that inflation can cause consumers and investors.

    To changer their speeding habits. When inflation occurs, people tend to spend less meaning that factories have to lay off workers because of a decline in orders. A third destabilizing effect of inflation is that some people choose to speculate heavily in an attempt to take advantage of the higher price level. Because some of the purchases are high-riskinvestments, spending is diverted from the normal channels and some structural unemployment may take place. Finally, inflation alters the distribution of income. Lenders are generally hurt more than borrowers during long inflationary periods, which means that loans made earlier are repaid later in inflated dollars.

    The Dangers of Inflation:

    In most cases with the rise in prices there is a rise in salaries. However, there may be some companies who, due to the need to compete with other businesses, aren't able to raise their prices therefore enabling them to raise the salaries of their employees. This in turn has a negative effect on those employees.

    Another danger with inflation is for those who are invested in a fixed income product such as bank CD's or bonds. With one of the solutions to inflation being higher interest rates those involved in a fixed rate investment will definitely lose out on the benefit of the prevailing interest rate.

    INFLATION IN INDIA:

    The 1990s is widely described in general as a price stability era all over the globe. During the early part of the decade developed and developing countries alike experienced "a distinct ebbing of inflation", so observes India's central banking authorities, Reserve Bank of India (RBI). Inflation in India, barring some external factors like bouts of increase in international oil price and natural disasters like drought or flood, is showing an ebbing trend. The first half of India's fiscal 2002-03 (beginning April 1, 2002) witnessed up trend in inflation largely due to increase in oil prices twice during the period and adverse impact of drought on agri- products leading to increase in prices - particularly of oilseeds and edible oils. The efficient handling of supply management helped inflation eased in the second half of the fiscal. As a whole at the end of the fiscal 2002-03 inflation was up 3.3 percentage points. In the light of overall variation in wholesale price inflation, the inflation in fiscal 2002-03 was dominated by non-food items unlike preceding years, according to a RBI report.

    One of the major import contents of India's inflation in fiscal 2002-03 was edible oil and oil cakes that recorded highest price increase. Acute shortfall in production of the commodity led to about half the domestic demand met by imports. The RBI report also states that the underlying inflation (measured by average WPI) during this fiscal was dominated by manufactured product groups. Within manufactures again, edible oils, oil cakes and manmade fibres were largely responsible uppish trend in inflation. Inflation measured by average consumer price index for industrial workers (CPI-IW) however eased in fiscal 2002-03.

    How does India calculate inflation?

    Most developed countries use the Consumer Price Index (CPI) to calculate inflation but India uses the Wholesale Price Index (WPI) because the government cannot collect quickly the data to create the CPI. The main problem with WPI calculation is that more than 100 out of the 435 commodities included in the Index have ceased to be important from the consumption point of view. Retail prices are normally much higher than wholesale price.

    That is the reason when the people on the streets are experiencing at least 30 percent increases in prices the published figure from the government indicate only 7.4 percent increase. Consumers are currently paying as much as 60 per cent more than the wholesale price of essential commodities, which marks a threefold increase over the normal average difference between retail and wholesale prices. Farmers had also been hit hard due to the huge difference in wholesale and retail prices because the middlemen and traders normally benefits from these price increases.

    INFLATION IN 2004 TO 2005:

    The ADO 2004 growth forecasts for FY2004-FY2005 have been revised down. This is partly on account of a weak monsoon, and especially because of the sharp increase in oil prices, which is both reactivating inflation and damping growth. A range of forecasts for FY2004 was prepared, and the best estimate of 6.5%, adopted for theUpdate, reflects 2.0% growth in agriculture and a weak monsoon, and 7.8% growth in both services and industry. In FY2005, GDP growth is expected to decline to 6.0%, despite the assumption of 3.1% growth in agriculture and a normal monsoon. This is mainly on account of lower projected growth in both industry and services as a consequence of the expected downturn in the country's business cycle.

    The risks associated with these growth projections include another weak monsoon in FY2005, higher than assumed global interest rates and crude oil prices, and inadequate progress in fiscal consolidation. Of all of these, the price of crude oil is the most critical for India, as it imports most of its oil. Past experience shows that a steep rise in oil prices triggers inflation, adversely impacts on the balance of trade, and lowers growth.

    Rising inflation is likely to prevail through FY2004 and FY2005. Inflation is forecast at 5.7% and 6.8%, largely because of rising prices of oil and agricultural commodities in FY2004 and an expected escalation in the price of manufactured goods in FY2005. Manufacturers who are currently absorbing the increase in costs through reduced profit margins will eventually pass this on to consumers, leading to a lagged increase in industrial prices in FY2005 as a consequence of the oil price escalation in FY2004. The Government has taken some short-term measures to contain the impact on consumer prices, including a reduction in excise and customs duties on petroleum products, announced in August. For the long term, the Government is considering a strategic oil reserve in an attempt to moderate oil price volatility through buffer stock operations.

    Though the fiscal deficit showed a slight improvement in FY2003, it is likely to rise to 10.0% in FY2004. The federal budget has targeted a reduction in the FY2004 fiscal deficit to 4.4% in line with the FRBM Act. However, the target is likely to be overshot because of ad hoc fiscal concessions being introduced after the budget to contain the inflationary impact of rising oil prices and because of the incentives introduced in the new trade policy. Moreover, the fiscal position of state governments further deteriorated through FY2003, and the reduction in federal revenues in FY2004 will also reduce their receipts from their share of federal revenues.

    The fiscal situation of the federal Government, in contrast, is likely to recover in FY2005 because of the strong fiscal reform measures expected in that year's budget, and this will also have a positive impact through shared taxes on the revenue receipts of the states. This is likely to be reinforced by the states' fiscal consolidation proposals of the Twelfth Finance Commission, which will submit its recommendations in December 2004. Consequently, the consolidated fiscal deficit for FY2005 is projected to decline to 9.5% of GDP. Introduction of a VAT, which has been repeatedly postponed, has been tentatively rescheduled for 1 April 2005. However, even if it is introduced, its immediate impact on the fiscal deficit should be negligible, as it has been designed to be revenue neutral.

    Turning to the external sector, the outlook is buoyant. Based on expected strong global expansion, merchandise exports are projected to grow by 20.9% in FY2004 and 17.9% in FY2005. India's export basket is quite diversified, ranging from traditional products, such as textiles and garments, to chemicals and pharmaceuticals, transport equipment, and other engineering products. The rise in exports is likely to be concentrated in textiles (following the elimination of MFA quotas at end-2004), and pharmaceuticals and automotive ancillaries (products for which exports have been rising rapidly). Imports are projected to grow at 19.9% and 19.3% in FY2004 and FY2005, respectively, based on the above domestic growth projection. The major components of India's merchandise imports are petroleum products, gems and semiprecious stones, chemicals including fertilizers, and machinery and electronic goods. The projected increases in imports will be dominated by the increase in the oil import bill.

    With both merchandise exports and imports growing at similar high rates, the current account surplus is projected at 1.4% of GDP in FY2004, declining to 1.1% in FY2005 when merchandise imports are forecast to grow at a significantly higher rate than exports. Net invisibles income will continue to register robust growth. The overall annual net capital inflow of around $22 billion is likely to increase further on account of the liberalization of FDI ceilings. Given that foreign exchange reserves will likely rise to over $150 billion in FY2005, and the current account will remain in surplus, India's external position looks very comfortable over the medium term.

    INFLATION IN 2006 TO 2007:

    Inflation in India is still rising. Between March 2006 and March 2007, year-on-year wholesale price index inflation excluding food and energy rose from 2 per cent to 7.9 per cent.

    Leading indicators of inflation point one-way: continued price pressures. Excess capacity has shrunk to a 14 year low (according to the NCAER). In addition, there are signs of overheating in real estate and labour markets, with surveys showing the salaries of skilled workers rising by around 15 per cent annually. The Public Distribution System has virtually collapsed and the means that were available at least in theory to protect poorer sections of society have disappeared.

    International Situation:

    Rising demand due to buoyant economy in developing nations, production shortfall, higher crude oil prices and diversion of food crop for bio-fuel have all contributed to the runaway trend of commodity prices. These developments are largely demand driven, being the result of the increased demand from China. However, the extremely sharp increase in prices in recent months is not easily explained. Even though global stocks have been falling, they are still at a comfortable 114.8 million metric tones. The sharp increases in food prices are mainly due to the diversion of food for fuel production and the role of the "Future Market for Commodities" played to increase the speculative activity on the world scale. In 2006 the US diverted more than 20 per cent of its maize production to the production of ethanol; Brazil used half of its sugarcane production to make bio-fuel, and the European Union used the greater part of its vegetable oil production as well as imported vegetable oils, to make bio-fuel. This has naturally reduced the available land for producing food.

    Although India government and Indian observers are holding international situation as the culprit, such developments across the world have no relevance for India, except for the increasing price of crude petroleum. India is not a major importer of food but the second biggest exporter of rice. The government is holding down domestic energy prices using massive subsidies so that it is about to borrow Rs.70, 000 crore from the public to finance these subsidies. It may allow some increase in petrol prices, just as it did in 2004. That will certainly fed the inflation, but we cannot blame it for the recent increase in inflation rate. Inflation in India is mainly due to the wrong policy of the Indian government, when too much money is fueling speculative drive.

    Growth of Money:

    The source of money that is fueling inflation in India has three main sources: (a) money from the parallel economy; (b) money from abroad through short-term borrowing and investments; (c) foreign multinational companies.

    The parallel economy is just as big as the visible economy. According to some estimates, the government could not collect Rs.120, 000 Crore of taxes. The banks could not collect Rs.150, 000 crore of unpaid loans from the defaulters. A significant factor in the spiraling of prices in sectors like real estate, and the hoarding of commodities for speculative gain, can be attributed to this parallel economy.

    India is experiencing an unprecedented surge in short-term capital inflows. Net capital flows into the country rose from an already high $23.4 billion in 2006 to $44.9 billion in 2007. Net inflows of foreign institutional investments into India's stock and debt market that had risen significantly starting 2003. Only over the first 10 months of 2007 about $18.6 billion came to India, whereas during 2003 to 2006 only $8.8 billion a year on average came.

    Indian companies have been exploiting the liberalized external commercial borrowing policy of the Reserve Bank of India and borrowing massively abroad. Figures for the January to May period indicate that borrowing totaled $15.3 billion in 2007, with $10.8 billion and $3.4 billion during the corresponding periods in 2006 and 2005 respectively.

    Foreign exchange reserves that stood at $76 billion at the end of financial year 2002-03, nearly doubled to touch $151.6 billion by March-end 2006 and have risen to $199.2 billion by end-March 2007 and $266.5 billion on 2 November 2007. As a result the Reserve Bank of India has lost control over the supply of money.

    Due to the liberalization of rules regarding foreign capital inflows and the reduced taxation of capital gains made in the stock market monetary policy is now controlled not the government but these flows of foreign capital. To control this massive supply of money coming from abroad, Reserve Bank of India has initiated programme to sell government bonds to take out some money from the system, but it was too late and too little.

    It has started the Market Stabilization Scheme in April 2004, under which it has sold government bonds worth Rs. 60,000 crore. In November 7, 2007 the target was raised for 2007-08 to Rs.2, 50,000 crore, but it is still inadequate to control the flows of money to the economy.

    Food Situation:

    India has produced 227.32 million tons of food grains, including 76.78 million tons of wheat during 2007-08. The increase in output was due to good rainfall distribution and favourable temperature during Rabi season. Other crops, which saw a good harvest in 2007-08, include rice, maize, tur, urad, soyabean and cotton. Rice production is estimated at 95.68 MT while coarse cereals like maize, bajra and jowar have increased to 39.67 MT from 33.92 MT. Pulses production has also reached an all time high of 15.19 MT this year. Thus, there is no crisis on the food production at all.

    Total imports was of $600 million, which is again due to the wrong policy of the government to give foreign farmers prices which are 1.5 to two times the procurement price offered to domestic farmers. The government also has to pay continuously rising prices for the commodity. As compared with the weighted average price of $205 per tone paid for wheat imported in 2006-07, the average price paid on June 26, August 30 and November 12, 2007 was $326, $389 and $400 per tones respectively. This takes the weighted average price paid in 2007-8 to $372 per tone or 80 per cent higher than in 2006-7.

    As the government is not interested to maintain the public distribution system, it is not willing to give proper prices to the domestic farmers. That has created the shortfall in procurement and increased imports to a country where enough is available if the government is prepared to raise the procurement prices for the Indian farmers.

    Foreign funds in the stock market:

    India has witnessed over a decade of portfolio flows and with each passing year, portfolio flows have gained in their significance and have played a key role in the overall Indian economy. Although investment by foreign institutional investors are typically synonymous with portfolio investments in India, investments in Global Depository Reserve and offshore funds should be included in any analysis relating to portfolio flows.

    The year 2002-2003 was highlighted by significant events; both locally and internationally that had a bearing on the Indian economy. By end March 2003, cumulative portfolio investments totaled nearly US$16billion, which constituted nearly 11 percent of the country's stock market capitalization.

    The Union Budget 2003 announced that dividends would be exempt from tax in the hands of a shareholder. Henceforth, dividends declared by an Indian company would not be liable to Indian taxes. Further, long term capital gains arising on transfer of equity shares (held at least for one year) in a listed company, acquired between March 1, 2003 and February 28, 2004 would be exempt from tax. These initiatives were specifically targeted at attracting portfolio investments into India. India has emerged as the most favoured private equity (PE) destination attracting $2.21 billion of private equity investment in 2006 as against just $1, 992 million in 2005. India was followed by China with $1.72 billion. Singapore came third with $1.53 billion.

    Foreign funds in Real Estate:

    India's Foreign Direct Investment inflows have doubled to $2.9 billion during April-July 2006 as compared to the $1.5 billion during the same period in 2005. Sensing the demand of foreign investors, the Indian government has liberalized the laws relating to FDI in February 2005. Now Non Resident Indians (NRI"s) and Overseas Corporate Bodies (OCB"s) can invest up to 100% in the real estate sector.

    Foreign Direct Investment in real estate is now possible without the need for permission by the Foreign Investment Promotion Board. So, the liberalized FDI regime, coupled with the strong potential of the industry is going to help pump money into the sector. Currently, FDI in India is targeting township, housing, construction development projects, built-up infrastructure etc. The Indian government repealed the Urban Land Ceiling Act in 2001 and a large quantum of land is now free for construction. Investment is now also allowed for smaller projects of just 25 acres.

    Low interest rates and a stronger Rupee have boosted consumer demand. The excessive flows of money have 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. These sustained flows 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.

    INFLATION IN 2007 TO 2008:

    The Economic Survey Report of 2007-2008, tabled in the parliament today, 28th February 2008, indicated an inflation rate of 4.1% for the current fiscal year 2007-2008. This is much lower compared to the inflation rate of 5.6% inflation of the last fiscal year.

    The Economic Survey Report said that inflation in India has been led mainly by primary non-food items. Prime contributors to inflation in the fiscal year 2007-2008 are the fuel and power group. On the other hand there has been a decline in the inflation rate of investment goods from 5.6% to 4.3%. The Economic Survey Report of 2007-2008 has indicated that the investment climate in India is encouraging.

    While prices have been falling since March 2007, there has been some rise in prices in the last couple of weeks. Increase in the prices of coal and crude-oil have caused general price levels to rise. This was followed by the rise in the process of diesel and petrol.

    Inflation has been a concern area for the Indian economy. The decline in inflation is being considered as a positive sign for the economy. The Finance Minister, however, has stated today that there is no need to ensure non-inflationary growth in India at the moment.

    INFLATION IN 2008 TO 2009:

    Economic growth decelerates to 6.7 per cent in 2008-09 compared to 9 per cent in 2007-08 and 9.7 per cent in 2006-07.Per capita growth at 4.6 per cent.Deceleration in growth spread across all sectors except mining and quarrying; agriculture growth falls from 4.9 per cent in 2007-08 to 1.6 per cent 2008-09.Manufacturing grows at 2.4 per cent, slowdown attributed to fall in exports and a decline in domestic demand.Global financial meltdown and economic recession in developed economics major factors in India's economic slowdown.Investment remains relatively buoyant, ratio of fixed investment to GDP increased to 32.2 per cent in 2008-09 compared to 31.6 per cent in 2007-08.Fiscal deficit to GDP ratio stands at 6.2 per cent.Credit growth declines in the later part of 2008-09 reflecting slowdown of the economy in general and the industrial sector in particular.Increased plan expenditure, reduction in indirect taxes, sector specific measures for textile, housing, infrastructure through stimulus packages provides support to the real economy.Merchandise export grows at a modest 3.6 per cent in US Dollar terms while overall import growth pegged at 14.4 per cent.A large domestic market, resilient banking system and a policy of gradual liberalization of capital account to help early mitigation of the adverse effect of global financial crisis and recession.Sharp dip in the growth of private consumption a major concern at this stage.Medium to long-term capital flows likely to be lower as long as the de-leveraging process continues in the US economy.Revisiting the agenda of pending economic reforms imperative to renew the growth momentum.

    RBI steps will help contain inflation: government

    The Finance Ministry on Tuesday said the steps taken by the Reserve Bank of India, as part of the ongoing war against inflation, would help in moderating credit growth and thereby contain the price spiral.

    In a statement here, the Finance Ministry said: "[The] Government expects that the measures taken by the RBI today [on Tuesday], in continuation of the measures already taken over the last two months, will help in moderating and containing inflation."

    Continuing its hawkish stance on fighting inflation — even at the expense of a temporary slowdown in growth — in the wake of a disturbing global scenario, the RBI hiked the short-term lending rate yet again by 50 basis points from 8.5 to nine per cent.

    Alongside, to suck out more liquidity to the extent of about Rs. 8,000 crore, the RBI also raised the cash reserve ratio (CRR) — the mandatory deposit requirement for banks — by 25 basis points to nine per cent with effect from the fortnight beginning August 30 this year. The net effect of the two stringent steps, announced by the apex bank during the first quarter review of its monetary policy, would be higher rates of interest on all consumer-oriented loans, be it for housing, purchase of cars or consumer durables. Justifying the RBI decisions, the statement said: "The increase in the CRR and the Repo rate is a signal to the banks that credit growth must be moderated, having regard to the need to moderate aggregate demand. If requests for loans are carefully appraised and credit is allocated prudently, it is possible for the banks to ensure that adequate credit is available to the productive sectors."

    Steps Taken By RBI To Control Inflation:

    The Reserve Bank of India has raised Repo rate by 50 basis point to 9 per cent from the existing 8.5 per cent. This short-term rate at which the RBI lends cash to banks was last raised on June 24 by 50 basis points to 8.5 per cent. The move is directed at cooling inflation that is running at nearly 12 per cent on an annual basis by containing demand.

    The central bank has also raised the CRR (percentage of banks' deposits which they must keep with the central bank) by 25 basis points from the existing 8.75 per cent. This will come into effect from August 30.

    The reverse Repo rate (The short-term rate at which the central bank absorbs cash from the market) remains unchanged at 6 per cent. It has also held the Bank Rate (rates used to price long-term loans to firms and individuals) steady at 6.0 per cent.

    In the Quarterly Review of the Monetary Policy, Governor YV Reddy has given high priority to price stability, anchoring inflation expectations and orderly conditions in financial markets. This while sustaining the growth momentum.

    RBI says balancing growth, inflation key challenge

    The key challenge being faced by the Reserve Bank of India (RBI) was managing the economic recovery process while anchoring inflationary expectations, Deepak Mohanty, executive director at the central bank said today. "Here is the dilemma. Growth is still fragile and at the same time you have liquidity and inflation, though largely driven by supply side... We need to be careful. In the mid-term policy, we signaled the first phase of exit (from accommodative monetary policy)," Mohanty said at a conference on South Asian financial systems. In the mid-term review of its annual monetary policy, the RBI had last month announced withdrawal of some special liquidity measures, signaling the first phase of monetary tightening.

    He said the central bank had tried to "normalise" the level of liquidity, which rose due to a loose monetary policy adopted to boost local demand. "What we have done is that we have tried to lower the excess liquidity that we compounded into the system," he said. "We don't think the first phase of exit will affect growth. Liquidity is still comfortable and RBI is still observing Rs 1 lakh crore at its daily reverse repo tender." Since October 2008, RBI has cut repo and reverse repo rates by 425 bps each and cash reserve ratio by 400 bps to infuse liquidity and spur demand in the wake of the economic slowdown. Mohanty said excess liquidity in the banking system was likely to affect inflationary expectations, and might spill over to asset prices. He said the central bank has infused actual and potential liquidity to the tune of 11 per cent of the country's gross domestic product into the banking system as part of the stimulus. He said India was one of the few countries to have signalled the need to have a timeline for exit. Mohanty said the central bank's decision not to announce the October-March open market operation (OMO) calendar for gilts was part of the stimulus-exit strategy. In the RBI's mid-term review of the monetary policy, Governor D Subbarao had said OMO might be used as an instrument to take out liquidity. "There is no OMO calendar for the remaining fiscal. This is one of the ways to exit." RBI had started reverse auctions under OMO from February 19 to smoothen the government's large borrowing plan for the current fiscal, which is pegged at Rs 4.51 lakh crore. Commenting on the government's borrowing programme, Mohanty said, RBI was initially concerned about its massive size. "Public debt was an issue...The borrowing for 2009-10 is substantially high. We were sceptical about it. Again, we did not compromise. People were talking about monetisation, but we did not go down that path." He said government has already completed 82 per cent of the total borrowing for the year, and the remaining is likely to be completed smoothly.

    Inflation: Conclusion

    After reading this tutorial, you should have some insight into inflation and its effects. For starters, you now know that inflation isn't intrinsically good or bad. Like so many things in life, the impact of inflation depends on your personal sitution.

    • Inflationis a sustained increase in the general level of prices for goods and services.
    • When inflation goes up, there is a decline in the purchasing power of money.
    • Two theories as to the cause of inflation aredemand-pull inflationandcost-push inflation.
    • When there is unanticipated inflation, creditors lose, people on a fixed-income lose, "menu costs" go up, uncertainty reduces spending and exporters aren't as competitive.
    • Lack ofinflation (or deflation) is not necessarily a good thing.
    • Inflation is measured with a price index.
    • The two main groups of price indexes that measure inflation are theConsumer Price Indexand theProducer Price Indexes.
    • Interest rates are decided in the U.S. by theFederal Reserve. Inflation plays a large role in the Fed's decisions regarding interest rates.
    • In the long term, stocks are good protection against inflation.
    • Inflation is a serious problem forfixed income investors. It's important to understand the difference betweennominal interest ratesandreal interest rates.
    • Inflation-indexed securitiesoffer protection against inflation but offer low returns.

    REFERENCES

    • http://www.mysmp.com/bonds/inflation.html
    • http://www.personalfinanceology.com/the-effects-of-inflation-on-your-money/
    • http://www.indiaonestop.com/inflation.htm
    • http://www.adb.org/documents/books/ADO/2004/update/ind.asp
    • http://business.mapsofindia.com/news/inflation.html
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