[Eco – 104] Part 3/3 – Inflation – Tools to control Inflation – Monetary Policy/Fiscal policies/Supply Side Issues and More- Explained

Hi guys and girls,

As you know Economy as a subject has always been a traditional bottleneck for Civil Services aspirants. This is because most of us did not study it during our school days.

So in this series of articles, we will be taking up the numerous economic jargon, one by one and try to simplify them for you.

We aim to do the above by explaining various economic terms in a simple and a lucid manner. This will be especially beneficial for the students who are going to give their first attempt.

This is the last article in the 3 part series on Inflation. In the previous articles, we had understood the concept of Inflation and how inflation is measured in India.

If you haven’t read the part-1 of the Inflation series then Click Here

If you haven’t read the part-2 of the Inflation series then Click Here

In this article, we will try to understand

  1. The negative impact of the persistent high inflation on the economy
  2. What are the different means adopted by the Government/RBI to control Inflation.

So, let’s begin.

[1] Why a Persistent High inflation is bad for economy

#1 Private Investment

Rising inflation has an adverse impact on Private Investment.

To fight the rising inflation, Interest rates may be increased, which increases the cost of borrowing and may crimp investment. It could raise the cost of financing for investment and consumption activities, and thereby compress aggregate demand.

High inflation may lead to decline in demand especially from individuals on fixed incomes (such as salaried and Pensioners). Subdued demand may lead to decline in private investment. E.g. A manufacturing firm may not invest in new plants and machinery as the demand for their items has decreased.

Rising inflation in an economy may lead to flight of capital as FII may take their money out (as the real interest rate in economy declines). On the same line, rising inflation discourages capital inflow in the economy. Lack of adequate capital at cheaper rate discourage private investment.

Similarly, High inflation is unstable. There is uncertainty about future rates of inflation, which reduces the efficiency of investment and discourages potential investors.

#2 External Sector 

Rising inflation has an adverse impact on the export competitiveness of the economy

Rising inflation result in an increase in input prices of commodities. It may result in an increase in the prices of final products. Rising prices may, thus, impact the competitiveness of Indian export product in the global economy leading to a decline in exports

Similarly, rising inflation in India leads to the appreciation in real effective exchange rate (REER), which may again weaken the export growth in the country

Learning – let us know in the comment box the relationship between inflation and Real Effective Exchange rate

Rising inflation may lead to increase in input cost. This may result in a decline in the profit margin of the domestic firms (if the firm chooses not to increase prices of product). For example, domestic firms may find it difficult to pass on the rising input costs to consumers in the face of competition from cheaper imports. Thus they may not increase the prices amid rise in input price to make their products competitive against cheaper imports. Thus their profit margin declines. This may also affect their investment plans.

Decline in exports may lead to rise in Current Account deficit (as exports declines)

#3 Fiscal Imbalance

Rising inflation has adverse impact on the Fiscal position of the economy

With rising inflation, the government may be forced to increase subsidies (increase in food subsidies, fertilizer etc). This may delay the fiscal consolidation path and increase the Fiscal Deficit of the country.

Rising inflation affects tax collection of the government. Since people are less prone to go for expenditure (even more for high value transaction such as real estate etc), the net tax collection of the government declines. This lead to fiscal imbalances as government resort to excessive borrowing

In sum, the rising inflation is detrimental for economy in following ways

  • It leads to decline in external competitiveness and thus leads to decline in exports
  • It leads to decline in aggregate demand, which further leads to decline in Private investment
  • It leads to decline in net tax collection of the government
  • It leads to decline in profit margin of the domestic firms (if firm chooses not to pass rising input cost to end consumers amid cheaper imports) and thus affects their investment decisions
  • It affects the common man (especially fixed income group – salaries and pensioners) as purchasing power of money declines. Poor people may find it difficult to buy items of daily need such as food etc
  • It weakens the government resolve to follow fiscal consolidation path and may lead to fiscal imbalance (Rise in Fiscal Deficit)

Thus, the Government always tries to keep inflation at the moderate level.

However, persistent low inflation is also not good for the economy

Learning – Let us know in the comment box why a very low inflation rate is also not good for the economy. 

Since we have understood how persistent high inflation negatively impact economy, let us move forward and try to understand how government tackles high inflation. In other word, what are the ways through which government fight inflation

[2] Measures to fight/Contain Inflation

In India, Inflation is a complex phenomenon. It is caused not by one, but by several factors such as demand pull factors, Cost push factors and structural factors. These factors act together or alternatingly to cause inflationary price increase in the economy.

Therefore, we need a mix of macro-economic policies to manage the demand and the supply side as also to address the structural rigidities that exist in the economy.

Following methods are used by government to fight Inflation

  1. Monetary Policy Measures
  2. Fiscal Policy Measures
  3. Other Measures
#1 Monetary Policy Measures

Monetary policy refers to the policy of the central Bank with regard to use of monetary instruments under its control to manage money supply and interest rates.

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 main aim of Monetary policy is price control (keeping the inflation within the target band of 2% to 6%)

Monetary Policy Tools:

  1. Quantitative Tools
    1. Statutory Reserve Requirement
      1. Statutory Liquidity Ratio (SLR)
      2. Cash Reserve ratio
    2. Key Rates
      1. Liquidity Adjustment Facility
        1. Repo Rate
        2. Reverse Repo rate
      2. Bank Rate
      3. Marginal Standing Facility (MSF)
    3. Open market Operation
    4. Market Stabilisation Scheme
  2. Qualitative Tools
    1. Fixing Margin Requirement
    2. Moral Suasion
    3. Selective Credit Control

Key Quantitative tools and how they impact inflation/Deflation:

Quantitative Tools Their Impact on Inflation and deflation
Statutory Liquidity ratio (SLR) It is the share of net demand and time liabilities that banks must maintain in safe and liquid assets, such as, government securities, cash and gold etc.

At present SLR is 18%.

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

To fight Inflation, RBI must increase SLR. When SLR is increased, Banks are required to maintaining a higher amount with themselves in safe and liquid assets —- > Thus Bank’s ability to lend to market decreases —-> Lending rates will increase. Liquidity in the market decreases —> Thus inflation is contained

In the similar fashion, To fight deflation, RBI must decrease SLR. When SLR is decreased, Banks are required to maintain a lesser amount with themselves in safe and liquid assets —- > Thus Bank’s ability to lend to market increases —-> Lending rates will decrease. Liquidity in the market increases —> Thus deflation is tackled

Cash Reserve Ratio (CRR) It is the share of net demand and time liabilities that banks must maintain as cash balance with the Reserve Bank of India.

RBI do not pay any interest on it to the banks

At present CRR is 3%

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

To fight Inflation, RBI must increase CRR. When CRR is increased, Banks are required to maintaining a higher cash balance with the RBI —- > Thus Bank’s ability to lend to market decreases —->Liquidity in the market decreases.  Lending rates will increase.  —> Thus inflation is contained

In the similar fashion, To fight deflation, RBI must decrease CRR. When CRR is decreased, Banks are required to park less money in cash with RBI—- > Thus Bank’s ability to lend to market increases —->  Liquidity in the market increases. Lending rates will decrease. —> Thus deflation is tackled

Repo Rate It is the rate at which RBI provides short term loans to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).

At present repo rate is 4.40%.

During high levels of inflation, RBI increases Repo Rate to bring down flow of money in the economy. Rise in Repo rate disincentives banks to borrow from RBI. Thus liquidity in the market decreases. The lending rates increase making borrowing a costly affair for businesses and industries, which in turn slows down investment and money supply in the market. It helps in controlling inflation

In the similar fashion, to fight deflation, RBI decreases Repo Rate to increase flow of money in the economy. Decrease in Repo rate incentives banks to borrow from RBI (since they now get funds at cheaper rates). Thus liquidity in the market increases. The lending rates decrease making borrowing cheaper for businesses and industries, which in turn increases investment and money supply in the market. It helps in controlling deflation. 

Reverse Repo rate It is the rate at which banks park their surplus funds with RBI for short term. RBI provides collateral of government and other approved securities to banks which park their surplus fund with RBI.

At present the Reverse Repo rate is 3.75%

To fight high levels of inflation, RBI increases reverse Repo rate. It makes it attractive for the bank to park funds with the RBI (More certainty of return + more interest rate) rather than to lend to the private sector. It thus  reduces the liquidity in the market and increases the interest rate on borrowing.  Private players will find it costly to borrow and thus investment decreases. It helps to contain inflation.

To fight high levels of deflation, RBI decreases reverse Repo rate. It makes it unattractive/disincentivises for the bank to park funds with the RBI (lower interest rate). Thus,  Banks’s rather than parking excess fund to RBI, they lend it to private players. It thus increases the liquidity in the market and decreases the interest rate on borrowing.  Private players will find it cheaper to borrow and thus investment increases. It helps to contain de-flation.

Note – Policy Corridor – It is the range/width between Reverse Repo rate at the bottom, Repo rate at the middle and Marginal standing Facility at the top. 

Reverse Repo rate is at the bottom and MSF is at the top. Their values are tied with the value of Repo rate. For example – Any change is repo rate will automatically reflect changes in Reverse Repo Rate and Marginal Standing Facility

The policy corridor has been reduced to 0.25% (earlier it was 1% and then reduced to 0.5%). Thus if Repo Rate is 5%, then Reverse repo Rate and MSf automatically becomes 4.75% and 5.25% respectively.

So students must note that, Since Reverse repo rate is tied with the Repo rate (through policy corridor), it is usually the repo rate which is changed by the RBI (and Repo Rate automatically changes) 

Bank Rate It is the  rate at which banks borrow long term loans from RBI.

At present, it is not used by RBI for monetary management. 

It is now same as the (Marginal Standing Facility) MSF rate. 

Marginal Standing facility (MSF) It is the rate at which Banks can borrow short term funds from RBI. 

The MSF was launched by RBI while reforming the monetary policy in 2011-12.

It is penal rate at which banks can borrow money from the central bank over and above what is available to them through the Liquidity Adjustment Facility  window.

In case of Repo rate, Banks borrow short term funds by pledging government securities. Now ff Suppose bank has pledged all of its securities above SLR to the RBI for getting funds (means no eligible securities). Then, what the bank can do to get immediate money from the RBI?

Here MSF comes into picture. Under MSF, banks can borrow funds from the RBI by pledging government securities within the limits of the SLR.  

Thus MSR provides a safety valve against unanticipated liquidity shocks to the banking system.

MSF is upper band of the Policy Corridor (lower band being the Reverse Repo rate). Thus value of MSF is tied with the value of Repo Rate. Usually RBI changes Repo rate and MSF changes automatically.

Open Market Operation (OMO) It refers to conduct of market operations by RBI by way of sale/purchase of government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.

It is purchase/sale of govt securities by RBI.

To fight higher levels of inflation, RBI sucks out excess liquidity in the market by selling government securities. Banks borrow Government securities and provide money to the RBI. This reduces the excess liquidity in the economy. Lending rates increases and borrowing becomes costly, preventing private investment. It thus contain inflation.

In the similar fashion, in case of deflation, RBI provides excess liquidity in the market by buying government securities from banks. Banks gets funds by selling government securities. This increases liquidity in the economy. Lending rates decline and borrowing becomes cheaper, promoting private investment. It thus contain deflation.

Market Stabilisation Scheme (MSS) It is a monetary policy intervention by the RBI to withdraw excess liquidity (or money supply) by selling government securities in the economy.

It was introduced in the 2004.

In the MSS,  Liquidity of a more enduring nature arising from large capital flows is absorbed through sale of short-dated government securities and treasury bills.

The mobilised cash is held in a separate government account with the Reserve Bank. 

To fight Inflation, Similar to Open Market Operation, RBI sucks out excess liquidity in the economy by selling government securities. Banks borrow Government securities and provide money to the RBI. This reduces the excess liquidity in the economy. Lending rates increases and borrowing becomes costly, preventing private investment. It thus contain inflation.

MSS is incapable of fighting deflation, since it only involves selling of government securities by RBI.

Qualitative Tools

Qualitative tools Their Impact on Inflation and deflation
Fixing Margin Requirement  Higher Margin requirement means more collateral for the same amount of loan. For example for gold worth Rs. 1 lakh if the margin requirement is 20%, then a buyer will get only Rs 80,000 as loan (if it is increased to 30%, then maximum loan of Rs. 70,000 can be given) Thus to tackle inflation, RBI may prescribe higher margin requirements to make credit availability dearer. Thus less loan disbursement and less private investment, less demand and thus inflation reduces

Similarly, to fight deflation, RBI may prescribe lower margin requirement making cheaper credit available in the market.

Moral Suasion Here, The RBI convince/persuade banks  through advice, suggestion etc to co-operate with the central bank

For example – RBI may nudge banks to lower their lending rates when the Repo rate is lowered

Example – After demonetization in India on Nov 8, 2017, the governor advised the banks to be lenient with the farmers at the time currency exchange and ensure even flow of money in rural areas.

In case of High Inflation, RBI may nudge banks to increase their lending rates and follow dear money policy

Similarly in case of Deflation, RBI may nudge banks to reduce their lending rates and follow cheap money policy

Selective Credit Control Rbi can direct banks to increase lending in one sectors and reduce in other

For example, if inflation is rising in food articles, RBI can direct banks to increase loans in agricultural sectors to bring the prices down.

#2 Fiscal Policy Measures

Fiscal policy is the policy through which the government of a country controls the flow of tax revenues and public expenditure to navigate the economy. 

For example – during a slowdown, government may decide to spend more on infrastructure projects etc to revive the economy. Government may increase tax on rich people to increase its revenue.

Government uses various Fiscal policy measures to fight/contain inflation

  1. Public Expenditure
  2. Taxation

Public Expenditure

It is the spending made by the government of the country. Example, government builds public infrastructure – roads, railways, houses etc.

It is an important tool to fight inflation.

When inflation is high, the government reduces public expenditure. Decline in public expenditure affects private investment and results in decline of aggregate demand. 

For example – During the period of high inflation, the government trims its expenditure on rural infrastructure growth. It will lead to decline in demand in rural areas.

In the similar fashion, in case of deflation, Government increases public expenditure to increase private investment and increase aggregate demand.

Taxation 

Taxation policy can be used to facilitate/disincentivize household consumption/private investment by increasing/reducing the personal income tax, Corporate tax or indirect tax (Such as GST)

In case of high inflation, government may resort to increasing personal or corporate taxes to reduce household expenditure/ private investment. Rise in taxation leaves lesser money with the people for consumption (and private players for investment). This would lead to decline in aggregate demand and help in containing rising inflation

Similarly, in case of Deflation, Government reduces Taxation rate to spur household and private consumption leading to increase in aggregate demand

#3 Other Measures

Besides the monetary and fiscal instruments, the government. can also make use of other measures to maintain price stability and to control inflationary price rise in the economy.

These other measures include direct price controls, check over speculation and hoarding, use of buffer stocks, ban on exports, imports to augment the domestic supply and ban on futures trading in commodities. 

  1. Direct Price Control
    1. Under Essential Commodity Act 1955, government can declare a commodity as essential commodity to ensure it supply to people at fair prices
    2. Drug Price Control Order (DPCO) seeks to regulate the prices of pharmaceuticals drug
  2. Check over Speculation and Hoarding
    1. The Prevention of Black Marketing and Maintenance of Supplies of Essential Commodities Act, 1980 – This act empowers the central govt. or a state govt. to detain persons who are engaged in activities like hoarding, creating artificial scarcities of essential commodities in the market and rigging up of the prices.
  3. Buffer Stock Policy
    1. Govt. of India has been following the policy of maintaining buffer stocks of food grains to provide for any unwarranted situation.Food Corporation of India is responsible for undertaking purchase, storage, movement, transport, distribution and sale of food grains and other food stuff.
  4. Ban on Exports
    1. Government of India imposes Minimum Export Price (MIP) to discourage exports of commodities to ensure its availability in the domestic markets
  5. Ban on Future Trading of Commodities
    1. To reduce speculation – driven appreciation in prices, govt often ban future trading of the commodities (eg – Govt banned future trading on Chana etc.)

So, these are the ways through which inflation is tackled in India.

 

For revision purpose, solve the following questions which have come in the UPSC Prelims

Q1.  When the Reserve Bank of India reduces the Statutory Liquidity Ratio by 50 basis points which of the following is likely to happen?

      1. India’s GDP growth rate increases drastically
      2. Foreign Institutional Investors may bring more capital into our country
      3. Scheduled Commercial Banks may cut their lending rates.
      4. It may drastically reduce the liquidity to the banking system 

Q2. In context of Indian Economy, ‘Open Market Operation’ refers to (2013)

      1. Borrowing by scheduled banks from RBI
      2. Lending by commercial banks to industries and trade
      3. Purchase and sale of government securities by the RBI
      4. None of Above

Q3. An increase in the Bank Rate generally indicates that   (2015)

      1. The market rate of interest is likely to fall.
      2. Central Bank is no longer making loans to commercial banks.
      3. Central Bank is following an easy money policy.
      4. Central Bank is following a tight money policy

Let us know the answer in the comment section below

That’s it for this post. Thanks for reading. Do let us know how you found the article!!

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