Indian Inflation

Abstract:
The case provides insights into the inflationary situation witnessed in 2006-07 in India.

It examines the reasons behind the phenomenon of inflation and describes the various
measures taken by the Indian government and the nation's central bank to control it.

It also discusses some of the criticisms against the steps taken by the Indian government.

Issues:

»Understand the concept of inflation and its causes.

» Critically analyze the various initiatives taken by the Indian government and the RBI to
address inflation.

» Analyze the significance of Government and Central Bank in controlling inflation and
the possible effect of their initiatives on the economy.

Keywords:

Indian economy, Inflationary trends, Effect of High Growth on Inflation, Wholesale or

Consumer Price Index, Foreign Exchange rate, Bank Rate, Cash Reserve Ratio, Monetary
policy, Reserve Bank of India.

Introduction
In early 2007, in India, the inflation rate, as measured by the wholesale price index
(WPI)5, hovered around 6-6.8%, well above the level of 5-5.5% that would have been
acceptable to the Reserve Bank of India (RBI), the country's central bank.6 On February
15, 2007, the inflation rate reached a two-year high of 6.73%. In the past7, the main cause
of high inflation in India used to be rises in global oil prices. However, in early 2007, the
chief component of the inflation was the increase in the prices of food articles - caused by
increased demand as well as supply constraints. According to analysts, the increased
demand was due to high economic growth and increased money supply, while stagnant
agricultural productivity was behind the supply constraints.

Apart from the rise in prices of food articles, fuel and cement prices too recorded high
increases. The Government of India (GoI), together with the RBI, took several measures
to contain inflation. For example, the RBI increased the Cash Reserve Ratio (CRR)8 and
repo rates9 in an effort to check money supply; the GoI reduced import duties on several
food products and cut the price of diesel and petrol.

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The RBI also chose not to intervene when the Indian Rupee rallied against the US Dollar
between March 2007 and May 2007. The decision not to intervene was based on the idea
that a stronger Rupee would bring down the cost of imports, which, in turn, would help
reduce domestic prices of goods. Though the measures taken by the GoI were targeted at
inflation, some analysts feared that some of these measures, especially the ones leading to
higher interest rates, might induce recession in the Indian economy. There were others
who felt that letting the Rupee rise would not only have a negative effect on the bottom
lines of companies that earn a substantial percent of their profits from exports, but also
impact the long-term competitiveness of Indian exports.

What is Causing Inflation?

Inflation is the rise in prices which occurs when the demand for goods and services
exceeds their available supply. In simpler terms, inflation is a situation where too much
money chases too few goods (Refer Exhibit I to know more about 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,
constituting 22% of the index; fuel, constituting 14% of the index; and manufactured
goods, which accounted for the remaining 64% of the index (Refer Exhibit II for the
weightages of different commodities in the WPI).

For purposes of analysis and to measure more accurately the price levels for different
sections of society and as well for different regions, the RBI also kept track of consumer
price indices10 (Refer Exhibit III for the rates of inflation based on different indices
between 2001 and 2006)

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, CRISIL, "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%...

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Some Perspectives

The RBI's and the government's response to the inflation witnessed in 2006-07 was said
to be based on 'traditional' anti-inflation measures. However, some economists argued
that the steps taken by the government to control inflation were not enough...

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 (Refer Exhibit VI for inflation rates in some developed and developing
countries)...

For any query/discussion, write to jayshree.mandaviya@srimca.edu.in