Case Study on 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.
Contents:

Introduction What is Causing Inflation? Measures Taken Some Perspectives Outlook Exhibits
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. 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. The Indian Economy: Dealing with Inflation - Next Page
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 (JulySeptember) 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."11
Excerpts
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%...

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)...
Exhibits

Exhibit Exhibit Exhibit Exhibit Exhibit

I: A Brief Note on Inflation II: Weightage of Different Commodities in the WPI III: Rate of Inflation in India IV: Changes in CRR, Repo Rate and Bank Rate: 2009-11 V: Indian Rupee-US Dollar Foreign Exchange Rate