How Anti-Inflation Works

P. Chidambaram, an eligible person for the post of Finance Minister has taken all the possible measures to control inflation. Talking about the rising rate of inflation, which has accelerated to near three-year highs in recent weeks, he said that it will moderate over time as the impact of fiscal and monetary measures kick in.

So, how does the control on inflation work? There are two measures to control inflation – monetary and fiscal. Monetary measures include expansion and contraction of money while fiscal measures deal with the government’s policy related to expenditures and taxes. Let us talk about the fiscal measures first.

India exports the commodities in which it has a comparative advantage (incentives provided to the country by the means of opportunity costs), like tea, coffee, iron-ore and other such products. Similarly, India will import commodities from other countries which have a lower cost of production. Imports slash down the prices of the commodities in the domestic market as similar goods are produced at a higher cost within the country, providing the consumers a surplus. India imports nearly all the essential commodities like edible oil, food grains etc. from other countries.

An increase in prices in one country leads to an increase in prices in other countries as well, by the tool of exports and imports. This kind of situation is often described as ‘exported inflation’, assuming that the currency rate does not change. Likewise, India is also experiencing the same, a condition very common for the countries importing essential commodities. Encouraging imports and discouraging exports shifts the aggregate demand of the commodities towards the right, which means that the aggregate demand rises with an increase in imports. We know that India is producing below its capacity and there exists a lot of unemployment. Therefore, an increase in aggregate demand increases employment more than increase in prices. Our Finance Minister is concerned with encouraging imports and curbing exports, which also leads to currency depreciation. That is why he made the statement that he is likely to trade off economic growth in order to make the essential commodities available to the society; kudos to him for making a wise decision.

Now let us come to the monetary measures. Monetary measures are regulated by the Reserve Bank of India or the RBI. Each day, RBI buys US currency to maintain a desired level of the currency rate. The forces of demand and supply determine the currency rate. An increase in demand for a currency increases its price; the currency is tradable at a higher rate. Various factors are responsible for the change in currency rates like future expectations, interest rates for the investments, domestic prices etc.

There are three types of interest rates by the means of which the RBI sets its credit policy, along with the tools of demand and supply. First is called Repo rate. This is the rate at which the RBI lends funds to the commercial banks. It has a direct impact on the economy. Another tool is Reverse Repo Rate, the interest provided to the commercial banks for their overnight deposits at the RBI. There is also the Cash Reserve Ratio (CRR) rate, which is a percentage of the deposits that the commercial banks are impelled to keep with the RBI as reserves. An increase the CRR forces the commercial banks to squeeze the money available to lend funds. An increase in the CRR under the quarterly revision of the credit policy on April 25 is expected to suck out over Rs 9,000 crore excess funds from the banking system, while the 0.5 per cent increase in CRR announced on April 17 was aimed at squeezing out Rs 18,500 crore from the system.

Inflation is a result of increase in the demand for money. People are liquidating their savings in order to cope up with the sky rocketing prices. An increase in the demand for money has lead to an increase in the interest rates. Now, an increase in the CRR will suck out excess funds. Usually, higher interest rates encourage savings and leads consumers to defer or cut back on purchases until the rates soften. This leads to a lower demand for goods and services and in turn can squeeze inflation rates. An increase in the interest rates is generally meant to be targeted at the lives of the executives. In general, the executives substitute savings for the extra consumption they make, which brings down the demand for the goods and services leading to a lower inflation rate. Dr Yaga Venugopal Reddy assured that the home loans interest rates are not going to be changed as a large portion of the middle class families indulge in taking home loans. Following the interest rates, various supply side factors will be instilled into the system curbing the executive life and softening the inflation rates.

Besides the monetary and fiscal policies, our honourable Prime Minister Manmohan Singh has followed a method of persuasion and pressure requesting, the executives to cut back on executive life after raising the slogan ‘Simple living, high thinking’.

Sanjay Kataria

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