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Inflation in a DevelopingEconomyTheory and Policy
MIHIR RAKSHIT
We are all structuralists, knowingly or unknowingly.
Adapted from Molier, The Would-be Gentleman
AbstractOver the last one decade inflation in India has been due mostly to oil
price shocks or below normal harvests; only in 2006-07 did aggregate
demand pressure seem to play a role in raising the general price level. Inflation
originating in supply shocks is generally transitory and represents a movement
from one equilibrium price level to another. Only when aggregate demand
exceeds the economys production potential and the monetary policy is
accommodative can inflation be of a continuing nature. The two types of
inflation call for quite different policy responses. Anti-inflationary fiscal or
monetary measures are required when there is an excess demand situation, not
when there is a sectoral shock. Nor are policies like oil price freeze or cuts in
customs-cum-excise duties on cement or metals appropriate for containing an
increase in the general price level: such measures are distortionary and
counterproductive in as much as they reduce the countrys full employment
output and growth potential. Only in the case of shortage of food and other
essential items of poor mens consumption is it necessary to undertake supply
side management through reliance on PDS as well as open market sale of
foodgrains by FCI.
The purpose of the present paper is to examine the nature of
supply and demand side factors causing inflation in the Indian economy
and the efficacy of alternative anti-inflationary measures. In order to
motivate the discussion we summarise in Section I the main features of
two recent inflationary episodes with special reference to their official
diagnosis and the policies pursued to reduce the price pressure. In thecontext of this survey we pose in Section II some theoretical and policy
issues which appear important, but do not seem to have been properly
addressed. Sections III to V attempt at a resolution of these issues and
provide in the process a critique of the anti-inflationary policy response
of the fiscal and monetary authorities. The final section concludes.
I. A Tale of Two Inflationary EpisodesAs a backdrop to our analysis in the subsequent sections we
propose to consider the inflationary developments during 2004-05 and
As a backdrop to
our analysis in the
subsequent sections
we propose to
consider the
inflationary
developments
during 2004-05 and
2006-07. Our choice
is dictated by the
fact that the sources
of inflationary
pressure and the
state of the economy
during the two yearswere markedly
different.
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2006-07. Our choice is dictated by the fact that the sources of inflation-
ary pressure and the state of the economy during the two years were
markedly different.1 Apart from documenting the developments during
these years official reports and statements on the two episodes provide
a fairly clear idea regarding (a) perception of the inflationary process
on the part of the fiscal and monetary authorities; and (b) their views
on the most effective means of arresting the process. Before examining
the official diagnosis and prescription related to the two inflationary
situations an overview of their main features may be of some help.
The 2004-05 inflation was characterised by a steep increase in
fuel, but not so much in other prices: compared with the year-on-year
(y-o-y) average WPI inflation of 6.5 per cent, fuel price inflation was
10.1 per cent, while inflation of primary articles was 3.6 per cent2 and
that of manufactured products 6.3 per cent.3 In fact, the end-March
inflation rates for WPI, primary products and manufactured goods were
significantly lower at 5.1, 1.3 and 4.6 per cent respectively, but fuel
price inflation went up to 10.5 per cent.4 Quite different was the
composition of the 2006-07 inflation, beginning from May 06 and
peaking in end-January 075 at 6.7 per cent. The drivers of inflation this
time were prices of primary articles and manufactured products, the
former recording an (y-o-y) increase of 10.8 and the latter of 6.4 per
cent; in sharp contrast, the fuel price inflation was no more than 3.6
per cent. By the end of the financial year WPI inflation had subsided to
5.7 per cent, but inflation continued to remain high at 10.7 and 5.8 per
cent respectively for primary and manufactured products.
There was also a considerable difference between the behav-
iour of WPI and CPI (consumer price index) during the two inflationary
episodes. In the earlier year WPI inflation was way above the CPI,
especially CPI-AL6 and CPI-RL, inflation. Thus in end-March 05,
against a WPI inflation of 5.1 per cent, the CPI-IW, the CPI-UNME, the
CPI-AL and the CPI-RL inflation rates were significantly lower at 4.2,
1 Our primary purpose in this paper being examination of the analytical
and policy issues relating to inflation in a country like India, we have left out theintervening year (2005-06) when the year-on-year inflation was relatively mild (at4.1 per cent) and in fact was the second lowest rate between 1994-95 and 2006-07.
2 Food price inflation was in fact no more than 2.6 per cent.
3 Driven primarily by hardening of prices of metals and metal products.4 The wide difference between the yearly average and end-year WPI
inflation rates reflects two phases of inflation during the financial year. The first, theApril-August 04 phase, was marked by hardening of domestic prices, with WPIinflation peaking at 8.7 per cent by end-August 04. The second, beginning from
September 04, saw an abatement of price pressure and a decline in WPI inflationand its components except for the fuel price inflation.
5 The y-o-y WPI inflation rose by a full percentage point to 4.8 per cent
between April and May, 06, continued its upward journey to peak at 6.7 per cent inthe week ending on 27 January, 07, and declined to 5.7 per cent in the last week ofMarch, 07.
6 AL: Agricultural Labourers; RL: Rural Laboureres; IW: IndustrialWorkers; UNME: Urban Non-Manual Employees.
Quite different was
the composition of
the 2006-07
inflation, beginning
from May 06 and
peaking in end-
January 07 at 6.7%.
The drivers of
inflation this time
were prices of
primary articles and
manufactured
products.
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4.0, 2.4 and 2.4 per cent respectively. In 2006-07 the situation was the
opposite, with the CPI rates far exceeding the WPI inflation: in end-
February 2007, the y-o-y increases in WPI, CPI-IW, CPI-UNME, CPI-AL
and CPI-RL were 6.1, 7.6, 7.8, 9.8 and 9.5 per cent respectively. This
difference in the sign and magnitude of the gap between the WPI and
CPI inflation rates in 2004-05 and 2006-07 reflects the relative signifi-
cance of different groups of products in (a) driving inflation during the
two periods; and (b) their weights in the WPI and CPI baskets. Prices of
primary articles have a weight of 48.5-73.0 in CPI,7 but only 22.0 in
WPI.8 In sharp contrast weights of fuel and manufactured goods prices
are much larger in WPI than in CPI. Remembering that increases in
agricultural goods prices were quite modest in the earlier episode but
were at the double digit level in 2006-07, the sharp difference between
the WPI and CPI inflation rates in the two episodes is not difficult to
comprehend.9
In response to the emergence of inflationary pressure the
monetary and fiscal authorities undertook a series of measures for
reining in prices and containing inflation expectations. For an
appreciation of these policies it is useful to consider the official reading
of the reasons behind the price increases and then see how the remedy
was related to the diagnosis.
Identifying the Sources of Inflationary Pressure
Though macroeconomic factors like growth or increases in
money and credit are not ignored, the thrust of the analysis of inflation
by both the ministry of finance (FM) and the Reserve Bank of India
(RBI) is on the demand or supply side factors10 causing inflationary
pressure in markets for particular products that enter WPI or CPI. A
close reading of the official (especially RBI11) documents suggests that
7 Weights of food items (food, beverages, pan, supari, etc.) in CPI-IW,CPI-UMME, CPI-AL and CPI-RL are 48.5, 52.6, 73.0 and 70.5 respectively.
8 Prices entering into CPI and WPI are not identical since apart from the
fact that while prices in the former are wholesale and that in the latter are retail, thecriteria for classifying the commodities under the two indices are different. Indeed,there are many products prices of which are included in one, but not in the other
index (or indices). However, movements in prices of foods items tend to be quite
close to that of primary articles.9 Indeed, on the basis of CPI-AL and CPI-RL figures, there was hardly any
inflation in 2004-05.10 The views of the two official organs on the inflationary situation during
a year are set forth in FMs annual Economic Surveys (ESs) and Reserve Bank of
Indias annual, quarterly and mid-term review of Macroeconomic and MonetaryDevelopment(MMD). Reserve Banks Annual Reports also examine the nature ofthe inflationary trends. However, Report on Currency and Finance, a major annual
publication of RBI, need not, it is stated, reflect the central banks official views onthe price situation and other subjects covered.
11 MMDs provide a much more detailed analysis of the price situation
than ESs. There is however no major difference between the approaches of themonetary and fiscal authorities.
For an appreciation
of these policies it is
useful to consider
the official reading
of the reasons
behind the price
increases and then
see how the remedy
was related to the
diagnosis.
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the major step in the analysis consists in taking stock of the y-o-y price
increases of different groups of products and estimating their contribu-
tion to the overall WPI or CPI inflation in the period under considera-
tion.12 These y-o-y price increases in their turn are explained in terms
of changes in demand or supply in the concerned markets. For an
analysis of the impact of these changes a distinction is made (it
seems13) between three categories of markets. The first consists of goods
like petroleum products, coal and fertiliser whose prices are fully
administered. The second group covers commodities in respect of
which neither price control nor quantitative restrictions on imports or
exports are in force. This group includes practically all manufactured
products14 whose combined weight is the largest in WPI. Finally, in the
case of many agricultural commodities market prices are not fixed, but
their exports and imports are subject to quantitative controls. The
significance of this three-fold classification lies in the way the factors
governing price increases of the different groups of commodities are
sought to be identified.
For the first group inflation if any is attributed to hikes in their
administered prices. Thus irrespective of international or domestic
demand-supply conditions in the market for crude oil, inflation in
petroleum products is traced to upward revision in their prices effected
by the government.15 Again, since petroleum products are used directly
or indirectly as intermediate inputs in practically all industries, account
is also taken, using the input-output analysis, of the impact of such
revisions on prices of other products and hence on overall inflation.16
Thus according to the Reserve Bank, . . . in the absence of
countervailing policy intervention, . . . every US dollar increase in
crude oil prices could potentially add 15 basis points to WPI inflation
as a direct effect and another 15 basis points as an indirect effect (RBI,
2005). Hence according to such estimates, keeping domestic prices of
petro-products unchanged in the face of (say) a ten-dollar rise in crude
oil prices, WPI inflation is prevented from jumping by as much as 300
basis points. Similarly for the inflationary effects of administered price
changes of coal or other commodities in this category of products.17
Inflation in prices of the second group of commodities is
12 The contribution of the price of a product to (say) WPI inflation isnothing but its inflation during the period times its weight in WPI. The sum of the
contribution of all prices entering WPI is of necessity the WPI inflation.13 The qualification is added since the RBI itself does not explicitly make
such a classification. But its analysis may perhaps be better appreciated in terms of
the three-fold grouping presented here.14 Sugar and fertiliser being the major exceptions.15 This is not to deny that changes in international prices affect govern-
ment decisions, generally with a time lag.16 We shall presently discuss the analytical foundation of such estimates.17 However, except for prices of petroleum there are no official estimates
of the effects of revision in other administered prices on WPI or CPI inflation; onlythe direct impact of the revisions is taken note of in such cases.
For the first group
inflation if any is
attributed to hikes in
their administered
prices. Thus
irrespective of
international or
domestic demand-
supply conditions in
the market for crude
oil, inflation in
petroleum products
is traced to upward
revision in their
prices effected bythe government.
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explained in terms of (a) their price trends in the international market,
(b) changes in excise or customs duties on the products, and (c) appre-
ciation or depreciation of the exchange rate, though domestic demand
pressure is also referred to in some instances. In other words, for the
tradables which are free from quantitative restrictions, the difference
between the international and domestic rates of inflation is viewed as
being governed by (b) and (c): to the extent excise and customs duties
are cut or the rupee appreciates, domestic price increases will be less
than that in the international market.
Finally, given the quantitative controls on trade, domestic
demand-supply conditions, especially the monsoon, are considered the
main determinants of agricultural price inflation. Needless to say,
government policy changes concerning imports and exports of
foodgrains or other farm products can raise or lower the inflationary
pressure in these markets; but with trade remaining relatively small in
relation to domestic output for most agricultural goods, climatic and
other supply side conditions are perceived to be by far the most impor-
tant determinants of inflation in primary product prices.
Macroeconomic Factors
Though the major part of the analysis of both the ministry of
finance and the Reserve Bank is devoted to sectoral (or commodity-
wise) price increases, account is also taken of the macroeconomic
factors behind the overall inflationary pressure. In the context of the
increasing openness of the Indian economy the RBI analysis starts in
fact with a survey of the international inflationary scenario as also the
conditions prevailing in major industrialised and emerging market
economies.18 High global growth; cyclical upswing in a number of
developed countries including Germany and Japan; rising world
commodity prices due to large demand from fast growing emerging
market economies, especially China; and overflowing liquidity in
international financial marketsall these are taken stock of for an
appreciation of how domestic inflation might be governed by macr-
oeconomic factors operating at the global level.
The RBI analysis of the price situation in different markets of
the domestic economy is also preceded by an examination of the signals
and sources if any of aggregate demand pressure or overheating. The
main indicators/factors considered in this connection are GDP growth;
capacity utilisation; infrastructural bottlenecks; growth of reserve
money, broad money and credit; increases in trade deficit along with
that in non-oil imports;19 wage pressure or rising profit margins of
18 This is followed by an analysis of commodity price movements in theinternational markets, especially those that loom large in the domestic WPI and CPIs.
19 A sharp rise in trade deficit driven by non-oil imports comes about
primarily because of increases in aggregate demand outstripping that in domesticoutput. Sharp rises in oil imports (in terms of USD) can come about due to an oilprice hike, remembering that demand for petroleum products are price inelastic.
The RBI analysis of
the price situation in
different markets of
the domestic
economy is also
preceded by an
examination of the
signals and sources
if any of aggregate
demand pressure or
overheating.
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corporates; and asset price inflation. All these (other than reserve
money and broad money growth) may no doubt be considered as
symptoms rather than causes of overheating; but taken together they
are deemed to underscore the need for macroeconomic intervention for
tackling the inflationary pressure.
In line with the conventional theory, an important factor
frequently mentioned in all Reserve Bank analyses of price situations is
inflation expectations. Because of estimation difficulties no concrete
evidence is adduced relating to such expectations in the years under
review; but the RBI hammers on (a) how the inter-relation between the
actual and the expected inflation under an accommodative monetary
policy regime can make the inflationary forces get out of control; and
(b) the urgent need of monetary tightening before such expectations
gather strength.
We have noted earlier how the official analysis of inflation
runs primarily in terms of factors driving prices in different markets. So
it is not unreasonable to ask, how (in the official explanation) are the
macroeconomic factors supposed to affect price changes in particular
markets? The answer seems to be that, price increases of different
products due to sector specific shocks are enhanced or moderated
according as the economy experiences a rise in or lessening of the
aggregate demand pressure.
Diagnosis and Policies
Given the above approach to the analysis of inflation in official
circles, it is instructive to examine the RBI and the FM views on the
sources of inflationary pressure and the policies adopted to deal with it
during the years 2004-05 and 2006-07.
2004-05 Inflation
Though reference is made to the liquidity overhang prevail-
ing in the economy,20 the increase in the general price level in 2004-05
is attributed almost wholly to steep rise in the international prices of
mineral oil, coal and metals. During the year coal prices rose by more
than 100 per cent; crude oil prices by above 50 per cent; and the
average metal prices by 36.4 per cent, with the prices of steel products
registering a larger increase at 54.2 per cent. The significance of the
impact of these increases on the domestic price level is suggested by the
fact that petroleum products and metals contributed to more than half
of the WPI inflation during the year. The surge in global prices of iron
and steel and other metals tended to have an almost immediate impact
on the corresponding domestic prices. But in view of the system of
20 The other macroeconomic factor mentioned is the 6.6 per cent (nominal)
appreciation of the rupee helping to moderate the passthrough of the rise in prices ofpetroleum and other products in the international market.
We have noted
earlier how the
official analysis of
inflation runs
primarily in terms of
factors driving
prices in different
markets. So it is not
unreasonable to ask,
how (in the official
explanation) are the
macroeconomic
factors supposed to
affect price changes
in particularmarkets?
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government control in force, for the other products the transmission of
the increase from the global to the domestic market was not immedi-
ate.21 In a lagged response to their hardening in the international
market, coal prices were raised in June 2004, and petroleum prices
were revised upward in three stages, in June, August and November,
2004. Considering the large significance of these products as intermedi-
ate inputs in other industries, their direct plus indirect impact may be
taken to account for the lions share of domestic inflation; only a small
part of the increase in the general price level was accounted for by the
rise in vegetable oil and sugar prices.
The roots of the 2004-05 inflation were thus traced to interna-
tional supply shocks22 rather than domestic overheating; but for reining
in inflation and inflation expectations the Reserve Bank undertook a
series of restrictive monetary measures: the cash reserve ratio (CRR)
was raised from 4.5 per cent by 0.25 percentage point on September 18,
2004 and again on October 2, 2004 by the same magnitude. This was
followed by a hike in the reverse repo rate on October 27, 2004 by 25
basis points to 4.75 per cent.23
The main anti-inflationary initiatives were however sectoral.
Urea prices were left unchanged even though they registered a 65 per
cent rise in the international market. The extent of hike in the adminis-
tered prices of coal and petroleum products was considerably less than
their price increases abroad: domestic prices of coal and mineral oil
rose by only 17 and 13.7 per cent respectively as against the doubling
of global coal prices and a more than 50 per cent increase in prices of
the Dubai crude. Excise and customs duties on petroleum products were
cut substantially, but even so there was substantial under-recovery of
costs at the new prices. A part of these costs was blown by public sector
oil companies but major part was covered by the issue of oil bonds to
the losing concerns. Similar sector specific policies were extensively
used for containing the passthrough of other prices. Cuts in customs and
excise duties on raw materials as also finished products limited the
domestic iron and steel prices inflation to 21.3 per cent even through
their prices in the international market soared by 54.2 per cent. Other
sector specific anti-inflationary measures included cuts in tariffs on
vegetable oils, an increase in the quantum of free-sale sugar and a steep
hike in the margin for future trading of sugar.24
21 Or full, as we shall presently comment on.22 The coal and metal price inflation were no doubt due to global demand
pressure, especially from China; but from the viewpoint of the Indian economy thisrepresented a supply rather than demand side shock.
23 In conformity with the international usage, with effect from 29 October
2004 the reverse repo indicates absorption and the repo injection of liquidity. Priorto that date the meaning of the two terms was the opposite.
24 From 8 per cent to 30 per cent.
The roots of the
2004-05 inflation
were thus traced to
international supply
shocks rather than
domestic
overheating; but for
reining in inflation
and inflation
expectations the
Reserve Bank
undertook a series
of restrictive
monetary measures.
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2006-07 Inflation
External factors were not inconsequential for domestic inflation
during 2006-07, but unlike in the earlier period there was hardly any
change in global crude oil and coal prices in this year.25 Rather, the
supply shock from the rest of the world was transmitted through a
sharp increase in agricultural prices and prices of metal and non-
metallic mineral products (especially cement), the first due to severe
shortfall in world output, the second to the high global growth in
general and the large Chinese demand in particular. However, much
more important this time was the operation of domestic factors.
The surge in international prices of farm products coincided with an
adverse domestic supply situation in markets for wheat, pulses,
oilseeds, cotton and other agricultural goods, and much more impor-
tantly, with the emergence ofaggregate demand pressure in the
economy. As evidence of demand driven inflation in 2006-07, the RBI
refers to a whole host of macroeconomic developments. These include
the 9.4 per cent GDP growth during the year coming on top of the 9.0
per cent growth recorded in 2005-06; signs of strained capacity utilisa-
tion, rising pricing power of corporates along with indications of wage
pressure in some sectors; pick-up of non-oil import growth and widen-
ing of trade deficit; the y-o-y growth of reserve money, broad money
and non-food credit to the tune of 23.7, 22.0 and 29.5 per cent respec-
tively; and the sharp rise in real estate, share and other asset prices.
In the context of the factors identified above, the rise in prices
of primary products was ascribed to the adverse (sectoral) supply
shock, but inflation in other prices was viewed mainly as the outcome
of booming aggregate demand in the face of tightening capacity
constraint in the non-agricultural sector. Accordingly the policy pack-
age adopted for tackling the 2006-07 inflation consisted of sectoral as
well as macroeconomic measures. Indeed, despite the identification of
strong cyclical upswing as the major factor behind the inflationary
pressure, fiscal intervention in individual markets was widespread. For
curbing inflation in prices of primary articles the government permitted
imports (along with substantial cuts in tariffs26) of wheat, pulses,
oilseeds as well as edible oil, maize and sugar.27 These measures for
augmenting imports were supplemented by (a) bans on export of wheat,
pulses, and skimmed milk powder; (b) increased supply of wheat under
25 Starting from USD 60.9 per barrel in March 2006, the average crude
price peaked at USD 72.5 in July 2006, displayed a downward trend thereafter andreached USD 60.6 in March 2007.
26 Thus private imports of wheat were allowed at 5 per cent duty from
June 2006 and then at zero duty from September 2006. Duty free imports of pulses,sugar and maize were also permitted. But in all these cases imports were subject tosome ceiling.
27 This was from June 22, 2006 when sugar prices exhibited strong price
pressure. However, as already observed, in response to the bumper domestic andinternational output, sugar prices came crashing from August, 2006.
Indeed, despite the
identification of
strong cyclical
upswing as the
major factor behind
the inflationary
pressure, fiscal
intervention in
individual markets
was widespread.
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the FCIs open market sales scheme; (c) a hundred rupee hike in the
minimum support price (MSP) for wheat;28 and (d) imposition of bans
on futures market trading in wheat, tur and urad.29
Sector specific anti-inflationary fiscal measures were also
adopted in markets for non-agricultural commodities. For purposes
of reducing manufacturing costs and the price pressure in selected
markets, the government reduced customs duties on inorganic chemi-
cals, non-ferrous metals, cement,30 capital goods and project imports.
Of much greater significance in this respect was the policy relating to
pricing of petroleum products. With the rise in international prices of
crude oil during the first quarter of the financial year, in June 2006 the
government reduced customs duties on petrol and diesel from 10.0 to
7.5 per cent, and raised their prices by Rs. 2 and Re. 1 respectively.
However, in November 2006, the petrol and diesel prices were reduced
to their pre-June levels and in February 2007 their prices were slashed
further, by Rs. 2 and Re. 1 respectively. It is worth noting that through-
out the period the administered prices of the products fell far short of
their costs. The shortfall was the largest for kerosene and LPG whose
prices had been kept unchanged since 2004.
As is to be expected, macroeconomic policies adopted for
controlling inflation were much more important in 2006-07 than in the
earlier episode. Between January 2431 and July 25, 2006, the reverse
repo rate was raised from 5.25 per cent to 6.00 per cent in three stages,
with an increase of 25 basis points at each stage. The hike in the repo
rate was steeper and effected over a longer period: the rate was raised
by 150 basis points to 7.75 per cent in six stages between January 2006
to March 2007. The increase in these policy rates were backed by hikes
in CRR and large scale open market sale of government including MSS
(Market Stabilisation Scheme) bonds.32 The need for these measures
28 So that the Food Corporation of India (FCI) can raise the amountprocured and effectively intervene if necessary in the market through the publicdistribution system or open market sales.
29 Since such trades, it is argued, can be highly speculative and put pressureon spot prices.
30 From April 3, 2007 import of portland cement was exempted for
countervailing duty and special additional customs duty. This came on top of the
exemption from the basic customs duty, announced in January, 2007.31 In January when both the repo and reverse repo rates were raised, the
WPI inflation rate (at 4.2 per cent) was fairly moderate and within the ReserveBanks comfort zone. The hike was mostly a response to international developmentsincluding the successive increases in the federal fund rates by the Federal Reserve
Bank of the USA.32 Unlike in the case of ordinary government securities, proceeds from the
issue of these bonds are credited in a separate account and not available to the
government to finance its expenditure. Hence, issue of MSS bonds automaticallyreduces the supply of reserve money in the system. The Market Stabilisation Schemehas been in operation since April 2004 when in the absence of adequate government
securities at its disposal the Reserve Bank was faced with the problem of sterilisingthe large scale inflow of foreign funds.
It is worth noting
that throughout the
period the
administered prices
of the products fell
far short of their
costs. The shortfall
was the largest for
kerosene and LPG
whose prices had
been kept
unchanged since
2004.
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assumed urgency with the high growth of reserve money and excess
liquidity in the system, driven by large inflow of foreign capital. The
cumulative increase in CRR effected by the Reserve Bank amounted to
150 basis points, from 5.00 to 6.50 per cent, between December 2006
and April 2007. The successive increases in CRR helped to absorb bank
resources totalling Rs. 43,000 crore. The quantitative significance of
sale of MSS bonds in sucking up liquidity from the system was also
considerable: as much as Rs. 23,894 crore of reserve money were
withdrawn33 through this route between February 1 and March 23,
2007.
Though the hikes in the policy rates and CRR were fairly steep
and sales of MSS bonds substantial, they proved inadequate, in the face
of burgeoning foreign capital inflows, to moderate the growth of money
and credit. Hence the Reserve Bank, as in 2004-05, moderated some-
what its purchase of foreign currency and let the rupee appreciate,34
albeit mildly.
II. Some Analytical and Policy IssuesThe official analysis of and the measures adopted to tackle the
2004-05 and the 2006-07 inflation raise a whole host of issues, both
analytical and prescriptive. These may be posed in terms of some
basic, inter-related questions that a mainstream (neo-classical)
macroeconomist would be inclined to ask on a perusal of Section I.
1. Why should price increases (following, say, a one-off increase
in crude prices) which reflect adjustment to a new equilibrium
situation and are not of a continuingnature be regarded as
inflation? Do such price increases require any policy response?The questions do not amount to splitting hair,35 since the
adverse consequences of inflation arise from unanticipated and
continuing inflation, not from an increase in prices to their
equilibrium levels.
2. Does not the analysis or diagnosis of inflation in terms of the
behaviour of prices of particular commodities or product
33 It may be noted that the negative impact of absorption of (say) Rs. 100crore through the MSS route on broad money supply is larger than an equal amountof (first round) absorption of bank resources through a CRR hike. In the first case,the fall in broad money supply equals Rs. 100 crore times the money multiplier; but
in the second case the fall will be less than Rs. 100 crore as the initial decline in bankdeposit and credit is moderated through an increase in reserve money in thecommercial banking system (as the public tries to reduce their holding of currency in
line with the fall in bank deposits).34 Exchange rate appreciation, it is interesting to note, does not figure in
the Reserve Banks list of measures for containing actual inflation or inflation
expectations.35 Since one may be tempted to dismiss the first question on the ground
that it relates to definition and hence is not substantive.
The official analysis
of and the measures
adopted to tackle the
2004-05 and the
2006-07 inflation
raise a whole host
of issues, both
analytical and
prescriptive. These
may be posed in
terms of some
basic, inter-related
questions that a
mainstream
macroeconomistwould be inclined to
ask on a perusal of
Section I.
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groups go against the fundamental approach of economic
theory? In economics there is a clear cut distinction between
(a) factors governing the general price level and its temporal
behaviour on the one hand; and (b) the determinants of relative
prices and sectoral allocation of resources on the other. Hence,
as in the case of determination of aggregate employment in an
economy, how can the behaviour of the general price level be
ascertained by looking at the demand-supply conditions in
individual markets? Is it not necessary for this purpose to use a
macroeconomic framework where inter-linkages among sectors
considered important are explicitly taken into account?
3. What is the economic rationale of freezing some prices or
trying to curb their increase for purposes of controlling infla-
tion? Are such measures effective as anti-inflationary devices?
Are they desirable in all or in some cases?
4. When inflation is due to some sectoral cost push, but there is
evidence of excess capacity or demand deficiency elsewhere in
the economythe 2004-05 inflation seems to fall in this
categoryshould the central bank take recourse to monetary
tightening?
5. When the administered prices of petroleum or other products
are below their international levels, should the government
raise them when the overall inflation is low, but keep them
unchanged or lower them if the general price level exhibits a
strong upward trend due to sectoral or macroeconomic factors?
6. Since a major reason adduced by the central bank for mon-
etary tightening irrespective of the sources of inflation is the
need for containing inflation expectations, it is important to
ask, what are the determinants of such expectations? Or more
specifically, would not expected inflation be related to the basic
reasons behind the price increases, i.e., whether they are due to
aggregate demand pressure or some sectoral supply shock?
7. Why are all anti-inflationary fiscal measures sector specific,
not geared towards control of aggregate demand? Are mon-
etary policies enough in a country like India in smoothening
cycles and steering the economy close to its full capacity
growth path?
8. Is WPI superior to other price indices for purposes of initiating
anti-inflationary fiscal or monetary measures?
The rest of the paper is devoted toward addressing the ques-
tions and issues catalogued above. However, since the issues are closely
connected and their resolution often depends upon the factors behind
the price increases as well as the state of the domestic and international
economy, our analysis is organised around some models which appear
appropriate in the context of Indias inflationary experience in recent
years.
Since a major
reason adduced by
the central bank for
monetary tightening
irrespective of the
sources of inflation
is the need for
containing inflation
expectations, it is
important to ask,
what are the
determinants of
such expectations?
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III. Impact of Oil Price Shock and Policy InterventionOne reason for considering the oil shock related inflation first
is the overwhelming significance of such inflation in the Indian
economy since the mid-1990s. During the twelve-year period, 1995-
2007, there were six years when the fuel price inflation was double
digit and in one year it was shy of 9 per cent (See Table 1 in the
Appendix). In almost all those years the WPI inflation was also high, at
more than 5 per cent.36 The more important reason for considering first
the consequences of oil price increases in some detail is however
analytical: many of the issues posed in the preceding section can be
examined in terms of models designed for tracing these consequences.
The models are also relatively simple to construct and comprehend,
given the fact that sources of the oil shock are completely external and
that in respect of practically all imports, including oil, India may be
considered a price taker in the international market.37
It is interesting to note that between 1995-96 and 2006-07 all
the oil shocks occurred when there was substantial spare capacity in
manufacturing as well as services. Hence we shall consider the impact
of the shock first in a demand deficient and then in a full employment
economy. In both the cases for simplicity of exposition we shall abstract
from the agricultural sector.
Oil Price Shock in a Demand Deficient Economy38
The simplest way of examining the inflationary impact of an
oil price shock is in terms of an inter-industry input-output framework,
remembering that crude oil is a universal intermediate and used
directly and indirectly in practically all industries. With labour and oil
as the two basic (variable) inputs in the system,39 the input-output
matrix yields the direct-cum-indirect amount of oil and labour required
for producing a unit ofnetoutput in each industry.40 The direct-cum-
indirect labour and oil coefficients along with the wage rate and oil
36 In 1997-98, the fuel price inflation was 13.7 per cent; but the onset ofdemand deficiency in manufacturing in the Indian economy as also in the crisis
ridden East Asian countries kept the overall inflation rate at a moderate 4.5 percent. In 2000-01 the WPI inflation at 4.9 per cent was relatively low in the context
of the 15.0 per cent inflation in fuel prices; the reason in this case lay in the bumperagricultural crop driving down the primary product prices (by 0.4 per cent), a uniquephenomenon during the 12-year period.
37 So that the feedback from the rest of the world to developments in the
domestic market may be ignored.38 For keeping the text uncluttered, the algebraic details of the models are
relegated to the Appendix.39 Were there excess capacity in the domestic oil sector, then it would have
formed part of the inter-industry matrix and labour would have been the only basicinput.
40 i.e., net of intermediate use of its own output in the process of produc-
tion. The net output of any industry is available for meeting the final demand forthe industrys production, by way of consumption, investment and exports.
The simplest way of
examining the
inflationary impact
of an oil price shock
is in terms of an
inter-industry input-
output framework,
remembering that
crude oil is a
universal
intermediate and
used directly and
indirectly in
practically all
industries.
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prices, yield a horizontal aggregate supply (AS) schedule41 showing
that the price level P, the weighted average of all prices, remains
unchanged at different levels of output. The aggregate demand AD is
however downward sloping since a fall in P raises (a) the trade
balance through a depreciation of the real exchange rate;42 and (b) the
supply of money in real terms. The horizontal AS along with the
downward sloping AD yields the equilibrium output and the price level.
Now consider the effect of a rise in oil prices in the interna-
tional market. In the absence of any government intervention, AS shifts
upward, the extent of the shift being greater, the higher the ratio of oil
to wage cost in the production of various goods and the larger the
weights in P of the more oil intensive products. Thus with no change
in aggregate demand, the equilibrium output level falls and the rise in
P equals the shift in AS on account of the oil price hike. However, in
view of the relatively inelastic demand for petroleum products an oil
shock raises the countrys net import bill43 which together with the
operation of the foreign trade multiplier effects a fall in aggregate
demand, i.e., shifts AD to the left. This reinforces the output reducing
effect of the oil price shock, but the magnitude of the price increase is
still governed by the effect operating through costs of production.
Under normal conditions however AS is upward rising,44 not
horizontal. Since an oil price hike shifts AS upward and AD leftward,
the effect of the hike is to raise P and reduce output even when AS is
upward rising; but the magnitude of the effects on both prices and
output are now lower.45 Indeed, when AS is fairly steep and AD rela-
tively flat, the effect on output is still unambiguously negative, but in
equilibrium the price level may register a fall!46 This suggests that the
consequences of an oil price shock will tend to vary with the state of
the macroeconomy. At lower levels of output, aggregate demand is
generally less price responsive, while AS tends to be flatter. Hence, the
shock will have a larger impact on prices and a smaller effect on
output when the economy operates with larger excess capacity.
What if the central bank adopts a hands-off policy in the
41 Up to full capacity output, remembering that input-output coefficients
are fixed. Horizontal AS also subsumes that prices are set on a mark-up basisnot
an unreasonable assumption in a demand deficient economy, where prices of the twobasic inputs do not change in response to variations in their levels of employment.
42 So that aggregate demand goes up by the incremental trade balancetimes the foreign trade multiplier.
43 At any given level of GDP.44 Given the fixity of capital stocks in the short run, beyond a point there
will be diminishing returns to the marginal productivity of the two basic (variable)inputs, labour and oil. This along with the tendency for money wages to rise with
increases in employment makes AS positively sloped.45 Given the slope and shift ofAD.46 The economic explanation is that, while a flatter AD induces a larger
fall in output, the decline in price for a given fall in production is larger, when AS issteeper.
At any given
exchange rate an oil
price hike reduces
aggregate demand.
But since the
exchange rate tends
to depreciate due to
the shock, there is
also a favourable
impact on domestic
demand.
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foreign currency market?47 In this case the factors affecting the macr-
oeconomic variables do not always pull in the same direction. At any
given exchange rate an oil price hike reduces aggregate demand. But
since the exchange rate tends to depreciate due to the shock, there is
also a favourable impact on domestic demand. The most plausible
result, as we show in the Appendix, is that exchange rate flexibility
moderates the fall in output and the extent of real exchange rate
appreciation, but magnifies the increase in the level of domestic
prices.48
Oil Shock in a Full Employment Economy
According to the mainstream literature, continuing inflation
can occur only in a full employment economy or at the NAIRU49 level
of output, not in a Keynesian economy. Hence it is important to
analyse the consequences of an oil price shock when the initial equilib-
rium is full employment. There is a general consensus that the short-run
effects of all disturbances, including an oil shock, are Keynesian:
irrespective of the initial output level, while an increase in aggregate
demand tends to raise output and prices, a cost push causes a fall in
output along with an increase in the general price level. However, with
adjustments in wages, prices and interest rates, the economy reverts to
a NAIRU equilibrium which may or may not be the same as the initial
one. Let us see if or how such an equilibrium is affected by a one-off oil
price shock.
Consider a neo-classical aggregate production function where
the capital stock is fixed and the two variable inputs are labour and oil.
While oil is available at a price fixed in terms of foreign currency, the
supply of labour is an increasing function of the real wage rate. The
real wage rate however is a weighted average of the rates in terms of
domestic and imported consumables. Given the production function,
full employment equilibrium in such an economy is characterised by
the demand-supply balance in three markets, labour, output and foreign
exchange.
In terms of the characteristics of the full employment equilib-
rium it is fairly easy to examine the implications of an oil price in-
crease for the domestic economy when the markets have adjusted to the
shock. The new (full employment) equilibrium will be characterised by
a lower level of output.50 The fall in output will be steeper, the higher
47 Note that in order to keep the exchange rate fixed, the central bank
needs to sell foreign currency if the trade (or rather, current account) deficit exceedsthe net capital inflow. At the same time it is necessary to undertake some openmarket purchase of securities so that money supply is not affected.
48 Since the output fall is smaller and the nominal exchange rate goes up inequilibrium.
49 The acronym for non-accelerating inflation rate of unemployment.50 In view of the fact that oil is an imported input, the fall in GDP will be
larger than that in output (as given by the aggregate production function).
In terms of the
characteristics of the
full employment
equilibrium it is
fairly easy to
examine the
implications of an
oil price increase for
the domestic
economy when the
markets have
adjusted to the
shock.
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the oil intensity of domestic output and the lower the elasticity of
substitution between labour and oil in the production function. With
relatively low elasticity of substitution between the two inputs, there
will also be a tendency for a fall in the real exchange rate. This
reinforces the output reducing effect of the shock, since a real exchange
rate depreciation reduces the real wage rate and hence the supply of
labour.
What about inflation and all that? As is to be expected in a
neo-classical model, the real variables are independent of the supply of
money or the monetary policy stance. Hence if money supply remains
unchanged, the reduction in full employment output will raise the
general price level. But this would be a one-shot increase in prices, not
inflation; nor does it have any significance for any of the real vari-
ables. It is only if the central bank persists in raising money supply
over time, can there be continuing inflation in the system.51
Resolving the Analytical and Policy Issues
The foregoing analysis underscores the well recognised need
among economists of a macro general equilibrium framework for
examining the inflationary consequences of a shock, even when the
shock is sectoral. Indeed, the fallacy of looking only at the cost side or
of a sector-by-sector analysis for tracing the change in the general price
level is dramatically illustrated by the possible negative impact of an
oil price hike on P when the supply price response to changes in
production is significant and the trade balance is sensitive to exchange
rate variationsconditions that are fairly undemanding. Let us turn to
the other issues raised in Section II and see if the above constructs are
of any use in their resolution.
Price Adjustment and Inflation
The perceptive reader must have noted that the change in the
general price level (and GDP) due to an oil price hike, as obtained from
the AD-AS and the full employment models, refers to a shift from one
equilibrium P to another and does notconstitute inflation, which
necessarily has to have a time dimension. In order to examine the
inflationary consequences of some (one-off) oil shock, we need to know
the time path or rapidity of adjustments in different markets from their
initial to the new equilibrium. The slower the rate of adjustment, the
longer will be the inflationary period, but the rate of inflation during
the earlier phase of adjustment will be lower. A fast rate of adjustment
on the other hand implies that the inflation rate will initially be high,
but then drops sharply and taper off fairly soon. In the extreme and
51 Strictly speaking, for such inflation the growth in money supply has to
persistently exceed the full employment growth of the economy times the incomeelasticity of demand for real balances.
The perceptive
reader must have
noted that the
change in the
general price level
(and GDP) due to an
oil price hike, as
obtained from the
AD-ASand the full
employment
models, refers to a
shift from one
equilibrium Pto
another and does
notconstituteinflation.
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implausible case, the adjustment could be instantaneous52 so that as
soon as there is a hike in oil prices, the general price level and other
macro variables jump to their new equilibrium values, but there is no
inflation thereafter.53
Does the adjustment rate matter, and if so, how? The central
bank and the fiscal authorities in India seem to think that a low infla-
tion spread over a long period is preferable to the one which starts with
a bang, but loses its steam quite rapidly: recall in this connection
(a) the government policy of controlling prices of petro-products and
raising them slowly when the overall inflation has turned mild; and
(b) the Reserve Banks pursuit of dear money policy when the WPI
inflation, though high, was palpably the fall-out of the oil price shock.
However, since the misalignment of prices from their equilibrium
configuration generally entails allocative inefficiency, the economic
costs of slow adjustment of prices need not be negligible. The point to
note here is that one needs to distinguish between (a) price increases
that arise in the course of adjustment of different markets to a new
equilibrium; and (b) inflation that originates in a fundamental imbal-
ance and hence is likely to be persistent. Remembering that the price
increase due to an oil price shock is of the first category, let us consider
the economic consequences of fiscal and monetary policies adopted in
response to such shocks.
On How Not to Tackle Oil Price Shocks
The most widely used policy followed in India for containing
oil price inflation has been freezing petroleum prices and setting them
below costs. Since apart from their macroeconomic impact such
measures have important allocative consequences, it is instructive to
examine first the implications of the policy for a full employment
economy.
The most important effect of oil price control, our earlier
analysis suggests, will be a reduction in the countrys full employment
GDP.54 The reasons are several. First, given the level of employment
and the real exchange rate, use of oil in the production process will
exceed the level at which its value marginal productivity equals its
marginal cost to the economy.55 This excess use of oil involves a loss of
GDP, remembering that the gap between the import cost and the value
of the marginal productivity of oil reflects the reduction in GDP at the
52 As in competitive markets where buyers and sellers are possessed of allrelevant information.
53 In view of the jump there is a discontinuity in the time path of P so that
the inflation rate at the moment the jump occurs is undefined.54From the level obtaining in the absence of such price control. Since oil is
an intermediate input imported from abroad, GDP equals aggregate output less the
cost of oil used in the production process.55 Both measured in terms of some common denominator.
The central bank
and the fiscal
authorities in India
seem to think that a
low inflation spread
over a long period is
preferable to the one
which starts with a
bang, but loses its
steam quite rapidly.
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margin. Second, the oil price freeze prevents adjustment towards the
(new) optimal oil-labour ratio and results in a fall in GDP at any given
level of output. Third, the increase in the oil import bill due to opera-
tion of these two factors causes a real exchange rate depreciation and
hence a reduction in GDP measured in terms of domestic output as well
as in the countrys command over imported consumption or investment
goods at any given level of GDP. Fourth, when the direct-cum-indirect
oil intensities of various goods and services differ widely and to the
final users their substitution possibilities are not negligible, the adverse
consequences of oil subsidy would be much larger than is suggested
from our analysis of a one-commodity, full employment economy.56
Fifth, given the distortionary and other costs of taxes in a country like
India, the GDP loss on account of (tax-financed) subsidisation of oil can
be fairly large.
More significant than the short-term GDP loss are perhaps the
longer term costs of an oil price freeze. Financing the subsidy bill
through oil bonds, as is done in India, only postpones the distortionary
costs of taxes and transfers, but does not avoid them. What is no less
important to recognise, the bond issues tend to reduce investment and
saving, and hence the growth potential of the economy.57 The growth
debilitating effects of distortions can be considerable since the substitu-
tion possibilities between factors through shifts in technology as well as
invention of new techniques are much greater in the long than in the
short run.
What about the increase in the general price level or inflation?
Our earlier analysis suggests that, given the supply of money and its
growth, the oil subsidy will in fact cause both a jump in the general
price level and an increase in the rate of inflation, the first through a
fall in (short-term) full employment GDP, the second through a reduc-
tion in growth. No wonder, common sense or partial analysis can be
quite misleading for analysing the behaviour of macro variables like
Inflation or GDP.
The second set of policies deployed for controlling petro-
inflation consists of monetary tightening. Let us consider the effects of
the policy in a full employment economy. A tight money policy may
imply two things: (a) a one-shot reduction in money supply with no
change in its growth rate thereafter; and (b) a cutback in the growth
rate of money supply. Remembering that an oil price shock causes a
fall in full employmentGDP, the price level will tend to go up in
56 The reason is that oil subsidy stands in the way of reallocation ofresources towards the optimum (less oil intensive) basket of production and
consumption. It is important to recognise that even if the technical input coefficientsare fixed in the short run, the substitution possibilities in consumption and invest-ment are considerable.
57 Recall that we are considering the effects of bond issues for providingsubsidy in a full employment economy.
More significant
than the short-term
GDP loss are
perhaps the longer
term costs of an oil
price freeze.
Financing the
subsidy bill through
oil bonds, as is
done in India, only
postpones the
distortionary costs
of taxes and
transfers, but does
not avoid them.
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equilibrium in the absence of any change in money supply. What
(a) can do is to moderate or prevent the rise in P. In a full employment
economy however a one-off increase in nominal (but not in relative)
prices is of little consequence. But even in such an economy inflation
above or below some range tends to have adverse consequences.58
Hence when an oil shock pulls down GDP growth, monetary tightening
in the sense of (b) becomes necessary to keep inflation close to its
optimum rate. The problem however is that while the negative impact
of an oil price increase on the level of full employment GDP is fairly
obvious, it is by no means clear whether or by how much there will be
a slowdown in growth.
We have throughout been concerned with a situation where
there is a one-shot rise in oil prices, but other external factors affecting
the domestic economy remain unchanged. Two caveats appear worth
mentioning in this regard. First, there is always an element of uncer-
tainty regarding the likely trend of oil prices in the future. Even when
the shock is expected to be temporary, the price freeze remains a
suboptimal response. Apart from the fact that the policy leads to
overuse of oil and does not allow for the substitution possibilities in
production, consumption and investment, it is generally preferable to
leave it to the economic agents to form their own expectations and
decide on their course of action accordingly: in respect of the global oil
economy the government is not better informed than most producers
and investors. Second, through an increase in NRI remittances, export
demand and capital flows, oil price bonanza often produces a favour-
able impact on the countrys economy. This calls for some policy
initiatives on the macroeconomic front,59 but does in no way justify oil
subsidy.
Policy Response in a Demand Deficient Economy
Practically all the oil shocks occurred when the Indian
economy had had under-utilised capacity; but the policies adopted for
dealing with the shocks still consisted of petroleum price control and
monetary tightening. Let us consider first some economics of the
former.
An oil price freeze prevents an upward shift in aggregate
supply (AS); but in view of the enhanced oil import bill there is still a
fall in aggregate demand (AD). As a result not only is the output
decline moderated,60 but the price level also tends to fall in equilib-
58 While high inflation tends also to be volatile and enhances risk, acrawling price level slows down optimal reallocation of resources under changing
demand or supply side factors, given the relatively small downward flexibility ofsome wages and prices.
59 e.g., those relating to exchange rate and current account deficit.60 Compared with what would have occurred in the absence of the price
freeze.
Through an increase
in NRI remittances,
export demand and
capital flows, oil
price bonanza often
produces a
favourable impact
on the countrys
economy. This calls
for some policy
initiatives on the
macroeconomic
front, but does in no
way justify oil
subsidy.
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rium. Again, since the output decline is less when the subsidy is
financed through bonds rather than taxes, the case for the oil price
policy pursued by the government may appear open and shut. Unfortu-
nately, the strength of the argument is more apparent than real.
Recall that freezing oil prices reduces a countryspotential
income and consumption in the short as well as the long run. The fact
that the actual output is less than its potential is no ground for follow-
ing wasteful policies, e.g., expenditure on digging holes and filling
them up, for boosting production. The most important point to note
here is that for dealing with macroeconomic problems, e.g., demand
deficiency or inflation, it is generally preferable to rely on overallfiscal
and monetary policies,61 not to tinker with sectoral prices. Only when
the price increase is likely to cause serious hardship to the indigent and
the government cannot directly mitigate the hardship through income
transfer is there a case for providing some subsidy. Anyway, such
subsidy is to be on some essential item of poor mans consumption like
kerosene, not intermediate inputs or products purchased by the rela-
tively well off.
What about the rise in prices in the absence of any subsidy? A
one-off increase in the general price level (P), as already emphasised,
does not constitute inflation or entail the adverse effects of a continuing
rise in prices. If for some reason the government does not want a rise in
P even when it is one-off, it is much more sensible to effect a propor-
tionate cutback in allindirect taxes,62 rather than subsidising oil or
cutting duties on imports of petro-products. Such an across-the-board
duty cut avoids inefficiency in resource use, including distortions in
imports and exports. The conclusion is inescapable that sectoral
intervention is generally a poor substitute of overall policies in dealing
with demand deficiency or inflation.
Our analysis also suggests the inappropriateness of government
policies relating to the timing of oil price revisions. These revisions are
made with a view to keeping the increase in the general price level
moderate: the government tends to raise prices of petroleum products63
when inflation has slowed down, but keeps them unchanged in periods
of relatively high inflation though international oil prices might have
hardened meanwhile.64 Apart from the fact that all delays in making
domestic oil prices conform to their international counterparts enlarge
distortionary costs, the aforementioned timingof price revisions is
likely to be counterproductive. When high inflation originates in
61 Since they do not distort relative prices.62 Assuming that the initial tax rates were optimum. If they were not,
some readjustment is necessary, but that is not directly related to the hike ininternational oil prices.
63 In order to reduce the subsidy bill.64 A cut in oil prices under these conditions would have been a more
consistent policy stance!
Apart from the fact
that all delays in
making domestic oil
prices conform to
their international
counterparts enlarge
distortionary costs,
the aforementioned
timingof price
revisions is
likely to be
counterproductive.
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aggregate demand-supply imbalance with the actual output overshoot-
ing the NAIRU level, oil price control, our analysis suggests, aggra-
vates the imbalance through an enlargement of demand and reduction
in supply.65 An upward revision of oil prices for closing the gap be-
tween the international and domestic prices would always be efficiency
enhancing; but such revisions unaccompanied with an expansionary
policy can have an adverse effect on output and employment in times of
low inflation resulting from overall demand deficiency.
Oil Inflation, Monetary Policy and Inflation Expectations
Monetary policy for dealing with sector specific shocks is no
less inappropriate than oil price control for tackling inflationary
pressure. Thus when the central bank takes recourse to monetary
tightening in response to an oil shock induced increase in WPI, the
demand reducing impact of the increase is reinforced by a credit crunch
so that losses in output and employment are magnified. For neutralising
the negative impact of the shock on the level of activity in a demand
constrained economy what is called for in fact is an expansionary
policy,66 not a monetary squeeze.
According to the Reserve Bank the main reason for monetary
tightening even though the economy may be demand deficient and the
price rise originates in a sectoral shock lies in the need for containing
inflation expectations. In order to appreciate their significance note
that, given the tendency of economic agents to extrapolate the recent
price trends into the future, a rise in current inflation is likely to raise
expected inflation as well. However, since investment demand as also
contracts concerning money wages, lending, borrowing, etc. are
crucially affected by expected inflation, the actual inflation itself is
influenced by price expectations. Hence arises the importance of
keeping the actual price increases in check before they degenerate into
a cumulative inflationary spiral. Of particular significance in this
context is reputation of the central bank or perception of private agents
regarding the central banks willingness and ability to keep inflation in
check. When the central banks credentials as an inflation hawk are
well established, an increase in current prices will not generally cause
inflation expectations and to that extent it becomes easier for the
central bank to keep the inflation rate range bound. But the cost of
central bank reputation is deemed to be eternal vigilance: while
establishing the reputation is a time consuming process, it is liable to
be lost if on one or two occasions the central bank does not take
rompt measures to arrest price increases. The implication is that, in
times of rising prices, whatever be their source, the central bank
65 With erosion of allocative efficiency in general and overuse of oil inparticular.
66 Assuming that the NAIRU output at the higher level of oil prices is notbelow the prevailing output level.
When the central
bank takes recourse
to monetary
tightening in
response to an oil
shock induced
increase in WPI, the
demand reducing
impact of the
increase is
reinforced by a
credit crunch so that
losses in output and
employment are
magnified.
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cannot afford to follow a neutral monetary policy, let alone an expan-
sionary one.
There are several flaws in the above line of reasoning. Recall
that the significance of inflation expectations is underlined in the
literature in the context of the time inconsistency problem (Kydland and
Prescott, 1977). The problem arises when the central bank seeks to
raise output above its NAIRU level through an expansionary monetary
policy. Given a low expected inflation rate formed on the basis of past
experience (or rather, the central banks revealed preference for low
inflation), the expansionary policy will succeed in raising employment
and output, but only at the cost of a rise in inflation above its expected
rate. This success is due to the unanticipatedrise in inflationor policy
surprise: had inflation been fully anticipated, there would have been no
change in output or any other real variable in the system. If the central
bank persists with such measures, economic agents would soon learn its
policy stance and revise their inflation expectations so that the economy
ends up suffering from a rise in inflation with no increase in output and
employment above their NAIRU levels.
Two crucial features of the foregoing analysis deserve especial
attention. First and the most fundamental, economic agents learn from
experience and are rational. Second and related to the first, they also
know how the economy operates under given conditions.67 If so, in the
absence of any central bank intervention following an oil price shock,
rational economic agents, knowing their AD-AS model, would expect
(a) the price increases (if any) to taper off over the adjustment period;
and (b) output and employment to fall in the short run. In other words,
the oil price induced price increase would not generate inflation
expectations. Indeed, economic agents would also know that at the new
equilibrium configuration, though prices of oil intensive products would
be higher, those of other goods and services would tend to fall.
One can go further and indicate the response of rational
economic agents when the central bank invariably follows a
contractionary monetary policy whenever the WPI inflation goes above
some targeted level, even though the increase may be due to a sectoral
shock and the economy demand deficient. Pursuit of such a policy is
likely to make economic agents lower their expectations regarding the
economys average capacity utilisation and employment level over the
business cycles. Such expectations on the part of investors cannot but
act as a damper on their plans for longer term capital accumulation
and effect a slowdown in economic growth.
67 Note that the time inconsistency problem arises when the central bankundertakes monetary expansion in a full employment economy. When such anexpansion takes place under conditions of unemployment, the result will be a rise in
both employment and the price level, but no continuing price pressure, even ifeconomic agents are fully aware of the measures being implemented by the centralbank.
Given a low
expected inflation
rate formed on the
basis of past
experience (or
rather, the central
banks revealed
preference for low
inflation), the
expansionary policy
will succeed in
raising employment
and output, but only
at the cost of a rise
in inflation above itsexpected rate.
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IV. Food Price InflationApart from oil, the other important source of sectoral supply
shock having a large impact on the general price level is the primary
sector in general and foodgrains production in particular.68 While
examining the inflationary consequences of such supply shocks, a few
distinguishing characteristics of the food market are worth keeping in
view. First, imports and exports of food (unlike that of petroleum
goods) are highly restricted so that the supply shock originates prima-
rily in the domestic economy. Second and related to the first, the shocks
are due almost wholly to climatic conditions and hence largely tempo-
rary, though, given the structural features of the economy, food produc-
tion in a year of normal or even bumper harvest still leaves a fairly
large number of people hungry or undernourished. Third, except for the
foodgrains sold through the public distribution system (PDS), food
prices are market clearing. Given these features of the food sector let us
consider the impact of a harvest failure on the general price level and
other macro variables.
Food Inflation in a Demand Deficient Economy
The appropriate framework for analysing the consequences of
a supply shock in the primary sector is the dual economy or structural-
ist models [e.g., in Taylor (1983), Bose (1989) and Rakshit (1982,
1989)] where interaction between the agricultural and non-agricultural
sectors of the economy are explicitly taken into account. In such models
while prices are market clearing in agriculture, the basic features of the
non-agricultural sector are as in mainstream macro models. Under
these condition there are four main routes through which the effect of
an agricultural supply shock is transmitted to the rest of the economy.
First, with the fall in income originating in the primary sector, there
will a decline in demand for non-agricultural products. Second, there is
also a cost-push effect operating through the rise in prices of agricul-
tural raw materials and upward (albeit imperfect) adjustment of money
wages to the rise in food prices. Third, given the relatively inelastic
demand for food, a rise in its prices will force workers to reduce their
consumption of non-agricultural goods. Finally, the real exchange rate
appreciation69 worsens the trade balance and constitutes yet another
source of decline in demand for non-agricultural products. The (short-
run) equilibrium of the system following the supply shock will thus be
68 Indeed, the weights of primary product prices in both WPI and CPIs aremuch larger than that of oil. While the weights of fuel and mineral oils in WPI are14.2 and 7.0 respectively, the weight of primary products is 22.0 and that of food
articles 15.4. With the inclusion of manufactured food products, the weight ofcomposite primary articles goes up to 37.7 and that of food items to 26.9. Needlessto say, in CPIs, especially in CPI-AL and CPI-RL, the weight of food articles is
overwhelming.69 Due to the rise in prices of both primary articles and non-agricultural
products.
Apart from oil, the
other important
source of sectoral
supply shock having
a large impact on
the general price
level is the primary
sector in general
and foodgrains
production in
particular.
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characterised by (i) a rise in prices of both agricultural and non-
agricultural articles, with a sharper increase in the former than in the
latter; (ii) a fall in non-agricultural output and employment; and (iii) an
appreciation of the real exchange rate.
The effects of agricultural supply failure are thus somewhat
similar to that of an oil price shock; but there are also crucial differ-
ences which call for a radically different policy response. Unlike an oil
price increase, which need not be reversed for a fairly long while, an
agricultural supply shock does not generally persist over time. It is for
this reason that the increase in the general price level and the fall in
GDP due to harvest failures tend to be transitory and the effects re-
versed when climatic conditions become normal. However, the need for
prompt and effective measures for dealing with supply shocks in agri-
culture is much more urgent, given the large-scale starvation and sharp
rise in the incidence of poverty that follow shortages of food supply.
Fortunately, government measures for dealing with food
inflation are much more sensible than policies pursued for tackling the
oil price shock. Since the major impact of draught or other climatic
disruptions on employment and income is in rural areas, public works
programmes along with provision of subsidised food through PDS
constitute a most potent means of alleviating the hardship of the worst
sufferers of the shock. However, operational-cum-administrative
hurdles tend to limit ready initiation of public works programmes in
many areas and the rationing system often leaves many a low income
households uncovered. Hence open market sale of foodgrains by FCI
becomes necessary to contain food price inflation and its impact on
poverty as well as on non-agricultural output and employment. The
policies are standard, but three issues relating to the measures merit
some comments.
The first concerns the inefficiency and waste involved in hastily
drawn and poorly administered projects. The concern is legitimate and
as far as possible injection of new funds should be in schemes vetted
through a careful cost-benefit calculus. Such calculus should however
take into account (a) the overwhelming social need for providing relief
in areas of widespread harvest failure; and (b) the near zero opportu-
nity cost of labour in these areas.
Second, one may harbour some unease regarding the rise in
government expenditure on account of public works projects and food
subsidy in the face of sharply rising prices. Would not the enhanced
expenditure fuel price increases? The important point to note in this
connection is that, keeping food prices in check helps to contain wage-
price spiral in the non-agricultural sector. Again, industries and services
burdened with excess capacity benefit from the positive demand side
impact of both government expenditure70 and reining in of food price
inflation.
The effects of
agricultural supply
failure are thus
somewhat similar to
that of an oil price
shock; but there are
also crucial
differences which
call for a radically
different policy
response.
70 Part of the government expenditure on public works and of consumption
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Third and the most important is the problem of supply man-
agement. When FCI is loaded with substantial food stock, the manage-
ment problem is relatively easy. If the economys average production of
foodgrains over the agricultural cycle is not inadequate, a buffer stock
policy should normally be sufficient to neutralise the adverse effects of
an agricultural supply shock. Barring the subsidy required for the
below poverty line (BPL) families, the policy should also be paying to
(a well managed) FCI. The difficulty may arise in exceptional years
when FCI stocks are inadequate to make up for the poor harvest. The
problem is compounded when international prices of foodgrains are
also high, as they were during 2006-07. The solution then lies in food
imports and their subsidised sale in the domestic market. Ideally, the
subsidised sales should only be to the poor; but because of the well
known problems of targeting the indigent, there is a strong case for
open market sale of foodgrains below costs if necessary. When the food
shortage is transient, depletion of forex reserves due to food imports
should be of no concern; in fact the resulting real exchange rate depre-
ciation would be salubrious for the non-agricultural sector suffering
from demand deficiency.
Except for public works programmes, all the measures consid-
ered above are sectoral, designed to augment market supply and
contain price increases of food items. But would not government
intervention in the food market create distortions of the sort we noted in
connection with oil subsidy? If the government could ensurethrough
public works programmes, employment guarantee schemes or
redistributive measuressome minimum income of BPL households, the
food economy could perhaps have been left to the operation of domestic
and international market forces. But in view of the absence of an
effective social safety net for the large majority of the indigent, subsi-
dised PDS and open market sales of foodgrains below costs may be
viewed as a second best solution. It is also worth emphasising that the
distortionary costs of food subsidy would be minuscule compared with
that of oil subsidy: food articles constitute items of final consumption,
not intermediate input; their substitution possibilities with other con-
sumption goods are small; and the subsidy can be fairly cost effective if
it is confined to coarse grains or other goods entering the poor mans
consumption basket.71 Again, so long as government intervention does
not preclude open markets in foodgrains, the effect of food subsidy will
primarily be redistributional.
Even apart from distributional considerations, there are three
compelling reasons for public intervention in the food sector, especially
in times of harvest failure. Given the credit market imperfections and
of the newly employed will be on non-agricultural products and this additionalexpenditure in its turn initiates a multiplier process (Rakshit, 1982).
71 It was on the basis of all these considerations that we favouredsubsidisation of kerosene among petroleum products.
In view of the
absence of an
effective social
safety net for the
large majority of the
indigent, subsidised
PDS and open
market sales of
foodgrains below
costs may be
viewed as a second
best solution.
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absence of insurance facilities in the unorganised sector, FCI operations
designed to keep prices of food and its consumption relatively stable
over the agricultural cycles72 cannot but be beneficial for both produc-
ers and consumers.
Second, insufficient food intake even over a few months saps
efficiency of workers, makes them diseas