Inflation and Price Policy - Fiscal Policy, Public Finance | Public Finance - B Com PDF Download

Introduction

Inflation is defined as a general rise in prices of all commodities. In the words of Samuelson, “by inflation we mean a time of generally rising prices for goods and factors of production – rising prices of bread, cakes, haircuts, rising wages, rents etc”. It is not the rise in the price of my favorite commodity e.g. McDonalds Pizza, but the overall rise in the prices of all the goods and services manufactured and consumed within the territory of a nation. When we say that the monthly rate of Inflation is 12%, what it means is that on an average, the prices of all goods and services have increased by 12% in the period of last one month. The essence of inflation is disequilibrium between aggregate demand and aggregate supply, i.e. excess of demand over supply that keeps the price level rising over time

Measures of Inflation

In India, Inflation is measured using WPI (Wholesale Price Index). It is very tedious to track each and every commodity and calculate its price rise. Instead of that an Index of several goods and services is prepared. India's WPI is a weighted-index of 435 commodities. It means price-rise of all commodities will not be treated equally. The price-rise of rice will have more weight-age than price-rise of a Maruti-car. That is because rice is consumed by a very large number of people compared to a Maruti car. The weight-age of a Mercedez car will be still lower in the WPI. So when this WPI increases from say 100 to 112, we say that the rate of inflation is 12%.

Many other countries like UK, USA, China, etc. use CPI (Consumer Price Index) to measure inflation. This is a more realistic measure because it computes the index based on the increase in actual price paid by the consumer. On the other hand, WPI considers the rise in the price by the Wholesalers of the goods and services.

Trends of Price Movement

Inflation wise, the past half a century can be divided into distinct phases, viz.,

1. Period of relative price stability (1951-1956). The average annual rate of price rise or inflation was almost nil during this period. Within this period the price changes varied between negative to positive. The overall price stability, or even negative inflation rate was mainly the result of bumper agricultural production and tremendous success of the first plan. However pressures of high demand towards the beginning of Second Plan caused the prices to rise.
2. Phase of Moderate Inflation (1956-1971). During the period 1956-1971, average annual inflation rate rose to 6.4 per cent. The price position during third five-year plan deteriorated badly. The average increase in prices was around 5.8 per cent. However there was a small decline (-1.1 per cent) during 1968-69 mainly due to the impact of a bumper crop in the year1966-67.
3. Period of High Inflation Rate (1971-1981). During the decade 1971-81, the annual average inflation rate (rate of increase in price level) became still higher to reach 10 percent. The crop failure in 1972 and the oil shock of 1973 were the main factors behind the inflation. The average inflation rate which was higher at 12 per cent during 1971-72 to 1975-76 and slightly lower at 8.5 per cent during 1976-77 and 1980-81. Planwise, the inflation rate which was high at around 9 percent during the fourth plan (1969-74) came down to 6.3 percent during the fifth plan 1974-79.
4. Slow down of Inflation (1981-1991). During this phase the annual inflation rate slightly came down to 8 per cent. The highest recorded price rise during this decade was 18 per cent in 1980-81 and lowest of 4.4 percent in 1985-86. But during the five- year period (seventh plan 1985-90) it rose to around 8 percent.
5. Price situation in the Nineties. The 1991-1996 periods witnessed the revival of strong inflationary pressures. But 1996 onwards inflation declined and inflation rate has declined to moderate levels varying between 4 to 6 per cent. Since then, the inflationary situation came under control with a noticeable decline in the prices of primary food articles as well as manufactured food products.
6. Recent Rise in Inflation. The price situation was stable and largely comfortable during the tenth plan (2002-2007) period. With the annual rate of inflation in India having touched 7 per cent on a point-to-point basis during the week-ending March 22, 2008. Indeed, by July 2008, the key Indian Inflation Rate, the Wholesale Price Index, has risen to 11.89%, its highest rate in 13 years. This is more than 6% higher than a year earlier and almost three times the RBI’s target of 4.1%.

Causes of Rising Prices

To understand the various causes that have contributed to the continuing price rise or inflation in India, we have to look into factors which have on one side, pulled the demand upwards and on the other side, prevented supply from keeping pace with this rising demand. Inflation is basically a combination of two types of phenomenon. Its causes could be nailed down to Cost-Push inflation and Demand-Pull inflation. 

Cost-Push Inflation is caused by rise in the cost of factors of production. In classical economic theory, there used to be only three factors of production - land, labor and capital. However, in today's complex world, infinite factors are required to produce a single product or commodity e.g. house-rent, electricity, admin-expenses, raw-materials, fuel (petroleum), steel, etc. The price rise in any one or more of these factors will increase the cost of production of the final product. The producer of the commodity (the businessman) will naturally shift this cost to his consumers by raising the cost of his final product. This phenomenon is called Cost-Push Inflation.

There are some of factors that have contributed to increase in cost of production are as follows:

• Fluctuation in output and supply.
• Increase in taxes i.e. taxation, as a factor in rising costs and prices.
• Changes in administered prices.
• Hike in oil prices and global inflation.

Let us take a simple example. Suppose a bakery owner produces bread by using several factors like wheat, flour, machines, labor, etc. The cost of production of one piece of bread comes to $8. He adds $2 as his profit-margin and sells it to consumers at $10. This continues for several days. Now suppose the price of wheat increases due to low production or crop failure. Now the owner recalculates his cost of production. It comes to $10. He now adds his margin of $2 and increases the cost of bread to $12. This directly results in 2% rise in the cost of bread, or in the bread component of the WPI.

Demand-Pull Inflation is another type of inflation. In this case, the cost of factors of production remains same. However, due to increase in the demand of the commodity by consumers in the market relative to its supply, the owner will naturally increase the prices. In this case, demand has increased, but supply has remained constant.

There are some factors behind rapid increase in demand and relatively slow growth over the past few decades. This is as follows:

• Increase in money supply.
• Massive increase in government expenditure.
• Rapid increase in population.
• Growth of black money.

Let us take a simple example, suppose the cost of production of one piece of bread remains constant at $8. He adds his margin of $2 and charges $10 to each consumer. Now suppose the preference of his bread increases among the consumers, as it becomes more popular. This results in an increased demand for bread (This is a simplified example, in real world demand and supply is more complex). So sensing more demand for his product, the owner increases the price to $12. 

Liquidity: The term Liquidity is usually used to identify hard cash. In fact Liquidity just means money in any form. Liquidity is also referred to the ability and ease with which an asset could be converted to money. For e.g. cash is the most liquid asset. Savings-account deposit could also be called liquid asset. How is Liquidity related to Inflation you may ask? The answer is simple. It's because of Demand-Pull Inflation. The demand for the commodity is directly influenced by the amount of money that people have. The Government or Central Bank can directly influence demand-pull inflation by controlling liquidity.

Consequences or effects of rising price

Inflation had caused serious imbalances in the Indian economy. Price relationships were badly distorted and production pattern had gone out of line with demand.

Adverse effect on production. Inflation had led to economic recession in many sectors of the Indian economy. Due to inflation, prices of certain important articles of consumption such as textiles had increased to very high levels forcing demand for such goods to decline specially from the poorer sections of the country. With increasing expenditure on essential goods, the expenditure on the other goods had declined. While demand had declined, production too had declined due to shortage of raw materials, transport, power and so on. Production had adversely affected by frequent labour troubles such as strikes and lockouts. Over and above all these, the rise in the price level had eroded the volume of investment in real terms. The decline in real investment worsened the economic recession still further till recently.

Adverse effect on the distribution of income. Under mild inflation or continued slow rise in prices, profit keep on increasing. As wages and salaries remain more or less fixed, income of the industrial and business classes increases relative to the income of working classes. Thus, there is a redistribution of income in favour of the rich capitalist and business people and therefore the gap between the rich and the poor increases. The share of profits in national income increases whereas that of wages and salaries falls and thus income redistribution takes place in favour of the richer section of society.

Objectives of Price Policy

Inflation is unjust and inequitable. It upsets the entire production process, generates speculative tendencies, hits the poor hard and adversely affects economic growth. Thus inflation needs to be controlled. But an undue reduction in price level can set deflationary trend in motion. This would adversely affect business activity through reduced profit expectations, and hamper the growth process. Thus, a suitable price policy is needed which fulfils the following objectives:

1. To maintain price stability of foodgrains and other goods consumed by the poor to insulate them against inflation.
2. To maintain incentives for stimulating production and economic growth, which can be done through a mild, slow and gradual price increases, and
3. To maintain inter-sectoral balance in prices of agriculture goods, industrial products and prices of other goods and services.

It is with these objectives in mind that various policy instruments have been used to control inflation and achieve a measure of price stability in India.

Remedial Measures to control Rising Prices

In India, the Ministry of Finance and the RBI (Reserve Bank of India) always strive to control inflation. Efforts should be made to curtail demand and improve supply management to control rising prices. Some of the measures to control inflation are discussed as below.

“The guiding principal in respect to inflation management continues to be that in the medium to long run, the increase in prices is largely sustained by monetary expansion. In short run, however, inflation could be affected by non-monetary, essentially supply side factors.”

Monetary Policy

Monetary policy refers to the policy measures that affect the economic variables, viz., output, prices, etc., through changes in money supply. In India, the RBI, being the central bank of the country formulates and implements monetary policy with the objective of stabilizing prices and promoting growth generating forces in output and employment levels. In general term, RBI uses its monetary policy to achieve a judicious balance between the growth of production and control of the general price level.  They control inflation by directly affecting the demand pull inflation by changing the amount of liquidity circulating in the economy. It helps to check speculative activity (in period of inflation). In July 2008, RBI has raised the interest rates and cash reserve ratio to check the volume of liquidity and credit in the country and thereby control the inflationary rise in prices taking place. The RBI (the Central Bank of India) can change the liquidity by its various tools .These tools of controls are broadly two: quantitative and qualitative controls.

Quantitative controls are used to control the volume of credit and indirectly to control inflationary and deflationary pressures caused by expansion and contraction of credit.

Quantitative controls are also known as general credit controls and consist of CRR, Bank-Rate (REPO and Reverse-REPO), SLR, etc

• CRR (Cash Reserve Ratio) is the proportion of amount which each commercial bank has to maintain in the form of hard cash. All commercial banks accept deposits from individuals and lend it to borrowers at a higher interest rate. The difference between the interest rate which they collect from borrowers and which they pay to their depositors is their profit. Naturally, each bank will try to lend all the money they collect from depositors. However, banks can't lend all the money they have. Under law, each bank has to maintain a certain proportion of cash as reserve. This is known as CRR. For e.g. if the CRR is 5% and the bank collects Rs. 100 from its depositors. Then it has to maintain Rs.5 as Reserve. It can lend other Rs.95 to its borrowers. RBI can decrease vast amounts of liquidity circulating in the economy by raising the CRR. When RBI increases the CRR, the bank's lending power decreases. Less lending means less borrowing, this in turn means less money in the economy. In July 2008, the RBI increased the CRR from 8.75% to 9% to control inflation.
• SLR (Statutory Liquidity Ratio) is also similar to CRR. But in case of SLR, Government-Securities need to be maintained by the commercial banks instead of cash. All commercial banks have to maintain liquid assets in the form of cash, gold and unencumbered approved securities equal to not less than 25 percent of their total demand and time deposit liabilities. RBI has stepped up the liquidity ratio for two reasons:

1. higher liquidity ratio forces commercial banks to maintain a larger proportion of their resources in liquid form and thus reduces their capacity to grant loans and advances to business and industry- thus it is anti-inflationary
2. higher SLR was used to divert bank funds to finance government expenditure.

It may be mentioned here that stepping up statutory liquidity requirements (SLR) and the cash reserve ratio (CRR) have same effect, viz., they reduce the capacity of commercial banks to expand credit to business and industry and thus are anti-inflationary.

Bank-Rate is basically the interest rate at which the Central Bank borrows from the other scheduled commercial banks. This rate is directly linked to the interest rates charged in turn by all the commercial banks to its customers. All these other interest rates on Home-loans, Personal-loans, etc. also increase with the increase in bank-rate. Thus, by raising the Bank-Rate and in turn all other Interest Rates, the RBI makes borrowing money from banks a very costly affair. People are thus discouraged to borrow more money and total amount of liquidity decreases in the economy. In July end, the RBI increased the Bank Rate from 8.5% to 9.5%. This was an increase of 50 basis-points (0.5%) to control inflation.

Although the rise in interest rates initially makes life difficult for people who have taken loans on floating interest rates, it is a required step to bring down inflation which is a larger evil. It might also be noted that RBI, by making the policy changes can control only one type of inflation i.e. demand-pull inflation. It cannot affect the other type of inflation i.e. cost-push inflation which is caused by rise in prices of raw-materials and other factors of production. That is why the rate of inflation is increasing continuously since last six months although the RBI is trying to control it.

Open market operation: During inflation, the central bank sells government securities and price bonds in the open market in order to contract the supply of money. This is done to influence the volume of cash reserves with commercial banks and thus influence the volume of loans and advances they can make to the industrial and commercial sectors. RBI had not used this tool for many years. Such a policy of buying government securities will be adopted to reverse economic recession in the country. It appears that RBI will actively use open market operations as an instrument of monetary policy and not simply to support the market for government bonds.

Fiscal Policy

Fiscal policy is budgetary policy in relation to taxation, public borrowing, and public expenditure. Changes in the total expenditure can be effected by fiscal measures Price policy designed to promote economic growth includes measures for controlling the volume of public expenditures in general and fiscal deficit in particular. The aim is to reduce any undue pressure on the limited supply of consumption goods. Besides, the consumer should be available at prices regarded reasonable from the point of view of low-income groups.

To combat inflation, fiscal measures would involve increase in taxation and decrease in government spending. During inflation the government is supposed to counteract an increase in private spending. A decline in public expenditure alone is not sufficient. Government must simultaneously increase taxes to affect a cut in private expenditure - in order to minimize inflationary pressures. Some of terms are explained below:

• Taxes: As we know, when more taxes are imposed, the size of the disposable income and the magnitude of the inflationary gap diminish, given the available supply of goods and services. Inflationary pressure is significantly weakened by the simultaneous curtailment of government expenditure and an increase in taxation due to a decline in disposable income with people. It has been argued that a tax policy can be directed towards restricting demand without restricting production. For instance, excise duties or sales tax on various commodities take away the buying power from the consumer goods market without discouraging the expansion of production capacity. Therefore excise duties should be rationalized to minimize their cost push effect. But, during inflation, a progressive direct tax is considered best; it is also justified in the interest of social equity.
• Government expenditure: The expenditure of the central and the state governments which have grown enormously must be controlled. Government must reduce its administrative expenditure by cutting down the size of the bloated government machinery. Non-essential and non-productive expenditure in the public sector must be reduced and if possible eliminated. In this connection, particular emphasis should be laid on reduction of non-plan expenditure of the government. Ultimately without government cutting down its expenditure it is not possible to control inflation.
• Subsidies: The massive amount of money that is used for subsidies on food, fertilizers, etc., must be rationalized. Only those subsidies which really help the poor and actually reach them and those which are crucial for country’s development should be continued and all others must be abolished. Thus subsidies need to be reduced substantially while protecting the interest of the really poor people. The government should also avoid popular measures and pre-election doles to retain political power.

Briefly, then, a reduction in public expenditure, and an increase in taxes produces a cash surplus in the budget. Keynes, however, suggested a programme of compulsory savings, such as “deferred pay” or “forced savings” as an anti- inflationary measure. Private savings have a strong disinflation effect on the economy and an increase in these is an important measure for controlling inflation. Government policy should, therefore, include devices for increasing savings. A strong savings drive reduces the spendable income of the people, without any harmful effect of the kind associated with higher taxation. Moreover, the effects of a large deficit budget, which is mainly responsible for inflation, can be reduced by covering the deficit through public borrowings.. Further, public debt may be managed in such a way that the supply of money in the country may be controlled. The government should avoid paying back any of its past loans during inflation in order to prevent an increase in the circulation of money. Anti-inflationary debt management also includes cancellation of public debt held by the central bank out of a budgetary surplus

Redesigning public distribution

It is necessary to so recast the distribution system that it serves better the interest of the poor. To enable people to purchase wheat, rice, kerosene etc at reasonable prices, the government had opened around 4.74 lakh fair price shops. People below the poverty line would get the foodgrains at half the price charged from those above e the poverty line. To make the system effectively serve the weaker sections, the income tax players have been excluded from the PDS.