#1 <\/span>Private Investment<\/b><\/h5>\nRising inflation has an adverse impact on Private Investment.<\/span><\/p>\nTo fight the rising inflation, Interest rates may be increased, which increases the cost of borrowing and may crimp investment. It could raise the cost of financing for investment and consumption activities, and thereby compress aggregate demand.<\/span><\/p>\nHigh inflation may lead to decline in demand especially from individuals on fixed incomes (such as salaried and Pensioners). Subdued demand may lead to decline in private investment. E.g. A manufacturing firm may not invest in new plants and machinery as the demand for their items has decreased.<\/span><\/p>\nRising inflation in an economy may lead to flight of capital as FII may take their money out (as the real interest rate in economy declines). On the same line, rising inflation discourages capital inflow in the economy. Lack of adequate capital at cheaper rate discourage private investment.<\/span><\/p>\nSimilarly, High inflation is unstable. There is uncertainty about future rates of inflation, which reduces the efficiency of investment and discourages potential investors.<\/span><\/p>\n#2 <\/span>External Sector\u00a0<\/b><\/h5>\nRising inflation has an adverse impact on the export competitiveness of the economy<\/span><\/p>\nRising inflation result in an increase in input prices of commodities. It may result in an increase in the prices of final products. Rising prices may, thus, impact the competitiveness of Indian export product in the global economy leading to a decline in exports<\/span><\/p>\nSimilarly, rising inflation in India leads to the appreciation in real effective exchange rate (REER), which may again weaken the export growth in the country<\/span><\/p>\nLearning<\/span> – let us know in the comment box the relationship between inflation and Real Effective Exchange rate<\/span><\/em><\/p>\nRising inflation may lead to increase in input cost. This may result in a decline in the profit margin of the domestic firms (if the firm chooses not to increase prices of product). For example, domestic firms may find it difficult to pass on the rising input costs to consumers in the face of competition from cheaper imports. Thus they may not increase the prices amid rise in input price to make their products competitive against cheaper imports. Thus their profit margin declines. This may also affect their investment plans.<\/span><\/p>\nDecline in exports may lead to rise in Current Account deficit (as exports declines)<\/span><\/p>\n#3 <\/span>Fiscal Imbalance<\/b><\/h5>\nRising inflation has adverse impact on the Fiscal position of the economy<\/span><\/p>\nWith rising inflation, the government may be forced to increase subsidies (increase in food subsidies, fertilizer etc). This may delay the fiscal consolidation path and increase the Fiscal Deficit of the country.<\/span><\/p>\nRising inflation affects tax collection of the government. Since people are less prone to go for expenditure (even more for high value transaction such as real estate etc), the net tax collection of the government declines. This lead to fiscal imbalances as government resort to excessive borrowing<\/span><\/p>\nIn sum, the rising inflation is detrimental for economy in following ways<\/span><\/p>\n\n- It leads to decline in external competitiveness and thus leads to decline in exports<\/span><\/li>\n
- It leads to decline in aggregate demand, which further leads to decline in Private investment<\/span><\/li>\n
- It leads to decline in net tax collection of the government<\/span><\/li>\n
- It leads to decline in profit margin of the domestic firms (if firm chooses not to pass rising input cost to end consumers amid cheaper imports) and thus affects their investment decisions<\/span><\/li>\n
- It affects the common man (especially fixed income group – salaries and pensioners) as purchasing power of money declines. Poor people may find it difficult to buy items of daily need such as food etc<\/span><\/li>\n
- It weakens the government resolve to follow fiscal consolidation path and may lead to fiscal imbalance (Rise in Fiscal Deficit)<\/span><\/li>\n<\/ul>\n
Thus, the Government always tries to keep inflation at the moderate level.<\/span><\/p>\nHowever, persistent low inflation is also not good for the economy<\/span><\/p>\nLearning<\/span><\/span> – Let us know in the comment box why a very low inflation rate is also not good for the economy.\u00a0<\/span><\/em><\/p>\nSince we have understood how persistent high inflation negatively impact economy, let us move forward and try to understand how government tackles high inflation. In other word, what are the ways through which government fight inflation<\/span><\/p>\n[2] Measures to fight\/Contain Inflation<\/b><\/h3>\n
In India, Inflation is a complex phenomenon. It is caused not by one, but by several factors such as demand pull factors, Cost push factors and structural factors. These factors act together or alternatingly to cause inflationary price increase in the economy.<\/span><\/p>\nTherefore, we need a mix of macro-economic policies to manage the demand and the supply side as also to address the structural rigidities that exist in the economy.<\/span><\/p>\nFollowing methods are used by government to fight Inflation<\/span><\/p>\n\n- Monetary Policy Measures<\/span><\/li>\n
- Fiscal Policy Measures<\/span><\/li>\n
- Other Measures<\/span><\/li>\n<\/ol>\n
#1 Monetary Policy Measures<\/b><\/h5>\n
Monetary policy refers to the policy of the central Bank with regard to use of monetary instruments under its control to manage money supply and interest rates.<\/span><\/p>\nIn May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework. The main aim of Monetary policy is price control (keeping the inflation within the target band of 2% to 6%)<\/span><\/p>\nMonetary Policy Tools:<\/span><\/p>\n\n- Quantitative Tools<\/span>\n
\n- Statutory Reserve Requirement<\/span>\n
\n- Statutory Liquidity Ratio (SLR)<\/span><\/li>\n
- Cash Reserve ratio<\/span><\/li>\n<\/ol>\n<\/li>\n
- Key Rates<\/span>\n
\n- Liquidity Adjustment Facility<\/span>\n
\n- Repo Rate<\/span><\/li>\n
- Reverse Repo rate<\/span><\/li>\n<\/ol>\n<\/li>\n
- Bank Rate<\/span><\/li>\n
- Marginal Standing Facility (MSF)<\/span><\/li>\n<\/ol>\n<\/li>\n
- Open market Operation<\/span><\/li>\n
- Market Stabilisation Scheme<\/span><\/li>\n<\/ol>\n<\/li>\n
- Qualitative Tools<\/span>\n
\n- Fixing Margin Requirement<\/span><\/li>\n
- Moral Suasion<\/span><\/li>\n
- Selective Credit Control<\/span><\/li>\n<\/ol>\n<\/li>\n<\/ol>\n
Key Quantitative tools and how they impact inflation\/Deflation:<\/span><\/p>\n\n\n\n| Quantitative Tools<\/span><\/td>\n | Their Impact on Inflation and deflation<\/span><\/td>\n<\/tr>\n\nStatutory Liquidity ratio (SLR)<\/strong><\/td>\n| It is the share of net demand and time liabilities that banks must maintain in safe and liquid assets, such as, government securities, cash and gold etc.<\/span><\/p>\n At present SLR is 18%.<\/span><\/p>\nChanges in SLR often influence the availability of resources in the banking system for lending to the private sector.<\/span><\/p>\nTo fight Inflation, RBI must <\/span>increase<\/b> SLR. When SLR is increased, Banks are required to maintaining a higher amount with themselves in safe and liquid assets —- > Thus Bank\u2019s ability to lend to market decreases —-> Lending rates will increase. Liquidity in the market decreases —> Thus inflation is contained<\/span><\/p>\nIn the similar fashion, To fight deflation, RBI must <\/span>decrease<\/b> SLR. When SLR is decreased, Banks are required to maintain a lesser amount with themselves in safe and liquid assets —- > Thus Bank\u2019s ability to lend to market increases —-> Lending rates will decrease. Liquidity in the market increases —> Thus deflation is tackled<\/span><\/td>\n<\/tr>\n\nCash Reserve Ratio (CRR)<\/strong><\/td>\n| It is the share of net demand and time liabilities that banks must maintain as cash balance with the Reserve Bank of India.<\/span><\/p>\n RBI do not pay any interest on it to the banks<\/span><\/p>\nAt present CRR is 3%<\/span><\/p>\nChanges in CRR often influence the availability of resources in the banking system for lending to the private sector.<\/span><\/p>\nTo fight Inflation, RBI must <\/span>increase<\/b> CRR. When CRR is increased, Banks are required to maintaining a higher cash balance with the RBI —- > Thus Bank\u2019s ability to lend to market decreases —->Liquidity in the market decreases.\u00a0 Lending rates will increase.\u00a0 —> Thus inflation is contained<\/span><\/p>\nIn the similar fashion, To fight deflation, RBI must <\/span>decrease<\/b> CRR. When CRR is decreased, Banks are required to park less money in cash with RBI—- > Thus Bank\u2019s ability to lend to market increases —->\u00a0 Liquidity in the market increases. Lending rates will decrease. —> Thus deflation is tackled<\/span><\/td>\n<\/tr>\n\nRepo Rate<\/strong><\/td>\n| It is the rate at which RBI provides short term loans to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).<\/span><\/p>\n At present repo rate is 4.40%.<\/span><\/p>\nDuring high levels of inflation, RBI<\/span> increases <\/b>Repo Rate to bring down flow of money in the economy. Rise in Repo rate disincentives banks to borrow from RBI. Thus liquidity in the market decreases. The lending rates increase making borrowing a costly affair for businesses and industries, which in turn slows down investment and money supply in the market. It helps in controlling inflation<\/span><\/p>\nIn the similar fashion, to fight deflation, RBI<\/span> decreases <\/b>Repo Rate to increase flow of money in the economy. Decrease in Repo rate incentives banks to borrow from RBI (since they now get funds at cheaper rates). Thus liquidity in the market increases. The lending rates decrease making borrowing cheaper for businesses and industries, which in turn increases investment and money supply in the market. It helps in controlling deflation.\u00a0<\/span><\/td>\n<\/tr>\n\nReverse Repo rate<\/strong><\/td>\n| It is the rate at which banks park their surplus funds with RBI for short term. RBI provides collateral of government and other approved securities to banks which park their surplus fund with RBI.<\/span><\/p>\n At present the Reverse Repo rate is 3.75%<\/span><\/p>\nTo fight high levels of inflation, RBI increases reverse Repo rate. It makes it attractive for the bank to park funds with the RBI (More certainty of return + more interest rate) rather than to lend to the private sector. It thus\u00a0 reduces the liquidity in the market and increases the interest rate on borrowing.\u00a0 Private players will find it costly to borrow and thus investment decreases. It helps to contain inflation.<\/span><\/p>\nTo fight high levels of deflation, RBI decreases reverse Repo rate. It makes it unattractive\/disincentivises for the bank to park funds with the RBI (lower interest rate). Thus,\u00a0 Banks\u2019s rather than parking excess fund to RBI, they lend it to private players. It thus increases the liquidity in the market and decreases the interest rate on borrowing.\u00a0 Private players will find it cheaper to borrow and thus investment increases. It helps to contain de-flation.<\/span><\/p>\nNote –<\/span> Policy Corridor<\/b> – It is the range\/width between Reverse Repo rate at the bottom, Repo rate at the middle and Marginal standing Facility at the top.\u00a0<\/span><\/p>\nReverse Repo rate is at the bottom and MSF is at the top. Their values are tied with the value of Repo rate. For example – Any change is repo rate will automatically reflect changes in Reverse Repo Rate and Marginal Standing Facility<\/span><\/p>\nThe policy corridor has been reduced to 0.25% (earlier it was 1% and then reduced to 0.5%). Thus if Repo Rate is 5%, then Reverse repo Rate and MSf automatically becomes 4.75% and 5.25% respectively.<\/span><\/p>\nSo students must note that, Since Reverse repo rate is tied with the Repo rate (through policy corridor), it is usually the repo rate which is changed by the RBI (and Repo Rate automatically changes)\u00a0<\/span><\/td>\n<\/tr>\n\nBank Rate<\/strong><\/td>\n| It is the\u00a0 rate at which banks borrow long term loans from RBI.<\/span><\/p>\n At present, it is not used by RBI for monetary management.\u00a0<\/span><\/p>\nIt is now same as the (Marginal Standing Facility) MSF rate.\u00a0<\/span><\/td>\n<\/tr>\n\nMarginal Standing facility (MSF)<\/strong><\/td>\n| It is the rate at which Banks can borrow short term funds from RBI.\u00a0<\/span><\/p>\n The MSF was launched by RBI while reforming the monetary policy in 2011-12.<\/span><\/p>\nIt is penal rate at which banks can borrow money from the central bank over and above what is available to them through the Liquidity Adjustment Facility<\/span>\u00a0 window<\/span>.<\/span><\/p>\nIn case of Repo rate, Banks borrow short term funds by pledging government securities. Now ff Suppose bank has pledged all of its securities above SLR to the RBI for getting funds (means no eligible securities). Then, what the bank can do to get immediate money from the RBI?<\/span><\/p>\nHere MSF comes into picture. Under MSF, banks can borrow funds from the RBI by pledging government securities within the limits of the SLR.\u00a0\u00a0<\/span><\/p>\nThus MSR provides a safety valve against unanticipated liquidity shocks to the banking system.<\/span><\/p>\nMSF is upper band of the Policy Corridor (lower band being the Reverse Repo rate). Thus value of MSF is tied with the value of Repo Rate. Usually RBI changes Repo rate and MSF changes automatically.<\/span><\/td>\n<\/tr>\n\nOpen Market Operation (OMO)<\/strong><\/td>\n| It refers to conduct of market operations by RBI by way of sale\/purchase of government securities to\/from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis<\/span>.<\/span><\/p>\n It is purchase\/sale of govt securities by RBI.<\/span><\/p>\nTo fight higher levels of inflation, RBI sucks out excess liquidity in the market by <\/span>selling government securities<\/b>. Banks borrow Government securities and provide money to the RBI. This reduces the excess liquidity in the economy. Lending rates increases and borrowing becomes costly, preventing private investment. It thus contain inflation.<\/span><\/p>\nIn the similar fashion, in case of deflation, RBI provides excess liquidity in the market by <\/span>buying government securities<\/b> from banks. Banks gets funds by selling government securities. This increases liquidity in the economy. Lending rates decline and borrowing becomes cheaper, promoting private investment. It thus contain deflation.<\/span><\/td>\n<\/tr>\n\n | | | | | | | | | | | | | | | |