2007 Sep Inflation MihirRakshit (1)

8/14/2019 2007 Sep Inflation MihirRakshit (1)

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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

2007 Sep Inflation MihirRakshit (1)

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