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Inflation declines to 6.87% in July – Finally Government got a magic stick

It’s surprising Inflection numbers has come down to 6.87%. Seems govt has used magic stick, which in general our PM used to mention all the time, he does not have a magic stick. It’s just a number game and well manipulated – hats off. With sugar prices from 34 to 44, wheat & atta prices soaring. Every day pulse prices high, rice prices soaring, edible oil prices and list goes on and on. All this mess up is manmade and specifically UPA govt and their so called policy are responsible. Let’s have a look what Govt and RBI have been doing in the name of Inflection control.

What all are the drivers of Inflation? There are five main drivers of inflation like the supply side constraints, the interest rates, the unearned money, government actions and the international commodity prices.

As far as supply side constraints are concerned, inflation would tend to go up if the demand is less elastic and the supply side constraints are limiting the supplies. Food grains and agriculture-based commodities are prime examples of this. Indian agriculture is mainly dependent on rainfall, hence when rainfall was lower than what was expected, agriculture production came down and this resulted in the continuous rise in prices of agriculture based commodities.

As far as Interest rates are concerned, there is a short term and a long term impact that interest rates have on inflation. In the short term, increase in interest rate makes money supply costly and more money flows towards bank fixed deposits and treasury bonds. This reduces supply of money for buying goods and services. This is the logic for fiscal measures to tame inflation. However, the impact is only for a short period. Demand for major items of consumption in India is less elastic than in developed countries. Soon people start buying and the impact is short-lived. The long term impact is that higher interest rates increase the cost of production due to the burden of high interest rates. High interest rates also make the investment in modernization of plants non-viable. They also make creation of new capacity difficult to justify. These three factors put together contribute to higher cost of production (current IIP data shows how bad interest rate hike impacted). As investments for modernization get discouraged, companies continue with their outdated, inefficient plants. This keeps Indian companies uncompetitive and makes them produce inferior goods, at a high cost. This makes them marginal players in the international market. When the short term policy of fiscal tightening becomes a long term policy, there are major problems. But even with the repeated hikes in interest rates, inflation continues.

As far as Unearned money is concerned, the money available in the hands of people who have not put legitimate efforts to earn it. The bribes and cuts received, payments received on false bills, emptying the treasury by falsification of records and scams, money earned in a parallel economy, et all come in this category. In our economy, unearned money is a major driver for inflation. Take an example of our Government’s five year plan – A big chunk of this becomes unearned money in the hands of influential people. Also fake currency is another aspect, which comes from neighboring Pakistan or is printed in the country – ads to the pool of unearned money.

As far as government actions are concerned, government’s non-plan expenditure is continuously raising due to its populist schemes like providing rice at 2-3/kg to BPL families, of giving free or subsidized power to farmers, of giving subsidized fertilizers to farmers and of waiving off the bank debts of farmers, et al. These schemes result in an additional burden on government finance, resulting in a fiscal deficit, which has to be bridged by printing notes or treasury bonds. When this money pumped in the system becomes a driver for inflation.

As far as the international commodity prices are concerned, it impacts affects inflation heavily. Most of the commodities like coal, gas, petroleum, et al; we import from international market and due to the movement in international commodity prices it has a direct impact on our cost of imports.

Precisely, the primary purpose is to control inflation and increase in interest rates alone is not likely to control inflation. If Government is serious about it, they need to address all five aspects that drive inflation. In nutshell, there are three components in the interest rate – first component is the real interest rate, second component is cover for risk and third component is cover for inflation. Therefore increase in interest rates would tend to increase the inflation because the real interest rates and the risk cover remain constant.

By : Biraja Prasad Nath

Written by Biraja

Progress Software, National Institute of Technology

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