Inflation in a Developing I C R A B U L L E T I N

Money
Economy &
Theory and Policy Finance
SEPTEMBER.2007

MIHIR RAKSHIT

We are all structuralists, knowingly or unknowingly.

Adapted from Molier, The Would-be Gentleman
As a backdrop to

our analysis in the

Abstract
Over the last one decade inflation in India has been due mostly to oil subsequent sections
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 we propose to
originating in supply shocks is generally transitory and represents a movement
from one equilibrium price level to another. Only when aggregate demand consider the
exceeds the economy’s production potential and the monetary policy is
accommodative can inflation be of a continuing nature. The two types of inflationary
inflation call for quite different policy responses. Anti-inflationary fiscal or
monetary measures are required when there is an excess demand situation, not
developments
when there is a sectoral shock. Nor are policies like oil price freeze or cuts in
during 2004-05 and
customs-cum-excise duties on cement or metals appropriate for containing an
increase in the general price level: such measures are distortionary and 2006-07. Our choice
counterproductive in as much as they reduce the country’s full employment
output and growth potential. Only in the case of shortage of food and other is dictated by the
essential items of poor men’s consumption is it necessary to undertake supply
side management through reliance on PDS as well as open market sale of fact that the sources
foodgrains by FCI.
of inflationary
The purpose of the present paper is to examine the nature of
supply and demand side factors causing inflation in the Indian economy pressure and the
and the efficacy of alternative anti-inflationary measures. In order to
motivate the discussion we summarise in Section I the main features of
state of the economy
two recent inflationary episodes with special reference to their official
during the two years
diagnosis and the policies pursued to reduce the price pressure. In the
context of this survey we pose in Section II some theoretical and policy were markedly
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 different.
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 Episodes

As a backdrop to our analysis in the subsequent sections we
propose to consider the inflationary developments during 2004-05 and 89
 I C R A B U L L E T I N 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
Money markedly different.1 Apart from documenting the developments during
& these years official reports and statements on the two episodes provide
Finance a fairly clear idea regarding (a) perception of the inflationary process
on the part of the fiscal and monetary authorities; and (b) their views
SEPTEMBER.2007
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
Quite different was
(y-o-y) average WPI inflation of 6.5 per cent, fuel price inflation was
the composition of 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
the 2006-07 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
inflation, beginning 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
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
peaking in end- 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
January 07 at 6.7%. 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
The drivers of
cent respectively for primary and manufactured products.
inflation this time There was also a considerable difference between the behav-
iour of WPI and CPI (consumer price index) during the two inflationary
were prices of episodes. In the earlier year WPI inflation was way above the CPI,
especially CPI-AL6 and CPI-RL, inflation. Thus in end-March 05,
primary articles and 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,
manufactured

products. 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 the
intervening year (2005-06) when the year-on-year inflation was relatively mild (at
4.1 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, the
April-August 04 phase, was marked by hardening of domestic prices, with WPI
inflation 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 inflation
and 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 in
the week ending on 27 January, 07, and declined to 5.7 per cent in the last week of
March, 07.
6 AL: Agricultural Labourers; RL: Rural Laboureres; IW: Industrial

90 Workers; UNME: Urban Non-Manual Employees.

4.0, 2.4 and 2.4 per cent respectively. In 2006-07 the situation was the I C R A B U L L E T I N

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
Money
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 Finance
CPI inflation rates in 2004-05 and 2006-07 reflects the relative signifi-
SEPTEMBER.2007
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
For an appreciation
agricultural goods prices were quite modest in the earlier episode but
were at the double digit level in 2006-07, the sharp difference between of these policies it is
the WPI and CPI inflation rates in the two episodes is not difficult to
comprehend.9 useful to consider
In response to the emergence of inflationary pressure the
monetary and fiscal authorities undertook a series of measures for the official reading
reining in prices and containing “inflation expectations”. For an
appreciation of these policies it is useful to consider the official reading of the reasons
of the reasons behind the price increases and then see how the remedy
was related to the diagnosis. behind the price

Identifying the Sources of Inflationary Pressure

increases and then
Though macroeconomic factors like growth or increases in
see how the remedy
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 was related to the
(RBI) is on the demand or supply side factors10 causing inflationary
pressure in markets for particular products that enter WPI or CPI. A diagnosis.
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, the
criteria 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 FM’s annual Economic Surveys (ESs) and Reserve Bank of
India’s annual, quarterly and mid-term review of Macroeconomic and Monetary
Development (MMD). Reserve Bank’s Annual Reports also examine the nature of
the inflationary trends. However, Report on Currency and Finance, a major annual
publication of RBI, need not, it is stated, reflect the central bank’s official views on
the 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 the
monetary and fiscal authorities. 91
 I C R A B U L L E T I N 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-
Money 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
Finance of changes in demand or supply in the concerned markets. For an
analysis of the impact of these changes a distinction is made (it
SEPTEMBER.2007
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
For the first group
products14 whose combined weight is the largest in WPI. Finally, in the
inflation if any is case of many agricultural commodities market prices are not fixed, but
their exports and imports are subject to quantitative controls. The
attributed to hikes in significance of this three-fold classification lies in the way the factors
governing price increases of the different groups of commodities are
their administered sought to be identified.
For the first group inflation if any is attributed to hikes in their
prices. Thus administered prices. Thus irrespective of international or domestic
demand-supply conditions in the market for crude oil, inflation in
irrespective of petroleum products is traced to upward revision in their prices effected
by the government.15 Again, since petroleum products are used directly
international or or indirectly as intermediate inputs in practically all industries, account
is also taken, using the input-output analysis, of the impact of such
domestic demand-
revisions on prices of other products and hence on overall inflation.16
supply conditions in Thus according to the Reserve Bank, “. . . in the absence of
countervailing policy intervention, . . . every US dollar increase in
the market for crude 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,
oil, inflation in 2005). Hence according to such estimates, keeping domestic prices of
petro-products unchanged in the face of (say) a ten-dollar rise in crude
petroleum products oil prices, WPI inflation is prevented from jumping by as much as 300
basis points. Similarly for the inflationary effects of administered price
is traced to upward changes of coal or other commodities in this category of products.17
Inflation in prices of the second group of commodities is
revision in their

prices effected by 12 The contribution of the price of a product to (say) WPI inflation is

nothing but its inflation during the period times its weight in WPI. The sum of the
the government. 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; only
92 the direct impact of the revisions is taken note of in such cases.
explained in terms of (a) their price trends in the international market, I C R A B U L L E T I N

(b) changes in excise or customs duties on the products, and (c) appre-
ciation or depreciation of the exchange rate, though domestic demand
Money
pressure is also referred to in some instances. In other words, for the &
tradables which are free from quantitative restrictions, the difference Finance
between the international and domestic rates of inflation is viewed as
SEPTEMBER.2007
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
The RBI analysis of
main determinants of agricultural price inflation. Needless to say,
government policy changes concerning imports and exports of the price situation in
foodgrains or other farm products can raise or lower the inflationary
pressure in these markets; but with trade remaining relatively small in different markets of
relation to domestic output for most agricultural goods, climatic and
other supply side conditions are perceived to be by far the most impor- the domestic
tant determinants of inflation in primary product prices.
economy is also
Macroeconomic Factors
Though the major part of the analysis of both the ministry of preceded by an
finance and the Reserve Bank is devoted to sectoral (or commodity-
wise) price increases, account is also taken of the macroeconomic
examination of the
factors behind the overall inflationary pressure. In the context of the
signals and sources
increasing openness of the Indian economy the RBI analysis starts in
fact with a survey of the international inflationary scenario as also the if any of aggregate
conditions prevailing in major industrialised and emerging market
economies.18 High global growth; cyclical upswing in a number of demand pressure or
developed countries including Germany and Japan; rising world
commodity prices due to large demand from fast growing emerging overheating.
market economies, especially China; and overflowing liquidity in
international financial markets—all 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 the

international 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 domestic

output. Sharp rises in oil imports (in terms of USD) can come about due to an oil
price hike, remembering that demand for petroleum products are price inelastic. 93
 I C R A B U L L E T I N corporates; and asset price inflation. All these (other than reserve
money and broad money growth) may no doubt be considered as
Money symptoms rather than causes of overheating; but taken together they
& are deemed to underscore the need for macroeconomic intervention for
Finance tackling the inflationary pressure.
In line with the conventional theory, an important factor
SEPTEMBER.2007
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
We have noted
policy regime can make the inflationary forces get out of control; and
earlier how the (b) the urgent need of monetary tightening before such expectations
gather strength.
official analysis of We have noted earlier how the official analysis of inflation
runs primarily in terms of factors driving prices in different markets. So
inflation runs it is not unreasonable to ask, how (in the official explanation) are the
macroeconomic factors supposed to affect price changes in particular
primarily in terms of markets? The answer seems to be that, price increases of different
products due to sector specific shocks are enhanced or moderated
factors driving according as the economy experiences a rise in or lessening of the
aggregate demand pressure.
prices in different
Diagnosis and Policies
markets. So it is not
Given the above approach to the analysis of inflation in official
unreasonable to ask, 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
how (in the official during the years 2004-05 and 2006-07.

explanation) are the 2004-05 Inflation

Though reference is made to the “liquidity overhang” prevail-
macroeconomic 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
factors supposed to 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
affect price changes
average metal prices by 36.4 per cent, with the prices of steel products
in particular 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
markets? 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 of
94 petroleum and other products in the international market.
government control in force, for the other products the transmission of I C R A B U L L E T I N

the increase from the global to the domestic market was not immedi-
ate.21 In a lagged response to their hardening in the international
Money
market, coal prices were raised in June 2004, and petroleum prices &
were revised upward in three stages, in June, August and November, Finance
2004. Considering the large significance of these products as intermedi-
SEPTEMBER.2007
ate inputs in other industries, their direct plus indirect impact may be
taken to account for the lion’s 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-
The roots of the
tional supply shocks22 rather than domestic overheating; but for reining
in inflation and “inflation expectations” the Reserve Bank undertook a 2004-05 inflation
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, were thus traced to
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 international supply
basis points to 4.75 per cent.23
The main anti-inflationary initiatives were however sectoral. shocks rather than
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- domestic
tered prices of coal and petroleum products was considerably less than
their price increases abroad: domestic prices of coal and mineral oil
overheating; but for
rose by only 17 and 13.7 per cent respectively as against the doubling
reining in inflation
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 and “inflation
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 expectations” the
oil companies but major part was covered by the issue of oil bonds to
the losing concerns. Similar sector specific policies were extensively Reserve Bank
used for containing the passthrough of other prices. Cuts in customs and
excise duties on raw materials as also finished products limited the undertook a series
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 of restrictive
sector specific anti-inflationary measures included cuts in tariffs on
monetary measures.
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 this
represented 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. Prior
to that date the meaning of the two terms was the opposite.
24 From 8 per cent to 30 per cent.
95
 I C R A B U L L E T I N 2006-07 Inflation
External factors were not inconsequential for domestic inflation
Money 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
Finance supply shock from the rest of the world was transmitted through a
sharp increase in agricultural prices and prices of metal and non-
SEPTEMBER.2007
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
Indeed, despite the
adverse domestic supply situation in markets for wheat, pulses,
identification of oilseeds, cotton and other agricultural goods, and much more impor-
tantly, with the emergence of aggregate demand pressure in the
strong cyclical economy. As evidence of demand driven inflation in 2006-07, the RBI
refers to a whole host of macroeconomic developments. These include
upswing as the 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-
major factor behind tion, rising pricing power of corporates along with indications of wage
pressure in some sectors; pick-up of non-oil import growth and widen-
the inflationary 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-
pressure, fiscal 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
intervention in
of primary products was ascribed to the adverse (sectoral) supply
individual markets shock, but inflation in other prices was viewed mainly as the outcome
of booming aggregate demand in the face of tightening capacity
was widespread. 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 and
reached 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 to
some ceiling.
27 This was from June 22, 2006 when sugar prices exhibited strong price

96 pressure. However, as already observed, in response to the bumper domestic and

international output, sugar prices came crashing from August, 2006.
the FCI’s open market sales scheme; (c) a hundred rupee hike in the I C R A B U L L E T I N

minimum support price (MSP) for wheat;28 and (d) imposition of bans
on futures market trading in wheat, tur and urad.29
Money
Sector specific anti-inflationary fiscal measures were also &
adopted in markets for non-agricultural commodities. For purposes Finance
of reducing manufacturing costs and the price pressure in selected
SEPTEMBER.2007
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
It is worth noting
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. that throughout the
However, in November 2006, the petrol and diesel prices were reduced
to their pre-June levels and in February 2007 their prices were slashed period the
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 administered prices
their costs. The shortfall was the largest for kerosene and LPG whose
prices had been kept unchanged since 2004. of the products fell
As is to be expected, macroeconomic policies adopted for
controlling inflation were much more important in 2006-07 than in the far short of their
earlier episode. Between January 24 31 and July 25, 2006, the reverse
repo rate was raised from 5.25 per cent to 6.00 per cent in three stages,
costs. The shortfall
with an increase of 25 basis points at each stage. The hike in the repo
was the largest for
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 kerosene and LPG
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 whose prices had
(Market Stabilisation Scheme) bonds.32 The need for these measures
been kept

28
unchanged since
So that the Food Corporation of India (FCI) can raise the amount
procured and effectively intervene if necessary in the market through the public
distribution system or open market sales. 2004.
29 Since such trades, it is argued, can be highly speculative and put pressure

on 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 Reserve
Bank’s comfort zone. The hike was mostly a response to international developments
including 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 automatically
reduces the supply of reserve money in the system. The Market Stabilisation Scheme
has 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 sterilising
the large scale inflow of foreign funds. 97
 I C R A B U L L E T I N assumed urgency with the high growth of reserve money and excess
liquidity in the system, driven by large inflow of foreign capital. The
Money 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
Finance and April 2007. The successive increases in CRR helped to absorb bank
resources totalling Rs. 43,000 crore. The quantitative significance of
SEPTEMBER.2007
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
The official analysis
and sales of MSS bonds substantial, they proved inadequate, in the face
of and the measures of burgeoning foreign capital inflows, to moderate the growth of money
and credit. Hence the Reserve Bank, as in 2004-05, moderated some-
adopted to tackle the what its purchase of foreign currency and let the rupee appreciate,34
albeit mildly.
2004-05 and the
II. Some Analytical and Policy Issues
2006-07 inflation 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
raise a whole host analytical and prescriptive. These may be posed in terms of some
basic, inter-related questions that a mainstream (neo-classical)
of issues, both macroeconomist would be inclined to ask on a perusal of Section I.
analytical and 1. Why should price increases (following, say, a one-off increase
in crude prices) which reflect adjustment to a new equilibrium
prescriptive. These situation and are not of a continuing nature be regarded as
inflation? Do such price increases require any policy response?
may be posed in The questions do not amount to splitting hair,35 since the
adverse consequences of inflation arise from unanticipated and
terms of some
continuing inflation, not from an increase in prices to their
basic, inter-related equilibrium levels.
2. Does not the analysis or diagnosis of inflation in terms of the
questions that a behaviour of prices of particular commodities or product

mainstream

macroeconomist 33 It may be noted that the negative impact of absorption of (say) Rs. 100

crore through the MSS route on broad money supply is larger than an equal amount
would be inclined to of (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
ask on a perusal of in the second case the fall will be less than Rs. 100 crore as the initial decline in bank
deposit and credit is moderated through an increase in reserve money in the
commercial banking system (as the public tries to reduce their holding of currency in
Section I. line with the fall in bank deposits).
34 Exchange rate appreciation, it is interesting to note, does not figure in

the Reserve Bank’s list of measures for containing actual inflation or inflation
expectations.

98
35 Since one may be tempted to dismiss the first question on the ground

that it relates to “definition” and hence is not substantive.

 groups go against the fundamental approach of economic I C R A B U L L E T I N

theory? In economics there is a clear cut distinction between

(a) factors governing the general price level and its temporal
Money
behaviour on the one hand; and (b) the determinants of relative &
prices and sectoral allocation of resources on the other. Hence, Finance
as in the case of determination of aggregate employment in an
SEPTEMBER.2007
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?
Since a major
3. What is the economic rationale of freezing some prices or
trying to curb their increase for purposes of controlling infla- reason adduced by
tion? Are such measures effective as anti-inflationary devices?
Are they desirable in all or in some cases? the central bank for
4. When inflation is due to some sectoral cost push, but there is
evidence of excess capacity or demand deficiency elsewhere in monetary tightening
the economy—the 2004-05 inflation seems to fall in this
category—should the central bank take recourse to monetary irrespective of the
tightening?
5. When the administered prices of petroleum or other products sources of inflation
are below their international levels, should the government
raise them when the overall inflation is low, but keep them
is the need for
unchanged or lower them if the general price level exhibits a
containing “inflation
strong upward trend due to sectoral or macroeconomic factors?
6. Since a major reason adduced by the central bank for mon- expectations”, it is
etary tightening irrespective of the sources of inflation is the
need for containing “inflation expectations”, it is important to important to ask,
ask, what are the determinants of such expectations? Or more
specifically, would not expected inflation be related to the basic what are the
reasons behind the price increases, i.e., whether they are due to
aggregate demand pressure or some sectoral supply shock? determinants of
7. Why are all anti-inflationary fiscal measures sector specific,
not geared towards control of aggregate demand? Are mon- such expectations?
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 India’s inflationary experience in recent
years.
99
 I C R A B U L L E T I N III. Impact of Oil Price Shock and Policy Intervention
One reason for considering the oil shock related inflation first
Money is the overwhelming significance of such inflation in the Indian
& economy since the mid-1990s. During the twelve-year period, 1995-
Finance 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
SEPTEMBER.2007
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 simplest way of
The models are also relatively simple to construct and comprehend,
examining the 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
inflationary impact considered a price taker in the international market. 37
It is interesting to note that between 1995-96 and 2006-07 all
of an oil price shock the oil shocks occurred when there was substantial spare capacity in
manufacturing as well as services. Hence we shall consider the impact
is in terms of an 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
inter-industry input- from the agricultural sector.

output framework, Oil Price Shock in a Demand Deficient Economy38

The simplest way of examining the inflationary impact of an
remembering that
oil price shock is in terms of an inter-industry input-output framework,
crude oil is a remembering that crude oil is a universal intermediate and used
directly and indirectly in practically all industries. With labour and oil
universal 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
intermediate and for producing a unit of net output in each industry.40 The direct-cum-
indirect labour and oil coefficients along with the wage rate and oil
used directly and

indirectly in
36 In 1997-98, the fuel price inflation was 13.7 per cent; but the onset of

practically all demand 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 per
cent. In 2000-01 the WPI inflation at 4.9 per cent was relatively low in the context
industries. of the 15.0 per cent inflation in fuel prices; the reason in this case lay in the bumper
agricultural crop driving down the primary product prices (by 0.4 per cent), a unique
phenomenon 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 basic
input.
40 i.e., net of intermediate use of its own output in the process of produc-

100 tion. The net output of any industry is available for meeting the final demand for
the industry’s production, by way of consumption, investment and exports.
prices, yield a horizontal aggregate supply (AS) schedule41 showing I C R A B U L L E T I N

that the price level P, the weighted average of all prices, remains
unchanged at different levels of output. The aggregate demand AD is
Money
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 Finance
supply of money in real terms. The horizontal AS along with the
SEPTEMBER.2007
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 At any given
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 exchange rate an oil
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 price hike reduces
shock raises the country’s net import bill43 which together with the
operation of the foreign trade multiplier effects a fall in aggregate aggregate demand.
demand, i.e., shifts AD to the left. This reinforces the output reducing
But since the
effect of the oil price shock, but the magnitude of the price increase is
still governed by the effect operating through costs of production. exchange rate tends
Under normal conditions however AS is upward rising,44 not
horizontal. Since an oil price hike shifts AS upward and AD leftward, to depreciate due to
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 the shock, there is
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 also a favourable
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 impact on domestic
the macroeconomy. At lower levels of output, aggregate demand is
generally less price responsive, while AS tends to be flatter. Hence, the
demand.
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 basis—not
an unreasonable assumption in a demand deficient economy, where prices of the two
basic inputs do not change in response to variations in their levels of employment.
42 So that aggregate demand goes up by the incremental trade balance

times 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 of AD.
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 is
steeper. 101
 I C R A B U L L E T I N foreign currency market?47 In this case the factors affecting the macr-
oeconomic variables do not always pull in the same direction. At any
Money given exchange rate an oil price hike reduces aggregate demand. But
& since the exchange rate tends to depreciate due to the shock, there is
Finance also a favourable impact on domestic demand. The most plausible
result, as we show in the Appendix, is that exchange rate flexibility
SEPTEMBER.2007
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

In terms of the
According to the mainstream literature, continuing inflation
characteristics of the 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
full employment 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
equilibrium it is effects of all disturbances, including an oil shock, are Keynesian:
irrespective of the initial output level, while an increase in aggregate
fairly easy to 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
examine the 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
implications of an one. Let us see if or how such an equilibrium is affected by a one-off oil
price shock.
oil price increase for
Consider a neo-classical aggregate production function where
the domestic 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
economy when 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
markets have domestic and imported consumables. Given the production function,
full employment equilibrium in such an economy is characterised by
adjusted to the the demand-supply balance in three markets, labour, output and foreign
exchange.
shock. 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 exceeds
the net capital inflow. At the same time it is necessary to undertake some open
market purchase of securities so that money supply is not affected.
48 Since the output fall is smaller and the nominal exchange rate goes up in

equilibrium.
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

102 larger than that in output (as given by the aggregate production function).
the oil intensity of domestic output and the lower the elasticity of I C R A B U L L E T I N

substitution between labour and oil in the production function. With

relatively low elasticity of substitution between the two inputs, there
Money
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 Finance
rate depreciation reduces the real wage rate and hence the supply of
SEPTEMBER.2007
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
The perceptive
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- reader must have
ables. It is only if the central bank persists in raising money supply
over time, can there be continuing inflation in the system.51 noted that the
Resolving the Analytical and Policy Issues change in the
The foregoing analysis underscores the well recognised need
among economists of a macro general equilibrium framework for general price level
examining the inflationary consequences of a shock, even when the
shock is sectoral. Indeed, the fallacy of looking only at the cost side or (and GDP) due to an
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, as
oil price hike on P when the supply price response to changes in
obtained from the
production is significant and the trade balance is sensitive to exchange
rate variations—conditions that are fairly undemanding. Let us turn to AD-AS and the full
the other issues raised in Section II and see if the above constructs are
of any use in their resolution. employment

Price Adjustment and Inflation models, refers to a

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 shift from one
the AD-AS and the full employment models, refers to a shift from one
equilibrium P to another and does not constitute inflation, which equilibrium P to
necessarily has to have a time dimension. In order to examine the
another and does
inflationary consequences of some (one-off) oil shock, we need to know
the time path or rapidity of adjustments in different markets from their not constitute
initial to the new equilibrium. The slower the rate of adjustment, the
longer will be the inflationary period, but the rate of inflation during inflation.
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 income
elasticity of demand for real balances. 103
 I C R A B U L L E T I N 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
Money macro variables jump to their new equilibrium values, but there is no
& inflation thereafter.53
Finance 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-
SEPTEMBER.2007
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 Bank’s pursuit of dear money policy when the WPI
The central bank
inflation, though high, was palpably the fall-out of the oil price shock.
and the fiscal However, since the misalignment of prices from their equilibrium
configuration generally entails allocative inefficiency, the economic
authorities in India 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
seem to think that a that arise in the course of adjustment of different markets to a new
equilibrium; and (b) inflation that originates in a fundamental imbal-
low inflation spread 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
over a long period is the economic consequences of fiscal and monetary policies adopted in
response to such shocks.
preferable to the one
On How Not to Tackle Oil Price Shocks
which starts with a
The most widely used policy followed in India for containing
bang, but loses its oil price inflation has been freezing petroleum prices and setting them
below costs. Since apart from their macroeconomic impact such
steam quite rapidly. 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 country’s 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 all

relevant 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.
104 55 Both measured in terms of some common denominator.
margin. Second, the oil price freeze prevents adjustment towards the I C R A B U L L E T I N

(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-
Money
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 Finance
as in the country’s command over imported consumption or investment
SEPTEMBER.2007
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
More significant
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 than the short-term
be fairly large.
More significant than the short-term GDP loss are perhaps the GDP loss are
longer term costs of an oil price freeze. Financing the subsidy bill
through oil bonds, as is done in India, only postpones the distortionary perhaps the longer
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 term costs of an oil
saving, and hence the growth potential of the economy.57 The growth
debilitating effects of distortions can be considerable since the substitu- price freeze.
tion possibilities between factors through shifts in technology as well as
invention of new techniques are much greater in the long than in the
Financing the
short run.
subsidy bill through
What about the increase in the general price level or inflation?
Our earlier analysis suggests that, given the supply of money and its oil bonds, as is
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 done in India, only
fall in (short-term) full employment GDP, the second through a reduc-
tion in growth. No wonder, common sense or partial analysis can be postpones the
quite misleading for analysing the behaviour of macro variables like
Inflation or GDP. distortionary costs
The second set of policies deployed for controlling petro-
inflation consists of monetary tightening. Let us consider the effects of of taxes and
the policy in a full employment economy. A tight money policy may
transfers, but does
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 not avoid them.
rate of money supply. Remembering that an oil price shock causes a
fall in full employment GDP, the price level will tend to go up in

56 The reason is that oil subsidy stands in the way of reallocation of

resources towards the optimum (less oil intensive) basket of production and
consumption. It is important to recognise that even if the technical input coefficients
are 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 providing

subsidy in a full employment economy. 105

 I C R A B U L L E T I N 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
Money economy however a one-off increase in nominal (but not in relative)
& prices is of little consequence. But even in such an economy inflation
Finance above or below some range tends to have adverse consequences. 58
Hence when an oil shock pulls down GDP growth, monetary tightening
SEPTEMBER.2007
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.
Through an increase
We have throughout been concerned with a situation where
in NRI remittances, there is a one-shot rise in oil prices, but other external factors affecting
the domestic economy remain unchanged. Two caveats appear worth
export demand and 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
capital flows, oil the shock is expected to be temporary, the price freeze remains a
suboptimal response. Apart from the fact that the policy leads to
price bonanza often overuse of oil and does not allow for the substitution possibilities in
production, consumption and investment, it is generally preferable to
produces a 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
favourable impact economy the government is not better informed than most producers
and investors. Second, through an increase in NRI remittances, export
on the country’s
demand and capital flows, oil price bonanza often produces a favour-
economy. This calls able impact on the country’s economy. This calls for some policy
initiatives on the macroeconomic front,59 but does in no way justify oil
for some policy subsidy.

initiatives on the Policy Response in a Demand Deficient Economy

Practically all the oil shocks occurred when the Indian
macroeconomic economy had had under-utilised capacity; but the policies adopted for
dealing with the shocks still consisted of petroleum price control and
front, but does in no monetary tightening. Let us consider first some economics of the
former.
way justify oil
An oil price freeze prevents an upward shift in aggregate
subsidy. 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, a

crawling price level slows down optimal reallocation of resources under changing
demand or supply side factors, given the relatively small downward flexibility of
some 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

106 freeze.
rium. Again, since the output decline is less when the subsidy is I C R A B U L L E T I N

financed through bonds rather than taxes, the case for the oil price
policy pursued by the government may appear open and shut. Unfortu-
Money
nately, the strength of the argument is more apparent than real. &
Recall that freezing oil prices reduces a country’s potential Finance
income and consumption in the short as well as the long run. The fact
SEPTEMBER.2007
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 overall fiscal
Apart from the fact
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 that all delays in
the government cannot directly mitigate the hardship through income
transfer is there a case for providing some subsidy. Anyway, such making domestic oil
subsidy is to be on some essential item of poor man’s consumption like
kerosene, not intermediate inputs or products purchased by the rela- prices conform to
tively well off.
What about the rise in prices in the absence of any subsidy? A their international
one-off increase in the general price level (P), as already emphasised,
does not constitute inflation or entail the adverse effects of a continuing counterparts enlarge
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-
distortionary costs,
tionate cutback in all indirect taxes,62 rather than subsidising oil or
the aforementioned
cutting duties on imports of petro-products. Such an across-the-board
duty cut avoids inefficiency in resource use, including distortions in timing of price
imports and exports. The conclusion is inescapable that sectoral
intervention is generally a poor substitute of overall policies in dealing revisions is
with demand deficiency or inflation.
Our analysis also suggests the inappropriateness of government likely to be
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 counterproductive.
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 timing of 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 in
international 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! 107

 I C R A B U L L E T I N aggregate demand-supply imbalance with the actual output overshoot-
ing the NAIRU level, oil price control, our analysis suggests, aggra-
Money vates the imbalance through an enlargement of demand and reduction
& in supply.65 An upward revision of oil prices for closing the gap be-
Finance tween the international and domestic prices would always be efficiency
enhancing; but such revisions unaccompanied with an expansionary
SEPTEMBER.2007
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
When the central
less inappropriate than oil price control for tackling inflationary
bank takes recourse pressure. Thus when the central bank takes recourse to monetary
tightening in response to an oil shock induced increase in WPI, the
to monetary demand reducing impact of the increase is reinforced by a credit crunch
so that losses in output and employment are magnified. For neutralising
tightening in 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
response to an oil policy,66 not a monetary squeeze.
According to the Reserve Bank the main reason for monetary
shock induced tightening even though the economy may be demand deficient and the
price rise originates in a sectoral shock lies in the need for containing
increase in WPI, the “inflation expectations”. In order to appreciate their significance note
that, given the tendency of economic agents to extrapolate the recent
demand reducing
price trends into the future, a rise in current inflation is likely to raise
impact of the expected inflation as well. However, since investment demand as also
contracts concerning money wages, lending, borrowing, etc. are
increase is crucially affected by expected inflation, the actual inflation itself is
influenced by price expectations. Hence arises the importance of
reinforced by a keeping the actual price increases in check before they degenerate into
a cumulative inflationary spiral. Of particular significance in this
credit crunch so that context is reputation of the central bank or perception of private agents
regarding the central bank’s willingness and ability to keep inflation in
losses in output and check. When the central bank’s credentials as an inflation hawk are
well established, an increase in current prices will not generally cause
employment are
inflation expectations and to that extent it becomes easier for the
magnified. 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 in

particular.
66 Assuming that the NAIRU output at the higher level of oil prices is not

108 below the prevailing output level.

cannot afford to follow a neutral monetary policy, let alone an expan- I C R A B U L L E T I N

sionary one.
There are several flaws in the above line of reasoning. Recall
Money
that the significance of inflation expectations is underlined in the &
literature in the context of the time inconsistency problem (Kydland and Finance
Prescott, 1977). The problem arises when the central bank seeks to
SEPTEMBER.2007
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 bank’s 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
Given a low
rate. This success is due to the unanticipated rise in inflation or policy
surprise: had inflation been fully anticipated, there would have been no expected inflation
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 rate formed on the
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 basis of past
employment above their NAIRU levels.
Two crucial features of the foregoing analysis deserve especial experience (or
attention. First and the most fundamental, economic agents learn from
experience and are rational. Second and related to the first, they also rather, the central
know how the economy operates under given conditions.67 If so, in the
absence of any central bank intervention following an oil price shock,
bank’s revealed
rational economic agents, knowing their AD-AS model, would expect
preference for low
(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, inflation), the
the oil price induced price increase would not generate inflation
expectations. Indeed, economic agents would also know that at the new expansionary policy
equilibrium configuration, though prices of oil intensive products would
be higher, those of other goods and services would tend to fall. will succeed in
One can go further and indicate the response of rational
economic agents when the central bank invariably follows a raising employment
contractionary monetary policy whenever the WPI inflation goes above
some targeted level, even though the increase may be due to a sectoral and output, but only
shock and the economy demand deficient. Pursuit of such a policy is
at the cost of a rise
likely to make economic agents lower their expectations regarding the
economy’s average capacity utilisation and employment level over the in inflation above its
business cycles. Such expectations on the part of investors cannot but
act as a damper on their plans for longer term capital accumulation expected rate.
and effect a slowdown in economic growth.

67 Note that the time inconsistency problem arises when the central bank

undertakes monetary expansion in a full employment economy. When such an

expansion 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 if
economic agents are fully aware of the measures being implemented by the central
bank. 109
 I C R A B U L L E T I N IV. Food Price Inflation
Apart from oil, the other important source of sectoral supply
Money shock having a large impact on the general price level is the primary
& sector in general and foodgrains production in particular.68 While
Finance examining the inflationary consequences of such supply shocks, a few
distinguishing characteristics of the food market are worth keeping in
SEPTEMBER.2007
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-
Apart from oil, the
tion in a year of normal or even bumper harvest still leaves a fairly
other important large number of people hungry or undernourished. Third, except for the
foodgrains sold through the public distribution system (PDS), food
source of sectoral 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
supply shock having other macro variables.

a large impact on Food Inflation in a Demand Deficient Economy

The appropriate framework for analysing the consequences of
the general price 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,
level is the primary 1989)] where interaction between the agricultural and non-agricultural
sectors of the economy are explicitly taken into account. In such models
sector in general
while prices are market clearing in agriculture, the basic features of the
and foodgrains non-agricultural sector are as in mainstream macro models. Under
these condition there are four main routes through which the effect of
production in an agricultural supply shock is transmitted to the rest of the economy.
First, with the fall in income originating in the primary sector, there
particular. 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 are

much larger than that of oil. While the weights of fuel and mineral oils in WPI are
14.2 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 of
composite primary articles goes up to 37.7 and that of food items to 26.9. Needless
to say, in CPIs, especially in CPI-AL and CPI-RL, the weight of food articles is
overwhelming.

110
69 Due to the rise in prices of both primary articles and non-agricultural

products.
characterised by (i) a rise in prices of both agricultural and non- I C R A B U L L E T I N

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
Money
appreciation of the real exchange rate. &
The effects of agricultural supply failure are thus somewhat Finance
similar to that of an oil price shock; but there are also crucial differ-
SEPTEMBER.2007
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-
The effects of
versed when climatic conditions become normal. However, the need for
prompt and effective measures for dealing with supply shocks in agri- agricultural supply
culture is much more urgent, given the large-scale starvation and sharp
rise in the incidence of poverty that follow shortages of food supply. failure are thus
Fortunately, government measures for dealing with food
inflation are much more sensible than policies pursued for tackling the somewhat similar to
oil price shock. Since the major impact of draught or other climatic
disruptions on employment and income is in rural areas, public works that of an oil price
programmes along with provision of subsidised food through PDS
constitute a most potent means of alleviating the hardship of the worst shock; but there are
sufferers of the shock. However, operational-cum-administrative
hurdles tend to limit ready initiation of public works programmes in
also crucial
many areas and the rationing system often leaves many a low income
differences which
households uncovered. Hence open market sale of foodgrains by FCI
becomes necessary to contain food price inflation and its impact on call for a radically
poverty as well as on non-agricultural output and employment. The
policies are standard, but three issues relating to the measures merit different policy
some comments.
The first concerns the inefficiency and waste involved in hastily response.
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.

70 Part of the government expenditure on public works and of consumption 111

 I C R A B U L L E T I N Third and the most important is the problem of supply man-
agement. When FCI is loaded with substantial food stock, the manage-
Money ment problem is relatively easy. If the economy’s average production of
& foodgrains over the agricultural cycle is not inadequate, a buffer stock
Finance policy should normally be sufficient to neutralise the adverse effects of
an agricultural supply shock. Barring the subsidy required for the
SEPTEMBER.2007
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
In view of the
imports and their subsidised sale in the domestic market. Ideally, the
absence of an 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
effective social open market sale of foodgrains below costs if necessary. When the food
shortage is transient, depletion of forex reserves due to food imports
safety net for the should be of no concern; in fact the resulting real exchange rate depre-
ciation would be salubrious for the non-agricultural sector suffering
large majority of the from demand deficiency.
Except for public works programmes, all the measures consid-
indigent, subsidised ered above are sectoral, designed to augment market supply and
contain price increases of food items. But would not government
PDS and open intervention in the food market create distortions of the sort we noted in
connection with oil subsidy? If the government could ensure—through
market sales of
public works programmes, employment guarantee schemes or
foodgrains below redistributive measures—some minimum income of BPL households, the
food economy could perhaps have been left to the operation of domestic
costs may be and international market forces. But in view of the absence of an
effective social safety net for the large majority of the indigent, subsi-
viewed as a second 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
best solution. 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 man’s
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 additional

expenditure in its turn initiates a multiplier process (Rakshit, 1982).
71 It was on the basis of all these considerations that we favoured

112 subsidisation of kerosene among petroleum products.

absence of insurance facilities in the unorganised sector, FCI operations I C R A B U L L E T I N

designed to keep prices of food and its consumption relatively stable

over the agricultural cycles72 cannot but be beneficial for both produc-
Money
ers and consumers. &
Second, insufficient food intake even over a few months saps Finance
efficiency of workers, makes them disease prone and tends to produce a
SEPTEMBER.2007
relatively prolonged negative impact on the effective supply of labour.
Guaranteeing some minimum food consumption is thus imperative for
preventing erosion of human capital and the resulting loss of the
economy’s production potential.
Finally, the crucial significance of supply side management in
The crucial
times of harvest failure may be appreciated from the serious difficulty
policy makers will otherwise face in tackling inflationary pressure on significance of
the one hand and arresting the decline in non-agricultural output and
employment on the other. Expansionary measures for preventing output supply side
loss will strengthen the (food price induced) wage-price spiral and may
not be much effective in reducing excess capacity if the available management in
quantum of food is too low to maintain the demand-supply balance at
the full capacity levels of (non-agricultural) output and employment. times of harvest
For resolution of the problems arising in this context we need to
unravel the inter-linkages between food supply, capacity utilisation and failure may be
inflation.
appreciated from the
Food Supply and Full Employment
serious difficulty
In order to examine the effects of harvest failure in a “full
employment” economy and the policies required to minimise its policy makers will
adverse consequences, it appears useful to distinguish between two
parts of the non-agricultural sector, organised (NO) and unorganised otherwise face in
(NU). The former uses modern machinery and equipment and employs
relatively skilled workers whose expenditure on food constitutes a tackling inflationary
relatively minor part of their consumption. The overwhelming part of
non-agricultural (wage-cum-self) employment is however in NU. For pressure on the one
the labourers engaged in this sub-sector food consumption not only
accounts for the lion’s share of their expenditure but is also a major hand and arresting
determinant of their efficiency. Hence even if a large number of labour-
the decline in non-
ers are willing to work at very low wages, there will be a floor to the
real wage rate measured in terms of food.73 agricultural output
Given the aforementioned characteristics of the economy, the
impact of harvest failure is not difficult to discern. As already noted, and employment on
the failure implies a fall in the supply of food to, as well as demand for
the other.

72 Which market forces alone will fail to ensure in view of the two factors
just noted.
73 A la the efficiency wage hypothesis, at the floor rate the cost per unit of

effective labour is minimised. A large enough demand for labour can push wages
above the floor rate; but excess supply of labour cannot pull down wages below this
rate. 113
 I C R A B U L L E T I N the produce of, the non-agricultural sector. With relatively sticky
money wages and prices, the short run effect of a fall in demand on
Money NO will be to reduce its output and employment. In NU though money
& wages and prices are flexible. Given the constant corn wage rate the
Finance rise in the ratio of food to NU product prices causes a fall in wage
employment along with a rise in self employment or unemployment.
SEPTEMBER.2007
The important point to note in this connection is that though output loss
due to fall in wage employment in NO and NU are likely to be large,
of no less consequence for social welfare is the loss of real income due
to increase in unemployment and self-employment, remembering that
both unemployment and involuntary self-employment entail inadequate
The solution to the
consumption and a decline in the current as well as the future produc-
problem lies in a tive capacity of workers.
The impact of an agricultural supply shock noted above is
two-fold policy accompanied with a rise in prices, but not inflation, so long as money
supply is kept constant. But absence of continuing inflation is a poor
initiative: along with consolation for the rise in the incidence of unemployment and hunger.
The solution to the problem lies in a two-fold policy initiative: along
management of food with management of food supply it is also necessary to adopt sector
specific fiscal and monetary measures. As in the earlier instance, one
supply it is also can hardly overemphasise the need for food subsidy and FCI sale of
foodgrains in the open market along with special employment genera-
necessary to adopt tion programmes in rural areas. The monetary instruments required
under this situation are also largely sectoral in nature. A harvest failure
sector specific fiscal
forces farmers to default on their debt dues and makes them ineligible
and monetary from formal credit for production or consumption. Similar is the
consequence for people engaged in NU. The result is that not only a
measures. large number of farmers and small producers find it difficult to meet
their basic consumption requirement, but credit crunch poses a serious
obstacle to their production activities. Hence even when the overall
monetary policy may have to be restrictive for preventing a sharp rise
in prices, it is necessary to ensure supply of production loans or credit
for working capital.74 This in fact has been the avowed policy stance of
the Reserve Bank even in the post-reforms period. Though official
documents do not betray awareness of the analytical foundations of
supply management or ensuring production loans for purposes of
controlling inflation,75 the fiscal and monetary authorities in India
have long been following some of the important structuralist policy
prescriptions.76

74 Indeed, as we have shown elsewhere, even in times of inflation in a

developing economy, a cutback on production loans tends to add to the supply side
failure and the inflationary pressure (Rakshit, 1987).
75 Note that these measures figure nowhere in the mainstream literature on

inflation.
76 Hence our reference at the beginning to the Molier character who was

114 pleasantly surprised to discover that he had been talking prose all his life.
 V. Excess Demand and Anti-inflationary Policy I C R A B U L L E T I N

In mainstream economics the basic source of inflation is not

supply shock, but an increase in demand in excess of the country’s
Money
productive capacity. Before considering some economics of imbalance &
between aggregate demand and aggregate supply it appears necessary Finance
to examine in the Indian context the sources and consequences of excess
SEPTEMBER.2007
demand in some markets for important industrial products, e.g., steel,
metals and cement. The reason is that a significant part of WPI infla-
tion is often attributed to price pressure in these markets and an impor-
tant plank of the government’s anti-inflationary stance consists in trying
to check price increases in these markets.
The ministry of
Sectoral Demand Shock finance seems to be
The sources of price pressure in the markets mentioned above
are both domestic and global. In recent years prices of these goods have of the view that
hardened in the international market on account of their voracious
demand from China and a number of other emerging market econo- intervention in
mies. Since 2002-03 a significant step-up in fixed capital investment
including housing has created excess demand conditions and added to markets exhibiting
the price pressure in markets for cement, steel, aluminium and other
metal products. The government’s concern regarding the rising prices of price pressure is a
these commodities seems to be due to two factors. First, the price
increases directly raise the WPI inflation. Second, the rise in the cost of
(if not the) most
these inputs, it is felt, is likely to pose a serious problem in undertaking
effective means of
the much needed investment in infrastructure and other important areas.
In view of the above concerns, the government has imple- containing inflation
mented a number of supply side measures to tackle price increases of
products that constitute major inputs of capital goods. Apart from and inflation
exhortation of producers to hold the price line (e.g., in the case of
cement), the policies include cuts in excise and/or customs duties on expectations. The
intermediate products in excess demand. Indeed, the ministry of finance
seems to be of the view that intervention in markets exhibiting price view is no doubt
pressure is a (if not the) most effective means of containing inflation
and inflation expectations.77 The view is no doubt commonsensical, but commonsensical,
not in accord with basic economic principles.
but not in accord
The flaw in the foregoing view lies in the perception of both
the mechanics of demand driven inflation and the broader consequences with basic economic
of sectoral intervention. The ultimate source of price pressure in steel,
cement or other intermediate inputs is galloping demand for final principles.
products, especially investment.78 An increased demand for capital
goods raises in the short run production and prices of these products as

77 As per a statement of the finance minister.

78 Practically all booms are led by investment, the reason being that
household consumption is governed primarily by private disposable income, not by
“animal spirits” or bursts of optimism and pessimism. 115
 I C R A B U L L E T I N well as that of their intermediate inputs. Again, additional incomes
generated in the process of production of investment goods and their
Money intermediate inputs lead to a rise in demand for consumption articles
& and hence for goods needed for their production. In other words,
Finance through the inter-industry input-output linkages and through additional
expenditure on various consumption goods out of extra income, an
SEPTEMBER.2007
increase in the final demand for some sector’s product may be expected
to raise the demand and the price pressure in other sectors as well. It is
for this reason that looking at sectoral price increases and computing
their respective contributions to WPI or CPI inflation may fail to reveal
the basic source of the inflationary pressure.
With no change in
While framing policies for tackling a demand driven inflation,
the real exchange it is important to recognise that when prices of some products increase
at a faster rate than that of others, the reason lies (mostly) in the more
rate, tariff cuts on stringent supply conditions in the former than in the latter. But that
does not make supply side intervention in markets displaying high price
selected items pressure the appropriate policy to adopt. To see why, consider the
consequences of cuts in excise-cum-customs duties on goods whose
mainly affect the prices are rising at a relatively fast pace. If the initial duty structure is
optimal,79 duty cuts would be distortionary and reduce the “full
composition of employment” output level.80 This along with the rise in private dispos-
able income (due to the revenue loss) adds to rather than reduces the
imports, but have overall price pressure. The important point here—of which there seems
to be little appreciation in the official circles—is that, with no change
very little impact on
in the real exchange rate, tariff cuts on selected items mainly affect the
the aggregate composition of imports, but have very little impact on the aggregate
supply of goods and services and hence the overall inflationary pressure
supply of goods and in the domestic market. Tackling inflation through the trade route
requires an increase in the real exchange rate which not only raises the
services and hence country’s net imports, but does so in a non-distortionary manner.
Changes in the country’s indirect tax structure over the trade cycle, our
the overall analysis suggests, are inefficient,81 and stand in the way of attaining the
twin objectives of full employment and low inflation.
inflationary pressure

in the domestic

market. 79 So that domestic price ratios of tradables are close to their international

counterparts. With duty cuts on selected products the two sets of price ratios diverge
and the composition of both domestic output and absorption become suboptimum.
80 Since the duty cuts are on intermediate goods, the actual output vector

of final goods will be forced below the country’s production possibility frontier.
81 What about the argument that a sharp rise in steel or cement prices will

seriously affect infrastructural investment and long-term growth. The relative

importance of such investments presumably arises from their large positive externali-
ties. The solution lies not in trying to lower steel or cement prices, but to (a)
subsidise these investments, a part of whose benefits cannot be internalised; and (b)
meet the subsidy bill through non-distortionary taxes as far as possible. If the
objective is not to permit a fall in aggregate investment, the non-distortionary
116 measure consists of raising taxes on consumption.
 Macroeconomic Policy Issues I C R A B U L L E T I N

In line with the currently ruling orthodoxy, anti-cyclical

(including anti-inflationary) macro policies are exclusive preserves of
Money
the Reserve Bank: except for dealing with sectoral price increases82 &
fiscal authorities seldom intervene to curb or boost aggregate demand. Finance
The main instrument used by the Reserve Bank, viz., variation of the
SEPTEMBER.2007
repo/reverse repo rates, is also mainstream. However, reflecting a
tension between the prevailing central banking paradigm and the
special problems facing the Indian economy, there is also an element of
heterodoxy or structuralism in the Reserve Bank’s policy stance and
statements. But these elements are far from substantive.83 Apart from
In line with the
the two legacies of the pre-liberalisation era, viz., the SLR and priority
sector credit requirement, the Reserve Bank’s main departure from the currently ruling
prevailing central banking paradigm lies in (a) the relative disregard of
the output gap as a signal for policy action; (b) the choice of WPI as the orthodoxy, anti-
most important indicator of the inflationary pressure; and (c) wide-
spread use of other monetary instruments along with the repo and cyclical (including
reverse repo rates. Before taking up the issues under (b), we record
below a few observations related to (a) and (c). anti-inflationary)
The Reserve Bank’s main objectives, like that of most central
banks, are to keep inflation rate moderate and the actual output close macro policies are
to its potential level;84 however, the Bank seems to attach much more
weight to the former than the latter. Since estimates of output gap or
exclusive preserves
unemployment are not available for the Indian economy85 it is difficult
of the Reserve Bank:
to judge the Reserve Bank’s preference function. However, as we have
already noted in connection with the 2004-05 inflation, even when the except for dealing
economy operates with substantial slack and the price pressure is both
sectoral and transitory, the Reserve Bank does not hesitate to follow a with sectoral price
contractionary monetary policy. This sets it apart from other central
increases fiscal

82
authorities seldom
Or falls, as happened in the case of sugar during the later part of 2006-07.
83 In its analysis and policy statements the Reserve Bank, like the structur-

alists, emphasises (a) the crucial role of agriculture in containing inflation in a intervene to curb or
country like India; and (b) the need for ensuring the supply of productive investment
even while contractionary policies are required to be pursued. However, except for boost aggregate
the priority sector credit requirement, which is still in force, no RBI policy is directly
related to agricultural production or growth. Nor can the Reserve Bank ensure,
under the liberalised regime, supply of credit for “productive investment” when there
demand.
is a monetary squeeze. This is apart from the fact that to be anti-inflationary, a
monetary policy needs to reduce (long-term) investment demand.
84 The behaviour of most central banks appears to be in conformity with

the Taylor rule (Taylor, 1993) under which the change in the central bank’s policy
rate is related negatively to the output gap (the gap between potential and actual
output), and positively to the inflation gap (the gap between the actual and
targeted or optimal inflation). A one percentage point rise in inflation under this rule
calls for a rise in the policy rate by more than one percentage point so that there is
an increase in the real rate of interest.
85 While no estimates are available for the output gap, that for unemploy-

ment are provided at irregular yearly intervals by NSS and hence are of little use to
the central bank for anti-cyclical policies. 117
 I C R A B U L L E T I N banks whose policies are guided more by the aggregate demand-supply
imbalance than by sectoral or transitory price pressure. 86
Money Again, unlike the central banks in countries like the USA or the
& UK, the Reserve Bank, apart from its policy rates, also uses a number
Finance of other instruments that have a much more direct impact on the supply
of money and credit. Indeed, as anti-inflationary instruments hikes in
SEPTEMBER.2007
CRR or open market purchases of government dated securities87
including MSS bonds were no less significant than upward revisions in
the repo or reverse repo rates during the latest inflationary experience.
The reasons behind the Reserve Bank’s catholicity in its choice
of monetary instruments are worth examining. In developed economies
Again, unlike the
with deep and extensive financial markets, the impact of a change in
central banks in short-term rate on the longer-term ones tends to be significant. There
are also several routes through which the interest rate changes affect
countries like the aggregate demand. Apart from investment, household consumption, as
the US experience demonstrates, is significantly affected by softening or
USA or the UK, the hardening of interest rates. This comes about through the wealth
effect88 and the effect on the consumers’ ability to borrow and spend
Reserve Bank, apart against the value of their houses. Finally, with no control on capital
movements and absence of central bank intervention in the foreign
from its policy rates, currency market, the impact of changes in policy rates on aggregate
demand through an appreciation or depreciation of the exchange rate
also uses a number can also be considerable.
The above mentioned channels through which short-term
of other instruments
policy rates affect aggregate demand are nearly absent or choked in the
that have a much Indian economy. In view of gross underdevelopment of the private bond
market, extensive recourse to self-financing along with external com-
more direct impact mercial borrowing by big and medium corporates in recent years, and
relatively small share of bank funds earmarked for long-term credit,89
on the supply of changes in policy rates do not on their own have much of an impact on
long term investment. Add to that the fact that loans against houses are
money and credit. extremely difficult to secure 90 and that the Reserve Bank’s management
prevents capital flows from having a commensurate impact on domestic
demand—and it is not difficult to see why hikes in repo or reverse repo
rates unaided by other measures do not constitute a potent anti-infla-

86 The difference, as we shall presently discuss, is closely related to the

Reserve Bank’s choice of WPI as the relevant inflation measure.
87 Open market operations of central banks in developed economies are

mostly confined to purchases and sales of treasury bills for making effective the
policy rate which is an overnight or an extremely short-term rate. In India however
purchases and sales of long-dated government securities constitute an important
monetary policy instrument.
88 As the prices of houses and shares change with variations in interest

rates.
89 Despite the diversification of the financial sector since 1991, banks

continue to remain by far the largest supplier of credit.

118 90 Especially when home loans have not been fully liquidated.
tionary device. In this context changes in the repo or the reverse repo I C R A B U L L E T I N

rates act more as signals of RBI’s intentions than as effective means of

controlling liquidity. Hence the enormous significance of CRR and
Money
open market sale of government dated securities including MSS bonds, &
even though since the late 1990s the Reserve Bank has opted for interest Finance
rate variations rather than monetary targeting for purposes of
SEPTEMBER.2007
macrostabilisation.

Exchange Rate, Capital Flows and Monetary Policy

While there is a strong case for the Reserve Bank’s heterodox
approach to the use of an array of monetary instruments, the same
The main point
cannot be said of its policy concerning the exchange rate or capital
flows.91 During the decade long slack the economy suffered from since that seems to
the mid-1990s, there was some ground for not letting the exchange rate
appreciate in the face of large capital inflows. However, permitting have escaped the
these inflows (especially FIIs), accumulating them in the form of low-
yield US or EU Treasury Bills, and adding to the government’s interest authorities
obligation while sterilising the accretion to foreign exchange reserves—
all these entail considerable cost to the economy in the short as well as altogether is that
the long run (Rakshit, 2003, 2006). The main point that seems to have
escaped the authorities altogether is that the need for foreign capital for the need for
supplementing domestic saving arises in times of full employment, not
when the economy is burdened with excess capacity. No less curious is
foreign capital for
large scale mopping up of capital inflows92 during 2006-07 and the first
supplementing
quarter of 2007-08 when the economy was acknowledged to be operat-
ing at close to full capacity. Recapitulation of some basics may be domestic saving
helpful in this connection.
A country experiencing high demand pressure can effectively arises in times of
use capital inflows for curbing inflationary tendencies and stepping up
capital accumulation. In the absence of central bank intervention in the full employment,
foreign currency market, the inflows cause the exchange rate to appre-
ciate so that imports tend to rise and exports fall. The resultant increase not when the
in the net availability of goods and services helps to reduce excess
demand in the domestic market. This mode of reducing inflationary economy is
pressure is non-distortionary and much more effective than cuts in
burdened with
customs duty on selected imports. Again, through appreciation of the
exchange rate capital inflows enable a country to raise domestic excess capacity.
investment93 and the country’s production potential, perhaps the most
effective bulwark against inflationary pressure in the medium and the

91 Though in respect of capital flows the responsibility seems to lie more

with the ministry of finance. Our purpose here is not to apportion credit or blame
between the two policy makers.
92 Accretion of foreign currency reserves amounted to as much as USD46.8

billion during 2006-07 and USD 14.2 billion in April-June, 2007. The former
amounted to about 4.7 per cent of the country’s GDP in 2006-07.
93 Above the full employment saving level.
119
 I C R A B U L L E T I N long run. The rupee was, to be sure, allowed to appreciate by about 9
per cent against the United States dollar (USD) between April 06 and
Money June 07; but the appreciation of the trade weighted real exchange rate
& was much smaller. Indeed, in the context of the urgent need for large
Finance scale infrastructural as well as agricultural investment while keeping
inflation in check, an addition of close to USD 71 billion to the coun-
SEPTEMBER.2007
try’s already overflowing foreign exchange reserves cannot but appear
contrary to economic reasoning.
Relying on exchange rate appreciation for absorption of capital
inflows and reducing inflationary pressure is not however problem free.
There is a danger of overshooting of the real exchange rate above what
Indeed, in the
is warranted by the country’s long term economic fundamentals. This is
context of the urgent likely to be so since the major part of capital flows (consisting of FIIs)
is driven by short term considerations or herd behaviour. Second, an
need for large scale appreciation of the exchange rate by itself is unlikely to promote
investments in infrastructure or in the farm sector, characterised as they
infrastructural as are by both indivisibilities and large external benefits (Rakshit, 2006a).
The solution to the problem is two-fold and requires coordination of
well as agricultural fiscal and monetary policies. It is important to discourage FIIs and
ensure that foreign capital flows are relatively stable and long term. At
investment while the same time, on the basis of the country’s (full employment) saving
potential and availability of long-term external finance, the govern-
keeping inflation in ment needs to support investments which add significantly to the
country’s growth potential, but do not yield commensurate return to
check, an addition
private investors. The two-pronged policy will not require a sharp rise
of close to USD 71 in the real exchange rate94 and go a long way in promoting non-
inflationary growth.
billion to the
Inflation Measures and their Policy Relevance
country’s already An important problem facing central banks everywhere relates
to which inflation to track for monetary tightening or loosening. In
overflowing foreign India while deciding on anti-inflationary measures, the Reserve Bank
focuses almost exclusively on the WPI inflation rate. In most countries
exchange reserves however it is the CPI inflation which the central banks consider rel-
evant for purposes of setting their policy rates. In the United States the
cannot but appear
Federal Reserve Bank’s preferred indicator of overheating is “core
contrary to inflation” which is nothing but the CPI inflation shorn of volatile items
like food and petroleum prices. Given such diversity of central bank
economic practices, it is important to examine whether the Reserve Bank’s choice
of the WPI inflation is the right one.
reasoning. The issue would not have been of much practical significance
had the different rates of inflation been close to one another. In the

94 In the process of bridging the infrastructural gap, the lion’s share of long

term capital inflows would be used up in raising domestic absorption through

120 increases in net imports.
medium and the long run the various rates do tend to move in a similar I C R A B U L L E T I N

manner. But as the 2004-05 and 2006-07 inflationary episodes illus-

trate, there could be significant differences between the movement of
Money
various price indices in the short run so that the central bank’s choice &
concerning the inflation measure can be quite crucial. Finance
In any analysis of the pros and cons of alternative measures of
SEPTEMBER.2007
inflation the main consideration has to be what it (the measure) is
intended for. Thus if we are interested in assessing changes in the real
income or well-being of (say) rural labourers, the CPI-RL inflation is
the relevant one to track95 and initiate policies. But the question is,
would a hike in the policy rates or adoption of other contractionary
As the 2004-05 and
measures be the most efficacious means of curving the CPI-RL inflation
(without causing significant falls in output and employment) when the 2006-07 inflationary
rise in other price indices is modest? The answer, our earlier analysis
suggests, is in the negative. The point to note here is that, since the episodes illustrate,
impact of policy rates is macroeconomic rather than sectoral and since
the policies are primarily meant to reduce aggregate demand, the there could be
central bank’s choice of inflation measures should be guided by two sets
of considerations. First, how far the measure constitutes a good indica- significant
tor of overall demand-supply imbalance. Second and related to the first,
how expectations of economic agents are affected by the (particular) differences between
inflation and what the consequences of the effect are for the dynamics
of price changes.
the movement of
Judged against the above considerations, not only the CPI-AL,
various price
but even the Reserve Bank’s chosen measure, viz., WPI inflation, does
not appear to be an appropriate indicator for purposes of monetary indices in the short
policy action. To see why, it is useful to take stock of the reasons
behind the preference for the CPI inflation rate of most central bankers run so that the
in mature economies. Recall that under the mainstream approach
continuing inflation suggests an excess demand for labour, with the central bank’s
actual real wage rate falling behind the labourers’ supply rate.96 The
proximate driver of inflation97 is thus rising (nominal) wage demand to choice concerning
make up for the gap between the labourers’ ex ante supply rate and the
actual real wage rate at the prevailing level of employment. Since the the inflation
workers’ real wage rate is nothing but the ratio of nominal wages to
measure can be
the consumer price index, the wage bargain is driven primarily by the
current and expected CPI inflation. No wonder then that, central quite crucial.
bankers in developed countries generally regard changes in CPI as a
much better indicator of inflationary pressure and potential than that in
other price indices.

95 Along with changes in their nominal incomes and wages. If the past

experience shows that money wages tend to lag far behind CPI-RL inflation, it may
by itself be a good indicator for prompt policy initiatives.
96 i.e., the rate at which the ex ante supply of labour would equal the

current level (with no divergence between the actual and expected rate of inflation).
97 Of a continuing nature, which the mainstream theory is primarily

concerned with. 121

 I C R A B U L L E T I N What about the Federal Reserve authorities’ preferred indica-
tor, viz., the core inflation? The rationale of the preference seems to be
Money that, when short term price changes of some products are due to
& temporary factors or random shocks, rational workers would consider
Finance the current ups and down in these prices as transient and disregard
them while negotiating for wage revision.98 Again, in the USA changes
SEPTEMBER.2007
in food and oil prices do not themselves indicate the state of overall
excess demand in the economy. Hence their inclusion in CPI is likely to
distort the signal regarding whether to initiate an expansionary or dear
money policy.
There is some substance in the above line of reasoning. But
The prices entering
variations in the so called volatile prices may not always be random or
WPI are wholesale, transient. When oil price increases are due to a step-up in growth of
emerging market economies or increasing cost of recovery with the
not what consumers depletion of oil reserves, workers are unlikely to view petroleum price
inflation as purely temporary. Similarly for food prices when their
pay. A large number increase is due not so much to climatic conditions, but more to global
demand-supply imbalances magnified by increasing use of corn or other
of items in WPI, agricultural goods for production of bio-fuel. This also implies that,
even if the domestic production of food and oil accounts for a minor
e.g., intermediate part of GDP, an increase in their prices can reduce the NAIRU output
and create overall demand pressure if the monetary policy remains
inputs and capital neutral. Thus complete exclusion of the so-called volatile items from
the “core” index may not be justified. What is required perhaps is to
goods, do not enter
include in the core rate not the y-o-y but the average inflation rates of
any of the CPIs; nor these prices over 3 to 6 months. More generally, the mainstream theory
of inflation suggests the need for an econometric exercise in order to
do services, which identify the price index that explains best the workers’ demand for
money wage changes.
currently account for The raison d’etre of the inflation measures used by central
banks of mature market economies is thus clear enough; but it is not so
around 55 per cent easy to discern the analytical basis of the Reserve Bank’s chosen
measure, the WPI inflation. The prices entering WPI are wholesale, not
of the country’s what consumers pay. A large number of items in WPI, e.g., intermedi-
ate inputs and capital goods,99 do not enter any of the CPIs; nor do
GDP, find any place
services, which currently account for around 55 per cent of the coun-
in WPI. try’s GDP, find any place in WPI. Given these characteristics, WPI
inflation can hardly be regarded as a good indicator of the overall
excess demand condition or of the potential for a wage-price inflation-
ary spiral. There are probably two reasons behind the use of the WPI
inflation as a guide to monetary policy initiative. First, the information
lag for WPI is one week, but that for CPIs is one month. Second, the

98Which is generally for a year or so.

99 In fact the combined weight of these goods (entering WPI but not CPI)
122 is overwhelming.
problem of combining the four CPI inflation rates into a single indica- I C R A B U L L E T I N

tor is by no means simple.100

None of the above reasons is quite compelling. The repo/
Money
reverse repo rates are not revised every week. Even if prompt action on &
the basis of a sharp change in WPI may be required at some point of Finance
time, the Reserve Bank, as the 2004-05 experience suggests, does not
SEPTEMBER.2007
revise its policies when information relating to CPIs reveals consider-
able divergence between the wholesale and the consumer price inflation
rates. Combining the CPIs into a single measure is no doubt tricky, but
that does not justify the use of a palpably inappropriate indicator. It
cannot be overemphasised that when there is an excess demand in the
It cannot be
labour market, the rational workers’ decision concerning wage claims
would be governed by the expected price increases of items entering overemphasised that
their consumption baskets, not by the expected WPI inflation.
The expected CPI inflation can also have a significant impact when there is an
on aggregate demand and hence on the overall price pressure through
changes in household consumption. Given the nominal interest rate, an excess demand in
expected increase in CPI inflation causes a substitution of current for
future consumption, remembering that it is the expected CPI, not WPI, the labour market,
inflation that is relevant for the real rate of interest governing decisions
relating to consumption and saving. the rational workers’
The other group of economic agents whose decisions affect the
inflationary process consists of producers and investors. While entering
decision concerning
into wage bargains, producers will be governed neither by the WPI, nor
wage claims would
by the CPI inflation, but by expectations relating to prices of their
products: the higher the expected producer price inflation, the larger the be governed by the
wage increases the employers will be willing to concede. Similarly,
given the nominal rate of interest, investment demand will be positively expected price
related to the expected producer price inflation.
Our analysis suggests that not only is WPI inflation a poor increases of items
indicator of overall excess demand conditions, but its expectations by
themselves also do not drive the behaviour of economic agents. But can entering their
we suggest anything better? As we have already argued, in the unor-
ganised sector, especially in rural areas, real wages cannot stay for consumption
long below the efficiency wage. The relevant price index affecting the
baskets, not by the
efficiency wage is the CPI-RW, remembering that the lion’s share of
expenditure of most labourers in the urban unorganised sector is also expected WPI
on food and fuel. However, tackling the CPI-RW inflation, as already
noted, requires supply management, not restrictive monetary measures. inflation.
It is important to recognise in this connection that, given the state of the
labour market and shortage of capital and infrastructural bottlenecks, a
wage-price spiral led by a rise in CPI inflation has been conspicuous by
its absence in the Indian economy. Wage increases are generally

100 The Reserve Bank’s recent initiative toward construction of a harmo-

nised consumer price index may offer some solution to the problem. 123
 I C R A B U L L E T I N sectoral and governed by an increase in demand for some categories of
skilled workers. In fact, in most cases rising demand for goods leads to
Money profit rather than wage inflation. Or more accurately, it is profit
& inflation which drives wage inflation. Under these conditions, a pro-
Finance ducer price index, encompassing both goods and services, would be a
more reliable indicator for monetary policy action.*
SEPTEMBER.2007

VI. Summary and Conclusion

For an examination of the analytical and policy issues related
to inflation in India we have taken as our point of departure the official
explanation of the price pressure and the anti-inflationary policies
It is extremely
adopted during two recent inflationary episodes, in 2004-05 and 2006-
important to make a 07. Though macroeconomic factors affecting aggregate demand are not
ignored altogether, the thrust of the official analysis is on the sources of
distinction between inflation in individual markets. Accordingly, sector specific measures
constitute a major plank of government policies for dealing with the
price increases inflationary pressure. The most important of these measures are (a)
setting domestic prices of petroleum, fertiliser and coal below their
which reflect a international levels; (b) reduction in excise-cum-customs duties on
cement, metals and metal products and (c) permitting imports at
movement towards reduced tariffs of foodgrains and edible oils along with open market
sale of wheat and rice by the Food Corporation of India. So far as
a new equilibrium macroeconomic measures are concerned, the entire responsibility, in
line with the ruling orthodoxy, seems to vest with the monetary, not the
following a one-off
fiscal authorities. In discharging its responsibility the Reserve Bank has
shock and proved extremely hawkish: irrespective of the sources of inflation or the
extent of overall demand pressure, the Bank promptly takes recourse to
continuing inflation monetary tightening whenever the WPI inflation moves above some
range.
due to some The official analysis of and the measures adopted during the
two inflationary episodes raise a number of important theoretical and
fundamental and policy related issues that do not seem to be adequately addressed by
analysts of the Indian macroeconomy. The main results of our examina-
enduring tion of the issues may be summarised as follows.
macroeconomic 1. It is extremely important to make a distinction between price
increases which reflect a movement towards a new equilibrium
imbalance. following a one-off shock and continuing inflation due to some
fundamental and enduring macroeconomic imbalance. It is
only the latter that calls for contractionary policies, monetary
or fiscal.
2. Analysis of inflation in terms of demand and supply side
factors operating in individual markets can be quite misleading

* For the goods entering into it WPI can serve as a producer price index;

but since the larger part of production is left out in estimating WPI, it fails to
124 provide a good measure of the aggregate demand pressure.
 and runs contrary to one of the most fundamental tenets of I C R A B U L L E T I N

economics: for analysing the behaviour of inflation or GDP we

need to use a macro general equilibrium framework where
Money
interactions among different markets (including the financial &
markets) are explicitly taken into account. Finance
3. When an increase in the general price level is due to oil or
SEPTEMBER.2007
other sector specific shocks, measures like price control or
excise-cum-customs duty cuts for rolling back prices in those
sectors are generally inefficient and may even be seriously
counter-productive. This is especially so in the case of interme-
diate inputs like petroleum, coal, fertiliser, cement or metals.
When the economy
The reason is that by misaligning the domestic from the
international price ratios, the policies impair allocative operates with some
efficiency in the use of domestic resources and distort the
pattern of exports and imports. The resulting fall in the coun- slack, oil price
try’s potential output adds to rather than reduces the inflation-
ary pressure when there is an overall excess demand situation subsidy or cuts in
in the economy.101 The longer term counter-productive effect
will tend to be greater, remembering that the substitution excise and customs
possibilities between inputs as well as between final uses of
goods tend to be much larger in the long than in the short run. duties on a few
4. When the economy operates with some slack, oil price subsidy
or cuts in excise and customs duties on a few widely used
widely used
intermediate inputs can no doubt be of help in preventing an
intermediate inputs
increase in the general price level and a fall in GDP. But this
does not make the policies appropriate. While judging the can no doubt be of
suitability of a sectoral or microeconomic measure, one should
always consider a full employment economy where all the help in preventing
resources have positive opportunity costs; otherwise one often
ends up advocating wasteful policies like digging-holes-and- an increase in the
filling-them-up or overstaffing government departments. To be
more specific, consider the policy needed to contain price general price level
increases due to an oil price shock when the economy is
burdened with considerable excess capacity. An across-the- and a fall in GDP.
board proportional duty cut on all goods and services will
But this does not
constitute a vastly superior alternative to an oil subsidy with its
cost shared between the government and oil companies. make the policies
5. Sectoral intervention for purposes of tackling inflation is
justified only in the case of food and other essential items in the appropriate.
poor man’s consumption basket. Keeping food prices low is
often the only effective means of reducing the incidence of
large scale hunger and malnutrition in the wake of a harvest
failure. Since demand for food is for consumption and rela-

101 With the actual output exceeding the NAIRU level. 125
 I C R A B U L L E T I N
Money
& recognise, in view of the strong consumption-productivity
Finance
SEPTEMBER.2007
The widely accepted
argument that
unless nipped in the
bud any short-term
price increase can
induce inflation
expectations and
hence trigger off a
cumulative increase
in prices, does not
stand up to close
scrutiny.
126 ment in the economy.
tively price inelastic, the distortionary costs of food subsidy
would be minor compared with that of subsidy on petroleum or
other intermediate products. What is much more important to
nexus at low levels of income, output and employment in the
unorganised sector, which accounts for the lion’s share of the
country’s labour absorption, are crucially dependent on food
supply, or rather, the ratio of food to other prices.102 Indeed,
sans an effective (supply-side) intervention in the food market,
macroeconomic measures would be of little avail: while
expansionary policies would strengthen a price-wage inflation-
ary spiral, a monetary or fiscal squeeze can stabilise the price
level only at the expense of large scale unemployment, GDP
loss and a sharp rise in the incidence of poverty.
6. When an oil or some other sectoral shock raises WPI, but the
actual GDP is below its potential, monetary tightening is
suboptimal. Apart from the fact that the policy worsens the
problem of unemployment and excess capacity, it needs to be
recognised that such inflation is transitory and peters off as
WPI approaches its new equilibrium level. The widely accepted
argument that unless nipped in the bud any short-term price
increase can induce inflation expectations and hence trigger off
a cumulative increase in prices, does not stand up to close
scrutiny. The argument presumes that economic agents are not
rational; do not learn from experience; or have little notion of
how the macroeconomy works. Indeed, if agents know that at
the first sign of a rise in WPI, whatever be its source,
contractionary measures will be put in place, there will be a
fall of expected average capacity utilisation and hence a
decline in investment and GDP growth.
7. In consonance with the ruling orthodoxy, anti-inflationary
measures (of a macroeconomic nature) are undertaken only by
the central bank, not the fiscal authorities. To its credit, the
Reserve Bank, unlike the central banks in developed countries,
uses, in the context of the vastly different financial set-up in the
Indian economy, not only the repo and the reverse repo rates,
but also CRR and open market sales of government securities
including MSS bonds. Even so, three major factors seem to
stand in the way of efficient conduct of monetary policy for
promoting non-inflationary growth.
First, given the absence of a well developed private
bond market and limited exposure of banks, by far the largest
102 The lower the ratio, the larger will tend to be production and employ-
 provider of finance, to the stock market and long-term funding, I C R A B U L L E T I N

monetary measures often fail to have the desired impact on

fixed capital investment, considered the driver of trade cycles.
Money
Similar is the consequence of underdevelopment of the mort- &
gage market and absence of loan facilities against houses. Finance
Second, despite the still professed objective of ensuring credit
SEPTEMBER.2007
for productive purposes even while there is a monetary
squeeze, under the liberalised environment the Reserve Bank
can do little to induce banks to provide loans for working
capital to producers in the unorganised sector and mitigate the
adverse supply side impact of the squeeze. Third, with increas-
ing liberalisation of foreign capital flows, especially of FII and
external commercial borrowing, not only has the RBI’s task of
controlling money and credit become extremely difficult, but
sans proactive fiscal measures, there is also little scope of
absorption of capital inflows into infrastructural investment
and keeping in check both (unintended) monetary expansion
and the quasi-fiscal costs of large accretion to foreign currency
reserves.
8. When there is considerable divergence among different infla-
tion measures, the WPI inflation, the RBI’s preferred indicator
for policy initiative, is of not much relevance. While for
sectoral intervention, especially in the food market, the rel-
evant measures are CPI-RL and CPI-IW inflation rates, for
macroeconomic policy purposes the appropriate index seems to
be that of producer prices encompassing both the goods and the
services sectors. Unfortunately, lack of demand on the part of
policy makers has prevented CSO from constructing such an
index.

127
I C R A B U L L E T I N Appendix I: Oil Prices and Inflation
1. Oil Price Passthrough: Input-Output Approach
Money The usual approach (including that of the Reserve Bank) to
& analysing inflation due to an oil shock is to examine, in terms of an
Finance input-output framework, how costs and prices of various products will
be affected by a given increase in crude oil prices. To be more specific,
SEPTEMBER.2007
let the input-output matrix be denoted by
[aij]=A
where aij = the amount of the ith sector’s product (directly) required (as
input) for producing one unit of j. The jth column of A thus gives the
intermediate input requirements from various industries per unit of j.
Assume further that apart from aij’s, production of a unit of j also
requires lj unit of labour and oj unit of oil.103
Given the input-output matrix A, the first step is to construct
the matrix

[α ] = [I − A]
ij
−1
(1)

Where α ij = the amount of ith sector’s output required directly

or indirectly as input for meeting one unit of final demand for the jth
output.104
Under cost-plus or mark-up pricing, Pj, the (nominal) price of j,
is given by

 n n

Pj = ∑ l i α ij w + ∑ oi α ij Po  (1 + λ j ) (2)
 i =1 i =1 
where w = the money wage rate;105 Po= Price of oil; and λ j is the
mark-up rate in the jth sector. Note that the first and the second terms
within the third brackets denote the direct-cum-indirect cost of labour
and oil respectively for producing a unit of j.
The effect of an increase in oil prices on Pj is immediate from (2):
n

α Pj ∑o α i ij Po
dPo dP
= n
i =1
n
⋅ = β oj ⋅ o (3)
∑l α w + ∑ oi α ij Po
Pj Po Po
i ij
i =1 i =1

103 Note that though domestic production of oil involves the use of

intermediate inputs from other industries, the fact that oil is required to be imported
on a large scale implies that domestic output of this sector, unlike that of others is
capacity constrained. Hence oil needs to be treated as a basic input for producing j
and its price taken as a parameter. This price may be fixed by the government and
may or may not equal the international price; but for validity of the input-output
analysis producers should not face any quantity constraint in meeting their demand
for oil or oil products.
104 The final demand consists of consumption, investment and export.

128
105 Assumed for simplicity to be uniform in all sectors.
where β oj = share of (direct-cum-indirect) oil in the (variable) cost I C R A B U L L E T I N

of j.
This confirms the intuitive conclusion that the percentage
Money
change in Pj due to an oil price shock will be proportional to the &
(direct-cum-indirect) oil intensity of j, given by β oj . Finance
The proportional change in the general price level, P, is then
SEPTEMBER.2007
easily obtained from (3):

dP n dPj n
dP
= ∑γ j = ∑ γ j β oj o (4)
P j =1 Pj i =1 Po
where γ j is the weight of Pj in the index of the general price level, P.
The relation (4) suggests that the higher the ratio of (direct-cum-
indirect) oil cost to wage cost of goods and services produced in the
economy and the larger the weights in P of prices of products that are
more oil intensive, the greater will be the proportional increase in the
general price level due to a rise in oil prices.

Equilibrium, Speed of Adjustment and Inflation

The perceptive reader must have realised that the value of
( )
dP , as given by (4), is not inflation (which necessarily has a time
P
dimension), but the proportional increase in P in equilibrium when all
prices have been fully adjusted to the oil price shock. The rate of
inflation as the economy moves from the initial to the new equilibrium
P (say P*) is generally obtained by specifying an adjustment function
like the following:

 1 dP(t )   P * − P (t ) 
Π (t )≡ ⋅  = φ   φ φ > 0 (5)
 P (t ) dt   P (t ) 
where φ is the rate at which the shortfall of actual price from its
equilibrium level is made up per unit of time.
The solution of (5) is standard and given by:

[ ]]
P(t ) = P * − P * − P(O ) ee −φt (6)

where P(O) is the initial price level.

The nature of inflation due to an oil price shock, as given by
(6), may be indicated in terms of a simple diagram (Fig. 1). Let P(O)
and P* be the pre- and the post-oil price shock equilibrium levels of
P respectively. AA1 and AA2 indicate the time paths of P following the
shock for two values of φ , AA1 for the smaller and AA2 the larger
value. The corresponding inflation rates over time are given by BB1
and BB2 respectively. Thus when φ is larger, the transition from P(O)
to P* occurs at a faster pace: the inflation rate is higher in the initial
phase, but declines more rapidly. But irrespective of the value of φ ,

129
I C R A B U L L E T I N there is no persistence of inflation in the long run.106 Indeed, if the
adjustment is instantaneous,107 P jumps from P(O) to P* as soon an oil
Money prices go up, but (as AA3 and BB3, show) there is no inflation!
&
Finance FIGURE 1a

SEPTEMBER.2007
In P

In P* AA3
AA2

AA1

In P(o)

Time

FIGURE 1b

Inflation

BB2

BB2

BB3
O
Time

106 In view of the fact that the price adjustment process (5) takes the form
of a first order differential equation, P approaches P* asymptotically. The economi-
cally sensible approach is to ignore the part of AA when the gap between P* and P
has become small enough, say 10 per cent of P* when inflation has practically
vanished.
130 107 Implying that φ =
∞.
 An implication of the above analysis is that under the new I C R A B U L L E T I N

equilibrium, there will be a fall in the real wage rate, and its propor-
tional fall exactly equals (in numerical terms) the proportional increase
Money
in P, as given by (4). Since money wages are likely to respond to &
changes in P as also the levels of output and employment, it is neces- Finance
sary to consider both the demand and the supply side effects of a rise in
SEPTEMBER.2007
oil prices. Let us examine these effects in terms of the widely used
aggregate demand-aggregate supply (AD-AS) framework suitably
modified for an open economy, characterised by Keynesian unemploy-
ment.

AD-AS Model for an Open Economy

Assuming that the central bank keeps the exchange rate fixed
and that the net capital inflow into the economy is autonomous, 108 the
AD-AS model may be specified as follows:
P2
P = P(Y , EPo ) P1 > 0, 1 > >0 (7)
EPo

 E 
Y = D[Y , r (Y , P ); M ] + NX Y , ⋅ Pn , ⋅ Po 
E
(8)
 P + P 

where Y = output; E = nominal exchange rate; D = aggregate demand

other than net exports (NX); r = interest rate; M = supply of money;
and Pn = foreign price of non-oil imports.
Relations (7) and (8) represent aggregate supply and aggregate
demand respectively, with r written as a function of Y and P from the
standard money market balance relation. The only features of (7) and
(8) that differentiate them from their textbook counterparts consist in
inclusion of EPo as an argument in AS and use of two price ratios in the
EP EPo
net export function ( n and ). The reason for inclusion of EPo is
P P
obvious: it enters the variable cost of production and hence affects
domestic prices109 at any given level of Y. The reason behind differen-
EPn EPo
tiation between two real exchange rates, and , is that the
P P
former has a positive, but the latter a negative effect on net exports.

108 i.e., not dependent on output, interest rate or price level in the domestic

economy. This may be due to control or capital account transactions. In case the
currency is fully capital account convertible and there is large scale capital inflow,
the central bank can still keep both money supply and the exchange rate fixed
through sterilisation of the inflow; but the bank loses control over either the money
supply or the exchange rate when there is a torrent of capital inflow.
109 As specified in (7), a rise in EP causes a less than proportionate

increase in P.
o
131
I C R A B U L L E T I N In Fig. 2 AS and AD represent aggregate supply and aggregate
demand respectively, for given value of E and Po. Since an increase in
Money P apart from raising interest rates also effects a real exchange rate
& appreciation,110 AD would tend to be flatter in an open than in a closed
Finance economy. This has an important implication for the impact of an oil
shock on Y and P: since the shock raises AS upward, the fall in Y will
SEPTEMBER.2007
be larger and the price increase smaller, the flatter the aggregate
demand curve. Again, given E. since an oil price increase reduces
aggregate demand through both the interest rate and the real exchange
rate effect, AD will shift to the left, with the magnitude of the shift
being positively related to the responsiveness of trade deficit to a rise in
Po and the value of the foreign trade multiplier. The net effect of an oil
price shock on Y, as shown in Fig. 2, is unambiguously negative; but a
theoretical curiosum, viz., a fall in equilibrium P following an oil price
shock, cannot be ruled out when the leftward shift of AD is large or AS
is fairly steep.

FIGURE 2

AS1

AS 0

A1 A0
P1
P0

AD0
AD1

O Y
Y1 Y0

132 110 Though the nominal exchange rate is fixed.

 When the exchange rate is fully flexible, E becomes a variable I C R A B U L L E T I N

in the system. We may then use (7) and (8) to represent Y as a function
of E. Remembering that an increase in E raises P less than proportion-
Money
ately, Y will tend to be positively impacted by E because of the effect &
operating through net exports. However, the increase in P and the Finance
associated hardening of interest rate tend to have an opposite effect on
SEPTEMBER.2007
aggregate demand. Hence the relation between Y and E, as shown by
YY in Fig. 3, may be positively or negatively sloped, though an upward
rising YY is more plausible since the effect operating through a depre-
ciation of the real exchange rate is likely to be dominant, especially
when the country’s trade-GDP ratio is fairly large.
For examining the nature of equilibrium in the foreign currency
market, we assume (a) the current account flows to be more dominant;
and (b) the net capital inflows to be relatively autonomous.111 The
balance relation determining the exchange rate (E) may then be
specified as follows:
 EP EP 
E
NX Y , n , o  + F = 0 (9)
 P P  P
 (+) (−) 

where F = net inflow of foreign capital.112

EE in Fig. 3 shows the relation between E and Y and is posi-
tively sloped. To see why, note that an increase in Y reduces both the
first and the second term of the l.h.s. of (9) so that there is an excess
demand for foreign currency. Again an increase in E such that E/P
remains unchanged does not fully eliminate the excess demand: the
direct effect of the increase in Y on the trade deficit is still there when
the real exchange rate has been restored to its initial level. Hence not
only is EE upward rising, but a North-East movement along EE also
signifies a real exchange rate depreciation (or rise in E/P).
Oil price hike, as may be verified from (7) to (9), shifts YY
leftward and EE upward. Hence arises some ambiguity relating to the
effects on output and the price level. Thus when YY is downward
sloping the effect on output is negative. But there is a possibility of an
increase in the equilibrium level of Y when YY is positively sloped.113
In the absence of any central bank intervention in the foreign currency
market, the most likely outcome is however that, output tends to fall
along with a depreciation of the nominal as well as the real exchange
rate.

111 Either because there are restrictions on capital movements or since

external factors are much more important than domestic economic conditions in
governing the flows.
112 Measured in terms of foreign currency.
113 When YY is upward rising, its slope needs to be steeper than that of EE

for stability of equilibrium. 133

I C R A B U L L E T I N FIGURE 3a
Money
& E

Finance YY1 YY0

SEPTEMBER.2007
EE1

EE0

A1

A0

O Y

FIGURE 3b

EE1
EE0

A0

A1

YY0

YY1

O
Y

134
 Oil Price Shock in a Full Employment Economy I C R A B U L L E T I N

Let the real exchange rate e, be defined as the ratio of the price
of non-oil imports (in terms of domestic currency) to P. With labour and
Money
oil as the variable inputs, the full employment equilibrium with given &
values of e and Po is characterised by the following set of relations: Finance
Y = F ( N , O; K ) (10) SEPTEMBER.2007

∂F W
= (≡ w d ) (11)
∂N P

wd
N = N (w d , ) (12)
+ e
+

∂F
= ePo (13)
∂O
where Y = aggregate output;114 N = employment; K = capital stock; W
= money wage rate; wd = real wage rate in terms of domestic output;
and wd/e = real wage rate in terms of foreign goods.
Equation (10) represents a neo-classical production function;
(11) along with (10) yields labour demand as a (declining) function of
wd (given O); (12) shows labour supply as a function of both wd and e
(since imported goods also enter the workers’ consumption basket); and
(13) in combination with (10) gives the demand for oil as a function of
ePo (given N).
For any given the international price of oil, Po, relations (10) to
(13) yield Y (along with N, O and wd) as a function of e, as shown by
Y*Y* in Fig. 4. The reason for YY being downward sloping is that other
things remaining the same, an increase in e reduces the supply of
labour and the profit-maximising level of O, as per (12) and (13)
respectively.
For closing the model we also need to specify the other blade of
the pair of scissors, viz., the balance of payments equilibrium condi-
tion, (9a):

NX ( Y , e , Po ) + e F = 0 (9a)
( −) (+ ) ( −)

where F , as before, is the net inflow of foreign capital. Since an

increase in Y requires a real exchange rate depreciation (or a rise in e)
to offset the fall in NX, ee, the balance of payments equilibrium
relation between e and Y will be upward rising, as shown by ee in
Fig. 4.

114 Since output here is gross of oil used, Y in this model exceeds GDP

which equals Y less O times eP. 135

I C R A B U L L E T I N FIGURE 4

Money e
&
Finance ee1
SEPTEMBER.2007
eeo

Ao
A1

Y *Yo*
* *
Y Y
1 1

o Y
Yo*

An increase in Po shifts Y*Y* leftward and ee upward so that

the effect of the oil shock on full employment income is unambiguously
negative. However, depending upon the relative shift of the two sched-
ules, the real exchange rate may move either way: there is an apprecia-
tion or depreciation of the real exchange rate according as the shift in
Y*Y* is larger or smaller than that in ee. The lower the elasticity of
substitution between labour and oil, the larger will be the leftward shift
in Y*Y*. The shift will be less pronounced if the supply of labour is
more sensitive to changes in real wages, though this is not very likely
in low income economies. So far as ee is concerned, while high oil
intensity of GDP causes the upward shift to be relatively large, positive
net capital inflows tend to moderate it: given the rise in trade deficit
due to an oil price shock and responsiveness of the current account
balance to changes in the real exchange rate, the real depreciation
required for preserving the balance of payments equilibrium at a given
Y, as be verified from (9), will be smaller, the larger the value of F .
Thus while an oil price shock causes a fall in the country’s income,115 it
is possible for the real exchange rate to appreciate, if capital inflows
are large enough and the relatively inelastic supply of labour moder-
ates the westward displacement of Y*Y*.

136 115 Measured in terms of domestic goods.

 Note I C R A B U L L E T I N

We have assumed throughout that the oil shock is not accom-

panied with any other charge in the country’s balance of payments. In
Money
fact, oil bonanza in the Middle East has generally tended to raise NRI &
remittance and opened up large export markets, especially for construc- Finance
tion and other projects, for Indian companies. This under the AD-AS
SEPTEMBER.2007
model would raise Y and can offset or even reversed (through exchange
rate appreciation) the cost-push effect of the shock. The effect operating
through appreciation of the exchange rate not only consists of a favour-
able movement of the terms of trade, but may also outweigh the
negative impact of oil price increases on the country’s full employment
GDP.

2. WPI Inflation and Its Composition 1995-2007

TABLE 1
Major Group’s WPI Inflation (year-on-year)
(per cent)

Year All Commodities Primary Fuel Group Manufactured

Articles Products

1995-96 4.4 3.1 5.1 4.7

1996-97 5.4 9.2 13.3 2.4
1997-98 4.5 4.6 13.7 2.3
1998-99 5.3 7.6 3.2 4.9
1999-00 6.5 4.0 26.7 2.4
2000-01 4.9 -0.4 15.0 3.8
2001-02 1.6 3.9 3.9 0.0
2002-03 6.5 6.1 10.8 5.1
2003-04 4.6 1.6 2.5 6.7
2004-05 5.1 1.3 10.5 4.6
2005-06 4.1 5.4 8.9 1.7
2006-07 5.7 10.7 1.0 5.8
Source: RBI (2007), Macroeconomic and Monetary Developments in 2006-07,
Mumbai

137
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