Economic Environment and Policy

Individual Essay

Ravi Teja P R,

M.Mgmt, Class of 2010,

A-Section, Roll: 08927883

Article
http://www.livemint.com/2008/11/13235932/Inflation-worries-recede.html?d=1
Nov 13 2008

Highlights from the Article

1. Price pressures are easing across Asia.

2. The rich economies are going through a period of recession.

3. Demand is falling at a very rapid pace in Asian countries.

4. The sharp drop in Indian inflation is also an advance warning of a sharp drop in local demand and
overall economic growth.

5. Industrial production growth in the first six months of this financial year is almost half of what it
was in the previous year.

6. The focus till now has been on interest rate cuts, though we still fear that a country such as India,
that has a large current account deficit, puts its currency at risk in the process.

7. Making money cheaper is unlikely to spur either investment or consumption though, given the
fear over the city.

8. The emerging global consensus is that governments will have to borrow and spend to support
effective demand.

9. India could have gone down this path, but for the fact that public debt and deficits are already too
high for comfort.
 Topics covered in this write up

1. Why sharp drop in inflation indicates a sharp drop in local demand and economic growth?

2. What is the relation between the interest rates of RBI and Inflation?

3. How to make money cheaper? How it influences the consumption and investments in India?

4. Why to borrow money and support demand? Why India is not doing so?
Why sharp drop in inflation indicates a sharp drop in local demand
and economic growth?

Inflation is a rise in the general level of prices of goods and services in an economy over a period of
time. This inflation can be caused by two reasons

1. By an excessive growth of the money supply.

2. By an excessive gap in between the demand and Supply of the goods.

Low inflation is important for ensuring stable and continuous growth. By having inflation we are
ensuring that there exists a small relative gap in the demand and supply of goods. A sharp decline in the
inflation indicates a sharp change in the demand and supply equation of the economy. We always should
ensure that the demand is always ahead of supply. The reasons why we need high demand are

1. With high demand only, the firms/producers /manufacturers in a country can have the
confidence of getting profits. When the demand of a nation is low, this confidence of the
producer turns into a dilemma and he starts thinking about whether he can getting profits or
not, or whether he can sell all his produced stock or not, will there be any person who will
buy this good or not, etc. So this results in lowering of overall production in a country.

2. All the households in a country will get the income from the factor market. The firms are the
ones who provide the income for the factor market. So if they reduce their production levels,
they are going to lower their payments to the factor market. Thus the households will get less
income from their work. In some cases there may even be some job cuts because the firms
want to cut down on production. So Unemployment increases because of lower inflation.

3. The income of the households is decreasing now. So there will be a substantial decrease in
the amount of money they consume from the economy and thus the demand for the entire
economy goes down. This will also cause a decline on the amount of taxes we pay for the
government. So there will be a decrease in developmental activities by the government.

4. The lower demand for goods will signal the producer that the goods he produces are
consumed by very less people. So he again reduces the production.
 5. Step 1 Continues and this will be a cyclic process.

So a sharp drop in inflation indicates a sharp drop in local demand and economic growth.

What is the relation between the interest rates of RBI and Inflation?

Inflation rates can be controlled by controlling the rate of growth of the money supply. In case of
India, there was a rapid increase in inflation in the months of august and September this year (2008). This
happened because of increase in the money supply in the economy. So there was very less demand for
Rupee. So the value of rupee also lost its value to Dollar and reached the level of Rs. 47/1 $. So RBI had
to take the decision to reduce this rapid fall in the value of money.
Because fall in the value of rupee will decrease the overall value of the economy in the global
arena (because we will be having very less Dollar GDP). As there is increase in the prices of all the
goods, the standards of living of the people in the country is also affected.
So RBI decided to raise all the interest rates by about 1-2%, So that it can suck all the additional
rupees in the system. So the banks had to pay more interest rate for RBI for the money took (Repo Rate).
Also they have to deposit more money in RBI (SLR), by buying its bonds and govt. securities, etc. As a
result, the lending rates of the bank to the households/firms also increased. So they took less money from
the bank as loans. As a result they spent less and thus the demand of the goods got reduced. So
tightening/increasing the interest rates will reduce the money supply in the economy and thus
decreases the inflation.
Then the effects of this rate cuts started showing the effect after a month, when the inflation was
getting reduced at 0.3% every week. At the same time in the early months of October, there was a huge
FII outflow that was happening from the Stock Market. All the money they invested in India was taken
away from them. As a result there was a scarcity of money in the entire system. The banks we running out
of money. There was a huge credit crunch in the economy. The inflation was touching 11 % at that time.
So RBI had to a decision to make, to cut the interest rate or not. First, if it cuts the interest rate, it will
increase the money supply for the economy. This will save the stock markets from crashing but will
aggregate the demand. Secondly, if we keep the interest rate the same, it will make the stock market fall
because it will be out of money. So after a lot of discussions RBI cut the interest rates. As a result there
was an additional flow of about 80,000 crores into the system. So there was money for the investors to
invest and households to spend. So this gave the money even to the manufacturers to produce more goods
to meet growing demand and thus in turn reduced the inflation. So this act of RBI was advantageous in
both the ways. This week inflation came out as 8.98%. So we can expect a rate cut by RBI this week.
 But in the present article the author feels that this sudden decrease in the inflation is not a positive
indication. He believes that this decrease is because of decrease in demand of goods for consumers rather
than increase in Supply of goods by producers. As discussed earlier, this is not good for any economy.

How to make money cheaper? How it influences the consumption

and investments in India?

The term “Making money cheaper” indicates that we should lessen the value of rupee in terms of
Dollars. This can be done by having excess supply of rupees in the economy by the RBI. This can be
done by decreasing the lending rates of all the banks (Repo rate) or by decreasing the percentage of
money that is required by the banks to purchase bonds (SLR) or both in some cases. This will infuse more
currency into the market.
This will allow household to get money from the banks at a less interest. So he takes the money,
spends it (Consumption). Decrease in interest rate will also encourage the firms/producers to get loans at
a cheaper rate. So they will also take the loan and then invest it in new ventures and to increase the
productivity of their manufacturing units. This will in return create some employment also.
But it has some disadvantages also. This will create the value of money to decrease and by
applying the PPP algorithm, it is clear that the overall value of economy is not increased considerably.
India if it were a closed economy, the decrease in interest rates would have caused a lot of economic
development, but would have decreased the value of economy in the world arena. But India being a open
economy, if it decreases the interest rates, a lot of arbitration happens and this results in the increase in the
value of goods and services in the economy which causes inflation. This inflation will again cripple the
purchasing capacity of the consumers This is a cyclic process.
That’s the reason why the author says that making money cheaper is not a good option to
increase consumption and investments especially in open economies like India.
Why to borrow money and support demand? Why India is not doing so?

As already discussed, one of the ways to increase the money supply in the market is to have
changes in the interest rates by the Central Bank (RBI). Another way to increase the liquidity in the
market is to take the money from the people as a part of investments. The GDP of the Country can be
defined as
Y=C+I+G
So if we are having a decrease in consumption because of slow growth, we can always try to
increase the total investments. These investments can either be in the form equities or debt instruments.
Let us now suppose that the RBI wants to get money from the system and then supply it back to the banks
at some (repo) rate. It sells bonds to the people/institutions and then gets money as a return for their
bonds. Thus they increase the money in the system by supplying this to the banks. This money which the
govt. owes is called the Govt. Debt. This Debt fund can also be raised by borrowing the money from
other economies. But we should be clear that money supply can be done by govt. debt, but govt. debt is
not intended solely for this. This is done primarily for govt. spending and development.
Also the money which the govt. takes comes with some interest. Many of the bonds are at a rate
of 8.5 – 10.5%. So the interest must be paid to the foreign debts and the money that has to be paid to the
maturing bonds, everything comes under the govt. expenditure.
Fiscal Deficit of a country can be defined as the difference between the govt. Expenditure and
govt. revenues. So taking this kind of debts will increase the load on fiscal deficit of the country.
The fiscal deficit of India is 3.17% of total GDP. This is one of the highest in the world. Also the
external debt of India is about US$ 201 billion.
So the author believes that the idea of taking debt and supporting demand is not a good option as
India has already missed its fiscal deficit target of 2.5% due to global recession. ……

Conclusion:
This article was taken from “The Mint” dated 13th Nov 2008. In this article the author mainly emphasizes
on the fact that decrease in inflation number is not always a positive indicator.