Indian Inflation Problem and Simulation using IS-LM Model edharmesh

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Indian Inflation Problem and Simulation using IS-LM Model

Posted on August 8, 2011 by edharmesh

As one of the fastest growing economies in the world, the Indian economy plays an increasingly important role on the global economic landscape. After riding out the global financial crisis of 2008 with relative comfort, in the recent quarters , Indian economy has been plagued with an overheated economy and very high inflation. Demand is outpacing the country s ability to increase its output, resulting in a GDP that is far above trend level and putting great a strain on the countrys resources. India s economic policy throughout the recessions has not helped matters . As India lowered its interest rates , aggregate demand grew further and inflation climbed higher yet. Search Indian government and the Reserve Bank of India (RBI) can combat the forces at play by demonstrating fiscal prudence and monetary constraint. The government and the RBI have taken some key steps in recent months to constrain the excess liquidity and balance the national budget. Initial inflation and GDP numbers look promising. However, more remains to be done, and tough choices lie ahead for the government and the RBI.

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Indian Economy
According to the Economic Survey Report for 2009 -10, the economic growth decelerated to 6.7% in 2008 -09, from 9 % in 2007 -08. The economy is expected to grow by 8 .7 % in 2010- 11, with a return to a growth rate of 9% in 2011 -12. Only China, among big economies, has defeated India s growth rate in the past year. India, along with China and other emerging markets, helped fuel the global recovery of the last economic downturn, and as a result it experienced an above -trend growth rate. This economic growth is occurring at an unsustainable rate. Recent data suggests that economic growth in emerging markets has slowed down, but is far above developed nations. India, the world s largest democracy , accounts for more than 1 billion people, and the population count is likely to surpass that of China by 2030 . As this vast population is lifted out of poverty , and continues increasing its consumption every year , it is likely that higher inflation rates will be painful and sustained for a significant period of time . And that is troublesome news for the government of India. An increase in government spending, an increase in net foreign investment, and the RBI s policy to keep interest rates low are all factors that contributed to India s current situation. The government continuously increased its spending throughout 2009 and 2010 (partly because of the hosting of The Commonwealth Games in India). Foreign investment/hot money has also flooded into the country since 2006 . The relationship between the two may also be responsible for India s rise in inflation and overheating. With the majority of India s vast population living close to or below the poverty line, inflation acts as a Poor Man s Tax. This effect is amplified when food prices rise, since food represents more than half of the total expenditure of this group. The dramatic increase in inflation will have both economic and political implications for the government. The increasing price levels caused RBI to raise its interest rate several times in the last year, in an effort to reduce spending (see Graph2 ), but the approach is countering the efforts by the government to decrease its growing budget deficit, which, at 5.5% of current GDP, is still higher than trend levels. The government expects inflation to ease in the coming period, reviving foreign investment and robust public finances. But inflation is still a pressing problem. For example , in last December street protests over the price of onions led the government to ban its exports. Onion prices have since collapsed, but other main causes of inflation remain.

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IS-LM Simulations
The model assumes that India is a medium open economy, with the understanding that economies change over time. For example , just a few years ago, it may have been more accurate to examine the Indian economy as a small open economy. The inflation rate of India has fluctuated over recent years (from as low as 4 % to as high as 16%), with January 2011 s inflation rate equaling that of the mid 2009 s . The macro-economic model is based on demand-supply equations representing realistic phenomena observed in modern-day economies, such as, when prices rise, aggregate demand falls, because wages take time to adjust and population s purchasing ability falls. These simulations capture the effects of overheating and inflation on a medium open economy , such as India s. The cause of inflation is a combination of fiscal and monetary factors. Fiscal factors include:

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supply (supply shock). Supply of grains , vegetables and fruits in India is highly dependent on good or bad monsoon season. The monsoon season in 2010 has not been particularly good. At the same time , rise in oil prices globally pushed the prices of LPG (Liquefied Petroleum Gas, primarily used for cooking in India) , gasoline and diesel higher . In the simulations , cost- push is represented by an upward shift of the short- run aggregate supply (SAS) curve. The monetary factors include: Domestic money supply: Similar to other central banks around the world, to come out of the global recession that started in 2008 , the Reserve Bank of India (RBI) flooded the market with liquidity by reducing the interest rates to historic low levels, lowering the Cash Reserve Ratio, and buying government bonds in open market operations. This opportunistic step dampened the effect of the global recession on the Indian economy, thankfully . However, this liquidity fuelled several asset bubbles , and pushed prices higher . In the simulation, this is represented by higher AD, because Y=C+I+G+NX. Foreign investments and remittances: Foreign investments, though lower than previous years, were still large in 2010 , as foreign investors continue to see BRIC countries as source of growth, amid lackluster western economic growth. Furthermore , favorable exchange rates (cheaper Indian rupee , compared to previous years) fueled remittances to record highs . India has seen highest levels of remittances in recent years, just shy of remittances to China. All this foreign investments and remittances fuelled asset prices up. In the simulation, this is phenomenon is also represented by higher AD , because Y=C+I+G+NX.

Simulation #1: Effects of Inflation and Overheating in a Medium Open Economy

The model in figure 1 is explained with the below sequence of events. The sequence is not to be taken literally, as all the factors change simultaneously in reality.

Figure 1: Effects from Overheating and Inflation 1. The AD curve shifts right, resultant of demand-pull ( 0 ). The SAS curve shifts up , resultant of cost- push (supply shock) . Assuming that supply tries to keep pace with increasing demand in the short run, the output moves up the SAS curve. As result of both these shifts , the GDP moves to Y1 beyond the trend GDP (Y) in short run , and general price level increase from P1 to P2 . 2. In a small open economy, interest rates are dictated globally and do not adjust. However, in a medium open economy , the interest rates do adjust to a certain extent. The LM curve moves left because P. The IS curve shifts right because

0.

1. The investment curve does not change because consumption is up and prices are up.

0 (business confidence) has not changed. The savings fall because

2. In the money market, the demand for money goes up because GDP is up . At the same time , real money supply falls because prices have increased. These changes bring the interest rates in line with funds market. 3. Amid falling domestic savings, domestic investment levels are maintained by higher foreign funds inflow, leading to further

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According to our analysis , this is the current state of the Indian economy , in terms of business cycle. Note that government of India has been running large deficits and negative trade balances, partly to continue sponsor its social program. This economic overheating has lowered exports further, and increased dependence on foreign funds. The situation can take many different turns from there . For instance, in a worst case, if the confidence of foreign investors falls ( a la Greece in 2010 ), wide spread reduction in government programs has to follow, likely not without social unrest, and resultant negative effects. The recent global events are not helping either. The continuously rising oil prices are increasing the government burden (gasoline and diesel prices are government subsidized in India) . The social unrest in Middle East is driving down western investors confidence in Africa and Asia . In another possible worst case scenario, if inflation goes rampant, people set expectations of even higher inflation , increasing prices of the goods . In an expectations lead the reality manner, spiraling higher prices can push the economy into a hyperinflation. However, hyper- inflation would also need increasing supply of money, which would happen only if the RBI stumbles, and goes the opposite way from the one outlined in the next simulation, which seems highly unlikely looking at RBIs recent actions. However, in an optimistic case, the economy may ride out the inflationary storm, but not without even higher inflationary perils . Hypothetically, following sequence of events can take place in absence of Government or Central Bank intervention. 1. Now, at some point in future, the short-run increase in GDP obtained by over-employment of resources and foreign funds flow cannot keep pace with permanently higher aggregate demand, the GDP will fall back to the trend GDP (Y), with still higher price levels P 3. However, because of lower exports , as seen in event 9 below, the aggregate demand falls slightly, leading to slightly lower price increase than originally expected . 2. The LM curve moves further left, as prices are further increased. Now that GDP has returned to trend level, savings are further reduced , and hence IS curve shifts slightly left. In the funds market, as savings are further reduced because of higher prices . As investments remain constant, the difference between investments and savings are accounted by further reduction NFI. In the money market, real money supply falls further (as prices have risen) , while money demand falls to its original levels because GDP has returned to trend level, both adjusting at higher interest rates r3 . 3. As interest rates rise, NFI falls further. This had led to leaving investments at the same level and compensating for lower savings in the previous event. Fall in NFI reduces supply of domestic currency, raising the real exchange rates, in turn. Higher real exchange rates leads to further reduced NX . This fall in NX is accounted for by slight lower aggregate demand (AD 3) than at the height of overheating. Note that the overheating and inflation has left the economy in quite a vulnerable position. The foreign debt has risen, while exports and savings have fallen. At the same time, people at the lowest levels in the economy feel the pinch, because those are the people who needed to adjust their demand lower , because supply simply cannot keep up .

Simulation #2: Countering Overheating and Inflation with Monetary Constraint

As seen in previous simulation, at the end of event # 6, the economy is operating at a higher pace than the trend levels . The higher demand is being met by short-run increase in GDP by unsustainable over- employment of resources and partially by reduction in net exports . Left on its own, the economy will return to its trend levels, albeit possibly at the end of a long and winding road. However, the economists at the Central Bank are not sure how long this overheated situation will last , and are worried of many possible negative consequences ( as discussed in event #6 above ) of being in this state for too long. To bring the economy back to the trend levels sooner, the Central bank employs several tools in tandem : Increasing cash reserve ratio (CRR): CRR is the oldest tool in monetary policy. By increasing the CRR, the banks are required to hold a larger percentage of their total deposits at the coffers of the Central Bank. This leads to a reduction in supply of funds available for lending at all the banks. Over the years, the central banks in US and Canada have stopped using CRR as a tool. For instance , Bank of Canada has left CRR at 0% since many years, while the Fed rarely changes it. However, RBI uses CRR as one of its primary tools. RBI has already increased the CRR in past few months. Raising Target interest rates: As the Central Bank raises target interest rates for overnight lending; it leads to increase in all kinds of interest rates in the economy . Higher interest rates discourage investment, and increase propensity to save (over consumption) by the population . Open market operations: Here, the Central Bank increases the selling of short-term and long- term government bonds in the funds market. This pushes bond yields higher . As banks and financial institutions buy the bonds, the liquid money is reduced in the market. This simulation begins where event #6 ends in the previous simulation, and in the next step, the Central Bank responds with monetary constraints to counter the situation (figure 2 below).

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Figure 2: Overheating and Inflation Countered by Monetary Constraints 1. Reduction in money supply discourages investment. Higher target interest rates discourage consumption, resulting in reduction in AD. The GDP falls back to its trend level. Note that , as intended, AD falls much faster and much further , compared to event #7 in previous simulation. Furthermore, unlike the previous simulation, the prices stop rising further from P 2, because demand is now dampened faster and further. As seen from prices not rising again, spiraling inflation is effectively curbed, much to the relief of general population, economists, and investors . 2. In the funds market, higher interest rates (as dictated by the Central Bank) dampen the domestic investments. At the same time , funds available for investment are also reduced , because of higher CRR, and banks buying government bonds. Note that funds supply is much constrained (S3 shifting left much further) in this case, compared to previous. In the money market, real money supply is left reduced because flow of borrowed funds available for purchases is constrained by the Central Bank. At the same time, money demand is reduced back to original level, because GDP has lowered, back to the trend GDP. 1. This event is same as event # 9 in the previous simulation. As interest rates rise, NFI falls further. Fall in NFI reduces supply of domestic currency, raising the real exchange rates , in turn. Higher real exchange rates leads to further reduced NX . This fall in NX is accounted for by slight lower aggregate demand (AD 3) than at the height of overheating. As seen from this simulation, monetary intervention would stabilize the price levels, or if applied at a lesser extent, would decrease the rate at which prices are increasing (disinflation) . Although the simulation shows a fall in net exports , in India s case, exports remain stable in the near future, because of comparatively cheap labor and a reputation of preferred outsourcing destination for western economies.

Simulation #3: Countering Overheating and Inflation with Fiscal Prudence

As discussed in previous two simulations , overheating and unexpected inflation can derail the normal economic growth at the trend level. Hence, economists and policy makers advocate countering economic overheating and out-of- control inflation. The previous simulation addressed countering the overheating and inflation with monetary policy . In this simulation, observe how inflationary pressures can be countered by fiscal policy . As now evident from the previous two simulations , whatever steps the government takes, it should lead to reduction in aggregate demand or increase in aggregate supply. Reduction in government spending and policies targeted at reduction in consumption and investment would lead to reduction in AD . For tractability, I limit this simulation to a fall in government spending, leaving consumption and investments unaffected by the government policy . The next section discusses possible steps government take to reduce the AD by affecting consumption and investments. In this section, continuing on the theoretic note, I start the simulation where event # 6 ends in the first simulation ( figure 3 below) .

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Figure 3: Overheating and Inflation Countered by Fiscal Prudence 1. With reduction in government spending, the AD falls, and the GDP falls back to its trend level, because Y = C+I+G+NX. Note that, as intended , AD falls much faster and much further, compared to event # 7 in the first simulation. Furthermore , unlike the previous simulation, the prices stop rising further from P2, because demand is now dampened faster and further. As seen from prices not rising again, spiraling inflation is effectively curbed, much to the relief of general population, economists, and investors . 2. In the funds market, increasing supply from government savings is available for investment, represented by right shift of savings curve. The interest rates adjust lower to the new equilibrium. In the money market, real money supply is left unchanged. At the same time , money demand is reduced , back to original level, because the GDP has lowered back to the trend GDP. 1. As interest rates adjust lower , NFI increases. Increase in NFI increase the supply of domestic currency, lowering the real exchange rates, in turn. Slightly lower real exchange rates lead to increased NX . This increase in NX is accounted for by slight higher aggregate demand (AD 3) than what might be in response to government prudence in a closed economy. From this and the previous simulation, it is evident that both fiscal prudence and monetary constraint would stabilize the price levels, or if applied at a lesser extent, would decrease the rate at which prices are increasing ( disinflation). Compared to monetary constraint, fiscal prudence leave the economy in a better state for long-term growth, because investments are not reduced and net exports recover a little bit.

Suggested Proposals
The economic simulations in the previous section lay down the theoretical underpinnings of possible government and Central Bank intervention. Possible responses to the current economic conditions can be monetary constraint, government prudence , or a combination thereof. From the mandated hikes in interest rates and cash reserve ratio in recent quarters , it is evident that the RBI is fully engaged in battling the economic overheating by slowly reversing the actions that it took in response to the global financial crisis started in 2008 . However, before the 2011 annual budget , the RBI was concerned whether the government would follow the suit, or continues with its expansionary fiscal policy, resulting in contradictory monetary and fiscal policies . The government of India has coupled an expansionary monetary policy with increased deficit spending over the years , intensifying these policies throughout the global financial crisis in 2008 . Since the change in direction from a centrally planned (read social) to a market based economy in 1991 , India has gradually opened its economy for foreign direct investment. In two decades, Indian economy has flourished under free market system. Over the last decade, increasing foreign investment and remittances have helped India in acquiring the crucially required capital for economic growth. However, the expansionary policy and foreign investments are now causing asset bubbles and fueling inflation by leaps and bounds . The governments strategy should be to reverse or control these two factors. Below are certain tactics that can be part of this strategy: Continue monetary constraint: It goes naturally that RBI should continue on reducing liquidity in the market by raising interest rates and CRR if economic data does not show signs of easing inflation. Interest rates are still not too high to constrain the natural economic growth. Supporting that, the current interest rates are still lower by 50 basis points than the same during the high growth period between 2006 and 2008 , before the global financial crisis hit. Supply-side innovation: The Indian economy still suffers from the inefficiencies that were inherited from the socialist regime from its independence in 1947 till 1991. In a socialist regime, in absence of potential for profit and threat of losses, economic entities do not perform efficiently . Situation is constantly improving since 1991, but India still carries single-lane pothole filled transport highways that often get traffic jammed, poor food storage and processing facilities, poor farming knowledge , and monsoon dependent irrigation systems to raise crops. Of course, improving all of these factors is a longterm process ; however , many of Indias entrepreneurs are at task to visibly improve this in relatively short term. A new breed of social entrepreneurs can lift the situation must faster. Government should institute policies that encourage and provide seed capital loans to this new breed, albeit in an open fashion , where only the market decides who wins and who loses . Reduce government spending: As shown in the previous section, compared to monetary constraint, fiscal prudence leave the economy in a better state for long-term growth, because investments are not reduced and net exports recover a little bit. However, for a developing economy like India, fiscal prudence is not an easy pill to swallow, because much of government spending is targeted towards social programs supporting and uplifting people below or near poverty line. It is evident that government could not take this tough stand in the 2011 annual fiscal plan revealed last month. However, unlike monetary policy, government policy can segment out rich from poor and target spending reduction that affect the affluent class . For instance , government can change the tax brackets that affect only the high earners. Reduce consumption : Government can encourage savings over consumption by increasing the various forms of

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investment tax credits given to the businesses. However, this should be a tool of last resort, because of the risk that the economy may over -adjust in another direction. The reduced investment may take long cycles (years) to recover.

Conclusion
India and its economy are of increasing importance in the world . Plagued with high inflation and an overheated economy , action must be taken to combat that. This post shows how fiscal prudence and monetary constraint responses would affect the situation . The situation however is delicate. If not done the right way, fiscal prudence could have a big negative impact the lives of the poorest people who are already near or below the poverty line. Monetary constraint, a more natural choice, could help to tackle Indias economic woes, but would leave investments in the economy lower a negative for long term growth. A combination of fiscal restraint and monetary constraint is likely the best answer to lead India out of its current economic state. These two actions, combined with investment in Indias toughest infrastructure challenges should help in solving the current issues both from the demand and supply side . With the recent announcement of the budget, the India government has taken steps to regaining control. It is sure that India will continue on its path to economic prosperity, with current crisis remembered as a stepping stone on that path.
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ABOUT EDHARMESH
I work for Research In Motion, maker of the iconic BlackBerry. I am also studying evening MBA at the Rotman School of Management at the University of Toronto. This is just little something to save and announce my thoughts . View all posts by edharmesh

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