EFFECT OF INFLATION ON AN ECONOMY :(A) CONSEQUENCES OF THE INFLATIONARY PRICE RISE
Effects of inflation on an economy : Economists often argue that a mild dose of inflation is good for an economy. When prices steadily rise at a rate of 4-5 per cent per annum, favourable climate is created for investment which eventually results in larger income and fuller employment.
But the way prices have risen in India over the period of planning, has done more harm than good to the economy and the people. This not only inflicted sufferings on the multitude of people, but also disrupted the developmental efforts time and again. Let us now examine the consequences of inflation in more detail:
Table of Contents
1. Increase in economic inequalities:
When prices rise continuously over the long period, inequalities of income and wealth increase. People with fixed income such as workers, government employees, teachers, etc. find that inflation results in erosion of their purchasing power.
Producer and trader simultaneously earn enormous profit.
This process if not immediately arrested wipes out even the lifetime savings of the people whose money incomes are more or less fixed, and the wealth of the country gets concentrated in the hands of traders and producers.
In India, the price rise during the planning period has been a little less ruthless and savings of the working population have not been completely wiped out. But there is no doubt about the fact that the price rise has not always been accompanied by an upward revision of wage rates.
Obviously the real wage of the various categories of workers have declined. The worst sufferers in the whole process have been the agricultural workers who are least organised in our country. With no alternative opportunities, their bargaining power is very little. Their money wage is generally determined conventionally and even a decline in the purchasing power of money will not alter it.
Industrial workers and the government employees have powerful organisations to protect their interests. Naturally, they have succeeded to some extent in getting money wage-hikes in order to offset the erosion of their real wage. Big farmers, industrialists and traders have benefited the most from this inflationary price rise. Big farmers, who had large marketable surplus, earned huge profits, when prices of agricultural products rose. Traders and industrialists also made fortune.
2. Changes in relative prices:
Over the years, prices of all the commodities have not increased uniformly. In some years relative prices of agricultural products increased more rapidly than that of manufactured products while in other years it was the other way round –i.e., the relative prices of manufactured products rose more rapidly than that of agricultural products.
In those years when relative prices of agricultural products rose more rapidly, large farmers derived great benefits. For small farmers, this development had little relevance. Interestingly, in India, agricultural incomes have been exempted from the income tax.
Therefore, not even a small fraction of the large income generated in the agricultural sector could be mobilised by the government for development projects in this sector.
Farmers, particularly in Punjab, Haryana and Western UP, have invested this newly created income in the mechanisation of agriculture, which has led to displacement of some farm labour in these States. Thus, the prosperity of the rural rich due to inflationary price rise has inflicted sufferings upon the rural poor.
3. Adverse effect on the balance of payments:
Although since the World War 2, inflation has been a worldwide phenomenon, prices in India have been risen more sharply than in most of the other countries. This created two problems in our country from the point of view of balance of payments.
First, the demand for India’s products declined in foreign markets and the task of increasing exports became more difficult. Moreover, in the home market the profitability increased and as such even the producers had little interest in stepping up exports. Secondly, Indian importers finding that foreign goods were cheaper, tried to increase imports.
4. Obstacle to development:
The continuous price rise during the planning period has turned out to be an obstacle to development. This is particularly due to the rigidity about plan outlays. Continuously rising prices in India in the past have discouraged savings.
According to C. Rangarajan, an important issue that arises in the context of development is “whether there is a trade-off between economic growth and inflation. In the short run perhaps there is such a trade-off. Some of the econometric models for India indicate the existence of a trade-off but at a heavy cost.
A higher growth rate can be achieved only at the cost of a fairly high inflation rate. Over a long period, growth can not be bought with the aid of higher prices. On the other hand, it is price stability which provides a better environment in which growth can occur and social justice can be insured.”
(B) ANTI-INFLATIONARY POLICY OF THE GOVERNMENT
Measures adopted by the Government of India to control inflationary pressures can be discussed under the following ways:
1. Monetary Policy
In a growing economy like the one we have in India, the central bank is not expected to be very rigid about the quantity of money. Normally, it should follow a policy of controlled expansion of money supply. Judging by this criterion, the policy of the Reserve Bank of India (RBI) does not seem to be quite satisfactory.
Over the years, while meeting the demand for money made by the Central Government for meeting its budgetary deficit, the RBI has actively contributed to creating inflationary pressures. Only when the price situation appeared to be somewhat out of control, it undertook various monetary control measures in a somewhat ad hoc manner for preventing further rise in prices.
For about three decades from 1962 to 1991, the RBI had employed both quantitative as well as qualitative measures of credit control.
On the recommendations of the Narashimham Committee , the government abandoned the policy of relying on CRR and SLR to control inflation. The RBI accordingly reduced both CRR and SLR in a phased manner. As of now, December 2023, repo rate is 6.50% and reverse repo rate is 3.35% .
2. The Reserve Bank introduced Liquidity Adjustment Facility (LAF) in June 2000.
Liquidity Adjustment Facility operates through reverse repo auctions, i.e., the sale of government securities from RBI portfolio for absorption of liquidity and repo auctions, i.e., buying of government securities for injection of liquidity on a daily basis, thereby creating a corridor for the call money rates and short-term interest rates, LAF has also emerged as the key instrument of managing capital inflows that India has experienced since 2001-02 through sterilisation.
This has helped in reducing the episodes of volatility in foreign exchange markets. In April 2004, the Market Stabilisation Scheme (MSS) was introduced to provide the Reserve Bank with an additional instrument of liquidity management and to relieve the LAF from the burden of sterilisation operations.
The MSS is an arrangement between the Government of India and the Reserve Bank to mop up excess liquidity generated on account of the accretion to the foreign exchange assets of the Bank to neutralize the monetary impact of capital flows.
3. Fiscal Policy
Fiscal policy can be effectively employed for checking inflation. In western countries due to built-in flexibility, manipulations in public expenditure, taxation and public debt obtain desired results. Their effectiveness in underdeveloped countries is, however, much less.
The Government of India adopted the Fiscal Responsibility and Budget Management (FRBM) Act in 2004 and committed itself to bring down the fiscal deficit. After declining to 4.8 per cent of GDP in 2010-11, fiscal deficit of the Central Government again rose to 5.8 per cent of GDP in 2011-12 but fell to 4.9 per cent in 2012-13 and further to 3.5 per cent of GDP in 2017-18.
4. Public Distribution System
On the basis of the past experience in India, an efficient distribution system requires a nexus between production, procurement, storage, transportation and distribution of essential consumer goods. In India, recently, these activities lacked proper coordination. But in COVID-19 period this system had work very efficiently to control the price rise and protected the poor to affecting the high inflation.
5. Supply Side Measures
In order to improve supply of essential commodities the government has often allowed their imports. Due to that, imports of edible oils, palmolein, sugar and pulses have been allowed in different time period. Further, the Food Corporation of India has continued its open market sale of rice and wheat to prevent increase in their market prices.
Therefore, with the abolition of quantitative controls, import of essential commodities can be made easily to augment their supply. This will definitely keep inflation under control.
(C) INFLATION TARGETING: URJIT PATEL COMMITTEE REPORT
In brief, an “Expert Committee to Revise and Strengthen the Monetary Policy Framework” was appointed in September 2013 by the then Governor of the Reserve Bank of India Raghuram Rajan under the chairmanship of Urjit R. Patel to examine the current monetary policy framework of the Reserve Bank and recommend what needs to be done to revise and strengthen it with a view to making it transparent and predictable.
The committee was also assigned the task to recommend an appropriate nominal anchor for the conduct of monetary policy. The Committee submitted its report in January 2014.
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