Context

The recent action of the Reserve Bank of India (RBI) to raise the repo rate by 40 basis points and cash reserve ratio (CRR) by 50 basis points is a recognition of the serious situation with respect to inflation in our country and the resolve to tackle inflation.

Inflation in India and role of government expenditure

• India’s CPI inflation has been fluctuating around a high level.
• As early as October 2020, it had hit a peak of 7.61%.
• It had remained at a high level of over 6% since April 2020.
• It did come down after December 2020 but has started rising significantly from January 2022.
• On the other hand, the Wholesale Price Index (WPI) inflation had remained in double digits since April 2021. The GDP implicit price deflator-based inflation rate for 2021-22 is 9.6%.
• Even though the RBI’s mandate is with respect to CPI inflation, policymakers cannot ignore the behaviour of other price indices.
• After the advent of COVID-19, the major concern of policymakers all over the world was to revive demand.
• Keynesian prescription: This was sought to be achieved by raising government expenditure.
• Thus, the expansion in government expenditure did not immediately result in increased production in countries where the lockdown was taken seriously.
• However, the Keynesian multiplier does not work when there are supply constraints as in developing countries.
• That is why the multiplier operates in nominal terms rather than in real terms in such countries.
• Something similar has happened in the present case where the supply constraint came from a non-mobility of factors of production.
• Nevertheless, the prescription of enhanced government expenditure is still valid under the present circumstances.
• Perhaps the increase in output could happen with a lag and also with the relaxation of restrictions.

Role of monetary policy

• Why lover money multiplier rate? Initially, the focus of monetary policy in India has been to keep the interest rate low and increase the availability of liquidity through various channels, some of which have been newly introduced.
• However, the growth rate of money was below the growth rate in reserve money.
• This is because of lower credit growth which also depends on business sentiment and investment climate.
• Thus the money multiplier is lower than usual.
• The Government’s borrowing programme which was larger went through smoothly, thanks to abundant liquidity.
• Even as the economy picked up steam in 2021-22, inflation also became an issue, this is a worldwide phenomenon.
• In India too there is a shift in monetary policy.

Analysing the cause of inflation

• While discussing inflation, analysts focus almost exclusively on the increases in the prices of individual commodities such as crude oil as the primary cause of inflation.
• General price level: Supply disruptions due to domestic or external factors may explain the behaviour of individual prices but not the general price level which is what inflation is about.
• Given a budget constraint, there will only be an adjustment of relative prices.
• Besides the fact that any cost-push increase in one commodity may get generalised, it is the adjustment that happens at the macro level which becomes critical.
• It is the adjustment in the macro level of liquidity that sustains inflation.

Inflation and growth

• The possible trade-off between inflation and growth has a long history in economic literature.
• The Phillip’s curve has been analysed theoretically and empirically.
• Tobin called the Phillip’s curve a ‘cruel dilemma’ because it suggested that full employment was not compatible with price stability. 
• The critical question flowing from these discussions on trade-off is whether cost-push factors can by themselves generate inflation.
• In the current situation, it is sometimes argued that inflation will come down, if some part of the increase in crude prices is absorbed by the government. 
• If the additional burden borne by the government (through loss of revenue) is not offset by expenditures, the overall deficit will widen.
• The borrowing programme will increase and additional liquidity support may be required.

Concomitant decisions on CRR and repo rate

• These are concomitant decisions. Central banks cannot order interest rates.
• For a rise in the interest rate to stick, appropriate actions must be taken to contract liquidity.
• That is what the rise in CRR will do.
• In the absence of a rise in CRR, liquidity will have to be sucked by open market operations.

Conclusion

Beyond a point, inflation itself can hinder growth. Negative real rates of interest on savings are not conducive to growth. If we want to control inflation, action on liquidity is very much needed with a concomitant rise in the interest rate on deposits and loans.

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