These days, international news is bombarded with excitement over India’s double-digit growth and speculations about when (and if) the Indian economy will surpass China’s. However, the scene is quite different domestically. In India, the hot topic of debate is the persistent growth in inflation.
Inflation Control: The Basic Steps
Inflation is basically the persistent increase in the general price level. While there are several factors responsible for the growth in inflation, the most significant cause of the inflationary pressure in India is the increase in Aggregate Demand, while the Aggregate Supply is relatively constant. (AD > AS)
The first step in curbing inflation in the country is filling the gap between the Aggregate Demand and the Aggregate Supply. In order to achieve this, either the AS can be increased or the AD can be decreased. However, the latter actually hampers economic development. In order to increase AS, it is imperative to expand the production capacity of all existing units and/or build new production plants.
The rise in prices is also a result of inefficiency in the basic industries and absence of adequate infrastructure. These create a bottleneck in the economic supply, which directly results in higher prices of commodities. For instance, it is much cheaper to transport goods by railways than roadways. Yet, because of the dearth of capacity in Indian railways, businesses have to invest in hiring or buying trucks, which further increases the cost of the final goods produced.
Therefore, the government should focus on building the country’s infrastructure and lowering the economic deficit. There is a need for a comprehensive strategy to improve the supply side economics.
Impact of RBI Policy on Inflation
The Central Bank can influence the economy with the monetary and fiscal policy. The monetary policy helps to manage the supply of money in the economic system, by altering the interest rates. On May 2, 2011, the Reserve Bank of India increased the policy rates by 50 basis points, taking the repo rate to 7.25 percent. Repo rate is the rate at which the Central Bank lends money to other commercial banks in the nation. An increase in the repo rate has made it difficult for companies to raise capital, thus adversely impacting their growth.
While the RBI does play a significant role in controlling inflation, but in a globalized economy there are several external factors that affect the domestic prices. For instance, when Standard and Poor’s downgraded the creating rating of US to AA+ from AAA, the global financial markets crashed on August 5, 2011- impacting the prices of several goods and services indirectly. Certainly, the government and the Central Bank have no control over such matters. Therefore, the only solution is to structure the domestic economy.