Inflation as a Macroeconomic Issue in the Indian Context

Abstract

 

This paper will talk about macroeconomic stability and why it is essential for the economy. It also gives insights about inflation in the Indian context and how Indian monetary policies help control and manage inflation. Finally, this paper will show how the IS-LM framework supports monetary policy and how it explains the shifts in the curve.

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Introduction

Macroeconomic stability in the contemporary world is necessary as the governments will be eyeing a particular set of problems that they wish to tackle within a set time limit. The solutions to these issues might hinder the macroeconomic stability of the country. Thus, measures must be taken and policies supporting stability must be implemented so that the economy is balanced out.

Macroeconomic stability by itself does not always promise or promote the economic growth of a nation. In many cases, growth depends on other factors like trade liberalisation, privatization etc. When there is macroeconomic stability, these factors will be well supported which, in turn, will bring growth to those sectors which are linked to these factors. (Ames. B, Brown. W, Devarajan. S, Izquierdo. A, n.d.)

 

Inflation

Inflation is one of the primary macroeconomic issue which exists in India. Over the last decade, it has emerged as a primary concern for India’s policymakers and citizens. Inflation is an economic state wherein the prices of goods and services prevailing in the country rise over a while. Inflation must be prevalent in the economy as zero inflation is also a concerning situation for the economy. But when the prices of commodities rise too high it becomes a challenge for both the producers and consumers.

How inflation works is that when prices of goods and services rise above a certain extent, each unit of currency can buy only fewer goods and services compared to when the general price level is moderate.  Inevitably, inflation brings about a reduction in purchasing power per unit of money, a loss of real value in the medium of exchange and unit of account within an economy. (Naresh. K, 2014)

Travelling back in time, we understand that inflation has been running in the Indian economic system ever since the British rule. During the second world war, there has been strong inflationary pressure on India’s economy. This is because of several factors, but a few primary ones are; rising money incomes, expansion in the supply of money and high demand and low supply due to population explosion in the country. Even when looking at the post-war period, there have been several events that have been contributing factors to India’s growing inflation rates. (Naresh. K, 2014)

The rates of the inflation is delineated by the ministry of commerce and industry of India. The wholesale price index is the primary measure of inflation. The WPI measures the price of a representative basket of wholesale goods. When we look into the demand and consumption of goods and services and how they contribute to the levels of inflation in the country, prices rise when people have a better outlook of their financial status, they spend more thus contributing to this. (Naresh. K, 2014)

 

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Monetary Policies in India

Monetary policies are formalised and regulated by the central bank, in India that is the RBI. They mostly are designed by having macroeconomic objectives like low inflation, high or full employment, the balance of payments equilibria and disequilibria and satisfactory growth of real income. The major aspects included in the monetary policies in India are: (Monetary and Fiscal Policies in India, n.d.)

-         - The degree of autonomy of the central bank v/s the government,

-         - The relations between monetary policy and other instruments of economic policy,

-         - The optimum blend of monetary and fiscal policy.

When having a glance at the Indian context, monetary policy has always emphasised the importance of price stability and growth. Apart from these objectives, a considerable effort by RBI has been seen in recent years to maintain conditions in the foreign exchange market. It also sets to curb destabilizing speculative activities. The objective of monetary policy has been to accelerate economic development in an environment of reasonable price stability. The RBI has formulated monetary policies to address two main things; Expansion in the supply of money and restraint of secondary expansion of credit. (Monetary and Fiscal Policies in India, n.d.)

 

 Reforms to India’s monetary policy in the 1990s:

After 1991, monetary detached from fiscal policy. The major changes in the Indian monetary policy during that 1990s consisted of : (Monetary and Fiscal Policies in India, n.d.)

1.       - Reduced reserve requirements

2.       - Increased microfinance

3.      - Fiscal monetary separation

4.      - Changed interest rate structure

5.      - Changes in accordance with the external reforms

6.      - Increased market orientation in banking

Monetary policies adjust the supply of money thereby enabling the economy to achieve some combination of inflation and output stabilization. The effects of Indian monetary policies have not been seen immediately. Most monetary policies to correct general prices do not show immediate effect in the short run. But in the long run, it is beneficial. This can be supported by the data of inflation rates in India in the last decade.

But still inflation rates in India are quite high and have not seen a significant improvement. There need to be policies formulated to address the problem at the grass-root level. Inflation brings a series of problems along with it; thus, the appropriate monetary policies can correct the issues which will bring balance and equilibrium in the economy.

 

IS/LM Framework

The IS-LM model is the fundamental model of aggregate demand that consists of money market and the goods market too. This model specifies the ways through which monetary and fiscal policies affect the economy. It is a standard tool for macroeconomic analysis that elucidates the relationship between interest rates and real output in the goods and services market and money market. (Monetary and Fiscal policy in the IS-LM framework)

Using the IS-LM framework, let us see how it is used to analyse the monetary policy. The policy initially affects the interest rates and then proceeds to affect the aggregate demand. The basic assumption is that increase in the money supply will lead to a decrease in the interest rates, increases aggregate demand, thus increases equilibrium output. (Monetary and Fiscal policy in IS-LM framework)

An expansionary monetary policy, which means an increase in the money supply would assist the LM curve to shift to the right. This might cause the gross domestic product to rise and interest rates to fall in the economy.

 

IS-LM Model to analyse Monetary policy

                                        (Monetary and Fiscal policies in IS-LM framework, n.d.)

 

Thus, expansionary monetary policy certainly has a positive effect on Y as the increase in the money supply causes interest rates to fall in order to restore market equilibrium on the goods side. In essence, we can see that the IS-LM framework proposed by John Hicks does support the monetary policy and would explain the shifts and movements to give the respective output.

 

References

Ames. B, Brown. W, Devarajan. S, Izquierdo. A, Chapter 12 Macroeconomic Issues. (n.d.) Retrieved from https://pdfs.semanticscholar.org/1e09/68092aae460586108678079ee59b6a6ab99f.pdf

Naresh. K, Volume 16, Issue 1. Ver. I Inflation and Indian Economy. (2014) Retrieved from http://iosrjournals.org/iosr-jbm/papers/Vol16-issue1/Version-1/E01612834.pdf

 “Monetary and Fiscal Policies in India”, (n.d.) Retrieved from https://shodhganga.inflibnet.ac.in/bitstream/10603/144090/12/12_chapter-5.pdf

“Monetary and Fiscal policies in IS-LM framework”, (n.d.) Retrieved from https://www.amu.ac.in/emp/studym/99998328.pdf