Page 192 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 11: Control of Inflation and Philips Curve

Notes
The petrol price decontrol was required — prices will now be free to fall as well as rise. But
the timing of the price rise, when inflation is dangerously high, is unfortunate.
Past oil price hikes have not led to sustained inflation because they either followed or led
to severe monetary tightening. The attempt to conserve the Macro Economic stimulus can
be consistent with falling inflation only if it enables a supply response.

Post-reform India has had loose fiscal and tight monetary policy. Direct subsidies created
hidden indirect costs and raised debt. But inflation harms electoral prospects, so instead of
inflating debt away, a severe monetary tightening would be imposed. There would be a
large sacrifice of output, but little reduction in chronic cost-driven inflation.
Fiscal Consolidation
The government now seems to be trying a better combination: Imposing fiscal consolidation
so monetary policy can be more accommodative. Lower debt, deficits and interest rates
are useful attributes for a more open economy to have. But rather than raise tax rates that
push up prices and costs, a better approach to fiscal consolidation is to reduce wasteful
government expenditure. Plugging leakages and cutting allocations in areas where budgets
have not been spent would create better incentives to spend.

The government has a poor record in spending effectively. Tax revenues have started
rising again with growth, but this boom should not be squandered like the last one. The
contribution of economic growth was 55 per cent and of spending cuts was 35 per cent to
Canada’s successful deficit reduction in the 1990s.
Monetary Policy
A sharp rise in interest rates has severe consequences. We saw the collapse in industry
following such a rise in the late 1990s and in July 2008. Policy should rather follow a path
of gradual rise in interest rates conditional on inflation. The knowledge of future rise will
reduce inflationary expectations, if combined with action to reduce costs.
A short-term nominal exchange rate appreciation reduces costs. This can be very useful to
contain a temporary spike in oil or food prices and will become more effective as petrol
prices are free and food prices reflect border prices. Today, the price of Washington apples
determines that of Indian apples.
The current depreciation runs counter to the attempt to reduce inflation. Changing one
exchange rate prevents thousands of nominal price changes that then become sticky and
persist, requiring painful prolonged adjustment. Small steps give the freedom to respond
to evolving circumstances. But to walk with baby steps one must start early and coordinate
action over several fronts.
Questions:
1. How does food inflation hurt the common man of India?

2. What can the government do to minimize the impact of food inflation?

Source: www.eastasiaforum.org/ Ashima Goyal
Self Assessment

Multiple Choice Questions:
6. Which of these is not a monetary policy instrument to check inflation?
(a) Bank rate policy (b) Open market operations
(c) Controlling taxes (d) Selective credit control

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