Page 237 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes Thus, the total lag period includes inside and outside lag. Milton Friedman uses statistical
inference or direct estimate method as suggested by Thomas Mayer to estimate total lag. The
total time lag may vary from six months to two years. The time lags must be reduced to ensure
economic growth with stability.

13.4.1 Effects of Monetary Policy on Inflation in India

The steps usually taken by the RBI to deal with inflation include a rise in repo rates (the rates at
which banks borrow from the RBI), a rise in Cash Reserve Ratio and a reduction in rate of
interest on cash deposited by banks with RBI. The signals are intended to encourage banks to
raise lending rates and to reduce the amount of credit given out. The RBI’s measures are expected
to extract a substantial sum from the banks. In effect, while the economy is flourishing and the
credit needs grow, the central bank is reducing the availability of credit.
The RBI also buys dollars from banks and exporters, partly to avert the dollars from flooding the
market and depressing the dollar — indirectly raising the rupee. In other words, the central
bank’s interactions have a advantageous objective — to keep the rupee devalued — which will
make India’s exports more competitive, but they increase liquidity.

To combat this, the RBI does what it calls “sterilisation” — it extracts the rupees it pays out for
dollars through sale of sterilisation bonds. It then sells these bonds to banks. Economists point
out that there has not been much success in such sterilisation attempts in India. The central
bank’s attempt to offload Government bonds on banks has not been too successful inasmuch as
the banks sell the bonds and get rupees instead.
Economists also contrast this with the successful experience of China, where the state-owned
banks strictly follow the central bank’s orders and absorb the sterilisation bonds. That discipline
is lacking in India. The net effect is that the RBI has to resort to indirect methods of sterilisation,
such as raising interest rates and raising CRR to contract liquidity. This makes India more
attractive for foreign capital flows that seek better returns and a vicious cycle follows. RBI has to
buy more foreign currency and sterilize. The cycle becomes worse.

13.4.2 What is RBI doing to Curb Inflation?

Recently, the Reserve Bank of India has raised key rates by a higher-than-expected 50 basis
points, stressing that tackling inflation is its main priority even if it comes at the expense of
overall growth in the short term. The central bank hiked the repo rate, its lending rate, by 50 bps
to 7.25%, and the reverse repo, its borrowing rate, also by 50 bps to 6.25%. The market had
expected a 25 bps hike by RBI.
According to the RBI, India’s headline inflation has passed even the most pessimistic projections
and it is expected to remain at higher level atleast during the first half of 2011-12. RBI’s baseline
projection for WPI (wholesale price index) inflation for March 2012 is 6% with an upward bias.
India’s inflation in March 2011 rose 8.98% from a year earlier. According to the RBI Governor
Duvvuri Subbarao the monetary policy actions are expected to contain inflation by reining in
demand side pressures, and sustain growth in the medium-term by containing inflation. He also
added that high and persistent inflation undermines growth by creating uncertainty for investors,
and driving up inflation expectations. An environment of price stability is a pre-condition for
sustaining growth in the medium-term. Reining in inflation should therefore take precedence
even if there are some short-term costs by way of lower growth.

RBI estimates India grew 8.6% in 2010-11, but going forward the growth rate is expected to
moderate due to high oil and other commodity prices coupled with its anti-inflationary monetary
stance. The central bank expects India’s real GDP to grow around 8% in 2011-12.

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