once again there is crr hike looming on the stock markets fate on monday.

there is
raise in repo rate and banks have already increased their prime lending rates; the
bank adr's have fallen up to 7% overnight here in new york. there have been talks
of all kind of nonsense along with this since the indices have not been going up
lately, much to the discomfort of everyone here in this group (including me) who
is very much used to gain a percent or two every day or week and just keep making
returns in the last 3-4 years.
there is a reason why there is inflation and why the reserve bank wants to fight
it. i know it's a very informative and will surely make sense in this scenario.
please read on.

what is inflation?

inflation is a process of continuous increase in the prices of most goods and

services in a country. this does not necessarily mean that all prices increase.
there may be some exceptions, such as computer prices which have actually declined
in recent years. inflation can therefore be described as a persistent general
increase in prices.

how inflation is measured?

inflation is measured by defining a basket of goods and services used by a

"typical" consumer and then keeping track of the cost of that basket. t his is a
chart of trend of gross domestic product and foreign trade of india at market
prices estimated by ministry of statistics and program implementation with figures
in millions of indian rupees.
year gross domestic product exports imports us dollar exchange in (rs.) inflation
index (2000=100)
1950 99,340 4.79
1955 108,730 4.79
1960 171,670 4.77
1965 276,680 4.78
1970 456,770 7.56
1975 832,690 8.39
1980 1,380,334 90,290 135,960 7.86 18
1985 2,729,350 149,510 217,540 12.36 28
1990 5,542,706 406,350 486,980 17.50 42
1995 11,571,882 1,307,330 1,449,530 32.42 69
2000 20,791,898 2,781,260 2,975,230 44.94 100
2005 34,195,278 44.09 121
why is inflation bad?

inflation is regarded as a bad process because it leads to distortions and

problems in an economy. a short list of the key disadvantages of inflation
includes the following:

losses to savers: if you save your money by hoarding cash, inflation erodes the
purchasing power of the amount saved. for instance, rs. 1000 put underneath a bed
ten years ago can now purchase only one third of the goods and services that it
could have done in 1987. even if you save in the form of savings deposits which
pay interest, the interest may not be enough to compensate you in full for
inflation. this also applies to pension planning, where a person may, for example,
save for a pension during his entire working life, just to find at the end of his
career that his savings have been eroded by inflation.

losses to people with fixed incomes: people with fixed incomes (such as the
interest on a fixed deposit, or a fixed salary) find that the purchasing power of
their income diminishes over time. the wealthy, in contrast, can usually partly
protect themselves against inflation by investing in assets, such as shares or
property, which increase in value during periods of inflation. inflation therefore
leads to an increase in the disparity between the wealth of the "haves" and the
"have-nots", or the rich and poor.

losses to taxpayers: if your salary increases in line with inflation, and no

adjustments are made to income tax, you will shift into a higher tax bracket and
end up paying a larger share of your salary to the taxman. this means that
government gains control over an increasing proportion of society's resources
without formally getting the approval of parliament to raise taxes.

confusing price signals to producers and slower expansion of businesses: a higher

price for a product would usually indicate that people want more of it, that more
profits can now be made from it and that more resources should therefore be
employed to produce it. in times of inflation, however, an increase in the price
of a product can occur either simply as part of the regular inflation related
adjustments to prices, or because the demand for that product has risen
permanently. entrepreneurs, not knowing which of the two kinds of price increases
have occurred, may wait much longer before expanding their businesses and
employing more resources in reaction to a permanent increase in demand.

speculation crowding out production: an environment of high inflation and

financial instability leads to more entrepreneurship and other resources being
devoted to speculation in existing assets such as real estate, and less to
expansion of production and employment.

reduced attention to productivity: higher productivity is an important sustainable

way of improving the overall standard of living in a country. in the absence of
inflation, wage negotiations are focused on proper compensation to employees in
accordance with improvements in their productivity. with high inflation, salary or
wage increases consist overwhelmingly of compensation for inflation, and
productivity issues become less important and may be neglected.

wastage of resources: during very high inflation episodes have to be increased

daily. a shop assistant, for example, may have the fulltime job of writing a new
price on each item every day or updating a list of the prices of the various
articles; the assistant would, without inflation, have been able to do more
productive work, such as selling items to clients. the lower the inflation, the
less time is spent on the re-pricing of items.

heightened tension and social disruption: a society plagued by high inflation

devotes more energy to redistributive issues, in which case each person or group
perpetually tries to gain or regain a better price, wage or position. this
destroys the fabric of society in a wider sense than simply through its impact on
the production of goods and services.

claims are often made by ill-informed people that inflation is not bad. they argue
that higher inflation will stimulate economic growth.

these claims are false. it is quite easy and inexpensive to print more money,
thereby boosting inflation; even the poorest countries could do that. if this were
the way to achieve economic prosperity, no poor countries would remain on earth.
if money is printed to stimulate the economy it may work for a short period of
time, but people will soon realize what is going on and instead of producing more
they would simply start to increase prices and wages much more rapidly. in the
end, the country would face high inflation with all the destructive and distortive
effects outlined above, and would be certainly left with a weaker economy.
the reserve bank of india, like central or federal banks in most countries, is
therefore strongly opposed to inflation, and uses its monetary policy to combat
it. such policy action is not bad for continued economic growth, prosperity and a
fair distribution of income and wealth. low inflation and a stable financial
environment are indeed prerequisites for the achievement of these objectives on a
sustainable basis.

what triggers price increases?

price increases can be triggered by many developments, such as:

? an increase in international oil prices;
? a fall in the exchange rate;
? a nationwide excessive salary and wage hike; or
? an increase in food prices and commodities etc.

what sustains inflation?

for a continuous rise in the general price level, the money supply has to keep on
expanding. only with "too much money chasing too few goods" can the general price
level continue to increase. it's proven that high rates of growth in the money
supply in india in the past went hand in hand with high rates of inflation. the
only effective way to contain inflation in the long run is therefore to restrict
the growth in the money supply. the likely rate of increase in the quantity of
goods and services which can be maintained without inflationary pressures is
usually related to more labor, entrepreneurship and capital goods, and better
skills, management and technology. growth in the money supply should accordingly
be linked to sustainable growth in production.

preventing excessive money supply growth is therefore a crucial element in

combating inflation. but how is this done?

how do you stop inflation?

one approach would be to freeze all prices. many countries have attempted this
over a long period of time. later attempts at directly controlling price increases
also failed because all these controls addressed the symptoms, but not the cause.

preventing excessive money supply growth

the banks in india are indebted to reserve bank of india. although the amount of
funds which they borrow from the rbi is small compared to the amount of funds
which they obtain in the form of deposits, their borrowing from the rbi is
important. this is because the rbi is the only supplier of legal tender ? notes
and coin ? to the economy. the terms and conditions under which the rbi is willing
to supply cash to the banks are important factors when the banks set their
interest rates.

the rbi lends cash to the banks at an interest rate determined by the monetary
policy committee. this interest rate is called the rbi's repurchase rate, or repo
rate for short. banks set their deposit interest rates somewhat below and their
lending rates somewhat above the repo rate. through the repo rate, the rbi
indirectly has a strong influence on all the short-term interest rates in the
banking system.

if the rbi's analysis shows that inflation is going to be higher than the
inflation target set by the government, it has to put a brake on the inflation
process. this is done in the following way:
? the rbi raises the repo rate.
? banks then usually raise their lending and deposit rates.
? when people face higher lending rates, they buy fewer goods on credit.
? this causes less credit to be used and less money to end up with shopkeepers.
? with less money, credit and expenditure in the economy, it becomes more
difficult to raise prices and wages.
? therefore, inflation is reduced.

conversely, if the rbi's reading of the economy indicates that inflation is going
to fall below the inflation target, it would reduce the repo rate and this would
reverse the sequence described above.

as a rule of thumb, lending rates must be significantly higher than the inflation
rate if excessive credit growth and money supply growth are to be prevented. in
addition to the repo rate, the rbi can also influence the banks' ability to lend
out money by using instruments such as open-market operations ( i.e. buying and
selling financial assets in the open market) and cash reserve requirements (i.e.
requiring the banks to deposit with the rbi part of the funds they receive from
the public).

although inflation can only be sustained if the amount of money in the country is
rising excessively, the rbi's task can be made easier by both the government and
the public. monetary policy will be more effective if it is supported by fiscal
discipline, i.e. if the government does not overspend or rapidly run up its debt.
inflationary pressures will also be alleviated if the general public works harder
and smarter, i.e. if an improvement in productivity raises the quantity (or
quality) of the goods and services produced.

bottom line

in summary, combating inflation requires the prevention of excessive money supply

growth. in turn, this requires the private-sector banks to maintain interest rates
at levels that are high enough to prevent excessive growth in bank credit
extension. to this end, the rbi sets its repurchase rate at an appropriate level.
this whole process of changing interest rates to influence credit, money supply
and inflation takes time to work through; this is why monetary policy requires
patience!