The Telegraph
Since 1st March, 1999
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- How quickly will the price rise in India be abated'

The budget for the next year will be revealed to us in less than a fortnight. In normal years, discussions about what is in store for us on February 28 — the day on which the finance minister announces the budget — occupy much of the space in newspapers and magazines. This year has turned out to be an exception. The current bout of inflation is the most important aspect of the economy featuring in newspaper headlines. This is not at all surprising since the rate of inflation is currently hovering around 7 per cent.

A couple of decades ago, many Indians would probably consider themselves lucky if prices rose by only 7 per cent during the year — the Indian economy had, in the past, typically experienced rather high rates of inflation. However, since the economy displayed remarkable price stability during the Nineties, we have now come to believe that anything above a 5 per cent annual rate of inflation is abnormally high.

Any unduly large increase in prices is not distribution-neutral. It affects the fixed-income group consisting of salaried employees, pensioners and daily-wage earners — and more generally the poorer sections — much more than the rest of society. Moreover, the adverse effects of the current price rise are not adequately captured by the aggregate figure. This year, the increase in food prices has actually been higher than the overall rate of price rise.

The plight of these poorer groups is even worse when food prices go through the roof because food occupies a significantly higher proportion of their total expenditure than it does for richer income groups. A government that is so dependent on the support of the left parties cannot afford to remain idle when the interests of the poor are affected. Indeed, both the Central government and the Reserve Bank of India have been quite prompt in launching fire-fighting exercises. The RBI has initiated steps to curb money-supply by increasing the cost of credit. The government has banned the export of wheat in order to augment supply in the domestic market. It has also reduced duties on some imports like cement and slashed the prices of both petroleum and diesel. Will these measures be effective' How quickly will the price rise be abated'

Prices can rise sharply when the economy is “overheated”. In somewhat simplistic terms, this happens when excess demand in the economy pushes up prices because supply falls short of demand. This phenomenon is most likely to occur when an economy is growing very fast. The Indian economy has certainly been growing at rates which were unimaginable a couple of decades ago, and that too over a sustained period. A very likely consequence of this high rate of growth is that many industries are now operating at full capacity, and so are not able to increase supply in the short run even though they realize that there is sufficient demand in the economy to mop up additional quantities. Similarly, rising per capita incomes have resulted in large increases in demand for food, while there has not been a corresponding increase in supply.

Obviously, an excess of demand over supply can be corrected either by reducing demand or increasing supply. The measures announced by the RBI and the Central government are designed to operate on both sides of the market. Efforts to reduce the availability of credit are the classic or “textbook” remedy to curtail aggregate demand. Any restriction on the supply of credit forces entrepreneurs to postpone their investment plans, and hence reduces the demand for investment goods. This, in turn, reduces aggregate demand. The ban on export of food items will also have some beneficial impact on domestic food supply, although the quantitative effect may be limited since current wheat exports have not been very high in any case. In addition, only the more expensive varieties of wheat are typically exported, and hence there may not be any increase in domestic supply of the more common varieties of wheat.

Of course, the government has also taken some direct steps to abate the price rise. The most important of these has been the reduction in the prices of petroleum and diesel. Fuel is an important component of the overall price index, and so any reduction in fuel prices has an immediate and direct impact on prices. Moreover, any reduction in their prices has an important indirect effect since this reduces transportation costs. This, in turn, brings down the costs of a wide variety of items of common consumption.

Unfortunately, the reduction in import duties on items such as cement cannot have any immediate impact on the welfare of the common man. While these measures may well reduce the cost of production of a large number of commodities, the effect will only be felt after some time.

In fact, the government’s short-term options are quite limited. Monetary policies designed to curb aggregate demand through reductions in availability of credit are not very effective in the short run since they take a long time to have any impact. Perhaps, the quickest remedy is to import large amounts of food. This will immediately increase food supply and bring down food prices. The RBI is sitting on huge stocks of foreign exchange, estimated to cover at least a year’s imports. So, even large foodgrain imports cannot cause any foreign exchange crisis.

Of course, these imports will result in an increase in the food subsidy bill. World foodgrain prices are now higher than the prices prevailing in domestic markets. So, the government will have to sell the imported food at prices that are lower than the levels at which it buys the food. Despite the adverse effect of this on the overall government deficit, this is a better option than harsh policies designed to curb aggregate demand. The latter set of policies can have quite severe deleterious effects on long-term rates of growth.

There is also no doubt that the Central government has been guilty of severe mismanagement. Unlike in the past, when, for instance, rising global oil prices sparked off inflationary pressures, this bout of inflation has not been imported from abroad. This has been a relatively simple case of domestic demand exceeding domestic supply. But why could the government not anticipate that this was going to happen' In this day and age, every competent Masters student in economics learns the techniques of demand projections. The government has a huge pool of trained economists. Surely, they should have been able to foresee the mismatch between demand and supply' If the government had acted earlier, then the cost of controlling inflation would have been significantly lower since it could have bought foodgrains when world prices were lower.

In the long run, the only feasible option is to increase domestic production, particularly of food. In recent years, the rate of growth in agriculture has been very low while the rest of the economy has galloped ahead. The production of items like pulses has more or less stagnated. This trend has to be reversed through massive increases in investment in agriculture combined with improved technologies.

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