eco article | Fiscal Policy | Inflation

Economic Environment and Policy Individual Essay

Ravi Teja P R, M.Mgmt, Class of 2010, A-Section, Roll: 08927883

Article .

8. 2. 3. Price pressures are easing across Asia. The sharp drop in Indian inflation is also an advance warning of a sharp drop in local demand and overall economic growth. given the fear over the city. The rich economies are going through a period of recession. The emerging global consensus is that governments will have to borrow and spend to support effective demand. but for the fact that public debt and deficits are already too high for comfort. 7. Industrial production growth in the first six months of this financial year is almost half of what it was in the previous year. . Demand is falling at a very rapid pace in Asian countries. The focus till now has been on interest rate India could have gone down this path.http://www. though we still fear that a country such as India. puts its currency at risk in the process.livemint. that has a large current account deficit. Making money cheaper is unlikely to spur either investment or consumption though. 9. 5.html?d=1 Nov 13 2008 Highlights from the Article 1. 4. 6.

Why sharp drop in inflation indicates a sharp drop in local demand and economic growth? 2.Topics covered in this write up 1. Why to borrow money and support demand? Why India is not doing so? . How to make money cheaper? How it influences the consumption and investments in India? 4. What is the relation between the interest rates of RBI and Inflation? 3.

etc. will there be any person who will buy this good or not. or whether he can sell all his produced stock or not. 4. With high demand only. So there will be a decrease in developmental activities by the government. This will also cause a decline on the amount of taxes we pay for the government. All the households in a country will get the income from the factor market.Why sharp drop in inflation indicates a sharp drop in local demand and economic growth? Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. So Unemployment increases because of lower inflation. By an excessive gap in between the demand and Supply of the goods. this confidence of the producer turns into a dilemma and he starts thinking about whether he can getting profits or not. The income of the households is decreasing now. By having inflation we are ensuring that there exists a small relative gap in the demand and supply of goods. 3. the firms/producers /manufacturers in a country can have the confidence of getting profits. So he again reduces the production. In some cases there may even be some job cuts because the firms want to cut down on production. Thus the households will get less income from their work. So if they reduce their production levels. Low inflation is important for ensuring stable and continuous growth. The reasons why we need high demand are 1. The firms are the ones who provide the income for the factor market. When the demand of a nation is low. 2. So this results in lowering of overall production in a country. they are going to lower their payments to the factor market. . We always should ensure that the demand is always ahead of supply. This inflation can be caused by two reasons 1. 2. The lower demand for goods will signal the producer that the goods he produces are consumed by very less people. So there will be a substantial decrease in the amount of money they consume from the economy and thus the demand for the entire economy goes down. By an excessive growth of the money supply. A sharp decline in the inflation indicates a sharp change in the demand and supply equation of the economy.

So that it can suck all the additional rupees in the system. So this act of RBI was advantageous in both the ways. At the same time in the early months of October. there was a huge FII outflow that was happening from the Stock Market. etc.98%.5. Step 1 Continues and this will be a cyclic process. In case of India. As there is increase in the prices of all the goods. All the money they invested in India was taken away from them. So there was very less demand for Rupee. when the inflation was getting reduced at 0. Secondly.3% every week. to cut the interest rate or not. This happened because of increase in the money supply in the economy. it will make the stock market fall because it will be out of money. there was a rapid increase in inflation in the months of august and September this year (2008). the lending rates of the bank to the households/firms also increased. As a result there was a scarcity of money in the entire system. As a result there was an additional flow of about 80. So RBI decided to raise all the interest rates by about 1-2%. What is the relation between the interest rates of RBI and Inflation? Inflation rates can be controlled by controlling the rate of growth of the money supply. Because fall in the value of rupee will decrease the overall value of the economy in the global arena (because we will be having very less Dollar GDP).000 crores into the system. the standards of living of the people in the country is also affected. So tightening/increasing the interest rates will reduce the money supply in the economy and thus decreases the inflation. The banks we running out of money. if it cuts the interest rate. The inflation was touching 11 % at that time. . First. Also they have to deposit more money in RBI (SLR). securities. So a sharp drop in inflation indicates a sharp drop in local demand and economic growth. it will increase the money supply for the economy. So there was money for the investors to invest and households to spend. As a result. 47/1 $. if we keep the interest rate the same. This will save the stock markets from crashing but will aggregate the demand. As a result they spent less and thus the demand of the goods got reduced. There was a huge credit crunch in the economy. So after a lot of discussions RBI cut the interest rates. Then the effects of this rate cuts started showing the effect after a month. So RBI had to take the decision to reduce this rapid fall in the value of money. So we can expect a rate cut by RBI this week. This week inflation came out as 8. So the banks had to pay more interest rate for RBI for the money took (Repo Rate). So this gave the money even to the manufacturers to produce more goods to meet growing demand and thus in turn reduced the inflation. So the value of rupee also lost its value to Dollar and reached the level of Rs. So they took less money from the bank as loans. by buying its bonds and govt. So RBI had to a decision to make.

He believes that this decrease is because of decrease in demand of goods for consumers rather than increase in Supply of goods by producers. As discussed earlier. if it decreases the interest rates. How to make money cheaper? How it influences the consumption and investments in India? The term “Making money cheaper” indicates that we should lessen the value of rupee in terms of Dollars.But in the present article the author feels that this sudden decrease in the inflation is not a positive indication. but would have decreased the value of economy in the world arena. But India being a open economy. But it has some disadvantages also. This will infuse more currency into the market. This will allow household to get money from the banks at a less interest. this is not good for any economy. This inflation will again cripple the purchasing capacity of the consumers This is a cyclic process. That’s the reason why the author says that making money cheaper is not a good option to increase consumption and investments especially in open economies like India. So he takes the money. . This can be done by having excess supply of rupees in the economy by the RBI. spends it (Consumption). a lot of arbitration happens and this results in the increase in the value of goods and services in the economy which causes inflation. Decrease in interest rate will also encourage the firms/producers to get loans at a cheaper rate. This can be done by decreasing the lending rates of all the banks (Repo rate) or by decreasing the percentage of money that is required by the banks to purchase bonds (SLR) or both in some cases. it is clear that the overall value of economy is not increased considerably. India if it were a closed economy. the decrease in interest rates would have caused a lot of economic development. This will create the value of money to decrease and by applying the PPP algorithm. So they will also take the loan and then invest it in new ventures and to increase the productivity of their manufacturing units. This will in return create some employment also.

So the interest must be paid to the foreign debts and the money that has to be paid to the maturing bonds. Debt. This Debt fund can also be raised by borrowing the money from other economies. everything comes under the govt. . spending and development. revenues. we can always try to increase the total investments. But we should be clear that money supply can be done by govt. debt is not intended solely for this. Thus they increase the money in the system by supplying this to the banks. …… Conclusion: This article was taken from “The Mint” dated 13th Nov 2008. In this article the author mainly emphasizes on the fact that decrease in inflation number is not always a positive indicator. The fiscal deficit of India is 3. takes comes with some interest. The GDP of the Country can be defined as Y=C+I+G So if we are having a decrease in consumption because of slow growth.5%. This is one of the highest in the world. debt. So taking this kind of debts will increase the load on fiscal deficit of the country. Many of the bonds are at a rate of 8.Why to borrow money and support demand? Why India is not doing so? As already discussed. Also the external debt of India is about US$ 201 billion. one of the ways to increase the money supply in the market is to have changes in the interest rates by the Central Bank (RBI). This is done primarily for govt. but govt. expenditure. owes is called the Govt. Expenditure and govt. Another way to increase the liquidity in the market is to take the money from the people as a part of investments. Let us now suppose that the RBI wants to get money from the system and then supply it back to the banks at some (repo) rate.5 – 10. These investments can either be in the form equities or debt instruments. This money which the govt.17% of total GDP. Fiscal Deficit of a country can be defined as the difference between the govt. So the author believes that the idea of taking debt and supporting demand is not a good option as India has already missed its fiscal deficit target of 2. Also the money which the govt. It sells bonds to the people/institutions and then gets money as a return for their bonds.5% due to global recession.

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