ROLE OF MONETARY POLICY IN CONTROLLING INFLATION

Submitted By:

Abhay Anand, (2102)

B.A. LL.B. (Hons.)

Submitted To:

Dr. Shivani Mohan

Assistant Professor of Economics

This Final Draft is submitted in the partial fulfilment in the course titled “Macro
Economics” for the completion of B.A. LL.B. (Hons.) course.

April 2021

Chanakya National Law University, Patna

 ACKNOWLEDGEMENT
Thanks to the Almighty who gave me the strength to accomplish the project with sheer hard
work and honesty. This research venture has been made possible due to the generous co-
operation of various persons. To list them all is not practicable, even to repay them with words is
beyond the domain of my lexicon.

This project wouldn’t have been possible without the help of my teacher Mr. Kumar Gaurav,
Assistant Professor of Law, CNLU Patna who had always been there at my side whenever I
needed some help regarding any information. He has been my mentor in the truest sense of the
term. The administration has also been kind enough to let me use their facilities for research
work, I thank them for this.

Kumar Sanjeev (2122)

B.A. LL.B., 2nd year

SEMESTER – 4th

CNLU, Patna
 1 INTRODUCTION
Inflation is taken into account to be a complex state of affairs for an economy. If inflation goes
on the far side a moderate rate, it will create disastrous situations for an economy; so is should be
in restraint. It is tasking to regulate inflation by employing a explicit measure or instrument. The
main aim of each measure is to reduce the inflow of money within the economy or reduce the
liquidity within the market.

Mostly Indian population, around 60%, lives in the rural area. Thus, raise in the necessary
commodities directly the middle and pauper class families. The increasing Inflation in India is
grave concern due to the difference between ‘rich and poor’. Excess money relative to the goods
and services produced are results of increased prices or Inflation. The monetary policies help the
country to achieve higher rate of growth with a stable inflation rate. Monetary policy making
authority, in recent year, given higher preference to price control and so has increased repo rate
as a result and never reduced it, even after peer pressure from the government.

The recommendation of the Chakraborty Committee in 1998-99, India has been following a
multiple targeting approach wherever the only target or objective is not either stable or higher
growth however multiple. Among the context of all this, this paper studies some necessary
factors affecting inflation which could help us analyze the monetary policy response to inflation.

Inflation is taken into account to be a complex state of affairs for an economy. If inflation goes
on the far side a moderate rate, it will create disastrous situations for an economy; so is should be
in restraint.It is tasking to regulate inflation by employing a explicit measure or instrument. The
main aim of each measure is to reduce the inflow of money within the economy or reduce the
liquidity within the market.

AIMS & OBJECTIVE

 To study the changing role & importance of Monetary instruments

 To examine the effectiveness of Monetary policy in ensuring price stability
DATA SOURCE & METHODOLOGY

This Study is exclusively based on Secondary data which are collected from-

 RBI Bulletin, RBI Occasional Papers, RBI Annual Report,

 Report on Currency & Finance, Economic Survey, Economic & Political Weekly,
 Asia Economic Review, Indian Economic Journal,
 World Bank Report, Internet etc.
 2 INFLATION- EFFECT AND CAUSE
Inflation is essentially misapprehended as simply “rise in prices”. There is also temporary
phenomena like fast bumper or sudden failure in production of sure sectors like agriculture that
cause temporary value modification. These value movements should not be conceptualized into
the inflation or deflation, however are merely market occurrences of temporary fluctuation in
supply. Inflation may be a varied economic conception and far a lot of complicated to contend
with.

As Kaushik Basu, the Chief Economic consultant to Ministry of Finance explains inflation as
“[Inflation] has very little to try and do with these changes in relative prices (though inflation is
also in the midst of it) of goods and services. It refers, instead, to a sustained rise in costs across
the board, that is, a phenomenon wherever the typical value of all goods is on an increasing
trajectory for a few stretch of time”.

Inflation mismatches pair between total supply and total demand and additionally of the policy
framework and implementation. Several sources—industrial and agricultural sector, corporate,
laborers, households and government contribute to the aggregate demand in an economy.
Therefore what any single supply will influence is restricted. Also, it's terribly troublesome to
find out, because of their mutually beneficial nature, and to trace out precisely source supply is
inflicting what and to what extent it is moving the economy. These restrains contribute to
generating inflation one in every of the toughest issues to handle creating it the emperor of
economic maladies.

CAUSES

It is argued that Demand is one among the foremost factors giving rise to inflation. Demand- Pull
inflation is caused once the provision within the market isn't able to match the demand. There are
several factors inflicting the demand to rise like increase in money supply and/or immense
amount of public expenditure could result in higher quantity of disposable income. Also, rise in
rural income and alter in consumption pattern has disturbed the supply flow. non-public sector
with its export oriented policy and large investment causes employment and high financial gain.
Government policies like deficit funding for reducing public debts or low-cost monetary policy
for credit growth, etc. raise the cash supply. These factors end in escalating the overall finances
in an economy, so giving rise to inflation.

EFFECT

The consequence of inflation is that the unreasonable transfer of wealth from poor to the rich- the
poor and therefore the socio-economic class suffer to the fastened nature of their financial gain
even as the costs skyrocket, whereas industrialists, traders, businessmen with their variable
financial gain gain plenty.

Inflation ends up in several negative effects like fall in purchasing power and erosion within the
real worth of money. It conjointly ends up in risk and uncertainty, particularly concerning the
long run purchasing power of money that discourages savings and investments. illusory inflated
incomes force taxpayers into higher taxation rates margin. With rising inflation, the speculation
cash additionally rises, encouraging hoarding and black-marketing. The economy gets cornered
into the wage-price spiral, wherever one is both the cause and impact of the opposite.
Persistently soaring inflation disturbs the investment pattern, therefore negatively moving the
economy.
 3 WHAT IS MONETARY POLICY
Central banks are the national authorities liable for providing currency and implementing
monetary policy. Monetary policy may be a set of actions through that the financial authority
determines the conditions below that it provides the money that circulates within the economy.
Monetary policy thus has an impact on short-run interest rates.

Setting monetary policy goals has been a shaping issue for economists and vox populi since the
consolidation of central banks because the entities accountable for providing the economies with
domestic currency and for implementing monetary policy. Parallel with educational progress and
knowledge during this matter, the understanding of monetary policy has advanced considerably
over the previous couple of decades.

Currently, it's clear that in each academic circles and among the world’s financial authorities,
monetary policy’s best contribution to sustained growth is to foster value stability. For that
reason, in recent years, the central banks of the many countries, as well as North American
nation, have reoriented their monetary policy objectives, setting value stability as their main
goal. This goal has been formalized, in most cases, by establishing low-level inflation targets.

The financial organisation doesn't control costs directly as a result of these are determined by the
provision and demand of the many goods and services. Notwithstanding, through monetary
policy the financial organisation will influence the price-determination method and therefore
attain its inflation target.

The latter suggests the intense want for the financial authority to spot the consequences that its
actions wear the final economy and, notably, on the price-determination method. The study of
the channels by that these effects present itself is thought because the monetary policy
mechanism.

TYPES OF MONETARY POLICY

 Contractionary monetary policy- This kind of policy is employed to decrease the

number of cash circulating throughout the economy. It's most frequently achieved by
 actions like marketing government bonds, raising interest rates and increasing the reserve
necessities for banks. This technique is employed once the govt desires to avoid inflation.
 Expansionary monetary policy- The aim of this kind of monetary policy is to extend the
money supply inside the economy by completing actions like decreasing interest rates,
lowering reserve necessities for banks and buying government securities by central
banks. This kind of monetary policy helps to lower unemployment rates similarly as
stimulate business activities and consumer spending. The general goal of this policy is to
fuel economic process. However, it also can have an adverse result, often resulting in
hyperinflation.

OBJECTIVE OF MONETARY POLICY

No matter what variety of monetary policy is getting used, it's continuously connected to at least
one of the subsequent 3 objectives:

 Manage inflation.- Most economists think about this the one true objective of
monetary policy. In general, low inflation is most contributing to a healthy, thriving
economy. Therefore, once inflation is on the increase, the central bank might
modify monetary policy to scale back inflation.
 Reduce unemployment.- Throughout depressions and recessions, unemployment
rates tend to soar. However, monetary policies conjointly play a significant role in
state rates. Once inflation problems are addressed, expansionary policies will then
be enforced to assist scale back unemployment rates. This works as a result of the
rise within the finances helps to stimulate the business that conjointly helps to form
a lot of jobs. Whereas there is also no way to totally succeed true economic
condition, the goal is to scale back the speed of state among people who are
prepared and willing to work for the prevailing wages.
 Balance currency exchange rates.- Providing stable exchange rates play such a
significant role in international trade, it's essential to search out ways that to stay
them balanced. Central banks have the ability to manage exchange rates between
foreign and domestic currencies. as an example, if the financial organisation opts to
 issue a lot of currency to extend the money supply, domestic currencies become
cheaper than foreign currencies.

MONETARY POLICY & PRICE STABILITY

The monetary policy has undergone extensive changes the world the globe within the Nineties.
There is, initial of all, a clearer target price stability as a principal - although not essentially the
only real - objective of monetary policy. Besides, with the release of economic markets and
economic process, the method of monetary policy formulation has noninheritable a way larger
market orientation than ever before, causing a shift from direct to indirect instruments of
financial control. This has been in the midst of many institutional changes within the monetary-
fiscal interface to confirm that central banks possess the autonomy to anchor inflation
expectations.

To analyze the effectiveness of monetary policy in guaranteeing worth stability in Bharat, we've
to require under consideration the changes within the credit, cash and inflation throughout the
amount of our study. Now, we are able to have a glance into the variations within the values of
those variables over the amount for locating out the explanations behind them. Whether or not
financial policy is effective in implementing worth and money stability or not, are going to be
clear from such a comparative analysis. The values of all the 3 things have accrued over the
year’s proportion changes in these values additionally show a positive image, however with
frequent ups and downs in variations. Whenever there have been worth hikes throughout the
years, financial authorities with success has created use of all the weapons effectively and
providentially, to rein the inflationary pressures and to take care of monetary stability within the
economy. Maintenance of low and stable inflation has therefore emerged as a key objective of
monetary policy.

However, monetary policy cannot modify economy reach price stability. In sight of seasonal
fluctuations in agricultural prices in Bharat, there's additionally want for supply management
policies for dominant inflationary pressures.

This is why the Chakravarty Committee has instructed a two-pronged strategy for achieving
worth stability:
 a) Raising output levels by the adoption of offer management policies through central
government directive, and
b) Dominant the growth in reserve cash and money supply by the RBI.

In this context, we've to grasp the connection among monetary resource, output and costs. Within
the last 20 years, the rise in reserve cash and in money supply has been mostly because of an
increase within the level of RBI credit to government.
 4 EFFECT OF MONETARY POLICY IN CONTROLLING INFLATION
The conduct of monetary policy is complicated. it's not solely progressive, it further additionally
grapples with an unsure future. further complexities arise within the case of an rising market like
India, that is in transition from a comparatively closed to a increasingly open economy. In an
atmosphere of increasing capital flows, narrowing cross-border rate of interest differentials and
surplus liquidity conditions, rate of exchange movements tend to possess linkages with rate of
interest movements. The challenge facing a financial authority is to balance the varied selections
into a coherent whole and to formulate a policy as an art of the possible.

Monetary policy is outlined as a public interventionist action that aims at manipulating the
amount and array of economic activity thus on accomplish specific, desired goals. Specifically,
monetary policies are aimed to figure underneath two economic variables that the amount of
inflation in an economy. Two aggregate variables are supply of money in circulation and also the
various rate of interest in an economy. Dominance of this channel was additionally evident from
the policy actions of reserve bank of India (RBI). Over the years, compared with different
financial policy instruments, the utilization of rate of interest instruments (repo and reverse repo)
by rbi has been a lot of frequent. Aside from the year 2008-09, once money reserve ratio (CRR)
and repo rate were reduced ten times and eight times, severally, within the wake of worldwide
monetary crisis, RBI has shown inflated preference of using interest rate as a primary tool of
financial policy. Throughout 2010-11, the repo rate was enhanced thirteen times for dominant
the high rate of inflation.

The Reserve Bank of India has adopted policies through that it decreases or will increase certain
rates to regulate inflation. Thus it's necessary to know what these rates are and the way they have
an effect on inflation.

1. Rate of Interest
a) Repo Rate- Repo rate (Repurchase or Repossession) that rate at which Reserve Bank of
India buys government securities with an agreement of repossession, from the industrial
banks. it's a short term borrowing from the financial organisation, against securities, to
 inject cash to fulfill the gap between the demand for cash (loans) and deposits within the
bank.
b) Reverse Repo rate- it's the rate at that the Reserve Bank of India borrows cash from the
business banks. Banks deposit cash in Reserve Bank of India once there's no different
profitable commercial invest the short term excess liquidity or once there's uncertainty
within the marketplace for a major amount of time.
c) Bank Rate- bank rate is that rate at which the Reserve Bank of India permits finance to
the domestic banks. it's usually for brief amount of time. Unlike, Repo rate, there aren't
any securities to be unbroken against the finance. But, in policies designed to regulate
inflation, Bank rates are rarely revised.

Increase in these interest rates means the Reserve Bank of India is creating it overpriced for the
industrial banks to borrow money (in case of reverse repo rate, moneymaking to stay the deposits
in RBI), so limiting the injection of cash in the market. Reserve Bank of India will this to
decrease the liquidity within the market.

2. Reserve Ratios
a) Cash Reserve Ratio- Banks are needed to stay a fraction of deposit liabilities within the
type of liquid cash, CRR, with the Reserve Bank of India to make sure safety and
liquidity of the deposits.
b) Statutory Liquidity Ratio- each bank in India should maintain a minimum proportion of
their exact demand and time deposits as liquid assets within the form of money, gold,
 precious and valuable stones. SLR has nearly remained constant since last fourteen years.
If there's increase within the reserve ratios, the entire quantity of deposits left with
industrial banks that it will provide as industrial loans decreases and thus there's
reduction within the loan granting capability of the banks. Reserve Bank of India uses
this instrument for credit control within the market.
3. Open Market Operations - The Reserve Bank of India should buy or sell Government
securities from or to the general public. To regulate inflation, the Reserve Bank of India
sells the securities within the securities industry that sucks out excess liquidity from the
market. Because the quantity of liquid cash decreases, demand goes down. This part of
financial policy is termed the open market operation.
4. Selective Credit Control- the Banking Regulation Act empowers the Reserve Bank of
India to regulate the extent and pattern of advances given by banks, by selection. The
Reserve Bank of India has been operative selective credit control to contain inflation of
goods that are short in provide or sensitive goods like food grains, vegetables, pulses,
oilseeds, cotton, sugar, gur, khansari, etc that are of mass consumption. The selective credit
management policy, therefore, is to discourage advances given by banks against these
essential commodities. Reserve Bank of India uses financial policy as a weapon to contain
inflation, that it's been religiously adjustment throughout the last financial year (one of its
kind within the history of Indian monetary System). Surveys (from RBI) show that the
financial tools are no-hit to combat inflation.

The objectives of financial policy are interconnected, and there are trade-offs further.
Historically, central banks have pursued the dual objectives of price stability and growth. For
this the central banks need to detain mind the issues of rate of exchange stability and financial
stability in following these basic objectives. Economists typically talk about Phillips curve, in
step with that there's a short-term negative relation between inflation and unemployment.
However, the financial organisation will scale back inflation solely at the value of higher
unemployment. Similar trade-offs exist among the opposite objectives further. visaged with
multiple objectives that are equally fascinating, there remains the matter of distribution to every
policy instrument the foremost applicable objective.
“In recent years so as to possess some fix for influencing inflation expectations at a time once
several central banks were inflation-targeters, the Reserve Bank of India detailed its objective
of price stability. whereas price stability remains a key objective, associate inflation targeting
framework alone is insufficient as a result of India is subject to variety of shocks and special
restrictive and body structures not essentially present in different countries. These shocks
embrace repeated offer shocks from vagaries of the monsoon; massive weight of food costs
(46-70 per cent) in numerous client consumer indices; massive variations in consumption habits
across totally different regions and therefore massive variations in however these shocks have
an effect on spending power; massive fiscal deficits and market borrowings by each the central
and state governments; and impediments to financial transmission because of administered
interest rates in some government savings instruments” (Mohan, 2007).

In order to review the effectiveness of financial policy in dominant inflation, the Taylor rule is
of nice importance within the gift economic conditions of high inflationary patterns. In
economic science, a Taylor rule may be a monetary-policy rule that stipulates what quantity the
financial organisation ought to amend to the nominal rate of interest in response to changes in
inflation, output, or different economic conditions. particularly, the rule stipulates that for every
onepercent increase in inflation, the financial organisation ought to raise the nominal rate of
interest by quite one decimal point. This side of the rule is commonly known as the Taylor
principle.

Taylor's rule isn't a advised framework for India despite its exaggerated quality within the
world. within the light of literature review, various factors are known that result in the
conclusion that India isn't nevertheless prepared for Inflation Targeting Framework (ITF). the
first reasons for this are: (1) offer aspect dominance as hostile demand aspect, as explained
within the Taylor's Rule; (2) Inflation can not be the only real objective of run and also the
charge per unit isn't the only real instrument for intermediate target of inflation, whereas
Taylor's rule needs refraining from using the other nominal anchor; (3) there's no sturdy
relationship found between inflation and rate of interest in India; (4) Reserve Bank of India
doesn't have complete independence pro re nata for the prosperous implementation of Inflation
Targeting Framework;(5) the steadiness of exchange rate and capital flows is of great concern
for Reserve Bank of India and inflation targeting creates larger volatility in exchange rate
through adjustment in interest rate; (6) High fiscal deficits additionally result in high
inflationary pressures within the economy and Indian economy is additionally characterised by
business deficit (although this pressure is reducing with passage of time).

Furthermore, adoption of ITF may imply volatility in interest and exchange rates and chronic
deviations from equilibrium levels. The Indian economy, with an oversized fiscal deficit and a
major portion of finance below administered interest rates together with indications of supply
side dominance, may have issue addressing that financial stance that depends on influencing
the demand aspect. However, the past and also the gift Governors of Reserve Bank of India
offer some justification for maintaining high interest rates so as to manage inflation.

According to D. Subbarao (2013), several contend that since inflation in India is essentially
because of provide shocks, it's imprudent for the financial policy to manage it. Text book
economic science tells us that if the provision shock is temporary, financial policy needn't react
to it; on the opposite hand, if the provision shock is structural in nature, it will result in
generalized inflation - within the initial spherical by the higher input prices, and within the
second spherical through its impact on inflation expectations and wage dialogue. Within the
presence of excess demand relative to produce, the generalization of inflation may well be fast
unless prevented through a innovative anti-inflationary financial policy stance. In short, once
supply shocks impact the core element of inflation, financial policy ought to respond.
determinative whether or not the provision shock is temporary or structural may be a frequent
challenge that central banks of emerging Market Economies (EMEs) need to confront.

Central bankers cannot management inflation these days because it is already completed. What
they will management is future inflation thence the target is medium term inflation. Current
inflation matters solely as a result of it conveys data regarding what may happen over the
medium term. however an honest central banker can pay attention to why inflation is high these
days, and to the seemingly future pattern of growth, decide regarding interest rates. as an
example, the U.S. Federal Reserve System, despite being ruled by an implicit inflation
objective, isn't raising rates within the face of higher current inflation as a result of it believes
slower future growth can quell inflation over the medium term. To repeat, the logic behind an
inflation objective is that the simplest the financial organization will do is to stay growth at tier
in keeping with the supply constraints within the economy. Tries to push growth on the far side
this through lower interest rates can merely end in a lot of, and accelerating, inflation, whereas
high rates that keep growth below potential can cut back inflation below the target, and waste
the economy's potential.
5 CONCLUSION