Uncovering the myths about - Inflation

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jayprakashimtn
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Re: Uncovering the myths about - Inflation

#1 Postby jayprakashimtn » Tue Apr 07, 2015 2:45 pm

To maintain the inflation rate at a certain level, the role of the central bank, in case of India, RBI is very important. The views of the central bank on inflation will decide the monetary policies adopted by the central bank. For example the 23rd governor of RBI, Raghuram Rajan believes that monetary policy should not be the preferred instrument to bring about long term changes in the economy, but instead India should rely on structural reforms, that over reliance on monetary policy to stimulate growth in the country is detrimental in the long run.hat is why Mr. Rajan has decided to keep the inflation under check.

ANKITSHAH
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Joined: Fri Nov 14, 2014 5:59 pm

Uncovering the myths about - Inflation

#2 Postby ANKITSHAH » Fri Dec 19, 2014 3:11 pm

How will be your reaction if someone tells you that year after year your salary has been going down in real terms. I think it will not be pleasant realization that if the inflation rate is greater than your annual salary percentage increase, your purchasing power is actually decreasing over the years. This is what inflation can do to you. Unfortunately for us, inflation has been quite high in the past few years in India and our central bank, Reserve Bank Of India (RBI) has been rightly taking various steps to control it. Here we try to analyze the relationship between inflation and the various monetary policies undertaken by RBI during the period 2008 to 2013.

Let us start with Inflation; Wholesale Price Index (WPI) is the most popular measure of inflation in India. It is measured based on the change in Wholesale prices of a gamut of commodities.

So, is inflation, always bad? No. A low but positive rate of inflation (like 1 or 2 percent) is actually necessary for economic activity. This incentivizes the producers to produce. RBI using monetary policy tries to keep the inflation at such levels.

Now let us turn our focus to monetary policy. Monetary policy is the process by which central bank of a country controls the supply of money. Monetary policies in India are conducted by our central bank, RBI. The stated objectives of monetary policies of the RBI, is to regulate the issue of bank notes and maintaining reserves to secure monetary stability in India. One of the objectives of our monetary policy is to keep inflation at a desired level, conducive to growth. But before we see how monetary policy impact inflation, let us try to understand various instruments used by RBI for implementing monetary policies.
The policy actions can be differentiated into direct and indirect instruments. Direct instruments operate by changes in policy rates or amount of credit outstanding through regulations. While indirect instruments operate through the market. But since India still doesn’t have developed financial markets, indirect instruments like Open Market Operations are limited in their capabilities to implement monetary policies.

Though there are various instruments available, Reserve requirements and Repo operations play a major role in monetary policies of RBI. Reserve requirements are basically obligations on commercial banks to hold a fraction of their deposits with RBI. Any increase in reserve requirements usually reflects contractionary monetary policy and will reduce the availability in the economy. The repo operations consist of repo and reverse repo operation and forms a part of the liquidity adjustment facility. A repo agreement is the sale of security with a commitment to repurchase the same security at a specified price and on a specified date, while a reverse repo is purchase of security with a commitment to selling it at a predetermined date and price. Repo operations are very short-term in nature.

Repo rate is the policy rate of choice of RBI when it comes to conducting monetary policies. Though there are various rates like Bank Rate (the rate at which RBI allows finance to commercial banks), Reverse repo rate (the rate at which RBI borrows money from commercial banks within the country) and Marginal standing facility rate (the penal rate at which banks borrow from the RBI after exhausting their borrowing limits under the repo window), most of these rates move along the Repo rate and hence we will be focusing only on the relationship between repo rate and WPI.

Other than repo operations, the reserve requirements play a major role in monetary policies in India. RBI has mandated Cash Reserve Requirement (CRR) and Statutory Liquidity Ratio (SLR) as reserve requirements. The below graph shows the CRR and SLR over the period under consideration:

If we calculate R-square using the regression analysis, which is a measure of how good the relationship holds, then we find that it comes out to be 0.7569. Therefore, we can say that inflation rate, empirically, in the short term indeed appears to be closely related to the monetary policy undertaken.


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