The Hindu Business Line : Is inflation a monetary phenomenon?

The most basic monetarist conviction is that the cause of persistent inflation is excess money creation. According to monetarists aggregate demand inflation can be caused by rapid increase in the supply of credit money. And it is in this sense that inflation is termed as a totally monetary phenomenon.

The most basic monetarist conviction is that the cause of persistent inflation is excess money creation. According to monetarists, aggregate demand inflation can be caused by rapid increase in the supply of credit money. It is in this sense that the monetarist's emphasis on controlling and restricting the rate of monetary growth is correct. Increase in bank credit permits borrowers to deficit-spend. Bank-financed deficit spending is not offset by planned surplus spending out of current income.

Inflation is of significance to the growth and welfare of consumers, producers or government because the level of real money balances depends negatively on the prevailing inflation rate. These are some of the concerns that made the monetary authorities repeatedly revise upwards the repo rate and cash reserve ratios to control money expansion, particularly domestic credit creation which was resulting in inflationary pressures.

Inflation rate up

In 2006-07, the inflation rate crossed 6 per cent despite various measures taken by the RBI. The central bank correctly estimated that along with economic expansion, bank credit was being diverted to speculative activities in non-productive assets, non-financial assets and financial assets.

Since the financial assets structure became interest-rate sensitive and wasputting hedge finance into speculative activities, the RBI raised the repo and CRR rates repetitively, without having corresponding salutary results. The contributory factor for zero effect of the RBI's monetary measures to restrain the growth of liquidity was its assumption that inflation is a monetary phenomenon — a monetarist version.

Hypothesis vs truth

The hypothesis was that given the velocity of money, increase in CRR couldreduce money supply and, consequently, the inflation rate. However, this did not turn out to be true. It may be mentioned that rise in inflation, along with increase in money supply, was also aggravated by induction of black money on a continuous basis, and black money does not fall in the net of monetary authority. This could be one of the reasons for the surge in inflation .

Also, inflation movements in 2006-07 were driven by increases in the prices of manufactured products and primary articles due to rise in the demand for capital goods and cement, and shortages of primary goods such as foodgrains and pulses. The government has taken steps such as reduction in import duties and petrol price to mitigate inflationary increases. However, the squeeze in credit supply and increase in capital cost can generate cost-push inflation which is not only anti-investment but anti-growth too. Increase in capital cost can hit exportcompetitiveness on account of rise in interest rates and the rupee appreciation.

If one looks at sources of money supply, it is not very difficult to understand that foreign exchange inflows have given a big push to domestic monetary liquidity in the economy. Foreign exchange entering the economy through various sources such as exports, foreign direct investment, FIIs investment, participatory notes and foreign remittances on account of private transfers gets converted into domestic money.

Asset price bubble

Foreign inflows are being encouraged. They get converted into rupees, which is used for different purposes. There is a possibility that the bubble in asset prices was generated because of massive use of such money.

Strict vigil must be kept on segments of the economy that attract foreign funds. The government must think of using forex reserves to increase supply of goods. This would reduce money supply from the system.

Goods and services

It is necessary to examine and evaluate the structure of GDP growth and determine if it can compete with the demand structure for goods and services. For instance, GDP growth in agriculture and allied sectors has been poor. It is common knowledge that the farm sector needs massive investment and diversification in production.

There has been a shortage of foodgrains and pulses. Sugar production is not commensurate with the domestic demand. India has been exporting many food items despite their not being available to the common man at affordable prices.

As regards manufactured products India must reduce tariff rates and facilitate import of capital goods, which fall short of growing demand. Inflationary pressures have to be managed in an integrated manner.

The Government must continuously keep a watch on the emerging shortages of goods and services to meet the people's growing demands. The central bank, on its part, must look selectively at those segments of the economy that show speculative demand due to easy availability of bank credit.

(The author is former economic adviser to Securities and Exchange Board of India.)