Column: Tough trade-offs in inflation control

Jun 02 2014, 04:21 IST
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SummaryFocusing on fiscal spending or interest rate policy may not be suited to bringing down inflation

One of the immediate tasks for the new government is to tackle inflation. This economic phenomenon has been the Achilles heel for the last 4 years. Ironically, it has come at a time when we have had good harvests with price pressures being manifested in the primary and fuel articles categories. Surprisingly, inflation when viewed for only manufactured products, has been the lowest averaging around 5% going by the WPI while primary and fuel products have registered increases of 8.3% and 7.9% respectively. While there is a lot of debate on whether RBI should lower interest rates or increase them and whether the government is spending too much money which is inflationary, conventional economic theory has actually been turned around, as these hypotheses may not be holding today.

First, has high government spending been responsible for inflation? Theoretically, it can be argued that when the government spends beyond a limit, there is too much liquidity in the system which drives prices up. Here the assumption is that there is excess demand for various commodities. But when inflation is on the side of food and fuel, this theory cannot be ratified. Further, RBI data shows that industry, as of December 2013, was operating with capacity utilisation levels of around 74%, which means that it could respond well to demand with the existing capacity. Further, if one looks at the inventories of the manufacturing sector, the ratio of finished goods to sales is around 18% while that of raw materials to sales is 25%. This again indicates that demand is slack and industry has the means provided someone provides demand. The problem is one of shortfall and not excess demand.

Second, a counter argument put is that the MGNREGA programme put a lot of money in the hands of individuals which though serving a social objective did not make economic sense as assets were not created and money was given to be spent. As an extension, this wage drove up wages in other sectors too as the minimum wage level went up thus exacerbating demand. Looking at MGNREGA on its own, total outlay was around R30,000 crore per annum, which often turned out to be lower than budgeted. Even so, this amount is around 1.5% of GDP from agriculture or 1% of value of output. Clearly, this amount is too small to influence prices. Also, given that MGNREGA or minimum wage paid is

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