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The poorer Rupee

Apr 21, 2008

The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. This is the dictionary definition of inflation. As inflation rises, every rupee will buy a smaller percentage of a good. For example, if the inflation rate is 7%, then Rs 10 worth of sugar will cost Rs 10.7 in a year. Rising inflation is what is worrying policy makers, central bankers, and economists world over, apart from the common man, who feels the pinch the most. Inflation is a rise in general level of prices over time.

Cause of the problem... Changes in inflation is the result of changes in the supply or demand for money or changes in demand for the goods and services. The current rise in inflation that we are witnessing domestically is owing to supply side concerns i.e. supply failing to keep pace with growth in demand. Further, growth in demand is been boosted by alternative uses such as land for food crops being utilised for bio fuels.

Among the products that are aggravating the problem of inflation are rising edible oil prices and commodity prices like steel and iron. Further, products such as food items, cereals, and items of basic necessity are facing the maximum impact of inflation. This is the biggest concern for the government, this being an election year.

The measure...
Last month when the inflation marked 13 month high of 6.7%, government in a move to contain inflation banned exports of few cereals and edible oils. Simultaneously it also reduced import duties bringing it to nil in case of crude edible oil.

This was not enough as inflation mounted to 7.4% in March 2008, a 40-month, high despite the restrictive measures. In a move to restrict inflation from mounting further the government has proposed ban on cement exports, after having earlier removed tax incentives on exports. Ban on exports plus increased imports may help to hold prices at current levels if not reduced.

Further, the government is also considering banning steel exports. In a move to reduce money supply the RBI (Reserve Bank of India) has hiked CRR rate by 50 basis points in two tranches to 8%. This move would restrict money supply in the system by Rs 185 bn as liquidity is one of the key factors that are responsible for rising inflation.

What does this mean for the economy?
The moves are intended to curtail inflation so as not to hurt the growth of the economy from a long-term point of view. Not with standing the fact that these measures may hurt growth in the short run, considering the long term it is imperative to control inflation as it reduces value of the currency.

  • Reduced value of money impacts consumption if the disposable income does not maintain the pace of growth of inflation.

  • Bad for lenders as owing to inflation what they will get may not be the worth what was lent.

  • Investment decisions of businesses get affected. With rising future inflation future investments in future projects may decrease, as one may not find return from investments as attractive. Deferred investments or decreased investments impacts production or infrastructure built up in the country in turn adversely impacting growth of the economy.

To what extent all these moves can help curtail inflation remains to be seen as the much of headline inflation is also been propped up by rising commodity prices globally such as oil and iron ore, thus boosting the price of the end product, apart from the demand supply mismatch.

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