REUTERS - It’s no surprise that Reserve Bank of India has come out with a tighter credit policy in a bid to contain inflation.
The RBI has increased the cash reserve ratio (CRR) by 25 basis point, from 8 to 8.25 percent. However, the efficacy of such a policy measure should be carefully considered.
Inflation happens when there is a mismatch between demand and supply. From a layman’s perspective managing inflation is about managing the demand side, supply side factors, or a combination of the two.
Demand side factors, are consumption expenditure, investment expenditure, government expenditures, and demand for exports and imports.
Managing demand therefore means managing any one of these components, which will ultimately have an impact on controlling inflation.
For instance, the economic expansion of 2005 which lasted until the early part of 2007 was primarily due to an increase in consumption expenditure.
A subsequent higher interest rate, which translated into higher loan rates, not only contained consumption expenditure but also investment expenditure, and thereby lessened inflation.
Clearly, a tighter credit policy in April 2007 was influential in reducing inflation rates from as high as 6.7 percent to around 3.5 percent within a quarter.
But things are different now. The main reasons for inflation are predominantly supply side factors, such as the rising price of crude-oil, commodity prices and food prices.
The weakening dollar is adding more to the problem. Under the current circumstances, what will matter more are prudent fiscal measures as opposed to monetary measures.
An ideal policy would therefore call for more fiscal prudence, a reduction in prices of essential inputs like iron and steel, cement, etc., and controls on government spending, like a cap on pay hikes.
On the other hand monetary policy which is too tight could sacrifice growth and lead to stagflation (a combination of higher inflation and unemployment) - something none of us would like to see.
Nilanjan Banik is associate professor at the Institute for Financial Management and Research, Chennai. The views expressed in this column are his own.