Economics of Money and Banking - Inflation in India - Term Paper Example

Economics of Money and Banking: Inflation in India Student Name: Institutional Affiliation: University: Inflation in India 1.0. Introduction The persistent inflation levels in India have raised great concern; with authorities calling for concerned efforts to develop alternative means of to enhance food security in the nation. Similar to many other Nations in the world, India has been experiencing severe inflation due to the effects of the financial crisis that affected the world’s economy to a significant extent. The inflation is also associated with the 2009 drought that affected agricultural output severely, thus leading to skyrocketing prices (OneIndia, 2011). In this paper, the situation in India is analyzed in relation to inflation literature; with an objective of establishing the link between inflation and interest rates in this economy. Further, the paper will determine whether the current interest rates in the country are right, too low or too high in reference to the price level in India. 2.0. Discussion 2.1. Inflation Inflation is often used to denote a general price increase of goods and services during a particular period of time (Grant & Vidler, 2000). This is normally presented as an annualized change in price index over time and expressed in percentage. Inflation is accompanied by eroded purchasing power, product shortage, declining savings and investment and declining real value of money (Mankiw, 2008). It is generally accepted among economists that excessive money supply is ideally behind high inflation rates. Moderate and low inflation on the other hand may be attributed to changes in real demand and supply as well as money supply growth. Moderate inflation (between 5-10%) is in most circumstances considered undesirable for a company because it often turns out to be too expensive and bothersome for the country (Mankiw, 2008). There are various factors that are put into consideration whenever the issue of moderate inflation and its impacts on the economy is discussed. These include effects such as tax distortions, “shoe leather costs” and money illusion; all which increase the risk of nominal asset holders such as banks (Blanchard, 2000). Moderate inflation levels are known to alter the investment and consumption patterns due to the above alterations. Tax distortions that are inflation-induced can be harmful to the economy as they deprive investors of their earnings (Blanchard, 2000). To begin with, the size of capital gains tends to be exaggerated by inflation and this in turn increases the investors’ tax burden. Further, nominal interest from savings is often considered as income during the calculation of income tax, yet part of the nominal interest ideally compensates for inflation (Mankiw, 2008). This makes savings less attractive to individuals and potential economic growth is therefore hampered. The shoe leather costs” denote the costs incurred, both in terms of time and effort, in counteracting inflation effects (Blanchard, 2000). It is often referred to as the opportunity cost of energy and time in the process of fighting inflation and this may occur through holding less cash and the need to visit the bank additional times. The term is derived from the fact that historically, people would have to walk more as they made trips to the bank before the advent of internet banking, insinuating that their shoes would thus wear out quickly (O’Reilley & Bank of Canada, 2008). During times of inflation, people may tend to reduce the amount of money held in cash than when there is no inflation and this ideally tends to eventually end up in higher costs and wastage of time and energy which could have been channeled to other activities. Lastly, moderate inflation leads to the creation of money illusion such that the country seems to be experiencing high growth. This may lead to false indication of growth in the country. 2.2. Inflation concerns in India In April 2011, Manmohan Singh, the Prime Minister of India admitted that the country was experiencing persistent inflation (OneIndia, 2011). This is especially in the food sector where food security has been identified as a serious problem for the country. While India has consistently sought to control inflation, the food prices in the country have continued to rise since the year 2009 when the country was faced by drought, thus affecting agricultural productivity. The need for action is therefore necessary to curb the persistent inflation levels in the country. The following graph indicates the recent changes in the inflation rate in India which peaked between January and February 2010 (Trading Economics, 2011). While the inflation rate has reduced significantly following this period, it is notable that inflation continues to affect India even today. It is particularly unfortunate that the inflation ranges between 5-10%; which is considered undesirable in any economy. Fig. 1: India Inflation rate (Jan 2009-August 2011) Source: TradingEconomics.com 2.3. Inflation, Nominal interest, Real interest statistics in India The data on inflation in India indicate that the country has experienced inflation for a significant period of time. In the figure 2 below, the inflation rate only became negative between the year 1976 and 1978. A record low was recorded in May 1976 at -11.31 percent (Trading Economics, 2011). In the rest of the years beginning 1969, inflation has been fluctuating, with the highest figure being recorded at 34.68% in 1974, followed by 20% in 1998 (Trading Economics, 2011). The average inflation rate during the given period (1969-2011) is 7.99%. Fig. 2: India Inflation rate (Jan 1969-August 2011) Source: TradingEconomics.com To aid comparison and establish a relationship among inflation, nominal interest rate and real interest rate, the data indicated in figure 3, 4 and 5 is used. The figures represent the statistics for India’s inflation, real and nominal interest rates from the year 2000 to 2011 (A total of 10 years and 7 months). Fig. 3: India Inflation rate (January 2002 -August 2011) Source: TradingEconomics.com Figure 3 indicates that the highest inflation was recorded between February to March 2010 at 16.3%. The high level of inflation has however declined over the following months to reach 8.62 in June 2011. This figure is an indication that the country is still struggling with inflation and this could be a cause of alarm as persistent inflation rates could impact significantly on the economy of India. Nominal interest rates Fig. 4: Nominal interest rate (Jan 2000-August 2011) Source: TradingEconomics.com Real interest rates Fig. 5: Real interest rate (Jan 2000-August 2011) Source: TradingEconomics.com Figure 4 and 5 above represent the nominal and real interest in India. From the figures given above, it is notable that the nominal interest is generally higher than the real interest. This can be explained by the calculations needed in factoring the level of inflation in the interest rate to obtain the real interest rate. According to Grant & Vidler (2000), nominal interest rate consists to interest has not been adjusted to cover inflation. It is real interest, obtained once inflation has been factored that reflects the cost of borrowing more accurately. In the year 2009 for example, the real interest rate was 4%. This can be calculated as follows. ir = i-πθ = 13.3 - 9.3 = 4% 2.4. Linking inflation and interest rate There is a clear link between inflation and interest rate in India as indicated in the graphs above. Inflation is often accompanied by increasing interest rates due to the need to control the level of money supply in the economy (Grant & Vidler, 2000). This is a factor that can be identified from figure 3 and 4 whereby rising inflation rates between 2008 and 2010 are accompanied by rising interest rates. There is a rising trend in both variables, where the inflation rate rises to a high of 10.3% in 2009 from 5.6% in 2008, while the interest rates in rise from 13% in 2008 to 13.3% in 2009 (Trading Economics, 2011). This therefore indicates a clear relation between inflation and interest rates. The statistics indicate that the higher the rate of inflation, the lesser the real interest. This can be attributed to the fact that real interest is obtained once the nominal interest is adjusted for inflation. If the rate of inflation is high, this means that more will be subtracted from the nominal interest rate to obtain the real interest rate. 2.5. Conclusion on interest rates Currently, the interest rates in the country can be said to be relatively high given the trend in previous interest rates. The latest statistics in the interest rate is 13.31%, a figure established in the year 2008 (Trading Economics, 2011). This figure is high and can be attributed to high inflation levels which have led to the increase in interest rate in the country. 3.0. Conclusion This discussion establishes that India has been faced by economic difficulties as a consequence of persistent inflation over the years. Currently, the inflation rate ranges between 5 and 10%, a range that is considered to represent moderate inflation. In this research, it is established that moderate inflation is often harmful to the economy as it is expected to have a negative impact due to tax distortions, “shoe leather costs” and money illusion; which often discourage savings and investment within a country. In this report, the link between inflation and interest rate is determined and it is notable that high inflation rates tend to push interest rates higher. In conclusion, India’s interest rates are still moderately high and the need to deal with the persistent inflation is therefore necessary. References Blanchard, O. (2000). Macroeconomics (2nd ed.). N.J: Prentice Hall: Englewood Cliffs. Grant, S. & Vidler, C. (2000). Economics in Context. London, UK: Heinemann. Mankiw, N. G. (2008). Principles of Macroeconomics. London: Cengage Learning. Mankiw, N. G. (2002). Macroeconomics (5th ed.). New York: Worth. O’Reilley, B. & Bank of Canada. (2008). The benefits of low inflation: taking stock. Canada: Bank of Canada. OneIndia. (2011). Persistent inflation a cause of concern: Manmohan Singh. Retrieved 25 August, 2011 from http://news.oneindia.in/2011/04/21/persistentinflation-a-cause-of-concernpm-aid0126.html TradingEconomics. (2011). India National Statistical data. Retrieved 25 August, 2011 from http://www.tradingeconomics.com/india/indicators Read More