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Inflation Case Study (a)(i) Using Figure 1, compare the change in consumer prices for India and China from 2002 onwards. • Inflation has generally risen for both countries from 2002 to 2008. • India has had the higher level of inflation and it has increased tremendously since 2005. • OR China’s inflation rate is slowing down or decelerating [from 4%, drop to close to 1%], whereas India’s inflation rate is accelerating [from 4% to above 6% within the 2 year span from 2004-2006] • Evidence: India’s curries hotter than the fieriest of Chinese hotpots likewise the temperature of the two economies” (a)(ii)Define the term “inflation” and explain its impacts on India. • Inflation refers to the sustained • Consequence: Due to high inflation increase in price level of goods and rates, Indian exports lose its services over a given time period. competitiveness and the demand for India‟s exports will fall, as its trading partners switch to relatively cheaper Optional question: Identify the type of alternatives from other countries. inflation India is experiencing in 2006 • Higher prices at home will likely to • According to Ext 3 para 3… In 2006, increase the demand for imports, as India was experiencing demand-pull foreign goods are now relatively inflation caused by the pursuit of cheaper than domestic goods. “loose” monetary and fiscal policy Assuming PEDx >1 and PEDm > 1, this will lead to falling export revenues and rising import expenditure • Hence cause the balance of payments to deteriorate and the exchange rate may also weaken (because there is a fall in demand for rupees due to a fall in demand for Indian exports, and yet there is an increase in the supply of rupees due to an increase in the demand for foreign imports. Show Diagram. (b)(i)Referring to Table 3, explain the current state of India‟s fiscal budget. • India is having a fiscal • The fiscal deficit is due to deficit where government the pursuit of a loose spending exceeds fiscal policy [Ext 3], which government revenue with possibly involved an evidence from Table 3 increase in government (as seen from negative spending on value in relation to the infrastructure (3-4% of size of GDP) GDP) [Ext 4] b)(ii)Explain why the current fiscal budget is unsustainable in the long run. • In the long run, India will incur a ballooning 3. Borrow from the public – The Indian national debt. This persistent budget deficit government could, through its central bank, implies the need to borrow to finance the issue bond to the public to raise revenue for overspending. its fiscal deficit. However, in order to attract the public to lend them money, the returns • Given that the Indian government is already on the bonds will have to be higher than the “highly indebted” further borrowing might returns on private investments. This will incur an unbearably heavy debt burden on inevitable crowd out private investments and future generation of taxpayers. economic growth may be adversely affected 1. Increase taxation – A large national debt 4. Borrow from other countries – this involves presents the government with the task of interest repayments on the national debt raising large sums of money to meet the (external), which will lead to an outflow of interest charges on its national debt. These capital from the capital account. As such the charges have to be met out of tax revenues BOP position will be unfavourable. and they may cause the tax burden to reach Moreover, this represents a transfer of levels which have disincentive effects on wealth / resources abroad and constitutes a work effort, savings & investment. This will real burden on the economy affect economic growth of the Indian economy 2. Lower government spending – This would mean a slower rate of infrastructural development / upgrading and hence the supply-side bottlenecks are not likely to be eased. This will lower productivity levels and affect economic growth. Besides the government might have limited reserves for continuous spending (b)(iii)Explain how loose monetary and fiscal policy can result in India running the risk of overheating. Loose MP • Overheating: Actual growth rising at a • Lower interest rates: faster pace than the growth in the • Fall in cost of borrowing for the firm economy‟s potential output or and hence increase expected rate of productive capacity, such that GPL return (MEI), I increases increase at an increasing rate without significant increase in real output (i.e., • Increase in demand for consumer AD shifts right to a greater extent than durables (eg cars, furniture and big AS shifts right). purchases) due to lower interest repayments [lower cost of borrowing for the household], hence C increases • MP and FP are demand-management • Also people will tend to save less since policies, which will affect AD. Loose the opp cost of consumption is now MP and FP are expansionary in nature lower, C increases and hence AD will shift to the right by a large extent • With a lower domestic interest rate, there will be hot money outflows to countries with higher interest rates, Loose FP: since the returns on these short-term • Increase in G will increase in AD investments will be higher. Supply of (since G is a component of AD) domestic currency will increase as • Fall in T: investors convert to the foreign currency. The domestic currency will • Fall in income tax, Increase in depreciate and net exports will rise if disposable income and hence C Marshall-Lerner condition holds. (can increases bring in forex diagram here to show • Fall in corporate tax, more after-tax depreciation). profits, increase in expected rate of • Increase Money supply will lower returns (MEI), and I increases interest rates according to the Liquidity Preference Theory (b)(iii)Explain how loose monetary and fiscal policy can result in India running the risk of overheating. • Hence for loose MP and FP, the collective increase in C, I, G and (X-M) will increase AD. This would mean a run-down on unplanned stocks and producers will produce more. However, given the supply- side bottlenecks, producers will have to bid more for the limited FOPs. This increased cost of production will be transferred as higher prices in the economy, hence GPL increases at an increasing rate • Illustrate with AD/AS diagram: • AD: Aggregate spending is over-stimulated by a combination of loose or expansionary fiscal and monetary policies. AD shifts very far out to the right. • LRAS: Not increasing quite as fast due to supply bottlenecks especially India‟s fame under-investment in infrastructure [Ext 2: India‟s infrastructure bottlenecks]. As a result even as real potential output increases over time, the rate of expansion in productive capacity is likely to be insufficient in keeping inflationary pressures under control. (c)(i)Assess the impacts of a possible „hard landing‟ of the Indian economy on the economic indicators shown in Table 4. • Qn requires students to consider how a „hard landing‟ would affect the indicators listed in Table 4, namely: GDP growth rate, Inflation rate, Current Account balance, and unemployment rate. State what has happened to that indicator as per data and then explain how a hard landing will change the indicator. • „Hard landing‟ implies sharp contraction in a country‟s Real NI (c)(i)Assess the impacts of a possible „hard landing‟ of the Indian economy on the economic indicators shown in Table 4. Negative impact Positive impact • Growth rate: A hard landing might derail or • Inflation rate: The trend in inflation rate setback the trend of India‟s current growth suggests that India‟s economy is showing rate which is amongst the highest in the signs of overheating [Data shows a jump world (2nd fastest amongst the world‟s giant from 3.9% to 6.9% ie doubling within the economies). space of 5 years]. • The sharp decline in growth likely to • A hard landing however, will lead to a translate into a fall in incomes and rise in reduction of inflationary pressures in India. poverty levels amongst the population. Hence we expect the inflation rate to be less than 6.9% • Unemployment: With a fall in RNI, growth rate is adversely affected. This implies an • Current Account: Has been negative since unplanned increase in stocks and producers 2004 suggesting that India is either over- will produce less, which in turn means that importing or under-exporting or both. A hard- they demand less FOPs and hire less landing is expected to improve its trade workers. Hence India‟s unemployment rate position. will be aggravated and possibly be more • With a fall in GPL, this could enhance the than 8.9%. export competitiveness of Indian goods in • With an increase in unemployment, less tax the international market since Indian revenue will be collected for the Indian products are relatively cheaper. Assuming government and thus, may cause them to Marshall-Lerner condition holds (PEDx >1), cut back on spending on infrastructure which there will be a more than proportionate is already in shabby condition. Foreign increase in qty dd for Indian exports. investors might back off due to the • Total exports revenue will increase. In uncertainty of the economy. This has addition, the Indian economy should see a adverse effects on both actual and potential cutback in imports as incomes and growth for the Indian economy. purchasing power falls. Hence there will be an improvement the current account position (not nec surplus, it can be less negative). Overall stand: • A soft landing would be preferred so that the negative impacts of a hard landing will be minimized. However, it also depends on India‟s priorities of its macroeconomic goals. If it deems inflation to be a main concern then, it will have to bear with a slower growth rate with some levels of unemployment. (c)(ii)Assume you are the economic advisor to India. Justify the economic policies that you would recommend to avert India from overheating. Tighter Monetary Policy: Tighter Fiscal policy: • Explain how raising interest rates and • Explain how cutting govt spending introducing credit rationing e.g. tighten and/or raising taxes will dampen AD. regulation for extending credit, etc will dampen AD • Evaluation: • Time-lag issues- implementation takes Evaluation: time (unlike MP) • In a booming economy like India („too • Constraints on G spending: A large hot to handle‟) rising i/r might not deter part of G spending is on infrastructure the demand for credit (Ext 5: Indians (Ext 5: government stepping up borrowing and splurging to buy homes investments in infrastructure like and cars) roads, energy plants and ports) so a • Demand for investment and cut in G spending on infrastructure consumption could be interest inelastic (road repairs, airport construction and urban transport) might result in adverse LR supply-side effects. Therefore, should cut back G spending on wasteful consumption goods • Disincentives to work and invest, reduce attractiveness to foreign investors and irreversibility of government spending (c)(ii)Assume you are the economic advisor to India. Justify the economic policies that you would recommend to avert India from overheating. Supply-side Policies: Conclusion: 1. Measures to contain short run business costs • The success of the policies boils down • Wage controls (“wages are rocketing”) to the ability of the policymakers to and price controls. balance the growth in spending or AD • Exchange rate appreciation to keep with the expansion in productive down imported cost push inflation if capacity. If the balance is right then any. India can experience what is called a non-inflationary sustained growth rate. However, in reality this may not be 2. Measures to expand long run easy to achieve. productive capacity • e.g. R&D; attracting more FDI inflows; improve labour productivity through education and training (shortages of skilled labour), improve infrastructure etc Evaluation : • Long gestation period. Takes time to bear fruit. So meantime the issue is how to stop the inflation fires from raging.
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