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Inflation by niusheng11



Case Study
(a)(i) Using Figure 1, compare the change in
consumer prices for India and China from 2002
• 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.[3]
•   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
                                           •   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
(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.[3]
•   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

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
(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

Evaluation :
• Long gestation period. Takes time to
   bear fruit. So meantime the issue is
   how to stop the inflation fires from

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