The Inflation dilemma 

The Inflation dilemma 

Subject: Economy

Section: Inflation

Context:

Even though the RBI’s mandate is with respect to CPI inflation, policymakers cannot ignore the behaviour of other price indices.

Details:

• The Wholesale Price Index (WPI) inflation had remained in double digits since April 2021.
• The GDP implicit price deflator-based inflation rate for 2021-22 is 9.6%.

Cause:

• Cost push-Policy initiatives during COVID lockdowns based on keynesian multiplier–
  • Expansionary fiscal policy increased public expenditure of production could not rise due lockdown induced supply chain disruption.
  • As V.K.R.V. Rao earlier pointed out in the 1950s,that the Keynesian multiplier did not work when there were supply constraints as in developing countries.
  • Due to supply restriction output could not rise in real terms but in nominal terms (rise in monetary value/prices)

• Liquidity Overhung-Ineffective accommodative monetary policy which led liquidity overhung-
• Uncertainty and lack of investment appetite led to slow growth in credit and at a lower rate of interest. This further led to slower growth in money multiplier and ample liquidity for government borrowing.
• Increased borrowing vis a vis low demand for bonds led to the excess liquidity.
• Validity of phillips curve- may explain the possible trade off between growth and price

Measures required:

• Contract liquidity-Rise in CRR, SLR, HTM Limit, Operation twist etc..
• Supply chain diversification-increase alternative food options
• Reduce excise on crude oil

Concept:

• A Keynesian multiplier is a theory that states the economy will flourish the more the government spends.

Keynes noted that the government spending could add to aggregate demand and that this fiscal stimulus would create a “multiplier effect” through increases in consumer demand. Regardless of the type of government spending, it will lead to cycles of economic prosperity and increased employment, raising gross domestic product (GDP) by a larger amount. So $1 billion in government spending will raise a country’s GDP by more than the amount spent.

• The Phillips curve is a graphic representation of the inverse relationship between unemployment and inflation. According to the hypothesis, the lower the unemployment rate, the higher the rate of inflation, and vice versa.

As a result, high levels of employment can only be obtained when inflation is low.

• The GDP deflator, also called implicit price deflator, is a measure of inflation. It is the ratio of the value of goods and services an economy produces in a particular year at current prices to that of prices that prevailed during the base year.
  This ratio helps show the extent to which the increase in gross domestic product has happened on account of higher prices rather than increase in output.

Since the deflator covers the entire range of goods and services produced in the economy — as against the limited commodity baskets for the wholesale or consumer price indices — it is seen as a more comprehensive measure of inflation

GDP GDP price deflator measures the difference between real GDP and nominal GDP. Nominal GDP differs from real GDP as the former doesn’t include inflation, while the latter does.As a result, nominal GDP will most often be higher than real GDP in an expanding economy.

GDP price deflator = (nominal GDP ÷ real GDP) x 100