Candidate number: 002798-014

Session: May 2013

Commentary 2

EXTRACT 2
Interest rates will come down when inflation softens: RBI1
AHMEDABAD: Stating that rising prices should have been controlled faster, RBI Deputy
Governor K C Chakrabarty today said interest rate will be reduced as and when inflation
comes down.
"As and when inflation rate comes down, interest rates will come down...." he said on the
sidelines of an event here.
"Our policy rate was 3.5 per cent in 2008. Then inflation went up to 10 per cent, we should
have controlled inflation faster," he said while delivering a lecture on 'Indian Economy:
Today and Tomorrow' organised by the Gujarat Chamber of Commerce and Industry (GCCI).
He said inflation in manufacturing and services sector can be reduced by lowering the cost of
production services with the use of technology.
Inflation in July moderated to 6.87 per cent, helped by decline in vegetable prices, even as
food inflation stayed in double digits and manufactured items remained under price pressure.
Though the inflation has moderated in July, from 7.25 per cent in June, it remains much
above the 5-6 per cent comfort level of the Reserve Bank.
On the high current account deficit (CAD), he said it is mainly because of high oil and gold
imports.

1Interest rates will come down when inflation softens: RBI, economictimes, September 1, 2012,
Economy section, Indian edition. (http://articles.economictimes.indiatimes.com/2012-0901/news/33535380_1_cent-comfort-level-inflation-rate-policy-rate) (Accessed on September 2, 2012).

Candidate number: 002798-014

Session: May 2013

Commentary 2

In a lighter vein he said, "Ahmedabad is notorious for gold .. Do not use gold for the next five
years ... I think the problem shall be solved."
"People should start travelling on bicycle and save fuel," he said.
In its balance of payment statement in June, the Reserve Bank in July had said that India's
CAD widened to the highest ever level to 4.5 per cent of GDP at USD 21.7 billion in
January-March period of 2011-12 due to higher imports of oil and gold.
Chakrabarty also said a growth of at least 9-10 per cent shall be required over the next 20
years.
"We need to grow at least by 9-10 per cent for next 20 years if the society has to survive and
this burden has to be shouldered by you all," he said.
On the global economic situation, he said, "This is a crisis, absolutely no doubt, it comes
once in a lifetime... I can say we shall not be alive when this type of crisis comes next...."
Drawing attention to countries like Greece which are in midst of sovereign debt crisis, he said
they have to work hard and as well as sacrifice. "The envoy of Portugal told me his salary has
gone down by 20 per cent year-on-year, but how many of you had to do this here," he
wondered.
Across the globe food prices are going to go up and they may not be able solve the true
inflation for a pretty long time, he said.
To a particular query, Chakrabarty said the issue on payments from Iran was a political issue.
"You should contact the Prime Minister or Finance Ministry on this count," he said.

Candidate number: 002798-014

Session: May 2013

Commentary 2

COMMENTARY 1
Strategic implementation of policies
The current economic crisis faced by India is dwelt on in this article. India is finding itself in a
situation where not only is there rapid inflation but also slowed down growth due to tight credit
conditions. The Reserve bank of India was recently questioned about sticking to high interest rates in
spite of a slowing economy and in response to this, the Deputy Governor of India said that an
expansionary monetary policy to boost investments and consumer spending can be resorted to only
when Indias inflation rate comes down to a comfortable level of 5-6%. Inflation is defined as the
rate at which the general level of prices for goods and services is rising, and, subsequently,
purchasing power is falling.2
As of now the RBI is resorting to the use of a contractionary monetary policy to keep inflation under
control. Monetary policy is carried out by the central bank, through changes in the money supply,
which are undertaken in order to influence the rate of interest3 A contractionary monetary policy is
generally adopted when inflation is caused by an increase in aggregate demand due to other factors
such as change in attitude towards spending, legal/institutional changes, changes in wealth, etc. The
rise in consumption spending and investments lead to higher prices since the supply remains
constant.

LRAS

Price level

SRAS

P2

Figure 1:Demand-pull inflation

P1
AD2

AD1
Y1

Y2

Real GDP

2 Investopedia US, Inflation, investopedia.com,

http://www.investopedia.com/terms/i/inflation.asp#ixzz2B6U94lTF
3 Tragakes, Ellie. Economics for the IB Diploma, United Kingdom: Cambridge University Press, 2009,253.

Candidate number: 002798-014

Session: May 2013

Commentary 2

In the above diagram, we can see that since the Aggregate demand (which is the total
amount of goods and services demanded in the economy at a given overall price level and in
a given time period4) is increasing from AD1 to AD2, the general price level is also going up
from P1 to P2 as the supply is constant at SRAS (Short run aggregate supply) 5.This increase in
AD creates an inflationary gap (the increase in consumption expenditure, investments,
government expenditure or net exports which causes real GDP to rise in the short run/causes
an inflationary gap6). This is known as demand-pull inflation and to combat this, a
contractionary monetary policy is being used.
Sm2

Interest
rate

Sm1

Int2
Int1
Dm
Q2

Q1

Quantity of money
Figure 2: The money market: change in interest rates

In the above diagram, the RBIs contractionary monetary policy and its impact on the interest
rates is shown. They have reduced the supply of money from Sm1 to Sm2 which leads to an
increase in the interest rate from Int1 to Int2. Due to this increase in interest rates, people
reduce their consumption spending and businesses reduce investments as borrowing money
becomes dearer; a lot more interest has to be paid back on the borrowed amount. A fall in

4 Investopedia US, Aggregate Demand, investopedia.com,

http://www.investopedia.com/terms/a/aggregatedemand.asp#axzz2MUQAUQZL
5The aggregate supply curve depicts the quantity of real GDP that is supplied by the economy at
different price levels. (John Wiley & Sons, Aggregate Supply (AS) curve, cliffnotes.com,
http://www.cliffsnotes.com/study_guide/Aggregate-Supply-AS-Curve.topicArticleId-9789,articleId-9738.html)
6 Investopedia US, Inflationary Gap, investopedia.com,
http://www.investopedia.com/terms/i/inflationary_gap.asp#axzz2MUQAUQZL.

Candidate number: 002798-014

Session: May 2013

Commentary 2

consumption and investment expenditure causes the aggregate demand to fall from AD1 to
AD2. This brought down the price level in the economy to Pl2 as demonstrated below:
LRAS
SRAS

Pl1

Price level

Pl2

AD1
AD2
Ye

Yp

Real GDP

Figure 3: Impact of high interest rates on inflation

Thus, if the RBI reduces interest rates, before bringing inflation rate down to a comfortable
level, the situation could worsen.
Ideally a contractionary monetary policy should help reduce inflation but in India, Inflation is
a result of supply-side bottlenecks. The article suggests that one of the major causes for
inflation is the price of commodities such as vegetables. Another reason is the rise in cost of
production due to lack of modern technology. Thus one could say that India is experiencing
cost-push inflation.
LRAS

SRAS2

SRAS1
Price level

Pl2
Pl1
AD1

Yrec

Yp

Real GDP
Figure 4: Cost-push inflation

Candidate number: 002798-014

Session: May 2013

Commentary 2

Cost-push inflation is caused by a fall in aggregate supply, in turn resulting from increase in
wages or prices of other inputs.7 Due to the increase in the price of a factor of production,
the Short run aggregate supply is shifting towards the left from SRAS1 to SRAS2. This fall in
supply met with unchanged demand AD1 leads to an increase in price from Pl1 to Pl2.
Under such circumstances use of supply-side policies like bringing in better technology,
maintaining sufficient buffer stocks or removing minimum wage policies can help bring
down the cost of production and in turn, the rate of inflation without having to slow down the
economy by increasing interest rates and decreasing consumption spending and investments.

7Tragakes, Ellie. Economics for the IB Diploma, United Kingdom: Cambridge University Press, 2009,290.

Candidate number: 002798-014

Session: May 2013

Commentary 2

Bibliography:
Books:

Tragakes, Ellie. Economics for the IB Diploma. United Kingdom: Cambridge

University Press, 2009 (Accessed on September 5, 2012)

Websites:

Interest rates will come down when inflation softens: RBI. Economictimes.
September 1, 2012. Economy section. Indian edition.
(http://articles.economictimes.indiatimes.com/2012-09-01/news/33535380_1_centcomfort-level-inflation-rate-policy-rate). (Accessed on September 2, 2012).

Investopedia US. Aggregate Demand. investopedia.com.

http://www.investopedia.com/terms/a/aggregatedemand.asp#axzz2MUQAUQZL
((Accessed on September 5, 2012).

Investopedia US. Inflation, investopedia.com.

http://www.investopedia.com/terms/i/inflation.asp#ixzz2B6U94lTF (Accessed on
September 5, 2012).

Investopedia US. Inflationary Gap. investopedia.com.

http://www.investopedia.com/terms/i/inflationary_gap.asp#axzz2MUQAUQZL
(Accessed on September 5, 2012).

John Wiley & Sons. Aggregate Supply (AS) curve. cliffnotes.com.

http://www.cliffsnotes.com/study_guide/Aggregate-Supply-AS-Curve.topicArticleId9789,articleId-9738.html (Accessed on September 5, 2012).