MONETARY POLICY PERSPECTIVES A CASE STUDY OF INFLATIONARY FACTORS AT SECTORAL LEVELS IN INDIA AND A RATIONALE FOR DEVELOPING AN INTEGRATED

D APPROACH

GROUP MEMBERS:

Ruchika Damani (222), Vrishali Bagree (237), Aditi Tibrewal (239), Rishabh Maheshwary (244), Kashmira Gupta (259), Radhika Bhatter (287), Nishtha Agarwal (288), Shruti Bhandari (289), Sudarshan Bagaria (290), Vijay Daniel Anthony (21293) Under the Guidance of Dr. P. P. Ghosh ( St. Xaviers College, Kolkata)

INTRODUCTION
Monetary policy is an economic strategy of the government in deciding the contraction and expansion of money supply in the economy or targeting interest rates. Our aim is to study the monetary policies of different countries, how they function and how they impact the economy as a whole The tools employed by Central Bank are: 1. Buying or selling national debt 2. Changing credit restrictions 3. Changing interest rates by changing reserve requirements

In India, the RBI has always aimed at the controlled expansion of bank credit and money supply. The objectives of monetary policy are: 1. 2. 3. 4. 5. Rapid Economic Growth Price stability Exchange rate stability Balance of payment equilibrium Full employment

OBJECTIVES OF THE MONETARY POLICY

INSTRUMENTS OF THE MONETARY POLICY

Using intermediate or alternative intermediate targets can control inflation and output. The alternative intermediate targets that the central banks have adopted are the following: 1. Monetary or credit targets 2. Interest Rates

MONEY SUPPLY TARGETTING WITH IS CURVE SHOCKS

INTEREST RATE TARGETTING WITH IS CURVE SHOCKS

INTEREST RATE TARGETTING WITH LM CURVE SHOCKS

MONEY SUPPLY TARGETTING WITH LM CURVE SHOCKS

MONETARY POLICY OF USA

The Federal Reserve is incharge of the monetary policy in US The goals are : 1. Promoting economic growth 2. Full employment 3. Price stability 4. Balanced trade The tools used are : 1. Open market operations 2. Financial institutional Reserve requirements 3. Discount Rate The policy follows the Taylors Rule defined by the equation

It= t + Rt* + a(t - t *) + ay (yt - yt *)

The Fed uses either Tight or Easy monetary policy

MONETARY POLICY OF EUROPE

1. 2. 3. 1. 2. 3. The European Central Bank is incharge of the monetary policy The goals are : Price stability Promoting economic growth Increasing Employment One of the main indicators is the exchange rate developments of the euro The tools used are : Open market operations Standing Facilities Minimum Reserves The main feature of the policy is the high level of flexibility

MONETARY POLICY OF INDIA

The Reserve Bank of India is incharge of the monetary policy in India The 4 main channels are : 1. Quantum channel 2. Interest rate channel 3. Exchange rate channel 4. Asset price The main tools are : 1. Cash reserve ratio 2. Statutory liquidity ratio 3. Repo rate 4. Reverse repo rate An important component is the Liquidity Adjustment Facility

LITERATURE REVIEW
Several works have been carried out with regard to input output integrated models in developing countries, some of which are mentioned below : Bangladesh (Chowdhury, 1983, 1984) : The objective is to analyze the working of the Bangladesh economy for the period 1959-60 to 1980-81. Chowdhury argues strongly in favor of using this type of model. Sri Lanka (Ghosh, 2010) : The objective is to analyze the structure and growth of the economy with special reference to Linkage and multiplier analysis in IO framework in order to analyze structural change Estimation of macro model, GNP by value added. MIMFSE, Egypt (Elkhafif, 1997) : the objective of the macro econometric and input output model is for forecasting and stimulation of the Egyptian economy. Nigeria (Ajakaiye, 1986) : the objective of building an integrated macroeconomic and input output model is to stimulate employment and manpower implications for macroeconomic policies in Nigeria. Sectoral level study have been carried out even with regard to developing countries like Nepal, Brazil, Lithuania and Mexico.

FLOWCHART OF THE MODEL

ECONOMETRIC ESTIMATES OF FINAL DEMAND SECTOR-WISE DISTRIBUTION OF FINAL DEMAND LEONTIEF INVERSE MATRIX VALUE ADDITION MATRIX EXOGENOUS AND/OR POLICY VARIABLES GDP FROM VALUE ADDED SECTORWISE VALUES ADDED

THE INPUT-OUTPUT SUB-MODEL

The Leontief Solution is given by x = (I-A) -1 f or, x=Lf .. (i), where x represents the vector of gross outputs, L is the familiar Leontief Inverse and f is the vector of final demands Thus, we obtain value added: V j = x j - ni=1 aij.x j = (1 - ni=1 aij) x j , j = 1,2,.,n , j = 1,2,.,n

..(ii)

In matrix notation, we have: V =x = L f (using the Leontief Solution) ..(iii) The Final Demand f is estimated from a Macro-econometric Model

THE MACROECONOMETRIC SUB-MODEL

EXPENDITURE BLOCK CP= PRIVATE CONSUMPTION EXPENDITURE CG= GOVERNMENT CONSUMPTION EXPENDITURE ID= DOMESTIC INVESTMENT TI= TOTAL INVESTMENT EX= EXPORTS IM= IMPORTS

GDP= GROSS DOMESTIC PRODUCT

MONETARY BLOCK

R= NOMINAL RATE OF INTEREST

CPI= CONSUMER PRICE INDEX RR= REAL RATE OF INTEREST INFL= INFLATION

SECTOR-LEVEL DISTRIBUTION OF FINAL DEMAND

This model allows for detailed sector-level estimation of the components of Final Demand in order to supplement the Macro model. For example In the area of Private Consumption we can estimate different functional forms for the various sectors of the economy. Similarly, sector level investment can be modeled, and so on.

These econometric estimates are checked for consistency with the macro model and fed into an INPUT-OUTPUT SUBMODEL

DEFINITIONS OF QUANTITIES & INCOMES

Sector-level output of the ith Industry is

xi = jaijxj + Ci + Ii + Ei + Fi
Total quantities are given by

X= i xi; C = i Ci; I = i Ii; E = i Ei; F =i Fi

Labor-Income and Non-Labor Income

L= j lj; Q= j qj
Non-Labor Income from industry j

qj=(xj- Ej)pj + EjpEj iaijxjpi - amjxjpmj - lj- sj - dj

BEHAVIORAL EQUATIONS SHOWING SECTOR LEVEL DISTRIBUTION

Components of Final Demand: Consumption Functions, Investment Functions and Export Functions

Ci = f ( Ci,-1, L+Q , pi/Pc);

f1,f2>0, f3<0

Ii = f ( Ii ,-1, Q , pi/PI , X , X-X-1); f1,f2,f4,f5>0,f3<0

Ei = f ( Ei, -1, XA, pE i/PAC);

f1,f2>0, f3<0

Thus the price mechanism is endogenised.

DEFINITIONS OF PRICE & QUANTITY INDICES

Price Index for Consumption Goods, Investment Goods, and Export Goods

Pc = i piCi,-1 / i Ci,-1; PI = i piIi,-1 / i Ii,-1; PE = i pEiEi,-1 / i Ei,-1;

Foreign Cost of Living Index, Wholesale price Index and Net Production Index are given exogenously as

PAC, PAG and XA respectively.

Home Price and Export Price Functions, Wage Bill and Tax Functions are given as:

pi = f (pi,-1, ki, ddi , pmi); f1,f2,f3,f4>0; where ki = li/xi and ddi is % industrial capacity utilization

pEi =f ( pEi,-1, pi, XA, PAC);

li = f ( li, -1, Pc, xi);
si = f (xi pi);

f1,f2,f3,f4>0 f1,f2,f3>0 f1>0.

Empirical Analysis 1989-1990 to 2008-2009

The above graph shows the fluctuations in the overall GDP inflation rate in India. Inflation was at peak level during 1991-92 at around 13.8%. In the subsequent years the fluctuation in the GDP inflation occurred at a modest scale. We now look into the sectoral wise studies divided into 3 phases vis 1989-1990 to 1995-1996 1996-1997 to 2003-2004 2004-2005 to 2008-2009

10

12

14

0 1989-90 1990-91 1991-92

Industrial inflation

1992-93
1993-94 1994-95 1995-96 1996-97 1997-98

Industrial Inflation

Time
1998-99 1999-00 2000-01 2001-02 2002-03

2003-04
2004-05 2005-06 2006-07 2007-08 2008-09

Industrial Inflation

Phase 1 1989-1990 to 1995-1996

Reasons for rise in agricultural inflation : Supply and demand imbalances in essential items Tight BOP position Erratic monsoons and cost push inflation Reasons for fall in agricultural inflation : Restrictions on imports and hence increase in domestic supply Reduction in import duties for pulses and edible oil Good monsoons leading to bumper crops

Reasons for rise in industrial inflation : Shortage of imported raw materials and rise in export demand for metals etc Cost push inflation due to rise in fuel price and distribution costs Infrastructural bottlenecks and unutilized capacity constraints Reasons for fall in industrial inflation : Reduction in customs and export duties Liberalized policies led to relaxation of import restrictions Lowering of prices of essential and primary articles led to lowering of prices of manufactured goods

Phase 2 1996-1997 to 2003-2004

Reasons for rise in agricultural inflation : Improved terms of trade for agriculture Increased investment in fertilizers and other agricultural inputs Agricultural exports increased Reasons for fall in agricultural inflation : Higher production and consequent increased availability in the market led to higher domestic prices compared to international prices Targeted Public Distribution System replaced the erstwhile PDS Increase in the inflow of institutional rural credit

Industrial Inflation for the period 1996-97 to 2003-04

8 7 6 Industrial Inflation 5 4 3 2 1 0 1996-97 1997-98 1998-99 1999-00 Time 2000-01 2001-02 2002-03 2003-04 Industrial Inflation

Reasons for rise in industrial inflation : Slowdown of industrial growth Lack of domestic demand for intermediate goods, low inventory demand for capital goods Excess capacity in some sectors Reasons for fall in industrial inflation : Fall in the imports of capital goods The higher growth of basic goods, intermediate goods and consumer durables Rise in Business Confidence Index (BCI), better corporate performance and the bullish sentiments in stock markets

Phase 3 2004-2005 to 2008-2009

Reasons for rise in agricultural inflation : Demand supply imbalances on food grains Erratic monsoons Agricultural products like cereals and pulses, coffee ,spices and condiments experienced higher prices Reasons for fall in agricultural inflation : Rise in agricultural credit Reduction in excise and custom duties

Industrial Inflation for the period 2004-05 to 2008-09

9 8 7 Industrial Inflation 6 5 Industrial Inflation 4 3 2 1 0 2004-05 2005-06 2006-07 Time 2007-08 2008-09

Reasons for rise in industrial inflation : Rise in price of petroleum Decelerated growth of the manufacturing sector Rise in global demand Reasons for fall in industrial inflation : Higher rate of growth of industrial sector Coal and mining recorded lower inflation rate Fall in exports followed by a decline in domestic demand

We bring into light the structural view of Prof. Mihir Rakshit to show how inflation is more dependent on structural factors than on the money supply. The study shows that macro economic factors like growth rate of GDP, narrow money and broad money do not have a statistically significant effect on inflation

The findings highlight the role of sectoral factors in driving them. The fuel prices have a greater impact on core as well as headline WPI as compared to impact of food prices.

HOW WERE THE POLICIES UNDERTAKEN BY THE RBI DIFFERENT FROM THE OTHERS?
There was no dilution of collateral standards that were mostly Government securities incase of India. The balance sheet of RBI was more or less stable in spite of large liquidity expansion. Better sequencing of monetary and liquidity measures was enabled due to greater availability of multiple instruments. Financial stability was enhanced with the use of pro cyclical and counter cyclical regulations ahead of the global crisis.

CONCLUSION

The correlation coefficient between the rate of growth money supply (broad money) and agricultural inflation is 0.25064092.

The correlation coefficient between the rate of growth of money supply and industrial inflation is 0.14347801.

The correlation coefficient between the rate of growth of money supply and service inflation is 0.18298621

Thus we conclude that at the sector levels there maybe various structural influences or on the endogenous prices and quantities in an economic system. The interplay of such sector level relations consistent with a overall macroeconomic framework would be more useful for analyzing the performance of the economy and adopting appropriate policy measures. In this project we have carried out a pilot survey of inflationary trends in the agricultural and industrial sector that reveals the importance of structural and inter-sector factors in determining inflation at a disaggregated level. This lends credibility to the case for building an integrated input output and macro model for the Indian economy.

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