Inflation

There are usually two drivers of inflation - cost push and demand pull. Demand pull assumes an increase in the money supply in the economy relative to the production of goods and services. It could also come from a cut in interest rates, tax cuts or even exuberance in goods and services markets and capital markets. On the other hand cost push assume an increase in production costs which could result from either producing close to full capacity and/or an increase in commodity prices. Indirect taxes also contribute on this front. There is another equation which relates inflation to exchange rates. An increase in inflation is usually associated with a depreciating currency. This coupling between the two occurs through the interaction between goods market and capital market. Capital flows are the mechanism through which this interaction is possible. Capital flows occur in a manner such that more expected inflation reduces the expected return from investing in a currency and hence demand for that currency falls resulting in its depreciation. However, expectations of growth in an economy can also influence these flows. A huge current account surplus usually should result in appreciation of the currency or in an increased inflation. In both cases the foreign goods become cheaper for the country. Eventually, the economy has to let it's currency appreciate if it wants to arrest inflation. Goods markets are usually slower to respond and hence we observe overshooting in capital markets. Sometimes, an increase in productivity also results in inflation without affecting the exchange rates as has been the case with Eastern European nations.

An issue to ponder about is the causal relationship between inflation and exchange rates. Just like a high inflation may result in the depreciation of currency, allowing the currency to appreciate will help arrest inflation. But we talk about allowing the currency to appreciate rather than making it appreciate. Currency is allowed to appreciate when it's already undervalued in terms of its demand relative to other currencies. Only those economies can achieve it which have a huge foreign exchange kitty to back the appreciation of the currency.

Going forward, we can clearly see that tackling inflation requires clear identification of which factors and to what extent are affecting inflation. When it is a demand pull problem it calls for interest rate hikes and reduction in money supply. When it is a cost push phenomena due to capacity constraints, Government should make more capital formation possible. It could also try to restrain demand so that companies start operating below their capacities. When the cost push has resulted from increase commodity prices globally, the economy might have to allow its currency to appreciate in which case exports markets might suffer. It's a fine balance between how much we want to export and how much we want to import to support the domestic economy. When inflation results from movements in currency markets one needs to look at what is driving this movement. If it is a growth differential then inflation becomes a natural phenomenon just like it would have been when productivity of the economy was increasing. If it is driven by interest rate differentials then appropriate policy measures should be taken keeping in mind whether we are targeting inflation or exchange rate.

For India, I think all the factors are playing some roles. Hence, the policy of raising interest rates should be coupled with ensuring sufficient liquidity in the system to be able to sustain growth. That is what RBI is exactly doing. The balancing act between exports and imports and growth and inflation is what's keeping the GOI busy. After all, inflation being one of the direct consequences of high fiscal deficits is GOI's responsibility only.