Controlling Inflation

Inflation has political ramification. If corrective measures are not taken at right time to rein inflation then it has the potential to bring down the government.

The government along with the central bank takes several steps to control inflation. Controlling inflation is Herculean task because sometimes there is very little which a government can actually do. Moreover inflation has spiraling effect i.e. it has overall impact on the economic growth of the country.

There are three types of inflation:

Cost-push inflation: It is due to supply side constraint.

Demand-pull inflation: Demand for product increases due to excess liquidity in the system.

Built in inflation: It occurs due to hike in wages which results into price increase.

Steps taken to control inflation:

Cost-push inflation: In case of cost-push inflation the government can do very little. It is not easy to increase the supply of the commodity overnight. However government takes certain measures to ensure that the essential commodities are available to its people. Ban is imposed on the export of certain items which is essential for the people and which are in shortages. Certain administrative measures are taken to see that the hoarders have not accumulated essential items.

Built in inflation: It carries the legacy of the past. It results into price/wage spiral. To curtail it certain price and wage control mechanisms needs to be adopted.

Demand pull inflation: If there is excess liquidity in the market then it also results into inflation which is termed as demand pull inflation. When people have excess cash they are ready to pay extra to buy products. This leads to overall increase in the price of the product. Both the government and the central bank intervene to control price rise. Central bank takes certain monetary measures to suck out excess liquidity from the market. It is done either by increasing the CRR (Cash Reserve Ratio) or by increasing the repo and reverse repo rate. It ensures that the excess liquidity from the market is sucked out which helps in controlling inflation.

Repo rate is the rate at which the central bank borrows money to flush out excess liquidity from the market. Reverse repo rate is the rate at which the central bank lends money. CRR is the statutory amount which any bank has to keep with the central bank.

Central bank has to be very cautious while taking these steps. Increase in interest rate will make money costlier and may control inflation but it may derail growth in the long run. Similarly increase in CRR will suck out liquidity from the market and in turn will decrease consumer demand. So, whatever monetary measures the central bank takes to rein inflation it has to ensure that it does not have catastrophic effect on the economy of the country in the long run.

Increasing the tax or reducing the government spending is certain fiscal measures which the finance ministry takes to control inflation.

Inflation cannot be controlled overnight. Whatever steps the government or the central bank takes will show results only after a month or two.