Dynamics of Inflation

by
Dr. C. Rangarajan*
Chairman
Economic Advisory Council to the Prime Minister
I feel greatly honoured to deliver the P.R. Brahmananda memorial
lecture. Prof. Brahmananda was one of Indias outstanding economists,
having made significant contributions to the development of economic
thought in India. He has not been afraid to articulate his views on economic
policy even when he was in a minority. In the early decades after
Independence when almost all economists and policy makers were in favour
of a path of development which emphasised industrialisation and more
particularly in heavy industries, he along with Prof. C.N. Vakil stood out in
favour of an alternative path which emphasised the development of wage
goods industries including agriculture. Perhaps, if India had adopted the
alternative route, the growth rate in the earlier period might have been much
higher than what it turned out to be. Prof. Brahmananda was also a leading
monetary economist of the country. He was a crusader in the cause of
fighting inflation. He was convinced that high growth was possible only in an
environment of low inflation. Control of money supply, according to him, was
key to controlling inflation. In this lecture which has been instituted to
honour his memory I, therefore, have chosen to speak on Dynamics of
Inflation, a subject dear to his heart.
Inflation may be broadly defined as the sustained increase in prices.
Prices can be measured either by the wholesale price index or the consumer
price index. In India, policy makers very often use the wholesale price
index. This is so only because of the speed with which these data are
available. It is true that the two indices do not always show the same
behaviour. In years when food inflation is high, the retail inflation is always
higher, as food commodities have a higher weight in retail price index than
WPI (Table 1 and Chart 1). Between 2007-08 and 2010-11, this is what
happened.

P.R. Brahmananda Memorial Lecture delivered at 95 th Annual Conference of The

Indian Economic Association held at GITAM University, Visakhapatnam on
December 28, 2012. The author is thankful to Mr. E.M. Vibeesh for his assistance
in the various statistical calculations.
1

Table 1: Wholesale and Retail Inflation

Year
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12

WPI

CPI (IW)
4.4
6.7
6.2
9.1
12.2
10.5
8.4

4.4
6.6
4.7
8.1
3.8
9.6
8.9

CPI (IW)-Food
4.1
9.2
8.4
12.3
15.2
9.9
6.3

The two interesting questions that arise in the context of explaining the
phenomenon of inflation are (1) what causes inflation?, and (2) what can be
done to tame inflation? Let me look at these two questions in the context of
the recent bout of inflation in India. Before doing so, let me also address the
issue of trade-off between growth and price stability.

Chart 1: Whole sale and Retail Inflation

Growth and Price Stability

A crucial issue in the conduct of policy is whether the pursuit of the
objective of price stability by monetary authorities undermines the ability of
the economy to attain and sustain high growth. Empirical evidence on the
relationship between growth and inflation in a cross country framework is
somewhat inconclusive because such studies include countries with an
inflation rate as low as one to two per cent to those with inflation rates going
beyond 200 to 300 per cent. These studies, however, clearly establish that
growth rates become increasingly weaker at higher rates of inflation (Bruno,
1995).
The trade-off between price stability and economic growth has been
discussed in the framework of labour and output markets. The well known
Phillips curve postulated an inverse relationship between unemployment
and wage rate. Several economists have challenged the basic micro
economic underpinning of the wage and price mechanism that leads to the
possibility of trade-off between inflation and growth. Several studies have
established that in the long run there is no trade-off between the two. The
Phillips curve becomes purely vertical, if the role of expectations is explicitly
included. An environment of reasonable price stability is more conducive to
economic growth; price stability is thus a necessary condition for long run
growth. However, there is a possible trade-off in the short run. It is,
nevertheless, important not to over use this opportunity as it can undermine
the long term imperative.
The case of price stability as a major objective of economic policy
rests on the assumption that volatility in prices creates uncertainties in
decision making. Rising prices adversely affect savings while they make
speculative investments more attractive.
These apart, there is a crucial
social dimension, particularly in developing countries. Inflation adversely
affects those who have no hedges against it and that include all the poorer
sections of the community. This is indeed a very strong argument in favour
of maintenance of price stability in emerging economies.
In resolving the short run trade-off between price stability and output
growth, in the industrial countries, a solution is sought through the adoption
by policy makers of rule bound monetary policies such as the Taylors rule.
The Taylor rule prescribes that the signal interest rate be fixed taking into
account the deviations of inflation rate from the target and actual output from
its potential. The rule requires the federal funds rate in the U.S. to be raised,

if inflation increases above the target or if real GDP rises above trend GDP.
In the original version, the weights of deviation from target inflation and
potential output were assumed to be the same at 0.5. However, it was
subsequently felt that the coefficient of inflation deviation term must be
higher at one. While the rule is intuitively appealing, there are serious
problems in determining the values of the coefficients. There is also a lot of
judgment involved in determining the potential output and target inflation
rate. However, the rule offers a convenient way of determining when the
Central Bank should act.
Another way of reconciling the conflicting objectives of price stability
and economic growth in the short run is through estimating the threshold
level of inflation, a level beyond which costs of inflation begin to rise steeply
and affect growth. It is this inflation threshold that can provide some
guidance to the policy makers. Below and around this threshold level of
inflation, there is greater maneuverability for the policy makers to take into
account other considerations. Interestingly, the Chakravarty Committee
regarded the acceptable rise in prices in India as 4 per cent. This, according
to the Committee, will reflect changes in relative prices necessary to attract
resources to growth sectors. I have myself indicated that in the Indian
context, inflation rate around 5 per cent may be acceptable. Some studies
have estimated the level of threshold inflation in India to be in the range of 5
to 6 per cent. There is some amount of judgment involved in this, as
econometric models are not in a position to capture all the costs of inflation.
This approach provides some guidance as to when policy has to become
tight or to be loosened. It is also necessary for the policy makers to note
that this order of inflation is higher than what the industrial countries are
aiming at. This will have some implications for the exchange rate of the
currency. While an open economy helps to overcome domestic supply
shocks, it also imposes the burden to keep the inflation rate in alignment
with other countries (Rangarajan, 1998).

Current Inflation
We have had three years of high inflation (Chart 2, Table 2). Inflation
has remained above 7 per cent since November 2009. 2009-10 was badly
affected because of the deficient monsoon. Foodgrain production declined
by 17 million tonnes. The decline in the production of rice alone was 11
million tones. As a consequence, inflation was triggered by the increase in
foodgrain prices. Food inflation which crossed the double digit level in June
5

Chart 2: Behaviour of different Components of Whole sale Inflation

Table 2: Behaviour of different Components of Whole sale Inflation

Index

2008

2007

Year

Month
Jan
Feb
Mar
Apr
May
June
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
Apr
May
June
Jul
Aug
Sep
Oct
Nov
Dec

Food
Article

Non
Food
Grain

118.90
119.20
118.90
121.50
122.30
121.80
124.80
126.10
125.50
126.00
125.20
121.60
119.90
122.50
125.60
128.90
130.20
130.30
133.40
134.40
135.80
140.30
141.10
136.30

114.88
115.37
116.13
119.12
120.55
119.94
123.27
124.70
123.82
123.29
122.13
117.43
114.77
117.96
121.08
124.72
126.63
126.60
130.28
130.94
132.77
137.49
138.14
131.38

Non
Food MP

All
Commo
dities

Food
Article

109.83
110.10
110.65
112.32
112.57
112.68
112.71
112.87
112.96
113.55
113.71
114.02
115.62
116.40
118.20
119.75
119.70
121.14
121.81
122.11
122.02
121.85
120.38
119.39

112.40
112.60
112.80
114.50
114.70
114.80
115.70
116.00
116.00
116.30
116.80
116.70
117.50
119.00
121.50
123.50
124.10
127.30
128.60
128.90
128.50
128.70
126.90
124.50

11.43
12.35
13.24
14.19
12.93
8.94
11.23
9.75
6.27
5.18
4.42
3.23
0.84
2.77
5.63
6.09
6.46
6.98
6.89
6.58
8.21
11.35
12.70
12.09

Inflation (Y-o-Y)
Non
Food
Non
Grain
Food
Article
MP

10.10
11.88
14.08
14.75
14.18
9.07
11.58
9.66
6.28
5.07
5.00
3.73
-0.10
2.24
4.26
4.70
5.04
5.55
5.69
5.00
7.23
11.52
13.11
11.88

6.83
6.75
6.76
5.81
5.43
5.18
4.52
4.20
3.91
4.25
4.38
4.48
5.27
5.73
6.82
6.61
6.33
7.50
8.07
8.19
8.02
7.31
5.87
4.70

All
Comm
odities

6.64
6.63
6.72
6.22
5.52
4.46
4.42
4.04
3.39
3.19
3.73
4.01
4.54
5.68
7.71
7.86
8.20
10.89
11.15
11.12
10.78
10.66
8.65
6.68

Table 2: Continues
Index

2010

2009

Year

Month
Jan
Feb
Mar
Apr
May
June
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
Apr
May
June
Jul
Aug
Sep
Oct
Nov
Dec

Food
Article

Non
Food
Grain

Non
Food
MP

All
Commo
dities

Food
Article

137.20
134.10
135.60
140.10
141.80
145.00
150.40
153.70
154.70
157.80
164.70
164.60
164.90
163.40
163.60
168.80
172.10
175.40
178.20
176.70
179.90
180.90
181.40
189.40

132.22
126.88
128.96
134.32
136.05
140.10
147.05
150.78
150.91
154.15
161.06
159.60
159.30
158.72
160.14
167.53
172.07
176.20
179.78
177.60
182.35
183.88
184.25
195.07

119.38
118.96
119.23
119.08
119.41
119.54
119.60
120.02
120.32
120.48
120.56
120.94
122.32
122.62
123.41
126.09
126.22
126.07
126.05
126.27
126.63
127.12
127.50
128.45

124.40
123.30
123.50
125.00
125.90
126.80
128.20
129.60
130.30
131.00
132.90
133.40
135.20
135.20
136.30
138.60
139.10
139.80
141.00
141.10
142.00
142.90
143.80
146.00

14.43
9.47
7.96
8.69
8.91
11.28
12.74
14.36
13.92
12.47
16.73
20.76
20.19
21.85
20.65
20.49
21.37
20.97
18.48
14.96
16.29
14.64
10.14
15.07

Inflation (Y-o-Y)
Non
Food
Non
Grain
Food
Article
MP

15.20
7.57
6.51
7.69
7.44
10.67
12.87
15.16
13.67
12.12
16.59
21.48
20.48
25.09
24.18
24.73
26.48
25.77
22.25
17.79
20.83
19.28
14.39
22.22

3.25
2.20
0.87
-0.56
-0.24
-1.32
-1.81
-1.71
-1.39
-1.13
0.15
1.30
2.46
3.08
3.51
5.89
5.70
5.47
5.39
5.21
5.24
5.51
5.76
6.21

All
Comm
odities

5.87
3.61
1.65
1.21
1.45
-0.39
-0.31
0.54
1.40
1.79
4.73
7.15
8.68
9.65
10.36
10.88
10.48
10.25
9.98
8.87
8.98
9.08
8.20
9.45

Table 2: Continues
Index

2012

2011

Year

Month
Jan
Feb
Mar
Apr
May
June
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov

Inflation (Y-o-Y)

Food
Article

Non
Food
Grain

Non
Food
MP

All
Commo
dities

Food
Article

Non
Food
Grain
Article

192.40
181.30
179.00
186.80
186.30
188.80
192.80
193.70
197.20
199.30
196.50
190.90
191.10
192.40
197.10
207.20
206.10
209.40
212.40
211.80
213.10
212.50
213.20

198.79
182.47
180.34
191.32
190.05
193.58
198.47
199.16
203.76
205.84
202.09
194.39
194.25
195.98
201.61
214.54
212.45
215.79
217.48
213.49
213.60
212.99
213.46

130.30
132.03
133.88
134.90
135.39
135.89
135.74
136.10
136.68
137.38
138.23
138.71
139.39
139.74
140.60
141.69
142.43
142.99
143.42
143.95
144.51
144.51
144.43

148.00
148.10
149.50
152.10
152.40
153.10
154.20
154.90
156.20
157.00
157.40
157.30
158.70
159.30
161.00
163.50
163.90
164.70
165.80
167.30
168.80
168.70
168.80

16.68
10.95
9.41
10.66
8.25
7.64
8.19
9.62
9.62
10.17
8.32
0.79
-0.68
6.12
10.11
10.92
10.63
10.91
10.17
9.34
8.06
6.62
8.50

24.79
14.97
12.61
14.20
10.45
9.86
10.40
12.14
11.75
11.94
9.69
-0.35
-2.28
7.41
11.80
12.14
11.78
11.47
9.58
7.19
4.83
3.47
5.63

Non
Food
MP

6.53
7.68
8.48
6.99
7.26
7.78
7.69
7.78
7.93
8.07
8.42
7.99
6.98
5.84
5.02
5.03
5.20
5.23
5.66
5.77
5.73
5.19
4.49

All
Comm
odities

9.47
9.54
9.68
9.74
9.56
9.51
9.36
9.78
10.00
9.87
9.46
7.74
7.23
7.56
7.69
7.50
7.55
7.58
7.52
8.01
8.07
7.45
7.24

2009 crossed 20 per cent in December 2009 and stood at that level till
June 2010. Overall inflation as measured by the wholesale price
index started rising from December 2009 and crossed the 10 per cent mark
in March 2010. At that point non-food manufacturing inflation was still low at
3.5 per cent. It was expected that inflation would moderate through 2010-11.
This in fact started happening and the trend continued till November 2010.
From the peak of 10.9 per cent in April 2010, it came down to 8.2 per cent in
November 2010.

However, prices started rising after that because of unseasonal rains

which triggered food prices to rise again. By March 2011, year on year
inflation had touched 9.7 per cent. While the food price inflation of 2009-10
was triggered by the rise in foodgrain prices, in 2010-11 it was triggered by
the rise in the prices of vegetables, fruits and eggs, meat and fish. The
increase in vegetable prices was significant. The late rains had a severe
impact on the supply of some vegetables including onion. Inflation in
vegetables rose to 34 per cent in December 2010 and 67 per cent in
January 2011. Normally, vegetable prices show a seasonal decline during
winter months. During 2010-11, prices of raw cotton rose on an average by
43 per cent. The persistence of food inflation led to the spread of inflation to
other sectors. Inflation in non-food manufactures rose from 3.51 per cent in
March 2010 to 8.5 per cent in March 2011, with the weighted contribution of
the manufacturing sector to total inflation at 41.8 per cent.
Inflation continued to remain an area of concern through most of 201112. From April 2011 to November 2011 for eight consecutive months
inflation remained above 9 per cent. The break came in December 2011
when inflation fell to 7.7 per cent and it fell further to 7.2 per cent in January
2012. Inflation in food articles eased from 10.7 per cent in April 2011 to
-0.68 per cent in January 2012. The significant decline in the headline
inflation was primarily due to the strong decline in food articles and that too
particularly in vegetables. The relief from the decline in food inflation was
short lived. Both headline inflation and food inflation started to rise from the
low levels reached in January 2012. Even as of November 2012, food
inflation is as high as 8.5 per cent. Headline inflation after remaining steady
at around 7.5 per cent rose to 8 per cent in August and September 2012.
Since then, we have seen a decline with the November figure touching 7.2
per cent. Non-food manufacturing inflation has declined from 8 per cent in
December 2011 to 4.49 per cent in November 2012. However, CPI inflation
still remains at double digit level.

10

Some Key Questions

In the context of the analysis of the inflationary developments in the last
three years some key questions arise. These are:
1.

In a situation where inflation is primarily triggered by rise in food prices,

what is the role of monetary policy?

2.

How much weight should policy makers attach to considerations of

growth while fighting inflation?

3.

What has contributed to the persistence of food inflation in India? Can

monetary policy play any role in moderating food price inflation?

4.

With the emergence of certain structural rigidities in price formation

should the acceptable level of inflation be higher than before?

Role of Monetary Policy

It is true that the extraordinarily high level of inflation seen in the last
three years is due to certain severe supply side constraints, particularly of
agricultural products (Basu, 2011). The fact that inflation is triggered
primarily by the supply side shocks does not mean that monetary policy or
for that matter fiscal policy has no role to play in such conditions. As
indicated earlier, food price inflation, if it persists long enough, gets
generalised. Non-food manufacturing inflation, sometimes called the core
inflation, can be treated as an indicator of demand pressure. This has also
remained high since April 2010. In March, October and November 2011 it
had crossed 8 per cent despite a declining growth rate in output. Thus
monetary policy along with fiscal policy have to play their part in containing
the overall demand pressures. This calls for a tightening despite the origins
of inflationary pressures (Mohanty, 2011).
It is only in this context one can understand the series of actions taken
by the Reserve Bank to raise policy rate to control inflation. The repo rates
were raised 13 times. This is largely done in baby steps of 25 basis points
every time. Perhaps, a sharper increase earlier could have been attempted.
Nevertheless, the policy was in the right direction. Much of the increase in
the repo rate was a correction of the reduction in the repo rate done in the
context of the international financial crisis. In fact the policy rate had
remained negative in real terms in almost the entire period. The signal for

reversal of the policy will be when headline inflation and core inflation show
definite signs of decline.

Relative Weights of Growth and Inflation

What weight should be given to considerations of growth in policy
making has become a critical issue in our recent inflation experience, as the
rise in inflation also coincided with a period of declining growth. While in
2010-11 growth rate continued to remain high, the slow down started in
2011-12, more particularly in the second half. The manufacturing growth
rate for the year as a whole was only 2.5 per cent. However, inflation
remained high and the process of tightening by monetary authorities
continued till end January 2012. The repo rate reached its peak of 8.5 per
cent at that point in time. Since then, there has been a process of easing.
The repo rate was once reduced by 50 basis points to reach 8 per cent. The
cash reserve ratio which in my view is a more direct instrument has been
brought down from 6 per cent to 4.25 per cent. Thus since the beginning of
2012-13 there has been no tightening but only easing of the policy in small
steps. The need to balance different objectives is inescapable. However,
different arms of the government have special responsibility in relation to
achievement of objectives. This is what is described as the assignment
rule in policy analysis. Thus among multiple objectives faced by monetary
authorities, control of inflation becomes the dominant objective of monetary
policy and takes precedence over other objectives. However, it goes without
saying that all policy makers including monetary authorities must be forward
looking and recognise the lags involved in the impact of policies. They must
know when to tighten and when to loosen.

Food Inflation and Monetary Policy

One factor that stands out prominently in the recent inflation
experience in our country is the persistence of food inflation (Gokarn, 2011)
(Srinivasan, 2011). Food articles themselves are not one category; they
comprise of several categories of foodgrains, vegetables, fruits, milk, and
eggs, meat and fish. What we have seen in the last three years is food
inflation had remained high because of the spurt in the prices of one
category of food articles or the other. Inflation in foodgrain prices started
almost from the beginning of 2008-09, much before the failure of the
monsoon of 2009. But the failure of monsoon in 2009 pushed up the prices
to very high levels beginning December 2009. It was at that point overall
food inflation exceeded 20 per cent. Food inflation spurted again towards
12

the end of 2010 because of the abnormal increase in the prices of

vegetables. The price of vegetables rose by 34 per cent in December 2010
and 66 per cent in January 2011. Both milk and eggs, meat and fish also
saw consistently high price increases in 2009 and 2010. While inflation in
these commodities somewhat moderated in 2011, they have shown a spurt
once again in 2012 (Table 3). What are the major factors behind the rise in
food inflation? While foodgrain production had been affected by the
vagaries of monsoon, over the years, it had kept pace with the rise in
population. While sudden spurts in the prices of foodgrains can be
explained by weather related factors, the persistent high level of foodgrain
prices is largely attributable to one structural factor, namely, the consistent
increase in the minimum support prices. These increases have rather been
sharp in recent years. In the case of other food articles, while the growth in
output has been reasonable (Table 4), demand had outstripped supply. With
the rise in income, the per capita consumption of commodities such as
vegetables has been increasing at a rate much faster than the population
growth (Table 5). It is obvious that food inflation can be controlled only by
appropriate responses on the supply side. Not only should the production of
agriculture increase but also its composition must change with the changing
tastes and demand patterns of the households. Hopefully, the market
signals will find adequate response. Prices of most food articles in India are
insulated from world market prices. Of course, in the case of foodgrains,
we have a fundamental problem because of the operation of minimum
support prices. Policy makers need to take due note of the impact of the
continuous increase in the minimum support prices on food inflation.
Because of the minimum support price and open-ended procurement, food
stocks at the disposal of the public distribution system have enormously
increased. As of a recent date, stocks of rice and wheat exceeded 65 million
tonnes. This has reduced the availability in the open market (see Appendix
for the impact of procurement prices on market prices). Therefore, when
open market prices rise, there must be a steady and judicious release of
foodgrains from the public stocks at prices below prevailing market prices in
order to bring down prices. Intervention in the foodgrain market by using
the stocks has an important role to play in moderating increase in foodgrain
prices. However, the structural factor remains. In relation to foodgrain as
well as other food articles, there is also the demand pressure arising in the
rural areas through some of the schemes we have introduced such as
MGNREGS. It has been reported that there has been a distinct rise in rural
wages not only in nominal terms but also in real terms. In August 2011, the
year-on-year increase in nominal rural wages was 22 per cent; it has since
come down to about 18 per cent in August 2012. In real terms, the
13

Table 3: Behaviour of different Components of Food

Inflation

Index

2009

2008

2007

Year

Month
Jan
Feb
Mar
Apr
May
June
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
Apr
May
June
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
Apr
May
June
Jul
Aug
Sep

Food
Grains

Veget
ables

128.8
128.8
125.9
127.3
126.8
126.5
128.7
129.7
129.7
132.8
133.0
132.2
132.7
134.1
137.0
139.5
139.0
139.5
141.3
143.2
143.2
147.3
148.3
148.4
149.8
152.0
152.1
154.7
156.1
157.1
158.9
161.1
164.1

112.3
108.3
114.5
124.4
130.8
140.3
162.4
169.3
159.0
153.3
144.5
122.6
108.9
109.4
119.9
114.4
118.6
129.9
139.8
145.1
152.5
173.6
188.3
153.8
149.5
121.0
116.2
133.2
140.4
156.0
178.5
184.5
170.7

Inflation (Y-o-Y)

Milk

Eggs,
Meat
& Fish

Food
Article
s

110.3
112.0
112.1
112.2
112.0
111.5
112.5
113.5
113.7
115.3
116.3
116.3
116.5
117.4
117.8
119.3
120.1
121.0
121.2
121.7
122.2
123.0
123.4
123.9
124.5
124.7
133.9
133.3
133.9
136.2
138.5
139.1
142.7

114.9
116.9
116.2
117.9
122.0
120.5
118.8
115.0
112.8
113.3
115.7
113.6
112.3
116.8
117.7
119.9
124.1
122.3
124.6
126.1
126.3
126.5
127.1
127.0
126.9
126.8
127.0
126.9
127.2
132.6
143.2
149.7
151.4

118.9
119.2
118.9
121.5
122.3
121.8
124.8
126.1
125.5
126.0
125.2
121.6
119.9
122.5
125.6
128.9
130.2
130.3
133.4
134.4
135.8
140.3
141.1
136.3
137.2
134.1
135.6
140.1
141.8
145.0
150.4
153.7
154.7

14

Food
Grains

Veget
ables

14.39
7.57
13.58 17.46
11.32 32.68
12.75 43.82
10.36 41.71
8.49 28.72
10.38 45.52
10.10 35.66
6.14 23.26
5.23 12.89
3.26 11.15
2.16
4.52
3.03
-3.03
4.11
1.02
8.82
4.72
9.58
-8.04
9.62
-9.33
10.28
-7.41
9.79 -13.92
10.41 -14.29
10.41
-4.09
10.92 13.24
11.50 30.31
12.25 25.45
12.89 37.28
13.35 10.60
11.02
-3.09
10.90 16.43
12.30 18.38
12.62 20.09
12.46 27.68
12.50 27.15
14.59 11.93

Milk

Eggs,
Meat
& Fish

Food
Article
s

8.88
9.06
8.52
8.51
6.16
2.67
4.65
5.39
3.93
3.69
5.25
6.21
5.62
4.82
5.08
6.33
7.23
8.52
7.73
7.22
7.48
6.68
6.10
6.53
6.87
6.22
13.67
11.74
11.49
12.56
14.27
14.30
16.78

2.68
7.25
10.04
8.56
10.31
6.26
3.94
0.26
-0.70
4.62
4.42
2.43
-2.26
-0.09
1.29
1.70
1.72
1.49
4.88
9.65
11.97
11.65
9.85
11.80
13.00
8.56
7.90
5.84
2.50
8.42
14.93
18.72
19.87

11.43
12.35
13.24
14.19
12.93
8.94
11.23
9.75
6.27
5.18
4.42
3.23
0.84
2.77
5.63
6.09
6.46
6.98
6.89
6.58
8.21
11.35
12.70
12.09
14.43
9.47
7.96
8.69
8.91
11.28
12.74
14.36
13.92

Oct
Nov
Dec

166.9
173.6
177.3

179.3
191.8
180.0

146.4
150.7
151.0

150.9
162.2
164.3

157.8
164.7
164.6

13.31
17.06
19.47

3.28
1.86
17.04

19.02
22.12
21.87

19.29
27.62
29.37

Table 3: Continues
Index

2012

2011

2010

Year

Food
Grains

Vegeta
bles

May
June
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
Apr
May
June
Jul
Aug
Sep
Oct
Nov

179.0
175.3
172.2
171.8
172.2
173.4
174.2
174.4
174.0
173.4
174.4
175.2
176.4
178.2
175.6
175.5
176.7
177.0
178.6
180.2
180.8
182.9
182.4

156.8
138.4
132.0
143.9
150.9
175.1
172.0
176.2
189.5
193.9
189.2
240.5
261.1
158.3
143.3
146.8
149.9
163.8
185.4
199.4
216.8
224.3
209.4

Dec
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct

182.1
183.3
183.5
185.6
188.9
190.4
193.3
199.8
207.6
212.0
211.2

157.4
146.9
161.0
190.0
237.6
224.7
245.9
230.1
219.5
202.2
207.6

Month
Jan
Feb
Mar
Apr

Inflation (Y-o-Y)

Milk

Eggs,
Meat
& Fish

Food
Articles

Food
Grains

Veget
ables

Milk

157.6
160.3
167.2
170.5
171.9
171.9
174.6
176.5
177.1
177.2
177.9
178.7
179.3
180.4
174.6
175.4
182.4
191.7
193.4
193.1
195.3
196.9
197.3

167.0
170.3
172.1
175.9
185.1
184.3
188.2
190.1
196.1
192.2
192.9
196.2
193.2
192.0
195.4
195.5
197.3
202.5
206.2
209.9
219.4
216.1
214.9

164.9
163.4
163.6
168.8
172.1
175.4
178.2
176.7
179.9
180.9
181.4
189.4
192.4
181.3
179.0
186.8
186.3
188.8
192.8
193.7
197.2
199.3
196.5

19.49
15.33
13.21
11.05
10.31
10.38
9.63
8.26
6.03
3.89
0.46
-1.18
-1.45
1.65
1.97
2.15
2.61
2.08
2.53
3.33
3.91
5.48
4.59

4.88
14.38
13.60
8.03
7.48
12.24
-3.64
-4.50
11.01
8.14
-1.36
33.61
66.52
14.38
8.56
2.02
-0.66
-6.45
7.79
13.17
14.41
15.68
10.68

198.4
201.4
201.5
201.3
202.9
204.1
206.0
208.9
206.0
207.9
209.4

221.9
228.5
230.4
229.4
229.8
231.1
236.3
240.4
239.7
248.4
244.8

190.9
191.1
192.4
197.1
207.2
206.1
209.4
212.4
211.8
213.1
212.5

3.94
3.91
2.97
5.69
7.64
7.75
9.21
11.87
15.21
17.26
15.47

-34.55
-43.74
1.71
32.59
61.85
49.90
50.12
24.11
10.08
-6.73
-7.45

15

Eggs,
Meat
& Fish

Food
Article
s

26.59
28.55
24.87
27.91
28.38
26.21
26.06
26.89
24.11
21.04
18.05
18.34
13.77
12.54
4.43
2.87
6.11
11.52
10.77
9.41
10.28
11.12
10.91

31.60
34.31
35.51
38.61
45.52
38.99
31.42
26.99
29.52
27.37
18.93
19.42
15.69
12.74
13.54
11.14
6.59
9.88
9.56
10.42
11.88
12.43
11.40

20.19
21.85
20.65
20.49
21.37
20.97
18.48
14.96
16.29
14.64
10.14
15.07
16.68
10.95
9.41
10.66
8.25
7.64
8.19
9.62
9.62
10.17
8.32

11.02
12.33
11.70
15.29
15.68
11.90
7.46
8.01
6.68
6.45
6.35

13.10
18.27
20.00
17.40
17.54
17.13
16.69
16.59
14.20
13.22
13.28

0.79
-0.68
6.12
10.11
10.92
10.63
10.91
10.17
9.34
8.06
6.62

12.47
16.73
20.76

Nov

212.5

206.9

209.5

245.4

213.2

16.50

-1.19

6.18

14.19

8.50

Table 4: Growth in Production of Vegetables, Fruits,

Milk, Eggs and Fish Between 2004 and 2010
Commodity
Vegetables
Fruits
Milk: liquid
Eggs (No.)
Fish (kg.)

CAGR in %
5.72
7.05
3.99
5.76
4.48

Table 5: Per Capita Consumption of Vegetables, Eggs

and Fish Between Different Rounds of NSS

Commodity
Vegetables
Eggs (No.)
Fish (kg)

CAGR (2004-10)
CAGR (1993-00)
Rural
Urban All India Rural
Urban
All India
6.70
5.38
6.33
3.34
3.08
3.29
11.40
9.23
10.91
9.28
5.67
8.02
8.37
3.54
5.08
2.60
1.60
2.35

Source: National Sample Survey Organization (50, 55, 61 & 66 th round)

wage growth came down from 11 per cent in August 2011 to 8 per cent in
2012 (Reserve Bank of India, 2012). All these go to emphasise the need for
much faster rate of growth in agricultural and allied activities, if inflation is to
remain low. Also in relation to some food articles such as vegetables, there
16

is an urgent need to improve the current marketing arrangements which are

archaic.
To come back to monetary policy, while changes in monetary policy
cannot have a direct impact on food inflation, it can have a moderating
influence through containing overall demand pressures. At the same time, it
must be recognised that as the income elasticity for food is low, this channel
of transmission may have only limited impact. However, as stressed earlier,
if the persistence in food inflation leads to generalised inflation, monetary
policy has to necessarily intervene (see Appendix for the relationship
between Food and Non-food inflation).

Acceptable Level of Inflation

With the persistence of food inflation and the structural factors
contributing towards such a rise, a question has been raised whether the
acceptable level of inflation in the country must be raised upwards. Some
people call it the new normal. As mentioned earlier, the Chakravarty
Committee had thought of 4 per cent as the appropriate level of inflation.
Subsequently, monetary authorities have acted more or less on the
assumption that the comfortable level of inflation is in the region of 5 per
cent. We have indicated earlier, why price stability is a desirable objective.
Advanced economies have an acceptable level of inflation in the region of 2
to 3 per cent. Most fast growing Asian economies also work around this
number. It would be inappropriate for Indian authorities to raise the
acceptable level of inflation. Of course, inflation currently runs way above
any acceptable level of inflation. It may take more than a year to bring it
down to 6 per cent. Even accepting foodgrain inflation is intractable
because of policy issues as cereals have a weight of only 4 per cent in WPI,
five per cent as the acceptable level of overall inflation is still consistent with
it. Some people seem to argue that high growth warrants higher inflation.
This contention is not justified even by our historical record. In the three
years when we grew at a rate higher than 9 per cent, the average inflation
rate was much lower at 5.2 per cent. What is needed is a much greater
supply response to inflation. High levels of inflation undercut motivation for
savings and divert investment into speculative channels. It would be best for
the policy makers to work with an acceptable level of inflation of 5 per cent.
One may not fully agree with Milton Friedmans statement that
inflation is always and everywhere a monetary phenomenon.
Nevertheless, monetary factors play a key role in the determination of
inflation (see Appendix on the relationship between Money and Prices). This
17

is true even if supply side shocks trigger the initial increase in prices. Sector
specific supply shocks explain at best only changes in relative prices. While
monetary authorities may have multiple objectives, they need to steer in a
clear direction and prioritization of objectives becomes essential. It has to
create a hierarchy of objectives. The mandates of the central banks have
become wider. This is inevitable with the increasing complexity of the
system in which central banks operate. However, the primacy of price
stability as an objective of monetary policy particularly in developing
economies must be recognized. Our own experience in the last three years
is a clear reminder of this.

18

Appendix I

Some Econometric Relationships

Against the background of the recent developments in inflation, an
attempt has been made to test three relationships. First, an inverted
demand function for money was estimated to find out the relationship
between price on the one hand and money supply and income, on the other.
Second, an attempt was made to measure the extent of pass-through of
food prices to non-food manufacturing prices. Third, an attempt was made
to measure the impact of changes in procurement prices of wheat and rice
on their respective wholesale prices.

Money, output and prices

How strong is the impact of money supply on prices? A visual
inspection of the movements of money supply (M 3) and inflation in WPI show
close correspondence between the two series till 2003 (Chart 3). Thereafter,
the behaviour is not consistent. However to understand the full picture, we
need to bring in the impact of income. To test more rigorously the
relationship among these three variables, the following equation was
estimated:
Pt = 0 + 1Yt + 2Mt + 3Pt-1 + t

(1)

where P = Log of WPI (average of weeks)

Y = Log of GDP at factor cost at 2004-05 constant prices
M = Log of Broad Money i.e. M3 (outstanding on 31st March)
The coefficients of this model have the following interpretations:
Long run price elasticity of money = 2/(1- 3)
Long run price elasticity of output = 1/(1- 3)
Income elasticity of money demand =

1
The results of the estimates are presented in Table 6. I had earlier
estimated a similar equation for the period 1971-2003 (Rangarajan, 2009).
The results of the earlier study are reported along with the current results
which covered the period 1971-2012.
19

Chart 3: Inflation and Growth in M3

Table 6

Impact on Price of Money and Income

Variables

1971-2003

1971-2012

Log (M3)

0.26*
(0.07)

0.263*
(0.072)

Log (GDP)

-0.39*
(0.14)

-0.313*
(0.105)

Log [WPI(-1)]

0.70*
(0.10)

0.644*
(0.093)

Constant

3.60**
(1.34)

2.284*
(0.726)

R-squared

0.99

0.99

Long-run price elasticity of money

0.87

0.739

Long-run price elasticity of output

-1.33

-0.879

Income elasticity of money demand

1.53
1.190
_____________________________________________________
Note:

*, **, represent 1% and 5% level of significance and

the numbers in brackets are robust standard errors.

The legitimacy of estimating the equations in the form presented

above has been tested. All the variables are found to be non-stationary of
order 1 but cointegrated. In the short run, a 1 per cent increase in M3
increases WPI by 0.26 per cent. The long run price elasticity of money is
0.74. It may be noted that both the long run price elasticity of money and
the long run price elasticity output for the extended period are slightly lower
than the estimates made earlier for a shorter period. The implicit income
elasticity of demand for money is 1.19. A declining income elasticity of
demand for money means a rising velocity of circulation which is what
happens when the financial sector grows. The shifting nature of the
parameter does pose a problem for policy makers. However, if the shift is in
a narrow band, the policymakers can fix the range of money supply growth
which is consistent with non-inflationary growth.

Pass-through of Food Inflation

The second relationship which we want to study is the extent of passthrough of food inflation to non-food manufacturing inflation. If food inflation
persists long enough, it gets generalized because it results in an upward
pressure on wages and, therefore, on manufacturing inflation. However,
inflation of non-food manufactures is also dependent on other factors. Apart
from demand and supply gaps, there is also the impact of imported inflation
due to increase in the prices of imported raw materials. In Chart 4 we have
shown the quarterly inflation in food articles and non-food manufactures.
The visual inspection does not show a coherent pattern. There could be a
lag in terms of the impact of food inflation on manufacturing inflation which
may not be obvious from a visual inspection.

22

Chart 4: Behaviour of Food Articles and Non-Food Manufacturing Inflation (Q-o-Q)

In order to test the relationship between non-food manufacturing

inflation with food inflation, we analyzed the quarterly Indices of both from
2005 to 2012. Appropriate tests indicated that they are Co-integrated or in
other words there is a long run relationship between food and non-food
manufacturing inflation. We then proceeded to estimate three equations
using the quarterly data for the period from 2 nd quarter of 2005 to 2nd quarter
2012.
1. LnQWPINFMt = 2.637* + 0.432* LnQWPIFAt
(0.099)

(0.020)

R2 = 0.94
2. LnQWPINFMt = 2.569* + 0.39* LnQWPIFAt + 0.047** LnQINDxCrudePricet
( 0.096) (0.024)

( 0.020)

R2 = 0.95
3. LnQWPINFMt = 0.33*** + 0.045*** LnQWPIFAt +
(0.18)

(0.03)

0.033*LnQINDxCrudePricet + 0.85* LnQWPINFMt-1

(0.008)

(0.068)

R2 = 0.99

Where
QWPINFM = Quarterly WPI of non-food manufacturing
QWPIFA = Quarterly WPI of food articles
QINDxCrudePrice = Quarterly index of Global Crude oil price
Note: Values in the parenthesis are the respective S.E of the coefficients
*, ** and ** indicate statistical significance at 1%, 5% and 10%
respectively

These equations clearly establish a strong relationship between Food

inflation and Non-food inflation. From equation (3) it is seen that the long
run elasticity is .3. That is 1 per cent increase in Food inflation leads 0.3 per
cent increase in Non-food inflation.

Impact of Changes in Procurement Prices

We also examined the impact of changes in procurement prices of rice
and wheat on the wholesale prices of these commodities. One should
normally expect to find a close correspondence between the two. However,
there could be periods when the two may not move in the same direction.
Looking over a longer period, there is a strong relationship between the
procurement prices and the wholesale prices of these commodities. To
establish the relation between Minimum Support Price (MSP) and WPI, we
regressed log of WPI of wheat and rice on the respective log value of MSP.
We have estimated two equations for two different time periods. The results
are summarized in the Table 7 below.

Table 7
Impact of MSP
Variables
Log MSP
Constant
Adj

1993-94 to 2009-10
(WPI base 1993-94)

Wheat
0.789*
(0.046)
0.064
(0.294)
R0.95

2004-05 to 2010-11
(WPI base 2004-05)

Rice
Wheat
0.754*
0.837*
(0.044)
(0.084)
0.363
-0.742
(0.272)
(0.565)
0.95
0.94

Rice
0.792*
(0.059)
-0.365
(0.386)
0.97

Squared
*
represent the statistical significance at 1%. The
numbers in the bracket are standard errors.

The conclusion that we can draw from the above results is that there is
a strong positive relation between MSP of wheat and rice with their
25

respective WPIs. The 1 per cent increase in MSP of wheat causes an

increase of 0.84 per cent in WPI. Similarly, 1 per cent increase in the MSP
of rice leads to a 0.79 per cent increase in its WPI.

References
Basu, Kaushik (2011): Understanding Inflation and Controlling It, Economic
and Political Weekly, XLVI, No. 41, October.
Bruno, Michael (1995): Does Inflation Really Lower Growth?, Finance &
Development, September.
Gokarn, Subir (2011): Food Inflation: This Time Its Different, Reserve Bank
of India Bulletin, Mumbai, December.
Mohanty, Deepak (2011): Changing Inflation Dynamics in India, Reserve
Bank of India Bulletin, Mumbai, August.
Rangarajan, C (1998): Development, Inflation and Monetary Policy in
Ahluwalia, I.J. and Little, M.D., (ed.) Indias Economic Reforms and
Development, Oxford University Press, New Delhi.
Rangarajan, C. (2009) Challenges for Monetary Policy in India: Monetary
Policy, Financial Stability and Other Essays Academic Foundation,
New Delhi.
Reserve Bank of India (2012): Macroeconomic and Monetary Developments
Second Quarter Review 2012-13 (Issued with the Second Quarter
Review of Monetary Policy 2012-13).
Srinivasan, T.N. (2011): Recent Bouts of Inflation in India: Policy
Paralysis?, Third Shri R. Venkataraman Endowment Lecture, Madras
School of Economics, Chennai.

26