Inflation in India &Fiscal tools to control it…. Submitted by Apparao.G FW 10/12(B1)
Inflation in IndiaInflationDef: Inflation is a rise in the general level of prices of goods and services inan economy over a period of time. When the price level rises, each unit ofcurrency buys fewer goods and services. A chief measure of price inflation isthe inflation rate.When Prices rise the Value of Money falls.Causes of Inflation: There were different schools of thought as to the causes of inflation.Most can be divided into two broad areas: quality theories of inflation andquantity theories of inflation. The quality theory of inflation rests on theexpectation of a seller accepting currency to be able to exchange thatcurrency at a later time for goods that are desirable as a buyer. The quantitytheory of inflation rests on the quantity equation of money, that relates themoney supply, its velocity, and the nominal value of exchanges.AdamSmith and David Hume proposed a quantity theory of inflation for money,and a quality theory of inflation for production. Currently, the quantity theory of money is widely accepted as anaccurate model of inflation in the long run. Consequently, there is now broadagreement among economists that in the long run, the inflation rate isessentially dependent on the growth rate of money supply. However, in theshort and medium term inflation may be affected by supply and demandpressures in the economy, and influenced by the relative elasticity of wages,prices and interest rates.India Inflation Rate The inflation rate in India was last reported at 9.5 percent in March of2012. From 1969 until 2010, the average inflation rate in India was 7.99percent reaching an historical high of 34.68 percent in September of 1974 anda record low of -11.31 percent in May of 1976. Inflation rate refers to ageneral rise in prices measured against a standard level of purchasing power.The most well known measures of Inflation are the CPI which measures
consumer prices, and the GDP deflator, which measures inflation in thewhole of the domestic economy.Types of Inflation: There are mainly three types of Inflation they are 1. Demand-Pull Inflation 2. Cost-Push Inflation 3. Built-in inflationDemand-pull inflation: It is caused by increases in aggregate demand due to increased privateand government spending, etc. Demand inflation is constructive to a fasterrate of economic growth since the excess demand and favourable marketconditions will stimulate investment and expansion.Causes for Increase in Demand :- a) Increase in Money Supply b) Increase in Black Marketing c) Increase in Hoarding d) Repayment of Past Internal Debt e) Increase in Exports f) Deficit Financing g) Increase in Income h) Demonstration Effect i) Increase in Black money j) Increase in Credit facilitiesCost-push inflation:- It is also called "supply shock inflation," is caused by a drop inaggregate supply (potential output). This may be due to natural disasters, or
increased prices of inputs. For example, a sudden decrease in the supply ofoil, leading to increased oil prices, can cause cost-push inflation. Producersfor whom oil is a part of their costs could then pass this on to consumers inthe form of increased prices. Another example stems from unexpectedly highInsured Losses, either legitimate (catastrophes) or fraudulent.Causes for Increase in Cost :- a) Increase in cost of raw materials b) Shortage of Supplies c) Natural calamities d) Industrial Disputes e) Increase in Exports f) Increase in Wages g) Increase in Transportation Cost h) Huge Expenditure on AdvertisementEffects of Inflation:- • Inflation can have positive and negative effects on an economy. Negative effects of inflation include loss in stability in the real value of money and other monetary items over time; uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include a mitigation of economic recessions, and debt relief by reducing the real level of debt.
Stages of inflation:- 1. CREEPING INFLATION (0%-3%) 2. WALKING INFLATION ( 3% - 7%) 3. RUNNING INFLATION (10% - 20 %) 4. HYPER INFLATION ( 20% and abv)Fiscal Policy: Fiscal policy involves government expenditure and revenue, throughtaxes, borrowing and printing money. Anti inflationary fiscal policy wouldfocus on with- drawing purchasing power from the public so that they spendless, relieving the upward pressure on prices. This can be done by raisingtaxes and borrowing from the public without spending the proceeds. As theorigin of inflation in most developing countries has been increasinggovernment claim on productive resources (required for public sectorprojects), a decrease in government expenditure leaving taxes undiminishedmay still be more effective. Fiscal policy is regarded as deliberatemanipulation of the relation between government expenditure andgovernment receipts with a view to maneuvering the level of aggregatedemand in the desired direction"1Manipulation of aggregate demand is not the only way fiscal policy cantarget inflation. Spending money in a way that increases the supply of goodsand services can also help governments check the rising trend in prices.It has been rightly observed that inflation as we know it is a modernphenomenon. The price level was stable for nearly a century till 1914.2 But anumber of factors, among which debt financing of the two world wars wasonly one, caused most countries to experience rising prices since the middleof the century till the eighties. The same period also saw a phenomenal rise inpublic spending which globally reached 43% of the GDP by 1980.3 As aresult inflation is commonly perceived as a consequence of rising public
expenditure. This, however, may not always be true.4 One has to examinespecific cases to arrive at a conclusion.The Islamic Framework: The Islamic framework within which this study examines the role offiscal policy in controlling inflation is defined, in the first instance, by thegoals of an Islamic economy. It is need fulfillment, justice and equity. Alsoincluded in these goals is to provide the state with the means required fordefence, law and order and fulfillment of other socially obligatory duties(furud kifaya) which the private sector fails to fullfil. In the context of money,finance and government policies the Islamic framework can be furtherspecified by prohibition of interest and gambling, minimization of hazard anduncertainty and keeping government intervention in the market limited towhat is necessary for the realization of the above mentioned goals.Furthermore can be mentioned the concept of moderation in consumption andtreating public money as a trust which have an impact on our subject matter.That there is a role for fiscal policy in realizing the goals ! of an Islamic stateis quite obvious. But that is not our subject in this study.What needs emphasisis that anti inflationary fiscal policy should not jeopardize the long termarrangements for realizing the goals of Shariah. But before we proceed toexamine the scope for such policies we have to note another dimension of thematter which shall not be discussed by us: the hypothat the fullimplementation of Islamic teachings, i.e. the operationalisation of the Islamicframework noted above, will prevent inflation or at the least, minimize itsincidence. This is due to the presence of several built in stabilizers in thesystem.The hypothesis is supported mainly, by four arguments. 1. In the Islamic economic system debt financing which is the chief source of inflation and instability in the contemporary economies will have been replaced by equity and sharing based finance which are non inflationary and stable.The change from debt finance to share finance also integrates saving and
investment decisions making the system more stable than its capitalist counterpart. 2. Thanks to Zakat, inheritance laws and other redistributive provisions,Islam will effect a less unequal distribution of income and wealth (as compared to the same economy under capitalism). This will change the composition of aggregate demand in favour of the necessities of life thereby reducing the fluctuations in aggregate demand. 3. Islam will induce people to moderation in consumption, to shun wasteful life styles and conpicuous consumption. This will result in a decrease in aggregate demand. 4. Islamic governments, treating public money as trust will be frugal, keeping public expenditure within the bounds set by the available means. Public borrowing will be minimum and deficit financing rare. Financing public expenditure by printing new money will be almost non existent.It is not necessary to examine this hypothesis in a discussion on the role offiscal policy in controlling inflation. Since the possibility of inflation in anIslamic economy is not denied and since it is very likely that an Islamisingregime inherits inflation from the earlier regime, it would be quite logical forus to narrow down our focus on control as distinct from prevention. This isstill the more credible a methodology in view of a third and more compellingreason. Inflation may impose itself on an economy from outside, caused byglobal moves beyond its control, especially if it is a small economy. Whatfollows is, therefore, not affected by ones acceptance or rejection of some orall of these arguments. Those who take the hypothesis skeptically due to lackto empirical evidence will, of course, find the subsequent arguments morecompelling. But those who whole- heartedly support the hypothesis will alsofind good reason to attach due weight to them.Prevention and ControlThere are two significant differences between fiscal policies designed tocontrol already existing inflation and those designed to prevent inflation from
afflicting an economy which at the time is free of inflation. The firstdifference relates to time horizon and the speed at which a policy measure iscarried out. The second relates to the size of the change required in therelevant variables e.g. government expenditure, taxes, etc. Policies designedto control inflation have to have an impact now. They must be fast actingshowing their results in a matter of months. This in turn may require bigreduction in government expenditure, large increases in taxes, huge amountsof domestic borrowing etc. Given these measures successfully implementedover a short period of time aggregate demand will decrease and the trend ofprices to rise will be checked. The big question is, how far is it possible anddesirable to do so.Let us have a look at the way government decides how much to spend. Partof government expenditure relates to the core of governance, no governmentcan function without these. They can be reduced if they are inflated but thereis a limit to such reduction. Expenditure on salaries and offices of theexecutive, legislative and judicial branches of government come under thiscategory. Then come the expenditure on defence and law and order, bothpermanently mandated by Shariah. The volume of expenditure on theseheads may be dictated by circumstances beyond the government control e.g.geopolitical situation, moral degeneration, etc.Reduction in Public ExpenditureIt is only when we come to the other public goods and the welfare activitiesof the government that reduction in government expenditure becomes a realpossibility. But the actual scope of such reduction depends on the historicalpath followed by (the increase in) government expenditure. Modern daygovernments have shown little ability to reduce expenditure on education andhealth care. For an Islamic state in a developing country the idea of reducingexpenditure on education and health care is still the less apealing. This is inview of the priority of these items on the Islamic agenda and the neglect fromwhich they suffered in the past. The most a developing country can manageto do is to prevent expenditure on these items from increasing further.Reducing the current levels of expenditure on education and health care areno where a real option. In fact any attempt to do so would be economicallydisastrous and politically suicidal for the regime.
It has been rightly observed that public expenditure increases as the nationaloutput increases, often at a faster rate.1 It is very difficult to envisage areduction in publicThere is a strong case for reducing public expenditure when it is necessary todo so for controlling inflation. But the practical scope for doing so is verylimited. If there is an accross the board reduction in the salaries ofgovernment employees many of them may be forced to find better paid jobsin the private sector, even abroad, affecting the quality of the bureaucracy tothe detriment of public interest. Reduction in ostentatiousexpenses onceremonies, etc. may not involve significant amounts. As we hinted above,reduction in the expenditure on defence and internal security may not bepractical. Some relief is expected from elimination of corrupt practices,bribes and kick backs. This will reduce the cost of doing business, expandingtrade and investment and, ultimately, boosting production. These reformsmay also reduce the cost of public projects, reducing governmentexpenditure.Increase in Tax RevenuesOne should also consider the possibility of an Islamic state eliminating taxevasion and even coaxing people to pay donations ---- over and above taxes--- to enable their government do good things for them. The likely gains inrevenue terms are however, likely to be more than conterbalanced by twoother inevitable changes. There are certain indirect taxes on basic necessitiesof life which Islamic economists regard to be antipoor and worth scrapping.Then there is mandatory lowering of tariffs and custom duties as part of onesbelonging to a world set to reduce them globally.Let us now turn to the other policy measure, withdrawal of purchasing powerfrom the public through increased taxation and domesticborrowing not accompanied by a corresponding rise in public expenditure.This in fact is only a textbook proposition insofar as the developing countriesare concerned. These countries are not able to meet even current levels ofpublic expenditure through all the taxes and domestic borrowing they canmanage, thereby taking recourse to printing new money. As regards anIslamic economy domestic borrowing ceases to be an option as no interestcan be paid to the lenders. A resort to compulsory borrowing free of interest
as suggested by some1 would be hardly feasible in political terms. Additionaltaxation with the sole purpose of withdrawing some purchasing power andfreezing it implies that the money should be paid back when the time comesto defreeze it. That makes it akin to compulsory borrowing. There is no empi!rical evidence of any developing country ever having adopted these policiessuccessfully.Increasing the Supply of Goods and ServicesThat leaves us with the last opption noted under the heading fiscal policy:spending money in a way that increases supply of goods and services. Thisspending does not have to be done by the government itself, at least not all ofit. Tax reduction that encourages private investment may serve the samepurpose. Lowering corporation taxes and lowering or scrapping capital gainstaxes, even scaling down the income taxes may boost production byincreasing the incentive to work and the incentive to save. Another possiblemeasure is to restructure the subsidies, if any, in favour of the intermediateindustries whose products are needed for expanding the production ofconsumer goods. Building the infrastructure --- roads, bridges, irrigationsystems, electricity and telecommunication, etc. --- at public cost and makingthem available to the private sector at affordable prices has also been afavourite policy of mid-century developmental planning. These can beadopted after due consideration of the lessons from the past.Even though each one of these policies is slow acting and of modest impacttheir cumulative impact over time would be significant. There can be no surerway to check the rising trend in prices than to arrange for increasing thesupply of the very things whose prices are increasing. Fiscal policy has noother way to make a durable contribution to solve the problem of inflationsince the two other options examined above are limited in scope and notpractical. Unlike the impact of anti inflationary monetary policy which maybe immediate but temporary, the impact of supply increasing fiscal policies isslow but durable.In seems the scope for reducing public expenditure from their current levelsis very limited insofar the contemporary Muslim countries are concerned.The same applies to the possibility of withdrawing purchasing power fromthe public without spending the proceeds. This leaves us with the slow acting
option of trying to maneuver public expenditure and taxation in a way thatincreases the incentives to work, save and invest and / or directly contributesto increasing the supply of goods and services.Moderation, Abolition of Interest and ZakatWe shall now proceed briefly to examine if the three other Islamic provisionsnoted above, i.e. moderation in consumption, abolition of interest andgambling and Zakat can play some role in controlling inflation.In an already inflationary situation prices of necessities and other consumergoods would be rising. In such a situation people can not be expected tospend less in money terms as that would mean drastic reduction in their livingstandards. In fact they have to spend more to stay where they are. If currentlevels of consumption are perceived to be extravagant the most that can beexpected in the name of moderation is for spending not to increase in moneyterms. As regards luxuries some additional revenue can be raised byincreasing sales taxes with a view to reducing demand. But the rich who buythese goods may be the same people who become richer due to inflation.They could afford higher prices. Then there is always the danger of excessivetaxes driving goods into the black market and increasing the incentive toevade taxes. In any case there is no empirical evidence of forced moderationhaving contributed to controlling inflation in a free ! market economy.Abolition of interest and introduction of new arrangements for financialintermediation based on profit sharing will ensure financial stability. Savingswill flow from households to firms smoothly through financial intermediarieswho will be able to plough back to the savers attractive returns gotten fromthe businessmen. Abolition of gambling and the resulting curbs onspeculation will further contribute to the stability of the financial system. Astable financial system is, however, a necessary but not a sufficient conditionfor price stability. Changes in technology and tastes may throw wholeindustries out of gear causing the levels of output, employment, and incomesto change despite a stable financial system. For a single country influx offoreign capital, favourable balance of payment or similar causes originatingoutside may cause the prices to rise by affecting the domestic money supply.What is more important for our purpose in this study is, howev! er, the factthat the change over form debt-finance to share-based finance will not by
itself bring down prices. Inflationary prices boost business profits which willtranslate themselves in to higher profits (though not higher ratios of profitsharing) for financial intermediaries as well as for the savers / depositors.Profit-sharing may not necessarily feed the inflationary process but it shallnot check it either. More direct intervention may be needed to rectify thesituation. Redirection of investible funds by sectorally different ratios ofprofit-sharing or out right controls on incomes, profits and prices maybecome necessary in certain circumstances. But these options are outside thescope of this study.The role of Zakat in reducing inequality in the distribution of income andwealth and thereby contributing to a change in the composition of aggregatedemand that would make it more stable has already been noted above. Ourfocus now is the possible contribution of Zakat in bringing down prices whenthey are high and rising. It has been rightly pointed out that advancecollection of Zakat due in the future and/or delaying the expenditureof Zakat proceeds till a more appropriate time can contribute to controllinginflation.1 It is also suggested that aggregate supply may be manipulated bycollection and distribution of Zakat in kind.2Appropriate Policy MixThe role of fiscal policy in controlling inflation shouldnot be discussed inisolation from the role of the monetary policy and exchange rate policy. Thetrue picture can be obtained only by considering a mix of these policies in thecontext of a given situation. The size of a countrys economy, the relativesizes of its domestic and external economies, the historical path throughwhich an inflationary situation has come to hold are all important aspects ofthe situation. Also important is whether the chief source of inflation is in thelabour market and/or goods market or in the money supply. The moralstandards of the people, the level of corruption, the governments credibilityand the degree of the peoples trust in government too are forces to bereckoned with. Bereft of these data no meaningfull study can be made on therole of fiscal policy in controlling inflation in an Islamic framework. Thereason in simple. All the three terms appearing in our title: fiscal policy,inflation and Islamic framework derive their meaning - operational meaning -from these data.
EpilogueThe type of inflation experienced in early Islamic history was different innature from the one experienced in twentieth century. More often than not therise in prices was sharp but short lived. Instances of a sustained upward trendin the level of prices are rare. There are, however, instances of a gradual risein prices at a low rate caused by continued influx of gold and silver.1 Alsothere were brief spurts of rising prices due to the same cause as happened inthe third and fourth decades of Islamic history. But most of the times it wasclimatic conditions or disruption in transportation that caused a failure insupply leading to sharp rise in food prices.1 Also in later Islamic history,especially after the disintegration of the Abbasids, it was debasement ofcurrency, excessive issue of subsidiary (copper ) coins (fulus) and circulationof large quantities of counterfeit that caused spurts of inflation. These, were,generally, localized and temporary.2 Protests from the populace often resultedin cancelletion of new issues and rectification of debasement. No specialmeasures are reported to counter the rise in prices due to influx of gold andsilver. A fast expanding economy with widespread foreign trade was able toabsorb the new money without serious problems.Price rise caused by famine and disruption in supply caused great pain andsuffering. Egypt during the Mamluk period was specially afflicted by thesedevastations as recorded, among others, by Maqrizi.3 If and when thesituation did evoke a response from the authorities it was in the form ofarranging additional supplies of food grains at public expense.1 Sometimesthey also tried to ensure larger imports by reducing import duties.2Putting an end to debasement of currency and meeting rise in prices byarranging for increased supply are policies rooted in Islamic tradition, thedifference in the nature of inflation notwithstanding. These policies are likelyto evoke public cooperation as well as endorsement by the Ulama. The twoother fiscal measures noted above, reduction in public expenditure (withwelfare provisions bearing most of the cut) and increased taxation (anddomestic borrowing) are doubly doomed. They are not practical. They haveno roots in the Islamic past, hence they do not sound familiar, neither to thepopulace nor to the Ulama.
Instruments of Fiscal Policy: • 1. Reduction of Govt. Expenditure • 2. Increase in Taxation • 3. Imposition of new Taxes • 4. Wage Control • 5.Rationing • 6. Public Debt • 7. Increase in savings • 8. Maintaining Surplus BudgetOther Measures: • 1. Increase in Imports of Raw materials • 2. Decrease in Exports • 3. Increase in Productivity • 4. Provision of Subsidies • 5. Use of Latest Technology • 6. Rational Industrial Policy