What is the link between rising food prices and central banks raising interest rates? – INSIGHTSIAS

Gs Paper-3

 Syllabus: Indian Economy and issues relating to planning, mobilisation of resources, growth, development and employment.

 

Context:

Last week the US central bank (Fed) announced that it will raise interest rates by 75 basis points (or 0.75 percentage points) to bring down inflation to its target rate of 2% from 9%. However, there is a fear that such as a move may lead to the US going into recession and thus impacting India and the world.

 

This article is also in continuation to the article on 16^th June 2022.

What is inflation?

Inflation is the rate at which prices rise. A 2% inflation implies the general price level in April this year was 2% more than what it was in April last year.

• Inflation rate in India has steadily gone up from close to 4% in September last year to almost 8% in April this year.

 

Why is inflation bad?

• It makes commodities costly.
• It essentially erodes the basis on which one makes economic decisions– meaning it reduces the value of money.

 

What is a recession?

A recession is said to occur if an economy contract for two consecutive quarters (a quarter is a period of three months).

 

Why is a recession bad?

Recession essentially leads to a low growth rate thereby starting a vicious circle wherein the country experiences low production and high unemployment.

 

 

 Fed and RBI increasing interest rates may cut inflation to some extent but may not help in reducing food and fuel price-led inflation, but raising interest rates may bring about a recession. Then why are all these central banks still trying to do this? The answer lies in something called “inflation expectations”.

 

What are inflation expectations?

Inflation expectations refer to people’s (or households’ expectation of what the inflation rate will be in the future). And they matter because this expectation is what determines people’s economic behaviour.

• If people expect higher inflation in the future, they may start purchasing things in present times to be used in future.
• The net effect of these individual decisions to advance or postpone purchases or ask for higher wages etc. determine the course of a country’s economy.
• For example, if people expect higher inflation and advance their purchases, all of a sudden there will be a spike in demand, far in excess of the supply, thus causing higher inflation.
• As such, policymakers try to gauge what is happening to inflation expectations.

 

Impact of Inflation expectation:

• Reduced investment: Businesses will hold back fresh investment as costs (such as wages) go up. This, in turn, hurts the country’s competitiveness.
• Increase in Gold Demand: People pull out money from their savings and put it into non-productive assets such as gold. In India’s case, since 98% of all gold demand is met from imports, this essentially implies capital going to other countries.

How raising the interest rate will bring down inflation expectations?

 

• Inflation expectations tend to be “backwards-looking”: (Households) tend to look at a recent food and fuel prices which are salient items in the average consumption basket and they form their opinion about what inflation would be in the future, say three months or a year from now. If RBI/Fed starts taking preventive measures then households will have confidence that inflation will be controlled in future and thus stabilize ‘inflation expectations’.
• Dampen demand-side inflation: While high-interest rates may not affect the supply-side inflation, it does dampen the demand for other goods and services (by disincentivizing borrowing (because it is now costlier))
  • It reduces inflation by bringing down demand
  • It gives time for the supply to catch up with the demand.

 

Core argument: Ensuring inflation expectations stay “anchored” is the essential goal for monetary policy. Reducing inflation is a way to achieve that goal and raising interest rates is a way to achieve lower inflation.

 

India’s RBI is also trying to achieve the same goal: keeping inflation expectations anchored. (Target rate is 4-6% in the case of India). But as central banks try to achieve this goal, more interest rate hikes in the coming months are expected, which, in turn, will dampen economic activity all around.

 

Insta Links

Basics: Managing Inflation

Inflation’s Long Shadow

 

Practice Questions:

Q. In India, which one of the following is responsible for maintaining price stability by controlling inflation? (UPSC CSE 2022)

1. Department of Consumer Affairs
2. Expenditure Management Commission
3. Financial Stability and Development Council
4. Reserve Bank of India

 

Answer: D

 

Q. Which among the following steps is most likely to be taken at the time of an economic recession? (UPSC CSE 2021)

1. Cut in tax rates accompanied by increase in interest rate.
2. Increase in expenditure on public projects.
3. Increase in tax rates accompanied by reduction of interest rate.
4. Reduction of expenditure on public projects.

Answer: b

 

Q. With reference to Indian economy, demand pull-inflation can be caused/increased by which of the following?

1. Expansionary policies
2. Fiscal stimulus
3. Inflation-indexing wages
4. Higher – purchasing power
5. Rising interest rates

Select the correct answer using the codes given below.

1. 1, 2 and 4 Only
2. 3, 4 and 5 Only
3. 1, 2, 3 and 5 Only
4. 1, 2, 3, 4 and 5

Answer: A

 

Q. If the interest rate is decreased in an economy, it will (UPSC CSE 2014)

(a) decrease the consumption expenditure in the economy

(b) increase the tax collection of the Government

(c) increase the investment expenditure in the economy

(d) increase the total savings in the economy

Answer: C

In the interest rate is decreased, it becomes easier to borrow money at a low-interest rate and therefore individuals/companies will increase their investment expenditure.

 

Q. Inflation further exacerbates inequalities and affects the poor the most. Discuss the policy measures that are needed to ensure that inequalities do not deepen amidst rising inflation. (10M)

Q. Distinguish between demand-pull and cost-push inflation. Examine the factors that are causing inflation in India. What measures are needed to keep inflation under check? (10M)

Sources: Indian express