Pump Priming, Inflation and Money Supply in India: Analysis of inflation in India in relation to pump priming can be traced to early 2000s as this was the period when the government adopted most of the monetary and fiscal policies that are currently in use. In the early 2000s, India was experiencing a significant slowdown in its economic growth due to both international and external factors. The levels of inflation in the country were low due to the low demand. In addition, during this period, the government was implementing policies to facilitate economic recovery from the impact of the Asian financial crisis. This was highlighted by the fact that the RBI reduced the interest rate by 300 basis points between 2001 and 2005 (Khundrakpam, & Pattanaik, 2010).
By 2005, the economy had recovered fully and inflationary pressures had started to manifest. This prompted the government to develop tightening monetary policies. The introduction of FRBM in 2004 led to a reduction in the budget deficit of the government from 4.3% in the financial year 2003/ 04 to 2.5% in the financial year 2007/08. FRBM helped in reducing the expansionary fiscal policies, which advocated for pump priming to facilitate the growth of the economy. The expansionary fiscal policies increased aggregate demand, which led to inflationary pressures. However, after the introduction of FRBM, there were steady capital inflows. This led to the appreciation of the currency, which helped in reducing the imported inflationary pressures (Bhattacharya, Patnaik, & Shah, 2008). Therefore, the average inflation during this period was steady at 5% to 6% that conformed to the policy objectives.
However, by 2008, the level of inflation as determined by the WPI, had gone over the comfort zone. Inflation as measured by the consumer price index (CPI) increased significantly. An increase in the global commodity prices such as that of oil, was the main factor that led to the increase in inflation during this period. Nevertheless, the economy did not have any signs of overheating after experiencing successive periods of high economic growth. Unprecedented levels of capital flows helped in reducing the surplus liquidity in the market.
The economy experienced growth despite the fact that the RBI had increased interest rates by 300 basis points. During this period, the monetary policy was implemented in an environment that was characterized by unprecedented levels of capital inflows. The RBI also increased the cash reserve ratio to mop up the surplus liquidity in the market and facilitate monetary transmission. The RBI also engaged in sterilization of the market using a market stabilization scheme (Raj, Khundrakpam, & Das, 2011).
The onset of the global financial crisis in 2008 led to a sharp contraction of the external demand. In addition, the freezing of the foreign financial markets led to a disruption in the short-term lending provided by banks and other financial institutions. This had a negative impact on the domestic trade and other economic activities in India. By 2009, India had recovered from the impact of the global financial crisis. Its GDP growth was 9% in the financial year 2010/11, which was the GDP growth it was experiencing prior to the onset of the global financial crisis.
Pump priming is one of the main factors that facilitated the recovery of the Indian economy from the global financial crisis as the government spent billions of dollars in various infrastructural projects. During this period, inflation as measured by CPI, was very high. On the other hand, inflation as measured by WPI moved from negative levels in 2009 to approximately 10% in 2010. Increase in the food prices due to monsoon shocks was the main factor that led to the increase in the inflation during this period. The high prices of food products persisted even after the end of the monsoon shocks. The measures taken by the government to tackle increase in food prices due to the monsoon shocks and developments in the labor market helped in maintaining the prices at a high level. For instance, the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) and the Minimum Support Prices (MSPs) led to changes in the food consumption patterns and in turn increased household incomes. In addition, it led to mismatches in the demand and supply of certain food products. The increase in the price of oil in the world market also exacerbated the situation. Therefore, the slowdown in the output, significant increase in demand, and increase in the cost of inputs such as labor and raw materials created inflationary pressures.
During this period, the monetary policy was characterized by normalization from the expansionary policies that were used during the global financial crisis period before tightening control measures were implemented to tackle inflation. Nevertheless, the government continued using pump priming to support certain sectors of the economy whose recovery from the impact of the global financial crisis was slow. This exposed the economy to various challenges as the increase in domestic consumption subjected the economy to inflationary pressures.
In 2014, RBI adopted a policy that lead to the gradual reduction of the level of CPI inflation from the then level to 8% in 2015, 6% in 2016, and finally to acceptable levels. By the end of 2014, inflation had reduced significantly especially due to the fall in the price of oil in the global market and the relative stability of the rupee. Better supply management also helped in maintaining the prices of food products despite the presence of monsoon shocks during this period. By January 2015, the CPI inflation had reduced to 5.2%, which was better than the level of inflation projected by RBI in 2014. In January 2016, the CPI inflation was 5.7% as conditions of inflation evolved in accordance with the specifications of the disinflation glide path created by RBI.
In May 2016, amendments to the Reserve Bank Act 1934 provided the RBI with the responsibility of maintaining price stability as one of its major monetary policy objectives. The RBI was also given the mandate of developing flexible inflation targeting with CPI assuming the nominal anchor of the monetary policy. The RBI was also tasked with the responsibility of establishing the Monetary Policy Committee (MPC) whose role would be to set the policy rate to facilitate the attainment of the policy objectives. As such, in August 2016, RBI set an inflation target of 4% for the period up to March 31, 2021. The upper and lower tolerance of the inflation targets would be 6% and 2% respectively.
The lack of a nominal anchor is the main factor that made it difficult for the monetary policy to control inflation. In addition, price shocks due to internal or external factors created inflationary pressures on the Indian economy. The setting up of CPI as the monetary anchor would improve the ability of the RBI to control inflation.