does the repo rate really control inflation ?

7/30/2019 does the repo rate really control inflation ?

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Volume 2, Issue 3 (March, 2012) ISSN: 22497323AJRBF

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A Peer R eviewed I nter national J our nal of A sian

R esearch C onsorti um

AJ RBF:A S I A N J O U R N A L O F

R E S E A R C H I N B A N K I N GA N D F I N A N C E

DOES THE REPO RATE REALLYCONTROL INFLATION?

N SURESH*

*Lecturer,

Department of CommerceM V S Government Degree College

Mahaboob Nagar.

ABSTRACT

It has become the common practice of Reserve Bank of India to rotate the repo ratein very frequent intervals to stabilize the supply of money and to curtail the pressuresof inflation. The prudence of RBI certainly works when the inflation is caused due tothe mounting pressures of demand side economies. But the bank rates can hardlyyield any benefits if the inflation is cost pulled and stands to be the residual of supply

side problems. It could be the reason why the consumer price index of the countryhas been sending alarming signals of proliferating inflation and making the reporate a destitute of positive effects. So, this paper makes a preliminary attempt todiscuss whether, the repo rate succeeds in managing inflation. Or, is there any needto find the formidable path of mitigating undesired rate of inflation.

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INTRODUCTION

Inflation is one of the prime economic parameter reflecting the increase in the aggregate pricesof goods and services in a particular time period and generally quantified as a percentage change

in the consumer price index of the country. it not only replicate the purchasing power of moneybut also impacts the other important variables like exchange rate of the currency and interestrates of the banks and ultimately turns the financial system of the country to be more turbulent.It is the reason why, central bank of any country is expected to foster the most adroit monetarypolicy and to strike the fine balance between demand and supply of money to harness the pricelevels of goods and services. Reserve Bank of India is by no means an exemption from thisplausible assumption. Hence, the following objectives are proposed to be examined in this paperto analyze the repurchase rates and inflation management in India.


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OBJ ECTIVES OF THE PAPER

1)To find the non monetary causes of inflation2)To examine the effect of repo rates on inflation

METHODOLOGY

The first objective is designed to find the non monetary determinants of inflation so as to form apreliminary opinion with respect to the influence of monetary variables like repo rate oninflation. This objective shall be accomplished through reviewing the literature available insecondary data sources.

The second objective forms the core of this paper, which shall be examined by means of ahypothesis.

Null hypothesis H0 : there is no significant difference between the repo rates and inflation inIndia.

Alternative hypothesis H1 : there is significant difference between the repo rate and inflation inIndia.

The null hypothesis shall be tested with the help of t distribution which establishes the perfectstatistical tradeoff between the observations of small sample.

NON MONETARY CAUSES OF INFLATION IN INDIA

It should not be confined to the mere hypothesis that inflation is caused only due to theimbalances of demand and supply side economies of money. Rather, inflation may take place inthe following circumstances either.

Increase in the cost of production may lead to cost pulled inflation. Tim Callen (2001)1found from his empirical study that cost of overheads like fuel and energy prices havebeen showing spiraling impact on the ultimate prices and driving inflation to paramount.He further added that energy cost itself is leading 14 % changes in the price levels.

Deregulation of the essential commodities may lead to artificial scarcity and causesinflation in the long run. Battacharya (2009)2 argued that deregulation of essential natural

resources certainly leads to the formation of inflation. He took petroleum pricederegulation as the underlying resource and proved that price regulation is better thanprice management. Chand (2010)3has also expressed similar opinions while finding thecauses of food sector inflation. He stated that the poor management of food grains interms of ensuring the optimum supply is one of the major causes of inflation in India.

Forward trading is being emerged as the prime determinant of inflation which isnevertheless subjected to prudent regulation in India. Sahi( 2006)4has considered the


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forward contract prices of National Commodity and Derivative Exchange to illustrate theimpact of forward trading on inflation. He applied Johansens co integration model withthe short term data and drew the conclusion that there is significant impact of futureprices of commodities on the core sector inflation. Nath (2008)5has also expressedsimilar interpretations. He applied simple linier regression and Granger causality test inthis pursuit, and stated that, there is indispensable effect of forward trading on the pricesof spot market. Hence it is obvious that inflation is also caused due to forward tradingand not merely by the excess supply of money which has to be curtailed with repo rateadjustment. It is perhaps the reason why Indian government has imposed restrictions onforward trading in edible commodities in the recent past.

Import restriction measures of the local government often lead to supply scarcity andform an avenue for inflation to run. Ball (2006) 6is of the firm belief that importrestriction and export promotion measures of the local government often creates thescarcity of supply in the local markets and accelerates the rate of inflation in the short

run. Nevertheless these measures are unavoidable to safeguard the long run interests.

Failure of the public distribution system (PDS) in any country enhances the gap betweendemand and supply of commodities and increases their prices to give a fillip to headlineinflation. Swaminathan (1996)7has stated that price fluctuations are common in thetransitional economies like India. But such fluctuations must be managed bystrengthening the public distribution system which also avoids unwanted intermediariesin the market and controls the inflationary pressure.

TRENDS OF INFL ATION AND REPO RATES IN THE PAST TEN YEARS

The following secondary data reflects the changes in inflation from the year 2002 and thecorresponding changes made by RBI in terms of repo rate.

year Repo rate( %) Inflation(%)

2002 7 3.888

2003 7.05 4.158

2004 6 3.194

2005 6.25 4.062

2006 6.875 6.332

2007 7.75 6.452

2008 7.75 8.333


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2009 8 11.888

2010 8.25 11.25

2011 8.3 8.427

Source: RBI bulletin September 2011

RBI adjusts repo rate in the frequent intervals of a single financial year. Therefore the repo ratesprojected in the table are the average values of intra annual repo rates. However, the inflationdirectly replicates the annual percentage change of the CPI.

It can be seen from the above graph that, inflation kept on mounting, except in the two intervalsin spite of the spontaneous increase in the repo rate. In other words, the negative relation can beseen between the repo rate and inflation only in the years 2010 and 2011.this minor deviationcould have been caused due to some other exogenous parameters which can be better addressedby extending the graphical analysis to statistical analysis by means of t distribution which

considers the correlation between repo rate and inflation in the selected time period to decidewhether to accept the null hypothesis or not. The t distribution can be established with the help offollowing formula.

T=r{ 21/2 rn }

Where n=number of observations and r is the correlation value

0

2

4

6

8

10

12

14

1 2 3 4 5 6 7 8 9 10

Reporate(%)Inflation(%)


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( )( ) ( ) ( )22

= yyxxyyxxr

Where, x and y represent repo and inflation rates respectively.

TESTING OF HYPOTHESIS

The residuals are calculated with the help of Excel spread sheet. Accordingly,

R=0.848222

T= ( ) ( 2848.01210848.0

=4.42

INTERPRETATION

The calculated value of t is 4.42 with the two tail test where as the acceptable degrees ofdeviation from the table value at 5 % degrees of freedom is 2. 31. I.e. tcal>ttab which compels usto accept the null hypothesis hence it is possible to state that the increase in repo rate could notshow any significant difference in inflation.

CONCLUSIONS

The statistical inference of this paper empowers us to draw the bold conclusion that, therepo rate volatility may not curtail the mounting problem of inflation.

Increase in repo rate may lead to increase in the cost of capital which in turn showsadverse impact on inflation.

The Burdon of controlling inflation should not be shifted to the central bank of thecountry unless; such inflation is proved to be the consequent of excess money supply.

Continuous increase in repo rate may hit the performance levels of banks which canbecome more detrimental to the credit rating of banks, instead of controlling the pricelevels.

Managing the supply side economies of real sector is the best way of managing inflationin long run.

KEYWORDS

Repo rate: it is the rete of interest at which banks borrow money from RBI

CPI: it is the Consumer Price Index used to replicate the percentage change in inflation.


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Non monetary determinants: the determinants of money other then that of money supply.

REFERENCES

1 Tim Callen, India at cross roads,IMF journal, 2001

2 S C Battacharya, united nations sustainable development journal volume 4 2009

3 Ramesh Chand, understanding the nature and causes of food inflation in India, EPW, vol 27,2010

4 G S Sahi, commodity futures market efficiency in India and effect on inflation, 2006 ssn.com

5 G Nath, derivative market and its impact on spot market, 2008, papers.ssm.com

6 L M Ball, has globalization changed inflation? NBER paper no 12687, 2006

7 Swaminathan M, Structural adjustment food security and syste of public distribution, EPW,1996

does the repo rate really control inflation ?

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