Perturbed by accelerating rate of inflation, government has been advocating various measures to combat the same. Recently the government has advised the RBI to take appropriate measures to curb inflation. Following government’s advice RBI has even increased Repo rate, Cash Reserve Ratio (CRR) etc., but has so far refrained from changing bank rate for the time being.

In the week ending June 24, 2008, rate of inflation has climbed to 11.63 percent, breaking 13 years record. Though government blames petrol-diesel price hike to the present spurt in inflation, but contradictory statements coming from the government circles, have also been the major cause of confusion about the causes of inflation. This confusion is creating distrust about effectiveness of the measures being adopted by the government to combat inflation.

At first government was citing economic growth as major reason for high rate of inflation, but later it changed its stand and started accusing price rise internationally for the same. Recently government even blamed steel and cement companies conspiring by forming ‘cartels’ and pushing the prices upward. At other instance government even blamed hoarding by traders causing price hike of food items. And now government has added a new chapter by asking RBI to adopt appropriate monetary measures to check fast rising inflation.

According to economic principles excess demand, costs escalation and structural factors cause inflation. For the past few months combination of all these factors have played their role in accelerating inflation. Major reason for present inflation is unprecedented increasing in the supply of money in recent years. It is important to note that currency held with the public which was 3, 55,666 crores on May 31st 2005 increased to 6,02,706 crores by 2008. This implies an increase of 2, 47,043 crores in just 3 years and 2 months. According to monetary economists money supply in the economy increases by approximately twice that of increase in the currency held with the public and reserve money. According to RBI, reserve money increased by 28.5 percent in the year 2007-08.

RBI has only limited powers
This unprecedented increase in money supply is basically caused by large scale purchase of foreign exchange by RBI, populist government policies, heavy deficit financing by the government and rampant corruption at government level. In order to gain cheap publicity government is successively making populist schemes, ultimately leading to large scale deficit financing and thereby increasing money supply.

Now the major question is, whether RBI would be able to stop inflation. To find answer to this question, we need to understand the limitations of RBI. According to Constitution of India, RBI cannot compel government to limit or reduce deficit financing. RBI is obliged to purchase foreign exchange brought to it by international investors and other investors. RBI even has no right to restrain government to adopt populist schemes. All this is leading to unprecedented increase in quantity of currency held by the public. It is true that currency is issued by RBI but it has no right to stop or reduce the issue of currency for all such purposes.

RBI has jurisdiction only with regard to variation in Cash Reserve Ratio (CCR), Repo Rate, Bank Rate, sale and purchase of government securities in open market operations or Statutory Liquidity Ratio (SLR). All these measures can affect changes, only in the limited way, the capacity to create credit by commercial banks. But these measures have drawbacks as well as they affect economic growth adversely. In this context the decision of the RBI, not to increase bank rate is a step in right direction. Though it is obligatory for RBI to purchase foreign exchange brought before it, but it was possible to pay rising oil bills from large and overflowing foreign exchange reserves accumulated so far. This act could have stopped devaluation of rupee and petrol price hike to some extent.

Need to attack basic causes of inflation
Government needs to directly attack basic causes of inflation. No doubt government has no control on fast rising international crude prices, but its impact on consumers can be reduced by providing relief in taxes. To curb price hike in food products, we need to end policy of neglecting agriculture. Investment in agriculture needs to be encouraged. Farmers should be provided remunerative price for their produce and agricultural costs be reduced. Buffer shocks should be maintained by procuring as products from the farmers and the practice of periodical sale from buffer shock should be re-established to curb unwanted upheavals in prices of food products.