Relevance: Mains: G.S paper III: Economy
Context:
- The most important economic reforms accomplished by the government was the Agreement on Monetary Policy Framework, which formalized the targeting of inflation.
Strengthen monetary policy framework:
- In 2014, the Reserve Bank of India (RBI) had set up a committee under the chairmanship of Urjit Patel to revise and strengthen the monetary policy framework, and the committee recommended the adoption of this framework.
• The idea has been popular, and is considered very effective in delivering low and stable inflation. Since 1990, it has been adopted by eight advanced and 32 emerging economies.
Highlights the agreement between RBI and GOI:
- According to the agreement between the Indian government and RBI, the objective of monetary policy is primarily to maintain price stability, while keeping in mind the objective of growth.
• It mandates RBI to contain consumer price inflation within 4% with a band of (+/-) 2%, and the central bank would be seen as having failed to meet its goal if it goes above 6%, or slips under 2%, for three consecutive quarters.
• If this happens, RBI will have to explain the reasons for its failure and give a time frame within which the target would be achieved.
Background:
- The implementation of the idea has led to a considerable fall in retail inflation over the years; from its peak of 11.16% in November 2013 to 1.46% in June 2017.
• It was at 1.97% as recently as in January 2019, and at 4.62% in October 2019, though it rose to 5.56% last month.
• In fact, even prior to the formal announcement of inflation-targeting, a disinflationary process had started, and, within the span of one year, from November 2013 to December 2014, 6.23 percentage points were knocked off the inflation rate.
• It has been observed that RBI’s monetary policy has been successful in achieving its stated objective of disinflation, removing a significant economic imposition on the poor.
• However, an issue that received minimal attention in the Urjit Patel committee report and in the recent debate on the growth slowdown is that of the output cost of such large and quick disinflation.
Sacrifice ratio:
- The sacrifice ratio is an economic ratio that measures the effect of rising and falling inflation on a country’s total production and output. Costs are associated with the slowing of economic output in response to a drop in inflation.
How it works?
- The percentage of a year’s real gross domestic product that must be forgone to reduce inflation by one percentage point is dependent on several factors, such as how quickly people revise their expectations of future inflation.
• If the revision is not quick, the sacrifice ratio can be relatively large.
• Similarly, countries with inflexible wage-setting institutions may also have larger sacrifice ratios.
Way ahead:
- All this indicates that while analysing the reasons for India’s recent growth slowdown, it’s very important to investigate the implications of the recent disinflationary phase.
• India is better off with low and stable inflation, but this has surely not been costless.