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Causes, effects and control of inflation: inflation targeting and the Monetary Policy Committee

Inflation · Part 2 / 1 · Fact-checked on · how we check

Written with AI from the sources listed at the bottom of this page, then fact-checked by a separate AI.

Why prices rise (demand-pull, cost-push, imported and structural), inflation by speed, deflation, disinflation, reflation and stagflation, the Phillips curve, who gains and loses, the inflation target under the RBI Act (s.45ZA, s.45ZN), the Monetary Policy Committee (s.45ZB) and the monetary, fiscal and supply-side tools of control.

Part 1 showed how inflation is measured. This part asks three further questions. Why do prices rise? Who gains and who loses when they do? And how does India try to keep inflation low and stable? Since 2016 India's answer to the last question has a legal form called inflation targeting: the Central Government fixes a numerical target for consumer price inflation, and a Monetary Policy Committee in the RBI sets the policy interest rate to meet it. The RBI is not the only actor, though. Many price shocks in India start with food or fuel, and these are handled mainly by the government through buffer stocks, trade rules and taxes.

demand-pull inflation arises when total demand in the economy grows faster than the economy's ability to supply goods and services. Demand can rise because the government spends more than it collects, because banks lend freely at low interest rates, because incomes rise quickly, or because the money supply grows faster than output. When factories and farms are already working close to capacity, extra spending cannot be met by extra production, so sellers raise prices instead. Because demand-pull inflation comes from spending, it responds to the tools that cool spending, such as higher interest rates and tighter government budgets.

cost-push inflation starts on the supply side. When the cost of producing goods rises, firms pass it on to buyers even if demand has not changed. Common triggers are a rise in the price of crude oil, costlier raw materials, higher wages that are not matched by higher productivity, and a fall in the rupee that makes imports dearer, a form called imported inflation. Supply shocks such as a drought, floods or a pest attack cut the output of crops and push up food prices. In India many bouts of food inflation are also structural: weak storage, gaps in cold chains and transport, and low yields in crops such as pulses keep supply from responding quickly. Cost-push and demand-pull pressures can feed each other in a wage-price spiral, in which workers demand higher wages to keep up with prices and firms then raise prices to cover the higher wage bill.

Inflation is also described by its speed. Creeping inflation is mild, a low single-digit rise each year that most people barely notice. Walking or trotting inflation is moderate but noticeable and starts to affect decisions. Galloping inflation runs into double or even triple digits a year, and money begins to lose its usefulness as a store of value. Hyperinflation is an extreme case in which prices rise so fast that people rush to spend money the moment they receive it; Germany in 1923 and Zimbabwe in 2008 are well-known examples. Most economists see low and stable inflation as healthy rather than harmful. This is why India's target is a positive number, 4 per cent, rather than zero.

Several related terms are easy to confuse. deflation is a fall in the general price level, that is, negative inflation. It sounds pleasant but is dangerous: people postpone purchases in the hope of lower prices, firms cut output and jobs, and the real burden of debts rises because loans must be repaid in money that is worth more; Japan struggled with falling prices for years from the late 1990s. disinflation is different: inflation is still positive but its rate is falling, for example from 7 per cent to 4 per cent, so prices are rising more slowly. Reflation is a deliberate policy push, through lower interest rates or higher public spending, to lift prices and output back up after a slump or a spell of deflation. stagflation combines high inflation with stagnant output and high unemployment. It was the experience of many countries after the oil price shocks of the 1970s, and it is especially hard to treat because the remedy for one problem worsens the other.

Inflation and its look-alikes
TermWhat happens to pricesWhat happens to outputExample
InflationGeneral level risesVariesCPI rising 5 per cent a year
DisinflationStill rise, but more slowlyVariesInflation falling from 7 to 4 per cent
DeflationGeneral level fallsOften weakJapan from the late 1990s
ReflationPushed back up by policyRecoveringRate cuts and spending after a slump
StagflationRise fastStagnant, high unemploymentMany countries after the 1970s oil shocks
HyperinflationRise extremely fastCollapsesGermany 1923, Zimbabwe 2008

The link between inflation and jobs is summed up in the Phillips curve. In 1958 the economist A.W. Phillips, studying British data, found that years of low unemployment tended to be years of fast-rising money wages, and the reverse. Read as a menu, this suggested that a government could buy lower unemployment at the price of somewhat higher inflation. The stagflation of the 1970s broke that idea: inflation and unemployment rose together. The lesson drawn by later economists was that the trade-off holds, if at all, only in the short run. Once people come to expect higher inflation, they build it into wage demands and prices, and unemployment returns to its earlier level while inflation stays high. This is why modern central banks put so much weight on keeping inflation expectations anchored, and it is the thinking behind a clear, public numerical target.

Inflation does not hurt everyone equally; it moves purchasing power from some people to others. Borrowers tend to gain and lenders to lose when inflation turns out higher than expected, because a loan is repaid in rupees that buy less than when it was taken. People on fixed money incomes, such as pensioners without price-linked increases or workers whose wages are revised rarely, lose. Savers lose when the interest on their deposits is below the inflation rate. The real interest rate is roughly the nominal rate minus inflation: a deposit paying 7 per cent when inflation is 5 per cent earns a real return of only about 2 per cent. The poor, who hold much of their wealth as cash and spend most of their income on food, are hit hardest, which is why inflation is sometimes called a tax on the poor.

The Expert Committee to Revise and Strengthen the Monetary Policy Framework, chaired by Urjit Patel, recommended in 2014 that CPI (Combined) inflation become the nominal anchor, with a target of 4 per cent and a band of 2 percentage points on either side. In February 2015 the government and the RBI signed a Monetary Policy Framework Agreement on these lines, and the Finance Act, 2016 then wrote inflation targeting into the RBI Act, 1934. Under section 45ZA, the Central Government, in consultation with the RBI, determines the inflation target in terms of the CPI once every five years and notifies it in the Official Gazette. The target of 4 per cent CPI (Combined) inflation, with an upper tolerance of 6 per cent and a lower tolerance of 2 per cent, was first notified in 2016, retained in 2021, and retained again in 2026 for the period from 1 April 2026 to 31 March 2031.

A target needs a test of success and a duty to explain failure. The Central Government has defined failure as average CPI inflation staying above the upper tolerance level or below the lower tolerance level for any three consecutive quarters; a single bad month is not a failure. When failure occurs, section 45ZN of the RBI Act requires the RBI to send a report to the Central Government setting out the reasons for the failure, the remedial actions it proposes, and an estimate of the time within which the target will be achieved. This provision was used for the first time in November 2022, after average inflation stayed above 6 per cent in each of the first three quarters of 2022.

The rate decision itself belongs to the Monetary Policy Committee (MPC), set up under section 45ZB of the RBI Act; it first met in October 2016. It has six members: the RBI Governor as chairperson, the Deputy Governor in charge of monetary policy, one RBI officer nominated by the RBI's Central Board, and three persons appointed by the Central Government. The three external members hold office for four years and cannot be reappointed. The MPC must meet at least four times a year; in practice it meets about every two months. Four members make a quorum, each member has one vote, and if votes are tied the Governor has a second or casting vote. After each meeting the RBI publishes the resolution, and the minutes, including each member's vote and statement, are published on the fourteenth day. The RBI also publishes a Monetary Policy Report every six months.

To bring inflation down, the MPC raises the policy repo rate, the rate at which the RBI lends to banks for short periods. Banks then charge more for loans and pay more on deposits, so households and firms borrow and spend less, and demand cools. The government has its own instruments. On the fiscal side it can cut its spending or deficit, or reduce indirect taxes on items such as fuel. On the supply side it holds buffer stocks of foodgrains and sells them in the open market through the Food Corporation of India, builds stocks of onions and pulses through a Price Stabilisation Fund, imposes stock limits on traders under the Essential Commodities Act, 1955, eases imports by cutting duties, and restricts exports, as with the ban on exports of non-basmati white rice in July 2023.

The pieces now fit together. India's answer is a division of labour fixed in law: the Central Government sets the target of 4 per cent CPI (Combined) inflation with a 2 to 6 per cent band every five years; the six-member MPC uses the repo rate to steer demand towards it, and must explain any failure that lasts three consecutive quarters; and the government handles the supply side through food stocks, taxes and trade measures. Monetary and supply measures work best together, because interest rates cannot grow pulses and buffer stocks cannot cool an overheated economy.

Exam traps

Recap

Practice questions

Q1. Under the Reserve Bank of India Act, 1934, the inflation target is determined by:

  1. The Monetary Policy Committee
  2. The Central Board of the RBI
  3. The Central Government in consultation with the RBI
  4. Parliament by a resolution
Show answer

Answer: C. The Central Government in consultation with the RBI

Section 45ZA gives this power to the Central Government, in consultation with the RBI, once every five years. The MPC decides the policy rate to meet the target but does not set it; the RBI's Central Board has no role in fixing it; and Parliament does not pass a resolution on it.

Q2. Consider the following statements about the Monetary Policy Committee:
1. It has six members, three of whom are appointed by the Central Government.
2. In the event of a tie, the RBI Governor has a second or casting vote.
Which of the statements given above is/are correct?

  1. 1 only
  2. 2 only
  3. Both 1 and 2
  4. Neither 1 nor 2
Show answer

Answer: C. Both 1 and 2

Both statements are correct: the MPC has the Governor, a Deputy Governor and one RBI officer plus three members appointed by the Central Government, and the Governor breaks a tie with a casting vote. So '1 only', '2 only' and 'neither' are each wrong.

Q3. Match List I with List II:
List I: A. Deflation B. Disinflation C. Stagflation
List II: 1. Inflation rate falls but stays positive 2. High inflation with stagnant output 3. Fall in the general price level
Select the correct answer using the code given below:

  1. A-1, B-3, C-2
  2. A-3, B-1, C-2
  3. A-3, B-2, C-1
  4. A-2, B-1, C-3
Show answer

Answer: B. A-3, B-1, C-2

Deflation is a fall in the price level (A-3), disinflation a slowing but positive inflation rate (B-1), and stagflation high inflation with stagnation (C-2). The first code swaps deflation and disinflation; the third swaps disinflation and stagflation; the fourth gives deflation the meaning of stagflation.

Q4. Consider the following statements about the inflation targeting framework:
1. The RBI is deemed to have failed if CPI inflation exceeds 6 per cent in any single month.
2. On failure, the RBI must report to the Central Government the reasons, the remedial actions proposed and the time within which the target will be achieved.
Which of the statements given above is/are correct?

  1. 1 only
  2. 2 only
  3. Both 1 and 2
  4. Neither 1 nor 2
Show answer

Answer: B. 2 only

Statement 1 is wrong: failure means average inflation outside the 2-6 per cent band for three consecutive quarters. Statement 2 is correct under section 45ZN. So '1 only' and 'both' are wrong, and 'neither' misses statement 2.

Q5. Inflation that turns out higher than expected generally benefits:

  1. Lenders who gave loans at a fixed rate
  2. Borrowers who took loans at a fixed rate
  3. Pensioners on a fixed money pension
  4. Savers holding cash
Show answer

Answer: B. Borrowers who took loans at a fixed rate

Borrowers repay in rupees that buy less, so they gain. Lenders receive repayment of lower real value, pensioners on fixed money pensions can buy less with the same amount, and cash loses purchasing power, so the other three lose.

Q6. Which one of the following is an example of cost-push inflation?

  1. A rise in global crude oil prices raises transport and production costs
  2. A large pay rise for millions of employees boosts spending
  3. Banks lend freely at low interest rates
  4. A cut in income tax raises household consumption
Show answer

Answer: A. A rise in global crude oil prices raises transport and production costs

A rise in the cost of crude oil pushes up production costs, which is cost-push. The other three raise spending or demand: a pay rise, cheap credit and a tax cut are all sources of demand-pull inflation.

Q7. The Phillips curve describes the relationship between:

  1. Tax rates and tax revenue
  2. Unemployment and the rate of inflation
  3. Income and the share of food in spending
  4. Interest rates and exchange rates
Show answer

Answer: B. Unemployment and the rate of inflation

The Phillips curve links unemployment with the rate of wage and price inflation, suggesting a short-run trade-off. The link between tax rates and revenue is the Laffer curve; the falling share of food as income rises is Engel's law; interest and exchange rates are a separate topic of the external sector.

Q8. Which of the following are supply-side measures to control food inflation?
1. Open market sale of foodgrains by the Food Corporation of India
2. An increase in the policy repo rate
3. Stock limits on traders under the Essential Commodities Act, 1955
Select the correct answer using the code given below:

  1. 1 and 2 only
  2. 1 and 3 only
  3. 2 and 3 only
  4. 1, 2 and 3
Show answer

Answer: B. 1 and 3 only

Open market sales and stock limits act on the supply of food, so 1 and 3 are supply-side. A higher repo rate is a monetary tool that works on demand, so every option that includes 2 is wrong.

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