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GS-III : Economic Issues Monetary Policy

15 October, 2020
5 Min Read

The RBI tunes in to the economy

Context:

The article analyzes how the COVID-19-triggered recession had led to some of the strongly held economic assumptions being revised around the world.

US Federal Reserve:

The chairman of the Federal Reserve (Fed) of the US, has declared that the Fed will not let inflation stand in the way of maximising employment implying that it will no longer raise rates pre-emptively(in anticipation of inflation).
The reasoning seems to be that the Phillips Curve (the relationship between inflation and unemployment) may no longer hold in the U.S. economy. The Phillips Curve principle has had wide acceptance in Anglo-American economics.

Philips curve:

The Phillips curve suggests there is an inverse relationship between inflation and unemployment.

Reserve Bank of India:

The latest monetary policy review by the newly reconstituted Monetary Policy Committee seems to be indicative of signs of the RBI shifting away from its rigid inflation targeting policy.
Available data shows that the model that currently guides India’s inflation control strategy may be quite irrelevant as seen in the recent behaviour of inflation in India.
Despite the staggering decline in output by 23% in the first quarter of this year, the inflation rate did not decrease in India.
This observation goes against the argument that inflation reflects an ‘over heating’ economy, one growing too fast in relation to its potential.
This conception of inflation represents the RBI’s official understanding of inflation, and presumably forms the basis of its policy of inflation targeting.
Also going by the Phillips Curve, inflation should have abated as India’s economy contracted during the lockdown.

Models for inflation forecasting:

A recent working paper of the RBI’s research department proposes a model that accepts a role for food prices.
Newer evidence has noted food prices as an important determinant of inflation along with imported inflation. Hence a macroeconomic contraction need not lower inflation.
This could lead to better forecasting of inflation in India as this is more in tune with the Indian scenario, as against the western economic models which do not attach much weightage for food prices in their inflation monitoring.

Way forward:

RBI has been evolving itself to better align its policies more in line with the Indian economy is a welcome and much-needed move.

Source: TH

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