RBI has an official inflation target of 4% +/- 2% set by the government and will primarily set its monetary policy to achieve its inflation target. The official rate of inflation is the CPI, which currently at around 4% levels is right on target though RBI is still circumspect on the downward trajectory of inflation.
CPI inflation has trended down from over 10% levels to 4% levels over the last few years largely on the back of oil prices coming off by 50% on global supply glut, fall in global commodity prices on the back of China slowdown and fall in growth in aggregate demand in the economy due to a general economic slowdown. However with oil prices bottoming out, global commodity prices showing an uptrend and government spending expected to push up economic growth, inflation expectations could rise.
RBI has come under a lot of flak on Demonetisation, largely due to the fact that it was not able to supply new notes to replace old notes. This was because of capacity constraints in its mints. However the concept of demonetisation ties in with the inflation target of RBI and the central bank was right in accepting the government’s notice on demonetisation.
Currency in Circulation when it rises can lead to a fall in demand for goods and services as the public hoards cash and this sharply brings down inflation in the economy. The Great Depression in the US in the 1930’s was largely due to the public hoarding cash, as they did not trust the banking system.
In India, rise in Currency in Circulation is attributed to tax evasion, which leads to unproductive use of funds such as investments in gold and real estate, illegal transfer of wealth abroad and hoarding activities that leads to rise in prices of essential commodities. Unproductive use of funds leads to investments being diverted away from capacity creation, which balances out the demand supply factor in the economy and keeps inflation in check.
Inflation in India is largely attributed to a demand supply imbalance that is exacerbated by a cash economy, which is seen as unproductive.
RBI, given its inflation target, views demonetisation as a one time reform that could lower inflation expectations in the economy. The demonetisation move would move the economy from a cash driven unorganised one to a digital organised one, which will then help increase government revenues, lower fiscal deficit and provide more funds for the private sector. This will increase investments in the economy, help in creating capacities, which will lower long term inflation expectations.
In theory, RBI is right in accepting demonetisation but it remains to be seen whether the whole exercise will turn out as theorised by the central bank.
