IMPORTED INFLATION
1. Context
The Asian Development Bank recently warned that India could face imported inflation as the rupee could depreciate amid the rise in interest rates in the West. A rise in interest rates in the West tends to cause the currencies of developing countries to depreciate
2. What is Imported Inflation?
Imported inflation refers to the phenomenon where a country experiences inflationary pressure due to rising prices of imported goods and services
Imported inflation can have a cascading effect. When imported goods become more expensive, it can raise the cost of production for domestically manufactured goods that rely on imported materials or components. Producers may then pass on these increased costs to consumers by raising prices, leading to general inflation across the economy
This can occur for various reasons:
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Exchange Rates: If the domestic currency depreciates against other currencies, it makes imports more expensive. As a result, the cost of imported goods and services rises, leading to inflationary pressures.
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Global Commodity Prices: Fluctuations in global commodity prices can affect the cost of imported raw materials and energy, which in turn can lead to higher prices for domestically produced goods and services.
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Trade Policies: Changes in trade policies, such as tariffs or quotas, can influence the cost of imports. If tariffs increase, for example, it raises the cost of imported goods, contributing to inflation.
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Supply Chain Disruptions: Disruptions in global supply chains, such as natural disasters, geopolitical tensions, or pandemics, can lead to shortages of imported goods. When demand exceeds supply, prices tend to rise, causing inflation.
3. A Fall in the rupee value
- A decrease in the worth of a nation's currency is generally regarded as the primary cause of imported inflation within an economy.
- This is because when a nation's currency loses value, its residents need to spend more of their local currency to acquire the necessary foreign currency for purchasing foreign goods or services.
- Consequently, they effectively end up paying more for any imports. The Asian Development Bank recently cautioned that India might encounter imported inflation due to the potential depreciation of the rupee amidst increasing interest rates in Western countries.
- Elevated interest rates in the West typically result in the depreciation of currencies in developing nations against Western currencies, thereby escalating import expenses for these nations.
- Moreover, a surge in import expenses, even in the absence of currency depreciation, is believed to induce import-related inflation.
- For instance, an increase in global crude oil prices due to a reduction in oil production is anticipated to trigger price hikes across an economy reliant on oil imports for producing goods and services.
- It's important to note that the concept of imported inflation essentially reflects a form of cost-push inflation, indicating that a surge in input costs can lead to inflation in the prices of final goods and services
4. Consumers and Prices
- Critics of the idea that increasing import expenses can lead to inflation argue that it is a flawed economic concept.
- They contend that while it may seem intuitive to assume that input costs dictate prices, and therefore higher costs should result in higher prices for goods and services—given that many businesses in reality raise prices when their input costs increase—this perspective doesn't hold true from an economic standpoint.
- Instead, critics argue that prices are determined by what customers are willing to pay for final goods and services. They emphasize that producers decide what price they can sell their final output for to customers, and based on this, they determine the cost they're willing to pay for inputs.
- Critics stress that if input costs were set higher than what producers are willing to pay (in line with final consumer demand), the excess supply of inputs would remain unsold because producers wouldn't purchase them.
- Consequently, this surplus would drive down the price of inputs in line with final consumer demand.
- In essence, critics assert that value is attributed retroactively from final consumer goods and services to the inputs used in their production
5. Effects of Imported Inflation
Imported inflation can have several effects on an economy:
- As the cost of imported goods and services increases, consumers may experience higher prices for a wide range of products. This can lead to a decrease in purchasing power and a reduction in the standard of living for households
- Imported inflation can contribute to overall inflationary pressures in the economy, particularly if imported goods and services are significant components of the consumer basket. This can prompt central banks to tighten monetary policy to control inflation, potentially leading to higher interest rates and reduced economic growth
- Businesses that rely heavily on imported inputs may face higher production costs, which can squeeze profit margins. In response, they may pass on some of these increased costs to consumers through higher prices, leading to a further rise in inflation
- A sustained increase in import prices can worsen a country's trade balance if the higher cost of imports is not offset by increased export revenues. This can lead to a deterioration in the current account balance and put downward pressure on the domestic currency
- Imported inflation can affect different income groups unevenly. Lower-income households, which typically spend a larger proportion of their income on essentials like food and fuel, may be disproportionately impacted by price increases
- Policymakers may face challenges in addressing imported inflation, especially if it is driven by external factors such as exchange rate movements or global commodity prices
6. Way Forward
It can be further argued that even when import costs rise due to a depreciating currency, the rise in costs is still ultimately driven by the demand for the final output among consumers. To understand this, it should be noted that the value of a currency depreciates against a foreign currency when its supply becomes relatively more abundant than the foreign currency in the forex market. In other words, the exchange rate of a currency depreciates to reflect the greater demand for the foreign currency in terms of the local currency. So, the resulting rise in import costs due to depreciation itself can be seen simply as a reflection of a change in the nominal demand for inputs
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For Prelims: Inflation, MPC, CPI, WPI, food Inflation, RBI, Headline inflation, Core inflation For Mains:
1. Explain the concept of inflation and its impact on an economy. Discuss the various causes of inflation and the measures that can be taken to control it, with specific reference to India. (250 Words)
2. What are the challenges and opportunities associated with managing inflation in India? Evaluate the effectiveness of recent policy measures in addressing inflationary pressures and maintaining price stability. Suggest strategies for sustainable economic growth while managing inflation risks. (250 Words)
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Previous Year Questions
1. Consider the following statements: (UPSC 2021)
1. The Governor of the Reserve Bank of India (RBI) is appointed by the Central Government.
2. Certain provisions in the Constitution of India give the Central Government the right to issue directions to the RBI in the public interest.
3. The Governor of the RBI draws his natural power from the RBI Act.
Which of the above statements is/are correct?
A. 1 and 2 only B. 2 and 3 only C. 1 and 3 only D. 1, 2 and 3
2. Concerning the Indian economy, consider the following: (UPSC 2015)
Which of the above is/are component(s) of Monetary Policy? (a) 1 only (b) 2, 3 and 4 (c) 1 and 2 (d) 1, 3 and 4
3. An increase in Bank Rate generally indicates: (UPSC 2013) (a) Market rate of interest is likely to fall.
(b) Central bank is no longer making loans to commercial banks.
(c) Central bank is following an easy money policy.
(d) Central bank is following a tight money policy.
4. Which of the following statements is/are correct regarding the Monetary Policy Committee (MPC)? (UPSC 2017) 1. It decides the RBI's benchmark interest rates.
2. It is a 12-member body including the Governor of RBI and is reconstituted every year.
3. It functions under the chairmanship of the Union Finance Minister.
Select the correct answer using the code given below: A. 1 only B. 1 and 2 only C. 3 only D. 2 and 3 only 5. Read the following passage and answer the question that follows. Your answers to these items should be based on the passage only.
Policymakers and media have placed the blame for skyrocketing food prices on a variety of factors, including high fuel prices, bad weather in key food producing countries, and the diversion of land to non-food production. Increased emphasis, however, has been placed on a surge in demand for food from the most populous emerging economics. It seems highly probable that mass consumption in these countries could be well poised to create a food crisis.
With reference to the above passage, the following assumptions have been made: (UPSC 2021)
1. Oil producing countries are one of the reasons for high food prices.
2. If there is a food crisis in the world in the near future, it will be in the emerging economies. Which of the above assumptions is/are valid?
A. 1 only B. 2 only C. Both 1 and 2 D. Neither 1 nor 2
6. India has experienced persistent and high food inflation in the recent past. What could be the reasons? (UPSC 2011)
1. Due to a gradual switchover to the cultivation of commercial crops, the area under the cultivation of food grains has steadily decreased in the last five years by about 30.
2. As a consequence of increasing incomes, the consumption patterns of the people have undergone a significant change.
3. The food supply chain has structural constraints.
Which of the statements given above are correct?
A. 1 and 2 only B. 2 and 3 only C. 1 and 3 only D. 1, 2 and 3
7. With reference to inflation in India, which of the following statements is correct? (UPSC 2015)
A. Controlling the inflation in India is the responsibility of the Government of India only
B. The Reserve Bank of India has no role in controlling the inflation
C. Decreased money circulation helps in controlling the inflation
D. Increased money circulation helps in controlling the inflation
8. With reference to the Agreement at the UNFCCC Meeting in Paris in 2015, which of the following statements is/are correct? (UPSC 2016)
1. The Agreement was signed by all the member countries of the UN and it will go into effect in 2017
2. The Agreement aims to limit greenhouse gas emissions so that the rise in average global temperature by the end of this century does not exceed 2°C or even 1.5°C above pre-industrial levels.
3. Developed countries acknowledged their historical responsibility in global warming and committed to donate $ 1000 billion a year from 2020 to help developing countries to cope with climate change.
Select the correct answer using the code given below:
A. 1 and 3 only B. 2 only C. 2 and 3 only D. 1, 2 and 3
Answers: 1-C, 2-C, 3-D, 4-A, 5-D, 6-B, 6-C, 7-B
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Source: The Hindu
