Look for Inflatable Model

Context: In the light of Consumer Price Index (CPI) inflation touching 6.9%, there is a need for a more explicit analysis of monetary policy on inflation: 

Issues with the Monetary Policy:

• Focused on sectoral price increases (food price): rather than the increase in the general price. For a general price to increase, we need to look beyond individual price formations.
• Low money multiplier: The money multiplier depends upon how active banks are in terms of lending.

• Injection of liquidity is not increasing money supply: because of poor lending by the banks.
• Rise in excess reserves: Much of the increase in liquidity ended up as excess reserves, with very little impact on the money supply.

• No Explicit discussion on the role of policy rate change on inflation: and how it will affect the behaviour of prices.

Steps taken by the Reserve Bank of India to raise liquidity

• Open market operations (OMOs), long-term repos (LTRs) and reduction of cash reserve ratio (CRR).
• No Explicit discussion on the role of policy rate change on inflation: and how it will affect the behaviour of prices.
• No Explicit discussion on the role of policy rate change on inflation: and how it will affect the behaviour of prices.

Significance of Monetary Policy in managing Inflation: 

• Relationship between Inflation and Monetary Policy: Economist Milton Friedman had famously stated, ‘Inflation is always and everywhere a monetary phenomenon.’

• While the focus of policymakers has shifted from quantity to interest rate, the fact remains that inflation can’t happen without the intervention of a macro variable, such as money or liquidity.
• While the ‘Structuralist School’ says that inflation happens only when society is operating at the limit of its capacity- leading to ‘overheating’ which remains unsustainable in the long term.

• Policy rates do have a liquidity impact: Central banks are required to maintain that lowering of policy rates are accompanied by an enlargement of liquidity.
• For, E.g. When the monetary policies in many developed economies didn’t provide results after the 2008 crisis, they moved directly to ‘quantitative easing’ to increase liquidity. 
• Impact of liquidity increase: It has a dual effect- increase in output and an increase in demand, where an increase in demand being stronger according to studies.

• Steps taken by RBI such as Open market operation, Long Term Repos and reduction in CRR along with Government’s increased borrowing from RBI, will increase liquidity in the market.

Conclusion: Monetary Policy Statements should explicitly analyse possible impacts of change in the policy rate and money supply on the general price level in the Economy.