The exchange rate, i.e, rupee value of the foreign currency, say, dollar is determined by market forces. If the government tries to keep the exchange rate stable through monetary policy then it will be difficult for the government to see an interest rate regime which is stable. Similarly, it will be difficult for the economy to experience a stable rate of inflation.
Why is this so? One can consider a concrete example. The developed countries are expecting a low rate of growth. However, the 'sub prime' crisis is effecting the financial sector both in Europe and America. This causes flows of FDI and FII into the Indian economy. The capital account of balance of payment of the country experiences a potential surplus. The demand for Indian rupee increases because investment in India requires use of rupee. Due to increased supply of dollar, the rupee value of dollar falls. Say, it was Rs. 45 per 1 dollar earlier. It falls to Rs. 25 per dollar. This hits the country's export sector like the garment sector or the IT sector. Earlier one could earn Rs. 45 by exporting 1 dollar worth of goods or services. Now, one can earn only Rs. 25 . The dream of export led growth takes a beating. To minimize the problem, the Reserve Bank of India (RBI) can start purchasing dollar with rupee. This will increase supply of rupee in the financial market. This has a potential of creating inflationary tendencies in the economy. The excess liquidity may generate investment in real estate, speculative business, and retail business and so on. RBI tries to absorb this excess money by selling government bonds at low price or equivalently a high rate of interest. (If the price of a bond is Rs. 100and perpetual interest RS. 10, then rate of interest is 10 percent. If the price is reduced at Rs. 50, then the rate of interest is 20 percent.) This rise in rate of interest is the price of creating the inflationary pressure in control. But a higher interest regime may crowd out private investment from manufacturing and service sector. This will have negative impact on the long run growth prospect of the economy.
The 'openness' of the economy has led to certain issues in which monetary policy and fiscal policy shall require thoughtful calibration and clearer assignment of domains.
So far the story is for the demand side of the economy and monitory policy outcomes when RBI tries to keep the exchange rate stable. Enter fiscal policy. Fiscal policy can take the negative impact on the private investment as granted. Then the question is how to boost private investment? How to boost different components of aggregate demand?
One of the ways to boost domestic private investment is to give the economy better infrastructure through low interest dedicated funds created for the purpose. Interest subsidies, tax concessions and excise tax concessions are options.
But on the whole, what are the 'short- term' expectations about different components of aggregate demand? Net exports may not rise immediately. Firstly, there is global economic slow down related to sub- prime lending crisis. Secondly, the exchange rate may not be favourable. Private investment may not be so forthcoming without better infrastructure and business expectation. Government expenditure is tied -down by Fiscal Responsibility and Budget Management Act and by the commitment to keep Fiscal Deficit low at around 3 percent of GDP. The only remaining component is private consumption expenditure which can be immediately stimulated.
Thus one can turn to consumption-led growth model. This is the type of economic logic behind the Budget of 2008-09 of Sri P.Chidambaram.
Consumption is boosted through change in income tax slabs which give tax savings from Rs. 4000 to Rs. 44000. This is surely helpful for raising private consumption expenditure.
Will this boost in demand lead to food price inflation? Possibly not. Why? The answer lies in the so called Engel's Law. This law states that high income households, read, income tax paying households, spend a low percent of their expenditure on food items. Therefore, there is no upward pressure on food prices from this consumption of high income households.
However, the economy is experiencing a food price inflation of 8 to 10 percent. This is more a cost- push inflation rather than demand pull inflation. With implementation of rural employment programme in all the districts, mid-day meal upto upper primary level, increasing the minimum wages of agricultural labourers, providing minimum support price to wheat and rice, the demand pull factors may also come into play. Food price inflation is then likely.
