Maintaining The Inflation Target At 4%

Gs3_Economy

Backdrop

On the last day of the financial year 2020-21,the Finance Ministry announced that the inflation target for the five years between April 2021 and March 2026 will remain unchanged at 4%, with an upper tolerance level of 6% and a lower tolerance level of 2%. This is the retail inflation target that will drive the country’s monetary policy framework and influence its decision to raise, hold or lower interest rates.

What are the implications of the Finance Ministry’s decision for monetary policy and is this approach necessary?

Why is this important?

  • India switched to an inflation target based monetary policy framework in 2015, with the 4% target kicking in from 2016-17.
  • Many developed countries adopted an inflation rate focus as the key for policy formulation for interest rates rather than other variables  like the currency exchange rate or controlling money supply growth.

Emerging economies also have been gradually adopting this approach. In adopting a target for a period of five years, the central bank has the visibility and the time to smoothly alter and adjust its policies in order to attain the targeted inflation levels over the medium term, rather than seek to achieve it every month

Inflation

  • Inflation refers to the rise in the prices of  goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc.
  • Inflation measures the average price change in a basket of commodities and services over time.
  • Inflation is indicative of the decrease in the purchasing power of a unit of a country’s currency. This could ultimately lead to a deceleration in economic growth.
  • However, a moderate level of inflation is required in the economy to ensure that production is promoted.
  • In India, inflation is primarily measured by two main indices — WPI (Wholesale Price Index) and CPI (Consumer Price Index) which measure wholesale and retail-level price changes, respectively.

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