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THE EFFECT OF INFLATION AND THE INCREASE IN INTEREST RATE ON

BUSINESS FINANCE

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Journal of Indian School of Political Economy
ISSN : 0971-0396
Volume: 35, No: 07, July – December : 2023
THE EFFECT OF INFLATION AND THE INCREASE IN INTEREST RATE ON BUSINESS
FINANCE

[Link] Research Scholar P.G. Dept. of Commerce Loyola College (Autonomous)

Nungambakkam, Chennai 600 034. Email: nishu.0391@[Link]
Dr. S. JAYALAKSHMI Assistant Professor Dept. of Commerce ST. Thomas College of Arts &
Science Koyambedu, Chennai 600 107. Email: drsjayalakshmi@[Link]

ABSTRACT:
The financial sector promotes economic growth through capital accumulation and technological
progress by increasing the saving rate, providing information about investment, and improving capital
allocation. These two measure inflation on a monthly basis taking into account different approaches to
calculate the change in prices of goods and services. Monetary Measures to Control Inflation Monetary
interventions are aimed at reducing revenue from money.(a) Management of Credit: Monetary policy
is one of the essential monetary interventions. Therefore, in summary Inflation creates a situation
where these long-term investments that pay a low-interest rate have decreased buying power because
inflation pushes the price of goods and services up.

Keywords:
Inflation, Financial Sector, Consumer Price Index (CPI), Wholesale Price Index (WPI).

Introduction
The financial sector is the main source of financing productive economic projects in any economy in
the world. It plays a major role in the functioning of the economy through financial intermediation.
Simply, the role of financial sector lies between savers and borrowers: it takes money from savers (in
the form of deposits) and lends it to those who wish to borrow, such as companies, governments, or
individuals. The financial sector promotes economic growth through capital accumulation and
technological progress by increasing the saving rate, providing information about investment, and
improving capital allocation. Numerous studies indicate that the development of financial sector plays
an important role in economic development, such as (Bose & Cothren, 1996, 1997; Saint-Paul, 1992).
They have introduced an endogenous growth theoretical model to clarify how the development of
financial markets eases informational frictions in financial markets, enhances the economy’s efficiency
of resource allocations, and thereby fosters economic growth.
The upside and downside risks to inflation are known as Inflation at Risk (in notation, IaR) in the
literature, a measure similar in notion and concept to Value at Risk (VaR) in financial risk-management
theory to estimate the market and credit risk of a portfolio (Andrade, Ghysels, and Idier, 2012; Banerjee
et al., 2020; López-Salido and Loria, 2020). The conventional approach assumes the symmetric
distribution of errors around the mean path, which, however, may not always hold. Thus, the
asymmetric nature of future inflation distribution may be useful in explaining the tail risks (i.e., the
possibility of extreme values on either side) of inflation and in helping the monetary policy in
communicating the balance of risks.
Besides the asymmetry, understanding and accounting for the uncertainty around the central tendency
are also crucial in stabilising inflation. Inflation uncertainty is one of the primary costs of inflation to
the real economy as expected inflation is an important factor while making economic decisions.
Uncertainty surrounding future inflation creates uncertainty regarding the future value of savings and
investments, which in turn, may distort the efficient allocation of resources (Chowdhury, 2014).
Consequently, inflation uncertainty can adversely affect consumption, investment, and growth. Since
the monetary authority’s primary objective is to stabilise prices, it is also crucial to empirically examine
whether it accounts for inflation uncertainty in monetary policy formulation.

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Journal of Indian School of Political Economy
ISSN : 0971-0396
Volume: 35, No: 07, July – December : 2023

Source: [Link]

Average Inflation Rate in India

The country’s retail inflation, which is measured by the consumer price index (CPI), accelerated to
6.50% in Jan. 2023. Inflation data on the wholesale Price Index (WPI), which calculates the overall
prices of goods before selling at retail prices, eased to 4.73% during the period. In 2022, CPI hit the
highest of 7.79% in Apr, and WPI reached 15.88% in May. Compared to inflation in Jan. 2020, CPI is
down 1.09%, whereas WPI is up 1.72%.

Average Inflation Rate in India Last 10 Years

Source: [Link]
February 14, 2023: CPI Inflation Declines to 3-year low for CY 2023; Eyes on Fed’s Decision to
lower rates
The RBI has hiked the policy Repo Rate by 25 bps to 6.50% on Feb. 2023. The RBI governor
Shaktikanta Das at post-MPC announcement address said the policy rate has been adjusted for
inflation, and still remains accommodative. Inflation has found mention in the RBI’s monetary policy
committee’s reviews repeatedly as among the reasons for rate increases. Das expects inflation to
moderate in 2023-24, to remain above the 4% target. Inflation is expected to average 5.6% in Q4 of
2023-24. Further, the RBI projects the real GDP growth for 2022-23 at 6.8% and at 7.1% for the Q1
2023-24.
Moving forward, the inflation trajectory largely depends on the prices of domestic commodities like
vegetables, cereals, spices, etc. Earlier, the RBI had blamed effects of the pandemic, the geo-political
conflict, and the weakness in the Indian rupee manifesting in the demand-supply mismatch of goods

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Journal of Indian School of Political Economy
ISSN : 0971-0396
Volume: 35, No: 07, July – December : 2023
and services, leading to downside risks to growth. The U.S Federal Reserve too has maintained its
position on high inflation denting the country’s economic progress, and closed out the year with its
seventh consecutive rate hike in Dec. 2022. The Fed has indicated that signs of peak inflation have
arrived since hitting a 40-year high in June above 9%. Market participants expect the actual inflation
to come down in the next six to 12 months. It is projected that the Fed will slow interest rate increases
and potentially stop hiking in 2023.

Calculation methods of Inflation Rate in India

There are two indices that are used to measure inflation in India the consumer price index (CPI) and
the wholesale price index (WPI). These two measure inflation on a monthly basis taking into account
different approaches to calculate the change in prices of goods and services. The study helps the
government and the Reserve Bank of India (RBI) to understand the price change in the market and
thus keep a tab on inflation.
The CPI, which refers to the Consumer Price Index, analyzes the retail inflation of goods and services
in the economy across 260 commodities. The CPI-based retail inflation considers the change in prices
at which the consumers buy goods. The data is collected separately by the Ministry of Statistics and
Program Implementation and the Ministry of Labour. The WPI, which refers to the Wholesale Price
Index, analyzes the inflation of only goods across 697 commodities. The WPI-based wholesale
inflation considers the change in prices at which consumers buy goods at a wholesale price or in bulk
from factory, mandis, etc.

Statement of the Problem:

The Impact of Inflation is it reduces the purchasing power of households due to an increase in prices.
The impact of inflation is felt across different sectors of the economy which are favorable to some and
unfavorable to others. Due to this price uncertainty, may discourage investment and savings for the
future. As a result, India is importing high global inflation. This problem could intensify, if the rupee
depreciates further, as advanced country central banks continue to tighten monetary conditions by
raising interest rates. Finally, cereal inflation remains exceptionally high, at 13%. In an inflationary
environment, unevenly rising prices inevitably reduce the purchasing power of some consumers, and
this erosion of real income is the single biggest cost of inflation. Inflation can also distort purchasing
power over time for recipients and payers of fixed interest rates.

The paper has the following objectives:

1. To determine the price effect on the commodities and services in economics.
2. To measure the overall impact of price changes for a diversified set of products and services. It
allows for a single value representation of the increase in the price level of goods and services in an
economy over a period of time.
3. Estimate tail risks of inflation in India corresponding to various domestic and global drivers and
test whether inflation risks have stabilised in the IT period;
4. Examine shifting of the conditional distribution of inflation for different domestic and global
shocks;
5. Estimate expected tail values of inflation and examine the robustness of the models;
6. Examine the causal relationship between inflation and inflation uncertainty and assess the reaction
of the monetary policy to the asymmetric nature of conditional distribution and uncertainty around the
central tendency.

Research Methodology
The study is done to analyse the impact of inflation on Indian economy in general and for the purpose
secondary data and reports are used which are collected from various published reports, magazines,

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Journal of Indian School of Political Economy
ISSN : 0971-0396
Volume: 35, No: 07, July – December : 2023
RBI annual report, research articles and financial and websites. After the judicious evaluation of
inflation various suggestions and recommendation are made.

Literature Review
Studies that focus explicitly on the analysis of tail risks of inflation are relatively new in the literature
(Banerjee, Contreras, et al., 2020; López-Salido and Loria, 2020). However, a few studies in the last
decade analyse the quantiles of inflation and their dynamics; for instance, Wolters and Tillmann (2015)
examine the persistence of different quantiles in the conditional distribution of inflation. Gupta, Jooste,
and Ranjbar (2017) find higher persistence of inflation for higher quantiles in the case of South Africa.
In related literature on convergence, Tsong and Lee (2011) in a study of 12 OECD countries find
asymmetric convergence of inflation to long-run value post negative and positive shocks using the
quantile regression approach. They find that positive shocks are more persistent than negative shocks
and converge slowly to the long-run level. Similar empirical evidence is also seen in Uganda (Anguyo,
Gupta, and Kotzé, 2020).
Several studies have focussed on various determinants of inflation in a quantile regression framework;
for instance, Iddrisu and Alagidede (2020) explain food inflation and its various determinants, such as
economic growth, world food price inflation, monetary policy, etc., using quantile regression for South
Africa. Lahiani (2019) explores the transmission of crude oil prices to different quantiles of overall
prices for the US.
Inflation at Risk is similar to the concept of Value at Risk (VaR) in financial risk management, i.e.,
the extreme quantiles for a given level of probability. Among macroeconomic variables, a similar
measure is also available for economic growth as Growth at Risk (Prasad et al., 2019). López-Salido
and Loria (2020) in their study of advanced economies explicitly derived the conditional distribution
based on quantiles. Banerjee et al. (2020) extended the analysis by including emerging economies and
estimated the conditional density. Their study concludes that countries with IT show a relative
moderation in inflation risks than non-IT countries. Banerjee, Mehrotra, and Zampolli (2020) model
the impact of the COVID-19 pandemic and find higher upside and downside risks to inflation in
emerging economies, and higher downside risks in the case of advanced economies.
The advancement in deriving the conditional distribution based on quantile is a novel contribution in
the above studies as compared to earlier studies that used quantile regression to study the quantiles of
inflation and their dynamics. These studies highlight, in particular, the impact of different shocks on
the tail risks of inflation. In our analysis, we augment the above-discussed analysis for India and
examine certain country-specific features to explain the dynamics of tail risks of inflation.
In related literature, Andrade et al. (2012) examine the response of the monetary policy to inflation
asymmetry and uncertainty based on the professional forecasters’ survey data on inflation. A few
studies explicitly analyse the relevance of inflation asymmetry on monetary policy formulation
(Andrade et al., 2012; Evans, Fisher, Gourio, and Krane, 2016). Further, there exist several studies that
discuss the causality and reverse causality between the level of inflation and inflation uncertainty
(Cukierman and Meltzer, 1986; Sharaf, 2015; Su, Yu, Chang, and Li, 2017).
In the case of India, Chowdhury (2014) finds evidence in support of this hypothesis using the
generalised autoregressive conditional heteroscedasticity (GARCH) model. Kundu, Bhoi, and Kishore
(2018) also present similar evidence between inflation and inflation volatility graphically at the sub-
national level.
Inflation uncertainty is a major concern for the monetary authority, as it assigns weights inter-
temporarily to minimise its loss preference. Although not explicitly, a few studies have shown the
detrimental effect of high inflation uncertainty on economic activity (Sauer and Bohara, 1995; Zhang,
2010). Hence, it becomes imperative for the monetary authority to reduce inflation uncertainty through
appropriate policy instruments (Gan, Yee, Hadi, and Jalil, 2019; Zhang, 2010). In a standard monetary
policy rule, besides output gap and inflation, studies have included exchange rate, global policy rate,
and global economic growth to examine their impact on the monetary policy rate (Hutchison,

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Journal of Indian School of Political Economy
ISSN : 0971-0396
Volume: 35, No: 07, July – December : 2023
Sengupta, and Singh, 2010; Reserve Bank of India, 2021). However, there are very few studies that
explicitly model inflation uncertainty in the monetary policy rule to estimate its impact (Andrade et
al., 2012).
Daal et al. (2005) studied the relationship in a number of developed and developing countries including
India. For India, they found support for the Friedman-Ball and Holland hypothesis (negative
relationship between inflation and inflation uncertainty). Rizvi et al. (2009) found bi-directional
causality between inflation and uncertainty in a number of Asian countries including India.

Empirical Analysis
Stylised Facts : The uncertainty around food price inflation spills over to the uncertainty around
headline inflation as food is a major contributor to CPI headline inflation variance (Chart 1)3 . Within
the FIT framework, price stability - avoiding high inflation rates or very low inflation rates over time
- is the primary mandate for the RBI as volatile prices distort the economy’s price signals and may
result in the misallocation of resources.

The CPI-C headline inflation has undergone significant changes in its distribution over the last decade
in line with the evolving macroeconomic conditions (Chart 2a). Too high or too low inflation
representing the upside and downside tail risks to inflation, respectively, is detrimental to RBI’s
secondary objective of growth as well, and thus, requires a proper assessment of these risks. The FIT
period coincided with a moderation in CPI inflation on the back of consecutive years of bumper food
grains and horticulture production and relatively stable global commodity prices, particularly the crude
oil. Irrespective of the broad easing of inflation, headline inflation deviated from the target, and went
once below the lower bound of 2 per cent (in June 2017) and above the upper bound of 6 per cent
consistently during December 2019-December 2020 mirroring the developments in food prices
primarily owing to monsoon-related shocks and the COVID-19 pandemic-related supply disruptions
(Chart 2b).
3. Contribution of subgroup (say, A) to variance in total (A+B+C) is calculated using the following
formula: Contribution (A) = W(A)W(A) Cov (A, A) + W(A)W(B) Cov (A, B) + W(A)W(C ) Cov(A
,C), where W is the weight of the sub-group and Cov is covariance.

FACTORS INFLUENCING INFLATION IN INDIA

India following are the Factors influencing Inflation: The major categorised determinants of the
inflation in regard to the employment generation and growth are :  Demand factors  Supply factors
 Domestic factors  External factors

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Journal of Indian School of Political Economy
ISSN : 0971-0396
Volume: 35, No: 07, July – December : 2023
Demand factors: The demand factors are with regard to the position when aggregate demand exceeds
aggregate supply. Owing to the paucity of the supply too much money chases the existing few
commodities. This has usually seen in India in context with the agrarian society. It is mainly owing to
the drought and floods where the storage of food grains suffers the scarcity of supply and leads to
deteriorated output hence increasing the prices for the goods.
Supply factors: The supply side inflation is a key part for the increasing inflation in India. The
agricultural insufficiency or the damage in forwarding creates a shortage causing high inflationary
pressures where the high cost of labour ultimately increases the production cost and leads to a high
price for the goods and services. The negative impact will be on the cost of production which further
increases the value of the final output produced. These supply driven factors have basically have a
fiscal gadget for stipulations and moderation.
Domestic factors: These factors often address the issues related to well-structured financial markets.
Developing economies like India have universally a meaningless developed financial market which
creates a brittle bonding between the interest rates and the aggregate demand. As the result the money
gap increases the relative importance of price rise and inflation in India.
External factors: These factors are with notice to the external market forces, foreign exchange rates
and import export related factors. The foreign exchange rate usually decides the external factors and
is an important component for the inflationary pressures that arises in the India. The liberal economic
outlook in India affects the internal markets. As the prices in United States of America rises it impacts
India where the goods are imported at a higher price impacting the price rise. These import/export
factors largely measures Competitiveness and challenges for the economy in terms of price rise and
increased foreign exchange rates.

Summary of Suggestions and Conclusion

The government can use fiscal policy to fix inflation by increasing taxes or cutting spending.
Increasing taxes leads to decreased individual demand and a reduction in the supply of money in the
economy. Inflation can be controlled by a contractionary monetary policy is one common method of
managing inflation. A contractionary policy aims to reduce the supply of money within an economy
by lowering the prices of bonds and rising interest rates. Thus, consumption falls, prices fall and
inflation slows down. Government spending, public borrowing, and taxes comprise the Fiscal Policies
to Combat Inflation. The Keynesian economists often referred to as "Fiscal," argue that due to an
excess of aggregate demand over aggregate supply, demand-pull inflation is induced. Owing to
spending by individuals, companies, and the government, aggregate demand rises (usually excessive
spending by the government). This rise in demand due to the government or household spending can
be effectively regulated by fiscal policies. Fiscal policy and fiscal initiatives are thus effective weapons
of demand-pull inflation management. If the key trigger behind demand-pull inflation is government
spending, then it can be regulated by reducing public expenditure. The public demand for goods and
services declines with a decline in public spending, along with a decrease in private income and
consumption expenditure. In cases where demand increases due to an increase in private spending, the
most effective way to manage inflation is by taxing profits. The taxation of private income decreases
the disposable income in question, and also reduces consumer spending. This has the effect of reducing
aggregate demand. In the event of a very high persistent inflation rate, both such steps may be taken
simultaneously by the government to contain inflation. In the case of a decrease in public spending,
the rate of taxes on private income is increased to keep demand under control. This form of policy of
concurrently using both measures is called the "Surplus Budgeting Policy," which notes that "the
government should spend less than tax revenue".
Monetary Measures to Control Inflation Monetary interventions are aimed at reducing revenue from
money.(a) Management of Credit: Monetary policy is one of the essential monetary interventions. A
variety of strategies are employed by the country's central bank to regulate the quantity and quality of
credit. To that end, bank rates are raised, securities are sold on the open market, the reserve ratio is

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Journal of Indian School of Political Economy
ISSN : 0971-0396
Volume: 35, No: 07, July – December : 2023
raised and a range of selective credit management steps are taken, such as raising margin thresholds
and controlling consumer credit. When inflation is due to cost-push variables, monetary policy will
not be effective in managing inflation. Due to demand-pull variables, monetary policy can only be
effective in managing inflation.(b) Currency Demonetisation: One of the monetary steps is to
demonetize higher-denomination currencies. Such a step is typically taken when the country has a
surplus of black currency.(c) New Currency Issuance: The problem of a new currency in place of the
old currency is the most drastic monetary measure. Under this process, one new note is exchanged for
several old currency notes. Likewise, the value of bank deposits is set accordingly. Such a measure is
introduced when the issue of notes is excessive and hyperinflation occurs in the region. It is a measure
that is very successful. But it is wrong because it affects the tiny depositors the most.

Conclusion
In general, it can be of the opinion that Inflation carries both good and undesirable impact on the
overall economy of the country. Therefore, it is considered that bonds, often require investors to lock
into a guaranteed rate for a long time and regarded as the safe investments in the long term. Therefore,
in summary Inflation creates a situation where these long-term investments that pay a low-interest rate
have decreased buying power because inflation pushes the price of goods and services up. Though
inflation reduces the purchasing power of the households and creates a demand-supply mismatch it is
necessary to the economy. Inflation as a result of an increase in demand for goods and services will
help in increased production and contribute to the growth of the economy.

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ISSN : 0971-0396
Volume: 35, No: 07, July – December : 2023
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