1. Inflation in India
&
Fiscal tools to control it….
Submitted by
Apparao.G
FW 10/12(B1)

2. Inflation in India
Inflation
Def: Inflation is a rise in the general level of prices of goods and services in
an economy over a period of time. When the price level rises, each unit of
currency buys fewer goods and services. A chief measure of price inflation is
the inflation rate.When Prices rise the Value of Money falls.
Causes of Inflation:
There were different schools of thought as to the causes of inflation.
Most can be divided into two broad areas: quality theories of inflation and
quantity theories of inflation. The quality theory of inflation rests on the
expectation of a seller accepting currency to be able to exchange that
currency at a later time for goods that are desirable as a buyer. The quantity
theory of inflation rests on the quantity equation of money, that relates the
money supply, its velocity, and the nominal value of exchanges.Adam
Smith and David Hume proposed a quantity theory of inflation for money,
and a quality theory of inflation for production.
Currently, the quantity theory of money is widely accepted as an
accurate model of inflation in the long run. Consequently, there is now broad
agreement among economists that in the long run, the inflation rate is
essentially dependent on the growth rate of money supply. However, in the
short and medium term inflation may be affected by supply and demand
pressures in the economy, and influenced by the relative elasticity of wages,
prices and interest rates.
India Inflation Rate
The inflation rate in India was last reported at 9.5 percent in March of
2012. From 1969 until 2010, the average inflation rate in India was 7.99
percent reaching an historical high of 34.68 percent in September of 1974 and
a record low of -11.31 percent in May of 1976. Inflation rate refers to a
general rise in prices measured against a standard level of purchasing power.
The most well known measures of Inflation are the CPI which measures

3. consumer prices, and the GDP deflator, which measures inflation in the
whole of the domestic economy.
Types of Inflation:
There are mainly three types of Inflation they are
1. Demand-Pull Inflation
2. Cost-Push Inflation
3. Built-in inflation
Demand-pull inflation:
It is caused by increases in aggregate demand due to increased private
and government spending, etc. Demand inflation is constructive to a faster
rate of economic growth since the excess demand and favourable market
conditions will stimulate investment and expansion.
Causes for Increase in Demand :-
a) Increase in Money Supply
b) Increase in Black Marketing
c) Increase in Hoarding
d) Repayment of Past Internal Debt
e) Increase in Exports
f) Deficit Financing
g) Increase in Income
h) Demonstration Effect
i) Increase in Black money
j) Increase in Credit facilities
Cost-push inflation:-
It is also called "supply shock inflation," is caused by a drop in
aggregate supply (potential output). This may be due to natural disasters, or

4. increased prices of inputs. For example, a sudden decrease in the supply of
oil, leading to increased oil prices, can cause cost-push inflation. Producers
for whom oil is a part of their costs could then pass this on to consumers in
the form of increased prices. Another example stems from unexpectedly high
Insured Losses, either legitimate (catastrophes) or fraudulent.
Causes for Increase in Cost :-
a) Increase in cost of raw materials
b) Shortage of Supplies
c) Natural calamities
d) Industrial Disputes
e) Increase in Exports
f) Increase in Wages
g) Increase in Transportation Cost
h) Huge Expenditure on Advertisement
Effects of Inflation:-
• Inflation can have positive and negative effects on an
economy. Negative effects of inflation include loss in stability in the
real value of money and other monetary items over time; uncertainty
about future inflation may discourage investment and saving, and high
inflation may lead to shortages of goods if consumers begin hoarding
out of concern that prices will increase in the future. Positive effects
include a mitigation of economic recessions, and debt relief by
reducing the real level of debt.

5. Stages of inflation:-
1. CREEPING INFLATION (0%-3%)
2. WALKING INFLATION ( 3% - 7%)
3. RUNNING INFLATION (10% - 20 %)
4. HYPER INFLATION ( 20% and abv)
Fiscal Policy:
Fiscal policy involves government expenditure and revenue, through
taxes, borrowing and printing money. Anti inflationary fiscal policy would
focus on with- drawing purchasing power from the public so that they spend
less, relieving the upward pressure on prices. This can be done by raising
taxes and borrowing from the public without spending the proceeds. As the
origin of inflation in most developing countries has been increasing
government claim on productive resources (required for public sector
projects), a decrease in government expenditure leaving taxes undiminished
may still be more effective. Fiscal policy is regarded as 'deliberate
manipulation of the relation between government expenditure and
government receipts with a view to maneuvering the level of aggregate
demand in the desired direction"1
Manipulation of aggregate demand is not the only way fiscal policy can
target inflation. Spending money in a way that increases the supply of goods
and services can also help governments check the rising trend in prices.
It has been rightly observed that inflation as we know it is a modern
phenomenon. The price level was stable for nearly a century till 1914.2 But a
number of factors, among which debt financing of the two world wars was
only one, caused most countries to experience rising prices since the middle
of the century till the eighties. The same period also saw a phenomenal rise in
public spending which globally reached 43% of the GDP by 1980.3 As a
result inflation is commonly perceived as a consequence of rising public

6. expenditure. This, however, may not always be true.4 One has to examine
specific cases to arrive at a conclusion.
The Islamic Framework:
The Islamic framework within which this study examines the role of
fiscal policy in controlling inflation is defined, in the first instance, by the
goals of an Islamic economy. It is need fulfillment, justice and equity. Also
included in these goals is to provide the state with the means required for
defence, law and order and fulfillment of other socially obligatory duties
(furud kifaya) which the private sector fails to fullfil. In the context of money,
finance and government policies the Islamic framework can be further
specified by prohibition of interest and gambling, minimization of hazard and
uncertainty and keeping government intervention in the market limited to
what is necessary for the realization of the above mentioned goals.
Furthermore can be mentioned the concept of moderation in consumption and
treating public money as a trust which have an impact on our subject matter.
That there is a role for fiscal policy in realizing the goals ! of an Islamic state
is quite obvious. But that is not our subject in this study.What needs emphasis
is that anti inflationary fiscal policy should not jeopardize the long term
arrangements for realizing the goals of Shari'ah. But before we proceed to
examine the scope for such policies we have to note another dimension of the
matter which shall not be discussed by us: the hypothat the full
implementation of Islamic teachings, i.e. the operationalisation of the 'Islamic
framework' noted above, will prevent inflation or at the least, minimize its
incidence. This is due to the presence of several 'built in stabilizers' in the
system.
The hypothesis is supported mainly, by four arguments.
1. In the Islamic economic system debt financing which is the
chief source of inflation and instability in the contemporary
economies will have been replaced by equity and sharing based
finance which are non inflationary and stable.The change from
debt finance to share finance also integrates saving and

7. investment decisions making the system more stable than its
capitalist counterpart.
2. Thanks to Zakat, inheritance laws and other redistributive
provisions,Islam will effect a less unequal distribution of income
and wealth (as compared to the same economy under capitalism).
This will change the composition of aggregate demand in favour
of the necessities of life thereby reducing the fluctuations in
aggregate demand.
3. Islam will induce people to moderation in consumption, to
shun wasteful life styles and conpicuous consumption. This will
result in a decrease in aggregate demand.
4. Islamic governments, treating public money as trust will be
frugal, keeping public expenditure within the bounds set by the
available means. Public borrowing will be minimum and deficit
financing rare. Financing public expenditure by printing new
money will be almost non existent.
It is not necessary to examine this hypothesis in a discussion on the role of
fiscal policy in controlling inflation. Since the possibility of inflation in an
Islamic economy is not denied and since it is very likely that an Islamising
regime inherits inflation from the earlier regime, it would be quite logical for
us to narrow down our focus on control as distinct from prevention. This is
still the more credible a methodology in view of a third and more compelling
reason. Inflation may impose itself on an economy from outside, caused by
global moves beyond its control, especially if it is a small economy. What
follows is, therefore, not affected by one's acceptance or rejection of some or
all of these arguments. Those who take the hypothesis skeptically due to lack
to empirical evidence will, of course, find the subsequent arguments more
compelling. But those who whole- heartedly support the hypothesis will also
find good reason to attach due weight to them.
Prevention and Control
There are two significant differences between fiscal policies designed to
control already existing inflation and those designed to prevent inflation from

8. afflicting an economy which at the time is free of inflation. The first
difference relates to time horizon and the speed at which a policy measure is
carried out. The second relates to the size of the change required in the
relevant variables e.g. government expenditure, taxes, etc. Policies designed
to control inflation have to have an impact now. They must be fast acting
showing their results in a matter of months. This in turn may require big
reduction in government expenditure, large increases in taxes, huge amounts
of domestic borrowing etc. Given these measures successfully implemented
over a short period of time aggregate demand will decrease and the trend of
prices to rise will be checked. The big question is, how far is it possible and
desirable to do so.
Let us have a look at the way government decides how much to spend. Part
of government expenditure relates to the core of governance, no government
can function without these. They can be reduced if they are inflated but there
is a limit to such reduction. Expenditure on salaries and offices of the
executive, legislative and judicial branches of government come under this
category. Then come the expenditure on defence and law and order, both
permanently mandated by Shari'ah. The volume of expenditure on these
heads may be dictated by circumstances beyond the government control e.g.
geopolitical situation, moral degeneration, etc.
Reduction in Public Expenditure
It is only when we come to the other public goods and the welfare activities
of the government that reduction in government expenditure becomes a real
possibility. But the actual scope of such reduction depends on the historical
path followed by (the increase in) government expenditure. Modern day
governments have shown little ability to reduce expenditure on education and
health care. For an Islamic state in a developing country the idea of reducing
expenditure on education and health care is still the less apealing. This is in
view of the priority of these items on the Islamic agenda and the neglect from
which they suffered in the past. The most a developing country can manage
to do is to prevent expenditure on these items from increasing further.
Reducing the current levels of expenditure on education and health care are
no where a real option. In fact any attempt to do so would be economically
disastrous and politically suicidal for the regime.

9. It has been rightly observed that public expenditure increases as the national
output increases, often at a faster rate.1 It is very difficult to envisage a
reduction in public
There is a strong case for reducing public expenditure when it is necessary to
do so for controlling inflation. But the practical scope for doing so is very
limited. If there is an accross the board reduction in the salaries of
government employees many of them may be forced to find better paid jobs
in the private sector, even abroad, affecting the quality of the bureaucracy to
the detriment of public interest. Reduction in ostentatiousexpenses on
ceremonies, etc. may not involve significant amounts. As we hinted above,
reduction in the expenditure on defence and internal security may not be
practical. Some relief is expected from elimination of corrupt practices,
bribes and kick backs. This will reduce the cost of doing business, expanding
trade and investment and, ultimately, boosting production. These reforms
may also reduce the cost of public projects, reducing government
expenditure.
Increase in Tax Revenues
One should also consider the possibility of an Islamic state eliminating tax
evasion and even coaxing people to pay 'donations' ---- over and above taxes
--- to enable their government do good things for them. The likely gains in
revenue terms are however, likely to be more than conterbalanced by two
other inevitable changes. There are certain indirect taxes on basic necessities
of life which Islamic economists regard to be antipoor and worth scrapping.
Then there is mandatory lowering of tariffs and custom duties as part of ones
belonging to a world set to reduce them globally.
Let us now turn to the other policy measure, withdrawal of purchasing power
from the public through increased taxation and domestic
borrowing not accompanied by a corresponding rise in public expenditure.
This in fact is only a textbook proposition insofar as the developing countries
are concerned. These countries are not able to meet even current levels of
public expenditure through all the taxes and domestic borrowing they can
manage, thereby taking recourse to printing new money. As regards an
Islamic economy domestic borrowing ceases to be an option as no interest
can be paid to the lenders. A resort to compulsory borrowing free of interest

10. as suggested by some1 would be hardly feasible in political terms. Additional
taxation with the sole purpose of withdrawing some purchasing power and
freezing it implies that the money should be paid back when the time comes
to defreeze it. That makes it akin to compulsory borrowing. There is no empi!
rical evidence of any developing country ever having adopted these policies
successfully.
Increasing the Supply of Goods and Services
That leaves us with the last opption noted under the heading fiscal policy:
spending money in a way that increases supply of goods and services. This
spending does not have to be done by the government itself, at least not all of
it. Tax reduction that encourages private investment may serve the same
purpose. Lowering corporation taxes and lowering or scrapping capital gains
taxes, even scaling down the income taxes may boost production by
increasing the incentive to work and the incentive to save. Another possible
measure is to restructure the subsidies, if any, in favour of the intermediate
industries whose products are needed for expanding the production of
consumer goods. Building the infrastructure --- roads, bridges, irrigation
systems, electricity and telecommunication, etc. --- at public cost and making
them available to the private sector at affordable prices has also been a
favourite policy of mid-century developmental planning. These can be
adopted after due consideration of the lessons from the past.
Even though each one of these policies is slow acting and of modest impact
their cumulative impact over time would be significant. There can be no surer
way to check the rising trend in prices than to arrange for increasing the
supply of the very things whose prices are increasing. Fiscal policy has no
other way to make a durable contribution to solve the problem of inflation
since the two other options examined above are limited in scope and not
practical. Unlike the impact of anti inflationary monetary policy which may
be immediate but temporary, the impact of supply increasing fiscal policies is
slow but durable.
In seems the scope for reducing public expenditure from their current levels
is very limited insofar the contemporary Muslim countries are concerned.
The same applies to the possibility of withdrawing purchasing power from
the public without spending the proceeds. This leaves us with the slow acting

11. option of trying to maneuver public expenditure and taxation in a way that
increases the incentives to work, save and invest and / or directly contributes
to increasing the supply of goods and services.
Moderation, Abolition of Interest and Zakat
We shall now proceed briefly to examine if the three other Islamic provisions
noted above, i.e. moderation in consumption, abolition of interest and
gambling and Zakat can play some role in controlling inflation.
In an already inflationary situation prices of necessities and other consumer
goods would be rising. In such a situation people can not be expected to
spend less in money terms as that would mean drastic reduction in their living
standards. In fact they have to spend more to stay where they are. If current
levels of consumption are perceived to be extravagant the most that can be
expected in the name of moderation is for spending not to increase in money
terms. As regards luxuries some additional revenue can be raised by
increasing sales taxes with a view to reducing demand. But the rich who buy
these goods may be the same people who become richer due to inflation.
They could afford higher prices. Then there is always the danger of excessive
taxes driving goods into the black market and increasing the incentive to
evade taxes. In any case there is no empirical evidence of forced moderation
having contributed to controlling inflation in a free ! market economy.
Abolition of interest and introduction of new arrangements for financial
intermediation based on profit sharing will ensure financial stability. Savings
will flow from households to firms smoothly through financial intermediaries
who will be able to plough back to the savers attractive returns gotten from
the businessmen. Abolition of gambling and the resulting curbs on
speculation will further contribute to the stability of the financial system. A
stable financial system is, however, a necessary but not a sufficient condition
for price stability. Changes in technology and tastes may throw whole
industries out of gear causing the levels of output, employment, and incomes
to change despite a stable financial system. For a single country influx of
foreign capital, favourable balance of payment or similar causes originating
outside may cause the prices to rise by affecting the domestic money supply.
What is more important for our purpose in this study is, howev! er, the fact
that the change over form debt-finance to share-based finance will not by

12. itself bring down prices. Inflationary prices boost business profits which will
translate themselves in to higher profits (though not higher ratios of profit
sharing) for financial intermediaries as well as for the savers / depositors.
Profit-sharing may not necessarily feed the inflationary process but it shall
not check it either. More direct intervention may be needed to rectify the
situation. Redirection of investible funds by sectorally different ratios of
profit-sharing or out right controls on incomes, profits and prices may
become necessary in certain circumstances. But these options are outside the
scope of this study.
The role of Zakat in reducing inequality in the distribution of income and
wealth and thereby contributing to a change in the composition of aggregate
demand that would make it more stable has already been noted above. Our
focus now is the possible contribution of Zakat in bringing down prices when
they are high and rising. It has been rightly pointed out that advance
collection of Zakat due in the future and/or delaying the expenditure
of Zakat proceeds till a more appropriate time can contribute to controlling
inflation.1 It is also suggested that aggregate supply may be manipulated by
collection and distribution of Zakat in kind.2
Appropriate Policy Mix
The role of fiscal policy in controlling inflation shouldnot be discussed in
isolation from the role of the monetary policy and exchange rate policy. The
true picture can be obtained only by considering a mix of these policies in the
context of a given situation. The size of a country's economy, the relative
sizes of its domestic and external economies, the historical path through
which an inflationary situation has come to hold are all important aspects of
the situation. Also important is whether the chief source of inflation is in the
labour market and/or goods market or in the money supply. The moral
standards of the people, the level of corruption, the government's credibility
and the degree of the people's trust in government too are forces to be
reckoned with. Bereft of these data no meaningfull study can be made on the
role of fiscal policy in controlling inflation in an Islamic framework. The
reason in simple. All the three terms appearing in our title: fiscal policy,
inflation and Islamic framework derive their meaning - operational meaning -
from these data.

13. Epilogue
The type of inflation experienced in early Islamic history was different in
nature from the one experienced in twentieth century. More often than not the
rise in prices was sharp but short lived. Instances of 'a sustained upward trend
in the level of prices' are rare. There are, however, instances of a gradual rise
in prices at a low rate caused by continued influx of gold and silver.1 Also
there were brief spurts of rising prices due to the same cause as happened in
the third and fourth decades of Islamic history. But most of the times it was
climatic conditions or disruption in transportation that caused a failure in
supply leading to sharp rise in food prices.1 Also in later Islamic history,
especially after the disintegration of the Abbasids, it was debasement of
currency, excessive issue of subsidiary (copper ) coins (fulus) and circulation
of large quantities of counterfeit that caused spurts of inflation. These, were,
generally, localized and temporary.2 Protests from the populace often resulted
in cancelletion of new issues and rectification of debasement. No special
measures are reported to counter the rise in prices due to influx of gold and
silver. A fast expanding economy with widespread foreign trade was able to
absorb the new money without serious problems.
Price rise caused by famine and disruption in supply caused great pain and
suffering. Egypt during the Mamluk period was specially afflicted by these
devastations as recorded, among others, by Maqrizi.3 If and when the
situation did evoke a response from the authorities it was in the form of
arranging additional supplies of food grains at public expense.1 Sometimes
they also tried to ensure larger imports by reducing import duties.2
Putting an end to debasement of currency and meeting rise in prices by
arranging for increased supply are policies rooted in Islamic tradition, the
difference in the nature of inflation notwithstanding. These policies are likely
to evoke public cooperation as well as endorsement by the Ulama. The two
other fiscal measures noted above, reduction in public expenditure (with
welfare provisions bearing most of the cut) and increased taxation (and
domestic borrowing) are doubly doomed. They are not practical. They have
no roots in the Islamic past, hence they do not sound familiar, neither to the
populace nor to the Ulama.

14. Instruments of Fiscal Policy:
• 1. Reduction of Govt. Expenditure
• 2. Increase in Taxation
• 3. Imposition of new Taxes
• 4. Wage Control
• 5.Rationing
• 6. Public Debt
• 7. Increase in savings
• 8. Maintaining Surplus Budget
Other Measures:
• 1. Increase in Imports of Raw materials
• 2. Decrease in Exports
• 3. Increase in Productivity
• 4. Provision of Subsidies
• 5. Use of Latest Technology
• 6. Rational Industrial Policy