The general understanding of inflation that laymen possess, is that steady rise in prices of goods and services indicate an inflation in the economy. Inflation is most often perceived as a negative effect on the economy, while a certain rate of inflation is crucial for the growth of economy as well. However, a massive rate of inflation does not only mean bad news but could send the economy crashing.
A black swan event like the COVID-19 pandemic has pushed economies across the world to witness unusually high inflation rates that could demand a sizeable amount of time to recover. In 2020, when the pandemic’s large-scale disruption gave the economy a big blow, governments were grasping at straws to shift the market in a positive direction. The United States’ Federal Reserve began increasing the money supply by printing colossal amounts of dollars, to fight the economy that was failing rapidly.
The U.S Federal Reserve in its slightly twisted approach, increased the money supply to make large-asset purchases from the markets and thus pumping money to the reserves of banks. In return for this, U.S Treasury securities issues a huge bulk of bonds to the Fed. The large purchases made by the Fed triggers the market yet again and money starts flowing smoothly. Banks hold more money and are essentially capable of lending, at relatively lower rates of interests. This maintains lower borrowing costs for those interested in obtaining a loan.
While this serves as an immediate fix to the ongoing economic fiasco, it could potentially hurt the economy more. When the money supply increases in the market compared to its economic output, the inflation rate naturally increases, as a result, it affects the purchasing power of any currency.
Often, governments use a Contractionary Monetary Policy, which is a widely accepted method of curbing inflation rates. In this method, the Central Banks reduce the money supply within an economy, decrease the prices of bonds and increase interest rates. As a result, people with money tend to save it and minimize spending drastically. This minimization is crucial during an inflationary period as minimized spending equates to lesser purchases, which further equates to slower inflation.
The Reserve Bank of India has always campaigned for a more responsible approach to tackling the growing inflation rates. The issue of government bonds normally is intended to gather funds from the public at a certain rate of interest, that the government was not able to gather by collecting taxes. During inflation, Central Banks can issue bonds, wherein the Central Bank borrows money from the deposits held with itself, which are in turn part of the Cash Reserve Ratio of individual banks.
As a result of this, the money that previously existed in the market is now being taken out of circulation, thus reducing the money supply available for consumption. With lesser money being available for borrowing, the interest rates for borrowing go high, resulting in further slow down of purchases. The overall demand for goods falls and in turn the prices also reduce. The economy gradually recovers from an inflation.
This method of tackling inflation, although tedious and rewarding at a later point, hurts the economy lesser and prevents increase in stringency in the economy.
In India, due to the COVID-19 pandemic, inflation rates have skyrocketed deviating the government from its target inflation rate of 4%. In 2020, the recorded inflation rate was at 6.2% and 4.76% in 2019.
The Reserve Bank of India, in an effort to adapt to the economy’s climate, purchased 25,000 crore worth of government securities in an open market operation, inducing liquidity into the market and increasing the lending activities of banks to individuals and institutions. The bond market has positively responded to this move, as the Reserve Bank has done so without massively increasing the money supply but keeping steady and stable.