Since 1973, cost-push inflation had its origins in cost increases. Cost shocks such as the oil-price hike become inflationary if they are accommodated by an increase in the quantity of money. Such an increase in the quantity of money can occur if a monetary policy feedback rule is used. A fixed-rule policy for the money stock makes cost-push inflation virtually impossible.

In theory, with a fixed rule for zero-money growth and no change in taxes or government purchases of goods and services, the government pays noattention to the fact that there has been an increase in the oil price. No policy actions are taken. But the economy experiences staqflation. However, unless the oil price falls, the economy will remain depressed. But eventually, the low level of real GDP and poor sales will probably bring a fall in the oil price.

In India and other developing countries, however, the monetary feedback rule is followed. The rule is to increase the quantity of money when the real GDP is below the potential GDP. With the potential GDP exceeding actual real GDP, the central bank pumps money into the economy. Aggregate demand increases and the price level rises, and the real GDP returns to the original level. The economy moves back to high employment, but at a higher price level.

There are, however, no checks on incentives to push up costs if the government accommodates price rises. If some groups see a temporary gain from poshing up the price at which they are selling their resources and if the RBI always accommodates toprevent unemployment and slack business conditions from emerging, then cost-push elements will have a free rein. But when the RBI pursues a fixed-rule policy, the incentive to attempt to steal a temporary advantage from a price increase is severely weakened. The cost of higher unemployment and lower output is a consequence that each group will have to face and recognize.

Thus a fixed rule is capable of delivering a steady inflation rate (and even zero inflation), while a feedback rule, in the face of cost-push pressures, leaves the inflation rate free to rise and fall at the whims of whichever group that believes a temporary advantage is available in pushing up its price.

However, often the problem is not to avoid inflation but to tame it. How can inflation, once it has set in be cured?

When the government under Manmohan Singh slowed down inflation in 1991, we all paid a high price. The governments monetary-policy action was unpredictable.

The consequence was recession, a decrease in the real GDP anda rise in unemployment. Couldn't the government have lowered inflation without causing recession by telling people beforehand that it did indeed plan to slow down the growth rate of aggregate demand?

The answer appears to be no. The main reason is that people form their expectations of the governments action on the basis of the actual behaviour, not on the basis of stated intentions. To form expectations of the governments actions, people look at its past actions, not its stated intentions.

Over a period of time, Singh won credibility for his anti-inflation policies by earning a reputation for being tough with monetary policy. In recent years, several EU governments have adopted explicit inflation targets as a means of enhancing their credibility. If the central bank and the government think that the real GDP is growing faster than the potential GDP, they will expect inflation to rise from its current position. The central bank will reduce the money supply and raise the rate of interest to slow thegrowth of the economy and forestall a potential rise in inflation. If the central bank and the government think that real GDP is growing slower than the potential GDP, they expect inflation to fall from its current position. So the central bank will increase the money supply and lower the rate of interest.

A radical suggestion for strengthening the RBI's reputation as the guardian of price stability is to make the bank independent of the government and to charge it with the single responsibility of achieving and maintaining price- level stability.

If a durable arrangement could be devised for making the RBI take a long-term view, concentrating only on inflation, it is possible that inflation could be kept low at a low cost.