June 02, 2008
Abstract: A hypothetical stress scenario for the Indian economy in the event of a spike in oil prices is developed to examine the best interventions.
Rising oil prices result in high overall inflation, which in turn adversely affect aggregate demand and corporate profitability, and discourage investments. Further, the resultant growth slowdown will reduce tax revenues and increase fiscal deficit (already serious because of subsidies to protect consumers from high oil prices). Slower growth will also lead to a decline in capital inflows, widening of the current account deficit and rupee depreciation. The upshot of these factors is the scary macroeconomic scenario of slowing growth, high inflation and/or fiscal deficit, widening balance-of-payments deficit and currency depreciation!
The best solution lies in first removing the subsidy and allowing the prices of petroleum products to rise, and second, lowering interest rates, to counter the slowdown in growth induced by higher energy prices. The threat of a spiralling fiscal deficit will abate and the current account deficit will be reduced because of lower oil imports.
Keywords: oil prices; growth slowdown; inflation; fiscal deficit; rupee depreciation