This year's inflationary episode has two odd features: near-normal growth of aggregate demand and a very large monetised deficit. The price rise of recent months stemmed from a shortage of agricultural goods. Monetary pressure has had little to do with prices so far, but it may yet boost aggregate demand. If this results in capacity constraints, the rate of decline in prices will be braked. The slow down in industrial production this year may suggest that there is enough capacity slack to accommodate a rise in aggregate demand without stoking prices. However, industrial production is measured in value added terms. The data miss out volume growth. Corporates have raised the output of manufactures, but have faced a squeeze on margins. The chances are that capacity utilisation is on the rise. A rise in aggregate demand could thus make an impact on inflation. One safety valve seems to be the slack in exports, but here too there has been volume growth atdeclining US dollar unit prices.

The baffling question is why has aggregate demand remained near-stable so far, despite the galloping increase in money supply? Perhaps, demand is flowing into gold, imports of which have risen sharply this year. The policy maker must nuance inflation control. Phobia about inflation will lead to a curb on aggregate demand via dear money. This will dampen investment demand, which has remained deficient for over three years. This, in turn, will sustain the inflow of gold at the expense of investment in the real economy.