How does subsidy in oil lead to petrol inflation?

economy : How does subsidy in oil lead to petrol inflation? 2

Answer by Alok Pandey:

Subsidies has already been defined comprehensively by Jai Parimi. Let me add my 2 cents to it.

A sum of money granted by the government or a public body to assist an industry or business so that the price of a commodity or service may remain low or competitive.

And why only oil, it's usually true for any commodity.

Actually subsidies aren't bad at all, IF are well thought out and properly planned to achieve intended objectives. Like Deng Xiaoping did in the field of agrarian reforms, when he came to power in China in the late 70s. He provided subsidized capital goods and auxiliary farming items to the farming families and told them to promise a certain amount of produce to the government. The surplus if they manage to produce, they can do whatever the hell they want to do with it. Farmers almost doubled the produce in the following years, the government recovered what it spent and gradually reduced the subsidies.

Subsidies, if properly planned are like the seed capital that should be there to kick start the jammed sections of the economy and when there purpose is achieved and the government breaks even for what it invested, the subsidies should gradually be phased out. Sometimes, the government provides subsidies for some commodities that are otherwise too dear(and yet necessary) for an average man to purchase. They too, must be introduced as a temporary solution with an aim to find a permanent one. Like if it is providing subsidies for fertilizers, aim to set up fertilizer manufacturing plants and tackle the demand-supply issue directly.

Now we know that how are petrol prices decided and the role of the government in that. I have prepared a pictorial flow of the process using a brilliant answer by Akand Sitra.

I hope you noticed the penultimate step in the pricing mechanism.

Now coming to your question, subsidies are also part of the government expenditure.

So effectively they contribute to the fiscal deficit of a country, if any – India seems to have a perpetual one. đŸ˜›

To tackle fiscal deficit, government either borrows from the people(government bonds, etc) or from RBI(treasury bonds, etc) or uses its own existing cash reserves with the RBI. If it borrows from the people, fiscal deficit worsens and there are chances of fiscal slippage.
Alok Pandey's answer to What is fiscal slippage? How do we combat it?
If it borrows from RBI or withdraws from its own cash reserves, the amount of money in the economy increase directly increasing the money in the hands of the people(because where else would it go, right!!) thus increasing the demand but not the supply, leading to yep..inflation.

And let me further add, usually subsidies are inflation linked, so if inflation increases, governments might increase the subsidy, thus continuing the vicious cycle. The only solution like I said, a well thought out targeted subsidy with a clear plan of gradual phasing out.

How does subsidy in oil lead to petrol inflation?

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