Tuesday, May 13, 2008

On Inflation – The necessary Evil

Everyone is talking about inflation these days and it seems to be an issue worth the attention… After all inflation has reached a 3 and a half year high and soared to a 7.5% + in the last few weeks!!!!

And today the headlines of the paper were even more depressing: “industrial growth falls to 3% - the lowest growth figure for any month in the past 6 tears”

Probe deeper into the news articles and the sub headings read as “inflation hurts industrial growth”, fallout of inflation – industrial slow down” and so on…

Now is the slow down in industry because of inflation? Well, maybe yes.
Do we now have to deal with both – inflation as well as industrial slow down? Well maybe NO.

Think about it. What is inflation? General rise in the price level across commodities. Effectively, it means that my hard earned money is losing its value. Something like - The same note of 10 rupee will now fetch me 75 grams of bread instead of 100 grams. Right?

Why does this happen? Simple. Demand outweighs supply. More people demand bread and so my bread becomes dearer and I become poorer. So, I conclude that inflation is a sin. The government must help me.

What do the policy makers typically do in such a situation? They try to control this “excessive demand”.

To fight this nuance of inflation, RBI (or any central bank) tightens the monetary policy and makes credit dearer – by increasing interest rates, repo rates, CRR, SLR, etc. The Central bank does this with a good intention - to control excessive demand in the economy, which is seen as the culprit behind inflation.

When credit becomes dear, the users of credit reduce their consumption of credit. Industrial investment, in most cases is the biggest source of demand for credit, and naturally investors reduce investment and the industry as a whole slows down because of paucity of fresh investment which fuels growth.

This is exactly what has happening in our economy. In an attempt to control inflation which starting soaring in mid Feb, the RBI took steps such as increasing CRR which made credit less available in the economy, coupled of course with high cost of certain raw materials. All this has now shown its side effect in the form of a 2.9% industrial growth in March.

This slow down clearly indicates that that ruling out supply shocks, inflation should be curtailed in the coming months.

What does this mean? This only means that the RBI is working in the right direction, if the policy of the government and the popular opinion is to reduce inflation at any cost.

Now comes the second bigger question? Would it be right for the govt to control inflation by putting brakes on growth? This is a question of national priorities. What are my nation’s priorities – growth at the cost of inflation or vice versa?

No doubt, in the short run, there is always a clear cut trade off between inflation and unemployment (a proxy measure for output slow down). Try to control inflation and you are bound to see a slowdown in output and employment. Similarly, when output and employment expand, inflation naturally starts spreading its wings.

The economic logic again is simple. As output expands, employment expands. When more people are employed, aggregate demand for goods rises. This leads to inflation.
From here in follows the logic that trying to control inflation amounts to trying to curtail demand and output.

The economy of the US witnessed a situation of this type in the 1980’s under Fed chairman Paul Volcker (The famous Volcker disinflation episode of US history). The decade of 80’s began in US with inflation soaring to 10%. The Fed followed aggressive policies to curtail inflation. As a result inflation reduced to 3% from 10% by 1983, but unemployment reached a 40 hear high!

Its now on our government to decide what it wants – inflation or unemployment. The sacrifice ratio is high! A central bank engineered attempt to reduce inflation by 1% will lead to a GDP slow down of any thing between 2.5% to 5%

Also lets stop looking at inflation as a parasite… It just one of the indicators of buoyant and at times unsustainable growth.

P.S: Inflation is different from hyperinflation (which equals an inflation rate in excess of 1000% per month). The above theory of trade off between inflation and outputs fails in the case of hyperinflation. But hyperinflation is a result of reckless printing of money by the govt (termed as Seigniorage). Thankfully, India is not in the clutches of hyperinflation! :)


Varun Reddy Sevva said...


You write rarely but you write well. And the side-bar of your blog was good. I will also write something about my blog in that so that anyone who visits can know about it. Thanks for the comment. BTW, how did you come across my blog? A mere co-incidence or what?


Sugandha said...

Varun, Thanks for the appreciation. Highly appreciated!! :-)
I read a lot of blogs... Anyway I was looking for reviews on Bhagat's new book when I stumbled across ur blog on google... You seem to be a good and diligent writer...

Varun Reddy Sevva said...

Oh... Same here... I also love reading blogs, helps me develop appreciation to different viewpoints... Well, blogging helped me revive my dormant monster of writing skills... What do you do presently? I guess you work at that consultancy that you mentioned in one of your posts abt the "IIM-C" call... BTW, I study at IIM Lucknow...

AlladdinJasmine said...

Good blog...hum jaise ganwron ko economics samajh aa gayi,...meri english mein takleef hai..so i m writing comment in hindi

Sugandha said...

Dhanyawaad Prateek :) Apne hamesha ki tarah hamari rachnayen padhne ka kasht kiya :D