Inflation has become the buzzword in recent times both globally and in India. In India, as a political weapon in the hands of opposition parties, it has attained the same status as corruption to beat up the party in power. Relentless media coverage about Inflation as a public enemy only added to the confusion about the phenomenon being described, the causes being attributed and the policy actions being suggested.
Inflation, though popular, is one of the most misused words in economics. According to Prof Michael Bryan of University of Chicago, for many years the word inflation was not a statement about prices but a condition of paper money (On the Origin and Evolution of the Word Inflation, Federal Reserve Bank of Cleveland, 1997). It referred to a rise in the amount of paper currency in circulation relative to the precious metal that backed it. Later, the term referred to the amount of money in circulation relative to the money actually needed for trade. Today, however, people typically use the word to refer to a rise in some set of prices or even a single price with no necessary reference to money at all. So now we have various types of inflation: food inflation, oil-price inflation, wage inflation and so on. An outcome of this evolution, unfortunately, is that general public no longer distinguishes between two very different types of price pressures.
According to the classical economists, inflation refers only to a drop in the purchasing power of money that results when a central bank creates more money than the public wants to hold. Such inflation manifests in a generalised increase in all prices and wages, and not just some set of prices. People, of course, use money to conduct their day-to-day transactions, and their demand for money generally expands as the economy grows. If the public’s demand for money grows, say, at 5 per cent every year, but the central bank creates money by 10 per cent every year, then all prices and wages will eventually have to rise at 5 per cent every year to be in equilibrium. Prices would continue to rise so long as the disparity between supply and demand for money continues.
Inflation, as understood in this way, will always result from monetary mismatch. Which is why Milton Friedman said inflation is always and everywhere a monetary phenomenon. It has very little to do with the dwindling supplies of food stocks resulting from a terrible hurricane or a sudden shock to oil prices or even workers’ demand for wages. And, as a monetary phenomenon, it has to be always under the control of a central bank. That said, the speed with which an inflationary monetary impulse filters through to all wages and prices depends on many factors. Most significantly, it depends on the degree of excess capacities in the economy and on the state of people’s expectations. In times when the economy is operating near full capacity or the public generally anticipates inflation, monetary excesses can quickly translate into higher prices and wages.
Relative price changes, similar to general inflation, also generate price pressures in the economy. We experience them every day and they cause changes in standard price indices. But the similarity ends there. Relative price changes are not a monetary phenomenon. They arise in market economies as individual prices adjust to the ebb and flow of supply and demand for various goods. The relative price increases, therefore, will always results from a demand-supply mismatch for commodities. They, in turn, convey important information about the scarcity of particular goods and services. A rising relative price indicates that the demand is outstripping the supply, while a falling relative price means just the opposite. A rising relative price induces or forces consumers to conserve the good in question and look for substitutes. Similarly, a rising relative price, by increasing the profitable opportunities, entices producers and traders to bring a greater quantity of the good to the market. If producers and traders expect the price rise, relative or absolute, to continue into the future, then they would resort to hoarding which can further generate a price pressure.
In this way, the relative price changes, however uncomfortable they may be for consumers or producers or government, transmit vital information necessary for an efficient allocation of resources throughout any market economy. Inflation, by contrast, contains no information that may be useful for our consumption, production or making labour choices. If anything, it can temporarily distort vital relative price signals, leading people to make unsound economic choices such as shifting resources away from activities that foster production and long-term economic growth to activities that are intended to protect their wealth rather than expand it.
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Though any price rise, relative or absolute, will have adverse welfare consequences for the common man, it is important to understand the differences between them since they are fundamentally caused by different factors, and hence would require fundamentally different, but coordinated, policy responses. Inflation control is the clearest and most important mandate for any central bank, but they can do very little about relative prices since they do not have supply-side management instruments. However, relative price rises do not fundamentally impair the ability of central banks to control aggregate inflation, as has been suggested in some policy circles in India in the recent past. They would complicate the conduct of monetary policy in the short term, by highlighting the inflation-output trade-off. Any signal emanating from the central bank indicating its inability to control inflation would lead to spiralling inflation expectations, which would have disastrous consequences for everyone. To sum up, anchoring the generalised inflation expectations should be the primary focus of monetary policy, while the supply-side measures should tackle the rising relative prices.
gangadarbha@yahoo.com
The writer works with an investment bank. The views expressed are personal