Causes Of Inflation

Long term inflation occurs when the money supply (currency and check writing deposits) grows at a faster rate than the output of goods and services. When there is more money available than is needed to accommodate normal growth in output, consumers and businesses want to purchase more goods and services than can be produced with current resources (labor, materials, and manufacturing facilities) causing upward pressure on prices. This is often described as "too much money chasing too few goods." Over a shorter term, inflation can result from various shocks to the economy. Food and energy price shocks are common examples of this in the U.S. The price of a critical commodity such as fuel may rise suddenly and sharply relative to other prices. Since the market does not have time to adjust other prices downward in response, a short-term increase in overall prices occurs. The rate of inflation is sometimes reported with food and energy omitted so the long-term, underlying (or "core") inflation rate is revealed. Governments need to control high levels of unpredictable inflation since it can severely disrupt the economy, cause uncertainty in financial decisions, and redistribute wealth unevenly. The tools they have available include: monetary policy (increase or decrease the money supply), fiscal policy (change the amount of taxes and governmental spending), and various controls on prices, tariffs, and monopolies. Many nations (including the U.S.) choose monetary policy as their primary tool since it has proven to be very effective, it is less disruptive to market operations, and it is easier and quicker to implement since adjusting the money supply does not require legislative approval as would, for instance, changing the tax structure. Monetary policy is almost always carried out by a government-controlled central bank that is usually somewhat insulated from political pressure. It is given the responsibility of maintaining an orderly market and juggling the sometimes conflicting goals of steady growth, low unemployment, and low inflation. The governments of some nations require the central bank to maintain a low, positive rate of inflation (usually well under 3%) as the over-riding goal of their monetary policy.2, 4 They must keep the money supply at a level that accommodates steady growth in goods and services, but is not so high as to cause excessive inflation or so low that deflation (an overall decrease in prices) results. The Federal Reserve System ("Fed"), the central bank of the U.S., does not publicly target a goal for the inflation rate. Instead, they announce goals for the Federal Funds Rate, the interest rate at which banks lend their excess reserves to one another. When the Fed wants to increase the money supply and thereby stimulate the economy, they publicly announce that they intend to lower the Fed Fund Rate. They then buy Treasury securites on the open market which, through a complicated combination of market transactions and federal banking regulations, will increase the amount of loans that private banks can make to consumers and businesses. As banks compete for customers for these new loans, short term interest rates will tend to fall toward the Fed Fund goal. With credit readily available at low interest, comsumers will tend to take out more loans for high-end goods such as homes and cars, and businesses will invest more in facilities and employ more workers to meet the demand. The increase in money supply is essentially borrowed into existance through the private banking system.

If the demand becomes greater then the current workforce and manufacturing facilities can produce at their natural growth limits, inflation will generally occur. The Fed can reduce economic activity by announcing a higher goal for the Fed Fund Rate and then selling Treasury securities to shrink the money supply, raise rates, and thereby ward off inflation. Although the Fed does not publicly state an inflation goal as part of their policy, they have kept prices reasonably stable since about 1996 as shown in Figure 1.

With example: Inflation is the phenomenon of a generally rising prices over a period of time. its measured by the rise in the average prices of goods and services or the rise in the general price indexes like the Consumer Price Index or the Producers Price Indix or the Fuel Price Index or the Food Price Index and so on. If inflation means rising prices on an average ( prices of some items mat decline but most prices are rising), the purchasing power of money falls. Higher prices mean you get to purchase lower quantity of goods and services within the same income or same expenditure budget. This causes a hardships to those whose incomes do not rise at the eams rate of rise in prices. Rising prices also means the value or purchasing power of past savings also falls. People become poorer to that extent. An one-shot rise in prices of goods and services in not inflation, though even that would also mean fall in the purchasing power of money. Prices must be showing continuous rise over successive weeks to be called as inflation. There are two broad ways that a process of rising prices can work through its way. Let us consider an increase in demand caused by say sudden increase in govt. expenditure through deficit financing to fund a disasterous widespread natural calamity resulting in loss of standing crops and damage to grain storages. This means excess demand situation in food markets resulting in food prices. The rise in food prices causes the cost of labor to industries go up. Now if the demand for goods produced by industries also goes up following strong demand from fresh labor employed by Govt. on rehabilitation and relief work in an economy which was already in expansion phase, the producers may raise prices of industry made goods. This may lead to all round rise in prices. In the meantime oil exporting countries also raise their orices taking advantage of their oligopolistic market situation. This causes cost of production and transportation to go up further and a process of price spiral strengthens. As prices of some goods rise, these increases the costs of production of other goods and their prices goes up to lead to cost and price rise in other goods. Thus, demand-supply imbalances, large deficit spending in an expansion phase, sudden price shocks from oligopolistic markets and cost- price relationship can rwesult in an inflation. The above example is too extreme in terms of all types of factors working out. In reality in most cases inflation can take place from sudden and sustained demand supply imbalances (shortage of supply) and/ or market imperfections, price increases feeding in to cost increases, etc. Too strong growth in govt. expenditure financed by printing money and large expansion of money supply in the face of production capacity shortages and market imperfections like monopoly/ oligo[oly/ strikes/ lockouts can cause an inflationary price spiral up.

How Can Inflation Lead To Rise In GDP?

If prices go up, they will induce new investments. Investments will create jobs, income and outputs. If productivity is higher than wage rate, outputs will grow faster than prices. Real GDP will increase.

Does Growth Cause Inflation?

For the last few years, the claim that an increase in economic growth leads to an increase in inflation and that decreased growth reduces inflation has been a mantra. Tightening monetary policy slows

spending growth, opens up some slack temporarily in labor and product markets, and allows the slack to reduce inflation. Yet, taken literally, that claim cannot be true. All other things being equal, an increase in economic growth must cause inflation to drop. Heres why. The seat-of-the-pants explanation of inflation is that it is caused by too much money chasing too few goods. It follows that the more goods that are produced, the lower the prices of goods. This connection between the level of production and the level of prices also holds for the rate of change of production (that is, the rate of economic growth) and the rate of change of prices (that is, the inflation rate). Some simple arithmetic will help clarify. Start with the famous equation of exchange, MV = Pq, where M is the money supply; V is the velocity of money, that is, the speed at which money circulates; P is the price level; and q is the real output of the economy. If the growth rate of the economy increases, that is, if the growth rate of q increases, then, if the growth rates of M and V are held constant, the growth rate of the price level must fall. Since the growth rate of the price level is just another term for the inflation rate, the inflation rate must fall. An increase in the rate of economic growth means more goods for money to chase, which puts downward pressure on the inflation rate. Assume, for illustrative purposes, that the money supply grows at 6 percent a year and velocity is constant. Then, if annual economic growth is 3 percent, inflation must be 3 percent. (Actually, inflation must be 2.9 percent, which is approximately 3 percent). If, however, economic growth rises to 4 percent, inflation falls to 2 percent. (Actually, it falls to 1.9 percent.) That higher economic growth must reduce inflation is straightforward. Why, then, does a man as brilliant as Federal Reserve chairman Alan Greenspan not get it? Actually, he does. He just never says things simply and straightforwardly when he can be complicated and obtuse instead. In 1995 Chairman Greenspan testified before the Senate Committee on Finance: One factor in judging the inflationary risks in the economy is the potential for expansion of our productive capacity. If potential GDP is growing rapidly, actual output can also continue to grow rapidly without intensifying pressures on resources. Translation: if growth is higher, inflation is lower.

Can Productivity Grow? Of course, its hard to know at any given time what the potential growth rate of an economy is. Various macro economists, especially those trained in the Keynesian tradition, may tell us that the upper limit on an economys long-term growth rate is 2 or 2.5 percent. But if you push them for their reasons, the best they can do is to tell you that the economys growth rate equals the sum of employment growth and productivity growth, that employment growth cant be much more than 1 percent in the long run, and that productivity cant be expected to grow by much more than about 1.25 percent a year. The first statement is necessarily true: an economys growth rate does equal the growth of employment plus the growth rate of output per worker (productivity). The second statement is probably true, but it depends on the unstated, and crucial, assumption that limits on immigration to the United States are not progressively relaxed: allowing the number of workers admitted into the United States to increase by a million a year, for example, would increase the U.S. labor force by about 0.8 percent. The third statement is the most controversial. People who believe that productivity growth will be limited point to the past: between 1973 and 1993, for example, measured productivity output per man-hourin the United States increased by an annual average of 1.23 percent. But that past says little about the future. Even in the recent past, between 1993 and 1998, productivity growth averaged 1.46 percent, above what the growth skeptics thought was the upper limit. This higher productivity growth is one of the reasons that real gross domestic product has grown by an average of 3.4 percent, much higher than the 2 to 2.5 percent that was anticipated by the growth skeptics. (The other, more important reason for higher growth is that employment grew by 2.56 percent a year between 1993 and 1998.) There is strong reason to believe that productivity can grow by 1.5 to 2 percent a year. Analysts who have studied the information technology (IT) industries can point to many ways in which the Internet, computers, and software will be able to increase productivity further. Some have compared the role of the IT industries in the current U.S. economy to the economic role of electricity toward the end of the 19th century before electricity had been completely integrated into the economy. If theyre right, then we can expect an explosion of growth as the IT industries are further integrated into the economy. Moreover, exciting advances in biotechnology and artificial intelligence will likely lead to further productivity improvements over the next 10 to 20 years. Stock prices have risen greatly over the last 5 years because the market has increasingly come to anticipate large productivity increases, some of which will be captured by the firms that create them.

Why is inflation in India so stubbornly high and so much higher than other emerging markets, even those that are supposedly overheating, such as China, Korea and Indonesia, where inflation is closer to 3 per cent?
Consider a few standard explanations. The first - call it the supply shock factor - relates to agriculture. The weather Gods failed us last year, India's agricultural output suffered a sharp drop as a result, supply declined and prices rose. The second explanation is what we might call policy shock. Prices of fuel have recently been increased, which is contributing to overall price inflation. Minimum support prices for agriculture have also been increasing. Further, in the face of agricultural supply shocks, price smoothing by the government through greater imports and faster depletion of domestic stocks has been woefully inadequate. In some ways, the more plausible these explanations are, the less worrying the prospects for the Indian economy. The monsoon is looking better this year, so the agricultural shock factor will not have the same bite going forward. And fuel price increases should be of a one-off nature rather than an ongoing source of inflation. The most telling pieces of evidence against the view that inflation is supply shock and policydriven are twofold. High inflation, especially consumer price inflation, predated the monsoon shock of last year. Moreover, rising prices are not restricted to agricultural goods and have now spilled over into other commodities: double-digit price increases are no longer confined to agricultural commodities. In this case, we are forced to turn to the third standard, and more worrying, explanation, namely that inflation also reflects overheating: the supply capacity of the economy is simply unable to match the demands on that capacity. Now, overheating in India can be an agricultural phenomenon or an economy-wide pathology. In either case, there is cause for worry because the implication is that the economy's current growth rate of 7-8 per cent is above its potential or trend growth rate. In this view, and unless capacity can be significantly increased, attaining China-type double-digit growth rates will remain elusive. In agriculture, it seems easy to identify the causes of overheating because a scissors effect seems to be at work. On the one hand, productivity growth, especially in pulses, is anaemic and possibly weakening further. On the other hand, purchasing power and hence demand are accelerating, courtesy the NREGS (which is increasingly looking like a pure cash-transfer programme).

We do not know for sure what the bottlenecks are in the rest of the economy. They could be inadequate investment in infrastructure, inadequate supplies of skilled labour (always a possibility in India because its growth model is so skills-reliant), slow total factor productivity growth or some combination of all the three. Regardless, these constraints - as indeed those in agriculture - are not addressed very quickly. So, even if faster growth is possible, it will not be immediately achievable. And a corollary is that, given the capacity situation, aggressive monetary policy action will be warranted to bring inflation below 5 per cent, which is believed to be the "Lakshman Rekha [ Images ]" that politicians dare cross only at their own peril. There may, however, be another explanation of high and persistent inflation that is more cheering in suggesting that inflation is less due to overheating than due to a different type of cost-push inflation. Here's a possible hypothesis. Serious micro-economic distortions afflict the land market. In itself, this distortion cannot cause inflation because presumably the distortion leads to a one-off increase in the price of land as an input. In other words, the distortion, unless it is continually worsening, will have increased the price level but cannot cause price inflation. But suppose that these micro-distortions interact with macroeconomic factors such as surging capital inflows into real estate and housing. Such surges will lead to sudden increases in the price of land and related inputs, raising the cost of production in the economy as a whole. A whole range of services, such as retail, construction, entertainment, education and finance which account for progressively larger shares of the economy use significant amounts of land as an input, a fact that gets overlooked in inflation discussions, which tend to focus on agriculture and manufacturing (this may also explain why inflation in consumer prices, which reflect services to a greater extent than wholesale prices, has tended to be above wholesale price inflation). Generalised cost-push inflation could then be a natural consequence with the push resulting from the interaction between a pre-existing microeconomic distortion and a macroeconomic factor that serves to aggravate this distortion, converting a price-level effect into an inflation effect. If this is the diagnosis, what is the cure? Clearly, the first best solution is to eliminate the distortions in the land market of which there are many, including urban land ceiling and tenancy laws. The resulting boost to productivity would increase the overall supply capacity of the economy, making inflation less likely. Structural reforms of the land market will thus be good for inflation and good for growth.

But if land market reforms are infeasible, and inflation continues to be above acceptable levels, policy-makers may have little choice but to address the macroeconomic factors that aggravate the underlying distortion. In some cases, this may require dampening foreign capital flows, especially those going to real estate and housing; or they may involve other prudential measures such as higher provisioning requirements for real-estate lending. Thus, the diagnosis of and cures for inflation may need some rethinking. Inflation may have a lot more to do with services and land as an input. And curing it may require addressing the macroeconomic aggravators of microeconomic distortions in addition to traditional monetary policies. Exceptionalism characterises India's development pattern, but does it also apply to the nature of its inflation?