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Knowledge Center » Economics » THE ABC OF INFLATION

No subject is so much discussed today or so little understood as inflation. Our politicians talk of it as if it were some horrible visitation over which they had no control—like a flood, a foreign invasion, or a plague. It is something they are always promising to "fight". Yet the plain truth is that our political leaders have brought on inflation by their own money and fiscal policies. They are promising to fight with their right hand the conditions brought on with their left.Inflation has been with humankind ever since we moved away from barter to the use of mediums of exchange, like paper money or precious metals. Inflation, always and everywhere, is primarily caused by an increase in the supply of money and credit. When the supply of money is increased, people have more money to offer for goods. If the supply of goods does not increase or does not increase as much as the supply of money then the prices of goods will go up. Each individual Rupee becomes less valuable because there are more Rupees. Therefore more of them will be offered against, say, a pair of shoes than before. A "price" is an exchange ratio between a Rupee and a unit of goods. When people have more Rupees, they value each Rupee less. Goods then rise in price, not because goods are scarcer than before, but because Rupee availability is more abundant.Suppose that, by a miracle, every family in India were to wake up one morning to find four times the money they had in their bank account on the night before. Every family would then be eager to rush out and buy things it had previously longed for and gone without. The first comers might be able to buy things at the old prices. But the later comers would bid prices up against each other. Merchants, with their stocks going down, would reorder, raising wholesale prices. For the common person, there is something threatening about the phenomenon of inflation, especially on those occasions when the rise in prices of goods is not matched by an equivalent increase in the price of labour.Many different factors and policies have been held responsible for inflation. Some say aggregate demand rising faster than aggregate supply "pulls up" prices and wages ("demand-pull inflation"). The rise in demand in turn may be due to a government deficit ("government inflation"), an expansion of bank credit for private investment ("credit expansion"), rising demand from abroad ("imported inflation"), or an increase in gold production ("gold' inflation"). Others say prices are being "pushed up" by wage increase forced upon the economy by labour unions under threat of strike ("wage-push inflation"), or costs may be raised by business monopolies ("administered price inflation").WPI (Wholsesale Price Index) & CPI (Consumer Price Index) is most extensively used as a measure of Inflation and important monetary & fiscal policy changes are often linked to it.WPI in India is used extensively for short term policy intervention because it is the only index that is available on a weekly basis with a two weeks’ lag. A number of consumer price indices like Consumer Price index for Industrial Workers (CPI-IW), for Agricultural Labourers (CPI-AL), and for Urban Non-Manual Employees (CPI-UNME) are compiled on a monthly basis. The Labour Bureau of Government of India prepares the CPI-IW. It attempts to measure changes in the retail prices of fixed baskets of goods and services being consumed by the target group namely the average working class family. The coverage of CPI-IW is broader than that for CPI-AL and for CPI-UNME. The CPI-AL and CPI-UNME are designed for specific groups of population with the main objective of measuring the impact of increase in prices on rural and urban poverty. The CPI-IW captures to some extent the price increase in the service sector. Whenever the supply of money increases faster than the supply of goods, prices go up. This is practically inevitable. If this year's shoe production is twice as that of last year's the price of a pair of shoe drops violently compared with last year. Similarly, the more the money supply increases, the more the purchasing power of a single unit declines.  The rise of prices, which is merely a consequence of the inflation, is commonly talked of as if it were itself the inflation. This mistaken identification leads many people to overlook the real cause of the inflation which is the increase in the money supply. Therefore inflation which is infact a direct result of increase in money supply can be curbed by controlling the same. This is where our Central Bank, the Reserve Bank of India comes into play. Our Central Bank has been instrumental in controlling the money supply via monetary policy. For this it uses various instruments viz. Open Market Operations, CRR & SLR, Repo & Reverse Repo rate, Bank rate.Open Market Operations: RBI buys or sells government securities in open market. When RBI purchases Government securities it is pouring additional money into the system thereby increasing the liquidity. On the other hand, when RBI sells Government securities the purchaser is giving cash to RBI to purchase the securities therefore money is sucked out of the system by RBI. Hence liquidity is decreased.Cash Reserve Ratio (CRR) is a fraction of the demand & time liabilities that the commercial banks must keep with RBI. Statutory Liquidity Ratio (SLR) is a fraction of the demand & time liabilities that the commercial banks must invest in liquid assets. Therefore the banks can lend only the balance which is left after satisfying the CRR & SLR requirements. Hence these tools restrict the lending power of commercial banks. When RBI wants to decrease the money supply it will increase the ratios and vice versa.Reverse Repo Rate is interest rate paid by RBI to the Central Government, State Government, all banks & NBFCs for short term loans. RBI sells government securities to these parties and agrees to buy back those securities after certain time at a higher price. The purchaser gains from the difference between the purchase price and the selling price and RBI in exchange receives funds for short term. Similarly Repo Rate is the interest rate RBI charges interest from Central / State Government or Banks / FIs for short term loans. In this case RBI purchases government securities and the other party undertakes to buy back those at a higher price after a certain time. RBI may vary these rates to either increase or decrease the money supply in the economy.Bank Rate is the interest rate at which RBI lends money for long term. Commercial banks can borrow money from RBI at the bank rate when they run short of reserves. A high bank rate makes such borrowing from RBI costly and, in effect, encourages the commercial banks to maintain a healthy liquidity.It is assumed in popular discourse that if interest rates are raised, the demand for credit will go down therefore RBI manages to influence interest rates through the adjustment of repo and reverse repo rates or CRR/SLR etc. this in turn influence liquidity and, through that, inflation.Apart from these, the government uses its fiscal policies like taxation policies and control on its expenditure to control inflation.Monetary policy has the great advantage that measures can be initiated and changed quickly in case of need, while fiscal policy changes are subject to long delays because they have to go through lengthy parliamentary procedures. Moreover, in countries where the monetary authorities have some political independence monetary policy is less subject to political pressures than fiscal policy. However if the battle against inflation is to be won, monetary and fiscal policy should be coordinated. At the very least they must not be operated at cross purposes. While it is true that we do not fully understand inflation and, to that extent it remains a threat, what is comforting is that years of data collection and research have given us deep insights into this troubling phenomenon. And even though we do not fully understand its origins we have developed techniques and policy interventions that can control it.Inflation makes it possible for some people to get rich by speculation and windfall instead of by hard work. It rewards gambling and penalizes thrift. It conceals and encourages waste and inefficiency in production. It finally tends to demoralize the whole community. It promotes speculation, gambling, luxury, envy, resentment, discontent, corruption, crime, and increasing drift toward more intervention which may end in dictatorship.How long will inflation continue? How far will it go? No one has a sure answer to such questions. The answer is in the hands of the people themselves. Inflation is not necessary and it is never inevitable. The choice between chaos and stability is still ours to make.