Fixing Inflation

This article raises an issue very relevant to the times we live in – fixing inflation. Summarising what Mr. Subbarao says, inflation is a supply side problem. That means that according to him, inability of the system of production to keep up with the ever-rising demand for goods and services is responsible for steadily rising prices. This inability, he implies, is due to fiscal policy failures and a slow pace of reform dragging economic growth down. The responsibility for fixing the problem, as per Mr. Subbarao, lies with the government. In his opinion, there is precious little that the RBI can do to stimulate growth without stoking the fires of inflation.

Mr. Chidambaram, on the other hand, believes that he has done what he could and was expected to do, i.e., keep fiscal deficit under control, to keep inflation under control, and that the ball is now in the RBI’s court. He believes it is time for the RBI to cut interest rates and tinker with other parameters in its control (like CRR and SLR) to boost growth.

What do we, as ordinary people, make of this debate happening in rarefied environs? Let me make a beginning by focusing, in this article, on inflation.

What is inflation?

The commonly accepted definition of inflation is the steady rise in prices, which is measured through price indices like WPI and CPI. The Classical (Original) definition of inflation, however, is the increase in money supply. This might come as a surprise to many of you because all you may have heard is the commonly accepted definition given above. So here, here, here and here are some links that confirm what I am saying.

Which of these is meaningful and useful?

Only the Classical definition of inflation is meaningful and helps us understand real world phenomena like ever-rising prices while the commonly accepted definition is utterly useless.

Why is the Classical definition meaningful and useful?

Money is a commodity like any other. It has a price too. That price is determined, like it is for all other commodities, by the forces of supply and demand. When money supply increases, the price of money falls. When the price of money falls, the prices of goods and services denominated in that money rise. A steady rise in the supply of money causes a steady rise in prices. Thus, the Classical definition of inflation helps us understand the real world phenomenon of rising prices from fundamentals and is therefore meaningful.

Why is the commonly accepted definition of inflation useless?

Defining inflation as the steady rise in prices tells us nothing about what caused prices to rise in the first place. Explanations like the demand-pull and cost-push theories, and structural/built-in inflation are based on elementary economic fallacies and errors. For instance, if we say that prices are rising because demand is rising, what caused the demand to rise in the first place? If we say prices rise because costs rise, aren’t costs prices themselves? Are we then not bound to explain what caused THOSE prices to rise first? If we do not, would we not be guilty of engaging in circular reasoning by saying that rising prices cause prices to rise? And is saying that some price rise is “built-in” not a negation of economic theory itself, especially price theory, which seeks to explain prices from fundamentals?

A small point of caution while using the Classical definition of Inflation

It often happens that productivity improvements send supply of goods and services up so rapidly that we do not see rising prices but stable or even mildly falling prices. In such cases, it is important to bear in mind that in the absence of inflation, prices of these goods and services would have been much lower than they currently are. So, merely observing stable, slowly rising or mildly falling prices in the face of increase in money supply does not negate the Classical definition of inflation.

What causes money supply to increase steadily?

As explained in my previous post, the banking system that we live with is the fundamental and most proximate cause of inflation. Fractional Reserve Banking is based on creating money many multiples of the monetary base we start with. A banking system with a 10% reserve ratio can multiply every Re. 1 into Rs. 10. The Rs. 9 is addition of money supply by the banking system.

Central Banks (like RBI) make matters worse. They have reserve ratios of their own based on which they lend reserves to banks. The US Fed, for instance, has a reserve ratio of 35%. This means that the Fed multiplies the banking system’s monetary base by 1/0.35 or 2.9 times. Combined with the banking system’s reserve ratio, every $1 can be multiplied into $29. The inflationary potential of the banking system is thus magnified by Central Banks.

Government spending draws resources from the private sector through taxation and borrowing. All this leads to a pressure to keep increasing money supply.

It is these 3 factors – the Banking System, Central Banks and Government – that are responsible for causing inflation (as per the Classical definition).

What does this help us do?

At the very least, it helps us pin the blame for the phenomenon of ever-rising prices. At a deeper level, it gives a solution to the problem. All it takes to solve the problem of inflation is for the triumvirate identified above to stop engaging in inflation (as per the Classical definition).

The question is, would they? And if they would not, why is it so? These are important questions that we will find answers to in subsequent posts.

Fixing Inflation
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  1. Pingback: Is MNREGS a significant cause of rapidly rising prices? | Vanguard Business School – Blog

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