Inflation is now at 12.01%. Persistently high inflation has attracted much attention from economists, bankers and policy advisers. There is widespread belief that inflation is largely a result of the rise in oil and food prices in the international market. Such a line of reasoning is, however, dangerously flawed.
Illustration: Jayachandran / Mint
All consumers are subject to budget constraints; if they have to spend more on some goods, say oil and food, then they will have to spend less on others. A lower demand for non-oil non-food goods would in turn lower their prices. Of course, consumers may borrow to spend, but their borrowing would be limited by their ability to pay back; and when borrowers spend more than their income, lenders by definition spend less than their income. In short, a rise in the price of oil and food cannot explain a general price rise (or inflation), because income-constrained consumers exert equal and opposite pressure on the prices of other goods, neutralizing the impact of a rise in oil and food prices on the overall price level.
As Milton Friedman said: “Inflation is always and everywhere a monetary phenomenon.” A general rise in prices is a reflection of the fact that there is too much money chasing too few goods. In 2005-06 and 2006-07, reserve money grew at 17.2% and M3 (broad measure of money supply) at 17.0% and 21.3%, respectively. In short, the monetary base has grown at rates much faster than real goods and services (which grew at around 15% in nominal terms).
There are then two ways to deal with inflation. First, reduce the “too much money” part by a hike in the interest rate. Second, increase the “too few goods” part by liberating the Indian economy and unleashing its entrepreneurial spirits. The former policy approach would indeed have an adverse effect on growth, while the second sees growth as the solution to inflation. This is not to argue that the central bank does not need to tighten monetary policy, but to point towards a brilliant opportunity that lies behind the inflation crisis.
Niccolo Machiavelli, Italian political philosopher of the Renaissance, once said: “Entrepreneurs are simply those who understand that there is little difference between obstacle and opportunity and are able to turn both to their advantage.” We hope the United Progressive Alliance government sees the opportunity for further liberalization and growth, now that the government’s economic vision is no longer tinted red.
Monetary tightening or price control, how should inflation be tackled? Write to us at email@example.com