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Ask Mint | Tough choice for central banks: control inflation or sacrifice economic growth

Ask Mint | Tough choice for central banks: control inflation or sacrifice economic growth
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First Published: Sun, Oct 19 2008. 10 08 PM IST

Updated: Sun, Oct 19 2008. 10 08 PM IST
In their fight against inflation, central banks would love to kill just one bird with one stone. But unfortunately, when your singing canary is sitting on top of an owl, the stone that you throw may end up killing both.
It is a difficult choice for central banks if controlling inflation requires the sacrifice of economic growth. But central banks really do not have any other option. They know very well that the instruments of monetary policy they are going to use to kill inflation would invariably also kill GDP (gross domestic product) growth. Let’s try to understand how and why monetary policy instruments work in such manner.
Johnny: Why is it that controlling inflation requires the sacrifice of economic growth? Can’t we use monetary policy instruments in such a way that they kill inflation without hurting growth?
Jinny: Well, all monetary policy instruments in one way or the other try to influence just one thing—how much money is available with people. A tightening of interest rates or an increase in the cash reserve ratio reduces the amount of money that banks can create through their lending activities. As a result, less money is available with people. But how does this affect growth and inflation?
To know the answer, we need to understand the intricate relationship between money, GDP growth and inflation. Think of it like this. By restricting money supply, the central bank is, in fact, restricting the upper limit for the value of the country’s nominal GDP.
Nominal GDP, as you are aware, is measured by adding the present market value of all goods and services without making any adjustment for inflation. Two factors determine the size of nominal GDP—actual increase in output and inflation.
The nominal GDP of a country can keep on increasing thanks to inflation even without any increase in the output. But there is a limit. Prices of goods and services ultimately can’t exceed the amount of money that is available with people. People can buy goods at a particular price only when they have money in their pockets. More money encourages people to bid up the prices of the same amount of goods and services, which would show an increase in the value of nominal GDP.
Less money has the opposite effect. People stop buying at higher prices. But, the prices do not start falling immediately. Instead, less money first of all affects real output.
Johnny: Why? Tighter monetary policy should immediately lead to a fall in prices. Why instead does it lead to a fall in the real output?
Jinny: In the realm of money, nothing follows a straight line. Suppose the real output growth is 4% and inflation rate is 6%. Then your nominal GDP would grow by 10%. To support a nominal GDP growth of 10%, we need at least a 10% growth in money supply.
What happens if the money supply is growing by only 8%? In such a scenario, either real output or prices would have to decline by 2% to make adjustments for the squeeze in money supply. But which one of the two would decline first?
Actual experiences show that it is real output which declines first. The reason is not difficult to understand. The roots of inflation extend far beyond the simple arithmetic of money supply. It is deeply embedded in the psychology of people, or what economists call “inflationary expectations”.
If the prices have been rising recently, people tend to believe that they would continue to do so in the near future also. The result is that people ask for higher prices for whatever goods and services they are producing. More prices for raw materials, more wages for workers and more prices for finished goods.
Once the prices start moving in a circle, it is difficult to break the spiral. You can’t convince anybody to take less when they are expecting more. But ultimately it is the money supply that finally determines how far we can go on increasing prices.
Johnny: Tell me, how do prices finally fall?
Jinny: People would soon discover that the prices of all goods and services are far more than the money in their pockets. If an economy is producing only four goods priced at Rs10 each, then people need at least Rs40 to be able to buy all of them.
What happens if people have got only Rs30? One of the goods would remain unsold unless the producers decrease prices. But beyond a certain limit, producers can’t decrease the price unless wages and costs of raw materials also come down.
The simple option is to produce less. Produce only three goods priced at Rs10 each when people have only Rs30 in their pockets.
As a natural outcome of a decrease in output, producers start consuming fewer raw material and hiring less people. Soon the clock unwinds. Workers start accepting employment even at lower wages, suppliers start asking for lower price for their raw material. This is how prices start moving downward.
Johnny: Thanks, Jinny, for explaining all this. Hitting at the owl is actually risky when the canary is perched on it.
What: Apart from controlling inflation, instruments of monetary policy also affect GDP growth.
How: Instruments of monetary policy control money supply, which in turn affects both Inflation and GDP growth.
When: Prices start falling after a slowdown in economic growth.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Oct 19 2008. 10 08 PM IST