Ask Mint | Inflation revisited: causes, effects and a ready reckoner on basic terms and facts

Ask Mint | Inflation revisited: causes, effects and a ready reckoner on basic terms and facts
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First Published: Mon, Jul 21 2008. 10 38 AM IST

(Illustration: Jayachandran /Mint)
(Illustration: Jayachandran /Mint)
Updated: Mon, Jul 21 2008. 10 38 AM IST
Whenever we talk about inflation, everything seems to be a repeat of the past. The script has all the obvious elements: price shocks, excess money supply, declining output, monetary tightening, fiscal measures, et al. Grown-ups have seen many such phases of ups and downs. But kids born in the last 10 years are seeing double-digit inflation for the first time in their lives. So let’s put together some of the basic terms associated with inflation that will serve as a ready reference for all time.
Jinny: Wherever I go these days, I see inflation-hit faces. What to say of kids, even some of our older folks are looking utterly confused. Many of them seem to have blissfully forgotten the old lessons.
Johnny: I think, Jinny, it’s the right time to repeat the old lessons. Tell me the most basic thing first: What do we mean by inflation?
Jinny: Inflation is defined as an increase in the general level of prices of goods and services from one period to another (generally one year). It is measured in terms of per cent change in the value of a price index consisting of a basket of goods and services. An inflation rate of 10% means that the general level of prices of goods and services has increased by 10% over the period. In other words, it means that for purchasing the same amount of goods and services, you have to pay 10% more money.
(Illustration: Jayachandran /Mint)
But, you may ask, why do prices increase year after year? Can’t we have constant prices over a period? Or better still, can’t we make prices actually fall from one period to another? Well, the prices of goods and services in a free market are determined by the forces of demand and supply. So you can’t have constant prices unless your demand and supply remain constant. Generally, it is observed that demand increases faster than the supply of goods and services, leading to increases in prices of goods and services over a period.
However, in unusual times, when demand is slacking, you may actually observe a fall in the general level of prices, which in technical terms is called deflation. This is the opposite of inflation.
Is that good for the economy? No. Both high inflation and deflation adversely affect the economy. It is believed that moderate inflation over a period of time is good for the economy because it encourages producers to increase output.
However, an unexpectedly high increase or fall in prices has the opposite effect. High inflation reduces the purchasing power of the money in the hands of people, leading to a decline in aggregate demand in the economy, which compels producers to decrease output.
Falling prices, on the other hand, make production of additional goods non-lucrative and so encourage producers to voluntarily cut their output.
J ohnny: So, the problem of inflation is actually a problem of unexpectedly high increases in prices. Now tell me, how is cost-push inflation different from demand-pull inflation?
Jinny: Demand-pull inflation is caused by excess money leading to an increase in aggregate demand in the economy. It is a case of “too much money chasing too few goods”. Aggregate demand includes both consumption and investment.
This kind of inflation is best controlled by monetary measures such as high interest rates and asking banks to maintain high cash reserves, which act as brakes on money supply.
Cost-push inflation, on the other hand, is caused by supply-side constraints. The high cost of labour or raw materials may force producers to increase the prices of their goods and services. High crude oil and food prices are examples of supply shocks leading to unexpected increases in prices of other goods and services. This kind of inflation requires more careful use of monetary and fiscal measures.
Johnny: Economists talk about core and headline inflation. Now what are these?
Jinny: Headline inflation is most commonly represented by a price index consisting of a basket of different goods and services. Core inflation is what we get after removing volatile elements such as oil and food from this basket of goods and services. So, headline inflation is often higher than core inflation.
Johnny: I often hear that inflation hurts the old and the poor the most. How does inflation affect our lives?
Jinny: Well, how inflation is going to affect you depends on where you are placed. People living on fixed incomes, such as retirees, feel the pinch more. Inflation eats away the value of their fixed income day by day.
A person living on borrowed money is probably better off because inflation decreases the real value of the debt if the inflation rate is higher than the interest rate. Today, you can have breakfast and lunch with the borrowed money.
But tomorrow, when you pay back the money, your lender realizes that he can only buy breakfast with the same amount of money. Uncertainty about the future always hurts economic growth.
Johnny: That’s true, Jinny. We need to save our kids from the uncertainty of inflation.
What: Inflation is defined as an increase in the general level of prices of goods and services from one period to another.
How: Demand-pull inflation is caused by increase in aggregate demand in the economy whereas cost-push inflation is caused by supply-side constraints.
Why: High inflation reduces the purchasing power of money, leading to a decrease in aggregate demand, which slows 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: Mon, Jul 21 2008. 10 38 AM IST