Inflation for dummies (in context of India)

by Sakshi Rai

Posted on September 26, 2020

One of the most influential figures in the history of Modern Economics, John Maynard Keynes said, “By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” Let’s discover inflation and answer the question: Is this a necessary evil? Inflation refers to an increase in average price levels of goods and services in an economy over a period of time. It causes a rise in the cost of living and a decline in the value of money. It is often dubbed as the phenomena of “Too much money chasing too few goods.” The famous American baseball player Sam Ewing put it this way: “Inflation is when you pay fifteen dollars for the ten dollar haircut you used to get for five dollars when you had hair.” For example, earlier Rs 1000 bought us 100 goods which translates into Rs 10 per good. This was followed by RBI printing and circulating Rs 200 into the economy. Now Rs 1200 chase 100 goods in the economy i.e. Rs 12 per good. The surge of Rs 2 per good is the inflation in this case. Inflated prices lead to lesser money left in the pockets of the people. It reduces the real value of money and the purchasing power of the consumer in an economy and also depreciates the value of your savings.

The cause of inflation can be broadly bifurcated into two types: Demand Pull and Cost Push Inflation. Demand Pull Inflation occurs when there is an increased money supply in the economy due to excess demand by consumers. Lower rates of Demand Pull inflation are preferred in an economy because it boosts growth by encouraging production to meet the excess demand in the market. However, it is also detrimental in the sense that it reduces the value of your savings and affects disposable income of individuals in the economy. Under Demand pull inflation, India is battling on many fronts. A major contributor to this type of inflation is the deficit financing taken up by the government. RBI has frequently increased the supply of money in the economy by deficit financing This act of printing more money has led to an influx of money in the economy and has increased the money supply. This resulted in improved purchasing power of the consumer and they started demanding more goods and services.This condition of excess demand in the Indian market creates demand pull inflation in the market.

India also has large reserves of black money hoarded up abroad in tax havens. Black money is the undocumented money hidden from tax administartion of a country. It is estimated to be around $1.06 - $1.4 trillion and routinely affects the functioning of the economy. Another peril at bay is the growth of unregulated transfer of money under the table. This is called the Hawala economy, a form of underground banking. The problem with this form of alternative remittance channel is that the details of transactions are maintained in informal journals. Since it provides anonymity in transactions, it often goes unregulated. The Hawala economy increases money supply without the government being able to quantify its contribution and is a major cause of inflation in the status quo. Depreciation of currency also acts as a leading cause of inflationary pressure on the economy. Trends show that Indian Rupee has constantly slumped against the dollar which is equally true for most of the currencies in the world. A similar trend was observed during the global financial crisis of 2008-09 when people started hoarding the most important bonds, yields and the US currency to safeguard themselves. This is a recurring trend in the past 2-3 years as well. This excess demand for US dollars weakens the currencies of other countries- India being one of them. Nevertheless, it becomes imperative to understand how depreciated currency sets off a trail of inflationary shockwaves in the economy.

What has been the ramifications of depreciation of Indian Rupee?

Earlier for importing goods, you paid Rs 60 for each dollar. Now, the same quantity of imported goods make you spend Rs 74 per dollar. This has reduced imports in our country since it is costlier to import goods now. On the other hand, exports see a boost in the economy because every dollar fetches you more benefit than before. This creates an imbalance in the economy because imports are continuously decreasing and exports are experiencing a surge. This creates an inflationary gap and adversely affects the national income. The second type of inflation is Cost Push Inflation. It occurs when there is a reduction in supply of goods in an economy. This happens due to a surge in cost of production which makes it costly for producers to produce and supply goods. This type of inflation is extremely undesirable because it always leads to contraction of national income. Indian economy has faced cost push inflation due to an increase in prices of inputs. Inputs in production include land, labour, capital and entrepreneurship. Post demonetisation, real estate has seen a downward sloping curve. The collapse has been attributed to increased cost of financing and stringent and complicated regulatory mechanisms in India. Adding to this, the covid-19 crisis has reduced the demand for office spaces. Dearth of investors have made real estate charge exorbitant prices from industries to survive and maintain breakeven. The pandemic has also created a situation of labour scarcity because many have migrated to their villages to avoid spread. A major contributor to this type of inflation is the illegal hoarding and speculation which disrupts the flow of goods in an economy and reduces supply. The previous decade saw an excessive fluctuation in the price of crude oil owing to a variety of reasons. This included hostile international relations between Arab countries (which hold large reserves of natural resources) with the rest of the world. There was an internal tussle in the Middle East due to a proxy war between Saudi Arabia and Iran, two important dealing partners of India and humanitarian crisis in Syria and Yemen. Naturally, India had to bear the repercussions of this conflict as well. It had to pay inflated prices for procuring crude oil. Government identified a need to offset the inflated prices by introducing fiscal stimulus at the start of the previous decade. It had two salient features: Tax deduction and increase in government expenditure. Though these steps provided some relief to the targeted population, it also led to inflation due to excessive money supply.

At this point, it becomes imperative for us to analyse the consequences of inflation. It has affected the Indian economy severely. India's gross domestic product or GDP contracted by a whooping 23.9 per cent in the April-June period of 2020 as compared to the same period in 2019. This magnitude of real GDP drop is unprecedented since the country started publishing quarterly GDP estimates in 1996. This has triggered a prospective economic disaster as the coronavirus pandemic brought key industries to a halt and rendered millions of people jobless. Unemployment Rate in India averaged 9.21 percent from 2018 until 2020, reaching an all time high of 23.50 percent in April of 2020. This has pushed a huge section of the population into the vicious cycle of eternal poverty and vulnerability. It has eroded the purchasing power of the people. Inflation coupled with the pandemic has waged wars at many fronts for the common man to withstand: increased cost of borrowing, dwindling savings, greater uncertainty about the future and social unrest.

How to fix this?

Policy measures can be roughly bifurcated into: Monetary and Fiscal Policy Measures The first set of policies are called monetary policy. They are used to reduce money supply to curb inflation and are implemented by the Central Bank, RBI in case of India.We use Contractionary Monetary Policy in India. Some measures used by RBI include- increasing Cash Reserve Ratio, Statutory Reserve Ratio, Bank Rate, Repo Rate and Reverse Repo Rate to regulate money supply in the economy. All of them aim towards making money dearer i.e. reducing disposable income so that aggregate demand is reduced in the economy and the situation of excess demand which increases money supply, is curbed effectively. The second set of policies are called Fiscal Policies. It refers to revenue and expenditure policy implemented by the government and deals with the finances of the public treasury. It is also called budgetary policy and released by the finance ministry. Tools of fiscal policy at State Level includes: Increasing Taxes (Direct or Indirect), Decrease in Government expenditure or public spending, reduction in borrowings to curb the reduction in supply and combat inflationary pressure. Anti Hoarding Law: The Essential Commodities Act is an act of Parliament of India which was passed to ensure the delivery of certain commodities or products, the supply of which if obstructed owing to hoarding or blackmarketing would affect the normal life of the people. This includes foodstuff, drugs, fuel (petroleum products) etc. Regulation of Hawala economy: It is important to tap the undocumented market. Without being cognisant of how much money remains undocumented in the economy, it becomes extremely difficult for Central Bank and the government to formulate policies to effectively control inflation. The most baffling question remains: Is inflation always bad? Not necessarily, if your wages rise faster than inflation, your effective purchasing power will still increase. A moderate level of inflation is often preferred by financial institutions to push for economic growth. Finally, this piece of writing was aimed towards covering the causes and consequences of inflation in India in the past 2-3 years and discussing policy measures that should be implemented to maintain stability in an economy which is prone to snowball into an inflationary disaster, if not done so.


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Sakshi Rai, SSCBS

She is currently pursuing Bachelors in Management Studies from Shaheed Sukhdev College of Business Studies, University of Delhi. She heads the editing department for The CBS Post, official newsletter of SSCBS. She is also a columnist and has written several opinion pieces covering multiplicity of topics. She enjoys debating and has participated at various tournaments. A hardcore Tharoor fan, she likes to read books on Indian subcontinent and its culture with a special liking towards politics and international relations.