The Story Behind Inflation

Kripananda Chidambaram, 09 Jan 2010

Inflation is about money supply. If the government prints more money, or if the money goes around faster in the economy, there is inflation. Sometimes, not enough goods are produced (like due to the monsoon failure of 2009). So the same money ends up chasing too few goods, and there is inflation again. This last is called supply-side inflation. The government often tries to blame most episodes of inflation to supply side, and claim that these things are beyond its control. However, the fact is that inflation is nearly always a money-supply issue.

Why does the Government print more money?

This happens when it has borrowed too much, and cannot figure out a way to pay back. So Government being what it is, gets out of the hole by printing Rupees, and making all of us poorer in the process (since our money has lost some purchasing power). Of course, the Government cannot do this recklessly, since that would put prices on an uncontrollable spiral.

Why does the money go around faster?

This brings us to interest rate, which is an important determinant of how fast money goes around. If the interest rate is low, there is more incentive to borrow and utilise the money for economic activity. Banks lend, households or businesses borrow, deploy the money and the cycle is completed faster. On the other hand, a higher interest rate discourages this entire cycle by acting as a barrier to borrow in the first place.

The Reserve Bank of India uses this mechanism to control how fast money goes around. If inflation is rising, it raises rates and tries to apply brakes. Vice versa if inflation is low and no economic activity is to be seen. This action is constitutes monetary policy.

We can also see here the conflict - any businessman would want rates to be low. He too is affected by inflation, but he is much more directly affected if its borrowing is too costly. Government is another borrower, so it too would like rates low. Most households on the other hand, are much more worried about inflation - they would like low inflation, even if it means high rates. RBI needs to proactively manage this conflict. When it fails, one side gains at the expense of the other (currently it is business gaining at the expense of households, and hence the support for the Bandh).


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