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Is Inflation good for the Economy?

Inflation: Good or Bad

In a healthy economy, prices tend to go up – a process called inflation. While you might not like that as a consumer, moderate price growth is a sign of a healthy, growing economy. And, historically at least, wages tend to go up at about the same pace during periods of inflation.

Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over some period of time. It refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc. It is the rise in the general level of prices where a unit of currency effectively buys less than it did in prior periods. Often expressed as a percentage, inflation thus indicates a decrease in the purchasing power of a nation’s currency.

Inflation is and has been a highly debated phenomenon in economics. Even the use of the word "inflation" has different meanings in different contexts. Many economists, businessmen, and politicians maintain that moderate inflation levels are needed to drive consumption, assuming that higher levels of spending are crucial for economic growth.

The RBI typically targets an annual rate of inflation for the economy, believing that a slowly increasing price level keeps businesses profitable and prevents consumers from waiting for lower prices before making purchases. There are some, in fact, who believe that the primary function of inflation is to prevent deflation.

Others, however, argue that inflation is less important and even a net drag on the economy. Rising prices make savings harder, driving individuals to engage in riskier investment strategies to increase or even maintain their wealth. Some claim that inflation benefits some businesses or individuals at the expense of most others.

Who measures Inflation in India?

Inflation is measured by a central government authority, which is in charge of adopting measures to ensure the smooth running of the economy. In India, the Ministry of Statistics and Programme Implementation measures inflation.

How is Inflation measured?

In India, inflation is primarily measured by two main indices — WPI (Wholesale Price Index) and CPI (Consumer Price Index), which measure wholesale and retail-level price changes, respectively. The CPI calculates the difference in the price of commodities and services such as food, medical care, education, electronics etc, which Indian consumers buy for use.

On the other hand, the goods or services sold by businesses to smaller businesses for selling further is captured by the WPI. In India, both WPI and CPI are used to measure inflation.

Causes of Inflation

Rising prices are the root of inflation, though this can be attributed to different factors. In the context of causes, inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.

Demand-Pull Effect

Demand-pull inflation occurs when the overall demand for goods and services in an economy increases more rapidly than the economy's production capacity. It creates a demand-supply gap with higher demand and lower supply, which results in higher prices. For instance, when the oil producing nations decide to cut down on oil production, the supply diminishes. This lower supply for existing demand leads to a rise in price and contributes to inflation.

Additionally, an increase in money supply in an economy also leads to inflation. With more money available to individuals, positive consumer sentiment leads to higher spending. This increases demand and leads to price rises. Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, or by devaluing (reducing the value of) the currency. In all such cases of demand increase, the money loses its purchasing power.

Cost-Push Effect

Cost-push inflation is a result of the increase in the prices of production process inputs. Examples include an increase in labour costs to manufacture a good or offer a service or increase in the cost of raw material. These developments lead to higher cost for the finished product or service and contribute to inflation.

Built-In Inflation

Built-in inflation is the third cause that links to adaptive expectations. As the price of goods and services rises, labour expects and demands more costs/wages to maintain their cost of living. Their increased wages result in higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.

Theoretically, monetarism establishes the relation between inflation and money supply of an economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and especially silver flowed into the Spanish and other European economies. Since the money supply had rapidly increased, prices spiked and the value of money fell, contributing to economic collapse.

Is Inflation bad for everyone?

Inflation is perceived differently by everyone depending upon the kind of assets they possess. For someone with investments in real estate or stocked commodity, inflation means that the prices of their assets is set for a hike. For those who possess cash, they may be adversely affected by inflation as the value of their cash erodes.

Reasons Why Inflation Is Good

Inflation is good when it is mild. There are two situations where this occurs. The first is when inflation makes consumers expect prices to continue rising. When prices are going up, people want to buy now rather than pay more later. This increases demand in the short term. As a result, stores sell more and factories produce more now. They are more likely to hire new workers to meet demand. It creates a virtuous cycle, boosting economic growth.

The second is when it removes the risk of deflation. That’s when prices fall. When that happens, people wait to see if prices will drop more before buying. It cuts back demand, and businesses reduce their inventory. As a result, factories produce less and lay off workers. Unemployment rises, leading to wage deflation. Workers have less money to spend, which reduces demand even more. Businesses lower their prices. That makes deflation worse. For this reason, deflation is even more corrosive to economic growth than inflation. 

Deflation (a fall in prices – negative inflation) is very harmful. When prices are falling, people are reluctant to spend money because they feel that goods will be cheaper in the future; therefore, they keep delaying purchases. Also, deflation increases the real value of debt and reduces the disposable income of individuals who are struggling to pay off their debt. When people take on a debt like a mortgage, they generally expect an inflation rate of 2% to help erode the value of debt over time. If this inflation rate of 2% fails to materialise, their debt burden will be greater than expected. Periods of deflation caused serious problems for the UK in 1920s, Japan in 1990s and 2000s and Eurozone in 2010s.

Moderate inflation enables adjustment of wages. It is argued a moderate rate of inflation makes it easier to adjust relative wages. For example, it may be difficult to cut nominal wages (workers resent and resist a nominal wage cut). But, if average wages are rising due to moderate inflation, it is easier to increase the wages of productive workers; unproductive workers can have their wages frozen – which is effectively a real wage cut. If we had zero inflation, we could end up with more real wage unemployment, with firms unable to cut wages to attract workers.

Inflation enables adjustment of relative prices. Similar to the last point, moderate inflation makes it easier to adjust relative prices. This is particularly important for a single currency like the Eurozone. Southern European countries like Italy, Spain and Greece became uncompetitive, leading to large current account deficit. Because Spain and Greece cannot devalue in the Single Currency, they have to cut relative prices to regain competitiveness. With very low inflation in Europe, this means they have to cut prices and cut wages which cause lower growth (due to the effects of deflation). If the Eurozone had moderate inflation, it would be easier for southern Europe to adjust and regain competitive without resorting to deflation.

Inflation can boost growth. At times of very low inflation, the economy may be stuck in a recession. Arguably targeting a higher rate of inflation can enable a boost in economic growth. This view is controversial. Not all economists would support targeting a higher inflation rate. However, some would target higher inflation, if the economy was stuck in a prolonged recession.

The only thing worse than inflation, joke economists, is deflation. A fall in prices can cause an increase in the real debt burden and discourage spending and investment. Deflation was a factor in the Great Depression of the 1930s.

When Is Inflation Good for the Economy?

When the economy is not running at capacity, meaning there is unused labour or resources, inflation theoretically helps increase production. As they say, one man’s expense is another man’s income. More money translates to more spending, which equates to more aggregated demand. More demand, in turn, triggers more production to meet that demand.

British economist John Maynard Keynes believed that some inflation was necessary to prevent the Paradox of Thrift. Which says, if consumer prices are allowed to fall consistently because the country is becoming too productive, consumers learn to hold off their purchases to wait for a better deal. The net effect of this paradox is to reduce aggregate demand, leading to less production, layoffs, and a faltering economy.

Inflation also makes it easier on debtors, who repay their loans with money that is less valuable than the money they borrowed. This encourages borrowing and lending, which again increases spending on all levels. Perhaps most important to the Federal Reserve is that the U.S. government is the largest debtor in the world, and inflation helps soften the blow of its massive debt. 

Economists once believed an inverse relationship existed between inflation and unemployment, and that rising unemployment could be fought with increased inflation. This relationship was defined in the famous Phillips curve. The Phillips curve was largely discredited in the 1970s when the U.S. experienced stagflation.

Why low inflation is bad?

Very low inflation usually signals demand for goods and services is lower than it should be, and this tends to slow economic growth and depress wages. This low demand can even lead to a recession with increases in unemployment – as we saw a decade ago during the Great Recession.

Deflation, or falling prices, is particularly bad. When prices are decreasing, consumers will delay purchases. For example, why buy a new washing machine today if you could wait a few months to get it cheaper?

Deflation also discourages lending because it leads to lower interest rates. Lenders typically don’t want to lend money at rates that give them a very small return.

And too much can be even worse

But getting the balance right isn’t easy. Too much inflation can cause the same problems as low inflation.

If left unchecked, inflation could spike, which would likely cause the economy to slow down quickly and unemployment to increase. The combination of rising inflation and unemployment is called “stagflation,” and is feared by economists, central bankers and pretty much everyone else. It’s what can cause an economic boom to suddenly turn to bust, as Americans saw in the late 1970s.

A balancing act

So returning to the current situation, the RBI has to tread carefully.

Cutting interest rates now should boost the Indian economy but risks driving up inflation beyond “healthy” levels. If the central bank does nothing, inflation may fall as economic growth slows. Either path could lead to a recession.

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