The Hindu Business Line : Understanding inflation

I have some exciting news fresh from the mysterious vaulted chambers of the Ministry of Statistics and Programme Implementation, New Delhi. The inflation rate in our country has come down to a measly 3.52 per cent over the last 12 months as against a whopping 5 per cent expected by the Reserve Bank of India.

And boy am I relieved! This drop in inflation has far reaching implications for our economy, all of which you young managers must be well aware of due to the extreme focus and discipline you exercised during your macroeconomics classes at business school.

Ha ha! What a fun joke that was!

So without further ado we will leap headfirst into the tumultuous world of inflation and all the associated economic fundas and principles.

First of all, inflation, in its most basic sense, explains one of the most fundamental tenets of life: Most ambitious MBA managers find out as soon as they start working that they begin to put on weight like one of those caterpillars on Discovery. You know, the types that eat several times their body weight each day till one day they miraculously transform into — nature is glorious indeed — breakfast for a pigeon.

Whoa! Whoa! Wrong inflation!

No, I’m talking about the inflation that is a measure of how prices for regularly consumed commodities rise and fall over a period of time. It is a fundamental fact of life that prices for everything we use almost always rise over a period of time unless Chinese imports are allowed.

For instance, ask your grandparents how much they paid to rent their palatial two-bedroom apartment downtown in 1975. They will mention some ridiculously small number in the region of Rs 10 a month.

Inflation describes the mechanics of these price rises and then, since this alone is so fundamentally simple to understand, economists connect it to other complex elements in the economy such as money supply, interest rates and global warming. Suddenly, everything is so confusing and people are winning Nobel Prizes.

Let’s move on and understand inflation in greater detail.

Schools of thought

First of all, there are two, you guessed it, economic schools of thought when it comes to the causes of inflation. The first is the monetarist school of thought that believes that all economic activity can be described in terms of money supply. According to them, if the supply of money is greater than the demand for money, this gives rise to inflation.

This has never happened in my life so far.

(Warning: In order to avoid confusion, I am overly simplifying the economics in this fortnight’s column. What you are reading right now is akin to describing nuclear weapons as follows: Boom!)

For a long time, economists were cool with this simple idea of inflation till it suddenly occurred to some of them that there was a serious flaw with the monetarist theory: Potential to be understood by normal people.

They immediately rectified it by coming up with a new school of economic theory known as the Keynesian school named after the famous economist John Maynard Keynes who once famously said: “In the long run, we are all dead.” He was not quite the life of the tea party, if you know what I mean.

The Keynesian school states that money supply in addition to interest rates and output (of something or the other which I will not detail now) all add up to causing inflation. Also, and I cannot reiterate this enough, a central conclusion of Keynesian economics is that there is no strong automatic tendency for output and employment to move toward full employment levels.

In the ‘neoclassical synthesis’, which combines Keynesian macro concepts with a micro foundation, the conditions of General Equilibrium allow for price adjustment to achieve this goal. Phew!

This new definition was a triumph for economists everywhere because anyone without a PhD in Economics nodded along as they heard this theory and then requested a bathroom break from whence they never returned. By this time Nobel prizes were being flung around like confetti in a confetti-flinging contest.

Suddenly, there was increased interest in Economics at a scale never seen before. Universities opened departments all over the world, economists where being hired in droves and everyone lived happily ever after.

But that is not the point of this column. In fact, I encourage you to e-mail me the point of all this when you find it. Meanwhile, I continue relentlessly.

Now first of all, a drop in inflation means that prices of several commodities are dropping. Which does not mean that you should immediately go out and do your shopping now while inflation is low. No, Sir. This is because inflation is measured in shops where these goods are sold, but which are not open to the public — you and me.

It is measured in outlets secretly operated and observed by the people at the Ministry of Statistics and Programme Implementation. (Black suits, dark glasses and armed with lethal scientific calculators with graphing functions.)

Price index

A word is due here about what this 3.52 per cent and 5 per cent means. The MOSPI measures inflation on a periodic basis by using what is known as a ‘price index”. This is a weighted index of the prices of various commodities. The price of this basket of goods is measured over a period of time and the rise and fall of the total price is what is reported as inflation.

This means that even if inflation falls significantly over a period of time, you may not save too much money because the drop in inflation could be entirely due to a fall in the prices of nuclear reactors.

So inflation can be a little confusing if we don’t look at it closely. A prolonged and detailed scrutiny of the overall inflation in the economy reveals both the subtle mechanics underlying price movements and the fact that you need to go out a little more and meet new people.

Now that our fundas on inflation are crystal clear, we move on to understanding the impact of this on our daily lives.

First of all, inflation has an effect on interest rates. If inflation goes up a lot, the RBI tends to jack up interest rates.

In addition to this, there is a tendency for exchange rates to move as well. Some of you may have noticed that the rupee-dollar exchange rate has become very low in the recent past. This will make many of you young managers very happy and patriotic. Which is a good thing as many of you in the software industry are possibly being fired as we speak. Other things also mysteriously happen because of inflation. People tend to swap cash for other valuables like gold. In fact, there is currently a huge demand for gold in the Indian market and most of it from my wife alone.

And let’s not even get into the impact of inflation on FDI inflows which, I have been told, are “huge”.

So there. In a remarkably short time, we have learnt so much about inflation and various economic schools of thought.

Feel free to use them in your workplace. Throw those names around a little. Let people know you’re smart and well informed. See you all next fortnight.

(The writer, an alumnus of IIM-A, was a management consultant before quitting to work as a freelance writer, author and general handyman. He blogs at www.whatay.com)

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