That sinking feeling

Inflation is a natural result when demand is in excess of supply in the long run. In India, the previous few months have shown a spurt in prices, particularly in consumer goods. A second successive poor monsoon coupled with unseasonal heavy rain in South India does not offer hope for bountiful production of food items. Hence, a rebound in inflation is on the cards.

A natural question that comes to mind is whether the inflation rate has any welfare cost for individuals. Individuals by and large care more about real magnitudes of inflation particularly when it is a regular feature. Theoretically speaking, there is only one variable, market-determined interest rate, which takes different values for different rates of money creation and inflation.

The value of real money stock depends negatively on the prevailing inflation rate. It can also be suggested that inflation rate generates anti-welfare effect for the holders of small real balances of money. Even domestic savings for a nation goes on declining in terms of commodities and services and consequently diminishes the welfare of people particularly those who are in lower or fixed income brackets.

When there’s inflation individuals behaving as economically rational beings would prefer not to hold money. Moreover, nominal income/money on hand loses value at the rate of inflation.

Inflation does not reduce the volume of monetary services but dilutes the welfare of holders of money. Further, inflation also imposes a cost by bringing about a lower level of real money holdings of government.

Moreover the welfare impact of benefit transfers to individuals and households also gets eroded by inflation.

Inflation reduces not only the real balances of individuals but those of government also on account of rise in government expenditure on goods and services. In real terms inflation diminishes capital formation in the government sector, and in turn government’s demand for capital goods from private sector also declines due to inflation.

There are innumerable distributional effects of inflation, such as wealth losses for the lender and wealth benefits for borrowers. But the real damage is done when inflation hits food articles and basic raw material. Food and raw material inflation tends to generate cost inflation in manufacturing sectors and engulfs the whole economy.

Inflation is a curse which harms the welfare of both individuals and the economy. The government needs to be particularly wary of food inflation. Here, the role of the government should be to undertake short term and long term steps to increase the supply of food items.

The writer is a former Economic Advisor to SEBI

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