Young Investor

How much inflation do you need?

Adarsh Gopalakrishnan | Updated on September 03, 2011


Ever wondered why that large bar of chocolate you paid Rs 5 for as a kid now costs Rs 15 ? Economists have a word to describe why your Rs 100 note buys you a little less with every passing year: inflation. Much like a dose of medicine, inflation in small amounts can save an economy but can collapse one in larger doses.

Imagine a country named Harmony-Ville, whose economy is growing at a decent clip - its inhabitants, who produce all that they require within its borders, are generally content with their standard of living. Prices remain stable as producers and consumers are clued into roughly how many more cars, shoes, shirts, steel or oil they might need.

The rulers and bankers of this young, wholly integrated economy anticipate that things will chug along at three per cent a year - everyone and everything in the economy will be paid or will be worth three per cent more with every passing year. This way no one feels richer or poorer with every passing year. After all, in an economy with such prescience and little uncertainty, things remain blissful and its inhabitants pleased with their rulers who maintain the law.

One day, the country's key oil well hits a snag and is forced to shut down for a bit. The rulers decide not to panic and request everyone to go easy on the oil consumption over the next month. But the common man finds it difficult to do without his daily quota of crude oil. Each person continues claiming his share assuming that other people are giving up theirs and hence his consumption won't make a significant difference. Cumulatively, everyone is now consuming more than the well is producing. With the oil rig still out of order and judging that no one's really abstaining from using it, the rulers decide to allow the oil producers break the ‘three per cent hike' rule just once this time with just this one product. This, they hope will push their inhabitants to consume crude with a little less vigour.

However, the rulers overlook one of the several spill-over effects of higher crude prices: Expensive fertilizers. To add to their woes, quite a few farmers are unable to produce as much wheat as they did a year ago as their fields are parched. They have been eking out grain year after year, living off the modest profits. But now they find themselves paying a little more for fertilizers while not producing as much grain. They rush to the rulers, who decide to break the three per cent rule just one more time. The hike of wheat prices turns out to be enough for farmers now get to earn a little bit more than they were a year ago.

Unaccustomed to paying more for their crude oil and food, people find themselves on the back foot. They are not saving as much as they used to and the kitchen shelves are not as well-stocked. In their despair, a few inhabitants band together and decide to ask the government for a raise in their three per cent to cope with the tough times. The government decides now is when we need to draw the line and say no to this three per cent hike. The aggrieved inhabitants are now depressed. They are not saving as much and are spending more on commuting and essential commodities than they did a year ago.

This sparks of an unusual trend. The inhabitants believe that the wheat and crude oil will be back to their usual prices next year, and decide not to eat or travel as much as last year. The oil producers and farmers now notice that they are sitting on more crude and wheat in their storage than they'd like to. So, they decide to cut prices in the hope that people will eat and travel more. But this doesn't have its desired effect as people are convinced that things will get even cheaper. They sit on their money and decide to wait. The crude-producers and farmers are now panicking! One of the farmers tried to sell his farm and got a rate which was far lower than what his neighbour paid a year ago. So what we now have are unhappy inhabitants who are convined their standard of living has dropped, farmers and oil producers who can't seem to discount their produce enough to get people to buy it. The rulers are promptly asked to leave their thrones.

In real life

Inflation as initially witnessed in the story can be a good thing provided all parties involved have an idea of how much more expensive life can get in the coming years. This allows employers to pay their employees a little bit more and prices their products accordingly. Lenders also know how much they can afford to lend at and what is the right amount to pay their depositors. This rather delicate balance is easily disrupted though, as witnessed when oil-production and wheat-output is hit. The danger lies in how quickly rising prices of one product can spill over into the rest of the economy.

Inflation works much like a self-fulfilling prophecy. With rising prices lead to a series of hikes in wages, input costs and associated businessesIndia, China, Brazil among other developing economies see prices rise every year at moderate rates. This is due to the inability to ramp up the output of certain goods and services or managing resources inefficiently. A low confidence level in the government's ability to regulate things can make this condition worse as witnessed with a severe form of inflation (hyperinflation) in economies such as Zimbabwe over the last five years.

The fickle nature of the confidence or lack of it, which drives prices up can also leave people drained of confidence and push them to consume less. Negative inflation implies that price levels of goods and services are dropping. A prolonged spell of dropping prices leave people sceptical as to whether the assets and companies producing those goods ought to be worth as much. This leads to a downward spiral in prices of land and machinery among other items. This phenomenon is known as deflation and can lead to as much trouble as high inflation can. Japan's inhabitants are saving money and are unwilling to fall for government incentives to kick-start consumption. The Japanese are convinced that things can get cheaper and be snapped up at lower prices. The problem is if enough people believe this, things will and can never get cheap enough.

Published on September 03, 2011

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