Inflation
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once again there is crr hike looming on the stock markets fate on monday. there is raise in repo rate and banks have already increased their prime lending rates; the bank adr's have fallen up to 7% overnight here in new york. there have been talks of all kind of nonsense along with this since the indices have not been going up lately, much to the discomfort of everyone here in this group (including me) who is very much used to gain a percent or two every day or week and just keep making returns in the last 3-4 years. there is a reason why there is inflation and why the reserve bank wants to fight it. i know it's a very informative and will surely make sense in this scenario. please read on. what is inflation? inflation is a process of continuous increase in the prices of most goods and services in a country. this does not necessarily mean that all prices increase. there may be some exceptions, such as computer prices which have actually declined in recent years. inflation can therefore be described as a persistent general increase in prices. how inflation is measured? inflation is measured by defining a basket of goods and services used by a "typical" consumer and then keeping track of the cost of that basket. t his is a chart of trend of gross domestic product and foreign trade of india at market prices estimated by ministry of statistics and program implementation with figures in millions of indian rupees. year gross domestic product exports imports us dollar exchange in (rs.) inflation index (2000=100) 1950 99,340 4.79 1955 108,730 4.79 1960 171,670 4.77 1965 276,680 4.78 1970 456,770 7.56 1975 832,690 8.39 1980 1,380,334 90,290 135,960 7.86 18 1985 2,729,350 149,510 217,540 12.36 28 1990 5,542,706 406,350 486,980 17.50 42 1995 11,571,882 1,307,330 1,449,530 32.42 69 2000 20,791,898 2,781,260 2,975,230 44.94 100 2005 34,195,278 44.09 121 why is inflation bad? inflation is regarded as a bad process because it leads to distortions and problems in an economy. a short list of the key disadvantages of inflation includes the following: losses to savers: if you save your money by hoarding cash, inflation erodes the purchasing power of the amount saved. for instance, rs. 1000 put underneath a bed ten years ago can now purchase only one third of the goods and services that it could have done in 1987. even if you save in the form of savings deposits which pay interest, the interest may not be enough to compensate you in full for inflation. this also applies to pension planning, where a person may, for example, save for a pension during his entire working life, just to find at the end of his career that his savings have been eroded by inflation. losses to people with fixed incomes: people with fixed incomes (such as the interest on a fixed deposit, or a fixed salary) find that the purchasing power of their income diminishes over time. the wealthy, in contrast, can usually partly
protect themselves against inflation by investing in assets, such as shares or property, which increase in value during periods of inflation. inflation therefore leads to an increase in the disparity between the wealth of the "haves" and the "have-nots", or the rich and poor. losses to taxpayers: if your salary increases in line with inflation, and no adjustments are made to income tax, you will shift into a higher tax bracket and end up paying a larger share of your salary to the taxman. this means that government gains control over an increasing proportion of society's resources without formally getting the approval of parliament to raise taxes. confusing price signals to producers and slower expansion of businesses: a higher price for a product would usually indicate that people want more of it, that more profits can now be made from it and that more resources should therefore be employed to produce it. in times of inflation, however, an increase in the price of a product can occur either simply as part of the regular inflation related adjustments to prices, or because the demand for that product has risen permanently. entrepreneurs, not knowing which of the two kinds of price increases have occurred, may wait much longer before expanding their businesses and employing more resources in reaction to a permanent increase in demand. speculation crowding out production: an environment of high inflation and financial instability leads to more entrepreneurship and other resources being devoted to speculation in existing assets such as real estate, and less to expansion of production and employment. reduced attention to productivity: higher productivity is an important sustainable way of improving the overall standard of living in a country. in the absence of inflation, wage negotiations are focused on proper compensation to employees in accordance with improvements in their productivity. with high inflation, salary or wage increases consist overwhelmingly of compensation for inflation, and productivity issues become less important and may be neglected. wastage of resources: during very high inflation episodes have to be increased daily. a shop assistant, for example, may have the fulltime job of writing a new price on each item every day or updating a list of the prices of the various articles; the assistant would, without inflation, have been able to do more productive work, such as selling items to clients. the lower the inflation, the less time is spent on the re-pricing of items. heightened tension and social disruption: a society plagued devotes more energy to redistributive issues, in which case perpetually tries to gain or regain a better price, wage or destroys the fabric of society in a wider sense than simply the production of goods and services.
by high inflation each person or group position. this through its impact on
claims are often made by ill-informed people that inflation is not bad. they argue that higher inflation will stimulate economic growth. these claims are false. it is quite easy and inexpensive to print more money, thereby boosting inflation; even the poorest countries could do that. if this were the way to achieve economic prosperity, no poor countries would remain on earth. if money is printed to stimulate the economy it may work for a short period of time, but people will soon realize what is going on and instead of producing more they would simply start to increase prices and wages much more rapidly. in the end, the country would face high inflation with all the destructive and distortive effects outlined above, and would be certainly left with a weaker economy.
the reserve bank of india, like central or federal banks in most countries, is therefore strongly opposed to inflation, and uses its monetary policy to combat it. such policy action is not bad for continued economic growth, prosperity and a fair distribution of income and wealth. low inflation and a stable financial environment are indeed prerequisites for the achievement of these objectives on a sustainable basis. what triggers price increases? price increases can be triggered by many developments, such as: ? an increase in international oil prices; ? a fall in the exchange rate; ? a nationwide excessive salary and wage hike; or ? an increase in food prices and commodities etc. what sustains inflation? for a continuous rise in the general price level, the money supply has to keep on expanding. only with "too much money chasing too few goods" can the general price level continue to increase. it's proven that high rates of growth in the money supply in india in the past went hand in hand with high rates of inflation. the only effective way to contain inflation in the long run is therefore to restrict the growth in the money supply. the likely rate of increase in the quantity of goods and services which can be maintained without inflationary pressures is usually related to more labor, entrepreneurship and capital goods, and better skills, management and technology. growth in the money supply should accordingly be linked to sustainable growth in production. preventing excessive money supply growth is therefore a crucial element in combating inflation. but how is this done? how do you stop inflation? one approach would be to freeze all prices. many countries have attempted this over a long period of time. later attempts at directly controlling price increases also failed because all these controls addressed the symptoms, but not the cause. preventing excessive money supply growth the banks in india are indebted to reserve bank of india. although the amount of funds which they borrow from the rbi is small compared to the amount of funds which they obtain in the form of deposits, their borrowing from the rbi is important. this is because the rbi is the only supplier of legal tender ? notes and coin ? to the economy. the terms and conditions under which the rbi is willing to supply cash to the banks are important factors when the banks set their interest rates. the rbi lends cash to the banks at an interest rate determined by the monetary policy committee. this interest rate is called the rbi's repurchase rate, or repo rate for short. banks set their deposit interest rates somewhat below and their lending rates somewhat above the repo rate. through the repo rate, the rbi indirectly has a strong influence on all the short-term interest rates in the banking system. if the rbi's analysis shows that inflation is going to be higher than the inflation target set by the government, it has to put a brake on the inflation process. this is done in the following way: ? the rbi raises the repo rate.
? banks then usually raise their lending and deposit rates. ? when people face higher lending rates, they buy fewer goods on credit. ? this causes less credit to be used and less money to end up with shopkeepers. ? with less money, credit and expenditure in the economy, it becomes more difficult to raise prices and wages. ? therefore, inflation is reduced. conversely, if the rbi's reading of the economy indicates that inflation is going to fall below the inflation target, it would reduce the repo rate and this would reverse the sequence described above. as a rule of thumb, lending rates must be significantly higher than the inflation rate if excessive credit growth and money supply growth are to be prevented. in addition to the repo rate, the rbi can also influence the banks' ability to lend out money by using instruments such as open-market operations ( i.e. buying and selling financial assets in the open market) and cash reserve requirements (i.e. requiring the banks to deposit with the rbi part of the funds they receive from the public). although inflation can only be sustained if the amount of money in the country is rising excessively, the rbi's task can be made easier by both the government and the public. monetary policy will be more effective if it is supported by fiscal discipline, i.e. if the government does not overspend or rapidly run up its debt. inflationary pressures will also be alleviated if the general public works harder and smarter, i.e. if an improvement in productivity raises the quantity (or quality) of the goods and services produced. bottom line in summary, combating inflation requires the prevention of excessive money supply growth. in turn, this requires the private-sector banks to maintain interest rates at levels that are high enough to prevent excessive growth in bank credit extension. to this end, the rbi sets its repurchase rate at an appropriate level. this whole process of changing interest rates to influence credit, money supply and inflation takes time to work through; this is why monetary policy requires patience!
protect themselves against inflation by investing in assets, such as shares or property, which increase in value during periods of inflation. inflation therefore leads to an increase in the disparity between the wealth of the "haves" and the "have-nots", or the rich and poor. losses to taxpayers: if your salary increases in line with inflation, and no adjustments are made to income tax, you will shift into a higher tax bracket and end up paying a larger share of your salary to the taxman. this means that government gains control over an increasing proportion of society's resources without formally getting the approval of parliament to raise taxes. confusing price signals to producers and slower expansion of businesses: a higher price for a product would usually indicate that people want more of it, that more profits can now be made from it and that more resources should therefore be employed to produce it. in times of inflation, however, an increase in the price of a product can occur either simply as part of the regular inflation related adjustments to prices, or because the demand for that product has risen permanently. entrepreneurs, not knowing which of the two kinds of price increases have occurred, may wait much longer before expanding their businesses and employing more resources in reaction to a permanent increase in demand. speculation crowding out production: an environment of high inflation and financial instability leads to more entrepreneurship and other resources being devoted to speculation in existing assets such as real estate, and less to expansion of production and employment. reduced attention to productivity: higher productivity is an important sustainable way of improving the overall standard of living in a country. in the absence of inflation, wage negotiations are focused on proper compensation to employees in accordance with improvements in their productivity. with high inflation, salary or wage increases consist overwhelmingly of compensation for inflation, and productivity issues become less important and may be neglected. wastage of resources: during very high inflation episodes have to be increased daily. a shop assistant, for example, may have the fulltime job of writing a new price on each item every day or updating a list of the prices of the various articles; the assistant would, without inflation, have been able to do more productive work, such as selling items to clients. the lower the inflation, the less time is spent on the re-pricing of items. heightened tension and social disruption: a society plagued devotes more energy to redistributive issues, in which case perpetually tries to gain or regain a better price, wage or destroys the fabric of society in a wider sense than simply the production of goods and services.
by high inflation each person or group position. this through its impact on
claims are often made by ill-informed people that inflation is not bad. they argue that higher inflation will stimulate economic growth. these claims are false. it is quite easy and inexpensive to print more money, thereby boosting inflation; even the poorest countries could do that. if this were the way to achieve economic prosperity, no poor countries would remain on earth. if money is printed to stimulate the economy it may work for a short period of time, but people will soon realize what is going on and instead of producing more they would simply start to increase prices and wages much more rapidly. in the end, the country would face high inflation with all the destructive and distortive effects outlined above, and would be certainly left with a weaker economy.
the reserve bank of india, like central or federal banks in most countries, is therefore strongly opposed to inflation, and uses its monetary policy to combat it. such policy action is not bad for continued economic growth, prosperity and a fair distribution of income and wealth. low inflation and a stable financial environment are indeed prerequisites for the achievement of these objectives on a sustainable basis. what triggers price increases? price increases can be triggered by many developments, such as: ? an increase in international oil prices; ? a fall in the exchange rate; ? a nationwide excessive salary and wage hike; or ? an increase in food prices and commodities etc. what sustains inflation? for a continuous rise in the general price level, the money supply has to keep on expanding. only with "too much money chasing too few goods" can the general price level continue to increase. it's proven that high rates of growth in the money supply in india in the past went hand in hand with high rates of inflation. the only effective way to contain inflation in the long run is therefore to restrict the growth in the money supply. the likely rate of increase in the quantity of goods and services which can be maintained without inflationary pressures is usually related to more labor, entrepreneurship and capital goods, and better skills, management and technology. growth in the money supply should accordingly be linked to sustainable growth in production. preventing excessive money supply growth is therefore a crucial element in combating inflation. but how is this done? how do you stop inflation? one approach would be to freeze all prices. many countries have attempted this over a long period of time. later attempts at directly controlling price increases also failed because all these controls addressed the symptoms, but not the cause. preventing excessive money supply growth the banks in india are indebted to reserve bank of india. although the amount of funds which they borrow from the rbi is small compared to the amount of funds which they obtain in the form of deposits, their borrowing from the rbi is important. this is because the rbi is the only supplier of legal tender ? notes and coin ? to the economy. the terms and conditions under which the rbi is willing to supply cash to the banks are important factors when the banks set their interest rates. the rbi lends cash to the banks at an interest rate determined by the monetary policy committee. this interest rate is called the rbi's repurchase rate, or repo rate for short. banks set their deposit interest rates somewhat below and their lending rates somewhat above the repo rate. through the repo rate, the rbi indirectly has a strong influence on all the short-term interest rates in the banking system. if the rbi's analysis shows that inflation is going to be higher than the inflation target set by the government, it has to put a brake on the inflation process. this is done in the following way: ? the rbi raises the repo rate.
? banks then usually raise their lending and deposit rates. ? when people face higher lending rates, they buy fewer goods on credit. ? this causes less credit to be used and less money to end up with shopkeepers. ? with less money, credit and expenditure in the economy, it becomes more difficult to raise prices and wages. ? therefore, inflation is reduced. conversely, if the rbi's reading of the economy indicates that inflation is going to fall below the inflation target, it would reduce the repo rate and this would reverse the sequence described above. as a rule of thumb, lending rates must be significantly higher than the inflation rate if excessive credit growth and money supply growth are to be prevented. in addition to the repo rate, the rbi can also influence the banks' ability to lend out money by using instruments such as open-market operations ( i.e. buying and selling financial assets in the open market) and cash reserve requirements (i.e. requiring the banks to deposit with the rbi part of the funds they receive from the public). although inflation can only be sustained if the amount of money in the country is rising excessively, the rbi's task can be made easier by both the government and the public. monetary policy will be more effective if it is supported by fiscal discipline, i.e. if the government does not overspend or rapidly run up its debt. inflationary pressures will also be alleviated if the general public works harder and smarter, i.e. if an improvement in productivity raises the quantity (or quality) of the goods and services produced. bottom line in summary, combating inflation requires the prevention of excessive money supply growth. in turn, this requires the private-sector banks to maintain interest rates at levels that are high enough to prevent excessive growth in bank credit extension. to this end, the rbi sets its repurchase rate at an appropriate level. this whole process of changing interest rates to influence credit, money supply and inflation takes time to work through; this is why monetary policy requires patience!
