Inflation: Theory vs Reality

The shift of focus from employment generation to inflation targeting seem to have taken place during the period India was being liberalised. Inflation, however, is a concern to the populace of any nation where wages are not indexed to inflation. In India, inflation poses problems as a rise in prices reduces the real wages and hence their purchasing power. Life, itself, can become difficult.

This post briefly tries to clarify how inflation is conceptualised in economics (neoclassical). Initially, it needs to be pointed out that neoclassical economics analyses equilibrium positions and differences between them – commonly termed as comparative statics. Another significant issue is that, in neoclassical demand and supply, the analysis is entirely carried out in logical time. Now, let us take a look at how prices are formed in equilibrium. In equilibrium, it is required that total demand of a commodity equals its total supply. And, if demand is more than the supply, prices are caused to rise, in order to restore equilibrium. Surprisingly, it is this insight that forms the basis of the current theory of inflation, which is mentioned in the media and talked about by economists.

Thinking through this ‘insight’, a few points come to my mind. First, an economy is never in a state of equilibrium. And neoclassical theory does not have the necessary tools to understand disequilibrium. Though, neoclassical theory can point out the characteristics of disequilibrium positions vis-a-vis equilibrium position. I doubt whether this is adequate. Secondly, prices in an economy does not rise, just because demand increases. Such a behaviour is commonly seen in markets for vegetables, fruits, meat, etc. It seems absurd to posit that prices of manufactured commodities will move according to changes in demand.

This much said, let us examine the impact of money supply on prices in an economy. Is there a relation between money supply and prices? The first question which needs to be answered is how are prices formed. According to neoclassical economics, when demand rises, it implies that money supply in the economy has risen compared to the equilibrium state of affairs. The quantity theory of money seems to corroborate the hypothesis that money supply and prices are directly related. But what if they are not? Wouldn’t the policies fail?

It is dangerous to build flimsy theories; for, policies draw arguments from these theories. For instance, the central bank tries to reduce money supply during inflationary conditions by raising the interest rates (indirectly) or through open market operations. How far are they effective? Or, is inflation just a temporary phenomenon? It needs to be mentioned that cases of hyperinflation is significantly different as they are strongly correlated with the breakdown of institutions.

This post ends by asking whether an increased rate of interest leads to decreased money supply? Or whether an increased rate of interest causes prices to rise because the cost of borrowing increases? Also, high interest rates attract capital from abroad. Very often, causes of inflation are not properly identified, which makes policy construction very difficult.

3 thoughts on “Inflation: Theory vs Reality

  1. How am I affected in the current situation, which people call inflation? I shell out more money to buy the same goods or receive the same services that I did in the past. How would I sustain? I pressurize my employer to raise my salary. Grudgingly he does so thus increasing his cost. He has to create his surplus too, so he increases the price of commodity of our organization. I have been affected by price rise and in a way have affected price rise too.
    Does my distress get reflected in inflation rate? It might or might not. It depends on what I really consume and what academics think are ‘consumed’ as the basket of items, whose prices are studied.
    How does this begin in the first place is for the intellectuals to argue. It does make heuristic sense, to foresee raise of prices when seller knows an interested customer has money to pay. So when Government announces a salary hike to its employees, businessmen know that people would be willing to pay more from a cup of tea to a tooth extraction. Prices rise and the whole cycle gets turned on.
    Alex ends his post asking whether an increased rate of interest leads to decreased money supply.
    Idea of increasing interest is ‘Keep the money in the bank. You will get good returns’ so that money is taken away from circulation reducing its supply. This is applicable to a person in surplus mode, which has more money than what he needs for survival. Survival mode people would believe ‘Let me buy now itself, I might not afford it later due to rising prices, even if it were to take a loan.’ Increasing interest rate can decrease this type of behaviour..
    Alex also asked if whether an increased rate of interest causes prices to rise because the cost of borrowing increases.
    This is interesting to note that increased interest rate affects the supply side of market increasing its cost due to borrowing and thereby the prices. This probably is related to how much of business happens through borrowing. If business were owned then this cost of borrowing would not increase the price. The counter argument to that would be if the investment was owned then why invest in businesses rather than banks which are offering good returns with increased interest rates. In that case of exit from market, there will be more demand on rest of the players, who could increase their prices. It does look like for the small business-man, who requires/required credit the situation becomes tough. I wish I were an economist to understand deeper issues of inflation.But it does not require me to be one to understand that inflation kills the purchasing power of the poor by rising prices and also making credit difficult.

  2. As an economist with an undergraduate degree in chemistry, the realization that a system in not in equilibria in no way diminishes the predictive power of determining the equilibrium state of a system. The only difference between equilibria and disequilibria is the time variable, which is pleasingly simple to deal with. Equilibria itself is an approximation.

    I have only one eyebrows to raise at your statement that demand will not cause prices of manufactured goods to rise.

  3. Pingback: 2009: A Round Up « Undergraduate Economist

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