Understanding Inflation – The Real Intolerance

Inflation is the rate at which the overall prices of goods and services rise.  It results in the decrease in the purchasing power of the common man. Inflation is mainly caused either by demand side or supply side or both the factors. Demand side factors result in demand-pull inflation while supply side factors lead to cost-push inflation.

The demand pull inflation is when aggregate demand in the economy is more than aggregate supply in the economy. Cost push inflation is when the aggregate demand is same but there is fall in supply. This fall in supply is mainly due to external factors. Though both give rise to increased price level, the differentiation becomes necessary as the remedies to control them are different.

Demand Pull Inflation

Demand pull inflation arises due to monetary factors and / or real factors. Monetary factors are major cause of inflation. Increase in money supply creates more liquidity and more money available for spending creating more demand for products. Real factors could be increase in government spending without change in taxes or vice-versa , decrease in savings, increase in exports, decrease in imports. It requires monetary and fiscal measures to control the same. India witnessed Demand Pull Inflation around 2010-11 a year or two before and after. The reason being setting aside of huge sums of money for social welfare schemes without matching rise in taxes & increased money supply. Since 2006 till 2014 y-o-y CPI inflation in every single month it exceeded 5 percent. Low and stable inflation figure requires it to be 4 to 5 percent. Supply bottlenecks were put forward as a reason for this. What is supply driven inflation then ?

Cost Push Inflation

Cost push inflation arises due to rise in prices of factors of production, or shortage of inputs which results in decrease in the supply of outputs. It may also be caused by depletion of natural resources, monopoly, sanctions, etc. Most recent example being Increase in Aluminium prices. To control cost push inflation policy recommendation is related to administrative control on price rise and income policy but without increasing unemployment.  Coming to the Indian inflation analysis – supply bottlenecks. The trouble with this explanation is that supply bottlenecks have always existed. They were there in both high and low inflation times. Still if it is the reason then remedy should have been administrative control on price rise. Recent development is APMC Act, 2016 which is pinching the monopoly of APMC controlled mandis.  Similar administrative controls have witnessed the y-o-y CPI figures below 5percent mark.

One needs to understand that demand pull inflation describes how price inflation begins on the other hand cost push inflation explains Why inflation is still there ?

There are two ways : change the structure of expectations or change the aggregate demand or supply conditions. First one is free lunch but the later is hard work; it inflicts pain. First one is making people believe that inflation is here to stay so be prepared while the other requires strong measures and action. Political intolerance was all needed to control the inflation as the tolerance for a period of high inflation was on the rise.

Understanding Inflation – The Real Intolerance
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