WTF is Inflation (Part 2)

 A Quick Recap: WTF is Inflation?

    Inflation, in economic terms, refers to a sustained increase in the general price level of goods and services within an economy, typically measured through indices such as the Consumer Price Index (CPI). Inflation erodes the purchasing power of money, as each unit of currency buys fewer goods and services. Conversely, deflation denotes a general decline in the price level. The most common metric for assessing inflation is the inflation rate, expressed as the annualized percentage change in a price index.

Click here for Part 1 of this article on inflation.

    Given that not all prices rise uniformly, the CPI is frequently employed to capture the average changes in prices faced by households. While inflation often elicits concern among the general public, many economists advocate for a low and stable inflation rate, which can facilitate economic adjustments and promote growth. Notably, inflation can implicitly transfer a portion of household income to governments, further fueling its unpopularity outside academic and policy circles.

    The responsibility for maintaining low and stable inflation is typically entrusted to central banks, The Reserve Bank of India, for example, which manage monetary policy through tools such as interest rate adjustments and open market operations.

1. What Fuels the Fire of Inflation?

    Prolonged periods of high (dubbed as "uncontrolled" by media houses) inflation are frequently attributed to inattentive and mostly bad monetary policy. When the growth of the money supply outpaces the productive capacity of an economy, the value of the currency diminishes, leading to a decline in purchasing power and an increase in the general price level. This dynamic is encapsulated in the quantity theory of money, one of the foundational principles in economic thought, which posits a direct relationship between the money supply and the economy's size.

    Inflationary pressures can also arise from disruptions on either the supply or demand side of the economy. Supply shocks, such as natural disasters or surges in input costs like oil prices, can constrain overall production capacity and lead to "cost-push" inflation, where the primary driver of rising prices originates from supply-side disruptions.

    The food and fuel inflation of 2008 was such a case for the global economy—sharply rising food and fuel prices were transmitted from country to country by trade.

   Conversely, inflationary pressures may result from demand shocks, such as a stock market rally, or expansionary policies, including central bank interest rate reductions or increased government spending. These factors can temporarily elevate aggregate demand and stimulate economic growth. However, if demand outpaces the economy’s productive capacity, resource constraints can lead to "demand-pull" inflation. Policymakers must carefully calibrate measures to support demand and growth without overstimulating the economy and triggering inflationary pressures.

    Inflation expectations are a critical determinant of future inflation dynamics. When households and firms anticipate higher prices, these expectations are often embedded in wage negotiations and contractual price adjustments, such as automatic rent escalations. This forward-looking behavior influences subsequent inflation outcomes, as realized wage and price increases align with prior expectations, rendering them self-fulfilling. Additionally, if expectations are anchored in recent inflation trends, inflation tends to exhibit inertia, perpetuating similar patterns over time.

2. Taming The Demon Named Inflation.

    The effectiveness of disinflationary policies—those designed to reduce inflation—depends on the underlying drivers of inflation. In cases where an economy has overheated, central banks committed to price stability can adopt contractionary measures to curb aggregate demand, typically by increasing interest rates. Alternatively, some central banks have sought to enforce monetary discipline by pegging their currency to another, thereby aligning their monetary policy with that of the anchor country. While this approach has yielded mixed results, its effectiveness is limited when inflation is driven by global factors rather than domestic conditions.

    In 2008, global inflation surged due to elevated food and fuel prices, prompting many countries to allow these international price increases to transmit to their domestic economies. In certain cases, governments intervened directly by administratively setting prices to shield consumers from the impact of rising global costs. Such interventions often led to substantial subsidy expenditures, as governments compensated producers for income losses incurred due to controlled pricing measures.

    Central banks are increasingly leveraging their ability to shape inflation expectations as a key instrument in achieving price stability. By signaling a commitment to temporarily restrain economic activity, policymakers aim to anchor expectations and reduce the inflationary bias embedded in forward-looking contracts. The effectiveness of this strategy is directly tied to the credibility of the central bank, as greater trust in their commitment enhances the impact of their guidance on inflation expectations.

Jishnu Chatterjee,
January, 2025.