The monster named inflation has raised its ugly head once again. It is eating up real wages and salaries, consumption baskets and, most important, the incomes of the retired who are already put at a huge disadvantage by drastic cuts in the nominal rates of interest. Nominal interest rates were slashed over the last couple of years or so, partly on the ground that the rate of inflation has come down. But now that the latter has gone up once again, indeed reaching the rate of 8 per cent per annum, the lowered nominal rates represent negative real rates of interest. It means that a saver, constrained to put his money in a bank, would get back in real terms only a fraction of what he had deposited. Still, concerns about the future induce people to save, accepting stoically the inevitable loss. One wonders why interest rates are not indexed to the rate of inflation like wages of unionized labour or salaries of government employees.
Inflation is sometimes said to be a kind of tax imposed by the government on the citizens. In fact, Monetarists of the Chicago School, headed by Milton Friedman, went further and pointed out that inflation imposes not one single tax but three different kinds of taxes on the people. First, by printing money, the government can directly finance its consumption, that is, it can buy the goods and services it requires from the market. This increases the demand for goods and services in the economy which, in turn, increases the price level. As prices go up, people, whose income levels have not changed as yet, are forced to reduce consumption, compensating for the consumption-gain enjoyed by the government. So inflation works just like a tax transferring resources from the private to the public sector. The Monetarists assume that resources are always fully employed so that a rise in demand necessarily leads to a rise in price. But even without this extreme assumption, the above argument goes through provided there are non-negligible supply bottle-necks present somewhere in the economy.
There is yet a third channel. Perhaps not in the very short run, but most certainly in the medium run, wages and salaries of unionized labour tend to go up following a sustained price rise. The nominal wages go up to protect the real wages, albeit partially. But the rise in nominal wages pushes the workers up into higher tax brackets. The poor worker does not gain a penny in real terms, but ends up paying a higher proportion of his income as tax to the government. In the process, his total tax payment, both in nominal and real terms, tends to go up.
Since the government seems to be the main beneficiary of an inflationary process, as the Monetarists would have us believe, should we take it for granted that behind every inflation, the ugly hands of the government are necessarily present' Can we say that inflation is always a monetary phenomenon brought about by changes in the supply of money at the will of the government' If so, can we trace the recent inflationary build-up in India to an increase in money supply alone and ignore the other causes, like increases in petroleum and steel prices or an irregular monsoon, which are being stressed so much in the media'
Before we try to answer these questions, we need to clear up a couple of things. First, it is to be noted that inflation refers to a process of continuing price-rise as opposed to a one-shot increase in prices. Second, it is a rise in all prices and not simply an increase in the price of certain goods and services relative to that of others. Now consider the recent rise in oil prices in the world market as the potential cause of the currently observed inflation. Oil being an essential input of almost any production process, a rise in the price of oil can quickly cause rises in all other prices. But oil price rises are essentially one shot in nature.
Therefore, they can cause once-and-for-all price-hikes, but not a sustained increase in prices. Of course, depending upon shocks in the world market, one can sometimes observe, in a quick succession, a series of oil price rises, as has been observed recently. But that does not make it an inflationary process involving a sustained price rise.
Some would argue that an initial one-shot price rise caused by a rise in the price of oil may still spark off an inflationary process through a wage-price spiral. An initial price rise increases the cost of living which, in the medium run, leads to a hike in wages and salaries of organized labour. The rise in wages and salaries leads to a further rise in costs and prices, and hence, to a further rise in wages and salaries, thus sparking off an upward price spiral. While apparently the argument seems plausible, a deeper reflection would induce one to ask: is this spiral at all possible if money supply remains unchanged' In fact, if prices are increasing but the money supply is not, the unchanged monetary stock would be too small to carry out economic transactions at the existing level. This would lead to a fall in demand in general, and therefore create a downward pressure on prices. The upward spiral would thus be broken.
It follows, therefore, that neither a rise in the price of oil nor of steel, nor an erratic monsoon can lead to a sustained price increase if money supply remains tight. In fact, in most cases, the government pumps in additional money into the economy to compensate its employees for an initial price rise and keeps on doing so as the wage-price spiral moves upward. Thus, without government support, a sustained price rise is impossible and to control the sustained price rise, it is of primary importance to control the supply of money.
In India, money supply had indeed been rising rather rapidly over the last couple of years. One reason for this is the increased flow of foreign exchange into the country. Whoever got this foreign exchange sold it to the Reserve Bank of India for Indian rupees and this led to an expansion of the domestic currency. Another reason for a rise in high-powered money was the expansion of bank credit because of an easy money policy adopted by the RBI. A third reason could be a spurt in government expenditure on the eve of the general elections held earlier this year.
Whatever be the reason, it is somewhat comforting to know that the present government seems to be aware of the problem. That must be the reason why the finance ministry has started to talk about controlling the supply of money. In any case, that is all it can do to control inflation. Other factors, like a rise in oil prices or an inadequate rainfall, are really outside its control.