When more money runs after few things then an inflation is set to occur. For instance, assume that there is only one house in the village and there are 10 of you who wants to buy that house. A bidding war eventually happens and the price of the house goes up. Theorem A:
In short, inflation goes up when money supply increases and the number of things available for sale don't go up sufficiently.
Here is the fundamental money equation:Money supply * velocity = Price * ProductionSource: Money supply
(Don't Worry: I will explain each of the factors in the equation above in detail).
Part A - Factors 1. Money Supply:
- Money supply - how much money circulates in the system
- Velocity of money - how frequently people spend their money
- Price: What are the average price levels of essential products? Are those prices increasing?
- Production: How much is produced in the system?
It is one of the most complex concepts in economics, so I will try to simplify a bit. Fundamentally, money is created by one main entity in a country - RBI in the case of India. They print the currency required by the system. This money is then "multiplied" by the financial system.Theorem B:
Money supply goes up with the number of loans made in the system.
Ram has Rs. 1,000,000 in his pocket. He wants to buy a piece of land and he goes to a seller and offers his million bucks. The seller is happy as he has a buyer now.
Instead of buying the land, Ram loans the million bucks to the biggest banker of the village, Som. Ram has a "promissory note" from the banker and Som has the million bucks. We have essentially created "money" here.
Ram can go to the seller and just give the banker's promissory note to get the land, and Som can go to the landlord and buy the land with the million in cash. If both of them want the land, now there will be a price war.
Whoa! Can a bank create money just by issuing a loan? Absolutely. In the same way, when banks refuse to lend money, money is destroyed. This is why world was almost on its knees when banks refused to lend in the wake of 2008 financial crisis.
Thus, a primary way for Central banks (RBI in the case of India and Federal Reserve in the case of USA) to control inflation is by controlling the money supply through the bank interest rates. If they want to increase money supply they will lower the interest rates
(In US interest rates are essentially ZERO) and viceversa in case they want to reduce money supply. When interest rate is almost zero and they still want to increase money supply, they can directly print extra currency (currently US Fed is doing that).
In the past 10 years, Indian banks have substantially brought down their loan standards and have dramatically increased the loans they provide. Thus, huge money is now sloshing around the system.
2. Velocity of Money:
Velocity refers to how quickly people spend a dollar they have got. If Ram doesn't spend the million bucks he got, he will never raise the inflation, because his money doesn't participate in the bidding war. However, if Ram is a spendthrift and quickly spends all he got, his money will frequently participate in a bidding war.
Money velocity generally goes up when the economy forecast is good. People see the things in a positive way and spend more freely. India is at a stage where people are overoptimistic and spend every penny they have earned. Thus, the velocity is substantially higher, increasing the inflation.
(See the money supply and velocity in US economy - red is velocity and blue is money supply. Given how they cancel each other, US economy has almost stopped growing)
When something is produced more in number, its value reduces. For instance, if there is a bumper harvest in tomatoes its price falls through the floor and vice versa. When a country's productivity doesn't match up to the people's optimism, bidding war occurs.
India has severe supply side issues - low electricity production, byzantine rules, business unfriendly practices, etc - that doesn't allow the production to go up.
So, you have high money supply, high velocity of money and low production. Now, let us revisit the equation at the top:Money supply * velocity = Price * Productivity
When the left side is substantially going up and productivity on the right side is going down, you will automatically see the price going up to balance the equation.
In summary, inflation is high because:
- High creation of money supply from excess loans (see the periods
- High velocity of money due to general optimism
- Low supply of products due to system issue
Now, you should be able to read a headline like this: Interest rate cut hopes fade as inflation sniffs double-digits - Hindustan Times
Apart from the fundamental reasons above, there are also international factors such as oil shocks, consumer behavior in developed markets etc. The supply side pressures should be apparent from the chart below (all emerging markets under inflationary pressure)
--------Part B - Solution
What should RBI do to solve this?
Let me go back to the basic money equation one more time:Money supply * velocity = Price * Production (Monetary Policy) (Fiscal Policy)
The left side of the equation is usually controlled by the Reserve Bank (with interest rate control and money supply control by controlling lending banks) and the right side of the equation (mostly the productivity part) is controlled by the government, where it helps improve production by having simpler rules, investing in education, infrastructure etc. Velocity
is almost an uncontrollable variable, and Price is the result of the other 3.
Thus, you will see Reserve banks and Governments tussling with each other as they are on opposite sides of the same equation. Governments want softer monetary policy (left side) and reserve banks want the governments to manage growth with better economic management. The solution will combine both:
- RBI's job: Temper the growth of loans, especially housing loans. In the last 10 years, they have exploded leading to unaffordable housing that is leading to price rises everywhere.
- Government's job: Improve production with a massive push in infrastructure, especially transportation and power. Simplify labor laws and let the business create. As more houses and more products get created, their prices will go down by the simple supply-demand law of economics.
Inflation is like the temperature rise in the body. It could mean common cold, or it could be malaria. Our inflation problem is a serious one. That said, the above chart should tell you that, we have seen far worse times than this.