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All You Need to Know About Inflation

Balaji ViswanathanBalaji Viswanathan, Teacher and a Product Manager.
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 * Production
Source: Money supply
(Don't Worry: I will explain each of the factors in the equation above in detail).
  1. Money supply - how much money circulates in the system
  2. Velocity of money - how frequently people spend their money
  3. Price: What are the average price levels of essential products? Are those prices increasing?
  4. Production: How much is produced in the system?

Part A - Factors
1. Money Supply: 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)

3. Productivity: 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:
  1. High creation of money supply from excess loans (see the periods
  2. High velocity of money due to general optimism
  3. 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:
  1. 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.
  2. 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.


This is a blog on economics, finance, investing...


Balaji Viswanathan
Balaji Viswanathan
Teacher and a Product Manager.