Tuesday, December 22, 2009

What is inflation and what causes it?

The inflation rate (WPI) for the week ended February 3 was 6.73 percent, the highest in two years. This gave rise to a lot of talk about why the rate was going up. The RBI increased the Cash Reserve Ratio (CRR) by 50 basis points and had previously increased the repo rate (the rate at which the RBI lends money to banks). Everyone has `inflation' on their lips but it is worth looking at what exactly inflation is, and how it arises.
Inflation pared down to the essentials means a rise in an index consisting of many goods that have weights attached to them. The index always has a base year. If a particular item has a higher weight and its price rises, it will have a greater effect on the inflation rate. At the end of the day it depends on how much weight a particular item is assigned. Most countries use a consumer price index (CPI) while India has a wholesale price index (WPI).

As their names suggest, the CPI pertains to a set of items that a consumer consumes while the WPI is a basket particular to the wholesale market. Therefore, if the inflation for a particular week is, say, 10 per cent, it means the index is 10 per cent higher than it was the same week the previous year. Then there is core-inflation, which means the inflation rate without taking into account food and fuel. Some say both need to be taken out because of their volatility, while some argue that both items cannot be taken out because a consumer does pay for the rise in their prices. The people arguing for the latter do have a point.

Milton Friedman once said: "Inflation is always and everywhere a monetary phenomenon." What exactly does that mean? It essentially means that inflation is always caused because of too much money in the system. In other words, inflation in a country is always caused because the supply of money is much greater than the demand for it. However, Prof Friedman later changed that to: "Substantial inflation is always and everywhere a monetary phenomenon," meaning that hyperinflation (a monthly inflation rate of 50 per cent or more) is caused because of too much money in the system and is usually the result of the central bank printing too much money to finance government operations.

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