Inflation conundrum

Okay, let’s start from basic definition of inflation which is increase in the prices of goods due to reasons such as high demand (which is demand-pull inflation), due to some supply constraints or increase in the resource cost (cost-push inflation) and inflation caused by some past events whose effects are still felt (hangover inflation). Inflation is also defined as too much money chasing too few goods. What it certainly means and what many people fail to see is that inflation is a monetary phenomenon.

Yes, I say it again; inflation is a monetary phenomenon which can entirely be controlled by manipulating the money supply in the market, as most central bankers in the world are busy doing these days. One of my friend argued that, if it is that simple then how would you explain that flood in Indonesian mines leads to increase in coal prices or something like even during the period when the money supply is constant, prices of goods continues going up? Well this post will try to answer just these questions.

Let’s take a simple example of a country with only three residents Amar, Akbar and Anthony. Every month Amar purchases some amount of coal from Akbar and rice from Anthony. He pays Rs.50 each for one kg of both items. One particular month, there’s not been much rain, so rice crop was not that great. So Anthony has to put some extra efforts to grow one kg of rice to sell to Amar. When Amar came to purchase rice from Anthony, he saw a sign board with a sign of "Rice – Rs.100/kg" at his shop. He was little disappointed as he had only Rs.100 in the pocket and he was also suppose to purchase one kg of coal from Akbar. So what should this poor guy do?

There are two ways this guy can go; either he purchase ½ kg of rice and 1 kg of coal or he may buy some more rice and cut a slack on amount of coal. In either case, the amount spend by Amar would sum up to Rs.100 only (considering he can go nowhere to borrow); only thing that will be affected will be demand for rice and maybe for coal, depending upon the priority of Amar, the buyer. That’s from the Amar's part, what about Akbar and Anthony who are left with extra rice and coal in their shop and no buyers. With no other options and buyers, they will sell the stuff at lower prices depending upon the demand, which in first case will be Rs.50/kg for one kg of both items (ideal case, of course). So, when Amar calculate his monthly expenditure, it still is Rs.100, so inflation for Amar is 0%. So, any change in demand and supply equation (supply shocks etc.) of the commodity did not have any effect on the prices in the case of constant money supply.

Now imagine that there is a banker, who is ready to provide Amar extra money, let’s say Rs.50 to purchase rice, what will happen then? Well, Amar is going to use that money in addition to the money he has, to buy one kg of rice at Rs.100 and coal at Rs.50 from Akbar and Anthony respectively. Now if you compare Amar’s commodity price basket, you may well comment that total expenditure for same quantity of goods has increased from Rs.100 to 150, an increase of Rs. 50 from previous month i.e. 50% inflation rate!

This inflation would not have been there, if there was no other source of liquidity available to this country. This change in price level has got nothing to do with the supply and demand of rice and coal but with the supply and demand of money. How much money is flowing in the market is actually the one and only determiner of inflation rate experienced by everyone. There might be few supply and demand shocks that may change the prices to drastic levels but that will be for short term as consumers will adjusts their portfolios to accommodate these changes. In the long run, it is the supply and demand of money which decided the inflation rate. As the central banker keeps on printing money, there will be more money available in the market which will lead to decline in the value of money which further will lead to every other good look expensive relative to the money.