Wednesday, 20 June 2012

Inflationary Heights

It is summer holidays and kids living in a posh building-- "Inflationary Heights" are having great fun. Their parents have filled their pockets with money and the kids now have buying power. There is an ice cream parlour down the street. The parlour sells ice cream to all the children of the area. The man in charge of the parlour is glad for making all the children happy with his different ice cream flavours. There is a steady balance between the joy of selling and buying ice cream. 


This summer, something happened which disturbed this balance. The kids from Inflationary Heights full of notes in their pockets start consuming double the volume of ice cream that they normally do. The parlour man realizes soon enough that the children from Inflationary Heights have a lot of money with them and even if he were to increase prices, they would continue to buy them. He then increases the prices and the demand continues unabated. While the parlour man gets richer by the day, the other children of the area see their smiles vanish. They no longer are able to afford the ice cream any longer.


They decide to meet the parents of the children from Inflationary Heights. During the meeting with the parents, they explain their problem. They request the parents to reduce the pocket money allowance of their children so that the price of ice cream drops. The parents are in a fix. They know that this will not be accepted by their children. While everyone celebrated when they had increased their allowance, the children may not be willing to accept a reduction. The parents do understand that if they reduce the allowance, their kids would have less money and consequently the demand for ice cream would drop. Thus, the inflation in ice cream at the parlour could be reduced by reducing the availability of money.


Just like the parents of the children of Inflationary Heights have the option to regulate the prices of the ice cream parlour by either increasing or decreasing the allowance money of their children, in the same way, RBI (Reserve Bank of India) has the option to regulate the flow of money into the economy and control prices. This is called demand side inflation that may get controlled by monetary policy measures. 


So, what is supply side inflation? Let us get back to the story. After the meeting, one of the parents, Mr. Idea Shankar, comes up with an idea that may not force them to reduce the allowance and at the same time may provide that prices at the parlour would come down. The next day, Mr. Idea Shankar calls on a few competitors of the ice cream parlour and informs them of the huge business potential in their area. He informs the competitors about how the children of Inflationary Heights have got a lot of cash to spend due to their higher allowance. Idea Shankar's idea works to perfection. Within two days, four new parlours open up in the area. Seeing this and fearing that he would lose business to the competitors, the parlour man immediately brings down prices. Now there are enough parlours and enough customers. In this scenario, the higher allowance does not impact prices in the parlours because there is adequate supply. In fact, some of the parlours who are new start offering discounts. 


All the children in the area are now happy because they can start enjoying their ice cream all over again. In fact, they can now eat more due to the discounts. Now they do not have any grievances against the children from Inflationary Heights. Some of them are even thankful to them because they now have wider variety at lower prices. 


The manner in which prices were regulated was by increasing the supply of ice-cream, in the same manner, the government may control inflation by making the necessary provisions for increasing the supply of products and services in the economy. This is the concept of supply side inflation. While it is easier to set up a few ice cream parlours, it is not as easy to set up many factories and services for the government as it would need land, labour and capital plus time to set up the supply.


However, controlling inflation from a supply perspective is more inclusive and sustainable. On the other hand, using monetary policy to stem inflation is short term in nature and not inclusive. Beyond a point, monetary policy ceases to be an effective tool for control of inflation. 


To some extent, the Indian economy stands at a cross road because of the role of RBI to control inflation is diminishing and the need for creating additional supply is getting imperative. Policies need to be drafted that attract entrepreneurs to invest in the economy so that they can create supply and demand by way of creating jobs. This could try and bring balance back to the economy.

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