Inflation: monetary phenomenon?

Inflation: monetary phenomenon?

Inflation is an inevitable phenomenon, with change in income over time’s. In the same passage of time’s, price of commodities jumps higher compared to changes in income. It seems to be increasing in the same way as human age increases. On the other hand, technological development sets price to decrease. Age increases with the theory of time-travel. At the same time, medical science provides anti-ageing solutions. Hence, inflation is similar to increasing trend of ageing, and non-inflation to anti-ageing.

However, inflation sets to change price of essentials more or less in monetary form. It is claimed that money supply is the cause of inflation which leads price level to increase. 'Too much money chases too few goods' is demand driven inflation. But too much money compared to output can create excess demand. This is, in another sense, a situation when too much money is in circulation.

Output commensurate with a given demand does not lead to change price level. But it is not easy to demarcate between demand drive and monetary phenomenon. In practical point of situation, excess demand is supposed to produce incremental output. The position then becomes squired, none needs to be blamed. Hence, there comes a question when demand-driven inflation exists. This happens due to supply shocks.

Through late 2019 to 2021, the world becomes locked down almost due to a small virus. Normal production process becomes hampered. Governments of different countries declare stimulus packages in the form of transfer payments under fiscal policy and easy money by way of loans through monetary framework. Fiscal supports work better and help to clear accumulated goods in markets. But easy money cannot produce output as per expectation. On bringing out from pandemic situation, gears of economies become changed with excess demand but output cannot support the demand. Supply shocks result in inflation exceeding 3.0 per cent to 8.0 per cent globally.

There are few countries known as bamboo economies which do not depend on others. It means that they do not need to import goods. But economies like ours need to depend on external sectors for goods ranging from consumer items to input contents. Shocks in global commodity markets bring imports of inflation. To contain price at reasonable level, market policy of particular commodities is found dictation by price fixation. There is a side effect of such imposition, market becomes drier.

The situation creates a parallel market where goods are traded at prices higher than the fixed ones. In respect of foreign exchange market, exchange rate for import payments is set by central bank. But banks do not sell foreign currency at the dictated rate. Importers are then forced to buy foreign currency from other banks at higher price for import payments. So, the market does not support fixation, flexibility works better here. During supply shocks, price level changes to a higher level but income level does not go to that range.

With price level remaining at higher level, central banks are found busy with fine tuning their monetary policy. As a part of the programme, central banks mock up money supply leading to hike in interest rate. Foreign exchange market is supported through supply of foreign currency to markets. These tools also make local currency markets dry and fuel interest rate to increase. Loans at individual levels are not intended for purchase of consumer goods, rather for big ticket purchases. Loans are particularly used for meeting business needs. Interest rate hike leads loans costly, discouraging incremental investment and making output loss. Hence, policy tools make money scarce in market, which results in other negative impacts.

The prevailing monetary system is based on fiat money. It is not supported by gold or other stable currencies. As such, it is not sound money. It is always prone to inflation.  Sterilisation mechanism keeps monetary base fixed. But it is not possible always. Market intervention by foreign currency brings local currency into central banks. This leads to decrease in foreign assets and dearth local currencies, resulting in reduction of monetary base. Under the system, foreign currency crosses border against imports, money market is in shortage of up to the extent. On the other hand, decrease in monetary base of central banks destroys loanable fund to manifolds.

Consumer finance can fuel demand leading to inflation. This situation may be required to promote production. The proposition is not workable if supply chain for inputs faces shocks. Whatever the situation is, access to finance by businesses needs to be smooth in all cases. Shocks in global supply chain may require foreign currency supports from central banks. But resultant impact of returning domestic money to central banks increases cost of loanable funds.

There is no scope or hedging mechanism to suppress import price. It becomes inevitable. But price at domestic markets needs to be reasonable without administrative intervention. It is easy to talk but implementation is not so easy. Price level change due to supply shocks is not smoothly manageable. There is a need for coordinated efforts. From the monetary point of view, liquidity needs to be injected into markets. But a process is needed to achieve that. There are different tools through which central banks monitor banking system. These are advance deposit ratio, statutory reserve requirement, and so on. Relaxation in some parameters can help achieve the goal. Otherwise, mechanism for extending special liquidity support needs to be devised by central banks. Import of finished commodities may be allowed to import under buyer's credit which can ease foreign exchange market for the time being. In this case, six months' external credit should be allowed with local credit support for the same tenure.

At the end of fiscal point, import taxes should be reduced as much as possible, including waiver of value added tax for a certain period of time. There is an opportunity cost to the Government for tax waiver. In this case, the Government needs to tighten fiscal regulations. But it should not follow austerity measures. As stated earlier, price fixation measure is not workable since it makes markets dry with creation of parallel markets with higher price. To contain this situation, fiscal supports in kind may be extended to vulnerable groups. Under the program, the vulnerable should be given consumerables at subsidised price. This is an alternative way to price fixation mechanism.

Supply shocks spread panics. This is done by vested quarters. To keep the markets within stable price level, rumours need to be faced cautiously. Without adopting inward looking programmes like price fixation, fixed cost for money, exchange rate detection and so on; application of different propositions can bring fruitful results.


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