Thursday, May 08, 2008

Increasing danger of Inflation in India

Last week I had written about the rising danger of inflation in India.  It was obvious - the very nature of macroeconomic dynamics warrants inflation in a growing economy unless the demand side growth is evenly matched by the supply side economics. Economies that operate at full employment are susceptible to a greater risk of inflation as there is very little buffer available to meet the growth in demand through increase in supply.  Unless, of course considerable technology improvements increase productivity of labor and capital to such an extent that the spikes in demand (part of it due to full employment -> more wage earners -> more consumption) are matched effectively by a supply response thus keeping inflation down.

Monetary policy is aimed at tweaking the interest rates such that the cost of capital affects both the supply and demand side of the equation. History has shown that central banks have become very adept at using this tool and have thus managed to steer economies off of high inflation and deep recessions.

The response of the Indian government to rising inflation has its pros and cons. There are some proponents of the theory that traders are the ones who are driving up the prices of commodities and energy.  Sure, they are not entirely responsible, but they have played their part more than satisfactorily.  Although I like this response, the only way the Indian government can really affect the inflation is by further tightening  interest rates which would obviously lead to an appreciation of the Indian rupee (more dollars will be chasing rupees due to better returns). The government is loathe to follow that route due to political reasons - but, the truth of the matter is there is no other way out.  With the Pay commission's reports putting billions of dollars in Indian hands - there are bound to be millions of government and PSU employees looking to buy their new cars, clothes, eat out among other things.  That would just be the catalyst to the inflation demons.

I hope better sense prevails and the government starts tackling inflation.  Already there is a huge gap between the rich and the poor due to the inequitable distribution of wealth creation from the last few years of growth.  If inflation raises its ugly head further the millions of households which found themselves in the lower middle class will be back in the lower class again erasing almost all the improvements made in the past decade or so.