Inflation in India explained in plain English

Welcome back!

This is the fourth part in a series of articles that are meant to explain government finances and how they affect our investments.

This part will explain inflation in India in an easy way.

Reading the earlier articles in the sequence below will be very helpful.

  1. Fiscal deficit of India in plain English
  2. Government borrowing in India explained in plain English
  3. What do the RBI and the Batman movie have in common? – Quantitative easing in India by the Reserve Bank of India (RBI)

Summary of earlier articles

  1. The Government of India spends more than it earns leading to persistent fiscal deficits.
  2. It borrows from the market to feed expenditure which is greater than income.
  3. The market may by be unwilling to fund the government at lower rates of interest.
  4. The RBI engages in quantitative easing, creates money out of thin air, and purchases a portion of the government bonds in the market.
  5. The government is able to meet its borrowing needs using the RBI as a crutch.

More money, more problems, a thought experiment

Suppose there’s a country Imaginaria  in which there are two people. Each of them owns a cycle. Suppose each of them has a Rs. 100/- note. So, two cycles and Rs. 200/- are present in this country’s economy. The price of each cycle should settle at Rs. 100/-

Example - 2 Rs. 100 notes and 2 cycles

Suppose the central bank of Imaginaria introduces Rs. 50/- in the economy. Central banks can print money by virtue of sovereignty.

Now we have two cycles and Rs. 250/-.

2 Rs. 100 notes, one Rs. 50 note and the same 2 cycles.

Like water finds its level, the price of each cycle should settle at Rs. 125/-

Thought experiment conclusion

  • The real assets in Imaginaria are the 2 cycles.
  • The assets are unchanged
  • Price increases because money supply increases.

The government lies to you

The Government of India and most other governments mislead their citizens.

 While doing this, we must also control inflation. This would pose some difficulty because of a bad monsoon this year – Manmohan Singh, Independence day speech, 15 August 2012

 

Inflation at its current level is due to high rate of increase in prices of vegetables, pulses and edible oils – Minister of State for Ministry of Finance,  Namo Narain Meena, 9 August 2012

 

…That in turn, to some extent at least, is a sign of growing prosperity of our country – Manhoman Singh, Prime Minister, 5 November 2011

Think for yourself

  • This year we are expecting the real Indian economy to grow by 5.5% this year. But even today money supply is growing at 13-15% levels.
  • OMOs add to money supply.
  • Supply of goods and services do not grow by the same amount.
  • Like the cycle example, prices increase because of the extra money.

When there are generalized increase in prices in the economy over the long-term it usually has got nothing to do with the nonsense that politicians will talk about. Take your pick from the usual excuses for not being able to control inflation.

  • Bad monsoon
  • Infrastructure bottlenecks
  • Supply-side issues
  • Low agricultural productivity in India
  • Food prices are not coming down
  • Rising crude oil
  • Add your favourite reason from the newspapers here. I’m sure there are more that you have seen!

Another small thought experiment

Assume that the public has Rs. 100/- for living expenses. You buy 2 things, food and clothes worth Rs. 50 respectively, in a year. Say, food, the favourite target of the government, rises by Rs. 5/- to Rs. 55/-, it necessarily means you will have Rs. 45 or Rs. 5/- less to spend on clothes.

I accept that food prices increased over  the last few years. Something else should have become cheaper. On the contrary all prices are going up.

And to counter our Prime Minister’s logic, prosperity has got nothing to with rising prices. It does not help if your salary increases and prices increase by the same. Prosperity is increase in real wealth not inflationary increase in wealth (Or as economists would call it, nominal wealth increase which is real wealth increase plus increase due to inflation)

Truths which the government does not want the citizens to know

  • The RBI  has overall control over the money supply in the country.
  • OMOs inject money into the economy increasing money supply.
  • The biggest truth is that inflation is not increase in prices, that’s what the government would like you to believe.
  • Just like high body temperature is not the illness but rather a symptom of fever due to an infection, rising prices are an outcome of some action.
  • The true definition of inflation is increase in money supply.

Summary

If you have seen the movie, “The Usual Suspects”, there is a fine dialogue by the character played by Kevin Spacey.

The greatest trick the Devil ever pulled was convincing the world he didn’t exist.

Don’t be fooled by the Government’s proclamations that they are trying their best to control inflation in India. If they wanted to they would have done it by now. The levers are in their hands.

 

In the next part I will explain how money supply inflation is actually daylight robbery by the Government. From whom you might ask? From the citizen’s pockets.

I hope this series of articles is useful to you. If there are any comments you would like to share please use the box below. The star rating system below also helps me improve my articles.

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Update

The next article in this series on government finances and how they affect our investments has been posted at Capital Orbit.

Click here to read How inflation destroys your wealth, explained in plain English.

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Comments

  1. says

    So what is the solution for Fiscal deficit? Put bans on imports or increase import duties to discourage imports? Why not simply increase earnings by taxing more?
    Put in a social security ID and start taxing the section of society which does not pay taxes at all. In fact most of the measures of the government are for this section … then again I am wearing tinted glasses B-)

    Btw, iska solution kya hain? Its a sorry state of affairs which even the learned masses (hey, that’s me!) are not aware about.

    • says

      Hi Kidakaka –

      Overall imports and exports are related to the current account deficit concept and not fiscal deficit.
      When we say fiscal deficit we are talking of purely expenditures and receipts of the government. Whatever the government is spending needs to be productive. It should not be spending to buy votes. Think of the TV’s being distributed in Tamil Nadu before elections. That’s expenditure which is useless. The state government has no business doing doling out TVs but it does. Similarly the Central Government has many spending outlays but there are many losses and outright robbery in many schemes and spending.

      Either this has to be set right or the absolute spending has to come down.

      The next thing is increasing income, primarily taxes. That is never palatable to voters. No government would try to increase taxes unless they are truly desperate. Else they get risk getting voted out. Well, sometimes people don’t know what’s good the country!

      What you or me can do is vote the right people in. Second, increase awareness of people. The government is sensitive to what is written in the media.

      I will leave you with a positive story. It talks of how illegal use of subsidised kerosene was reduced by around 85% in a test district in Rajasthan. Yes, reduced by 85%, not to 85%!
      http://www.businessworld.in/en/storypage/-/bw/direct-to-home/422114.0

      Attempts like these are the only way forward.

      For our finances
      Inflation will eat into our savings. Be aware that fixed income investment avenues like FDs, debt mutual funds are a loss-making proposition today if you consider inflation. Real assets like land, flats and gold give you inflation protection. Caution needs to be taken that you don’t get into overheated real assets, like real estate is right now.

  2. says

    Great article Kunal. I was researching inflation and how best to explain it to my readers. Your article is perfect. Such a simple and relatable explanation, made for a wonderful read. Thanks :)

    • says

      Thanks.

      You might want to explore the role of bank credit in an economy. Credit is effectively money today. I anyway will be writing about it soon. You can come back if you are interested.

      Sign up for the mailing list. That way, you don’t miss a thing.

  3. Shilpi says

    Kunal,

    Your article is really helpful among all present on web… :)

    Can you explain why govt increase prices of good after borrowing money from RBI , wheras that money should be used for returning debt?

    • says

      Thanks Shilpi. The govt. does not directly increase most prices in the market save for a few. Consider the minimum prices they declare for crops like rice, wheat, sugar cane. These have increased by leaps and bounds 12% plus on average over the last 4-5 years according to an article I had read. These increases have a ripple effect though. Food inflation goes up, living expenses go up, wage demands go higher, wages go up etc.

      Schemes like NREGA etc. with leakages also are uses of govt. money. Once this money enters the economy, there is upward pressure on prices. There is a social welfare angle in these schemes. But if there is leakage or misallocation of resources or unproductive work then it is a problem.

      The UPA-2 govt. has clearly bungled up badly in my opinion.

  4. Gaurav says

    Nice intelligible posts, appreciate the good work.
    It’s interesting though how you draw direct correlation between inflation and money supply in the economy. If the money supply is the only reason for inflation and everything else is an excuse, how do you explain drastic rise in inflation in countries like Russia as soon as oil prices crashed in 2014-15? I always though that because of depreciation in their currency, they might be ‘importing’ inflation. But I fail to draw an analogy with increased money supply in this scenario..any thoughts?

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