Monday, April 26, 2010

Inflation - top concern for tomorrow.

Posted on 23 Jan 2010

Welcome to our hub where we all share and learn the things. I have been getting quite encouraging response from many readers.

Well we spoke about hyperinflation last week and as if it's co-incidence we got this news from India this week.

This is still not hyperinflation. This is just hi-Inflation. Hyper inflation is still down the line unless central banks raise rate of interest considerably.

Let's try to understand how inflation comes and how it works.

There are 2 definitions of inflation. One is “Increase in money supply” which we will discuss in very detail later. More commonly used definition today is “% increase in consumer prices”.
In other words if Rice is 100 Rs a Kilo today @Inflation of 13 % it will become

113.00 Year 1
127.69 Year 2
144.28 Year 3
163.04 Year 4
184.24 Year 5
208.19 Year 6

This I believe is known to most of us. There are different parameters that we consider under inflation in different countries e.g. in India WPI (Wholesale Price Index) is measured. WPI Inflation is divided into three broad categories i.e. Primary Articles (Food), Fuel Products and Manufacturing Items. In US CPI (Core Inflation is Tracked). It does not include food and energy. On the top of it if car becomes costly say by 10% and is made safe by 10%, impact on CPI is null.
Anyway we calculate, I am completely convinced that inflation is a matter of worry no matter how we calculate it.

So real question is where it comes from. Of course it mainly comes from "expansion in money supply". And money supply comes from central banks e.g. Fed in US, RBI in India and so on.

This is little complex to understand. One of the most common reason for Increase in Money supply is due to Policy of making interest rates artificially lower then “Actual Inflation”. We will discuss it later in very details. Other reasons are. a) Many times they are forced to do it due to political pressure to run government programs that cost more then tax revenue. b) Also sometimes they do so to solve next immediate problem like credit crunch of 2008-09, collapsing banks, to bail out companies etc.... On the top of this, there are governments that have money and governments do not have.

See at above URL carefully. this is the current account balance. While governments who have the positive current account balance can take a call if they want to waive of loans or want to save banks / companies, Governments with negative current account balance just can’t do it.

So what they do is to increase money supply (Print Money) and that is exactly what leads to inflation in fact that’s the real definition of inflation.

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