IB economics commentary - Inflation

According to the article, rising prices of food items, petroleum and other commodities in India have increased consumer expenditure from 45,000 Crore rupees in 2008-2009 to 3,76,000 Crore rupees in 2010-2011. The brunt of these food price hikes have been mainly felt by the poor and vulnerable families. On the other hand, the prices of durable goods like electronics have fallen down which mainly benefits middle to higher income groups. All in all, if the government doesn’t boost food production, then high food inflation will be prevalent for a long time.

GDP, gross domestic product, is the total quantity of goods and services produced domestically within a country in the span of one year. Economic growth is when there is an increase in a country’s GDP. Inflation is a consistent increase in the general price level of goods which leads to a fall in the purchasing power or value of money.

Figure 1

Massive increase in private consumption expenditure is most likely due to an increase in population of the “upper and middle class”. Demand-pull inflation is the result of the aggregate demand growing too quickly compared to that of supply-side capacity which results in excess demand for goods. India is experiencing demand-pull inflation, as there is full employment of resources and aggregate demand is increasing.

In Figure 1, when the economy experiences more demand than supply, the aggregate demand curve, denoted by AD, shifts outwards to AD1. As a result, price increases from P1 to P2 reflecting price (GDP) inflation.

Food items were the most affected by the inflation due to the fact that they are necessities and consumed daily by all income classes. The prices of non-food products, such as durable goods, fell instead of rising; in fact, if you adjust the price drop for quality improvement of goods, the drop is even sharper. This is because these goods are classified as wants rather than necessities and their demand is not very high or frequent. Overall, since consumers spend more of their income on food, inevitably demand for non-food products dwindles thereby reducing their prices.

Consumers with higher incomes will benefit from the fall in prices of non-food products as they will be left with more disposable income for food and commodities. Consumers with lower incomes, however, already spend a very large part of their disposable income on food and durable product price reduction does not affect them in any way.

The government’s macroeconomic aims are to have sustained economic growth, high levels of employment, rise in living standards and stable prices. In order for prices to be stable, inflation must be kept at low levels. India’s government can reduce the rate of inflation by policies that will either slow down the growth of aggregate demand or boost the rate of growth of aggregate supply.

The government may tighten fiscal policy to control inflation by reducing expenditure on public and merit goods or they may choose to raise direct taxes, leading to a reduction in disposable income. Usually the government will cut consumer spending and raise tax revenues to help take out money from the circular flow of income. Monetary policy also involves higher interest rates, which will further reduce consumer spending.

Supply side policies are those that seek to increase supply thereby lowering inflation. The government should use more of supply side policies in strengthening the food production industry.

Firstly, the government could set up first class training and education centres for employees in the food production industry, which will improve labour productivity and eventually, the aggregate supply. Over a period of five to ten years, the government can rotate subsidies on various types of training programs. In the short run, its effects will not be felt as education and training are long term endeavours but eventually it will benefit the economy by boasting a more skilled and efficient labour force, thereby reducing cost of production and increasing food supply.  

Secondly, another option would be subsidising the India’s food production industry: Agriculture. To increase production, the Indian government could introduce new irrigation methods, better cultivation strategies, more efficient transport systems etc. to farmers in more rural areas. Moreover, the government can proactively draw the attention of worldwide fertilizer companies who are looking to enter a new market or showcase their new products; the farmers will also benefit from an increased yield. Benefits to both parties have short term as well as long term connotations and more importantly, food inflation will leave the face of India for good.