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Food Prices and the Inflation Tax

Eliana Cardoso's picture

Oscar Wilde, suspecting that the relationship between price and value hides reasons that reason itself ignores, observes in the Lady Windermere’s Fan that a cynic is “a man who knows the price of everything and the value of nothing”. The economist will laugh at Wilde’s one-liner. But after a brief moment, she would protest. Theory tells her that value and price is one and the same thing. And she will insist that what matters for South Asians today is the difference between an increase in the price level and an increase in the inflation rate.

The price level increases when there is a supply shock, such as an increase in food and fuel prices. The initial increase in the price level tends to transmit itself to other prices when the economy operates close to capacity. If the price increase is accommodated by monetary policy, the supply shock transforms itself in a spiral of prices and wages and inflation goes up. Monetary authorities do right by not tightening monetary policy in response to the primary impact of supply shocks, but have to be attentive in case the increase in food prices begins to encourage secondary inflationary effects.

Authorities have attributed the rising inflation in Bangladesh, Bhutan, India and Sri Lanka to a sharp rise in food prices. Factors contributing to this increase include the rise in international prices of some products, summer crop failure in India due to rainfall shortage, and the steady rise in demand.

Governments have tried to cushion the food price rise and its adverse impact through fiscal measures. They also avoided monetary tightening in response to food inflation. Yet, central banks will have to avoid the secondary effects of food price feeding into higher inflation rates as domestic activity levels begin to exceed capacity. They have to be cautious if they want to keep inflation expectations under control, as data indicates that there is reason to suspect that monetary policy may have been too accommodating and that interest rates are too low. You and I do not like inflation, because it erodes the value of both our cash balances and our non-interest paying demand deposits held at commercial banks.

The inflation tax (the erosion of the purchasing power of cash balances and demand deposits) came close to 2.5% of GDP in India in 2007 and 2008. Two and a half percentages points of GDP is a big number and this is why we can feel the pinch of inflation.

During the last five years, seignorage (or the revenue from money creation collected by the Reserve Bank of India and by commercial banks) has been much higher than the inflation tax paid by Indians. The reasons why banks could enjoy the extra seignorage revenue were strong economic growth and the incorporation of new sectors of the population, who have begun to open bank accounts. This process of incorporation of new agents could slow down in coming years. Furthermore, if inflation expectations continue to increase, people will choose to flee away from both cash and demand deposits in favor of other assets, such as foreign currency or gold. This could lead to further increases in inflation.

Do you think the central bank in your country is in control of inflation expectations? Do you believe inflation will come down during 2010?

Comments

Submitted by Prajwol on
I don't have faith in the Central Bank of my native country (Nepal) to control the inflation. What I never understood about Nepal is how they could keep the foreign currency exchange rate constant with India. One Indian Rupee is equivalent to 1.60 Nepali Rupee; it has been always the same since I last recall. India has made a significant progress in last decade while Nepal has been a stalemate (or even declining), but still 1 IRs = 1.60 NRs??? I can't make any sense of that. But as I am not an economist, there must surely be a reason why they keep that constant :( If observing the American market is any indicator that can be extrapolated to South Asia, I don't see inflation coming down. The Fed’s are hard pressed not to increase the interest rate, primarily because of the recession but also politically due to the upcoming election year. A very noticeable, exponential, increase of "Cash for Gold" type businesses in USA are the strongest indicator that people are beginning to have less faith in their currency.

Prajwol Sometimes it can be advantageous to keep your exchange rate fixed in relation to your main trade partner, as in the case of Nepal in relation to India. But of course Nepal looses degrees of freedom in setting its own monetary policy. Here, fiscal policy will have a major role to play in guaranteeing stability and competitiveness. Next week, I plan to discuss the role of fiscal policy in South Asia.

Submitted by Ahad Badar on
I am doing this project assigned to me in the university about the index of happiness in pakistan abnd find it very difficult to find a reason why people in the country should be happy. i want to know what are the factors that make pakistan in a condition where its public is not satisfied at all with the law and order, the prices, the terrorism and other such things...

Try a survey among the students of your university. Ask them to grade (1,2,3) how happy they are (unhappy, more or less happy, very happy). You could also ask them the reasons for their happiness (or unhappiness). Tabulate the results and try to understand them. Good luck with your assignment.

Submitted by Rakesh C on
Dear Eliana, Nice article. I like the Oscar Wilde one-liner. Last week, the Govt. of India announced a steep hike in the price of fuel. This, while the country is still trying to come to terms with the rise in food prices. I wonder if the central bank in India or the government has any real control over inflation. We see our policy makers spend considerable amount of time doing patch work trying to fix what's torn, instead of resolving issues. It's also interesting to note that the govt. announces an increase of as much as Rs.100 in the price of an LPG cylinder. And, we somehow know that, after several protests, it will probably be increased by 20-30 rupees; which is what the govt. intended anyway. The last thing the country needs is spiralling food and fuel prices. This will only increase the divide between the haves and the have-nots. Unless some serious corrective measures are taken, it seems like inflation is only headed in one direction - upwards! -Rakesh

Submitted by Anonymous on
The Reason for increase in food price is due India's has a long chain of supply chain with each penny added up and resulting in a huge price.

Submitted by Moye on
Great article you wrote, really inspired me! I wish I can be like you :)

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