Food Prices and the Inflation Tax

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ImageOscar 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?


Eliana Cardoso

Former Acting Chief Economist

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