Inflation

Inflation is the change in the prices prevailing in the economy. Inflation currently is around 6.3% in the Indian economy. This figure, which is also reported in the newspapers, is actually the rate of change in inflation. Inflation is one of the most important macro economic variables because of its impact on the interest rates. The interest rates prevailing in the economy at any point of time are the nominal interest rates, which is a sum of real interest rates & a premium for expected inflation. This is the famous Fischer’s relationship. Due to inflation, there is a decrease in purchasing power of every rupee earned on account of interest in the future, therefore the interest rates must include a premium for expected inflation. In the long run, when all adjustments have taken place, interest rates in an economy rise one for one with the inflation. That is the importance of inflation in the macro economy.

Also, the exchange rates between the currencies of two countries depend upon the level of inflation prevailing in the two countries. According to Purchasing Power Parity principle, the change in the value of one currency vis – a – vis another, is approximately equal to the inflation differential of the two countries. So the inflation levels provide an indication of the movement of currencies against each other.

Inflation rates in various countries:

Going by the trend, we can see that the inflation in India is a little high as compared to other developing countries, but it has increased only after budget & that too due to increased oil prices & reduction in subsidies.  Until recently, inflation in India was at its all time lows at around 3%.   And moreover, some inflation is necessary in the economy to keep the tempo of growth.  So the present level of inflation is not a cause of worry & the RBI is taking every step to control inflation.

Money Supply – Impact on Economy

Money supply is also a very important variable of macro economy. Traditionally, money supply is used to control the inflation in an economy. On the demand side, whenever money supply in the economy increases, consumer-spending increases immediately in the economy because of increased money in the system. But supply can’t vary in the short – term, so there is a temporary mismatch of demand & supply in the economy which exerts an upward pressure on inflation. This argument assumes that demand drives supply, which is generally the case. On the supply side, due to an increase in demand, supply can only be increased by capacity additions. This causes the cost of production to rise & that is reflected in inflation.

Money supply also has a direct relationship with the growth of an economy. Until an economy reaches full – employment level, the economy growth is the difference between money supply growth rate & the inflation, other things being equal. When an economy reaches full employment level, the growth in money supply is set off by a growth in inflation, other things being equal. This happens because output can’t rise after full employment & therefore inflation increases one for one with the money supply.

Money supply also has a relationship with interest rates. One variable can be used to control the other. Both can’t be controlled simultaneously. If the RBI wants to peg the interest rate at a certain level, it has to supply whatever money is demanded at that level of interest rate. If it wants to fix the money supply at a certain level, the demand & supply of money will determine the interest rates. Usually it is easier for RBI to control the interest rates through its open market operations (OMO). So, the money supply is allowed to vary but RBI controls it by playing around with interest rates through its OMO.