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Inflation101

Inflation has been blamed for a lot of things of late. From prices of onions to your boss refusing your annual salary hikes.

Inflation, in its simplest interpretation, means that stuff that used to cost less, now costs more. But this does NOT mean that stuff is more valuable! It’s just that the value of money itself has gone down, and the stuff (which still is just as valuable as before) now needs more money to match its value.

Inflation is caused when the people in charge put out extra money in the economy. Now, there are more notes chasing around the same amount of stuff, and this phenomenon is called inflation. Inflation usually happens when a country is growing really fast. In late 2007, India was growing at break-neck speeds, and inflation also sky rocketed along with it, hitting close to 13%! When inflation rises to such dizzying heights, the central bank usually steps in to remove the extra money that is causing this inflation. The RBI usually does this by raising interest rates. Now, higher interest rates makes borrowing much harder, so people stop spending and buying stuff like houses and cars.

Some people have said that this phenomenon has caused some of the recession. Higher inflation leads to higher interest rates which in turn leads to a fall in demand for stuff, which pushes countries into a recession.

Inflation has been paraded in recent years as the evil monster, but it is not always a bad thing. It is a tool in the armory of Central Bankers, and has been ominously called the “nuclear option”. To understand this, lets hear the story of one Mr Gabbar Singh.
Mr Gabbar has been living beyond his means the last few years. He ran up huge credit card bills and borrowed money to buy a large house. He also bought two cars, a flat screen plasma TV and a whole bunch of Chinese toys. Now, he suddenly finds himself $50,000 in debt. He has a job that pays $50 an hour, so he’s going to have to work 1,000 hours to pay off all his debt. In short, he’s in financial trouble.
Now lets say the central bank in Mr Gabbar’s country decides to inflate the currency. Overnight, it prints several truckloads of money, causing 50% inflation! Prices everywhere rise, and so do wages, by 50%, because of the inflation.

Now, Mr Gabbar is making $75 an hour, but the amount of money he owes the bank stays at $50,000. This is the key. The amount of money he owes the bank doesn’t change, but each dollar is now worth less. He has to now only work 666 hours to pay off his debt! By inflating by 50%, the central bank has reduced the real debt on Mr Gabbar by a third! Mr Gabbar lives happily ever after!

But wait, there is a catch. Lets say there is another Ms Basanti. Ms Basanti has been a good citizen for the last few years, has been regularly putting 20% of her income into savings. She hasn’t binged on debt like Mr Gabbar, and has lived within her means. She has $50,000 in savings in a bank.

Now there is suddenly 50% inflation. The amount of money in the bank stays at $50,000, but it is now worth much less. Ms Basanti has been saving to buy a small apartment, which cost $50,000, but because of the inflation, it is now worth $75,000. She has to now work for an additional 500 hours to be able to afford the apartment.

Inflation helps those in debt and hurts those that have saved. By printing all that money, the central bank has rewarded Mr Gabbar Singh for his bad and reckless behavior, while it has hurt the model citizen Ms Basanti. This is the “moral hazard” argument.

And here’s the twist in the story: If a country is filled with Mr Gabbars and only a few Ms Basantis, overall, it is a benefit to the country to inflate the currency. This is the situation the US and many developed countries find themselves in today. A nation full of debtors – its citizens are in debt, its local governments, government programs are in debt, and the central government is also in massive debt – will find the inflation nuclear option irresistible.

And this is where it comes full circle. If governments around the world start creating inflation to get out of debt, it will lead to higher interest rates down the road which leads lesser demand for stuff which leads us… right back to where we started – in a recession. Central bankers have a very challenging job of balancing the forces to make sure we don’t get stuck in this inflation cycle again!

– Aditya Kulkarni

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