Paradiddle: 2011

Wednesday, March 2, 2011

Inflation

There are usually two drivers of inflation - cost push and demand pull. Demand pull assumes an increase in the money supply in the economy relative to the production of goods and services. It could also come from a cut in interest rates, tax cuts or even exuberance in goods and services markets and capital markets. On the other hand cost push assume an increase in production costs which could result from either producing close to full capacity and/or an increase in commodity prices. Indirect taxes also contribute on this front. There is another equation which relates inflation to exchange rates. An increase in inflation is usually associated with a depreciating currency. This coupling between the two occurs through the interaction between goods market and capital market. Capital flows are the mechanism through which this interaction is possible. Capital flows occur in a manner such that more expected inflation reduces the expected return from investing in a currency and hence demand for that currency falls resulting in its depreciation. However, expectations of growth in an economy can also influence these flows. A huge current account surplus usually should result in appreciation of the currency or in an increased inflation. In both cases the foreign goods become cheaper for the country. Eventually, the economy has to let it's currency appreciate if it wants to arrest inflation. Goods markets are usually slower to respond and hence we observe overshooting in capital markets. Sometimes, an increase in productivity also results in inflation without affecting the exchange rates as has been the case with Eastern European nations.

An issue to ponder about is the causal relationship between inflation and exchange rates. Just like a high inflation may result in the depreciation of currency, allowing the currency to appreciate will help arrest inflation. But we talk about allowing the currency to appreciate rather than making it appreciate. Currency is allowed to appreciate when it's already undervalued in terms of its demand relative to other currencies. Only those economies can achieve it which have a huge foreign exchange kitty to back the appreciation of the currency.

Going forward, we can clearly see that tackling inflation requires clear identification of which factors and to what extent are affecting inflation. When it is a demand pull problem it calls for interest rate hikes and reduction in money supply. When it is a cost push phenomena due to capacity constraints, Government should make more capital formation possible. It could also try to restrain demand so that companies start operating below their capacities. When the cost push has resulted from increase commodity prices globally, the economy might have to allow its currency to appreciate in which case exports markets might suffer. It's a fine balance between how much we want to export and how much we want to import to support the domestic economy. When inflation results from movements in currency markets one needs to look at what is driving this movement. If it is a growth differential then inflation becomes a natural phenomenon just like it would have been when productivity of the economy was increasing. If it is driven by interest rate differentials then appropriate policy measures should be taken keeping in mind whether we are targeting inflation or exchange rate.

For India, I think all the factors are playing some roles. Hence, the policy of raising interest rates should be coupled with ensuring sufficient liquidity in the system to be able to sustain growth. That is what RBI is exactly doing. The balancing act between exports and imports and growth and inflation is what's keeping the GOI busy. After all, inflation being one of the direct consequences of high fiscal deficits is GOI's responsibility only.

Sunday, January 30, 2011

Let's "revolve" to the music!!!

Men want to believe that they are equal even when in their hearts they know they are not. Priests love to preach about how everyone is equal. Democracy believes in equality of every citizen. I wonder what equality means. Does it mean that in the end we are all a collection of some atoms and some ideas? Doesn't it matter that protons and electrons are way too different. Or can we get away by saying that they are two different things. Then why is not one human different from another. Maybe because equality and difference are human ideas. Nature doesn't believe in such trivialities. No two peaks are the same height in nature and yet the sea level everywhere is the same. I don't want equality for myself and yet I know I am no different from you. But can the ideas which originate from humans be used as benchmarks to define them?

There's a pattern in the nature. And it has got nothing to do with equality or not. This pattern reflects in the way the planets revolve around the sun and the electrons around the proton. And yet it seems like they won't ever meet. When they do, it destroys them. It's like a potential that keeps building up while their monotonous sojourns in their respective orbits continue. And eventually it gets released. This is another pattern of nature - things moving from higher potential to lower potential or in other words higher stability. All this when we know that the entropy of the system always keeps building up. Being more stable also means being more chaotic. Then why is it that the society equates control with freedom? Isn't it a pattern very similar to the patterns we talked of earlier.

When you think you have figured it out you just get bored and don't want to write anymore. But I do want to share the idea. Please bear with me if the language gets even more dull from hereon. Society is the big orbit where we start rotating all our lives. But rotation can get on your nerves. That's why we need hope. And hope makes us happy. And yet too much happiness is also not good and we end up getting frustrated. And when we think we could take it no more, hope sneaks upon us once more. GOD!!! Yes, that's what we call it or Him. This source of hope, and frustration also. I don't believe God exists to love us or hate us. He is one of the variables in the equation even if the most important. But the equation is the same - same patterns, same orbits, same motions. Mundane, isn't it? If you think electrons lead a mundane life, yes it is. But did I get smug at the idea that hey, it's all about hope and that I have figured it out. I was getting there in some way when someone made me realize that the degrees of freedom of the psychological plane are way too above those in the physical plane. So can I really write something off that's happening in this psychic plane?