Inflation

I am thinking of inflation caused after covid. Inflation is an increase in the prices of goods or a decrease of purchasing power of money. Both are not the same though.

Excess money supply after covid and supply chain bottlenecks have caused an increase in inflation throughout the world.

Each country has had a different experience with inflation.

I think an understanding of the following things is important to understand inflation

1. First thing to understand is that not all inflation is caused by an excess of the money supply. For example, wheat prices have surged due to Russia Ukraine war and drought/heatwave in major wheat producers. Hopefully by the next year if Russia Ukraine war is not still ongoing then wheat prices will normalize. Such price increases due to supply disruptions are temporary in nature.

But inflation caused excess money supply is more permanent in nature. This is what central banks try to avoid by an increase in interest rates.

2. The second important thing to understand is that once central banks increase the money supply, the increase in price of goods is not instantaneous. It takes time for the excess money supply to move from one sector of the economy to the other.

3. The third important thing is major financial institutions are always chasing risk-adjusted returns over their time horizon to park their funds.

They will invest in Indian equities if their expected return from equities less expected depreciation of Indian currency less risk premium for India is greater than their expected risk-free rate.

But everyone uses different methods for calculating expected returns. And their time horizons are different.







4.Fourth important thing is 

• When this excess supply of money reaches investors in terms of excess funds, they bid up prices of assets like house, housing etc.
• When excess supply of money reaches companies in form of profits they bid up price of their raw materials
• When these companies are part of supply chain then it leads to cascading impact of inflation.
• When excess supply of money reaches consumers they are willing to accept higher prices of consumables

All of these factors act together. So it is difficult to determine which is more important contributor.
But most importantly many companies and most individuals don't see an increase in profits/salaries but bear the burden of inflation. Further due to cascading impact on the supply chain along with supply-side shocks, increase in prices of commodities are not uniform.

Across the world, central banks try to maintain a small amount of inflation. Inflation becomes a problem when it becomes uncontrolled. As one of the causes of inflation is inflation expectations itself. 

Suppliers demand higher prices for goods when they expect higher inflation. 

Left unchecked this positive feedback loop can lead to hyperinflation. Hyperinflation is rare. But once central bank and government loses control. It can readily happen due to positive feedback loop. As can be seen in Turkey and Srilanka.

Steps being taken to control inflation

To reduce inflation Central Banks/Governments take following steps:

1) It tries to maintain stable exchange rate. As depreciation of currency leads to inflation. Hyperinflation are always the result of foreign investors losing trust on the currency. As currently is happening in Srilanka and Turkey.

2) It tries to discourage loans by banks by increasing interest rate and reserve ratios. More the banks give out loans, more they increase money supply in the economy as banks are allowed to lend (1/reserve ratio) times their deposits.

3) Government reduces imposes tax on goods and imposes export duty.







Source:

1) https://www.investopedia.com/articles/08/fight-recession.asp

2) https://www.investopedia.com/articles/insights/122016/9-common-effects-inflation.asp

3) https://www.investopedia.com/terms/l/liquiditytrap.asp