Understanding Macro Economy - Can inflation ever be considered good for an economy?

Most of us in India regard inflation as a beast that's spoiling our party. We only associate inflation with bad news. Yet economists suggest that inflation is good, inflation is necessary for growth. When is inflation good and when does it become bad?

We normally associate inflation with bad news..... In an earlier posts, we discussed inflation, broke it down into demand led inflation and cost push inflation and tried to understand the nature of inflation that we are experiencing in India. Most of us have over the years come to fear this beast called inflation. We immediately associate it with only bad news. Governments in India have fallen on account of inflation (remember onion prices and election results?) - such is the emotive power of inflation in our country. ....while some other countries yearn for inflation While we constantly fear the beast called inflation, there are other countries that long for inflation - countries that would love to see prices go up year after year, countries that make conscious attempts to fuel inflation in their economies. Japan is a case that immediately springs to mind. Why would they want to bring home a beast that we so dearly want to get rid of? Why do economists say inflation is necessary for growth? Economists argue that moderate inflation is necessary for spurring growth in an economy and stress on the fact that inflation is in fact necessary for any growing economy. How can inflation be seen as good news? To understand why some inflation is needed, let's consider a situation where the opposite of inflation is taking place - deflation. Imagine a situation where you see a trend of prices coming down year after year rather than going up. You want to buy a new car to replace your existing car, but you are quite sure that if you wait for 6-12 months more, you will get it cheaper. Same with a house you want to buy or a washing machine or a TV for the bedroom - or just about anything that you would count within consumption, maybe with the exception of food and essentials. Would your natural tendency be to postpone the purchase or to rush through with the purchase? As more people postpone purchases hoping for lower prices, demand falls even further, which in turn pushes prices down even more. This downward spiral chokes growth in an economy and breeds unemployment. The key to driving consumption in an economy is not therefore only about catering to the population's needs and wants, but also by holding out an implied suggestion that postponing the decision can be a costlier proposition for the consumer. Expectation of some inflation, in the minds of consumers, is therefore a key growth driver in any economy. What is good inflation and bad inflation? That brings us to another key issue - of what is good inflation and bad inflation. Simply put, inflation in food and essential products that are mass consumption items is bad inflation, as it negatively impacts the entire population, including those who can least afford it. Inflation in luxury products or infrequently purchased items (consumer durables like home electronics, TVs etc) can be considered neutral in nature as it does not usually leave a lasting impact in the pockets of those who cannot afford it. On the other hand, a modest inflation in wages and salaries is good inflation - as it increases disposable income in the hands of consumers, which can either be saved or consumed, as desired. Let's look at the business cycle to understand why inflation is necessary Why do economists suggest that modest inflation is necessary for any growing economy? Lets consider the business cycle to understand this better. If there is modest inflation, wages go up. This as we saw, results in higher disposable income, which in turn drives growth in consumption. When consumption grows, production rises and beyond a point, prices of goods and services rise. The increase in prices means healthier margins for producers, who are now enthused by high demand and healthy margins, to increase supply by creating fresh capacities. When they create fresh capacities, they kick start the investment cycle - which again contributes to another leg of growth. When new factories are set up that means more jobs created, more orders for capital equipment producers, more construction work - more growth in short that is led by investments rather than pure consumption. In this manner, growth becomes sustainable as consumption as well as investments contribute towards a more orderly economic growth. The starting point in this entire cycle, if you remember, was an increase in wages that helps drive consumption, even if it results in inflation. Moderate inflation is therefore a goal of most Governments, including ours. Where did this virtuous circle snap in our country? In a country like India, where more workers are found in farms than factories, increases in minimum support prices of food grains year after year, is what the Government resorts to, in order to effectively increase "wages" and put more disposable income in the hands of the majority of consumers. This consumption led growth should have led to the rest of the text book case spelt out above working its way through in our country. Where then did this chain snap? When prices increase, and demand is robust, manufacturers are usually spurred to create fresh capacities. But, if these manufacturers find creating fresh capacities too cumbersome - due to land acquisition problems for the factories, environmental clearances issues, no comfort on availability of power for their factories, and a fear of change in government policies due to coalition politics related pressures which can impact their expansion plans, they naturally tend to wait until clarity emerges on all of these aspects, before investing their money. You now have rising demand, rising prices, but no incremental supply - which is clearly unsustainable as the virtuous loop could not be closed. Economic growth suffers due to lack of investment led growth - which is what we have seen in recent years, and eventually consumption also reduces as sustained high inflation without sufficient growth (which would have provided more jobs, higher wages) puts too much of a burden on the consumer, who then starts cutting back on consumption, and pulls overall GDP growth down even further. To conclude To sum up, the expectations that prices will increase in future - whether of assets that you buy or goods that you consume - is pivotal for that investment or consumption decision to be taken by you. Inflation therefore is a necessary ingredient for growth. The key is to ensure that inflation remains modest (in India, RBI will be happy to see a 5% inflation rate on a long term basis) - just enough to spur economic activity, but not so much that it deters consumption.