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India disproves Friedman on inflation PDF Print E-mail
Friday, 18 April 2008

His claim that for a given money supply, a rise in the price of any one item will be offset by a fall in the price of another cannot be true in all cases, report agencies.

Inflation is always and everywhere a monetary phenomenon, said Nobel laureate Milton Friedman. Now, I have a lot of respect for Friedman.

But the inflation India and other developing countries are currently experiencing is not a monetary phenomenon, and cannot be curbed by monetary policy. Does money matter for inflation?

Of course. History has many examples of hyperinflations caused when central banks printed truckloads of currency. Zimbabwe is doing this right now, and hence is suffering from 100,000% inflation. But is inflation caused by money alone? Of course not.

In India, serious inflation has repeatedly occurred after major droughts. This is unrelated to the money supply. Friedman argued that money determined the overall price level in an economy, but not the price of any particular item, say rice.

If the price of rice went up, more money would be devoted by consumers to rice, and so less would be devoted to other items like TVs, whose price would therefore fall.

Overall, he argued, prices would be determined by money supply, and drought would simply change the relative prices of food and other items.

Two objections to Friedman’s analysis immediately spring to mind. The first is technical. For an overall picture of prices, you need to construct a price index. The weight attached to each item in the index is not absolute: it depends on what you aim to measure.

If your aim is to measure wholesale prices that are important for producers buying inputs, you create a wholesale price index, in which weights are linked to the traded value of each item in a benchmark year.

If your aim is to measure the impact on consumers, you have a rather different consumer price index, in which the weights will reflect typical consumption baskets. Different classes of consumers have different consumption patterns.

So India has separate consumer price indices for industrial workers, urban white collar workers, and agricultural labourers. This drives home the point that the inflation rate is not an absolute concept, as Friedman seems to imply: it varies depending on which basket of goods you are interested in.

Food accounts for half or more of the budget of poor agricultural labourers, so, the consumer price index for agricultural labour assigns very high weights to basic food items.

These items have somewhat lower weights in the index for industrial workers, who have higher incomes and spend more on non-food items. Food items have a much smaller weight in the wholesale price index, since agriculture now accounts for under 20% of GDP.

Friedman’s claim that, for a given money supply, a rise in the price of any one item will be offset by a fall in the price of another, cannot be true in all cases.

Even if it is true for one index, it may not be true for another. But in India the objection to Friedman’s analysis is not just technical. Above all, it is moral.

If a major drought sends food prices skyrocketing, millions will suffer severe hunger, and some may die. It is ridiculous, and immoral, to argue that this is offset by the gains of other folk who now find that TVs and computers have become cheaper.

In rich countries like the US, where Friedman spun his theories, families of four earning $21,000 (Rs 8.4 lakh) per year are categorised as poor. They do not starve when food prices rise. World prices of all basic foods - cereals, edible oils, meat - have skyrocketed in the last year, causing political tremors across developing countries. But they have not caused tremors in the US. Why not?

Because most of the cost of a loaf of bread in the US is on account of processing, packaging, advertising and trade margins. So, a 100% rise in wheat price may translate into just a 2% rise for a loaf of bread. These other components of a loaf’s price may be amenable to monetary policy.

So, in rich countries, most inflation may indeed be monetary. But even there, central banks recognise that food and fuel are less amenable to monetary manipulation than other items. So the European Central Bank, Bank of England and US Federal Reserve Board target not overall inflation but core inflation - that is, prices other than those of food and fuel.

Monetary policy is even more helpless to combat inflation in poor countries, where food and fuel account for a big chunk of the consumer price index. If the RBI raises interest rates and cuts money supply, it will hit industrial production without reducing food prices.

That is why several poor countries have used not monetary policy but changes in import-export policy to curb food inflation. India is not alone in abolishing import taxes on imported food items and banning the export of food staples. China, Thailand, Indonesia, Vietnam, Egypt, Ethiopia, Kazakhstan and Cambodia have done likewise. Friedman was simply wrong in saying that inflation is always and everywhere a monetary phenomenon.

It is not the case in poor countries where droughts or a sharp fall in global availability have suddenly caused inflation. Friedman’s thesis may have a fair amount of force in rich western countries. Indeed, his thesis has become the foundation of monetary policy for several western central banks that sometimes have a single-point programme - targeting inflation.

The European Central Bank focuses almost exclusively on controlling inflation, and so has kept interest rates high even though a global recession has probably started. By contrast, the US Federal Reserve has slashed interest rates, since it would rather focus on reviving growth than controlling inflation.

In India, the Raghuram Rajan Committee has just suggested that the Reserve Bank of India should cut down on its current multi-tasking, which covers exchange rates, growth and inflation, and focus principally on inflation control.

But in Indian conditions, non-core inflation is often the dominant part of inflation, and in such cases monetary policy is a weak tool to curb prices. India is not Europe, and so the RBI should not try to behave like the European central bank.

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