Inflation is an economic phenomenon where the national currency loses its purchasing power due to general increase in prices of goods and services. Since inflation could deter economic growth and depress consumption and demand, it is inevitable for economists and central bankers to rein in high inflation and optimize it to a level that incentivizes spending, through effective inflation targeting measures. Often high inflation leads to unemployment as corporations and businesses cut back on new investments for expansion and growth. This results in a deferment or suspension of budgetary allocation for human resources that adversely impacts hiring decisions. Private investment as a percentage of GDP is a key driver of economic growth. Inflation could also rise from the supply side if the cost of inputs in making a finished product or service increases over time.
‘Wage-Price Spiral’ is another factor contributing to high inflation and is related to future expectations of continued price rises by laborers and employees who demand higher wages to offset the escalating cost of living. Accordingly, inflation is classified into three, namely Demand-Pull Effect, Cost-Push Effect and Built-In Inflation based on their cause and effect. While Demand-Pull is a consequence of increase in money supply in the economy outpacing economic growth, Cost-Push Effect relates to rising commodity and raw material prices due to economic shocks, scarcity or speculation (OPEC cutting crude production), Wage-Price Spiral is an example of Built-In Inflation.
Investors in financial instruments and households with bank deposits, especially senior citizens who are pensioners are perennially concerned about falling interest rates in their savings account. Lower interest rates yield lower fixed income. People who hold cash deposits or cash convertible assets like stocks and bonds are elated to see interest rates rising, that yields better income in interest and capital gains. But if inflation rises commensurate with interest rates, their purchasing power declines over time. The adverse relationship between high inflation and interest rates affecting unit consumption were brilliantly explained by former governor of Reserve Bank of India, Dr. Raghuram Rajan. He used a popular pan Indian food item ‘Dosa’ to coin a neologism “DOSANOMICS”, to educate the masses about the perils of high inflationary pressures on incomes and purchasing power. DOSANOMICS is a portmanteau of two words Dosa and Economics. It works as follows:
Suppose a pensioner who has an income of Rs. 100,000 a year decides to spend everything (in a hypothetical world) on Dosas, costing Rs. 50 apiece. So, in a calendar year, he can consume 100,000/50 = 2000 Dosas.
If a populist government raises interest rates to 10%, the pensioner is delighted that he can now binge on his favorite Dosa. He thinks he can buy 110,000/50 = 2200 Dosas. But to his dismay, he doesn’t realize that inflation too has gone up by 10% and now a Dosa costs him Rs.55 instead of Rs. 50. Now his purchasing power has decreased to 110,000/55 = 2000 Dosas, less 200 Dosas in a year. Readers might be confused why inflation has also increased with increase in income. This is due to the fact that in the Dosa context, productivity enhancement for producing more Dosas hasn’t improved by virtue of technology or superior process innovation. Therefore, demand outstrips supply and true to inflation, too much money will be chasing few goods (Dosas). Dosa manufacturers will have to hire more cooks and increase inputs (rice batter, oil, fuel) which increases variable and marginal costs in the short-run and is invariably forced to pass on the higher total costs to the customer as higher selling price. Even if inflation is lower, emerging markets like India can have Dosa prices going up. This is due to ‘Balassa-Samuelson Effect’ in economic theory which states that unless technology improves productivity in high growth sectors, price inflation will be higher relative to other sectors due to rising wage costs.
By contrast, if interest rates are reduced to 8% (unpopular for savings account holders and Dosa lovers) from 10% and corresponding inflation rate also declines by 2%, from 10% in the previous year to 8% in current fiscal year, the total annual income of the aggrieved Dosa crazy pensioner falls to Rs. 108,000 but at 8% inflation the price of Dosa also falls to Rs. 49 from Rs. 50. The total Dosas he could now buy during the year will be 108,000/49 = 2204.08 Dosas. Thus, he could buy extra 200 Dosas even in a low interest rate, but low inflation regime than in a high interest rate, high inflation economy. Therefore, reflecting on the state of the economy while relishing on your favorite Dosa is also a worthwhile endeavor. Dosa budgeting while eating is not recommended though…
About the author: Jaykhosh Chidambaran is an accomplished management professional with over 20 years of diverse industry experience in MNC’s and is currently an EdTech Growth and Strategy Consultant for India & Middle East. He is an alumnus of Chicago Booth School of Business.
Disclaimer: The opinions expressed within this article are the personal opinions of the author. The facts and opinions appearing in the article do not reflect the views of TAS and TAS does not assume any responsibility or liability for the same.