The Great Indian Stagflation ?

The Great Indian Stagflation!


Scenario: A country on an island with ten inhabitants each holding 100 units of the localcurrency. The country imports ten bottles of beer from the neighboring island. The island produces ten bottles of its own beer. The price in local currency for both kind of bottles is five units of local currency. To increase the buying power of the country, the central bank increases the amount of local money by donating each inhabitant an additional five units.
The question is now, what happens to price of the two different beer.
For the island beer the price of production decreased, because the real salaries on the island shrunk. So one can expect the price for the local beer to remain at least constant or even decrease slightly.
For the foreign beer it's a different story.

Questions to ask might be: What happens to the import price for the bottle in foreign currency?

What happens to the exchange rate between the own and the foreign currency?

In a stagflation scenario the questions might be answered as follows: The import price in foreign currency remains constant (or increases). For one unit of the local currency, one receives now less than before compensating for the increase of the amount of money. Therefore the island price of the bottle has to increase in local currency for compensation.

One can learn that the root causes for the price of the imported beer remain outside the influence of the local monetary policy. Shifts in the amount of local money are just reflected in the price of the foreign good, not changing its effective price in the local currency.
The conclusion follows, the only way to decrease the price is on one hand that the other island increases the supply (external) of the beer or on the other hand that the inhabitants reducedrinking it (internal)

P.S: Now "find" and "replace" Beer with Crude oil ? and "currency" with the "US $" you will understand clearly todays scenario.

P.P.S: Of course our finance minister has an easy solution BAN DRINKING OF BEER,his counterpart in the ministry of health has been recently asking actors to stop drinking alcohol on screen(he wants them to drink cough syrup instead!!)

SO What am i Trying to Say : Hey Wake up, Inflation is not bad, and This is a Stag flation scenario Stupid!!!!

Stagflation is a macroeconomics term used to describe a period of inflation combined with stagnation (that is, slow economic growth and rising unemployment), generally including recession. The portmanteau term "stagflation" is generally attributed to United Kingdom Conservative MP and later Chancellor of the Exchequer Iain Macleod, who coined the term in a speech to Parliament in 1965.

Stagflation came to be recognized as a very serious macroeconomic problem in the 1970s, when it afflicted many countries in the developed and developing world. Prior to the 1970s, the prevailing Keynesian school of macroeconomics assumed that inflation and stagnation were unlikely to occur together. Until that time macroeconomists believed that stagnation could be cured by expansionary monetary or fiscal policies, while inflation could be cured by contractionary monetary or fiscal policies. When both stagnation and inflation occurred at the same time and persisted, this called into question existing macroeconomic theories and also posed a dilemma for the standard policy remedies that had been used to stabilize the economy in the past, since their coexistence resulted in a downward spiral.

Economists today offer twin simplistic explanations of stagflation, which follow, with the Caveat that if (or when) stagflation reappears within the 21st Century, the true explanation will be that the mix of these two elements went out of control.
First, stagflation can occur when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.
Second, both stagnation (recession) and inflation can be caused by inappropriate macroeconomic policies.
For example, central banks can cause inflation by permitting excessive growth of the money supply, and the government can cause stagnation by excessive regulation of goods markets and labor markets (Including present day scenario of the Ban on Futures Trading of commodities).

The global stagflation of the 1970s is often blamed on both causes: it was largely started by a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to try to avoid the resulting recession (stagnation), causing a runaway wage-price spiral.

In contrast to central bank responses to the oil price spike of the 1970s where similar policies were pursued on both sides of the Atlantic, the 21st Century begins with America going one way to fight recession and Europe going the other way to fight inflation.

When stagflation holds an economy fully within its grip, the tertiary consequence of rising unit costs because fixed costs(sunk cost?) are spread over fewer units sets in. From the makers of auto to the manufacturers of the marketed consumer brands, operating margins must begin to increase (inorder to maintain a fixed margin of profit or tolerable loss) to the extent that declining unit sales load greater costs per unit. This is the most basic of economic truths if even if it is from the mouth of not an economist but a chemical engineer.

Monetary Policy during times of Stagflation

Stagflation becomes a dilemma for monetary policy when policies usually used to increase economic growth will further increase runaway inflation while policies used to fight inflation will further the decline of an already-declining economy.

An important monetary mechanism to increase economic growth is by lowering interest rates, which reduces the cost for consumers to buy products on credit and businesses to borrow to expand production. While this can increase economic activity, it can also result in increased inflation.
The monetary mechanism to reduce inflation is by raising interest rates, which
increases the cost for consumers to buy products on credit and businesses to borrow to expand production. While this can reduce inflation, it can also result in decreased economic activity.

Stagflation becomes a problem only when the impact of the further use of the principal monetary policy tool available to assist central bank direction of the domestic economy does more marginal harm than marginal good, if used. Ultimately, the central bank can either stimulate the economy or attempt to rein it in through the mechanism of adjusting the domestic interest rate, its primary tool.

A choice can be implemented that tends to improve growth, but does it ignite systemic inflation?

A choice can be implemented that tends to fight inflation, but how badly does it impinge growth?
During periods properly described as stagflation both problems co-exist. In modern times, it will be only after the central bank has used all possible tools to meet both goals, using the best quantitative measures it has at its disposal, for stagflation to occur. Major economic conditions of unusual proportion will have already created near-crises on both fronts before stagflation can set in again. Stagflation is the name of the dilemma that exists when the central bank has rendered itself powerless to fix either inflation or stagnation.

The problem for fiscal policy is far less clear.
Both revenues and expenditures tend to rise with inflation, and with balanced budget politics, they fall as growth slows. Unless there is a differential impact on either revenues or spending due to stagflation, the impact of stagflation on the budget balance is not altogether clear. One school of thought is that the best policy mix
is one in which government stimulates growth through increased spending or reduced taxes, while the central bank fights inflation through higher interest rates. Whatever theory is employed, coordinating fiscal and monetary policy is not an easy task.

Common man sense to solving stag flation:

" The First step in curing alcholism is for the alcoholic to accept that he has a problem"

Stagflation undermined the dominant Keynesian consensus, and placed renewed emphasis on microeconomic behavior, particularly neo-classical economics with its attempt to root macroeconomics in microeconomic formalisms. The rise of conservative theories of economics, including monetarism, can be traced to the perceived failure of Keynesian policies to combat stagflation or even properly explain it.

Stagflation in the USA was defeated by then Federal Reserve chairman, Paul Volcker(yes the same Volcker report Volcker), who sharply increased interest rates to reduce money supply from 1979-1983 in what was called a"disinflationary scenario." This was the time when Gold Peaked to $851 (adjusted to inflation about $2100 in todays terms) Starting in 1983, fiscal stimulus and money supply growth combined to create a sharp economic recovery which is in line with standard macro-economic models; however, there was a five-to-six-year jump in unemployment during the Volcker disinflation. It appears that Volcker trusted unemployment to self-correct and return to its natural rate within a reasonable period, which it did.(Volcker Did not know about Maharashtras MREG's of the late 70's now in new avtar as The National Rural Employment Guarantee program!!!! ).

Supply-side economics emerged as a response to US stagflation in the 1970s. It largely attributed inflation to the ending of the Bretton Woods system in 1971 and the lack of a specific price reference in the subsequent monetary policies. Supply-side economics asserts that the contraction component of stagflation resulted from an inflation-induced rise in real tax rates. In addition certain states in the USA had laws limiting nominal interest rates, which under high inflation resulted in negative real interest rates. In some places this caused a collapse in lending to business. The reality, as described throughout this article, is that there was a major confluence of economic events in the 1970s that occurred as the US adjusted to a post-Vietnam War economy that contributed to stagflation.

Now can i say that History repeats itself?