DEMAND PULL INFLATION & COST PULL INFLATION

Inflation is as we all know, is the general rise in the price of goods and services. But why does inflation happen?
There are two major causes / theories behind Inflation

• 1. Demand Pull / demand side

• 2. Cost push / Supply side

What Is Demand Pull Inflation?

• Also known as demand-side inflation, monetary theory of inflation.

• Crux: When people have truckload of cash in their hand. But there are not truckloads of goods in the market.

• Consider this scenario:

• Government of India initiates a (bogus) scheme called MNREGA, total 40,000 crore rupees are sent from Delhi every year and we all know that most of the money is eaten by the Ministers and government officials before it reaches to the poor people. Now this minister has truckload of blackmoney in his hands and worried about how to invest it somewhere?

What Is Black Money?

• Black money is any money on which tax is not paid.

• Black money is not necessarily related with Corruption only.

• Only politicians and bureaucrats have black Money = Wrong statement.

• I run a medical store very honestly, earning 10 lakhs a year but on paper show only 2 lakhs of profit, to save myself higher income tax payment. So this 10 minus 2 = 8 lakh rupees on which income tax is not paid = black money.

• You purchase a home for 10 lakhs from a builder, but to save the stamp-duty payment, you give 2 lakhs as cheque, rest payment in cash without any bills. That 10 minus 2= 8 lakh rupees on which stamp-duty is not paid =black money.

Back to the topic;

What should the minister do with his black money?

• Deposit in his bank account? No, he cannot, because he'll get caught because income tax department keeps an eye on this. He will be booked for ‘disproportionate assets’ case just like Mulayam, Mayawati and Jaya Lalitha.

• Should he Invest in the share market? No, he can't do this either, because he has to give his PAN card number for every purchase and sale of shares, and the income tax department keeps a close eye on this activity.

• So he will use the very time-tested method of hiding black money:

• Either purchase gold, silver, platinum, diamonds  or

• Deposit in the Swiss bank account but he is feeling insecure about it, given the current activism by media, civil society and judiciary.

• or Purchase land, shopping-mall, farmhouse or other real estate: under Benami Transection

what is Benami Transection?

• In crude terms, when you purchase the land, property, car with your money but it is purchased in the name of your relative, friend, daughter-in-law, driver, peon any even a person that isn’t born yet or died a long time ago.

• So our beloved Minister purchases quite a few buildings, with the speculation that in future the price of these buildings will increase. (After all, there is no end to greed, he already made the cash, but still he would want to make more money out of his money.)

• Now we know that the land, or gold or the number of buildings that can be constructed on a land are in finite amount.

• So when normal people like you or me go to purchase an apartment, the builder will demand more money because there is same supply of apartments in the market but more people waiting in the line to purchase a home. What happened? Supply same, but demand increased = price rise.

• Same way, the minister would also invest part of his black money in gold and silver, thus increasing their prices also.

Moneylenders

• Minister will also invest some of his money with the moneylenders – who circulate it as loan @36% interest rate to the needy people.

• Who’re these needy people?

• #1: the urban middle-class men who suddenly loose lot of money in cricket betting thanks to Sachin or sharemarket speculation thanks to Anil Ambani’s IPO and then have to borrow immediately to settle payments. They can’t goto banks because banks take weeks and months to process personal loans.

• #2: the farmers in rural areas. They need money for two reasons:

• 1. settle payment of seeds, fertilizers, electricity, water, laborers or

• 2. Dowry for daughter’s marriage and other expenses related to social ceremonies associated with child-birth, marriage, death etc.

• Irrespective of their India-Bharat divide, the fate of these two categories of needy people is same: they remain in-debt forever or commit suicide, while minister continues to enjoy hefty 36% interest rate on his money from them. (Banks only pay about 7% on your savings account, consider the difference!)

Back to the topic: another factor responsible for “Demand-pull” inflation.

What is disposable income?

Every month you get salary,

• part of that salary goes in the EMI of car/bike/house loan payments,

• Part of that goes in the compulsory payment of electricity, telephone, Internet, newspaper, milk and vegetables.

• Part of the salary deposit in the savings account of your bank and then

• Whatever is money left in your hand for cinema, restaurant, spa, caller-tunes, branded clothes etc. non-essential, discretionary spending is called disposable income.

• Example. The sixth pay commission increased the salary of government employees, almost everybody suddenly got say Rs.50,000 per month, compared to 20,000 earlier.

• So even after the regular payments of EMI, Telephone bill etc. they will have more disposable income in their hands compared to earlier, what will they do?

• They will start visiting restaurants or cinema every Sunday instead of visiting them every month.

• Many of them may even plan holiday trip. What is the implication?

• 1000 families chasing total 500 seats of restaurant / multiplexes in their city

• Or 100 families chasing 50 hotel rooms in Goa.

• We know that supply of seats or hotel room is same as earlier, but demand has increased, the hotel owners would start charging more = inflation.

Dearness Allowence paid by Government

• Quoting a Line from Times of India

Giving relief to its employees and pensioners from inflation, the central government on Friday announced a seven percentage point increase in  dearness allowance (DA) which will cost the exchequer an additional Rs 7,500 crore. The new DA rate of 65 per cent of basic pay against 58 per cent earlier will be applicable retrospectively from January 1, 2012.

• What does it mean? Government keeps an eye on the inflation, and gives more salary to compensate the employee for the increased prices and cost of living.

• So, Government employee need not worry much about increased price of milk or vegetables.

• BUT private companies are not so generous about D.A. so people working in private companies (Atleast at the lower level) don’t have that much disposable income.

• Again money supply increased (Rs.7500 crores)= demand by Government employees increased= inflation is felt by the people working in private companies.

RBI’s monetary policy

• RBI Governor: behold my infinite wisdom and limitless awesomeness.  Repo rate is the interest rate at which we lend the money to banks. I’m omnipotent and omniscient so I say- decrease the repo-rate from 5% to 4%! Those Aam-Aadmis (common men) are unable to purchase homes thanks to that minister. If I reduce the interest rates, it’ll bring some relief to the common men.

• SBI manager: good. Lets borrow as much money as we can, from SBI, and then we lend it to juntaa.

• ICICI manager: I’m gonna do the same thing!

• SBI manager: damn it ICICI manager competition with me, but I’m gonna show who’s the real player here. (To his probationary officer) gang up as many annoying telemarking callers as you can, dial every number in the phone directory, sell our loans and schemes, If you don’t meet the sales-target of 500 policies a month, I’ll rip you apart and then make negative remarks in your performance report.

• ICICI manager follows the same suit.

• SBI Probationary Officer (To his manager): Sir it is not working. People are not interested in taking our loans or policies, ICICI is offering unlimited SMS, free caller-tunes, with each loan. Indian Juntaa loves mobile phones more than toilets. And they have rallied up Big B to do the advertisements.

• SBI Manager: damn it, I should have thought about it. Anyhow, I’m going to talk with MD.

• SBI MD: Reduce our interest rates. Then we see who’s the real-player here.

• Juntaa shifts to SBI loans because of lower interest rate. ICICI also follows the suit and decreases their interest rate.

• No0b loser pathetic college kid to his restaurant owner daddy: I want a Pulsar bike to impress my friends in college.

• Daddy: but I already increased your pocket money last month for Axe-perfume, Shahrukh Khan’s Fair and lovely skin whitening cream and John Abraham’s sunscreen lotion!!

• Bike Salesman in his makeshift ‘outlet’ just outside their home: come on sir, we get you easy loan from SBI.

• Daddy: alright damnit.

• This way, people get easy loans in their hands and they go out to purchase homes, cars, bikes.

• Businessmen also take loans, purchase trucks, machinery, hire more people in their company: these people also get more salary (compared to their earlier state of being unemployed)

• and hence people have more money, they demand more products = price rise = inflation.

So what is the problem here?

RBI worsened the problem by relaxing its monetary policy.
It is impossible to get zero percent inflation. RBI should only try to maintain the ‘tolerable’ level.

Should RBI have tighetend the monetary policy?

• What if RBI increased repo rate, thus increasing the home-loan interest rates?

• People would delay their decision of purchasing a home/car/ etc.

• They would instead deposit the money in savings account, or fixed deposit account or mutual funds.

• This will decrease the cash in the hands of people, thus decreasing the demand= inflation reduced.

• Now this is what RBI has been doing throughout last year, RBI Governor kept increasing the repo rate thinking that this will work.

But it did not work, we did not see any decrease in inflation despite RBI’s monetary measures, Why this “tightening of monetary policy” wasn’t effective? Because of two reasons,

• 1. The minister/bureaucrat with black money won’t decrease his spending. He will not put his money in banks, he will not delay his decision of buying a new SUV car, gold-jewelry or farm-house. RBI’s repo rates don’t have much direct effect on him.

• 2. Supply-side problems.

• Onions are expensive

• their supply is low because of bad-weather

• Many middle-men involved and each  getting Commission

• Diesel is expensive = transport expensive.

• Milk is expensive because

• Electricity is expensive. (For running the plant, coolers, machinery.)

• Crude oil is expensive (Plastic pouches, printing inks, lubricants for machinery: All derived directly or indirecty from crude oil.)

What could Government do?

• They could introduce a national savings certificate or kisan vikas patra etc with scheme “deposit your money in this, get your money doubled in 15 years, and no income-tax will be levied on it” this will make Government employees deposit their extra disposable income in savings. Thus reducing the moneysupply.

• Income tax Department could increase the raids on builders and businessmen.

• CBI could increase the investigation speed in NHRM and Mining scams involving politicians.

• Government could relax the Environmental “go and No-go” areas of coal mining= more coal= cheaper electricity

• Government could permit FDI in retail = middlemen removed = onions cheaper.

• And so many other steps that could have been taken but weren’t taken. 

• Also known as supply side inflation.
• it means the cost of production has increased hence the price of products have increased.

Theory#2 Cost Pull Inflation

What Are the Factors Responsible?
Increased Wages

• Maruti is producing 1000 cars per month, but the union workers of Maruti go on a strike and demand higher salary.
• Ultimately, Maruti agrees to the union demand, every worker will now get more salary. But of course the company never pays out of its own pocket and wants to keep the profit margin same so, the increased cost of car-production is always transferred to the customers. So the car that used to sell for two lakh rupees, will now sell for 2.17.

Increase In tax

• Finance Minister reads the newspaper headline – Indians have more mobile phones than toilets. So he thinks, why not increase the excise duty on the mobile phones and use that Revenue to give more funds under  “total sanitation campaign “ (TSC). That’ll help in building more toilets on the villages.
• But of course, the CEOs of Nokia, Samsung or Motorola are not going to pay the money out of their pockets to finance the toilet building in Indian villages, they'll pass the increased cost to the customers. MRP of Nokia Lumia is increased.
• The cash in your hands is same as earlier, but the MRP has been increased by the supplier’s side. 

Reduced Availability Of Raw Material

Consider the case of onion

• Bad weather= less production of onion or
• the blackmarketeers are intentionally stocking up or hoarding onions for better prices in future.
• Government declared attractive MSP (minimum support price) for Pulses (daal, Moong) so, farmers have shifted to producing those pulses instead of onions.
• UAE businessman is paying higher prices for Indian onions, because of bad weather conditions there. So our middlemen, find it lucrative to export onions to UAE rather than to local vegetable market in city.

In all four cases, because the supply of onions is reduced, the restaurant owner will

• A. Increase the per plate price of pau-bhaaji or
• B. Keep the per plate price same as usual but reduce the quantity of onion given, so that you’ve to pay extra for the extra ‘supply’ of onion salad.

What happened? Supply of onion reduced, so restaurant owner’s input cost increase and he had to push the menu prices higher.

To Get Higher Profit Margin

• The Supply of rice is same, the disposable income in your wallet is same, but the restaurant owner wants higher profit margin, so he decreases the size of  every Idli , but your hunger remains the same, so you’ll order more idlies and end up paying higher bill.= Inflation.
• The restaurant owner may not be the real-culprit here. Perhaps he is that daddy from the “demand pull pulsar bike” case: He had to increase the pocketmoney of his kid for that axe-perfume, SRK’s skin whitening cream and John Abraham’s sun-screen lotion.
• That’s why he has to increase his profit margin to pay for those unnecessary products.
• Or perhaps but real-estate market has gone up thanks to that Ministers in “Demand pull” inflation case. And so, restaurant owner has to increase his profit margin to pay for the house-loan.
• As you can see in ^this case, there is never a totally “demand pull” inflation or totally “cost-push” inflation. The final inflation that we feel in our real life, is resulted because of both of them. (Minister increased demand pull hence Restaurant owner had to increase the cost-push.) So this brings us to the third theory