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Understanding the difference between Supply side inflation and Demand side inflation
It is summer holidays and kids living in a posh building – “Inflationary Heights” are having great fun. Their parents have filled their pockets with money and the kids now have buying power. There is an ice cream parlor down the street. The parlor sells ice cream to all the children of the area. The man in charge of the parlor is glad for making all the children happy with his different ice cream flavors.
There is a nice balance between the joy of selling and buying ice cream. But this summer something happened which disturbed this balance.
The kids from Inflationary Heights full of notes in their pockets start consuming double the volume of ice cream that they normally do. The parlor man soon realizes that the children from Inflationary Heights have a lot of money with them and even if he were to increase prices, they would continue to buy. He increases prices and the demand continues unabated. While the parlor man gets richer by the day, the other children of the area see their smiles vanish. They no longer are able to afford the ice cream any longer.
They decide to meet the parents of the children of Inflationary Heights. During the meeting with the parents, they explain their problem. They request the parents to reduce the pocket money allowance of their children so that the price of ice cream drops. The parents are in a fix. They know that this will not be accepted by their children. While everyone celebrated when they had increased their allowance, the children may not be willing to accept a reduction.
The parents do understand that if they reduce the allowance, their kids would have less money and consequently the demand for ice cream would drop. Thus the inflation in ice cream at the parlor could be reduced by reducing the availability of money.
Just like the parents of the children of Inflationary Heights have the option to regulate the prices of the ice cream parlor by either increasing or decreasing the allowance money of their children, in the same way; RBI (Reserve Bank of India) has the option to regulate the flow of money into the economy and control prices. This is called demand side inflation that may get controlled by monetary policy measures.
So what is supply side inflation? Let's get back to the story.
After the meeting, one of the parents, Mr. Idea Shankar, comes up with an idea that may not force them to reduce allowance and at the same time may provide that prices at the parlor would come down.
The next day, Mr. Idea Shankar calls on a few competitors of the Ice Cream Parlor and informs them of the huge business potential in their area. He informs the competitors about how the children of Inflationary Heights have got a lot of cash to spend due to their higher allowance. Idea Shankar's idea works to perfection. Within two days, four new parlors spring up in the area. Seeing this and fearing that he would lose business to the competitors, the parlor man immediately brings down prices. Now there are enough parlors and enough customers. In this scenario, the higher allowance does not impact prices in the parlors because there is enough supply. In fact, some of the parlors who are new start offering discounts. All the children on the area are happy now because they can start enjoying their ice cream all over again. In fact, they can now eat more due to the discounts. Now they do not have any grievances against the children from Inflationary Heights. Some of them are even thankful to them because now they have more variety and at lower prices.
The manner in which prices were regulated was by increasing the supply of ice cream, in the same manner, the government may control inflation by making the necessary provisions for increasing the supply of products and services in the economy. This is the concept of supply side inflation. While it is easier to set up a few ice cream parlors, it is not as easy to set up many factories and services for the government as it would need land, labor and capital plus time to set up the supply.
However, controlling inflation from a supply perspective is more inclusive and sustainable. On the other hand, using monetary policy to stem inflation is short term in nature and not inclusive. Beyond a point, monetary policy ceases to be an effective tool for inflation control.
To some extent, the Indian economy stands at a cross road because the role of RBI to control inflation is diminishing and the need for creating additional supply is getting imperative. Policies need to be drafted that attract entrepreneurs to invest in the economy so that they can create supply and demand by way of creating jobs. This could try and bring balance back to the economy.
Source: Tata MF
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