Has India disproved Friedman on Inflation?

Someone slapped me this article when I was trying to explain him that inflation is caused by Money Supply.

Now this author is a research fellow in Cato institute and quite recognized in India.

 

Just wanted to know the response of you guys. Do you really think that Inflation being solely caused by money supply theory works only in "rich" countries and not in poor countries?

India disproves Friedman on inflation
16 Apr, 2008, 1755 hrs IST,Swaminathan S Anklesaria Aiyar, TNN
http://economictimes.indiatimes.com/India_disproves_Friedman_on_inflation/articleshow/2956991.cms

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.

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.

He's mistaking "inflation" as meaning "rise in price level".  The price level can change because of inflation, which is always a monetary phenomenon because it's defined as being an increase in money supply.  However, the price level can also change for other reasons, e.g. supply shocks like drought, or demand shocks like tax increases or bad fiscal policy.  That is, prices are affected not only by Ms (monetary supply) but also Md (monetary demand).

 

What on Earth is that article trying to prove? That droughts and shortages cause prices to rise? What is the author's solution? Banning food exports? That would lower the incentive to produce food.

Ego:

What is the author's solution? Banning food exports?

To be honest that has been everybody's solution in most of the countries, including India.

Look at this, India's Finance Minister hoodwinking everyone into thinking that everything BUT govt are responsible for inflation

"Inflation is on the rise. It is a matter that causes worry to any government. When inflation is on the rise, all of us should be concerned," Chidambaram told Lok Sabha in a reply to a question.

http://economictimes.indiatimes.com/articleshow/2865038.cms

 

Of course a shortage of a good causes its price to rise. That's the price mechanism of the market at work, and is not called inflation. It's sad that 'published authors' seem to lack a grasping of basic terminology.

 yeah i don't really get what he was trying to prove.  He was just saying since a large part of the poor population's income is devoted to food that when supply and demand increase prices (like a drought), the poor don't realize any of the decrease in prices for other items since they are dependent on non-core inflation items.  The author really didn't prove milton wrong.  Somewhere in the economy prices are falling for something but the poor don't purchase the products so it disproportionally hurts them. 

Plus I don't get what he was suggesting to do.  Anything?  just not raise rates or act the west..

First let me say, this author is an imbecile.

Inflation is by definition a monetary phenomenon. Inflation means an increase in the supply of money. It is related to, but not the same thing as, an increase in price levels.

 

Now we get into the really inane:

prashantpawar:

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.

He says that since his chart does not demonstrate Milton's Law, his chart proves Milton's Law incorrect. But that logic work both ways, in truth Milton's Law proves that his very narrowly drawn chart does not actually represent the economy. Only a chart that included all prices (impossible) could completely demonstrate Milton's Law.

prashantpawar:

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.

The author seems to want to interpret the law to mean that should price levels rise every individual will have their increased costs counterbalanced by a decrease in another good. The law does not mean that. Milton Friedman was not an apologist for price level increases, trying to paint them as benign.

The law is true only in the aggregate. If you sell shoes and the price of shoes fall, you're going to be hurt economically. So you'd better find out what price went up and start selling that.

prashantpawar:

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.

The law is an economic truth. It has makes no judgments about winners or losers. That is the job of people who make government policies.

prashantpawar:

These other components of a loaf's price may be amenable to monetary policy. So, in rich countries, most inflation may indeed be monetary.

All prices are monetary. What else could something that is expressed in units of money be?

prashantpawar:

. 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.

They don't include food and fuel, because those costs display the true rate of monetary expansion. Manufactured goods decrease in real cost over time, thanks to capitalism. Those reductions in cost mask the true rate of inflation. Without inflation we would see a general decrease in prices(again, not the same thing as deflation)

prashantpawar:

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.

And here we get to the meat. Our author wants the government to control the price of food.

prashantpawar:

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.

Droughts cause an increase in the price of agriculturally goods only. Because of Milton's Law we know that, even though that single price rose, other prices fell. So the over all price level did not rise. Even if we accept the author's inaccurate definition of inflation, meaning an increase in price levels, droughts do not cause inflation.

prashantpawar:

India is not alone in abolishing import taxes on imported food items and banning the export of food staples.

And here our author gets around to prescribing who he thinks the winners and losers should be.

Losers: Indian food growers, Indian food consumers, foreign food growers, foreign food consumers.

Winners: One political economist with snake oil to sell.

JonBostwick:

First let me say, this author is an imbecile.

I would have smashed him myself because he is just another Keynesian economist, but then I saw him on Cato's website, as a "research fellow", plus he is the largest syndicated economist with his article being published in many newspapers all over India. So I just wanted to get a second opinion from you guys before replying anything.

I think he is just another Paul Krugman.