And Sudhi Sharma2 abstract



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CONVERGENCE OF DEMAND PULL INTO COST PUSH INFLATION IN INDIAN ECONOMY

Shri Prakash1 and Sudhi Sharma2

ABSTRACT

The paper focuses on inflation in Indian economy; it answers the following research questions: (i) Is inflation in India monetary or structural? (ii) Does inflation occur simultaneously in the entire Indian economy? (iii) Does RBI’s policy focus on the cause of Indian inflation? (iv) Do food/agricultural prices affect prices of manufactures? (v) Is Demand Pull inflation induced by excess money supply or decline of output of agriculture? The paper uses four Input-Output models to answer these questions in theoretical framework of flex-fix prices. Input-Output table of 2008 and 2011-12 and 2013 price is the data base. Effect of changes in 41 flex-prices on 89 fix prices is analyzed to compare results of decomposed and integrated models.

Prices of agricultural goods, especially food items rise due to crop failures which affect all other prices in the economy. Thus, demand pull food inflation converges to cost push inflation, which envelops entire economy through inter-sector linkages, rising nominal wages and inflationary expectations Food inflation spreads in entire economy since 45% of all households’ budgets and 85-86 of total expenditure of the poor is absorbed by food, about 50% of total workforce is engaged in agriculture and related activities whose incomes fall with the fall in agricultural output. But inflation does not occur in all sectors of Indian economy simultaneously; it follows lead-lag pattern.

Elasticity of fix with respect to flex prices is derived from alternative scenarios based on different rates of increase in flex-prices. Arc elasticity derived from different points’ elasticity of fix with respect to flex-prices is stable over the entire range of changes. These are methodological and theoretical innovations. Findings support the thesis that food inflation is structural which envelops non-food sectors in a lead-lag fashion. Inflation is, therefore, structural rather than monetary in India. Prices of manufactures are determined by long run average cost. But prices of agricultural goods depend on flow and stock demand of intermediate traders. Traders’ Stocking Behavior depend future expectations of agricultural prices. These traders determine prices, while traders of manufactures take prices as given, they act as commission agents. This dichotomous behavior and lead lag relation of flex-fix prices underlies food and general inflation in India.

Key-Words: Inflation, Flex-Fix Prices, Input-Output, Decomposed, Integrated Models, Intermediate Traders

___________________________________________


  1. Professor of Eminence, BIMTECH, Knowledge Park II, Greater Noida, India

shri1j38@gmail.com

  1. Research Scholar, BIMTECH, Knowledge Park II, Greater Noida, India

Sudhisharma1983@gmail.com

  1. THEORETICAL AND EMPIRICAL BACKDROP OF INFLATION IN INDIA

This paper uses dichotomous behavior of flex-fix prices (Hicks, J.R., 1936, 1965, 1972) for analyzing inflation in Indian economy in input output framework. Inflation is and has been the perennial problem world over since times immemorial. But the Indian economy had been experiencing periodic inflationary pressures even before the problem became endemic in the developed economies. The genre of inflation in Indian economy is different from that of developed economies; inflation in Indian economy has never been a monetary phenomenon. India had been experiencing periodic crop failures and consequent famines; shortages of supplies of agricultural goods result in exceptionally high rise in prices of agricultural goods in general and food grains in particular. Impact of food inflation on Indian economy may be gauged from the fact that, on an average, 45% of all households’ expenditure is absorbed by expenditure on food, while 85-86% of total income/expenditure of the poor households is spent on food. Nearly 50% of total workforce is engaged in agriculture and related activities. Real incomes of cultivators, agricultural workers and related activities fall with a fall in agricultural output. The increase in nominal income due to outbreak of food inflation generally falls short of decrease in output. Besides, output of agro-based industries declines, while its material cost of production rises as an effect of crop failure; demand for output of agro-linked industries also falls, increases in interest rate and average wages raise fixed capital and wage cost of production. These industries are affected first by inflation, emanating from agriculture. Bur, rise in food and other agricultural prices due to sudden shortages is not explained by excess money supply. Money supply is given at the time of crop failures. Actual output is known after harvesting and the supply of money at that time is already given and fixed. In fact, demand for money increases in the wake of crop failure after inflation breaks out in the economy. But increase in demand for money is sector specific which is managed by inter-sector transfer of expenditure. Following equation will explain this:

Qst=M1tV1t+M2tV2t ………………………………………(1)

Qst is the supply of money at time t, say, just before the crops are harvested, M1 and M2 are the quantities of broad and narrow money, V1 and V2 show the corresponding velocity of circulation.

Qdt=PatTat+PnatTnat ……………………………….. (2)

Qdt, is total demand for money at time t. Pat and Pnat are average prices of agricultural /flex and non-agricultural prices/fix prices, Tat and Tnart are total transactions of two types of goods that take place at time t at the given average prices.. It is assumed that equilibrium exists in money market at time t:

Qst= Qdt;

or

M1tV1t+M2tV2t =PatTat+PnatTnat………………… (3)



Once the information about reduced output of agricultural goods reach the market and reduced supplies start moving from farms to markets, agricultural prices begin to boom by ΔPat. But Tat does not change due to price inelasticity of necessities. So, total expenditure on agricultural goods increases by ΔPatTat. Most of the agricultural goods fall in the category of necessities. Consequently, price inelasticity of demand of food and reduced real/nominal incomes together induce the households to transfer money to food expenditure from the amount of money allocated for consumption of non-agricultural goods. But fix prices are governed by cost rather than demand. Hence, the demand for such goods will decrease by ΔTnat. Thus, PnatΔTnat amount of money is transferred from second component of demand for money, that is, non-agricultural goods for increasing expenditure on agricultural goods. The quantity of non-agricultural goods has to decline since fix prices do not respond to changes in demand. PnatΔTnat amount is transferred from non-agriculture to consumption of agricultural goods which requires ΔPntTat additional amount for purchasing the same quantities, Tat as before. Fix prices remain invariant but amount of expenditure available for purchase of non-agricultural goods is now reduced by PnatΔTnat. Consequently, money spent on non-agricultural goods is reduced by PnatΔTna, Invariance of Pnat leads to reduction in quantity of purchase by ΔTnat. So, new demand for money for the purchase of agricultural and non-agricultural goods is shown by m

(Pat+ΔPat)Tat +Pnat (Tnat-ΔTnat)= Qdt.= M1tV1t+M2tV2t =Qst …………….. (4)

As

PnatΔTnat=ΔPatTat,……………………….. (5)



Total demand and supply of money are left unchanged, but the structure is changed. The expenditure on non-agricultural goods is reduced by the same amount by which expenditure on agricultural goods is increased due to inflation caused by rise in flex-prices. ΔTnat depict decline in demand, though the prices remain unchanged. Thus, demand recession in non-agricultural sectors, especially manufacturing, is in-built in the structural nature of inflation in Indian economy and invariance of fix-prices. If international economy also moves into demand recession at the time when inflation occurs in Indian economy, demand recession in non-agricultural sectors will be further accentuated. These twin facets of recession in the midst of inflation cannot be ameliorated by the policy of high interest rate, which RBI has been persistently following.1 The inter-sector linkages are the conveyors of impulses of demand pull inflation released by the flex-price sub-system to fix-price sub-system of Indian economy. Use of higher priced flex-price inputs in the production of fix-price goods leads to conversion of demand pull into cost push inflation. This is further aggravated by increased wage and interest costs resulting from inflation. This facet transforms inflation from purely monetary to a structural phenomenon in Indian economy. Therefore, structural approach is used to investigate convergence of demand pull into cost push inflation; inflation spreads from food sectors to the rest of the economy through the linkages embodied in input-output relations (Cf. Hirschman, 1957, Prakash, Shri, 1986, 1992). This is the basic thrust of this paper.

The problem of agricultural inflation may also be looked at in the context of the pattern of growth of Indian agriculture; it reveals that each peak and trough is higher than the earlier ones and the existing money supply generally takes care of the same in an inter-temporal framework. But the rising incomes and reduction in poverty bring about a change in the structure of food consumption of households. Such households, as moved above the poverty line and non-poor households whose incomes increased by economic growth substitute and/or supplement essential by protective foods; consequently, structure of food consumption change. It results in rapid increase in demand for fruits, vegetables, milk and milk products and other animal foods like eggs, dish, meat etc.. But agriculture, fishing, forestry and animal husbandry are the major constituents of flex price subsystem. Price of output of some other sectors, which are heavily dependent on above sectors, also acquire the trait of flex-price behavior partially if not fully (See, Prakash, Shri and Goel, Veena, 1986).



This paper uses ‘Demand Pull Inflation’ in the sense which differs from the usual connotation of demand pull inflation. Demand Pull conventionally refers to inflation caused by excess of aggregate supply of money relative to aggregate demand. In such a state of the economy prices of all sectors rise simultaneously. But food induced inflation does not occur in all sectors of Indian economy simultaneously; rise in prices follows lead-lag pattern. Rise in Nominal ahead of Real Income is itself the consequence of inflation in the economy. Demand pull inflation in Indian economy occurs if demand exceeds supplies of foods and other agricultural goods due to decrease in output, even though monetary incomes and aggregate supply of money are constant. This feature of the economy has not changed much despite seven and half decades of growth of Indian economy and structural changes thereof.

  1. DETERMINARION OF FLEX-FIX PRICES

Logic/theory used for identifying flex price sectors is that intermediate traders operate independently of producers in atomistic competition as the market makers of flex prices. The traders operate in mandis of food grains, fruits, vegetables and other auction markets such as tea, coffee, rubber, coal and other mining products on lines similar to that of Market Makers in stock markets (Prakash, S. and Bhatia, Chitra Arora, 2011). They purchase excess supply to absorb it in stocks; but the bid prices in such a state of the market are generally lower than flow equilibrium prices. Stocks are accumulated in such states of market. However, traders expect prices to rise in future at the time of purchase. As against this, traders meet excess demand over flow supply brought to the market by farmers and offer greater than flow equilibrium price; it induces flow supplies to rise. Stocks are depleted to meet excess demand in such state of the market. Thus, traders manage imbalances between flow demand and flow supply by stock operations. Stock management is based on price expectations. The traders themselves determine bid and offer prices with reference to shortfall or excess of supply relative to demand and thus operate as the makers of flex-prices. Stocking behavior of independent intermediate traders is governed by future price expectations based on current mismatch between flow demand and supply and price changes expected to materialize in future. Both demand and supply comprise flow and stock components. If traders expect prices to rise in future, they accumulate stocks; it boosts the demand and prices in the market. If, however, the forecast is for the harvesting of bumper crops, crop prices are expected to fall. Consequently, traders deplete their stocks, leading to increase in supply in excess of flow and stock demand. This makes market prices to decline. Flex price markets are in equilibrium if desired and actual stocks of traders are equal. Stock equilibrium itself embodies equilibrium of flow demand and supply ((Prakash, S. and Goel, V., 1986, Cf. Hicks, 1965, 1972).

Intermediate traders in fix-price markets are takers of prices; they operate as commission agents of producers, who determine fix-prices on the principle of long run average cost plus principle. Fix-prices are generally not affected by movements of demand; excess demand is managed by traders either by depletion of stocks or by the lengthening of order book and increase in waiting time for delivery. Traders of such goods have fixed annual or monthly quota of supply Mostly markets of manufactures, especially pricey consumer durables and basic and heavy capital goods operate on this principle. Fix-prices do not change with the change in demand, these prices change with the change in long run rather than short run transitory changes in cost of production.



These prices are determined on cost-plus basis. Structural approach to inflation in this paper uses flex-fix price theory as the framework of analysis.. Mostly markets of manufactures, especially pricey consumer durables and basic and heavy capital goods operate on this principle (Prakash, S, 1978/86, Mahtur, P.N. and Prakash, Shri, 1981, Prakash, Shri, 1981, Prakash, S. and Goel,V., 1986, Cf. Hicks, 1965, 1972).

The equilibrium prices, derived from integrated price model 7/11, are compared with the actual prices of 2011-12 and 2012-13 to identify 41 flex and 89 fix price sectors. If Pj12/Pj^ If, however, Pj12/Pj^j-th good/sector is identified as fix price. Pj12 or Pj13 and Pj^ are observed prices of 2012/2013 and equilibrium prices. Equilibrium prices, as already discussed, are long run cost based prices. These are estimated from equation 7/11.

Then, 41 flex-prices are determined by the incorporation of changes in flex prices in 2011-12 and 2012-13 respectively. A constant margin of λj < 0.20 and, , j=1,2,..130, is used as the bench mark for distinguishing fix from flex prices. If, however, 𝜆j<0.20, f Thus, 0.20 margin/ mark up rate over cost is used to distinguish fix from flex price sectors. The coefficient of margin, λabove the cost is assumed to operate in fix-price markets. Mark up rate operating in flex price markets is , Thus, Pj1.20Cj for all j=1,2,…, 41 holds. Flex price sectors are numbered from 1 to 41. As against this, Pj1.20Cj holds for all j=42, 43, …,130 as fix price sectors are numbered from 42 to 130. Therefore, composite price vector of model 7 comprises 41 flex and 89 fix prices. The sub-set comprising all flex prices constitute a sub-matrix of 41x89. This sub-matrix of 41 flex-price sectors uses inputs of flex-priced goods alone. This constitutes first upper segment of decomposed model. The other sub-matrix, having lower segment of 41 flex-price sectors, is 89x41; it uses 89 fix price inputs alone in the production of 41 flex-price sectors. This sub-matrix is the third lower segment of the segment of decomposed model. Similarly, second upper segment has sub-matrix 41x89 fix-price sectors where 41 flex-price inputs alone are used for producing 89 fix price goods. The second lower segment of sub-matrix 89x89 of the composite matrix is the fourth segment of decomposed model; it uses 89 fix-priced inputs alone for producing 89 goods of fix-price sectors.2

Correction of error of exclusion of 14 flex price sectors from the list in exploratory exercise increased flex price sectors from 27 to 41, while fix-price sectors declined from 103 to 89. Therefore, determination of 41 flex and 89 fix-price sectors is examined. Flex price sectors are reported in the table-1.



  1. STRUCTURAL APPROACH TO INFLATION

Pattern differs from the structure of inflation in an economy. Pattern refers to relative shares of primary, secondary and tertiary sectors in total rise in general price level. Greater the share of a sector in general price level, greater is the effect of rise in price of its output on inflation. Structure, as against pattern of inflation, is defined by the effect of rising prices of goods of specific sector(s) on prices of other sectors. Greater the proportion of output of a sector used as inputs in various sectors of the economy, greater is inflation effect of increased prices of its output. But inflationary impulses are transmitted from one to other sectors of the economy through inter-sector dependencies; backward and forward linkages embody these inter-dependencies of sectors. This paper focuses on percolation effect of inflation from the primary to rest of the sectors of Indian economy. Inter-sector dependences, based on relations of inputs and outputs, act as the conduit of transmission of inflationary impulses among the sectors of economy. Greater the share of a sector’s output, say sector i, in total inputs used in another sector, say j, greater shall be the impact of rise in price of ith sector’s output on the cost and price of output of sector j. Consequently, impulses of increased price of sector i’s and j’s outputs used in other sectors as inputs are passed over to the entire economy. Such changes in costs and prices ultimately emerge as general inflation in the economy. Therefore, both pattern and structure of production are important determinants of inflation. Besides, greater the proportion of output of a sector in final demand vector, greater shall be the inflation effect of rise in price of such sector’s output on households’ and public budgets. It directly affects consumption multiplier and investment accelerator of growth.

Packaging materials, certain chemicals, transportation, communication and energy resources constitute universal intermediaries in input output tables of all countries of the world. Consequently increase in freights and fares, call rates, water and electricity charges, etc. exercise pervading influence on general prices. Therefore, increase in administered prices of all hues either to mobilize additional resources and/or for bridging the gap between increased public expenditure and revenue affects general price level (Cf. Jha, Shikha and Mudle, Sudipto, 1987). Hence, increase in prices of such goods and services have not only big direct effect but a cascading/indirect effect on costs and prices of various sectors of the economy. Besides, shocks from within and outside the economy also affect prices. This is in addition to the price effect of imports either due to exchange rate fluctuations or otherwise. Inflation effect has also been rising with the increasing degree of openness of the Indian economy. Monetarist approach to control inflation misses not only above factors but inflation effect of inter-dependences among production sectors of the economy also falls beyond its purview. Monetary policy overlooks not only inter-dependencies in Indian economy but it also misses the genesis of inflation. National and international indirect tax policies also exert pressure on Indian general price level. This study takes care of only such missing parts in the analysis of inflation as are related to flex and fix prices.



  1. CONVENTIONAL INPUT OUTPUT MODELS OF QUANTITY AND PRICES

Input Output Modeling is the most powerful tool of (1) Capturing changes in the pattern and structure of the economy; (2). Impact and effect of even smallest change in any part is experienced throughout the economy; and (3). Matrix multiplier embodied in Leontief Inverse captures both direct and indirect effects of even smallest change. The paper developed four input output models from two equations of flex and fix prices; these models are applied to data and results of two models are compared. Two models are integrated and other two are decomposed models. Decomposition of I-O model is used as an innovation for extending and modifying Leontief price model into flex and fix price models. Changes in flex prices are treated as exogenous to the system though both flex price sectors (41) and fix price sectors (89) are an integral part of I-O table on which the empirical estimates of the models are based. Flex and fix price sectors of Indian economy are identified first. Transactions among 130 sectors of 2007-08 furnish the matrix of input coefficients and Leontief Inverse. Leontief’s static price model is applied to determine cost based equilibrium prices of all 130 sectors/commodity groups for 2007-08. This price model treats all prices in the economy as fix-prices, which are based on long run cost of production. The Basic Input Output models of Quantity and Price determination are outlined hereunder.

X= (I-A)-1*f …………………………………(6)

X is output vector, A is matrix of input coefficients, f is final demand vector and (I-A)-1 is Leontief inverse. The dual price model, corresponding to the primal quantity model, is given below:

P= V*(I-A)-1………………………………… (7)

P’ is the row vector of prices and V is the value added vector. Value added, Vj is the surplus of gross output, Xj of good j over the sum of intermediate inputs used up in producing Xj. Thus, the value added vector, V is the surplus of gross output vector, X of goods over the sum of values of intermediate inputs used up in the production of gross output. All prices are estimated from model equation 7 first. These prices are long run cost based equilibrium prices; cost of production is given by the following relation:

C =V*(I-A)-1……………. (8)

V=wL+rK=W+II……………………………. (9)

L is the vector of coefficients of labour per unit of output, w and r are the uniform wage and interest/profit rates, and K is vector of capital stock per unit of output. W and II are vectors of wage and profit/interest cost per unit of output of different sectors:

W= wL and II= rK

Then, long run cost of production, comprising direct and indirect materials, wage and capital costs, is given by relation 10:

C =(W+II)*(I-A)-1………………………………(10)

It includes direct and indirect material, wage and capital costs. Then, equilibrium fix-prices are given by relation 11:

P’=(W+II)*(I-A)-1………………………………(11)

Equations 6 to 11 represent conventional integrated quantity and price models.



  1. DECOMPOSING AN INTEGRATED MODEL

Decomposition is based on the principle relating to the structure of an economy, especially the economies of developing economies. Structure of a well integrated and extensively mutually inter-dependent economy is in-decomposable. However, structures of developing economies are either block-diagonal or even triangular with the result that several sets of zeros occur in their transactions’ matrices. Such zeros constitute null sub-matrices. Such economies either have block-diagonal or triangular sets of input output relations. The matrix, given below, is an example of a block diagonal transactions matrix. First two and last three sectors in above table constitute two blocks, which are the diagonal of the matrix.. Right upper hand and lower left hand corners constitute null sub-matrices. This represents a typically decomposable economic structure. A Decomposable Transactions Matrix:

X11 X12 0 0 0




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