I will begin by examining a particular argument which was being used in India in the context of the last 17 months of inflation, which began with a sharp upward rally of food prices. Food price inflation peaked in the early months of 2010, when it exceeded 20 per cent. Non-food inflation would pick up a little later.
It has often been argued that the sharp rise in food prices in 2009 and the early months of 2010 were likely caused by the drought of 2009, which led to a decline in foodgrains production but also by the fact that government had considerably expanded income support to the poor — for instance, through the NREGS and loan waivers to poor farmers. This explanation has run into controversy. Unfortunately so, because much of the argument can be sorted out through pure economic theory.
The Deputy Chairman of the Planning Commission, Mr Montek Singh Ahluwalia, has argued, as have several others, that the greater benefits given to the poor may have caused some of the initial food price inflation in 2009 and early 2010. Let me refer to this as the “benefits-based inflation hypothesis.”
This hypothesis has often given rise to a raucous debate with some mis-paraphrasing of this into: “The poor are to be blamed for the inflation.” As far as I know, no one has made that claim, so that can be safely put aside.
A more serious criticism of this claim that has been made may be summed up as follows:
If it were indeed true that it is the greater demand for food on the part of the poor that caused the inflation, then we would expect to see the poor consuming more. But (so goes this argument) there is no evidence for this. Hence, the benefits-based inflation hypothesis is invalid .
Consumption-based challenge
For ease of reference let me refer to this challenge to the hypothesis which is written in italics above as the “consumption-based challenge.”
What is easy to see is that the consumption-based challenge, though interesting prima facie , does not stand up to scrutiny. And the benefits-based inflation hypothesis does have plausibility, even though it may not be empirically established.
To understand this, note that the poorest quintile of the rural population devotes approximately 67 per cent of its consumption to food. We know this from 2004-05 NSSO household survey data (see Government of India, 2011).
The rich spend nowhere near that proportion of their money on food. So, if money and financial benefits are diverted to the poor from the rich, it only stands to reason that the demand for food will rise in the nation. If that happens, the price of food will rise disproportionately. Since this is exactly what was happening in the late 2009 and early 2010, the benefits-based inflation hypothesis seems to have plausibility.
But, then, what about the consumption-based challenge, which claims that there is no evidence that the poor are consuming more food and that this destroys the thesis that redistribution in favour of the poor has contributed to India's inflation?
A little thought will show that there is no contradiction between the two. Even if we do not contest the claim that the poor have not been consuming more food, it is possible to maintain that their higher income is contributing to the higher inflation. To see this, it is important to understand that a greater demand for food does not necessarily mean a greater consumption of food.
Let D{-o}, in the Figure, be the aggregate demand curve for food of the poor people. Now suppose that the poor get an income supplement which raises their demand for food.
Then the new demand curve will be like D{-1}.
Not consuming more
This however does not in itself mean that the poor will actually consume more. If the supply of food that is available to the poor is unchanged or, in other words, the supply curve of food is completely inelastic, then the increased demand will not translate into greater consumption of food but it nevertheless is the cause of food price rising.
It should be evident from the figure that the fact that the beneficiaries do not manage to consume more after their demand increases is the reason why prices rise even more. If the supply curve of food were merely upward sloping, instead of being vertical, the price increase would be less.
Interestingly, this phenomenon is also logically compatible with the poor becoming worse off, as we know from theoretical studies showing how the recipient of a benefit can end up worse off because his or her receiving that benefit causes such an adverse movement in the prices of goods that are consumed in large quantities by the recipient that the net benefit, in equilibrium, is negative.
Are the poor worse off?
This, of course, does not resolve the empirical question: Are the poor actually worse off? While the answer to this is not germane to the argument here, from the piecemeal evidence that we have, it is possible to claim that the answer has to be ‘no'.
The most recent round of NSS data shows that poverty in India has declined from around 37 per cent in 2004 to approximately 32 per cent in 2009 (using the Tendulkar measure of poverty in both cases).
While 32 per cent is still high and no reason for complacency, the sharp decline in poverty is commendable and suggests that the steps taken to transfer more buying power to the poor have had some effect. In conducting the above analysis, I have stayed clear of deeper general equilibrium questions. If larger benefits for the poor are made possible by transfers from the rich, then there must be a deflationary pressure on prices of goods consumed primarily by the rich.
So, while the relative price of food may rise, why should overall inflation increase? Such questions take us to the heart of some of the most puzzling questions about the connection between the real and the financial economies.
(Kaushik Basu is Chief Economic Adviser, Government of India.)
(Excerpted from the Tenth Gautam Mathur Lecture.)
(Concluded)