Understanding Demand Side and Supply Side Inflation
Understanding the Difference betweenSupply Side Inflation and Demand Side Inflation
It is summer holidays and kids living in aposh building – “Inflationary Heights” arehaving great fun. Their parents have filledtheir pockets with money and the kidsnow have buying power. There is an icecream parlor down the street. The man incharge of the parlor is glad for making allthe children happy with his different icecream flavors.
There is a nice balance between the joy ofselling and buying ice cream.But this summer something happened.The kids from “Inflationary Heights” startconsuming double the volume of ice creamthat they normally do.
The parlor man soon realizes that thechildren from “Inflationary Heights”are eating more ice cream.He increases prices and the demandcontinues unabated.While the parlor man gets richer by theday, the other children of the areacan’t afford the ice cream any longer.
They decide to meet the parents of thechildren of “Inflationary Heights”.They request the parents to reduce thepocket money allowance of their children.With less money in their pockets, theirdemand would drop and so would theprice of ice cream.
The parents are in a fix. They know thatthis will not be accepted by their children.But they do understand that if they reducethe allowance, their kids would have lessmoney and consequently the demand forice cream would drop.Thus the inflation in ice cream at the parlorcould be reduced by reducing theavailability of money.
In a similar fashion to the parents having theoption to regulate the prices of the ice creamparlor, by controlling the pocket money oftheir children, the RBI (Reserve Bank of India)has the option to regulate the flow of moneyinto the economy and control prices.This is called demand side inflation.This may get controlled by monetary policymeasures.
So what is supply side inflation? Lets get back to the story.
After the meeting, one of the parents, Mr.Idea Shankar comes up with an idea. The next day, Mr. Idea Shankar calls on afew competitors of the Ice Cream Parlorand tips them of the huge businesspotential in their area.
He tells the competitors that the children of“Inflationary Heights” have more cash to spend due totheir higher allowance.Within two days, four new parlors spring up in the area.Seeing this and fearing that he would lose business tocompetition, the parlor man immediately brings downprices.Now there are enough parlors and enough customers.
In this scenario, the higher allowance doesnot impact prices in the parlors becausethere is enough supply.In fact, some of the parlors start offeringdiscounts. All the children in the area arehappy now. In fact, they can now eat moredue to the discounts.
The manner in which prices were regulatedthis time was by increasing the supply ofice cream.In the same manner, the government maycontrol inflation by increasing the supply ofproducts and services in the economy.
This is the concept of supply side inflation.But there is a challenge.While it is easier to set up a few ice cream parlors, itis not as easy to set up many factories and servicesas it would need land, labor and capital plus time toset up the supply.
However, controlling inflation from a supplyperspective is more inclusive and sustainable.On the other hand, using monetary policy to steminflation is short term in nature and notsustainable. The shortage of supply, sooner orlater will catch through high pricesHence beyond a point, monetary policy ceases tobe an effective tool for inflation control.
To some extent, the Indian economy stands at a crossroad because the effectiveness of RBI to controlinflation by containing demand by way of regulatinginterest rates is reducing and the need for creatingadditional supply by the government is increasing.Hence policies need to be framed that attractentrepreneurs to invest in the economy so that theycan additional create supply.Creation of additional supply will create jobs, improvesentiments, increase demand and bring balance back into the economy.
Hope you have understood demand side and supply side inflation Please give us your feedback at email@example.com Disclaimer: The views expressed in this lesson are for information purposes only and do not construe to be any investment, legal or taxation advice. The contents are topical in nature and held true at the time of creation of the lesson. This is not indicative of future market trends, nor is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this presentation will be at your own risk. Tata Asset Management Ltd. will not be liable for the consequences of such action.Mutual Fund investments are subject to market risks, read all scheme related documents carefully.