There is much confusion about inflation and its causes in our country today. Firstly it is useful to remember that ‘inflation is a process’. We measure inflation by the increases in the price level. But this is not inflation but only a measure of inflation. We must not confuse the length of an object with the measuring tape.

This is the rate at which inflationary causes would impact on price levels if all of them were considered together in their effect on increasing prices. Economists talk of inflationary pressures or causes rather than inflation. A precise measurement of this concept is not possible however. But we know what causes are inflationary and what are not. Of course, price inflation is an important part of the estimate of real inflation. But "Inflationary forces" are what we really should be talking about when we speak of "inflation." These include all forces that increase demand without relationship to supply, or that decrease supply without any relationship to demand.

  Among inflationary causes - besides monetary inflation - are price controls and the expenditure of monetary reserves which the Central Bank uses to support the rupee in the foreign exchange market- both of which sustain the period of artificially expanded demand caused by the budget deficit. They are inflationary. So the Central Bank contributes to inflation when it holds the rupee at an unsustainably high value as it seems to be doing now.

As Dr Uswatte Aratchi has pointed out to The Island, exchange rate movements are no longer dominated by trade movements but by financial capital flows. So when we borrow externally, the rupee appreciates although it is not a sign of economic strength. But the Central Bank is asking the exporters to improve their productivity and not to expect a depreciation of the rupee as if they can do so with continuously rising inflation. Prices would actually decline with improvements in productivity if the government is not creating inflation.

When allocating blame for inflation, cause must be carefully distinguished from mere effect. Those government policies that increase demand without increasing supply or that restrict supply or decrease productivity are "inflationary." These government policies must bear all the blame for the rising prices, loss of purchasing power, slow or nonexistent productivity growth, capital flight, stagnant investment, stagflation or inflationary depression, and all the other ills that inflation causes.

The politicians must have scapegoats when price increases reach painful levels. They must hide their own responsibility for the policies that have led to the turmoil. Thus, the rising prices that could stop the inflation are branded "inflationary," and businessmen are blamed for increasing prices - while the inflationary policies that caused the price increases - the monetary expansion and various controls on prices - are all too often continued.

Many economists argue that inflation is strictly a monetary phenomenon and that inflation occurs when the rate of growth of the money supply is higher than the growth rate of the economy. This is the conventional monetarist linkage from the creation of base money to inflation when Central Banks issue money at a rate that exceeds the demand for cash balances at the existing price level and the increased demand in the goods market pushes up the price level as the public tries to get rid of its excess cash holdings.

With the introduction of paper money the term money printing came in to vogue although expansion of the money supply usually takes place more in the form of expanding bank deposits - the other component of money supply - rather than the currency in circulation. We are all familiar how cheques and credit cards can be used to buy goods. Where cheques are not accepted, they have to be first converted to currency before buying goods. But the cheques can be issued against loans and overdrafts and these constitute new money.  "Running the printing presses" was practiced most notoriously by the Central Bank of the Weimar Republic, which tried to stay ahead of the loss of purchasing power caused by price inflation by "maintaining liquidity balances." Our Central Bank limits money supply growth just to maintain purchasing power as per current inflation and not more.

It is the contention of these economists that the Central Banks can eliminate the link between budget deficits and inflation by refusing to monetize the deficit, i.e., by not buying the bonds issued by governments. But this is an oversimplification.

Higher deficit policies may lead to higher inflation even in the absence of Central Bank lending to the Treasury- printing money. With budget deficits the government’s borrowing requirement will increase the net credit demands in the economy, drive up the interest rates and crowd out private investment. The resulting reduction in the growth rate of the economy will lead to a decrease in the amount of goods available for a given level of cash balances and hence the increase in the price level. In an open economy net imports are anti-inflationary but they spill over into a larger current account deficit.

The other channel through which budget deficits can lead to higher inflation when Central Banks do not monetize the debt is the private monetization of deficits. This occurs when the high interest rates induce the financial sector to develop new interest bearing assets that are almost as liquid as money and are risk free. The other day when I went to the Commercial Bank I was told that the bank was offering 17% on 3-months fixed deposits. I was wondering why a sound bank was offering such a high rate of interest. It suddenly dawned on me that they were going to create more money may be to fund the budget deficit by taking up Treasury Bills or for funding the private sector.

How do they do that? Bank reserves consist not only of deposits with the Central Bank called Reserve Money which is being targeted by the Central Bank. It includes till cash in the vaults of the banks as well. Of course the bulk is the bankers deposits with the Central Bank. Thus, the government debt not monetized by the Central Bank is monetized by the private sector and the inflationary effects of higher deficit policies prevail. The February press review of monetary policy points out that the Reserve Money targets have been achieved and even Broad Money is in line with projections. But both average inflation (16%) and point-to-point inflation (21%) have gone up.

The connection from deficits to inflation is often analyzed in terms of the Quantity Theory of Money. It needs to be noted that money-inflation relation is a highly dynamic one for the following reasons: (i) inflation will cause the velocity of circulation to rise and even an intact money supply will generate more inflation; (ii) the rise in inflation will reduce the available inflation tax base for the government and the attempt on the part of the government to collect a given inflation tax revenue will bring forth an increase in the (inflation) tax rate; (iii) inflation might cause budget deficits to rise even further, and monetization could lead to even higher rates of inflation. But yet it can be said that inflationary process cannot be sustained unless the Central Bank accommodates it by providing sufficient money supply to cope with the current rate of inflation.

But that will at best mean the inflationary price level changes will remain at the current level not bring it down. To bring it down it must curtail the money supply growth sharply. But that will mean a contraction of output as well which is why the Central Bank will not do so.

Monetary inflation is actually a tax by which government - by expanding the money supply - transfers wealth from its people to itself. Indeed, inflation is perhaps the most destructive tax that can be imposed - but unfortunately it is the easiest one for a government to impose on its people since it is not visible.  It also results in the transfer of enormous amounts of wealth from the hands of ordinary people to the hands of those speculators shrewd enough to take advantage of the price volatility inflation causes in the markets.