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Sunday, January 30, 2011

Inflation in terms of income and prices

Inflation has emerged as one of the key challenges of the world at this time. However we tend to reflect on inflation in terms of prices of basket of products and services. I think such a metric serves us to understand only a part of the problem.

Inflation, as we measure it today, does not measure social benefits when job scenario is difficult. The theory behind inflation posits that when the inflation becomes known wages should adjust to reflect the same. If wages are stable and prices start rising, inflation rightly triggers alarm bells. However, if prices are stable and incomes are falling then inflation data tends to mask the underlying decline in living standards.

Generally, policy makers use two variables, inflation and real average income growth, together. However, rarely do we see both variables in same discussion. The problem arises because of difference in measurement techniques of prices and wages. However, limitations of measurement should not be a cause for erroneous policy.

I think we need to define inflation as difference between wage rise and price rise. Or we may use another metric that measures this difference. I believe it should give a proper indication of the on-the-ground situation of the economy. 

Thus, in the developed world, with economies losing jobs, we expect this metric to expand conveying the increasing difficulty in sustaining a lifestyle. This comes over a decade of falling prices with stable incomes which we may parallel with deflation. 

How such a variable will influence policy response is a difficult question. However, it should definitely improve our understanding of the realities.