Imported inflation refers to the rise in the prices of goods and services in a country that is caused by an increase in the price or the cost of imports into the country. It is believed that a rise in input costs pushes producers to raise the price they charge from their local customers, thus boosting inflation.
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A fall in the rupee
A depreciation in the value of a country’s currency is generally seen as the most important reason behind imported inflation in an economy. This is because when a country’s currency depreciates, people in the country will have to shell out more of their local currency to purchase the necessary foreign currency required to buy any foreign goods or services, which in turn means that they will effectively be paying more for anything that they import. The Asian Development Bank recently warned that India could face imported inflation as the rupee could depreciate amid the rise in interest rates in the West. A rise in interest rates in the West tends to cause the currencies of developing countries to depreciate against western currencies, which in turns can lead to higher import costs for these countries.
A rise in import costs even without depreciation in the value of a country’s currency is also believed to lead to import inflation. So a rise in international crude oil prices due to fall in oil output, for instance, is expected to cause prices to rise across an economy which imports oil to produce goods and services. The idea of imported inflation, it should be noted, is simply a variant of cost-push inflation which states that a rise in the cost of inputs can lead to an inflation in the prices of final goods and services.
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Consumers decide prices
Critics of the proposition that rising import costs can lead to a rise in inflation believe that it is a fallacious economic idea. They state that it might seem commonsensical to believe that input costs determine price, and hence that higher costs should lead to higher prices for goods and services. After all, it is common to see a lot of businesses in the real world raise the price of their products when their input costs rise. It may thus seem true, from an individual business’ point of view, that costs determine prices.
However, the critics state, it is simply not true that costs determine price when seen from an economic point of view. Instead, they state that it is the prices that customers are willing to pay for the final goods and services that ultimately determine the cost of all inputs that go into making products.
It should be carefully noted that producers are willing to pay for various inputs based on what price they believe they can sell their final output for to their customers. So, if the cost of inputs were set at a price that is higher than what producers are willing to pay (based on final consumer demand), this would cause the available supply of inputs to go unsold as producers are unwilling to purchase the inputs. This, in turn, would cause the price of inputs to drop in accordance with final consumer demand.
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Stated simply, value is imputed backwards from final consumer goods and services to inputs that go into making these final goods and services. The idea of imputation of value from final consumer goods and services to the various factors of production was elaborated famously by Austrian economist Carl Menger in his 1871 book Principles of Economics.
It can be further argued that even when import costs rise due to a depreciating currency, the rise in costs is still ultimately driven by the demand for the final output among consumers. To understand this, it should be noted that the value of a currency depreciates against a foreign currency when its supply becomes relatively more abundant than the foreign currency in the forex market. In other words, the exchange rate of a currency depreciates to reflect the greater demand for the foreign currency in terms of the local currency. So, the resulting rise in import costs due to depreciation itself can be seen simply as a reflection of a change in the nominal demand for inputs.
Stated simply, it is not currency depreciation that is causing input costs and the prices of final goods to rise; rather, the currency depreciation is simply a reflection of higher nominal demand for imported goods from final consumers.