Atanu Dey On India's Development

Does the NREGS Cause Inflation?

It makes sense to know a bit of economics, just as it is good to know how to do arithmetic. You don’t need to get yourself a PhD in mathematics in some area like topology or Lie groups. You just need to know basic arithmetic so that you can do your everyday figuring by yourself, so you know whether someone short-changed you or not. Thus spoke Joan Robinson: “The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.”

I am prompted by The Acorn’s post “How the rural employment scheme might cause inflation” where Prof Drèze is taken to task for saying that claims about the National Rural Employment Guarantee Scheme causing inflation are outlandish. Drèze is an economist and he is providing a ready-made answer and it is up to us to avoid being deceived by him by doing some basic economic reasoning. Drèze, I believe, is attempting to short-change us.

So what is the NREGS? It is an “employment scheme.” It basically transfers a bit of money to people who have not had an income.

Generally (but not in all cases) people who have an income are employed in come activity that produces something. Part of that production is paid as wages. That is income. In general, aggregate income and aggregate production have to be the same. Of course, a person working in a shoe factory does not get paid in shoes. The usual accounting method used is called “money.” He gets paid in money which he can then exchange for other stuff. The money income he gets is not real income. The real income is what he can buy with the money he gets paid.

Let’s take a simple economy producing widgets. 100 people producing 1,000 widgets. Average real income: 10 widgets. If each worker is paid Rs 1,000, then that is the nominal income. The price of a widget in this simple economy is Rs 100 per widget (divide the total amount of nominal income — 100,000 — by the total number of widgets — 1,000). If you don’t change the production of widgets but double the nominal wages, each worker gets Rs 2,000 but the real income does not change as the total production does not change. The price level goes up, though. From Rs 100 per widget, it goes up to Rs 200 per widget. That is inflation but in this simple model, it does not matter as the real income remains the same. Money is nominal. It is a method of accounting. It is not a “real” variable. The real variable is “the number of widgets.”

Now suppose you find that there are 10 additional people in the economy who you did not know of. They are not employed and so you decide to give them an income. OK, so you decide that each of these 10 people will be employed in digging holes in the ground (as there are no more widget making jobs) and filling them up. For this totally pointless exercise, you will give them each Rs 200 a month.

So here’s the new arithmetic.

100 people producing 1,000 widgets.
Each widget worker paid Rs 1,000
10 people digging and filling holes producing nothing
Each hole-digger paid Rs 500
Total nominal income: Rs 105,000
Price of a widget: 105,000 divided by 1000 = Rs 105.

So there you have it. You have inflation of 5 percent because now a widget worker with his Rs 1,000 income can buy less than 10 widgets. His real income has dropped. But the real income of the hole-digger has gone up. The scheme transferred some of the income from the widget workers. This may be good or bad — it all depends on what the objectives of the economy is. But the fact is that if you transfer incomes from one group to another, there will be winners and losers.

Inflation happens when the total amount of money increases relative to the total amount of goods that are produced in the economy. If a scheme merely adds more money to the pot without increasing production, it will cause inflation. If you increase production and at the same time increase the total amount of money appropriately, there is not inflation.

If you do a pure income transfer, without raising the total amount of money, you do not have inflation.

So what is the NREGS doing? If it is merely printing money and handing it to unemployed people (who are not producing anything), then it leads to inflation. This inflation reduces the real incomes of people who are producing something. So in this case, it is a pure income redistribution scheme. Drèze knows this as he knows basic economics. But he cannot admit the truth because his job depends on being economical with the truth.

[Related Post:

Aug 2005 -- The National Rural Employment Scheme.

Nov 2007 -- The National Rural Corruption Guarantee Scheme.]