In fact: From current deflation to future inflation

Today’s demonetisation-induced crash in farm produce may be a prelude to higher prices tomorrow

Written by Harish Damodaran | Updated: December 27, 2016 8:54 am
demonetisaton, demonetisation news, demonetisation effects, farmers, farmers demonetisation, demonetisation effects on farmers, india news Most fresh farm produce have seen price declines. But it is not the usual adjustment in prices forced by demand falling along the same curve. (Express Photo by Amit Mehra)

Since November 8, when demonetisation happened, prices of potatoes at Uttar Pradesh’s Agra mandi have plunged from an average of Rs 1,000-plus to Rs 480 per quintal, while sliding from Rs 700 to Rs 150 for tomatoes and from Rs 800 to below Rs 600 for onions in Maharashtra’s Pimpalgaon and Lasalgaon wholesale markets, respectively.

The collapse isn’t courtesy any ordinary supply increase or demand reduction — what economists term as “movement along the supply (or demand) curve”. Far from supplies rising significantly, cumulative arrivals of potatoes in Agra and onions in Lasalgaon during November 9 to December 26 are actually lower by 16.9% and 9.1%, respectively, compared to their levels for the corresponding period last year.

The price declines we are now seeing — extending to most fresh farm produce, including eggs and broiler chicken — have largely to do with demand. But this isn’t the usual price adjustment forced by demand falling along the same curve. Rather, it is about the demand curve itself “shifting” leftward. With severely cash-strapped consumers — households and traders — unable to make purchases following the overnight outlawing of all existing Rs 500 and Rs 1,000 banknotes, there’s less demand than before for produce even at the same price.


The accompanying chart shows what happens when the demand curve shifts — in this case, due to a sudden drying up of spendable cash with consumers. To start with, we have the normal pre-demonetisation supply (S0) and demand (D0) curves, where prices are plotted on the vertical and quantities on the horizontal axes. Everything else being the same, the higher the price for a commodity, the lower is the demand. On the other hand, the higher the price, the more is the quantity supplied by producers. The equilibrium price (P0) is the point where the quantity (Q0) of supply matches demand.

Post demonetisation, the demand curve has shifted leftward from D0 to D1. As less of the produce is demanded at each price, we have a new lower equilibrium price (P1), at which there is also reduced supply (Q1). The current situation in agricultural markets can be viewed in terms of equilibrium prices themselves changing because of the forced leftward shift in the demand curves for virtually every commodity. The important thing to note is that the shift may be temporary. In 4-5 months down the line, the demand curve might well revert to D0, as liquidity is restored and consumers have the cash to spend as they had prior to demonetisation.

The question to ask is what will happen at that point in time? This is where things could turn out interesting. While we can assume normalcy in demand to return in 4-5 months, this needn’t be true, however, for supply. The quantity that farmers would supply may not be Q0, but Q1.

Why? Because what farmers are going to bring to mandis 4-5 months from now would be a result of their current planting decisions, which are, in turn, a function of prices prevailing today. It is obvious, then, that they will plant only so much to yield a supply of Q1 at the post-demonetisation equilibrium price of P1. If prevailing prices of tomatoes, cauliflowers or chillies are at P1, why should farmers produce more than Q1?

There could, of course, be rational farmers who know that market prices will recover in 4-5 months’ time to P0, which allows for higher supply of Q0. The catch here, though, is that farmers today have hardly any cash to pay labour or invest adequately in good seeds, fertiliser and other inputs to be able to produce Q0. They will, therefore, end up supplying only Q1.

But if the demand curve shifts back to D0 and farmers supply only Q1, it also means that prices in the next 4-5 months wouldn’t be at their original equilibrium level of P0. They would, instead, be higher at P2. So, what we are looking at is higher prices due to both reduced supply as well as increased demand from cash returning to the system. This is the opposite of today’s cash crunch, which has led to a collapse of demand and prices, and supply also falling in response.

It is possible that farmers may be induced to produce more when prices are at P2, but that will happen only with a lag in the next kharif season. In all likelihood, they will also produce more than Q0, engendering further price declines and quantity adjustments before the old supply-demand equilibrium is reached. The latter movements would, however, not be as violent as those unleashed by the sudden shift in the demand curve post-demonetisation.

One indication of where supply and prices are headed in the coming months could be milk, where October-December is the peak period for purchases of animals. Farmers typically buy cows or buffaloes that are 8-9 months pregnant, so that these calve during December-January when milk production is at its highest. Reports from the ground suggest that farmers haven’t invested much in fresh stock this time. In Gujarat’s major dairy belts such as Sabarkantha and Kheda, for example, the new animal inductions have been only around a fifth of last year’s numbers. The reason for it is obvious: A cross-bred cow yielding 4,000-5,000 litres of milk annually costs Rs 40,000-50,000 and most farmers don’t have the cash to be in a position to buy.

But lack of investment in new stock also has implications for future supply. This, even as farmgate prices of cow milk in states like Maharashtra have already gone up to Rs 23-25 a litre, from Rs 16-18 at this time last year, and procurement by dairies is flat if not negative. Thus, just when production needs ramping up, especially in order to meet peak summer demand when cash would also have returned, we are possibly staring at a supply shortage ahead. Something similar is happening in rubber, where prices in Kottayam (Kerala) have recovered to around Rs 136 per kg, as against Rs 101.5 a year ago. Growers may be keen to produce more at today’s prices, but aren’t able to do so in the absence of cash to pay labourers for tapping the latex from trees.

If the dominant theme in agricultural markets now is of crashing demand and prices from demonetisation, the picture six months down the line could well be the return of food inflation.

For all the latest Explained News, download Indian Express App

  1. J
    Dec 27, 2016 at 7:23 am
    What are people eating if not buying vegetables? Have people started to starve?lt;br/gt;lt;br/gt;Looks like prices have crashed due to middle men disappearing. May be lower prices will stay as things are readapting in new configuration
    1. S
      Satendra kumar
      Dec 29, 2016 at 9:28 am
      Demonetisation did make inflationary for farm products it became cheaper mostly export crunch and local production became cheaper as payments for imports was mostly black market.
      1. R
        Dec 27, 2016 at 11:59 am
        Finally Modi has checked inflation.
        1. A
          Dec 27, 2016 at 7:02 pm
          You have a very fine understanding of economics, human psychology and the human;br/gt;lt;br/gt;It will take a long time to recover from this mess. In the interim, there will be inflation, which, like you said, is the exact opposite of the situation now. The Prime Minister has unleashed chaos, possibly in the hope that something miraculous will happen when our economic momentum is restored. Little does he realize that economic decisions are not like weekend plans or celebrating festivals. A lot of research and careful contemplation ought to go into them. But our Prime Minister suffers from lack of sleep and the yoga mats he uses are made in China. He is also frequently jet-lagged even from domestic travel (owing to sheer frequency of travel) and feels ill after leading over water rafts to inaugurate statue-making which is likely to destroy bio-diversity and the lives of local fisherman. He cannot be expected to indulge in research and thinking. In any case, his good friend, Sri Sri is into "thoughtless awareness". So, all decisions are taken without not just a second thought but without any thought at all.
          1. S
            Dec 27, 2016 at 8:39 am
            Interesting analysis. Let's wait and watch. Story is unfolding. No one can predict with hundred percent surety medium/long term impact of demonetization - positive or negative.
            1. Load More Comments