Inflation

 Economy - Inflation

• Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time.
• It is the constant rise in the general level of prices where a unit of currency buys less than it did in prior periods.
• Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation’s currency.
• Inflation can be viewed positively or negatively depending on the individual viewpoint.
• Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets.
• People holding cash may not like inflation, as it erodes the value of their cash holdings.
• Ideally, an optimum level of inflation is required to promote spending to a certain extent instead of saving, thereby nurturing economic growth.

Understanding Inflation

• As prices rise, a single unit of currency loses value as it buys fewer goods and services. This loss of purchasing power impacts the general cost of living for the common public which ultimately leads to a deceleration in economic growth. The consensus view among economists is that sustained inflation occurs when a nation's money supply growth outpaces economic growth.
• To combat this, a country's appropriate monetary authority, like the central bank, then takes the necessary measures to keep inflation within permissible limits and keep the economy running smoothly.
• Inflation is measured in a variety of ways depending upon the types of goods and a service considered and is the opposite of deflation which indicates a general decline occurring in prices for goods and services when the inflation rate falls below 0%.

Causes of Inflation

Rising prices are the root of inflation, though this can be attributed to different factors. In the context of causes, inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.

Demand Pull factors:

These are those set of factors due to which there may be an increase in the demand for goods and services in the economy. Increase in government expenditure:  

• Increased government expenditure results in increased demand for goods and services and consequent increase in prices. This is because increased government expenditure results in putting large money in the hands of public, thereby putting to affect too much money chasing too few goods.
• Rising population: Increasing population also acts as an important factor in pushing up prices because of increased demand especially when the supply is unable to meet the demand.
• Black Money: A large part of the black money is used in buying and selling of real estate in urban areas, extensive hoarding and black marketing in essential wage goods, such as cereals, pulses, etc. Black money, therefore, fuels demands and leads to rise in prices.
• Changing consumption patterns: Reserve Bank of India (RBI) put forward the theory that the inflation problem in India has its roots in a sharp increase in demand for certain food items that people eat more frequently as incomes rise. One example is protein-rich food. Increased consumption of pulses, eggs, fish and poultry were apparently driving up their prices in the economy.

Cost- Push Factors:

The reasons are:

• At times rise in wages, if greater than rise in productivity, increases the costs therefore increasing the prices too.
• Increase in indirect taxes also leads to cost side inflation. Taxes such as custom and excise duty raise the cost of production as these taxes are levied on commodities.
• Increase in administered prices such as the MSP (Minimum Support Price) for the food grains, petroleum products, etc also leads to inflation as they have a huge share in budget of common citizens.
• Infrastructural bottlenecks such as the lack of proper roads, electricity, water, etc rise per unit cost of production. This is one of the prime reasons for inflation in the context of Indian economy.
• Owing to events such as failed monsoons there is a drop in agricultural productivity, which inevitably results in inflation at times.

Types of Inflation

A. On the Basis of Causes:

(i) Currency inflation:

This type of infla­tion is caused by the printing of cur­rency notes.

(ii) Credit inflation:

Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.

(iii) Deficit-induced inflation:

The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may be called the deficit-induced inflation.

(iv) Demand- Pull inflation:

An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull in­flation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggre­gate demand to money supply. If the supply of money in an economy ex­ceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods.”

(v) Cost-push inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation is known as cost-push inflation (henceforth CPI). Cost of pro­duction may rise due to an increase in the prices of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not completely market-determined. Higher wage means high cost of production. Prices of commodities are thereby increased.

B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation:

If the speed of upward thrust in prices is slow but small then we have creeping inflation. What speed of annual price rise is a creeping one has not been stated by the economists. To some, a creeping or mild inflation is one when annual price rise varies between 2 p.c. and 3 p.c. If a rate of price rise is kept at this level, it is con­sidered to be helpful for economic development. Others argue that if annual price rise goes slightly beyond 3 p.c. mark, still then it is considered to be of no danger.

(ii) Walking Inflation:

If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of walking inflation. When mild inflation is allowed to fan out, walking inflation appears. These two types of inflation may be described as ‘moderate inflation’.

Often, one-digit inflation rate is called ‘moder­ate inflation’ which is not only predict­able, but also keeps people’s faith on the monetary system of the country. Peoples’ confidence gets lost once moderately maintained rate of inflation goes out of control and the economy is then caught with the galloping inflation.

(iii) Galloping and Hyperinflation:

Walking inflation may be converted into running inflation. Running inflation is danger­ous. If it is not controlled, it may ulti­mately be converted to galloping or hyperinflation. It is an extreme form of inflation when an economy gets shattered. “Inflation in the double or triple digit range of 20, 100 or 200 p.c. a year is labeled “galloping inflation”.

(iv) Hyper Inflation:

Hyperinflation is when the prices of goods and services rise more than 50 percent a month. It is fortunately very rare. In fact, most examples of hyperinflation have occurred when the government printed money recklessly to pay for war. Examples of hyperinflation include Germany in the 1920s, Zimbabwe in the 2000s, and during the American Civil War.

(v) Stagflation

Stagflation is when the economy experiences stagnant economic growth, high unemployment, and high inflation. It is unusual because policies to reduce inflation make life difficult for the unemployed, while steps to alleviate unemployment raise inflation.

(vi) Core Inflation

This shows price rise in all goods and services except food and energy due to high prices fluctuations. Oil is a highly volatile commodity, with daily price variations. Food prices change based on gas prices (it heavily reflects on transportation costs), which are directly linked to oil prices. As the government needs a fairly stable and true picture of inflation, core inflation is calculated.

(vii) Headline Inflation

This measure considers total inflation in an economy, including food and energy prices, which are more volatile.

How is Inflation Measured?

The inflation rate is calculated as a percentage change in a price index. The price indices widely used for this are the Consumer Price Index (CPI) - adopted by countries such as US, UK, Japan and China, and the Wholesale Price Index (WPI).

A. Wholesale Price Index (WPI)

• Wholesale Price Index, or WPI, measures the changes in the prices of goods sold and traded in bulk by wholesale businesses to other businesses.
• Analysts use the numbers to track the supply and demand dynamics in industry, manufacturing and construction.
• The numbers are released by the Economic Advisor in the Ministry of Commerce and Industry.
• An upward surge in the WPI print indicates inflationary pressure in the economy and vice versa.
• The quantum of rise in the WPI month-after-month is used to measure the level of wholesale inflation in the economy.

New series of WPI

• With an aim to align the index with the base year of other important economic indicators such as GDP and IIP, the base year was updated to 2011-12 from 2004-05 for the new series of Wholesale Price Index (WPI), effective from April 2017.

Major components of WPI

• Primary articles are a major component of WPI, further subdivided into Food Articles and Non-Food Articles.
• Food Articles include items such as Cereals, Paddy, Wheat, Pulses, Vegetables, Fruits, Milk, Eggs, Meat & Fish, etc.
• Non-Food Articles include Oil Seeds, Minerals and Crude Petroleum
• The next major basket in WPI is Fuel & Power, which tracks price movements in Petrol, Diesel and LPG
• The biggest basket is Manufactured Goods. It spans across a variety of manufactured products such as Textiles, Apparels, Paper, Chemicals, Plastic, Cement, Metals, and more.
• Manufactured Goods basket also includes manufactured food products such as Sugar, Tobacco Products, Vegetable and Animal Oils, and Fats.

How do you calculate Wholesale Price Index?

• The monthly WPI number shows the average price changes of goods usually expressed in ratios or percentages.
• The index is based on the wholesale prices of a few relevant commodities
• The commodities are chosen based on their significance in the region. These represent different strata of the economy and are expected to provide a comprehensive WPI value.
• The advanced base year 2011-12 adopted recently uses 697 items.

Problem/limitation

• One of the major limitations of WPI is that it does not include services such as the health, IT, Education, transport etc.
• Another problem with the WPI is that it does not account for the products of the unorganized sector in India, which constitutes about 35% of the manufactured output of the Indian economy.

Weightage in WPI

• Manufacturing products:97%
• Primary and food articles:12%
• Fuel and electricity:91%

B. Consumer Price Index

Consumer Price Index or CPI as it is commonly called is an index measuring retail inflation in the economy by collecting the change in prices of most common goods and services. Called market basket, CPI is calculated for a fixed list of items including food, housing, apparel, transportation, electronics, medical care, education, etc. Note that the price data is collected periodically, and thus, the CPI is used to calculate the inflation levels in an economy. This can be further used to compute the cost of living. This also provides insights as to how much a consumer can spend to be on par with the price change.

Who maintains Consumer Price Index in India?

In India, there are four consumer price index numbers, which are calculated, and these are as follows:

• CPI for Industrial Workers (IW)

• • The Consumer Price Index for the industrial workers (CPI-IW) has 260 items (plus the services) in its basket with 2001 as the base year (the first base year was 1958-59). The data is collected at 76 centres with one month’s frequency and the index has a time lag of one month. It contains 120-160 commodities in its basket. Basically,this index specifies the government employees (other than banks’ and embassies’ personnel). The wages/salaries of the central government employees are revised on the basis of the changes occurring in this index, the dearness allowance (DA) is announced twice a year. When the Pay Commissions recommend pay revisions, the base is the CPI (IW).

• CPI for Agricultural Labourers (AL)

• • The Consumer Price Index for Agricultural Labourers (CPI-AL) has 1986-87 as its base year with 260 commodities in its basket. The data is collected in 600 villages with a monthly frequency and has three weeks’ time lag. This index is used for revising minimum wages for agricultural labourers in different states.

• CPI for Rural Labourers (RL)

• • There is yet another Consumer Price Index for the Rural Labourers (CPI-RL) with 1983 as the base year, data is collected at 600 villages on monthly frequency with three weeks’ time lag, and its basket contains 260 commodities.
  • In 2011 the CSO brought out a revised CPI, which was CPI (Urban), CPI (Rural) and CPI (Urban + Rural) with 2010 as the base price. The combined one would take into account the data from both the indices taking appropriate weights.
  • When compared to the WPI, CPI has much larger weightage of primary articles which is 57%. What this essentially means is that food inflation is reflected much more appropriately in the CPI when compared to the WPI which gives only 20% weightage to primary articles.
  • To compile the database for CPI-urban, the federal statistics office has been collecting data from retail outlets in more than 100 cities, and for CPI-rural data collection is underway in more than 1,200 villages. Due to a shortage of staff, the statistics department has roped in officials from various departments including the postal department. More than 2,400 postmen were engaged in collection of retail prices from villages across the country. Currently, the labor ministry and the commerce and industry ministry are involved in compiling and releasing inflation figures. The ministry is also awaiting the cabinet’s approval for a single nodal agency for compiling data.

• CPI for Urban Non-Manual Employees (UNME).

• • This index depicts the changes in the level of average retail prices of goods and services consumed by the urban segment of the population.
  • The target group of this index was urban families who derived major portion of their income from non-manual occupations in the non-agricultural sector.
  • This index had a limited use as it was used for determining dearness allowances of employees of some foreign companies working in India in service sectors such as airlines, communications, banking, insurance and other financial services.

While the Ministry of Statistics and Program Implementation collects CPI (UNME) data and compiles it, the remaining three are collected by the Labour Bureau in the Ministry of Labour.

How does Consumer Price Index help?

• The Reserve Bank of India and other statistical agencies study CPI so as to understand the price change of various commodities and keep a tab on inflation. CPI is also a helpful pointer in understanding the real value of wages, salaries and pensions, the purchasing power of a country’s currency; and regulating prices.
• Economists are in charge of collecting data by surveying households on their buying patterns, most purchased items, and daily expenses.

Changes in methodology of measuring inflation

Reserve Bank of India (RBI) had adopted the new Consumer Price Index (CPI) (combined) as the key measure of inflation. The national CPI is meant to measure retail inflation. This index will combine urban and rural CPIs, both under preparation and to be released simultaneously. Unlike many other countries, India does not have a unified CPI and uses the WPI as a benchmark. The unified CPI will usher in a fundamental shift in the way the Reserve Bank of India (RBI) targets inflation.

Effects of Inflation:

• People’s desires are inconsistent. When they act as buyers they want prices of goods and services to remain stable but as sellers they expect the prices of goods and services should go up. Such a happy outcome may arise for some individuals; “but, when this happens, others will be getting the worst of both worlds.”
• When price level goes up, there is both a gainer and a loser. To evaluate the conse­quence of inflation, one must identify the na­ture of inflation which may be anticipated and unanticipated. If inflation is anticipated, peo­ple can adjust with the new situation and costs of inflation to the society will be smaller.

One can study the effects of unanticipated inflation under two broad head­ings:

(a) Effects of Inflation on Distribution of Income and Wealth:

• During inflation, usu­ally people experience rise in incomes. But some people gain during inflation at the ex­pense of others. Some individuals gain be­cause their money incomes rise more rapidly than the prices and some lose because prices rise more rapidly than their incomes during inflation. Thus, it redistributes income and wealth.
• Though no conclusive evidence can be cited, it can be asserted that following catego­ries of people are affected by inflation differ­ently:

(i) Creditors and debtors:

• Borrowers gain and lenders lose during inflation because debts are fixed in rupee terms. When debts are repaid their real value declines by the price level increase and, hence, creditors lose. An individual may be interested in buying a house by taking loan of Rs. 7 lakh from an in­stitution for 7 years.
• The borrower now wel­comes inflation since he will have to pay less in real terms than when it was borrowed. Lender, in the process, loses since the rate of interest payable remains unaltered as per agree­ment. Because of inflation, the borrower is given ‘dear’ rupees, but pays back ‘cheap’ ru­pees. However, if in an inflation-ridden economy creditors chronically loose, it is wise not to advance loans or to shut down business.
• Never does it happen. Rather, the loan-giving institution makes adequate safeguard against the erosion of real value. Above all, banks do not pay any interest on current account but charges interest on loans.

(ii) Bond and debenture-holders:

• In an economy, there are some people who live on interest income—they suffer most. Bondhold­ers earn fixed interest income: These people suffer a reduction in real income when prices rise. In other words, the value of one’s sav­ings decline if the interest rate falls short of inflation rate. Similarly, beneficiaries from life insurance programmes are also hit badly by inflation since real value of savings deterio­rate.

(iii) Investors:

• People who put their money in shares during inflation are expected to gain since the possibility of earning of business profit brightens. Higher profit induces own­ers of firm to distribute profit among inves­tors or shareholders.

(iv) Salaried people and wage-earners:

• Any­one earning a fixed income is damaged by in­flation. Sometimes, unionized worker suc­ceeds in raising wage rates of white-collar workers as compensation against price rise. But wage rate changes with a long time lag. In other words, wage rate increases always lag behind price increases. Naturally, inflation results in a reduction in real purchasing power of fixed income-earners.
• On the other hand, people earning flexible incomes may gain during inflation. The nominal incomes of such people outstrip the general price rise. As a re­sult, real incomes of this income group in­crease.

(v) Profit-earners, speculators and black marketers:

• It is argued that profit-earners gain from inflation. Profit tends to rise during inflation. Seeing inflation, businessmen raise the prices of their products. This results in a bigger profit. Profit margin, however, may not be high when the rate of inflation climbs to a high level.
• However, speculators dealing in business in essential commodities usually stand to gain by inflation. Black marketers are also ben­efited by inflation.

(b) Effect on Production and Economic Growth:

• Inflation may or may not result in higher output. Below the full employment stage, inflation has a favourable effect on production.
• In general, profit is a rising function of the price level.
• An inflationary situation gives an incentive to businessmen to raise prices of their products so as to earn higher volume of profit.
• Rising price and rising profit encourage firms to make larger investments.

How can Inflation be curbed?

Monetary, fiscal and administrative measures are taken to control inflation to an optimal level in the economy.

Monetary Measures

• The governments may take recourse to tighter monetary policy to cool down either the demand-pull or the cost-push inflation. For example, the RBI may increase the bank rates/repo rates. etc to curb the supply of money in the market.
• Because of such a step, the public may want to invest more in the banks and lead to a drop in the consumption, thereby driving down the inflation in the economy.
• It may also use qualitative control methods such as raise margins on loans for commodities for which traders have a tendency to speculate and hoard.
• Reserve Bank may also resort to other operations such as the Open Market Operations to mop out the liquidity from the market by selling government securities and bonds.
• But monetary steps can only be successful if inflation is due to demand pull factors and not structural in nature.
• Some of the limitations of raising interest rates to curb inflation have been discussed below:
• It has been observed several times in the past that the increase in bank rate by the RBI may not translate into a commensurate increase in interest rates by the banks.
• Banks necessarily do not raise their own interest rates at times even if the correct signals have been given by the RBI thereby defeating the entire purpose of the move.
• Another issue, which is important in a country like India, is the large presence of unorganized banking.Because of this RBI is not able to control a large part of the banking sector in the economy.

Fiscal Measures 

• As far as fiscal measures are concerned the government can take two routes to bring down the prices.
• Firstly, it can cut down its own spending on various schemes, projects, etc and secondly it can increase the taxes (either direct or indirect).
• As far as the first option is concerned most of the governments across the world do not employ this method for two simple reasons, first they cannot suddenly reduce the money, which is being spent on several critical projects pertaining to infrastructure, etc as it would not only bring down the image of the country but also create a negative market sentiment.
• Secondly, if they cut down spending on several important welfare schemes, etc then it may politically harm them in the next elections. So cutting down government expenditure is not considered feasible because of a mix of reasons. The second method is raising the taxes to discourage spending.
• The government may increase the private direct taxes to reduce the incomes and thereby decreasing the consumption tendencies among the public.
• It may also increase the indirect taxes on commodities raising their prices and thereby discouraging spending on them by the public.