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INFLATION

INFLATION

INTRODUCTION

  • Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.
  • As a result of inflation, the purchasing power of a unit of currency falls. For example, if the inflation rate is 10%, then 10 kg of wheat that costs ₹100 in a given year will cost ₹110 the next year. As more money is required to purchase goods and services, the implicit value of currency falls.

TYPES OF INFLATION 

Inflation can be classified into the following types:

  • Hyperinflation: Hyperinflation is very high inflation. Economists generally use the term “hyperinflation” to describe episodes when the monthly inflation rate is greater than 50%. At a monthly rate of 50%, an item that cost ₹1 on January 1 would cost ₹130 on January 1 of the following year. During times of hyperinflation, the value of currency declines continuously to the extent that people lose faith in domestic currency. As a result, they either prefer international currency or large stock of commodities.
    • Hyperinflation is caused by extremely rapid growth in the supply of “paper” money. It occurs when the government of a nation regularly issues large quantities of money to pay for a large stream of expenditures.
  • Galloping inflation: When the inflation rate rises to 10% or greater in a year, it is called galloping inflation. Money loses value so fast that businesses and income of workers cannot keep up with the prices of goods and services.
  • Walking inflation: When the inflation rate rises to 3-10% in a year, it is called walking inflation. It has a harmful effect on the economy. People start to buy more than they need, just to avoid much higher prices in the future. This drives the demand even further, so that suppliers fail to match the demand. As a result, common goods and services are priced out of the reach of most people.
  • Creeping inflation: When the inflation rate is up to 3%, it is called creeping inflation. It is defined as the situation when the inflation of a nation increases gradually, but continuously, over time. Creeping inflation is considered good for the economy because it acts as an incentive for suppliers to enhance production and indicates continuous rise in demand in the economy.
  • Deflation: When the overall price level decreases so that the inflation rate becomes negative, it is called deflation. It is the opposite of the often-encountered inflation. A reduction in money supply or credit availability is the reason for deflation in most cases. Reduced investment spending by the government or individuals may also lead to this situation.
    • Deflation is different from disinflation as the latter implies decrease in the level of inflation, whereas deflation implies negative inflation.
    • When the prices fall, the margin of suppliers reduces. As a result, some suppliers reduce and even shut down the production. Moreover, falling price level is indicative of falling demand in the economy, which further indicates fall in the living standard of people.
    • Usually, deflation is associated with fall in output and employment. On the other hand, disinflation does not lead to fall in output and inflation; it only means the return of prices to their normal level.
  • Stagflation: Stagflation is just like its name says: when economic growth is stagnant, but price inflation is still there. It is an unusual situation. A sluggish economy usually reduces the demand, enough to keep prices from rising. As workers get laid off, they buy less. As a result, businesses lower the prices to attract whatever customers remain. Slow growth in a normal market economy prevents inflation.
    • Policies that cause stagflation also create hyperinflation. The government or central banks expand the money supply in order to generate higher demand in the economy. At the same time, supply constraints prevent companies from producing more.
  • Headline inflation: In layman terms, headline inflation refers to the inflation as reported by newspaper headlines. At present, headline inflation is the inflation figure as reported through the consumer price index-(CPI), which is released monthly by the Bureau of Labour Statistics.
    • Earlier, headline inflation was based on the wholesale price index (WPI). The change has been undertaken because earlier the Reserve Bank of India (RBI) used to target inflation based on WPI, but now RBI targets inflation based on CPI.
  • Core inflation: It is an inflation measure that excludes transitory or temporary price volatility as in the case of some commodities such as food items, energy products, etc. It reflects the inflation trend in an economy.
    • If temporary price shocks are taken into account, they may affect the estimated overall inflation numbers in such a way that they are different from actual inflation. To eliminate this possibility, core inflation is calculated to gauge the actual inflation apart from the temporary shocks and volatility.
    • Difference between headline and core inflation
      • Headline inflation contains all items, including food and oil, whose prices are highly volatile. Core inflation does not contain volatile items. Thus, it gives a more real data, a clearer picture about the economy for the economists, while headline inflation is of more concern to the common people, who get much affected with, especially, the prices of food articles.
    • Asset inflation: Asset price inflation is an economic phenomenon denoting a rise in price of assets, as opposed to ordinary goods and services. Typical assets are financial instruments such as shares as well as real estate.
    • Wages inflation: Wage push inflation is a general increase in the cost of goods that is preceded by and results from an increase in wages. To maintain corporate profits after an increase in wages, employers must increase the prices they charge for the goods and services they provide.

EFFECTS OF INFLATION ON VARIOUS CLASSES OF PERSONS

  • Debtors and creditors: During periods of rising prices, debtors gain and creditors lose. When prices rise, the value of money falls. Though debtors return the same amount of money, but they pay less in terms of value of money. Thus, it brings about a redistribution of real wealth in favour of debtors at the cost of creditors.
  • Salaried persons: Salaried workers such as clerks, teachers, and other white collar persons lose purchasing power when there is inflation. The reason is that their salaries are slow to adjust to rising prices.
  • Wage earners: Wage earners may gain or lose depending on the speed with which their wages adjust to rising prices. If their unions are strong, they may get their wages linked to the cost of living index. In this way, they may be able to protect themselves from the bad effects of it.
  • Fixed-income group: The recipients of transfer payments such as pensions, unemployment insurance, social security, etc. and recipients of interest and rent live on fixed incomes. All such persons lose because they receive fixed payments, while the value of money continues to fall with rising prices.
  • Investors: Persons who hold shares of companies gain during inflation. When prices rise, business activities expand, which increases profits of companies. But those who invest in debentures, securities, bonds, etc., which carry a fixed interest rate, lose during inflation because they receive a fixed sum while the purchasing power is falling.
  • Business persons: Business persons of all types, such as producers, traders, and real estate holders, gain during periods of rising prices. When prices rise, the value of their inventories (goods in stock) rise in the same proportion. So they profit more when they sell their stored commodities.
  • Government: The government as a debtor gains at the expense of households who are its principal creditors. This is because interest rates on government bonds are fixed and are not raised to offset the expected rise in prices. With inflation, even the real value of bonds is reduced.

Thus, inflation redistributes income from wage earners and fixed-income groups to profit recipients, and from creditors to debtors. So far as wealth redistributions are concerned, the very poor are more likely to lose than the middle and high income groups. This is because the poor hold wealth in monetary form and is mostly wage earner. On the other hand, the middle income and rich people are likely to invest in shares and real estate, which witness price rise during times of it. Thus, it increases the gap between rich and poor.

EFFECTS OF INFLATION ON VARIOUS ECONOMIC PHENOMENON

  • Production: When prices start rising, production is encouraged. Producers earn windfall profits in the future. They invest more in anticipation of higher profits in the future.
  • Consumption: When prices start rising, consumption is discouraged.
  • Balance of payments: When prices rise more rapidly in the home country than in foreign countries, domestic products become costlier compared to foreign products.
  • This tends to increase imports and reduce exports, thereby making the balance of payments unfavourable for the country.

FACTORS AFFECTING INFLATION

Two types of factors affect inflation:

  • Demand-side (or price-pull) factors: The factors that lead to increased demand of goods and services in the economy are demand-side factors. Increased demand for goods and services may be on account of increase in population, increase in the income level of the people, etc.
  • Supply-side (or cost-push) factors: The factors that lead to increased cost of production, transportation, or sale of goods and services in the economy are supply-side factors. For instance, increase in cost of raw materials, wages, transportation fuel, etc.
  • It can be managed through change in both supply and demand-side factors. However, changes in supply-side factors can be brought in the long term. The demand-side factors can be changed in a relatively short term.

Role of RBI in Curtailing Inflation

  • To control it, the RBI reduces the money supply in the economy through the exercise of monetary policy. The reduction in money supply reduces the demand of various commodities in the economy.

INFLATION IN DIFFERENT TYPES OF PRODUCTS

  • Necessity goods: Necessity goods such as milk, food grains, etc. are consumed by rich as well as poor. Price rise in necessity goods forces poor to reduce the consumption or even stop the consumption of necessity goods. Thus, inflation in necessity goods has a pernicious effect.
  • Luxury goods: Luxury goods such as costly cars, gems and jewellery, etc. are afforded by the rich only. Thus, inflation in these goods is not that pernicious (as in necessity goods) because the rich have the capacity to bear inflation. In fact, some of the luxury items are Giffen goods, which are those goods that people consume more as the price rises and vice versa.
  • Intermediate goods: Intermediate goods are those goods that are used as inputs in the production of other goods. Inflation in intermediate goods leads to price rise in the final goods. For instance, increase in the price of natural gas will lead to increase in the prices of fertilizers.
  • Final goods: Final goods are those goods that are consumed by the final consumer. Inflation in final goods affects the ultimate consumer of these goods only.

Fuels

  • Petrol: Inflation in petrol is borne by the owner of automobile and thus does not lead to overall inflation in the economy.
  • Diesel: Inflation in diesel has impact on the overall price level of an economy because diesel is used in transportation of various goods and even in agriculture and industry.
  • Liquefied petroleum gas (LPG): LPG is used as a cooking fuel. Increase in LPG prices forces many households to use cow dung cakes and wood for cooking. To maintain low prices of LPG, the government provides subsidy.
  • Kerosene: Kerosene is consumed mainly by the poor to fulfil a variety of fuel needs such as cooking and lighting. Thus, rise in the prices of kerosene puts extra burden on the poor. To maintain low prices of kerosene, the government gives subsidy on kerosene.

INFLATION IN DEVELOPED AND DEVELOPING COUNTRIES

  • The present rate of inflation is high in developing countries as developing countries are growing at higher rates. High growth rate increases the income level of people. Consequently, people make more demand of commodities leading to it.
  • However, the overall price level is higher in developed nations. This is due to the fact that in the past, developed nations have experienced high growth rate and high inflation rate than that experienced by developing economies.

MEASUREMENT OF INFLATION

Inflation Indices 

  • In India, CPI and WPI are two major indices for measuring it.

Comparison between WPI and CPI

  • The WPI was the main index for measurement of inflation in India till April 2014 when the RBI adopted CPI as the key measure of inflation.
  • The WPI is computed by the Office of the Economic Adviser in the Ministry of Commerce and Industry, Government of India. CPI is of three types: CPI for industrial workers (DAT), CPI for agricultural labourers (AL)/rural labourers (RL), and CPI (rural/urban/combined). While the first two are compiled and released by the Labour Bureau in the Ministry of Labour and Employment, the third by the Central Statistics Office (CSO) in the Ministry of Statistics and Programme Implementation.

Both WPI and CPI are released monthly.

  • In 2017, the base year for the calculation of WPI was changed to 2011-12. The base year for calculating the CPI is also 2011-12. Thus, the base year for WPI has been made the same as that of CPI. Earlier, the base year for calculating the WPI was 2004-05.
  • There are 697 (earlier 676) items in the WPI. The numbers of items in the CPI basket are 448 in rural and 460 in urban.
  • The primary use of WPI is to have inflationary trend in the economy as a whole. However, CPI is used for calculating changes in the cost of living.
  • The WPI is based on wholesale prices for primary articles and ex-factory prices for manufactured products. On the other hand, CPI is based on retail prices, which include all distribution costs and taxes.
  • The prices for WPI are collected on voluntary basis, while the price data for CPI are collected by investigators by visiting markets.
  • The CPI covers only consumer goods and consumer services, while the WPI covers all goods, including intermediate goods transacted in the economy.
  • The WPI weights are primarily based on national accounts and enterprise survey data, and the CPI weights are derived from consumer expenditure survey data.

Note: The major changes in weights, number of items, and quotations between WPI 2004-05 and WPI 2011-12 are given in the following table:

Major Group Weights Number of items Number of quotations
  2004-05 2011-12 2004-05 2011-12 2004-05 2011-12
All commodities 100.00 100.00 676 697 5482 8331
Primary articles 20.12 22.62 102 117 579 983
Fuel and power 14.91 13.15 19 16 72 442
Manufactured products 64.97 64.23 555 564 4831 6906

 

The index basket of the new series has 697 items (as mentioned earlier), including 117 items for primary articles, 16 items for fuel and power, and 564 items for manufactured products.

Proportion of items in CPI

The items in CPI are divided into five main groups as follows:

 

Item group

 

Weightage(%)
Food and beverages

 

54.18

 

 

Pan, tobacco, and intoxicants 3.26
Clothing and footwear

 

7.36

 

Fuel and light

 

7.94

 

Miscellaneous

 

27.26

 

Total 100

 

Base year

  • The government has chosen an arbitrary year to be the base year and set that equal to 100. Currently, the base year is 2011-12.
  • Every month, the Bureau of Labour Statistics (BLS) surveys prices around the country for a basket of products and publishes the results as a number.
  • Let us assume for the sake of simplicity that the basket consists of one item and that one item costs ₹1 in 2012. The BLS published the index in 2012 at 100. If today the same item costs ₹1.85, the index would stand at 185.0. By itself, it does not tell us what the current inflation rate is.

Relevance of Base Year

  • The pattern of consumption by the people is ascertained in the base year as adopted at the discretion of the government.
  • Accordingly, based on the pattern of consumption, the commodities are selected and weights are allocated to the commodities for inclusion in CPI.
  • The weight allocated to each commodity reflects the amount of expenditure incurred on that particular commodity

Calculation of Inflation

  • Many people are confused by the difference between inflation and CPI. The CPI is, as its name implies, an index or “a number used to measure change in the cost of living”.

How does inflation or deflation relate to the CPI?

  • In order to calculate the inflation, we compare the CPI of the current month with the same month last year.
  • For instance, CPI (rural) values for November 2016-17 and November 2015-16 were 133.6 and 128.3, respectively.

Inflation rate (in rural areas) for the month of November 2016

(CPI November 2016 value – CPI November 2015 value)

=                                                                                                                                          x 100

(CPI November 2015)

(133.6 – 128.3)

=                                       x100 = 4.13%
128.3

Thus, we can conclude that the CPI is used to calculate the actual inflation rate.

Base effect: The consequence of abnormally high or low levels of inflation in the same month of the previous year distorts headline inflation numbers for the present month. A base effect can make it difficult to accurately assess its levels. In our example, the base month is November 2015.

MEASURES TO CONTROL INFLATION

  • Monetary measures: It can be curtailed by controlling the money supply.
  • Fiscal measures: It can be controlled by reducing government expenditure and increasing revenue collection.
  • Administrative measures: These measures refer to the actions undertaken by the government. Administrative measures such as a check on hoarding can also help in reducing prices.
  • Apart from these three measures, any change in demand and supply factors can also help in reducing it.

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Indian Economy

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