INFLATION

Inflation:
 Inflation refers to the persistent rise in general price level in the country over a period of time.
Inflation could be monetary or price inflation. During periods of inflation, there is an increase of
the money supply.

Cause of Inflation
 Inflation is caused due to a mismatch between demand and supply, i.e. when demand exceeds
supply. Thus, inflation can occur due to changes in the demand side or the supply side or both.

Demand Side Inflation

 It is also known as demand pull inflation. Increase in demand can occur due to many reasons,
such as:
- Increase in public expenditure, especially by the government operating large fiscal deficits.
- Loose Monetary Policy of the Central Bank, which leads to low interest rates and thus, higher
consumption.
- Rapid GDP growth, which leads to more employment, higher wages.
- Increase in population.
- Depreciation of exchange rate, which reduces imports, increases exports and thus, pulls up
demand.
- Reduction in direct taxes, which puts more money in the hands of households.
- Speculation in commodities market etc.

Supply Side Inflation

 It is also known as cost push inflation.

Factors influencing inflation from the supply side can also be many, such as:
- Backward agricultural sector, which is not able to produce enough food.
- Inefficient storage, transportation and marketing infrastructure, which leads to wastage and
reduction in supplies.
- Hoarding by traders of essential items, artificially reduces supply and causes inflation.
- Rise in labour costs.
- Higher costs of imported materials.
-Higher costs of capital due to squeezing of credit by the Central Bank.
- Cartelisation by a few big suppliers to fix prices arbitrarily to make undue profits.
- Monopoly of a single supplier in the market, enabling him to set arbitrary prices.
 -Pushing up of profits by the management of a company by increasing the prices also leads to
inflation.
- It has to be understood that it is not always easy to differentiate between demand and supply
side inflation and an example form the demand side can also be explained from the supply side
and vice-versa.

 Inflation:
-Inflation refers to a sustained rise in general level of prices of goods and services in an economy.
- Thus, it reflects the price rise of a particular basket of goods & services over a given period of
time.
- Inflation tends to reduce the purchasing power of money.

 Deflation:
- It is a persistent fall in general level of prices of goods and services, i.e. negative inflation.
- Deflation occurs when prices fall because the supply of goods is higher than the demand for
those goods. This is usually because of a reduction in money supply, credit or consumer
spending.
- It is not desirable as price level reduces along with fall in national Income, employment etc.,
leading to recession.

 Disinflation:
- It is a decrease in the rate of inflation. The inflation rate declines over time, but it remains
positive.
-For example, if the inflation rate is 5% in January, but decreases to 4% in March, economy is
said to be experiencing disinflation in the first quarter of the year.
- The general price level reduces without any adverse impact on national income, employment etc.
It is desirable.

 Reflation:- It is a situation in which general price level increases, along with increase in National
Income, output etc., during the phase of economic recovery.

 Stagflation:
- It is a situation in which the inflation rate is high, the economic growth rate slows, and
unemployment remains steadily high.
- It is, thus, a combination of economic stagnation and high inflation.
- It is usually due to cost push factors for eg. Rise in prices of oil during the Gulf crises in 1970s.
- A degree of stagflation also occurred in 2008, following the start of the global recession.
- Stagflation can be a dilemma for governments since most actions designed to lower inflation may
raise unemployment level, and policies designed to decrease unemployment may worsen the
inflation.
 Skewflation: - When the prices of certain items increases in a much higher proportion than the
prices of other items.

 Core Inflation – This measure is computed by policy makers to analyse inflation data, which
exclude Food & Fuel product. Core inflation is calculated by CPI.

 Business Cycle - Economists have pointed out that the business cycle is charecterised by six
stages in which economies alternate.

i) Depression – Though Depression has visited the world economy only once in 1929, economists
have pinpointed enough number of traits to recognize it. The major traits of depression could be
as given below :
a) An extremely low aggregate demand in the economy causes activities to decelerate.
b) The inflation being comparatively lower.
c) The employment avenues start shrinking forcing unemployment rate to grow fast.
d) To keep the business going production houses go for forced labour cuts or retrenchment etc.

ii) Recovery – An economy tries to come out of the low production phase to survive. The low
production phase might be depression, recession or slowdown. Hence government take many new
fiscal and monetary measures to boost demand and production. The major traits of recovery could
be as given below :
a) Increase in the level of production.
b) Productions process expands.
c) New investments become attractive.
d) Declining unemployment rate.

iii) Boom – A strong upward fluctuation in the economic activities is called Boom. The major
traits of Boom could be as given below :
a) An accelerated and prolonged increase in the demand.
b) Demand peaks up to such a high level that it exceeds sustainable production level.
c) Inflation starts going upward.
d) The economy might face structural problems like shortage of investible capital. Lower savings,
falling standard of living, creation of a sellers market.

iv) Recession -- This is somewhat similar to the phase of ‘Depression’ – we may call it a mild form
depression which is fatal for economy. The major traits of Boom could be as given below :
a) There is a general fall in demand as economic activities takes a downturn.
b) Inflation remains lower or and shows further signs of falling down.
c) Unemployment rate grows.
d) Industries resort to ‘price cuts’ to sustain their business.

v) Growth Recession – The lack of job creation makes it feel as if economy is in a recession, even
though the economy is still advancing.
In spite of gains in real GDP, job growth was either non-existent or was being destroyed at a faster
rate than new jobs were being added.
 vi) Double Dip Recession – A double dip recession refers to a recession followed by a short lived
recovery, followed by another recession – the GDP growth sliding back to negative after a quarter
or two of positive growth.
A double dip (which may be even Triple-dip) is a worst case scenario – fear of it moves the
economy into a deeper and longer recession and recovery becomes too difficult.
The concept of recession in the USA & Euro Zone is quite precise and technical – ‘two consecutive
quarter so of falling GDP’.

 Lowflation - Presistent deflation is called Lowflation. The concept was given by International
Monetary Fund (IMF) in 2014 for European Countries.

 Inflationary Gap : The excess of total government spending above the national income is known
as Inflationary Gap. This is intended to increase the production level, which ultimately pushes
the prices up due to extra creation of money during the process.

 Deflationary Gap – The shortfall in total spending of the government over National Income creates
Deflationary Gap in the economy. This is a situation of producing more than the demand and the
economy generally heads for a general slowdown in the level of demand. This is also known as
the ‘Output Gap’.

 Inflation Premium – The bonus brought by Inflation to the borrowers is known as the Inflation
premium. The interest banks charge on their lending is known as the Nominal Interest Rate.

 Inflation Accounting – A term popular in the area of corporate profit accounting. Basically, due
to Inflation the profit of firms / companies gets overstated.

 Infaltion Targetting – The announcement of an official target range for Inflation is known as
Inflation Targetting. It is done by the Central bank in an economy as a part of Monetary Policy.

TYPES OF INFLATION

 Based on rate of price rise:

a) Creeping Inflation: It is a gentle or a mild rise in prices, usually under 3% a year. A certain
level of low inflation is often considered good for the economy as it provides scope to the sellers to
make reasonable profits, there by incentivizing them to invest in economic expansion.

b) Trotting/Walking Inflation : This type of inflation is usually between 3-10% a year, and if not
controlled timely, proves to be harmful to economic growth of a country. People tend to purchase
more than they need, in expectation of future increase in prices. Thus, demand outstrips the
supply of goods and services.

c) Galloping Inflation: - When inflation rises to 10% or higher, it tends to destabilize the
economy. Money rapidly loses value and business and employee incomes can’t keep up with costs
and prices. Foreign investors avoid the country, depriving it of the needed capital.
 d) Hyperinflation:- There is no precise numerical definition to hyperinflation. It refers to an
extremely rapid or out of control inflation (“runaway inflation”) where annual rates are in million
or even trillion. The value of the national currency (money) of an affected country reduces almost
to zero, making paper money absolutely worthless. For example, the cases of Germany in 1920s,
Hungary in 1940s, Zimbabwe in 2000s, etc.

 Based on Government Control

a) Core Inflation:- It is based on the prices of only those items whose prices are relatively
stable.i.e. it doesn’t take into account prices of food and fuel (due to volatility in prices). Thus,
core inflation measures the long term trend in general price levels by factoring out temporary
effects and, therefore, is more important from the point of view of economists and policymakers.

b) Headline Inflation: - It is a measure of the total inflation within an economy and is based on
the prices of group of all the items.
- Headline inflation = Core inflation+ Non-core inflation

 Based on Causes
 a) Cost Push inflation-
- Cost push inflation refers to an increase in general price level due to rise in input costs such as
wages, raw material, import components etc.
- It is also known as supply shock inflation as it leads to reduced supplies as a result of
increased input prices.
For example:
 An increase in global crude prices results increased domestic production and transportation
costs, thereby pushing up the prices of final goods.
 A higher cost of capital resulting from increase in interest rates.
 A rising Minimum Support Prices (MSP) pushes up prices of agricultural produce in the market.

b) Demand Pull inflation- (Too much money chasing too few goods):
- It occurs when prices rise because the aggregate demand in an economy is far greater than the
aggregate supply.
- In the short run, since supply cannot be increased drastically, the increase in demand is met with
rising prices.
- Demand pull inflation can be caused by:

 An increase in money supply that puts too much purchasing power in the hands of consumers,
thereby increasing the overall demand vis a vis supply. For eg., the expansionary fiscal policy
followed by government in the aftermaths of 2008 economic crises.
 Rising incomes as a result rapid economic growth, consequently increasing demand. For eg.
Rising rural incomes/wages as a result of MGNREGA scheme created demand pressures,
especially on protein items like eg, meat, fish, milk etc.
 Other factors- Increase in foreign exchange, decrease in direct taxes, increase in net exports,
increase in population etc.
c) Structural Inflation (Bottleneck inflation)
- This type of inflation is often found in developing countries where the supply of good and services
remain inelastic due to structural rigidities found in these economies.
- For example:

 Backward agricultural sector characterized by defective system of land tenure, lack of irrigation,
finance, outdated technology and implements etc.
 Inefficient storage and distribution facilities leading to wastages and reduced supplies.
 Infrastructural bottlenecks in form of lack of power, transport, communication, fuel etc.
 Artificial scarcity caused by hoarding, cartelization, and speculation.

MESUREMENT OF INFLATION

WPI (WHOLESALE PRICE INDEX)

 WPI measures changes in the price of basket of gods at the Wholesale level.
 The Base Year is 2011-12, in line with GDP base year revision.
 WPI takes into account 697 commodities of various types to measure inflation but it does not take
into account services.
 WPI is published monthly by Office of Economic Advisor¸ Department of Industrial Policy and
Promotion (DIPP), Ministry of Commerce and Industry.
 Exclusions: WPI doesn’t include the following:
- Services eg. Transportation, construction etc.
- Manufactured output of unorganized sector.
- Indirect taxes,in order to remove impact of fiscal policy. This is in consonance with international
practices and will make the new WPI conceptually closer to ‘Producer Price Index’

CPI (CONSUMER PRICE INDEX)

 It tracks the prices paid by the end consumer in the retail market.
 It included Services (Health, Education, Entertainment, Transport etc.)
 It covers 448 items in the rural basket and 460 items in the urban busket.
 There are separate CPI indices for separate groups of people as: CPI-IW (Industrial Worker), CPI-
AL (Agricultural Labourer), CPI-RL (Rural Labourer)
 In the organized sector, CPI (IW) is used as cost of living index. MNREGA wages are indexed to CPI
(AL)
 CPI (combined – Rural & Urban) is used as a key indicator by RBI for Inflation targeting and
Monetary policies. It covers 200 weighted items in the basket.
 Headline Inflation is based on CPI (Combined).
 For computing Dearness Allowance CPI is used (not WPI).
 Now a days CPI is more popular method than WPI.
 It is published monthly by Central Statistics Office (CSO), Ministry of Statistics and Programme
 CIP Combined Base year- 2019-20
  CPI compiled using Geometric Mean (GM).

Wholesale Price Index Consumer Price Index

1. Base year – 2011-12. 1. Base Year – 2012.

2. No of commodities – 697 products. 2. No of commodities – 200 weighted

items.
3. WPI measures Inflation at each stage of
production. 3. CPI measures inflation only at final
stage of production.
4. WPI takes into account only goods.
4. CPI takes into accounts both goods
& services.

GDP DEFLATOR

 Gross Domestic Product (GDP) is the market value of all final goods and services produced
within an economy during a specified period.
 GDP deflator, thus, is a measure of change in price of all final goods and services produced in the
current year in an economy. It is a measure of general price inflation.
𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏 ×𝟏𝟎𝟎
 GDP Deflator=
𝐑𝐞𝐚𝐥 𝐆𝐃𝐏

IMPACT OF INFLATION
POSITIVE IMPACT

 A moderate inflation stimulates economic growth, if inflation is due to aggregate demand

exceeding aggregate supply.
 Inflation increases the profit margin of the seller, which encourages them to increase
production.
 It provides assurance to the sellers regarding the adequacy of demand in the economy. This
encourages them to invest an increased productive capacity in the economy.
 Philips Curve: Inverse relation between Inflation and Unemployment. So, unemployment reduces
with increase in inflation (Refer to the figure)
 Inflation also makes it easier on debtors, who repay their loans with money that is less valuable
then the money they borrowed.

NEGATIVE IMPACT

 Redistribution of wealth:
- Inflation redistributes wealth from creditors to debtors i.e. lenders suffer and borrowers
benefit.
- People living on fixed incomes like pensioners, students, dependants will be worse off in real
terms as value of money gets eroded with rising prices.
- Rise in prices of essential commodities (food & clothing) will affect the poor segment of the
society who spend a major part of their income on these goods. This will exacerbate inequality
and social unrest.
  Impact on Saving:
- Inflation reduces the real income held y people. Individuals, owing to the inflationary future
expectations, deem it more advantageous to spend money today than save for a later date.
- Savings also fall as people spend more to sustain their present standards of living.
- The real rate of return on savings deposited in the bank falls with inflation. A negative real rate
makes saving in banks undesirable.
 Impact on Investment
- High inflation leads to less saving and, thus, less availability of loanable funds to firms for
investment.
- If loans are indexed to inflation, then borrowing cost of the firm increase, reducing the
investment demand consequently.
- If loans are not indexed to inflation, the banks are the net losers as they receive repayments
that have been diminished in real terms by inflation.
- The Central Bank might use monetary tools to control high inflation rate by increasing
interest rates. This will increase the cost of borrowing and will have a negative effect on
investment.
 Impact on Balance of Payments:
- Inflation discourages exports as domestic market become more lucrative vis a vis international
market. This may lead to balance of payment problems.
- Inflation increases the cost of production, and if the imports demand is inelastic, it may
further exacerbate the gap. This may have an adverse impact on country’s international credit
rating and ability to raise foreign funds.
 Impact on Wages
- Inflation reduces the real wages and has a negative impact on the purchasing power and living
standard of the workers. It can result in industrial unrest and strikes
- Inflation may lead to wage-price spiral if wages are indexed to inflation.

MEASURES TO COUNTER INFLATION

 Monetary Measures: By selling Govt, securities through open market operation.

By increasing Cash Reserve Ratio.
By increasing Statutory liquidity Ratio.
By increasing Bank Rate.
By increasing Repo rate & Reverse Repo Rate.

 Fiscal Measures: By reducing private spending.

By decreasing non development government expenditure.
By avoiding deficit financing as far as possible.

 Reducing post-harvest agricultural losses: Building up supply chain logistics by setting up cold
storage and food processing Industries. Currently, 23-24% of fruits and vegetables go waste as per
Commission for Agricultural Cost and Prices (CACP).
 Liberalising of APMC (Agricultural Product Market Committee) provision: for seamless market
access for agricultural commodities, creating One Nation, One Market, One Food Zone, allowing
direct selling, e-aggregation etc.
 MSP and MGNREGA: Policy for ‘Development’ and not for ‘Populism’ should be the guiding
principle in such cases. Impact of increasing MSP and MNREGA wages needs to be carefully
analysed and balanced policies needs to be formulated.
 Rationalistion of subsidies: Using sun-set clause, DBT (direct benefit transfers), JAM trinity (Jan
Dhan, Aadhaar, Mobile) to eliminate leakages and ghost beneficiaries.
 Curbing corruption and black money: Black money leads to parallel economy and spiraling of
prices eg. Real estate sector, gold purchases. Formalisation of economy through digital trail,
crackdown on fake currency cells, strict implementation of laws like Prevention of Corruption Act
and Prevention of Money Laundering Act etc. Should be undertaken.
 Essential Commodities: Strict action against hoarding & black marketing and effectively enforce
the Essential Commodities Act, 1955 & the Prevention of Black-marketing and Maintenance of
Supplies of Essential Commodities Act, 1980 for commodities in short supply.