Inflation

FINANCE

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Inflation
• 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.

• Inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and
Built-In inflation.

• The most commonly used inflation indexes are the Consumer Price Index (CPI) and
the Wholesale Price Index (WPI).

• Inflation measures the average price change in a basket of commodities and

services over time. The opposite and rare fall in the price index of this basket of
items is called ‘deflation’.

• Inflation is indicative of the decrease in the purchasing power of a unit of a country’s

currency. This is measured in percentages.

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Advantages of Inflation
• Slow inflation enables economic growth

• Helps in adjustment of real wages

• It is better than deflation because it doesn’t lead to recession

• It allows adjustment of prices

Disadvantages of Inflation
• It may lead to uncertainty and lower investment

• Higher rate of inflation can lead to lower growth and instability

• It reduces international competitiveness

• It may also give rise to speculative investment

• Upsets the planning process

• It also may result in fall in value of savings

• It may lead to inequality in the distribution of income

What Drives Inflation

• Various factors can drive prices or inflation in an economy. Typically, inflation results
from an increase in production costs or an increase in demand for products and
services.

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Demand-Pull Inflation
• It occurs when aggregate demand is growing at an unsustainable rate leading
to increased pressure on scarce resources and a positive output gap.

• When there is excess demand, producers can make use of it and thus raise their
prices and achieve bigger profit margins.

• It can be summarized as “too much money chasing too few goods”.

Cause
• Depreciation of the exchange rate of the country currency: It will increase the
prices of imports and will reduce the foreign price of a country's exports. If
consumers buy fewer imports on one hand, and on the other exports grow, it will
ultimately result in a lack of goods for the domestic market.

• Higher government spending: Higher government spending will ultimately

increase the money supply in the economy and it will create extra demand in the
circular flow of income.

• Lower tax rate: If direct taxes are reduced, consumers will be left with more
disposable income causing demand to rise.

• Loose monetary policy: A fall in interest rates because of loose monetary policy by
the central bank may stimulate too much demand leading to inflation.

• Increase in standard of living: It will ultimately increase the demand for various
goods associated with descent living and ultimately causing inflation.

Cost-push Inflation
• It occurs when firms respond to rising costs of materials used in the manufacture of
goods by increasing prices to protect their profit margins.

• The cost of production may rise due to a rise in the cost of things such as wages,
taxes, or increased costs of imports.

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Cause
• A fall in the exchange rate of country currency: It may lead to an increase in the
prices of imported products such as essential raw materials, components, and
finished products and thereby increase in the prices of goods.

• Higher tax rate: If direct taxes are increased, it will ultimately increase the prices of
final goods. Because a certain rate of tax is charged on every product.

• Increase in labour cost: It may often rise when unemployment is low because
skilled workers become very scarce and this can drive their pay levels higher.
Wages might also increase when people expect higher inflation so they ask for more
pay to protect their real incomes in the future. Trade unions may also use their
bargaining power to increasing wages.

• Component costs: An increase in the prices of raw materials and other

components may also give rise to inflation. This may be because of a rise in
commodity prices such as oil, copper, and agricultural products used in
manufacturing goods.

• Tight monetary policy: It will ultimately drive the rate at which investors buy money
from the bank. Thus ultimately resulting in the increasing cost for the firm and thus
causing cost inflation.

Hyperinflation
• Hyperinflation is a term to describe rapid, excessive, and out-of-control price
increases in an economy, typically at rates exceeding 50% each month over time.

• Hyperinflation can occur in times of war and economic turmoil in the underlying
production economy, in conjunction with a central bank printing an excessive amount
of money.

• Hyperinflation can cause a surge in prices for basic goods such as food and fuel as
they become scarce.

• While hyperinflations are typically rare, once they begin they can spiral out of control.

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Cause
• Excessive Money Supply: If the increase in money supply is not supported by
economic growth as measured by gross domestic product (GDP), the result can lead
to hyperinflation.

• Hyperinflation often occurs when there is a loss of confidence in a country's

currency and the central bank's ability to maintain its currency's value in the
aftermath.

Measurement of Inflation
Inflation can be measured through the following indexes:

Consumer Price Index

• A comprehensive measure used for the estimation of price changes in a basket of
goods and services representative of consumption expenditure in an economy is
called the consumer price index.

• The calculation involved in the estimation of CPI is quite rigorous. Various categories
and sub-categories have been made for classifying consumption items and based on
consumer categories like urban or rural. Based on these indices and sub-indices
obtained, the final overall index of the price is calculated mostly by national statistical
agencies.

• It is one of the most important statistics for an economy and is generally based on
the weighted average of the prices of commodities. It gives an idea of the cost of
living.

• Inflation is measured using CPI. The percentage change in this index over some
time gives the amount of inflation over that specific period, i.e. the increase in prices
of a representative basket of goods consumed.

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• 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.

• 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)

 CPI for Agricultural Labourers (AL)

 CPI for Rural Labourers (RL) and

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

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 is Consumer Price Index calculated?

 The CPI is calculated with reference to a base year, which is used as a

benchmark. The price change pertains to that year.

 Remember, when you calculate the CPI, note that the price of the basket in 1
year has to be first divided by the price of the market basket of the base year.
Then, it is multiplied by 100.

• Consumer Price Index formula:

CPI = (Cost of basket divided by Cost of basket in the base year) multiplied by
100

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Wholesale Price Index

• Wholesale Price Index, or WPI, measures the changes in the prices of goods sold
and traded in bulk by wholesale businesses to other businesses.

• WPI is unlike the Consumer Price Index (CPI), which tracks the prices of goods and
services purchased by consumers. To put it simply, the WPI tracks prices at the
factory gate before the retail level.

• How do you calculate the 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

available.

 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.

• 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.

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Methods to Control Inflation

1. Monetary policy: The Central bank can increase interest rates. Higher rates will
make borrowing more expensive and saving more attractive. This would lead to
lower growth in consumer spending and investment. A higher interest rate should
also lead to a higher exchange rate thereby making imports cheaper and ultimately
resulting in increased supply.

2. Controlling money supply: As part of monetary policy, many countries have set up
an inflation target. The argument behind this is that if people believe the inflation
target is credible, then it will also help to lower inflation expectations. If inflation
expectations are lower, it will make it easier to control inflation.

3. Fiscal policy: The government can increase taxes and it may also cut its spending.
This will improve the government’s budget situation and helps to reduce demand in
the economy. Both these policies will help in reducing inflation by reducing the
growth of aggregate demand. If economic growth is rapid, reducing the growth of
aggregate demand can reduce inflationary pressures without causing a recession in
the economy.

4. Wage control: If inflation is caused by wage inflation then limiting wage growth can
also help to moderate inflation. Lower wage growth will help to reduce cost-push
inflation and it will also help to moderate demand-pull inflation.

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5. Supply-side policies: Often inflation is caused by persistent in competitiveness and

rising costs of raw materials. Supply-side policies may enable the economy to
become more competitive and it will also help to moderate inflationary pressures. For
example, more flexible labor markets will help in reducing inflationary pressure.
However, it can take a long time, and cannot deal with inflation caused by raising
aggregate demand.

6. Raising production

7. Having a rational wage policy

8. Price control

9. Rationing

10. Import those commodities which demand is high

11. Keep a check on hoarding and speculation

12. Decreasing exports

Effects of Inflation
Effect on the Distribution of Income and Wealth
1. Creditors and debtors: Debtors gain and creditors lose during inflation because
debts are fixed in rupee terms. When debts are repaid by debtors their real value
declines by the price level increase and, hence, creditors lose in monetary terms.
2. Bond and debenture holders: In an economy, some people live on interest
income because of inflation they suffer most. Bondhold­ers earn fixed interest
income thus these people suffer a reduction in real income when prices rise. In other
words, the value of one’s sav­ing will decline if the interest rate falls short of the
inflation rate.
3. Investors: People putting their money in shares during inflation are expected to gain
since the possibility of earning business profit brightens. Higher profit induces
owners of a firm to distribute profit among inves­tors or shareholders as such.

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4. Salaried people and wage-earners: Any­one earning a fixed income is damaged

by inflation. Naturally, it results in a reduction in the real purchasing power of fixed-
income earners. On the other hand, those people who earn flexible incomes may
gain during inflation. The nominal incomes of such people outstrip the general price
level rise. As a result, the real incomes of this income group will in ­the crease.
5. Profit-earners, speculators, and black marketers: Profit tends to rise during
inflation because by seeing inflation, businessmen raise the prices of their products
which ultimately results in a bigger profit. Speculators dealing in business in
essential commodities usually stand to gain by inflation and Black marketers are
also ben­efited by inflation.

Effect on Production and Economic Growth

1. Inflation may or may not result in increasing output. If there is a full-employment
stage, inflation will have a favorable effect on production. Ris­ing price and rising
profit encourage firms to make larger investments in the business.

2. As a result of this, the multi­plier effect of investment will come into opera­tion
resulting in higher national output in general. How­ever, such a favorable effect of
inflation will prove to be temporary if wages and production costs rise very rapidly.

3. Further, the inflationary situation may also be as­sociated with the fall in output,
particularly if it is of the cost-push variety.

4. It may also lower down further pro­duction levels.

5. It may also argue that inflation creates an air of uncertainty in the minds of the
business community, particularly when the rate of in­flation fluctuates very rapidly.

6. However, a slight dose of inflation is neces­sary for economic growth because Mild
inflation has an encouraging effect on national output. But it is very difficult to make
the price rise of a creep­ing rate.

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Inflation Targeting
• This refers to an approach to the monetary policy where the primary mandate of a
central bank is to manage the rate of price inflation in the wider economy.

• Economists who support inflation targeting believe that a stable inflation rate is
essential to keep the economy fully employed while protecting the value of the
currency at the same time.

• Central banks with an explicit inflation-targeting mandate usually have a target range
of inflation. They try to keep inflation within the target range by adjusting the
economy’s money supply.

• The policy of inflation targeting, which was first introduced in some European
countries in the 1970s, became a popular approach in the 1990s.

Recent Trends in Inflation in India

• India’s growth in the first quarter of 2020-21 at (-) 23.9% showed one of the highest
contractions globally.

• Global growth prospects for 2020 have been projected by several multilateral
institutions and rating agencies including that for India.

• The 2020-21 real GDP growth for India is forecast in the range of (-) 5.8% (the
Reserve Bank of India’s Survey of Professional Forecasters) to (-) 14.8% (Goldman
Sachs).

• The Organization for Economic Co-operation and Development (OECD) in its

September 2020 Interim Economic Outlook has projected a contraction of (-) 10.2%
in FY21 for India.

• The annual projections also indicate a strong likelihood of even the nominal GDP
growth showing a contraction for 2020-21.

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• The latest data released by the Ministry of Statistics indicate a Consumer Price
Index (CPI) inflation rate of 6.7% for August 2020. The average CPI inflation during
the first five months of 2020-21 is estimated at 6.6%.

• Given the injection of periodic liquidity into the system and the inflation trends, the
year as a whole may show a CPI inflation of close to 7%.

• Since deflator-based inflation tends to be lower than the CPI inflation, it may be
about 5% or less.

• In fact, in the first quarter of 2020-21, GDP-based deflator was only 1.8%. If we take
the OECD’s real GDP growth projection at (-) 10.2% and deflator-based inflation of
about 5%, the implied contraction in nominal GDP is about (-) 5.0% for 2020-21.

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