Chapter 5: Inflation

WHAT IS INFLATION?

Inflation is the sustained rise in the general price level of goods and services in an economy over a
period of time. As prices rise, each rupee buys fewer goods — purchasing power erodes.

 If you could buy 5 kg of onions for ₹100 last year, and only 4 kg this year, that lost kilogram is
inflation at work.

 Inflation is measured through price indices — a weighted basket of goods and services
tracked over time.

 The opposite — a persistent fall in the general price level — is deflation.

 In India, the Ministry of Statistics and Programme Implementation (MoSPI) is responsible

for compiling inflation data, primarily through the National Statistical Office (NSO).

CAUSES OF INFLATION

Economists classify the sources of inflation into several overlapping categories:

1. Demand-Pull Inflation

Too much money chasing too few goods. When aggregate demand outpaces the economy's
productive capacity, prices get pulled up.

Triggers:

 Rupee depreciation → exports surge, domestic supply shrinks → demand pressure

 Rising Forex reserves → RBI releases rupees to buy dollars → money supply expands →
demand rises

 Low interest rates → cheaper loans → households borrow and spend more; firms invest
more

 Festival/seasonal spending surges: Diwali, wedding seasons cause demand spikes in

consumer durables, gold, travel

 Expansionary fiscal policy: Tax cuts or direct benefit transfers put more money in people's
hands

2. Cost-Push Inflation

When the cost of production rises, producers pass it on to consumers through higher prices —
supply shrinks relative to demand.

Triggers:

 Crude oil price spikes: Transport, plastics, fertilisers — all become costlier. A global oil shock
hits India disproportionately because we import over 85% of our crude.

 Wage-push: Strong labour unions negotiating wage hikes beyond productivity gains

 Higher input costs: Steel, cement, chemicals price rises feed into construction and
manufacturing
  Supply chain disruptions: COVID-19 lockdowns, the Russia-Ukraine conflict, Red Sea
shipping disruptions

3. Monetary Inflation

When money supply grows faster than real output, each extra rupee chasing the same goods pushes
prices up. Classic monetarist explanation — famously summed up by Milton Friedman: "Inflation is
always and everywhere a monetary phenomenon."

 Central banks excessively printing money or keeping rates too low for too long

 Large-scale government borrowing monetised by the central bank (though RBI has moved
away from automatic monetisation)

4. Imported Inflation

When the domestic currency depreciates, the rupee price of imported goods goes up — even if the
global price hasn't changed.

 India imports crude oil, edible oils, pulses, gold, electronics, fertilisers — all become costlier

 Geopolitical shocks: Russia-Ukraine war → global crude and fertiliser prices surged → India's
import bill ballooned

5. Structural/Supply-Side Inflation

Unique to developing economies with weak institutional and market structures.

 Hoarding and black marketing → artificial scarcity

 Poor monsoons, inadequate irrigation → crop failure → food price spikes

 Fragmented supply chains → intermediaries inflate margins without adding value

 Rigidities in agricultural marketing (APMC constraints, lack of storage)

6. Profit-Induced Inflation

When firms with monopoly or oligopoly power exploit their position to widen profit margins by
raising prices beyond input cost increases. Common in sectors with limited competition —
pharmaceutical cartels, cement oligopolies.

TYPES OF INFLATION

Based on Scope/Coverage

Type What It Includes Utility Limitation

Headline All items in the price index Captures the full Volatile; spikes in a few
Inflation — food, fuel, everything picture items distort the trend

Core Inflation Headline minus food and Reflects underlying, May miss what matters
fuel persistent demand- most to households
side inflation (food & fuel)

Refined Core / Core minus petrol, diesel, Further removes Economic Survey 2022-
 Core-Core lubricants for vehicles volatile transport fuel 23 introduced this
Inflation noise concept

India's Context: Core inflation was first used in India around 2000-01. But it lost traction because a
majority of Indian household consumption is food and fuel — core inflation didn't reflect the average
citizen's lived experience. Since 2015-16, a narrower "core-core" (excluding food, fuel, light,
transport, and communication) has been tracked.

Economic Survey 2022-23 proposed "refined core inflation" — excludes specific motor fuel items
(petrol for vehicle, diesel for vehicle, lubricants & other fuels for vehicles) in addition to food &
beverages and fuel & light.

Based on Speed

Type Rate Range Description Real-World Example

Slow, predictable;
Creeping Most developed economies
1% – 4% considered healthy for
Inflation target ~2%
growth

Single-digit but rising;

Walking India's inflation in many pre-
2% – 10% central banks get
Inflation 2014 years
anxious

Double-digit; significant
Running India touched this during
10% – 20% erosion of purchasing
Inflation 2008-09 and briefly in 2013
power

Galloping Out of control; currency Turkey (2022), Argentina

20% – 1,000%
Inflation loses credibility (ongoing), Brazil (1980s-90s)

> 1,000% (or Total collapse of Germany 1923 (Weimar

Hyperinflation >50% per currency; barter may Republic), Zimbabwe 2008,
month) return Venezuela 2010s

A useful rule: Hyperinflation is when prices double in less than a year, or the monthly inflation rate
exceeds 50%.

KEY INFLATION TERMINOLOGIES

Term Meaning Example

Skewflation Price rise in a few specific commodities while Onion prices spike during monsoon;
others remain stable everything else steady

Stagflation Stagnation + Inflation: high prices, low/no India 1970s oil shock; advanced
growth, high unemployment economies after COVID supply
disruptions

Disinflation Inflation rate falls but remains positive Inflation drops from 8% to 5%
(prices still rising, just slower)

Deflation General price level actually falls (negative Japan's experience through much of
inflation rate) 1990s-2000s

Reflation Deliberate policy stimulation to pull an Post-2008 quantitative easing; post-

economy out of deflation/recession COVID stimulus

Depression Sustained, severe recession lasting years — Great Depression (1929-1939)

massive unemployment, collapsing demand

Inflationary Gap Aggregate demand > Aggregate supply at full Economy overheating; capacity
employment level. Real GDP exceeds constraints binding
Potential GDP

Deflationary Gap Aggregate demand < Aggregate supply at full Demand-deficient recession
employment. Shortfall in total spending

Bottleneck Structural rigidities restrict supply while APMC mandi infrastructure

Inflation demand remains intact bottlenecks push up vegetable prices

Inflation Tax Government's hidden gain: inflation pushes Bracket creep (see below)
nominal incomes into higher tax brackets →
higher tax revenue without raising rates

Inflation The extra interest lenders charge to Nominal rate = Real rate + Inflation
Premium compensate for expected inflation premium

Wage-Price Spiral Workers demand higher wages to cope with Common in economies with strong
inflation → firms raise prices to cover wage unions and indexation
costs → workers demand more wages →
vicious loop

Shoe-Leather The time and effort spent managing cash to People withdraw smaller amounts
Cost minimise inflation's erosion of value — more often to avoid holding
making more frequent bank trips depreciating cash

Bracket Creep Inflation pushes nominal incomes into higher Your salary gets a cost-of-living
tax brackets even though real income hasn't adjustment; but you now fall in the
risen → higher tax burden without a change 30% slab instead of 20%
in tax rates

Cobweb Cyclical production-price swings in Pulses and onions in India: classic

Phenomenon agriculture: High price → farmers cobweb cycles
overproduce next season → price crashes →
 farmers underproduce next season → price
spikes again

Full Employment All available resources (labour, capital) are The level at which further demand
utilised at their maximum sustainable level. stimulus only generates inflation, not
Not zero unemployment; includes output (NAIRU concept)
natural/frictional unemployment

THE PHILLIPS CURVE

An inverse relationship between unemployment and inflation, first documented by economist A.W.
Phillips using UK data.

 Short-run: As unemployment falls, wages rise (tight labour market), firms pass on higher
costs → inflation rises.

 Long-run: The trade-off breaks down. The economy settles at a Natural Rate of
Unemployment (NAIRU). Attempts to push unemployment below this rate only accelerate
inflation without lasting jobs gains.

Note: The stagflation of the 1970s (high inflation + high unemployment) challenged the simple
Phillips Curve. The modern view: the trade-off exists in the short run; in the long run, the curve is
vertical at the natural rate. The RBI's flexible inflation targeting framework implicitly acknowledges
this.

MEASURES OF INFLATION IN INDIA

1. Wholesale Price Index (WPI)

Feature Detail

Base Year 2011-12

Published by Office of Economic Adviser (OEA), Ministry of Commerce & Industry

Coverage Goods only (no services)

Components & Weight Manufactured Products (64.2%) > Primary Articles (22.6%) > Fuel & Power
(13.2%)

Frequency Monthly (with a 14-day lag)

Current Status No longer the primary inflation anchor; used as an indicator of producer-level
price trends

Why WPI lost primacy: It doesn't capture services (now ~55% of India's GDP). It measures
wholesale/bulk transaction prices, not what consumers actually pay. It includes indirect taxes; PPI is
conceptually cleaner.

2. Consumer Price Index (CPI)

Feature Detail
 Base Year 2012 (CPI combined); CPI-IW base year revised to 2016

Published by NSO, MoSPI (CPI Combined/Rural/Urban); MoLE (CPI-IW, CPI-AL, CPI-RL)

Coverage Goods and Services

Components & Food & Beverages (45.86%) > Miscellaneous (28.32%) > Housing (10.07%) > Fuel &
Weight (CPI-C) Light (6.84%) > Clothing & Footwear (6.53%) > Pan, Tobacco & Intoxicants (2.38%)

Policy Anchor CPI-Combined is the RBI's official inflation target under FIT (4% ± 2%)

Types of CPI in India:

CPI Type Published By Base Target Group

Year

CPI (Combined) — Rural NSO, MoSPI 2012 Economy-wide indicator; RBI's anchor
+ Urban

CPI – Industrial Workers Labour Bureau, 2016 Industrial workers; used for DA
(IW) MoLE calculation

CPI – Agricultural Labour Bureau, 1986- Agricultural labourers; used for

Labourers (AL) MoLE 87 MGNREGA wage revision

CPI – Rural Labourers Labour Bureau, 1986- Rural labourers

(RL) MoLE 87

3. GDP Deflator / Implicit Price Deflator

 GDP Deflator = (Nominal GDP ÷ Real GDP) × 100

 Measures the price change of all goods and services produced domestically — far broader
than WPI or CPI.

 Advantage: Comprehensive coverage; weights change with actual production patterns.

 Disadvantage: Available only quarterly (with GDP estimates); CPI and WPI are monthly.

Deflator Value Implication

= 100 (or 1 in ratio) No price change from base year

> 100 Prices have risen (inflation)

< 100 Prices have fallen (deflation)

4. Index of Industrial Production (IIP)

While IIP is a volume index (not a price index), it is closely watched alongside inflation data.

Feature Detail

Base Year 2011-12

Published by Central Statistical Organisation (CSO) / NSO

 Frequency Monthly

Sector Weights Manufacturing (77.63%) > Mining (14.37%) > Electricity (7.93%)

Core Industries (8) Refinery Products > Electricity > Steel > Coal > Crude Oil > Natural Gas >
Cement > Fertilisers

Core Industry Weight in IIP 40.27%

IIP tells you whether the volume of industrial output is growing. CPI/WPI tell you whether prices are
rising. Together, they complete the picture: real growth vs nominal growth.

5. Producer Price Index (PPI)

India does not yet have an official PPI, though work is underway.

WPI (Current) PPI (Proposed)

Captures wholesale/bulk transaction prices Captures prices received by producers at factory gate

Includes some indirect taxes and distribution costs Excludes indirect taxes — cleaner measure of
producer costs

Weights based on net traded value Weights derived from supply-side data (input-output
tables)

Multiple counting bias inherent Removes double/multiple counting

Covers only goods Covers both goods and services

Published by OEA, Ministry of Commerce PPI not yet published in India

Committees:

 B.N. Goldar Committee: Developing a PPI for India

 Ramesh Chandra Committee (NITI Aayog): Roadmap for transitioning from WPI to PPI

BASE EFFECT AND INFLATION

A statistical phenomenon where high or low inflation in the base period distorts the current
period's inflation rate.

 If last year's same-month inflation was very low (say 1%), even a modest price rise this year
yields a high inflation rate — even though the absolute price increase is small.

 If last year's inflation was high (say 8%), the same price rise this year yields a lower inflation
rate — even if actual prices rose more.

Example:

 January 2024: Price index = 150. January 2023: Price index = 148 → Inflation rate = (150-
148)/148 × 100 ≈ 1.35%

 January 2025: Price index = 154. January 2024: Price index = 150 → Inflation rate = (154-
150)/150 × 100 ≈ 2.67%
The same absolute increase of 2 index points gave two very different inflation readings because
the base differed. Policymakers must strip out the base effect to understand the underlying price
momentum.

INFLATION TARGETING IN INDIA

The Framework

India adopted Flexible Inflation Targeting (FIT) through the Monetary Policy Framework Agreement
(2015) between the RBI and the Government, later codified in the RBI Act (amended 2016).

Parameter Detail

Target 4% CPI-Combined

Tolerance Band ± 2% (i.e., 2% to 6%)

Target Set By Government of India, in consultation with the RBI, once every 5 years

Accountability If inflation stays outside 2%-6% for three consecutive quarters, RBI must report
to the government with reasons, remedial measures, and a timeline

Institutional Monetary Policy Committee (MPC) determines the policy rate to achieve the
Mechanism target

The Monetary Policy Committee (MPC)

Feature Detail

Established 2016 (based on Urjit Patel Committee recommendation)

Status Statutory body under RBI Act, 1934

Composition 6 members: RBI Governor (Chairperson, ex-officio), RBI Deputy Governor (MP), 1 RBI
officer, 3 external members appointed by Central Government

External Member 4 years, non-renewable

Term

Quorum 4 members

Voting Each member has one vote; Governor has casting vote (second vote) in case of a tie

Meetings At least 4 times a year (bi-monthly in practice)

Monetary Policy Published by RBI every 6 months, explaining inflation sources and forecasts for 6-18
Report months ahead

Objective Maintain price stability while keeping in mind the objective of growth

MEASURES TO COMBAT INFLATION

 Policy Type Measures Mechanism

Monetary (RBI) Increase Repo Rate, Bank Rate, CRR, Makes borrowing costlier → reduces spending
SLR → money supply contracts → demand cools

Open Market Operations (sell G- Absorbs liquidity from the banking system
Secs)

Tighten MSF access Signals hardening stance

Fiscal Increase taxes (direct & indirect) Reduces disposable income → lower private
(Government) spending

Cut government expenditure Reduces direct injection into aggregate demand

Introduce new taxes/cesses Absorbs excess purchasing power

Widen tax base Distributes the burden without raising rates

Administrative Price controls, stock limits on Short-term suppression; can create black
essential commodities markets if sustained

Import duty cuts on essential Increases domestic supply → eases prices

imports

Restrict exports of key commodities Diverts supply to domestic market

(e.g., onion export ban)

Wage restraint policies Breaks wage-price spiral

Strengthening PDS and buffer stocks Insulates vulnerable populations from price
volatility

EFFECTS OF INFLATION — A MULTI-DIMENSIONAL VIEW

On Consumers

Purchasing power falls. The same income buys fewer goods. Those with fixed incomes (pensioners,
salaried with rigid wages) suffer most.

On Creditors and Debtors

 Debtors (borrowers) gain: They repay in rupees that are worth less than when they
borrowed.

 Creditors (lenders) lose: The real value of the money they receive back has shrunk.

 This is why inflation acts as a hidden wealth transfer from lenders to borrowers.

On Investment (Short-Run)

 Inflation can temporarily boost investment: prices rise faster than costs → windfall
profits for producers

 Inventories held by businesses appreciate in value

  Entrepreneurs, being net borrowers, gain from debt-value erosion

On Savings

 Cash holdings lose value → shoe-leather cost: people make more frequent bank visits to
deposit cash, minimise idle money

 Real interest rates may turn negative if inflation exceeds nominal deposit rates → savers
penalised, savings decline

 Households may shift from financial savings to physical assets (gold, real estate) as inflation
hedges — a trend visible in India

On Taxpayers — Bracket Creep

 Inflation pushes nominal incomes into higher tax slabs, even if real income hasn't risen

 Indirect tax (GST) collections rise mechanically as prices increase

 Government gains unlegislated revenue — this is the "inflation tax"

On Exchange Rate

 Higher domestic inflation → domestic goods become relatively expensive → exports lose
competitiveness → demand for domestic currency falls → currency depreciates (under
flexible exchange rate)

On Exports

 Short-term (volume effect): Depreciation makes exports cheaper for foreign buyers →
export volumes may rise

 Short-term (value effect): In rupee terms, export revenue rises initially

 Long-term: Domestic cost pressures eat away competitiveness if inflation persists

On Imports

 Imported goods become costlier → demand shifts to domestic substitutes (import

substitution)

 But: For essential imports (crude oil, pharmaceuticals, technology), the import bill rises —
worsening the trade deficit

 India, as a net importer of crude oil and edible oil, is particularly vulnerable

On Employment

 Short run: Mild inflation can boost employment as firms expand output to capture higher
prices

 Long run: Persistent inflation creates uncertainty → investment falls → job creation stalls.
Inflation can become neutral or even harmful for employment.

On Income Distribution

 Inflation arbitrarily redistributes wealth:

 o Winners: Businessmen, speculators, debtors, holders of real assets

o Losers: Fixed-income earners, creditors, small savers, unorganised workers,

pensioners

 This erodes public morale and can fuel social discontent

On Trade Balance (India-Specific)

 For a developed, diversified exporter: inflation may improve trade balance (exports rise
more than imports)

 For India: the trade balance often worsens because import dependence (crude oil, edible oil,
electronics, gold) is inelastic — the import bill rises faster than export earnings

COMMITTEES RELATED TO INFLATION

Committee Focus Area Key Recommendation

Urjit Patel Committee (2014) Monetary Policy 4% ± 2% inflation target; MPC creation;
Framework CPI as nominal anchor

B.N. Goldar Committee Producer Price Index Develop PPI for India

Ramesh Chandra Committee (NITI WPI to PPI transition Roadmap for switching from WPI to PPI
Aayog)

Mahendra Dev Verman Committee MGNREGA wages Link MGNREGA wages to CPI-RL (Rural
Labour)