INFLATION

I) INFLATION:

INTRODUCTION:
Inflation means a general and persistent rise in the average price of a wide
variety of goods and services. If prices rise moderately, it is a positive
development as it shows there is growth in the economy. However if prices
rise steeply, there is no growth, no welfare and reduces purchasing power of
money. Further leads to depreciation of currency thus making imports costlier
which feeds in to inflation further. The entire macroeconomic stability rests on
inflation if it reaches unsustainable levels. Therefore, the government policies
aim at growth with price stability, which is moderate inflation on a long-term
basis.

TYPES OF INFLATION:
Depending on the rate of growth of prices,inflation can be of:

1)Creeping inflation - Rate of general price increase of up to 4 percent a year.

It is largely positive as it shows there is growth with price stability.

2)Trotting inflation - when creeping inflation increases.

3)Galloping inflation - If trottling inflation increases and further reaches to 8-

10 per cent a year.
4)Hyperinflation - it is a scenario where by prices of goods and services are out
of control. That is, a monthly inflation rate of 20 or 30 percent or more. It
reaches double or triple digits. If it aggravates, it leads to monetary collapse-
money loses its value.
Causes of hyper inflation:

 Wasteful government expenditure - Deficit financing.

 Low domestic production of goods and services.
 Incomplete reforms like land reforms, agriculture reforms.
  Too much dependence on imports even for basic goods and services.
 Expansionary monetary policy like excess printing of currency.
 Excess subsidy even when it is not required.
 Lack of diversification of economic activities.
 Government over dependence on exports for its revenue.

Note – Hyper inflation can be controlled by finding a solution to the causes of

Hyper inflation like – diversification of economic activities, targeted subsidy,
domestic production of basic goods and services and reducing over
dependence on imports to fulfil basic requirements like food, medicine etc.

5) Deflation - It is invariably associated with recession when economic growth

is negative. That is economy is producing less than what it is produced.
Deflation increases the value of money which allows one to buy more goods
and services than before with the same amount of currency.
When an economy experiences deflation, demand from consumers to buy
products goes down because they expect to pay less later as prices fall further.
With crashing demand, producers cannot sell and go bankrupt, unemployment
rises reducing demand further. That aggravates a deflation further. Debt
becomes unserviceable, the risk of default and bankruptcy rises too, and banks
become reluctant to lend as their own NPAs rise.

To decrease deflation fiscal and monetary responses were given by Keynesian.

Fiscal remedies: a)Tax cuts - boost demand from consumers and businesses &
b) Increase government spending on infrastructure projects that boost the
return on private investment.

Monetary remedies: a)Lowering interest rates to encourage demand for credit

& b)Printing more currency to boost money supply.

India didn’t ever face retail deflation but in 2014 and 2015, for 14 consecutive
months, wholesale price index(WPI) inflation was in negative. This also again
occurred for 4 months from april to july 2020.

6) Disinflation - It is the reduction of rate of inflation. It is the rate of growth of

prices that is slowing but prices are increasing. Reasons for disinflation can be
many : money supply may be reducing; economy may be slowing; supplies may
be increasing and becoming cheaper, etc.
7) Stagflation - It is a combination of inflation and rising unemployment due to
recession. It is a macroeconomic condition when the inflation rate is high, the
economic growth rate slows, or economy goes into recession(economic growth
below zero) and unemployment rises.

8) Reflation - When inflation returns after undergoing deflation, recession thus

showing growth is back.

9) Open inflation - When government cannot suppress the inflation with

subsidies and monetary policy is called open inflation.

10) Suppressed inflation - The problem of inflation is only managed not

resolved. So inflation can be suppressed by managing fiscal and monetary
policies.

11) Headline inflation - It is a measure of total inflation. Headline inflation is

what consumer experience.

12) Core or underlying inflation - It measures the long run trend in the general
price level. It excludes volatile items like food and fuel. Considers only stable
items.

13) Demand pull inflation - In an economy due to some situations, many a

times demand exceeds supply. Such a situation might lead to rise in prices. In
general it is called inflation. This type of inflation is called demand pull
inflation.

Some of the main factors leading to demand pull inflation are as follows:

i)Expansionary fiscal policy: Like reduction in direct taxes, increase in

subsidies, increase in government expenditure, increase in deficit financing. All
these factors have the potential to cause DPI.

To control inflation in this case the government should follow:

Contractionary fiscal policy: Increase in income taxes, reduction in subsidy

wherever not required etc,.

ii)Expansionary monetary policy: when RBI follows EMF like reduction in repo
rate, reduction in bank rate, increase in money supply or when RBI purchases
government bonds, all these situations might lead to DPI.
General factors: Change in taste and preference in the economy and increase
in population might put pressure on demand to rise faster than supply which
might trigger inflation.

Note:

  Agrregate Demand > Aggregate Supply  Price  (DPI).

 Expansionary fiscal policy -  Direct taxes, Subsidy, Govt
expenditure, Deficit financing.
 Expansionary monetary policy - Bank rate, Money supply, CRR,
SLR.
 General factors – vegan.

Q) Discuss the use of Monetary policy to control inflation?

A) To control inflation two types of monetary policy instruments are available.

 I) Qualitative monetary policy – under this approach RBI uses steps like
Moral Suasion to convince the banks to reduce liquidity in the economy.
Under moral suasion RBI uses national interest and economic well being
as an argument to convince the banks and gives them lectures to
persuade the banks to reduce liquidity.
 II) Quantitative monetary policy – To control inflation RBI can resort to
quantitative policy like increasing repo rate, increasing bank rate,
reducing money supply and selling government bonds – all these steps
would help RBI to reduce liquidity in the economy and control inflation.

Q2) Discuss the impact of CRR and SLR on inflation?

 If the CRR and SLR are increased by RBI – it might absorb liquidity and
help the RBI to control inflation.
 If RBI reduces CRR and SLR – liquidity will increase in the economy and it
might lead to inflation.

14) Cost push inflation- In the economy sometimes the situation arises
where by the price of raw material and other inputs like land,the salary of
workers etc. goes [Link] leads to increase in cost of production which further
leads to decrease in supply and it might lead to inflation. This type of inflation
is called as cost push inflation.
Note:
1) Imported inflation can directly lead to cost push inflation. Eg-Inflation might
be caused in india because of high prices of crue oil in the global market.
2) Indirect taxes can be easily transferred by producer to the consumer. So
when government imposes indirect taxes on producers it might lead to
inflation in the economy.
Measures to control cost push inflation - To control cost push inflation the
government should bring reforms and policies to increase the availability of
inputs like raw materials,workers with great skill,reduce the indirect taxes on
producers wherever possible,reduce our dependence on costly imported raw
materials like crude [Link] this government can look for alternatives to
imported crude oil like encouragement to renewable energy and reforms like
ethanol blended petrol.

15) Structural inflation – Many a times poor infrastructure like lack of roads,
lack of cold storages, lack of transportation, lack of electricity and also lack of
ease ease of doing business can lead to increase in prices in the economy
called as structural inflation. It is a typical feature of developing economy like
india.

16) Skewflation – Because of the nature of the economy sometimes we find

inflation in some sectors, normal prices in other sectors and deflation in some
sectors, this unique situation is called as Skewflation. This term was given by
Dr. Kaushik Basu.

Q) Discuss the administrative measures to control inflation?

A) i) In case of shortage of some commodities which is causing inflation we can

increase their import for a certain time period.

ii) The government also controls the export of commodities when we

experience inflation.

iii) If the prices of essential items go up in the economy – The government

might put price caps (or) price ceiling in order to control inflation.

iv) During inflation there is a higher tendency of hoarding – increased hoarding

leads to artificial scarcity (A.S) – A.S leads to even higher level of inflation –
which leads to further increase in hoarding called as Hoarding cycle. To break
this hoarding cycle law and order that is administrative action is required.

Note: economies based on per capita income:

 High income countries (HIC),

 Middle income countries (MIC)
o Upper – MIC – China
o Lower – MIC – India.
 Low income countries (LIC).

MEASURES OF INFLATION:
Inflation can be measured at three levels:

1) Whole Sale Level – WPI (Wholesale Price Index) – At whole sale level we can
measure inflation.

2) At Retail level we can measure inflation using CPI (consumer price index).

3) At producer level inflation can be measured using Producer Price Index (PPI).
It is not calculated officially. Therefore it is not used in policy making. PPI
concept is given by Goldar committee.

1) WHOLESALE PRICE INDEX (WPI):

WPI measures inflation in the wholesale mandis of india i.e., at the wholesale
level.

Note – In the wholesale market only goods are sold. Services are not part of
wholesale mandis.

How is WPI calculated in india? – GOI conducts a survey across around 8000
mandis (or) wholesale markets to findout the most important items traded in
the mandis. Currently, 697 such items have been identified which constitute
WPI basket.

Then, the GOI findsout the price of these 697 items (or) WPI basket in the base
year (2011) and then compares the price of the same basket with the current
year using the following formula,
 Current year price−Base year price
WPI (or) WPI-headline = Base year
X 100

Components/Constituents of WPI Basket – WPI basket comprises of 697 items

which can be divided into 3 categories:

Item group Weight

1. Primary 22.62%
2. Fuel & Power 13%
3. Manufactured 64%

Note:

 The weight of food related items in the WPI basket is equal to 24%.
 WPI is extremely sensitive towards the prices of manufactured items.
Compare to manufactured items WPI is less sensitive to prices of food
products.

WPI – CORE: [WPI-Core = WPI-Headline – (food,fuel)]

Core items are the stable items of the economy. Food and fuel are considered
to be Volatile. WPI-Core measures inflation in the other stable items in the
wholesale market.

2) CONSUMER PRICE INDEX (CPI):

CPI measures the inflation at retail level. In other words, CPI captures the
inflation faced by a common person on a day to day basis so it is used for
policy purposes.

How does government calculate CPI? – Based on the survey conducted in retail
market, the government finds out the CPI basket. Whose prices are calculated
in the base year (2012) and then compared with the current year prices using
the following formula,
Current year price−Base year price
CPI (or) CPI-Headline = Base year
X 100

The composition of CPI basket at all india level is as follows:

1. Food + Beverages  45.86%

2. Pan, Tobacco & Intoxicants  2.38%
 3. Clothing & Footwear  6.53%
4. Housing  10.07%
5. Fuel & Light  6.84%
6. Misc  28.32%
CPI-Food (CFPI)  39.06%

Note-

 Fuel and light = LPG + Kerosene + Electricity.

 Miscellaneous = services like health, education, entertainment,
transport & communication. Petrol and diesel are part of the Misc
category through transportation.

CPI-Core = CPI-Headline – (food & fuel).

CPI-Core consists of Volatile items like petrol & diesel. So the GOI also
calculates CPI-Refined core.

CPI-Refine Core = CPI-headline – (food, fuel & transportation)

CPI-Refined core is relatively stable compare to CPI-Core.

Types of CPI:

1. CPI-Industrial Worker (CPI-IW) : It measures the inflation faced by people

working in both government sector and private sector. CPI-IW is used to
provide dearness allowance (DA) to the workers.

2. CPI-Agricultural Labour (CPI-AL) : It measures the level of inflation faced by

people engaged in agriculture.

3. CPI-Rural Labour (CPI-RL) : It measures the inflation faced by people working

in small village & cottage industries.

4. CPI-Rural & CPI-Urban : They are used to measure the inflation in rural and
urban areas respectively.
*5. CPI-Headline = CPI-All India = CPI-(Rural+Urban) = CPI-Combined  CPI-
Headline is used at all india level for general policy making.

Note – In general/by default CPI-Headline is also called as CPI.

PHILIP’S CURVE:
According to Philip’s curve there is an inverse relationship between price and
unemployment.

A limited increase in price or a basic level of inflation motivates the producer

to increase production and provide employment. So as to a policy maker has to
be decide how to create a balance between inflation and employment.

Philip’s curve (Growth vs Inflation) –

1
Price ∝
unemployment
3) PRODUCER PRICE INDEX (PPI):
PPI is used to measure the impact of inflation at the level of production. PPI
can be measured in two different way:

A) Input PPI – It measures the impact of inflation when the inputs of

production like raw material, workers etc., are about to enter the factory.

B) Output PPI – It measures the impact of inflation when the finished product
is about to leave the factory gates.

Note – Input PPI and Output PPI together refer to as PPI.

In india we do not measure PPI officially. Because of lack of authentic data

related to inputs and outputs. Goldar committee has given a framework to
calculate PPI using input and output PPI.

Q) Discuss the impact of Inflation in general?

1. Inflation reduces the real value of currency.

2. Inflation reduces the purchasing power of a currency.
3. People with low income take a higher hit of inflation compare to people
with high income.
4. Fixed wage earners take a bigger hit of inflation compare to people
engaged in business activities.
5. During inflation the lender/creditor faces loss whereas the
borrower/debtor benefit during inflation.
6. During inflation the savings in the economy comes down.
7. When savings are going down in the economy. The domestic investment
also goes down.
8. When the economy faces price fluxuation and inflation, the foreign
investment also tends to go down. So, the overall investment in the
economy might go down during inflation and price fluxuations.
9. Inflation increases income inequality in the society.
[Link] standard of living of people will come down during inflation.

Concept of inflation, deflation and disinflation:

 Rise in prices above normal is called “Inflation”.

  Under disinflation the rate of inflation comes down over a period of
time.
 Deflation is the opposite of inflation. Deflation is also called as negative
inflation. Under deflation we observe that the price of goods and
services go down below their normal prices.
 Note – Normal prices are calculated using demand and supply in the
economy.

CONCEPT OF BASE YEAR:

Base year means reference year. The performance of economic variables like
GDP, inflation etc., are analysed in the current year by comparing the
performance in some reference year called as “Base Year”.

The following eligibility criteria is used to decide the base year in the economy-

 The base year should be as recent as possible.

 That the data related to reference year should be easily available.
 The base year should be a normal year. In other words, it should not be
the year of economic crisis (or) too much of volatility in the economy.

2010, 2011, 2012 – Old.

2013 – Policy Paralysis.

2014 – Govt changed

2015

2016 – Demonetisation (Nov 8th).

2017 – GST

2018, 19 – Slow down

2020, 2021 – Covid crisis.

Note – GOI is trying to create same base year to measure different types of
inflation like WPI, CPI etc., but in last 10 years we have faced situations like
policy paralysis, demonetization, GST, economic slowdown, COVID crisis etc.,
because of which the GOI unable to select a perfect base year.
We are facing the same problem in selecting the base year to measure GDP.

II) CAUSES OF INFLATION:

Money Supply - Excess currency (money) supply in an economy is one of the
primary cause of inflation. This happens when the money supply/circulation in
a nation grows above the economic growth, therefore reducing the value of
the currency.

In the modern era, countries have shifted from the traditional methods of
valuing money with the amount of gold they possessed. Modern methods of
money valuation are determined by the amount of currency that is in
circulation which is then followed by the public’s perception of the value of
that currency.

National Debt - There are a number of factors that influence national debt,
which include the nations borrowing and spending. In a situation where a
country’s debt increases, the respective country is left with two options:

 Taxes can be raised internally.

 Additional money can be printed to pay off the debt.

Exchange Rates - An economy with exposure to foreign markets mostly

functions on the basis of the dollar value. In a trading global economy,
exchange rates play an important factor in determining the rate of inflation.

Hoarding - Hoarders are people or entities who stockpile commodities and do

not release them to the market. Therefore, there is an artificially created
demand excess in the economy. This also leads to inflation.

Genuine Shortage - It is possible that at certain times, the factors of

production are short in supply. This affects production. Therefore, supply is less
than the demand, leading to an increase in prices and inflation.

Exports - In an economy, the total production must fulfill the domestic as well
as foreign demand. If it fails to meet these demands, then exports create
inflation in the domestic economy.
Tax Reduction - While taxes are known to increase with time,
sometimes, Governments reduce taxes to gain popularity among people. The
people are happy because they have more money in their hands.

However, if the rate of production does not increase with a corresponding

rate, then the excess cash in hand leads to inflation.

Non-economic Reasons - There are several non-economic factors which can

cause inflation in an economy. For example, if there is a flood, then crops are
destroyed. This reduces the supply of agricultural products leading to an
increase in the prices of the commodities.

Investment in Gold, Real estate, stocks, mutual funds, and other assets are
some of the ways to deal with Inflation.

In any economy, generally two sets of factors result in inflation – Demand Pull
factors and Cost Push factors. Demand-Pull factors may be those due to which
there is an increase in the demand for goods and services in general leading to
rising prices. On the other hand, cost push factors are those due to which there
may be shortfall in supply of goods/services and/or rise in the cost of
production of goods/services. At any given point of time, inflation is attributed
to both sets of factors.
Sometimes one may be more potent than the other. These factors are
explained below in the Indian context:

DEMAND-PULL FACTORS:
1. Population Pressure – Growing population puts pressure on aggregate
demand and on the price level.

2. Mounting Government Expenditure – Government expenditure in a country

like india generally shows a rising trend over the years. this leads to rise in
demand for goods and servies as it has the effect of putting in more money
incomes in the hands of general public thereby raising purchasing power and
stoking the fire of inflation. Thus, too much money starts chasing too few
goods.
3. Deficit Financing and Increase in Money Supply – Mounting government
expenditure financed through deficit financing i.e. Printing of fresh currency
directly pushes up money supply, increases purchasing power, and breeds
inflation without a corresponding rise in the supply of goods and service.

4. Black Money – Unaccounted or black money plays an important role in

pushing up prices by pushing up demand and conspicuous consumption. It has
both direct and indirect impact. Its direct impact is that it results in
conspicuous and luxury consumption and its indirect impact is by way of
demonstration effect. This implies that those who do not have black money
tend to imitate consumption patterns of the rich, which further escalates
demand and pushes up prices.

5. Forex Reserves – Rise in forex reserves leads to corresponding increase in

domestic money supply and fuels inflation. As more foreign exchange comes
into the country, RBI has to create corresponding domestic money as what is
spent in a country is its own currency.

6. Increase in Foreign Investment – If the foreign investors like Apple invest in

india, more people will get jobs. They would receive high salaries thus raising
their purchasing power and hence demands.

7. Rising Incomes and Wages including those under programmes like

MGNREGA have resulted in rising demand. It is often said about india that rural
demand has an important role to play in overall demand.

8. Changing Consumption Patterns in favour of high protein food items in

recent times have played a very important role in fuelling food inflation.
Whenever general price level rises in india, a large part of it is attributed to
rising food prices.

COST-PUSH AND SUPPLY-RELATED FACTORS:

1. Fluctuations in output and supply – Prices tend to rise when there occurs
violent fluctuation in output. In the Indian context, shortfalls in agricultural ad
industrial production are more often observed, leading to scarcity of goods and
rise in price level. seasonal factors like monsoon etc play a very important role
in creating shortages of agricultural goods like fruits, vegetables, food grains
from time to time. These are aggravated by speculation and hoarding.
2. Indirect taxes are known to have cost-cascading effects. These taxes, like
GST, excise and custom duties, raise the cost of production as these taxes are
on commodities.

3. Infrastructural Bottlenecks like shortage of power, transportation,

warehousing, etc. raise per unit cost of production and hence the price level in
general. These have played a very important role in fuelling inflation in a
country like india as these shortages raise per unit cost of both production and
distribution. A large chunk of food grains in india is destroyed due to scarcity of
storage.

4. Increase in Administered Prices like procurement prices of food grains,

petroleum prices and such other price which are arbitrarily fixed by the
government tend to push up the price level, as they have a high weightage in
the price index.

5. Rise in import prices pushes up domestic price levels and leads to what is
called import cost-push inflation. This factor is becoming increasingly
important in globalised scenario. Whenever international prices of oil, steel,
petroleum and other critical inputs rise, it raises prices in india.

While the above cost-push factors are generalized set factors built into the
Indian economy, there are other important factors causing distortions in the
entire supply chain from time to time and creating artificial scarcity as well as
critical supply bottleneck.

III) REMEDIES OF INFLATION:

Inflation is generally controlled by the central bank and/or the government.
The main policy used is monetary policy (changing interest rates). However, in
theory, there are a variety of tools to control inflation including –

1. Monetary Policy (Contractionary Policy) – The monetary policy of the RBI is

aimed at managing the quantity of money in order to meet the requirements
of different sectors of the economy and to boost economic growth.
This contractionary policy is manifested by A) decreasing bond prices
and increasing interest rates. This helps in reducing expenses during inflation
which ultimately helps that economic growth and, in turn, the rate of inflation.
B) The RBI can sell government securities in the open market (Open Market
Operations) to absorb excess liquidity. C) Raising the Cash Reserve Ratio (CRR)
or Statutory Liquidity Ratio (SLR) can limit the amount of money banks can
lend.

2. Fiscal Policy –

 Monetary policy is often seen separate from fiscal policy which deals
with taxation, spending by government and borrowing. Monetary policy
is either contractionary or expansionary.
 When the total money supply is increased rapidly than normal, it is
called an expansionary policy while a slower increase or even a decrease
of the same refers to a contractionary policy.
 It deals with the Revenue and Expenditure Policy of the government.

Tools of fiscal policy –

a. Direct taxes and indirect taxes – Direct taxes should be increased and
indirect taxes should be reduced.
b. Public expenditure should be increased (should borrow less from RBI
and more from other financial institutions).

3. Supply management measures –

 Import commodities that are in short supply.

 Decrease exports.
 Government may put a check on hoarding and speculation.
 Distribution through public distribution system (PDS).

4. Regulation and Price Controls :

 Temporary Price Controls - Implementing price controls on essential

goods can provide immediate relief, though they can lead to shortages
in the long run.
 Subsidies - Providing subsidies on essential commodities can help
mitigate the impact of rising prices on consumers.