A Sustained rise in the general level of prices.
* If the price of one good has gone up it is not inflation, it is inflation only if the prices of most goods have gone up.
* When the general level of price is falling over a period of time this is deflation, the opposite situation of inflation.
* It is also known as disinflation.
The rate of inflation is measured on the basis of price indices which are of two kinds.
* Wholesale Price Index (WPI)
* Consumer Price Index (CPI)
* A Price index is a measure of the average level of prices, which means that it does not show the exact prices rise or fall of a single good.
* Inflation is measured point-to-point.
* It means that the reference dates for the annual inflation is January 1st to January 1st of two consecutive years.
* The weekly rate of inflation is the change in one week reference being the two consecutive last days of the week.
The reasons responsible for inflation in two parts
* Pre - 1970's
* Post - 1970's
Pre - 1970's
Till the rise of the monetarist school, economists used to agree upon two reasons behind inflation.
Demand - Pull Inflation
A mis - match between demand and supply pulls up prices
* Either the demand increases over the same level of supply or the supply decreases with the same level of demand thus the situations of demand pull inflation arise.
* This was a Keynesian idea.
* The Keynesian School suggests cuts in spending as the way of tackling excess demand mainly by increasing taxes and reducing government expenditure.
Cost - Push Inflation
An increase in factor input costs (i.e., wages and raw material pushes up Prices).
* The price rise which is the result of increase in the production cost is cost - push inflation.
* The Keynesian school suggested controls on prices and incomes as direct ways of checking. Such inflation and moral suasions and measures to reduce the monopoly power of trade unions as the indirect measures.
Post - 1970's
After the rise of Monetaristic School of Economies in the early 1970's (Monetarism developed in opposition to Post - 1945 Keynesian idea of demand management)
* The School Provided monetarist explanation for inflation.
* The So - Called demand - pull or the cost - push which is excessive creation of money in the economy.
i) Demand - Pull Inflation
* For them a Demand - Pull inflation is creation of extra purchasing power to the consumer over the same level of production.
* This is the typical case of creating extra money. (either by Printing or Public borrowing)
* Without equivalent creation in production / Supply i.e., too much money chasing too little output.
ii) Cost - Push Inflation
* For monetarists Cost-Push is not a truly independent theory of inflation.
* It has to be financed by some extra money
* A Price rise does not get automatically reciprocated by Consumers Purchasing.
* Every Cost - Push inflation is a result of excessive creation of money
* Increasing money flow or money Supply
iii) Measure to check inflation
* The Governments utilise the following options to check the rising inflation.
i) As a supply side measure the government may go for the import of goods which are in short-supply as a short-term measure.
* As a long-term measure, governments go on to increase the production to matching the level of demand.
* Storage, transportation, distribution, hoarding are the other aspects of price management of this category.
ii) As a cost side measure government may try to cool down the price by cutting down the production cost of the goods showing price rise with the help of tax breaks.
* Cut in the excise and custom duties.
* This helps as a short-term measure.
* In the long-term, better production process, technological innovations, etc are helpful.
* Increasing income of the people is the monetary measure to avoid the heat of such inflation.
iii) The governments may take resource to tighter monetary policy to cool down either the demand-pull or the cost-push inflation.
Types of Inflation
Depending upon the range of increase, and its severity, inflation may be classified into three broad categories.
Such inflation is slow and on the predictable lines which might be called small or gradual.
* This inflation takes place in a longer period and the range of increase is usually in single digit.
* Such inflation has also been called as Creeping inflation.
This is a very high inflation running in the range of double digit or triple digit.
Some other names to this inflation
* Hopping inflation
* Jumping inflation
* Running or Runaway inflation.
This form of inflation is large and accelerating which might have the annual rates in million or even trillion.
* In such inflation not only range of increase is very large but the increase takes place in a very short span of time prices shoot up overnight.
* The best example of Hyper inflation that Economists cite is of Germany after the First world War in early 1920's.
* Such an inflation quickly leads to a complete loss of confidence in the domestic currency and people start opting for other forms of money.
* As for example Physical assets, gold and foreign currency and people might switch to barter exchange.
Other Variants of Inflation
* This inflation takes places when the supply falls drastically and the demand remains at the same level.
* Such situation arise due to supply-side accidents, hazards or mismanagement which is also known as structural inflation.
This nomenclature is based on the inclusion or exclusion of the goods and services while calculating inflation.
* In India, it was first time used in the financial year 2000 − 01 when the government expressed that it was under control.
* It means the prices of manufactured goods were under control.
The excess of total government spending above the national income (i.e., Fiscal Deficit) is known as the 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.
The short-fall in total spending of the government (i.e., fiscal surplus) over the national income creates deflationary gap in the economy.
* This is a situation of producing more than the demand and the economy usually heads for a general slow down in the level of demand.
* This is also known as the output gap.
* This is a situation of sustaining government expenditure, at the cost of people's income.
* This looks as it inflation in working as a tax.
* That is how the term inflation tax is also known as seigniorage.
* It means, inflation is always the level to which government may go for deficit financing.
* Level of deficit financing is directly reflected by the rate of inflation.
An inflationary situation in an Economy which results out of a process of wage and prices interaction when wages press prices up and prices pull wages up is known as the Inflationary Spiral.
* It is also known as the wage − price spiral.
Due to inflation the profit of firms/companies get overstated.
* When a firm calculates its profit after adjusting the effects of current level of inflation this process is known as Inflation Accounting.
* Such profits are the real profit of the firm.
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.
* The nominal rate of interest is adjusted with the effect of inflation and thus the interest rate we get is known as the real interest rate.
* Real interest is always lower than the nominal interest if the inflation is taking place. The difference is the inflation premium.
It is a graphic curve which advocates a relationship between inflation and unemployment in an economy.
* As per the curve there is a trade off between inflation and unemployment.
Reflation is a situation often deliberately brought by the government to reduce unemployment and increase demand by going for higher levels of economic growth. Governments go for higher public expenditure, tax cuts, interest rate cuts, etc.,
A situation in an economy when inflation and unemployment both are at higher levels, contrary to conventional belief.
* Stagflation is basically a combination of high inflation and low growth.
The announcement of official target ranges for the inflation is known as Inflation Targeting.
* It is done by the Central Bank in a Economy as part of their monetary policy to realise the objective of a stable rate of inflation.
A third phenomenon namely one in which there is a price rise of one or a small group of commodities over a sustained period of time, without a traditional designation.
* Skew flation is a relatively new term to describe this third category of price
* The skewedness of inflation in India in the early months of 2010 was obvious from the fact that food price inflation crossed the 20 per cent mark in multiple months. Whereas Wholesale Price Index (WPI) inflation never once crossed 11 per cent.
This is the ratio between GDP at current prices and GDP at constant prices.
Effects of Inflation
There are multi-dimensional effects of inflation on an Economy both at the micro and macro levels.
The effects of inflation are
On creditors and debtors
Inflation redistributes wealth from creditors to debtors i.e. lenders suffer and borrowers benefit out of inflation
* The opposite effect takes place when inflation falls.
With the rise in inflation, lending institutions feel the pressure of higher lending.
* Institutions don't revise the nominal rate of interest as the real cost of borrowing falls by the same percentage with which inflation rises.
On Aggregate Demand
Rising inflation indicates rising aggregate demand and indicates comparatively lower supply and higher purchasing capacity among the consumers.
* Usually, higher inflation suggests the producers to increases their production level as it is generally considered as an indication of higher demand in the economy.
Investment in the Economy is boosted by inflation because of two reasons
a) Higher inflation indicates higher demand and suggests entrepreneurs to expand their production level.
b) Higher the inflation lower the cost of loan.
In the long − run higher inflation depletes the saving rate in an economy
* Just the opposite situation arises when inflation falls or shows falling traits with decreasing saving in short-run and increasing saving in the long-run, respectively.
On Tax structure of the economy, inflation creates two distortions
a) Tax − Payers suffer while paying their direct and and indirect taxes.
b) The extent to which tax collections of the government are concerned, inflation increased the nominal value gross tax revenue while real value of the tax collection does not compare with the current pace of inflation as there is a lag (delay) in the tax collection in all economies.
On Exchange Rate
With every inflation the currency of the economy depreciates (loses its exchange value in front of a foreign currency) provided it follows the flexible currency regime.
with inflation, exportable items of an economy gain competitive prices in the world market. Due to this the volume of export increases (keep in mind that the value of export decreases here) and thus export income increases in the economy.
Inflation gives an economy the advantage of lower imports and import-substitution as foreign goods become costlier. But in the case of compulsory imports (i.e., oil, technology, drugs, etc). The economy does not get this benefit and loses more foreign currency in place of saving it.
On Trade Balance
In the case of a developed economy, inflation makes trade balance favourable while for the developing economies inflation is unfavourable concerning their trade balance.
Inflation increases employment in the short-run but becomes neutral or even negative in the long run.
Inflation increases the nominal (face) value of the wages while their real value falls. To neutralise this negative impact the Indian government provides dearness allowance to its personnel twice a year.
On Self − Employed
Inflation has a neutralising impact on the self employed people in the short-run numerically saying so. But in the long run they also get affected as the economy as a whole gets affected.
Inflation beyond both the limits of the range is never healthy for any economy.
* In the case of India it is considered 4 to 5 percent which is also known as the comfort zone of inflation in India.
* Inflation beyond the limits of the decided/ prescribed ranges brings in recession to depression
Inflation In India
India calculates its inflation on two prices indices i.e.,
* The Wholesale Price Index (WPI)
* The Consumer Price Index (CPI)
* The WPI − Inflation is used at the macro level policy marketing.
* The CPI − Inflation is used for micro level analyses.
Wholesale Price Index
The first index number of wholesale prices commenced in India for the week January 10, 1942.
* It was having the base week ending august 19, 1939 = 100 which was published by the office of the Economic adviser to the government of India.
The WPI base year has been revised.
The base years are as given below
New Series of WPI
With the purpose of making inflation data in India more transparent, updated and similar to the practices among most of the economies a working group for revision of WPI number was set up under the chairmanship of the planning commission member Prof. Abhijit sen.
* In light of the recommendations the government recently announced the new series of wholesale price index.
* WPI is an important statistical indicator, as various policy decisions of the government, like inflation management, monitoring of prices of essential commodities etc., are based on it.
* WPI is also used by various departments for arriving at the escalation costs of various contracts.
* The revised series of WPI was officially launched on 14th September, 2010 by the Ministry of Commerce & Industry.
Revised Series: New Initiatives
The launch of the new series of WPI with base year 2004 − 05 has been one of the major initiatives of the ministry of Commerce & Industry.
* Since November 2009 the WPI data are already being released in the following way.
i) The first set of data of WPI are released on monthly basis.
ii) The second set of data of WPI (for the primary articles and energy and fuel group) are released on the weekly basis.
CPI − IW
* The Consumer Price Index for the Industrial Workers (CPI − IW) has 260 items (plus the services) in its basket with 2001 as the base year. (The first base year was 1958 − 59).
* The data is collected at 76 centres with one month's frequency and the index has a time lag of one month.
* It contains 120 − 160 commodities in its basket.
* This index specifies the government employees.
* The wages/salaries of the central government employees are revised on the basis of the changes occurring in this index.
* The Dearness Allowance (DA) is announced twice a year.
* When the Pay Commissions recommend Pay Revisions, the base is the CPI − IW.
CPI − UNME
The Consumer Price Index for the Urban Non-Manual Employees (CPI − UNME) has 1984 − 85 (first base year was 1958 − 59), as the base year and 146 − 365 commodities in the basket for which data is collected at the 59 centres in the country.
* Data collection frequency is monthly with two weeks time lag.
* This price index has limited use and is basically used for determining Dearness Allowances (DAs) of employees of some foreign companies operating in India.
* It is also used under the Income Tax Act to determine capital gains and by the CSO (Central Statistical Organisation) for deflating selected service sectors contribution to the GDP at factor cost and current prices to calculate the corresponding figure at constant prices.
CPI − AL
The Consumer Price Index for Agricultural Labourers (CPI − AL) has 1986 − 87 as its base year with 260 commodities in its basket.
* The data is collected in 600 villages with a monthly frequency and has three weeks time lag.
* The index is used for revising minimum wages for agricultural labourers in different states.
* For the revision the consumer expenditure data collected by the NSSO during its 61st NSSO Round (2004 − 05) is proposed to be used.
CPI − RL (Rural Labourer)
There is yet another consumer price index for the Rural Labourers (CPI − RL) with 1983 as the base year, data is collected at 600 villages as monthly frequency with three weeks time lag, its basket contains 260 commodities.
* The agricultural and the rural labourers in India create an overlap i.e. the same labourers work as the rural labourers once the farm sector has either low or no employment scope.
* Probably, due to this reason this index was dropped by the Government in 2001 − 02.
* But after the government change at the centre the index was revived again.
* With the purpose of making inflation data in India more transparent, updated and similar to the practices among most of the economies a working group for Revision of CPI number was set up under the Chairmanship of the Planning Commission Member, Prof. Abhijit sen.
New series of CPI for Urban Areas
Weighting diagrams (consumption patterns) of the CPI (Urban) have been derived from the results of the NSSO 61st round of Consumer Expenditure Survey (2004 − 05)
* For regular price collection, 310 towns have been selected which include all State/UT capitals.
* From each selected town price data are collected in respect of items consumed by the population of the respective State/UT.
* Prices of items are collected by the field officials of the National Sample Survey Office (NSSO).
New Series of CPI for rural areas
* CPI (Rural) number are compiled at State/UT and all India levels.
* Weighting diagrams of the CPI (Rural) have also been derived from the result of the NSSO 61st round of Consumer Expenditure Survey (2004 − 05).
* With a view to have a work load within manageable limits and considering the fact that the CPI (Rural) would provide the price change for the entire rural population of the country.
* A total of 1181 villages have been selected at all India level.
* The broad criterion of selection of villages is to have representation of all the districts within State/UT and two villages from each district have been selected randomly from different tehsils.
CSO will also compile national CPI by merging CPI (Rural) and CPI (Urban) with appropriate weight, as derived from NSS. 61st round of consumer expenditure survey (2004 − 05) data.
Revision of Indices
* These new CPI numbers would be revised on the basis of the results of the next round of consumer expenditure survey scheduled to be conducted during 2011 − 12 by the NSSO.
* Thereafter, revision will be undertaken every five years.
Trends in Inflation
Inflation has been a highly sensitive issue in India right since the independence and it has been so during the ongoing reforms process period, too.
Decadal inflation: In India looks comparatively normal with reference to many developing economies.
The Decadal inflation in India has been as given below:
i) During 1950s: Remained at 1.7 percent.
ii) During 1960s: Remained at 6.4 percent.
iii) During 1970s: Remained at 9.0 percent.
iv) During 1980s: Remained at 8.0 percent.
v) During 1990s: Remained at 9.5 percent.
Through it reached 0.5 per cent by the fourth quarter of the fiscal 1998 − 1999.
vi) During 2000 − 2001 to 2011 − 2012: Remained at 4.7 percent (upto August 2008) with the fiscal 2002 - 2003 at 3.4 percent (the lowest) and the fiscal 2004 − 2005 at 6.5 percent.
Economic survey 2012 − 2013 projects a moderate rate of inflation of 6 − 6.5 percent during the fiscal 2013 − 2014 with expected short-term shocks due to-inadequate food stocks, slip pages in the targets of the fiscal consolidation, checking real estate bubbles, and prices.
With few exceptional years, India has been facing the typical problem of bottleneck inflation (i.e., structural inflation) which a rises out of short falls in the supply of goods, a general crisis of a developing economy, rising demand but lack of invertible capital to produce the required level of goods.
Cost − Push Inflation
Due to inflation tax the price of goods and services in India have been rising as the Government took alternative recourse to increase its revenue receipts.
* The non Value Added Tax (Non-VAT) structure of India in the past was also having cascading effect on the prices of commodities in the country.
To finance the developmental requirements of the economy the governments became trapped in the cyclical process of over-money supply.
* At first it was done by external borrowing.
* A major part of the government's internal borrowing is contributed by the Reserve Bank of India (RBI) which leads to price rise.
* The higher revenue deficits and fiscal deficits make the government supply more money which pushes the inflation in the upward direction.
Recent Steps to Check Rising Inflation
The GOI took the following steps to check the rising inflation (basically, driven by the Primary articles i.e., the food items).
* The steps were taken by either the various central ministries or the RBI (as per the Economic Survey 2011 − 2012, P 88) which have been discussed in three set of measures viz. The fiscal, administrative and monetary.
1) Reduced import duties to zero to zero for rice, wheat, onion, pulses, edible oils (crude) and to 7.5 per cent for refined and hydrogenated oil and vegetable oils.
2) Permitted National Dairy Development Board (NDDB) to import 50,000 tones of skimmed milk powder and whole milk powder and 15,000 MT of butter, butter oil and anhydrous milk, fat at zero duty under tariff rate quota.
3) Permitted the State Trading Corporation of India (STC)/ Minerals and Metals Trading Corporation (MMTC) / Project Equipment Corporation (PEC) and National Agricultural corporative Marketing Federation of India (NAFED) To import duty-free white/ refined Sugar, initially with a Cap of 1 million tones
* Later duty − free import was also allowed by other Central/ State government agencies and Private trade without any Cap on quantity.
1) Removed levy obligation in respect of all imported raw sugar and white/ refined sugar.
2) Banned export of edible oils (Except coconut oil and forest based oil) and Pulses (except kabuli chana and organic pulses upto a maximum of 10,000 tones per annum.)
3) Imposed ban on export of non-basmati rice and wheat for short period of time.
4) Permitted export of edible oils in branded consumer packs of upto 5 kg subject to a limit of 10,000 tones.
5) Prohibited export of milk powders (including skimmed milk powder, whole milk powders, dairy whitener, and infant milk food), casein and casein products.
6) Effected no change in tariff rate values of edible oils
7) Ban on export of onion was imposed for short period of time whenever required.
8) Maintained the Central Issue Prices (CIP) for rice [at Rs.5.6 per kg for below poverty line (BPL) and Rs.3 per kg for Antyodaya Anna Yojana (AAY)] and wheat (at Rs.4.15 per kg for BPL and Rs.2 per kg for AAY) since 2002.
9) Suspension of futures trading in rice, urad, and tur.
10) Ten lakh tones of wheat and 10 lakh tones of rice allotted under the Open Market Sale Scheme (OMSS) and 15 lakh tones of wheat for bulk sale including sale to small traders for the period october 2011 to september 2012.
11) An additional ad hoc allocation of 50 lakh tones of food grains made on 16th may 2011 to all States/ UTs for BPL families at BPL issue price for distribution during the current year up to march, 2012.
12) Extended the scheme for distribution of subsidised imported edible oils through State Governments/ UTs with subsidy of Rs.15 per kg for distribution to ration card holders at 1 litre per ration card per month
As part of the monetary policy review stance, the RBI has taken suitable steps with 13 consecutive, increases in policy rates and related measures to moderate demand to levels consistent with the capacity of the economy to main it's growth out provoking price rise.
Product Price Index
A working group was set up in mid 2003 - 2004 under the chairmanship of prof. Abhijit Sen member, planning commission to fulfill the twin tasks of:
I) Revising the current series of the WPI (i.e., base 1993 − 1994).
II) Recommending a Producer Price Index (PPI) for India which could replace the WPI.
Housing Price Index
India's Official Housing Price Index (HPI) was launched by the finance minister on July 9th, 2007 in Mumbai.
Presently, the index has been introduced as a pilot project for five cities
* Kolkata and Mumbai
Which covers different localities in each of these cities for the five − year period.
Service Price Index
The Contribution of the tertiary sector in India's GDP has been strengthening for the past 6 to 7 years and today it stands approximately at 54 percent.
* The need for a Service Price Index (SPI) in India is warranted by the growing dominance of the sector in the economy.
The Economists have pointed out that the business cycle is characterised by four phases or stages in which economies alternate.
i) Depression ii) Recovery
iii) Boom iv) Recession
Though depression has visited the world economy only once in 1929, economists have pin−pointed enough number of traits to recognise it. The major traits of depression could be as given below
a) An extremely low aggregate demand in the Economy cause 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.
The business cycle of recovery may show the following major economy traits.
a) An upturn in aggregate (total) demand which has to be accompanied by increases in the level of production.
b) Production Process expands and new investments become attractive.
c) As demand goes upward, inflation also moves upward making borrowing cheaper for investors.
d) With an upturn in production new employment avenues are create and unemployed rate starts declining. etc.,
A strong upward fluctuation in the economic activities is called Boom.
The major economic traits of boom may be listed as given below
a) An accelerated and prolonged increase in the demand.
b) Demand peaks up such a high level that it exceeds sustainable output/production levels.
c) The economy heats up and a demand - supply lag is visible
d) The market forces mismatch (i.e. demand and supply disequilibirium) and tend to create a situation where inflation start going upward.
e) The economy might face structural problems like shortage of invertible capital, lower savings, falling standard of living, creation of a sellers' market
» Boom is usually followed by price rise
» As a boom is a strong upward fluctuation in an economy, the supply-side pattern of the economy starts lagging behind the pace of the accelerated aggregate demand.
The usual remedies are given below
i) Direct and indirect taxes should be cut down, so that the consumers have higher disposable incomes (incomes after paying direct tax i.e. income tax) on the one hand and the goods should becomes cheaper on the other hand thus there is hope that the demand might pick up.
ii) The burden of direct tax, specially the income tax, dividend tax, interest tax are slashed to enhance the disposable income. (i.e. income after direct tax payment). So that the people way create enhanced demand.
iii) Salaries and wages should be revised by the government to encourage general spending by the consumers.
iv) Indirect taxes such as custom duty, excise duty (Cenvag) Sales Tax, etc. should be cut down. So that produced goods reach the market at cheaper prices.
v) The government usually goes on to follow a cheap money supply policy by slashing down the interest rates across the board and the lending procedure is also liberalised.
vi) Tax breaks are new investments in the productive areas.
Business cycles are basically fluctuations in the production levels of economies above and below the trend of the equilibrium levels.
* There are many factors which are said to be responsible for it, as per the experts.
i) Economic instability and uncertainty (due to logical or illogical expectations) may discourage investments there by reducing growth in the long-term.
ii) A black of the creative destruction (i.e. innovation) may put the economy in a slump or slowdown in its overall production.
iii) Anti-inflationary government policies (specially when general elections are to come) may snatch the attraction of investment in the economy
iv) Unforseen disasters may cause economies to fluctuate.