Inflation

Concept of Inflation

• Inflation is a steady increase in the prices of goods and services in the economy.
• It is measured yearly and is usually represented as a rate: Rate of Inflation = (Price in this Period – Price in the Previous Period) X 100/Price in the Previous Period.
• It is measured by the Price Index.

Types of Inflation

• Creeping Inflation: A slow yet continuous increase in prices generally in the range of 2% to 3%.
• Walking Inflation or Trotting Inflation: Rate of price rise exceeding 2%, usually in the range of 3% to 10%.
• Galloping Inflation: Rate of price rise exceeding 10% and below 50%, which makes it unbearable for businesses and employees to maintain their incomes in comparison with their costs and prices.
• Hyperinflation: A condition of inflation wherein the rate of increase of prices is alarmingly high, usually more than 50% per month.

Types of Inflation based on Causes

• Demand-Pull Inflation: Increase in prices due to an increase in aggregate demand and consumption.
• Cost-Push Inflation: Increase in prices due to an increase in the cost of ‘factors of production’.
• Supply-Shock Inflation: A rise in prices due to an unexpected or unforeseen sharp fall in the supply of commodities.
• Structural Inflation or Bottleneck Inflation: A rise in prices due to deficiencies in the economy leading to shortages of supply.
• Protein Inflation: A rise in demand and prices of protein-rich items due to changing dietary habits.

Measures of Inflation

• In India, two indicators for measurement are used, which are the Wholesale Price Index and the Consumer Price Index.
• The third is GDP Deflator.

Indian Market Overview

Wholesale Price Index (WPI)

• It measures average change in commodity prices in the wholesale market.
• The three commodity groups are: Primary Products, Fuel and Power, and Manufactured Products.
• Weights assigned to each commodity are on the basis of production value net of net imports.
• Compiled and published monthly by the Office of Economic Advisor, Ministry of Commerce and Industry.
• Base year for WPI: 2011-12.

Consumer Price Index (CPI)

• Average change in prices paid by the ultimate consumers for a basket of goods and services over time.
• The types of CPIs are due to the diversity in the condition of society.
• Industrial Workers Price Index (CPI-IW): Measures commodity basket of industrial workers
• Consumer Price Index for Urban Non-Manual Employees (CPI-UNME): It measures the change in commodity baskets consumed by nonmanual employees.
• CPI for Rural Laborers and Agricultural Laborers (CPI-AL&RL): Measures change in commodity baskets consumed by rural laborers.

New CPIs

• Covers all segments of the population of India.
• Compilated and published by the Central Statistical Organisation (CSO) for All India Level and the State/UT Level.
• New Indices: CPI (Rural), CPI (Urban), and CPI (Combined).
• Reserve Bank of India (RBI) uses CPI (Combined) as the sole inflation measure for monetary policy.

• WPI and CPI are on the same base year, 2011-12, but with different commodity numbers and weights.
• Inflation based on WPI is generally low, while inflation based on CPI is generally high.
• WPI is not very suitable for monetary policy decisions, while CPI is very suitable.

Producer Price Index (PPI)

• PPI measures the average change in selling prices received by domestic producers over time.
• It measures price changes from the perspective of producers.

GDP Deflator

• GDP Deflator is the ratio between GDP at Current Prices and GDP at Constant Prices.
• It indicates the level of price rise by indicating changes in price levels.
• It is a better measure of inflation as it takes into account all goods and services of the economy.
• Redistribution of Income and Wealth: It causes loss to some group and gains to others.
• Borrower Vs Lender: The borrower is the gainer, the lender is the loser.
• Producer Vs Consumer: Consumers have to pay more money to producers for the same amount of goods and services.
• Flexible Income Group Vs Fixed Income Group: Flexible income groups aren’t affected; fixed-income groups lose since their purchasing power declines.
• Debentures or Bond Holders Vs Issuers: Issuers gain; bond holders lose.
• Equity Holders: In the inflationary condition, equity holders earn more income.

Effects of Inflation on Production and Consumption

• Increased prices can reduce the demand for goods and services, thereby reducing production and diverting investment to other sectors.
• Inflation decreases the value of money, hence a wise economic decision to deposit money in banks.
• In the short term, inflation is generally associated with economic growth and employment; however, in the long run, it may not always be so.
• High prices reduce exports and increase imports from other countries, which leads to an adverse Balance of Payment (BoP).
• High import and low export means high demand for foreign currencies that depreciate the domestic currency.

Measures to Control Inflation

• Investors compute a “Real Interest Rate” by adjusting the “Nominal Interest Rate” for inflation.
• Inflation Tax is an implicit tax resulting from the impact of inflation on nominal assets, like cash, bonds, and savings accounts.
• Phillips Curve is the inverse relationship between the unemployment rate and inflation.
• Monetary Measures: The RBI uses monetary instruments to reduce the money supply of the market, which diminishes demand and consequently prices.
• Fiscal Measures: Lesser government expenditure reduces demand and lowers price level.
• Trade Measures: To curb the shortage of goods in the domestic market, various trade measures could be taken.
• Administrative Measures: A logical Wage Policy helps control the cost of production and prices.

Related Concepts

• Deflation: A general persistent fall in the general level of prices, reverse of inflation.
• Disinflation: Inflation at a slow pace.
• Reflation: The deliberate act of the government to increase the rate of inflation to boost the economy.
• Core Inflation: The persistent rate of increase in the overall price level of goods and services.
• Headline Inflation: The total inflation occurring within an economy, in which all the items that consumers buy are taken into account.
• Stagflation: The simultaneous occurrence of stagnation and price rise.
• Skewflation: The increased price of a few items or a group of goods with the other items remaining at stable price levels.
• Inflationary Gap: The actual difference between the level of real GDP being experienced currently and the envisaged GDP that would have ensued if an economy is experiencing full employment.
• Inflation Spiral or Price Wage Spiral: A vicious circle in which increases in both wages and prices reinforce one another.