INFLATION

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BASIC CONCEPTS

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every rupee you own buys a smaller percentage of a good or service. 

INDEX

An Index number may be described as a specialized average designed to measure the relative change in the level of a phenomenon from time to time.

PRICE INDEX

Price index is a specialized average that measures the changes in prices over a period of time. The price indices are of two types:

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GENERAL PRICE INDEX (GPI)

General Price Index measures the changes in average prices of goods and services. A base year is selected and its index is assumed as 100 and on this basis, price index for further period is calculated.

CONSUMER PRICE INDEX (CPI)

Consumer Price Index measures the average change in prices paid by ultimate consumers for a particular basket of goods and services over a period of time. CPI actually measure the increase in prices a consumer will have to pay for the designated commodity basket (which may be revised every four-five years to factor in changes in consumption pattern)

 

CONSTRUCTION OF PRICE INDEX

                       Price Index = (Current year’s price / Base year’s Price) x 100

                                          = P1/P0 X 100

MEASUREMENT OF INFLATION

Inflation is measured with the help of Whole-sale or Consumer price index in India. The percentage of rise in the price index of a particular period from previous period price index is the rate of inflation.

Inflation = (current period price index – last period price index) / last period price index  x 100

Inflation is calculated on the basis of weighted index numbers.

Note: Base year is used only to calculate the index number. The inflation is calculated as a percentage of rise in index number over last year.

WEIGHTED INDEX NUMBERS

In India various weighted price index are calculated. They are

  1. Wholesale Price Index (WPI)
  2. Consumer Price Index for Industrial Workers (CPI – IW)
  3. Consumer Price Index for Urban Non – Manual Employees (CPI – UNME)
  4. Consumer Price Index for Agriculture Labourers (CPI – AL)
  5. Consumer Price Index for Rural Labourers (CPI – RL)

Among the above indices until October 2009, only the WPI was used to calculate inflation and made public through the newspapers. So, it is called the head line inflation. The other index numbers are published as index numbers and not as inflation.

The weights are assigned on the basis of whole sale transaction (value of quantities) for respective commodity groups for WPI. For other indices, the weights are assigned on the basis of consumer expenditure survey.

For example, in the wholesale market, out of the total transaction (value of quantities) 20.118 % of the transaction takes place in primary products in the base year. So, primary commodities are assigned 20.118 % weight. In consumer expenditure survey, it was found that people spend 46.19% of their total expenditure on food in the base year. So, food items are assigned with 46.19 % weight.

WHOLE SALE PRICE INDEX (WPI)

The Authority responsible for Compilation and Release: Office of the Economic Advisor, Department of Industrial Policy & Promotion

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OLD CONSUMER PRICE INDICES

Before February 2011, India had four consumer price indices viz. Consumer price Index for Industrial Workers (CPI-IW), Consumer Price Index for Urban Non–Manual Employees (CPI–UNME), Consumer Price index for Agriculture Labourers (CPI–AL) and Consumer Price Index for Rural Labourers (CPI – RL).

 

CONSUMER PRICE INDEX FOR INDUSTRIAL WORKER - CPI (IW)

This index measures the change in the price of commodity basket consumed by the industrial workers.

AUTHORITY FOR COMPILATION & RELEASE: Labour Bureau, Shimla, Ministry of Labour.

USE: Used for wage indexation in government and organized sector.

CONSUMER PRICE INDEX FOR URBAN NON-MANUAL EMPLOYEES (CPI – UNME)

This index measures the change in the price of commodity basket consumed by the non-manual employees like office goers. CPI-UNME earlier compiled by the Central Statistical Organization as an independent index has since been discontinued and is currently linked to the CPI-IW.

AUTHORITY FOR COMPILATION & RELEASE: CSO - Central Statistical Organisation, Ministry of Statistics and Programme Implementation.

CONSUMER PRICE INDEX FOR RURAL LABOURS AND AGRICULTURAL LABOURERS (CPI- AL)

Consumer Price Index for Rural labours measures the change in the price of commodity basket consumed by rural labourers like agriculture labourers, labourers of village and cottage industries etc.

Consumer Price Index for Agricultural Labourers (CPI-AL) is a subset of Consumer Price Index for Rural Labours (CPI-RL). It is basically used for revising minimum wages for agricultural labour in different states.

AUTHORITY FOR COMPILATION AND RELEASE OF BOTH INDICES: Labour Bureau, Shimla, Ministry of Labour.

 

NEW CONSUMER PRICE INDICES

The above consumer price indices cover only a segment of population like Agriculture Labour, Industrial worker etc., and do not give a nationwide picture. Therefore, three new indices are introduced with base year of 2010 (January – December) which cover all segments of population on all India basis. They are as follows:

  • CPI (Rural)
  • CPI (Urban)
  • CPI (Combined)

These indices are published for all India as well as State / Union Territory level. These indices are released with one-month time lag. The CPI (Combined) is computed by combining Rural and Urban index. From January 2012, these new indices are released. In addition to this, separate rural, urban, and combined Consumer Food Price Indices (CFPI) for all India were released from May 2014. The weighting diagram for the new CPI series was derived on the basis of average monthly consumer expenditure of an urban/rural household obtained from the Consumer Expenditure Survey data (2004-05) of 61st Round of the National Sample Survey (NSS). The CSO has revised the base year of the Consumer Price Index from 2010=100 to 2012=100 and the revised index numbers were released on 12 February 2015

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TYPES OF INFLATION

Inflation can be classified on the basis of rate of rise in prices and on the basis of causes.

DIFFERENT INFLATION BASED ON RATE OF RISE IN PRICES

1. CREEPING INFLATION:- Price rise at very slow rate (less than 3%) like that of a snail or creeper is called Creeping inflation. It is regarded safe and essential for economic growth.

2. WALKING OR TROTTING INFLATION :- Price rise moderately at the rate of 3 to 7% (or) less than 10% is called Walking or trotting inflation. It is a warning signal to the government to be prepared to control inflation. If the inflation crosses this range, it will have serious implication on the economy and individuals.

3. RUNNING INFLATION:- Running inflation means price rise rapidly like the running of a horse at a rate of 10-20%. It affects the economy adversely.

4. HYPERINFLATION (OR) RUNWAY (OR) GALLOPING INFLATION:- The price rise at very fast at double or triple digit rate from 20 to 100% or more is called Hyperinflation (or) Runaway (or) galloping inflation. Such a situation brings total collapse of the monetary system because of the continuous fall in the purchasing power of money.

DIFFERENT INFLATION BASED ON CAUSES

1. DEMAND PULL INFLATION

Demand pull inflation arises due to higher demand for goods and services over the available supply. Higher demand for goods and services arises due to increase in income of the people, increase in money supply and change in the taste and preference of people etc. In other words, demand pull inflation takes place when increase in production lags behind the increase in money supply.

2. COST PUSH INFLATION

Price rise due to increased input costs like raw material, wages, profit margin etc., is called Cost push inflation. 

Both demand pull inflation and cost push inflation are affected by forces of demand and supply.

FACTORS AFFECTING DEMAND

1. Increase in Money Supply

Increase in money supply leads to price rise. More money available with people induces people to purchase more goods and services. It means there is an increase in demand. So, prices move upward.

2. Increase in Disposable Income

The increase in the disposable income leads to higher spending on the part of households. It hikes the level of price.

3. Cheap Monetary Policy

Cheap monetary policy means loan availability at very low interest rate and at easy terms. It leads to more investment by investors with loaned money. It pushes up the demand for capital goods and rise in price of the same.

4. Increase in Public Expenditure

Increase in government expenditure over its income, leads to deficit budget. Increase in government spending increases the demand for consumption and capital goods and services. It increases the price of both goods and services.

5. Repayment of Public Debt

The repayment of public debt borrowed by government to public leaves people with more money. It induces people to spend more. It ultimately leads to increase in price of goods and services.

 

FACTORS AFFECTING SUPPLY

1. Shortage of Factors of production

The shortage in the factors of production viz., land, labour, and capital increases the cost of production. For example, shortage in the labour leads to higher wages. It increases the cost of production and price of goods and services.

2. Industrial Disputes

Industrial disputes lead to strike or lay off. It affects the production and supply of goods.  It results in increased prices.

3. Natural Calamities

Natural calamities like earth quake, land slide and tsunami, affect production and supply of goods and services. The end result is price rise.

4. Artificial Scarcities

Artificial scarcities created by activities like hoarding and speculative trading in commodities in the commodities future market, results in price hike.

5. Increase in Exports

Increase in export of a particular commodity leads to shortage of goods in the domestic market. It pushes up prices.

6. International Factors

International factors like oil price hike, shortage in production of certain commodities leads to higher import prices.

 

EFFECTS OF INFLATION

Inflation has impact on all the economic units. It has favorable impact on some and unfavorable impact on others. The effects are discussed under three different heads as under:

 

1. REDISTRIBUTION OF INCOME OF WEALTH

It redistributes income from one hand to another. It leads to loss to some group of people and gain to another group of people.

a) DEBTORS VS CREDITORS

In case of debtor and creditor, debtor is gainer and creditor is loser.

b) PRODUCERS VS CONSUMERS

In inflationary situation, the producers stand to gain and consumers stand to lose. The producer’s profit will increase as a result of inflation. The purchasing power of money held by consumer declines. So, they have to pay more money to purchase the same amount of goods and services what they bought before inflation. Here, the income of consumer gets transferred from consumers to producers.

c) FLEXIBLE INCOME GROUP VS FIXED INCOME GROUP

The flexile income groups like sellers, self employed, and employees of private concerns whose salary is adjusted according to inflation do not get affected, but fixed income groups like daily wage earners lose as the purchasing power of their income diminishes.

d) DEBENTURES OR BOND HOLDERS AND SAVERS VS EQUITY HOLDERS

The Debentures or Bond holders and Savers receive fixed periodical income from their financial assets. The purchasing power of their asset remains intact only if interest rate is more than rate of inflation.

The security holder’s income depends on the profit of the company. In inflationary situation, the companies earn more profit. So, the equity holders also earn more income.

 

2. EFFECTS ON PRODUCTION AND CONSUMPTION

The inflation may lead to fall in the demand for goods and services. It may curtail the amount of production. Inflation also leads to reallocation of resources. Sometimes, only few goods may experience price rise. In that case, the investment from other sectors may shift to these sectors.

In packaged items, in order to maintain same price per package, the producers reduce the quantity or quality or both instead of raising price. It means, less production  and consumption.

 

3. OTHER EFFECTS

a) BALANCE OF PAYMENT (BOP)

High price reduces the amount of export and increases import from other countries where goods are available at cheaper rate. It results in unfavorable balance of payment.

b) EXCHANGE RATE

High import and low export means high demand for foreign currencies compared to domestic currency. This depreciates domestic currency.

c) SOCIAL AND POLITICAL

Higher rate of inflation leads to social and political tension. The political parties and organized group of people call for strike, hartals and stage dharnas.

MEASURES TO CONTROL INFLATION

The control of inflation needs a multi-pronged strategy. All the strategies need cooperation and harmony among them.

1. MONETARY MEASURES

a) CREDIT CONTROL:- It is performed by Reserve Bank of India.

b) DEMONETIZATION OF CURRENCY:- Demonetization of currency means declaring that hereafter currencies of particular denominations are invalid. It suddenly reduces the money to the extent of money kept in those particular denominations. It is resorted to only in extreme cases.

 

2. FISCAL MEASURES

a) REDUCTION IN UNNECESSARY EXPENDITURE:- Reduction of unnecessary government expenditure means less demand from government side. It brings down the price level.

b) INCREASE IN DIRECT TAXES:- Increase in direct taxes like income tax reduces the disposable income available with people. It means low demand from households. Less demand leads to lower price.

c) DECREASE IN INDIRECT TAXES:- Decrease in indirect taxes like excise duty, sales tax brings the prices down.

d) SURPLUS BUDGET

Surplus budget means less expenditure than receipts. It reduces the money supply and government demand for goods and services. The price level is brought down due to this.

 

3. TRADE MEASURES

Trade measures refer to export and import of goods and services. In case of shortage of goods in domestic market the supply can be increased through import of goods from foreign countries at low or nil import duty. The restriction in the form of import licenses has to be eased to increase import. The higher supply helps to bring down the price.

 

4. ADMINISTRATIVE MEASURES

a) RATIONAL WAGE POLICY

Rational wage policy helps to keep the cost of production under control. The cost control means price control.

b) PRICE CONTROL

Direct price control also helps in inflation control. Price can be controlled by fixing maximum price limits through administered price system and subsidy from the government.

c) RATIONING

Rationing of goods in short supply keeps the demand under control so that price comes under control.

 

PHILIPS CURVE

Philips curve shows the relationship between rate of inflation and rate of unemployment. It shows that the relationship is negative. That is at high rate of inflation the unemployment rate is low as show in figure below.

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STAGFLATION

Stagflation refers to the situation of coexistence of stagnation and inflation in the economy. Stagnation means low National Income growth and high unemployment. The Philips curve shows that at high rate of inflation, there is low rate of unemployment. But stagflation proves the contrary.

Before 1970s, it was considered that at the time of inflation, the economy will be booming. 1970s scenario proved contrary with the existence of inflation and stagnation.

DEFLATION

Deflation is opposite to that of inflation. The persistent and appreciable fall in the general level of prices is called as deflation. The rate of change of price index is negative. The effects, cause and measures are also in the opposite direction.

DISINFLATION

The rate of inflation at a slower rate is called disinflation. For example, if the inflation of last month was 6% and rate of inflation in the current month is 5% it is termed as disinflation.

REFLATION

Reflation means deliberate action of government to increase rate of inflation to stimulate economy. It is usually done to redeem the economy from deflationary situation.

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The figure depicts the various rates of price changes in the economy. From the month of April to the end of May, the economy is experiencing negative rate of price range. It is called deflation. From the end of May to the mid of July, the price rate is recovering from negative zone. It is called reflation. From the mid of July, to the end of August, the price rate is moving upward in the positive territory. It is called Inflation. From September to the mid of October, the rate of price change is declining but still in the positive territory. It is called disinflation.

CORE INFLATION

Core inflation is a measure of inflation that excludes certain items that face volatile price movements. Core inflation eliminates products that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation.

BASE EFFECT

Base effect refers to the phenomenon of current year index being influenced by very low or high previous year index.

Case 1

Price index on 7th January, 2007 = 110

Price index on 7th January, 2008 = 120

Rate of inflation on 7th January, 2008 = 120-110/110*100 = 9.09 %

Case 2

Price index on 10th March, 2008 = 180

Price index on 10th March, 2009 = 190

Rate of inflation on 10th March, 2009 = 190 – 180/180*100 = 5.55%

In both the cases the index number increased by 10, but the rate of inflation is different. The rate of inflation is low in second case compared to first case. This is because of the difference in previous year index.

 

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