Inflation and Related Concepts

Inflation

• It refers to the persistent rise in the general price level, i.e., in

the price of goods and services.

• It reduces the purchasing power of money and ultimately hurt

the economy in many ways

• There is a loss in real value of money as medium of exchange

and unit account in the economy.
 Why Inflation Occurs

1. Increase in Money Supply

• The most important reason of inflation is excessive growth of
the money supply.
• A long sustained period of inflation is caused by money supply
growing faster than the rate of economic growth.
• When there is more money in the system, too much money
chases too few goods.
2. Increased Effective Demand
• Another important reason for inflation is increased effective
demand for goods and services. When there is an increased
demand, the people tend to offer higher price for same good or
commodity.
3. Decreased Effective Supply or aggregate output
• Negative changes in available supplies such as during scarcities
cause inflation.
 Classification of Inflation

Though causes of inflation are multi-dimensional but broadly it

could be expressed in two forms:

• Demand-pull-inflation
• Cost-push-Inflation

It means that inflation is caused either due to increase in demand,

because when demand will be high prices, will certainly go up and
increase in the cost of production, or due to both.
 Demand Pull Inflation

• Demand Pull Inflation occurs due to increase in aggregate

demand in economy, mainly due to increase in money supply
• It occurs when demand far exceeds the supply

Factors leading to Demand Pull Inflation

1. Increase in Money Supply in economy

2. Increase in the Population (Leads to increase in demand for goods and
services)
3. Increase in government expenditure (Deficit financing or high fiscal
deficit)
4. High inflow of Foreign Exchange in the economy, leads to high liquidity
in domestic currency
5. Prevalence of black economy (Black Money)
 Cost Push Inflation

Cost-Push Inflation
• It is also called as Supply Shock inflation, It is caused due to
reduced aggregate supply with constant demand or increase in
cost of products

Factors leading to Cost Push Inflation

1. Rise in cost of Factors of production like land, labour and capital :
When production costs go up, there is an increase in prices to
maintain profit margins. Increased costs can include things such as rise
in rent, wages and interest respectively
2. Infrastructural bottlenecks leading to fall in supply this type of
inflation is also called as Structural Inflation (Bottleneck Inflation)
3. Increase in Indirect taxes like GST adds up to the cost of commodity
4. Black marketing, speculation and hoarding causes the supply shock
and inflation
5. Rise in cost of fuel and petroleum products
6. Other seasonal factors like erratic monsoon, weather conditions etc
 Impact of Inflation
1. On Growth
• There is a trade off between Inflation and growth rate of
economy, increase in rate of inflation leads to increase in
growth rate and vice versa
• RBI controls inflation through monetary policy tools
• Sometimes measures taken to control inflation lead to decrease
in growth rates making inflation control a highly complicated
process

2. On Quality of Life
• Inflation reduces the purchasing power of money in the hands of
households thus declining their quality of life

3. On Creditors and Debtors

• Fall in purchasing power of money will affect the creditors as
the value of money is reduced during the maturity period of
loan
 Impact of Inflation
• 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 (i.e., deflation)

4. Redistribution of wealth from fixed income group to flexible income

group as salary of flexible income group is adjusted to inflation but
salary of fixed income group remains constant

5. Redistribution of wealth from Consumers to producers as the profit

of producers tend to increase with inflation but purchasing power of
money of consumer falls. Hence consumers pay more for the same
commodity whereas producers gain more
 Impact of Inflation
6. On Investment
Investment in the economy is boosted by the inflation (in the short-
run) because of two reasons:
i. Higher inflation indicates higher demand and suggests
entrepreneurs to invest more to expand their production
level to cater the demand, and
ii. Investors rush up and try to borrow loans and invest
before Monetary Policy Committee increases the interest
rates. (When inflation is higher, MPC will increase the
interest rates)
7. On Savings
• In encourages savings in bank in short run as holding money in
hand reduces its purchasing power. Interest on the deposits
offsets inflation to certain level

• But in long run, People tend to invest on inflation linked

commodities like gold instead of savings in bank
 Impact of Inflation
8. On Tax
Tax-payers suffer while paying their direct and indirect taxes.
• As indirect taxes are imposed ad valorem (on value), increased
prices of goods make tax-payers to pay increased indirect taxes
(like GST, vat, etc.,)
• Similarly, due to inflation, direct tax (income tax, interest tax,
etc.) burden of the tax-payers also increases as tax-payer’s gross
income moves to the upward slabs of official tax brackets (but
the real value of money does not increase due to inflation; in
fact, it falls).
• The extent to which tax collections of the government are
concerned, inflation increases the nominal value of the 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.
 Impact of Inflation
9. 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

10. On Export
• Cost push inflation discourages exports (Not certain)
• But export income increases due to depreciation of currency as
a result of inflation

11. On Import
• Demand pull inflation encourages Imports. Governments
encourage import to cater the demand and bring inflation under
control (Not certain)
• But imports become costlier due to depreciation of currency as a
result of inflation
 Measurement of Inflation
Inflation is measured by calculating the percentage rate of change of a price
index, which is called the inflation rate.
Inflation is often measured either in terms of Wholesale Price Index or in terms
of Consumer Price Index.

Wholesale Price Index(WPI)

The Wholesale Price Index is an indicator designed to measure the changes
in the price levels of commodities that flow into the wholesale trade
intermediaries. It measures inflation at wholesale level, that impacts the
manufacturers and firms
Consumer Price Index (CPI)
Consumer price index is specific to particular group in the population. It
shows the cost of living of the group. It is based on the changes in the
retail prices of goods or services.
Based on their incomes, consumer spends money on these particular set
of goods and services. There are different consumer price indices. Each
index tracks the changes in the retail prices for different set of consumers.
 Measurement of Inflation
Wholesale Price Index WPI

It is the most widely used inflation indicator in India.

• Published by the Office of Economic Adviser, Ministry of

Commerce and Industry.
• All transactions at the first point of bulk sale in the domestic
market are included.
• It shows the prices levels paid of firms and manufactureres
• The base year of All-India WPI has been revised from 2004-05 to
2011-12 in 2017.

This basket has been divided into three categories with 697
commodities
1. Primary articles: weightage to given to it is 20.118%
2. Energy and Fuel: Weightage= 14.910%
3. Manufactured Items: Weightage= 64.972%
 Measurement of Inflation
Consumer Price Index (CPI)
• It measures price changes from the perspective of a retail
buyer.
• It measures changes over time in the level of retail prices of
selected goods and services on which consumers of a
defined group spend their incomes.

Four types of CPI are as follows:

1. CPI for Industrial Workers (IW) – 2001 ( now changed to 2016 )
2. CPI for Agricultural Labourer (AL) - 1986-87
3. CPI for Rural Labourer (RL) - 1984-85
4. CPI ( Urban non Manual Employee) – 2001 – (discontinued from 2011)
Of these, the first three are compiled by the Labour Bureau in the Ministry of
Labour and Employment. Fourth is compiled by the Central Statistical
Organisation (CSO) in the Ministry of Statistics and Programme Implementation.
(CSO is now called as ‘NSO’ - National Statistical Organisation or Office)
Base Revision of Consumer Price Index
for Industrial Workers (CPI-IW)
• The CPI-IW is compiled and disseminated by the Labour Bureau on a monthly
basis.
• It measures changes in the retail prices of a fixed basket of goods and services
being consumed by an average working-class family.
• Apart from serving as a guide for policy formulations these index numbers are
utilized for fixing/revising wages, regulating the dearness allowances paid to
large number of manual workers and Central/ State Govt. employees.
• To capture the latest consumption pattern of working-class family, Labour
Bureau has revised the base year of the existing from 2001 to 2016
• The new series of CPI-IW covers the industrial workers from the existing seven
sectors viz.
• Mines, Plantation, Factories, Railways, Public Motor Transport
Undertakings,Ports & Docks and Electricity Generating & Distributing
Establishments
• The new series has a wider coverage in terms of sample size, number of centres,
markets/outlets, items etc.
Base Revision of Consumer Price
Index for Industrial Workers (CPI-IW)
Base Revision of Consumer Price Index for
Industrial Workers (CPI-IW)
 Measurement of Inflation
New CPI Series
• It was in 2011 that the government announced a new Consumer Price Index (CPI) –
1. CPI(Rural);
2. CPI (Urban) and
3. CPI (C) (where ‘C’ stands for‘Combined’).

• The base year was also revised from the existing 2010 to 2012 and published by CSO
 Measurement of Inflation
WPI vs CPI
• Food has higher weightage in CPI than in WPI
• Manufactured goods has higher weightage in WPI than in CPI
• WPI doesn’t include services, while CPI include services to a
limited extent
• Fuel has higher weightage in WPI than in CPI
• WPI is more or less uniform across India, whereas CPI varies
from region to region
• CPI (rural) doesn’t include housing, whereas CPI (urban) gives
6.84% value to the housing
• Fuel and Light has higher weightage in CPI (rural) than in CPI
(urban)
• Food and beverages has higher weightage in CPI (urban) than in
CPI (Rural)
 Measures to Control Inflation
1. Monetary Policy by RBI
i. Credit Control
Monetary Policy Committee uses several instruments like
CRR,SLR, Repo rate and Open market operations to regulate
the inflation

ii. Demonetisation of Currency and reduction of money supply to

bring down demand (Extreme cases)

iii. Issue of New Currency: Entire money supply is demonetized

and new currency is introduced. 1 unit of new currency is made
equivalent to several unit of older currency
 Measures to Control Inflation
2. Fiscal Policy by Government
i. Rationalisation of Expenditure
Cut down of unnecessary expenditure will reduce the demand
ii. Increase in Direct Taxes reduces the disposable income in hands of
households thus cutting down the demand
iii. Decrease in indirect taxes will bring down the cost of the
commodities
iv. Surplus budget (rare occasions)

3. Administrative Measures
i. Rational wage policy to keep the wage rates under factors of
production under control
ii. Price Control by fixing the prices of goods and services
iii. Strengthening the distribution system like PDS
iv. Easing the imports by cutting off Import duties and tariff restrictions
v. Export regulations
Other Related Concepts
 Other Related Concepts
1. Inflation
It refers to the persistent rise in the general price level, i.e., in the price of
goods and services when compared to base year prices

2. Deflation
It refers to the persistent fall in the general price level, below the base
level prices. The rate of change of price index is negative here

3. Disinflation
It is persistent fall in price levels, but prices are still above the base year
prices, the rate of change of price index is still positive

4. Reflation
It is a deliberate action taken by government to stimulate economy during
deflationary conditions
 Other Related Concepts
5. Classification of Inflation based on Rate
• Creeping Inflation: 1% - 3%
• Walking Inflation : 3% to 10 %
• Running Inflation : 10% to 20%
• Galloping Inflation : above 20%
• Hyper 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
the range of increase is very large, but the increase takes place in a
very short span of time, prices shoot up overnight.
Such an inflation quickly leads to a complete loss of confidence in the
domestic currency
 Other Related Concepts
6. Bottleneck Inflation
This inflation takes place when the supply falls drastically and the demand
remains at the same level. Such situations arise due to supply-side
hurdles, hazards or mismanagement which is also known as ‘structural
inflation’

7. Skewflation
• Economists usually distinguish between inflation and a relative price
increase. ‘Inflation’ refers to a sustained, across-the-board price
increase, whereas ‘a relative price increase’ is a reference to an
episodic price rise pertaining to one or a small group of commodities.
• This leaves a third phenomenon called skewflation, namely one in
which there is a price rise of one or a small group of commodities over
a sustained period of time.
• This skews the value of inflation, hence called skewflation
 Other Related Concepts
8. Core Inflation
This nomenclature is based on the inclusion or exclusion of the goods and
services while calculating inflation. Core inflation shows price rise in all
goods and services excluding energy and food articles which are often
volatile in nature and skews the value of Inflation

9. Inflationary Gap
The excess of total government spending above the national income (i.e.,
fiscal deficit) is known as 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.

10. Inflation Tax

Inflation erodes the value of money and the people who hold currency
suffer in this process. As the governments have authority of printing
currency and circulating it into the economy (as they do in the case of deficit
financing), this act functions as an income to the governments. This is a
situation of sustaining government expenditure at the cost of people’s
income. This looks as if inflation is working as a tax
 Other Related Concepts
11. Phillips Curve
• The inverse relationship between
unemployment rate and inflation when
graphically charted is called the Phillips
curve.
• The theory states that the higher the
rate of inflation, the lower the
unemployment and vice-versa.
• Thus, high levels of employment can be
achieved only at high levels of inflation.
• The implications of Phillips curve have
been found to be true only in the short
term.
• Phillips curve fails to justify the
situations of stagflation, when both
inflation and unemployment are
alarmingly high.
 Other Related Concepts
12. Stagflation
• Stagflation is a situation in an economy when inflation and
unemployment both are at higher levels, contrary to conventional belief
as given by Phillips Curve
• It was proposed by Milton Friedman

13. Inflation Premium

• 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, which might not be the real cost of borrowing paid by the
borrower to the banks.
• To calculate the real cost a borrower is paying on its loan, 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 rate, if the
inflation is taking place—the difference is the inflation premium.
 Other Related Concepts
14. Base Effect
• It refers to the impact of the rise in price level in the previous year (i.e., last
year’s inflation) over the corresponding rise in price levels in the current year
(i.e., current inflation).
• If the price index had risen at a high rate in the corresponding period of the
previous year, leading to a high inflation rate, some of the potential rise is
already factored in, therefore, a similar absolute increase in the Price index in
the current year will lead to a relatively lower inflation rates.
• On the other hand, if the inflation rate was too low in the corresponding
period of the previous year, even a relatively smaller rise in the Price Index will
arithmetically give a high rate of current inflation.
 Other Related Concepts
14. Base Effect
Consider the following two cases