Topic: Inflation : Concepts, Facts and Policy

Q. Define Inflation.

Answer : Inflation means a persistent rise in the price of goods and services. Inflation reduces the purchasing power of money. It hurts the poor more as a greater proportion of their incomes are needed to pay for their consumption. Inflation reduces savings; pushes up interest rates; dampens investment; leads to depreciation of currency thus making imports costlier.

Depending upon the rate of growth of prices, inflation can be of the following types

Creeping inflation is a rate of general price increase of I to 5 percent a year. Creeping inflation of 3 to 5 percent erodes the purchasing power of money when continued over many years, but it is “manageable.” Furthermore, a low creeping inflation could be good for the economy as producers and traders make reasonable profits encouraging them to invest.

Trotting inflation is usually defined as a 5 to 10 percent annual rate of increase in the general level of prices that, if not controlled, might accelerate into a galloping inflation of 10 to 20 percent a year. If it aggravates, galloping inflation can worsen to ‘runaway” inflation which may change into a hyperinflation. Hyperinflation is inflation that is “out of control,” a condition in which prices increase rapidly as a currency loses its value. No definition of hyperinflation is universally accepted. One simple definition requires a monthly inflation rate of 20 or 30% or more ‘an inflationary cycle without any tendency toward equilibrium’. The worst is a monetary collapse, if prices are not reined in, in time.

Other related concepts are

• deflation when there is a general fall in the level of prices

• disinflation which is the reduction of the rate of inflation

• stagflation which is a combination of inflation and rising unemployment due to recession and

• reflection, which is an attempt to raise prices to counteract deflationary pressures.

Q. Describe the measures of inflation.

Answer : CDP deflator

GDP stands for gross domestic product, the total value of all final goods and services produced within that economy during a specified period. GDP deflator is a measure of the change in prices of all new, domestically produced, final goods and services in an economy. The GDP deflator is not based on a fixed market basket of goods and services but applies to all goods and services domestically produced.

Cost of living index

The cost of living is the cost of maintaining a certain standard of living. It is defined with reference to a basket of goods and services. When their cost goes up, CoL is said to be dearer and the index will go up. It has a value of 100 in the base year. An index value of 105 indicates that the cost of living is five percent higher than in the base year.

PPI

Producer price index (PPIs) measures the change in the prices received by a producer. The difference with the WPI is accounted for by logistics, profits and taxes, mainly, Producer price inflation measures the price pressure due to increase in the costs of raw materials. It may be absorbed by them or made up by increases in productivity or passed on to the consumers. It depends on the market conditions.

WPI

Wholesale price indices, which measure the change in price of a selection of goods at wholesale, prior to retail sales thus excluding sales taxes. These are very similar to the Producer Price Indexes.

CP1

Consumer price index measures the changes in prices paid by the consumer at the retail level. It can be for the whole community or group-specific for example, CPI for industrial workers etc as in India.

Q. According to causes how many types of inflation?

Answer : There are four major types of inflation

• Demand-pull inflation: inflation caused by increases in demand due to increased private and government spending, etc. It involves inflation rising as real gross domestic product rises and unemployment falls. This is commonly described as ‘too much money chasing too few goods’. For example, India in 2010 when the economy is said to have overheated and demand outstripped supply and prices rose. Since supplies will be augmented to adjust to demand, prices will come down. It may be referred to as ‘growth inflation’ too. Demand- pull inflation can be caused by money supply increasing. For example, the expansionary monetary policy of the RBI in 2009 saw rates come down and easy and cheap credit pushed up prices as demand grew. Since 2010, repo rates were raised 11 times by July 2011 as RBI sought to control prices by reducing demand.

• Cost-push inflation: It is also referred to as “supply shock inflation,” caused by reduced supplies due to increased prices of inputs, for example, crude prices globally have gone up causing supply constraints which means higher costs of production and so higher prices. Crude and food prices shot up in 2008 July. Other examples are, higher cost of capital, increases in prices of imported raw materials. Just as a shortage of goods tends to push prices up, an oversupply of commodities tends to induce the opposite effect on prices.

• Structural inflation: A type of persistent inflation caused by deficiencies in certain conditions in the economy such as a backward agricultural sector that is unable to respond to people’s increased demand for food, inefficient distribution and storage facilities leading to artificial shortages of goods, and production of some goods controlled by some people. Food inflation currently being witnessed (2011) is structural in nature as the preference for protein foods is far ahead of its supplies and this is a phenomenon driven by income rise.

• Speculation

• Cartelization

• hoarding

Q. Give an account of Impact of High Inflation?

Answer :If inflation is high in an economy, the following problems can arise

• Low income groups are particularly hurt

• People on a fixed income (e.g. pensioners, students) will be worse off in real terms due to higher prices and equal income as before; this will lead to a reduction in the purchasing power of their income.

• Inflation discourages exports as domestic sales are attractive and BOP problems can be caused. Inflation may erode the external competitiveness of domestic products if it leads to higher production costs such as wage increases, higher interest rate and currency depreciation.

• Inflation can drag down growth as interest rates are raised and cost of credit increases.

• Increasing uncertainty may discourage investment and saving. The savings pattern is affected thus: with the declining value of money, people would be more inclined to spend than save anticipating that their money can buy even less in the future. Therefore, with its adverse effect on savings, inflation can also discourage investment.

• Inflation tax happens. When a government borrows and spends, the cash held by people erodes in value due to inflation

• It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw an inflation-linked income and businesses.

• strikes can take place for higher wages which can cause age spiral. Also if strikes occur in an important industry which has a comparative advantage the nation may see a decrease in productivity, exports and growth.

Small Amount of Inflation Can be Good

It can be argued that a low level of inflation can be good if it is a result of innovation new products are launched at - high prices, which quickly come down through competition. Therefore, there is encouragement for innovation and the problem is short lived. Also, a small price rise is necessary for’ wages to go up. It further helps the economy keep off deflation which can otherwise set off a recession. Besides, inflation at a moderate level is an incentive to the producer. At any rate, small price rises are inevitable in a growing economy. Some see mild inflation as “greasing the wheels of commerce.”

To Control Inflation

• There are fiscal, monetary, supply-side and administrative measures to control inflation to ideal/optimal rates though zero rate of inflation is never preferred for the reasons cited elsewhere in the lesson.

• Fiscal measures include reduction in indirect taxes

• Dual pricing like in sugar.

• Monetary measures include rate and reserve requirements changes. Open market operations can stabilize prices under normal conditions Also, sterilization through Government bond transactions as in the case of MSBs.

• Supply side factors include making goods available- import of wheat in India.

• Administrative measures include implementation of dehoarding and anti-black-marketing measures. Wage and price controls can also be used

Indices of Inflation

Changes in the price levels at the wholesale and retail level are tracked by various price indices in India- WPI and CPI. CPIs exist for different consumer groups each of which is homogenous.

All price indices use a particular year as a “base year’. That means that rises or falls in prices are measured with reference to the price in that year. For example, the base year used for the Wholesale Price Index is 2004-05 since 2010. Wholesale prices of all products in the basket with their respective weightages in that year add upto 100.

Different base years are used for different price indices due to convenience, data availability, logistics etc.

Q. Write a short notes on wholesale Price index?

Answer : Government launched a new series of wholesale price index (WPI) with 2004-05 as base from September 2010. Earlier 1993-94 was used as base year to calculate WPI. The new series of WPI has 676 items as against 435 items in the previous series. Consumer items widely used by the middle class like ice cream, mineral water, flowers, microwave oven, washing machine, gold and silver are reflected in the new series of WPI. This would give better picture of the price variation. Readymade food, computer stationary, refrigerators, dish antenna, VCD, petroleum products and computers will also be part of the new series.

Under primary article group of the new WPI, there are 102 items against earlier 98, while fuel and power category remains static at 19. In the new series, there are 555 items of manufactured products compared to 318 items earlier.

241 new items are there in the basket of commodities making up the official wholesale price index in a bid to reflect changes in India’s price line and consumption pattern better.

The new series is based on the recommendations of a working group that was set up under Planning Commission Member Abhijit Sen.

Manufactured items now have a higher weight of 64.972 as against 63.749 earlier. The weight for fuels has also increased to 14.910 against 14.226. But for primary articles, the weight is down at 20.118 against 22.025.

In a bid to reflect the actual consumption pattern, the new series drops as many as 200 items such as typewriters, video cassette recorders, to make a room for items like computers, refrigerators, televisions and video disc players.

Government is also working on a two new indices to reflect the changes in the cost of services — one, on financial services and the other on trade and transport.

The WPI is published weekly by the Economic Advisor in the Ministry of Commerce and Industry, with a two week lag, tracks the wholesale traded price of 676 items that include agricultural commodities (such as rice, tea, raw cotton, groundnut Oil seed), industrial commodities. Such as’ iron ore, bauxite, coking coal), intermediate products for industry (such as cotton yarn, polyester fiber, synthetic resins, iron & steel, sheet glass), products for consumers (atta, sugar, paper, electricity, ceiling fans) and energy items (petrol, kerosene, electricity for commercial use). The weight attached to each item in the index is meant to reflect the volume (by value) of wholesale trade in that item in the Indian market.

The wholesale price index (WPI) is a vital guide in economic analysis arid policy formulation.

The WPI is not intended to capture the effect of price rise on the consumer though it generally and broadly indicates it.

WPI is the only price index in India which is available on a weekly basis with the shortest possible time lag of two weeks it has an all India character. It is due to these attributes that it is widely used in business and industry circles and in Government and is generally taken as an indicator of the rate of inflation in the

In short, The advantage of the WPI is that it covers more goods; is available with relatively small time lag of fortnight; is convenient to compile. Disadvantages are that it does not include services like transport, health, education etc.

This provisional weekly index is made final after a period of 8 weeks. The inflation rate is calculated on point to point basis i.e. on the basis of the variation between the index of the latest week of the current year and for the corresponding week of the previous ‘ear.

There are a number of agricultural commodities, especially, some fruits and vegetables, which are of a seasonal nature. Such seasonal items are handled in the index in a special manner. When a particular seasonal item disappears from the market and its prices are not quoted, the index of such an item ceases to get compiled and its weight is distributed over the remaining items and new seasonal items, if any, in the concerned sub-group.
Limitation of WPI

The accuracy of WPI is unsatisfactory even after the introduction of the revised series in 2010. Services such as rail and road transport, health care, postal banking and insurance, for example, are not part of the WPI basket. Neither are the products of the unorganized sector that are estimated to constitute about 35 per cent of the total manufactured output of the country. The index thus falls well short of being a broad based indicator of the price level even in its construction.

Government set up Abhijit Sen Committee on revising the WPI and the revised series was introduced in 2010 to broadbase the basket and update the goods.
From late 2009, government decided to have weekly release of inflation data on food and fuel prices on the WPI and monthly data on the general WPI. That is, inflation of primary goods within the WPI is reported on a weekly basis.
The earlier system was to release the wholesale price index every week and consumer price index, where food items have greater weightage, every month.

Q. Write a short notes on consumer Price Index.

Answer : There are three Consumer Price Indices in India. Each tracks the retail prices of goods and services for specific group of people, because the consumption patterns of different groups differ.

For Industrial Workers (CPI-IW), a basket of 370 commodities is tracked; for Urban Non-Manual Employees (CPI-UNME), 180 commodities; for Agricultural Labourers (CPI-AL), 60 commodities. The respective base years are 2001, 1984-85 and 1986- 87. The first two indices have services in them. These baskets and the weightages to each item have been determined on the basis of surveys of consumption patterns. Information also differs from centre to centre around the country, the all-India figures declared are averages.

Mahatma Gandhi NAREGA wages are to be indexed to the CPI (AL) from the beginning of the year 2011.

CSO decided to discontinue CPI (UNME) from 2008.

Each commodity is given a specific weightage, which differs from one index to another index. For example, the CPI-AL would give a greater weightage to foodgrains than the CPI-UNME, since a greater proportion of the agricultural labourer’s expenditure would go toward foodgrains, and he would be unlikely to buy the sort of items the office-goer would buy.

The coverage of CPI IW is broader than the other indices of CPI like the CPI for agricultural laborers (AL) and the CPI for urban non-manual employees (UNME).

In the organised sector, CPI-IW is used as a cost of living index.

CPI-AL and CPI-UNME are not considered as robust national inflation measures because they are designed for specific groups of population with the main purpose of measuring the impact of price rise on rural and urban poverty.

In accordance with the Government of India (Allocation of Business) Rules, 1961, as amended from time to time, it is the responsibility of the Ministry of Labour to compile and release the data on the CPI for Industrial Workers and the data on the CPI for Rural Labourers. It was the responsibility of the Ministry of Statistics and Programme Implementation to compile and release the data on the CPI for Urban Non-Manual Employees.
The Government of India (Allocation of Business) Rules, 1961, with subsequent amendments, assigns the responsibility for compiling the WPI to the Office of the Economic Adviser in the Department of Industrial Policy and Promotion under the Ministry of Commerce and Industry. The Economic Adviser holds the final authority for all decisions regarding the WPI.

The national income deflator (GDP deflator) is a comprehensive measure statistically derived, from national accounts data released by the Central Statistical Organization (CSO). Since it encompasses the entire spectrum of economic activities including services, the scope and coverage of national income deflator is wider than any other measure. At present, the GDP deflator is available only annually with a long lag of over one year and hence has very limited use for the conduct of policy.

Q. What is the difference between wholesale price Index and consumer price Index?

Answer: WPI measures price rise at the wholesale level. Wholesale means sale in large quantities and meant for resale It covers a certain set of goods that are traded at the wholesale level. CPI on the other hand measures price rise at the retail level. There is a difference between the two. The difference is due to a number of factors. A substantial portion of the differential is accounted for by the retailers margins which are built into what the consumer pays. Besides, the way the two indices are calculated differs both in terms of weightage assigned to products as well as the kind of items included in the basket of products.
While wholesale prices are more or less the same throughout the country, consumer prices or retail prices vary across regions (rural and urban) and also across cities according to the consumer preferences for certain products, supplies and purchasing power. Besides, taxes levied by states comprise an important component of the variation in prices of many products. Therefore, give WPI an important place in government policy as it is more representative; figures come quickly relatively; and has an all India character.

Which Index Should One Use?

The WPI is useful in certain contexts. For example, for industrialists, the costs of setting up a factory over the course of several years; and further to calculate the costs of production and returns over several years. The basket of items in the CPI does not include machinery, chemicals, and so on; secondly, the price of electricity in the CPI is the consumer tariffs, not the industrial tariffs; and so on.

Figures for inflation in the WPI are on the average much lower than those in the CPI indices. There could be two reasons for this difference in rates between the WPI and CPI: first, prices of the items in the CPI basket might have risen more sharply than items excluded from it — this would mean that prices of mass consumption goods have risen more sharply than inputs for production; secondly, the retail prices of commodities might have grown more sharply than the wholesale prices, indicating that middlemen have taken a bigger share;

Services and Price Index

While the WPI now does not include services, the two consumer price indices (CPI) meant for urban non-manual employees and industrial workers, do include certain services such as medical care, education, recreation and amusement, transport and communi-cation. On the other hand, some of the other major services such as trade, hotels, financing, insurance, real estate and business services do not find a mention either in the WPI or in the CPIs.

In India, the services sector accounts for about 55 per cent of the GDP.

In 2010, Department of Industrial Policy and Promotion (DIPP), Ministry of Commerce & Industry constituted an Expert Committee to render technical advice for development of Service Price Index (SPI) and its related issues. The Committee is chaired by Prof. C.P. Chandrasekhar,

Producer Price Index

The process of introducing the producer price index (PPI) is also underway in India, according to Dr. Abhijit Sen, Member of Planning Commission. It means prices of goods as they are sold to the wholesalers by the producers. The difference between WPI and PPI is accounted for by the margins and other transport and distribution costs.

‘Core’ or’ Underlying Inflation’

Core or underlying inflation measures the long-run trend in the general price level. Temporary effects on inflation are factored out to calculate core inflation. For this purpose, certain items are usually excluded from the computation of core inflation. These items include: changes in the price of fuel and food which are volatile or subject to short-term fluctuations and/or seasonal in nature like food items. In other words, core or underlying inflation is an alternative measure of inflation that eliminates transitory effects. These price changes are not within the control of monetary policy as much as these are supply shocks.
The main argument here is that the central bank should effectively be responding to the movements in permanent component of the price level rather than temporary deviations.

Q. What do you mean by Inflation Targeting?

Ans. Inflation targeting focuses mainly on achieving price stability as the ultimate objective of monetary policy. This approach entails the announcement of an inflation target- either a number or a range, that the central bank promises to achieve over a given time period. The targeted inflation rate will be set jointly by the RBI and the government, although the responsibility of achieving the target would rest primarily on the RBI. This would reflect an active government participation in achieving the goal of price stability with fiscal discipline by way of a rational borrowing programme (not borrowing in excess).
Monetary policy and fiscal policy have to converge for achievement of inflation targeting. Advantage is that it promotes transparency in the conduct of monetary policy. Further, it increases the accountability of monetary authorities to the inflation objective.

Prices impact on the macro economy in many ways — welfare of people, growth and stability of the economy in a globalised order.

Q. What do you mean by Ideal Inflation Rate?

Answer : Ideal inflation rate is one that takes into consideration human, social and economic impact. It is the level of inflation beyond which the adverse consequences are strong. Chakravarty Committee (1985) had indicated 4 per cent as an acceptable level of inflation on a long-term basis. However, such a level of inflation cannot be fixed at one level for all times. It depends on growth rate. It also depends on what the global levels are. RBI sees about 5.5% rate of inflation as ‘comfortable’ neither does it hurt in human terms nor in growth terms.

Collection of Statistics Act, 2008

Collection of Statistics Act, 2008 was made to bring in new rules aimed at improving data collection.
Government will levy higher penalty for not sharing data and tougher punishment will be imposed in cases where manipulation of data is involved, they say.
Under the new Act, people or companies not divulging data would have to pay a fine of Rs 1,000 and they would be given a 14-day notice period to comply. If the information is not provided even after two weeks the penalty will rise to Rs 5,000 per day.
Under the old Act, which was passed in 1953, the penalty was only Rs 500 for the first default and Rs 200 per day thereafter.
The new penalty scheme will ensure that data collection is done on time. It will increase the accuracy of the data.
The Act also makes wilful manipulation or omission of data a criminal offence, punishable by a prison term that may extend up to 6 months. This penalty will also apply if a company prevents or obstructs any employee from collecting data.
The Collection of Statistics Act, 2008 gives powers to the government to classify any statistics as “core statistics” and also determine the method to collect and disseminate the same.

Q. What is Philips’s Curve?

Ans. The inverse relationship between rate of inflation and rate of unemployment is shown in the Phillips curve: price stability has a trade-off against employment. Some level of inflation could be considered desirable in order to minimize unemployment
Potential output (sometimes called the natural gross domestic product) is an important concept in relation to inflation. It is the level of GDP where the economy is at its optimal level of production, given various constraints- institutional and natural.
This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU. If GDP exceeds its potential, inflation will accelerate and if GDP falls below its potential level, inflation will decelerate as suppliers attempt to use excess capacity by cutting prices.

Go Back To Main Page