Inflation

Inflation

This article deals with ‘Inflation.’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.


What is inflation?

  • Inflation can be defined as the persistent rise in the general level of prices of goods and services in an economy over a period of time
  • 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. 


Why does Inflation occur?

Inflation

1. Demand-pull  inflation

  • In his book “General Theory on employment, interest, money”, British Economist J.M. Keynes (1883) said, “when the economy is functioning at full employment, aggregate supply will match aggregate demand.” The economy will have a ‘General Price’ level at this equilibrium. 
  • Demand-pull Inflation happens when aggregate demand exceeds aggregate supply.   
  • It can happen (i.e. demand can exceed supply) in the following situations 
    1. Increase in money supply due to RBI’s expansionary or easy money policy.
    2. Increase in the propensity to consume.
    3. Increase in investment expenditure.
    4. Increase in the fiscal deficit of the governments.
    5. Increase in net exports.
  • To tackle such Inflation, the government can
    1. Reduce money supply by increasing interest on loans. 
    2. Induce people to save rather than consume by giving attractive investment options.
    3. Follow Fiscal Consolidation and keep fiscal deficit in check.
    4. Import goods in short supply.

2. Cost-push inflation

  • It is also known as supply shock inflation. 
  • When supply is reduced due to an increase in the price of raw material leading to a higher cost of production. 

3. Profit Push inflation

  • When Cartels, Monopolists, or Oligopolists deliberately cut their supply or hoard their produce or hike the price in greed of more profit.
  • E.g., OPEC increases the price of Petroleum or greedy Indian Merchant hoarding onion so that their price increases. 

4. Structural inflation

  • It is caused by deficiencies in certain conditions in the economy when it cannot respond to people’s increased demand for certain specific things or a lack of infra to make commodities available to consumers.

5. Repressed Inflation

  • During wars or natural disasters, governments impose price controls and rationing measures to keep prices in check. But after the controls are withdrawn at the end of war or disaster, prices will rise rapidly as traders try to cover up their earlier losses, leading to inflation. 

6. Other causes

  • The depreciation of Rupees makes the import of goods expensive.

Post Covid-19 Case Study

After the Covid-19 pandemic, high inflation was observed because 

  • Demand-push inflation was observed as most countries were following easy money policy and providing loans at low rates.
  • Repressed inflation was observed due to the pent up demand of the customers.
  • Cost-push inflation was observed due to an increase in the price of raw materials owing to supply chain disruptions. 
  • Profit-push inflation was observed in petroleum products because OPEC+ didn’t increase the supply of crude oil commensurate with the increase in demand.

Types of Inflation based on speed

Types of Inflation based on speed

1. Creeping Inflation

  • Inflation up to 4% (for the Indian economy).
  • It is regarded as safe and essential for job creation and economic growth.


2 . Walking

  • Inflation of more than 4% but limited to single-digit only.

3 . Galloping Inflation

  • Very high inflation in the range of double-digit or triple digits.
  • Examples : 
    1. In the 1970s and 1980s, Latin American countries such as Argentina, Chile and Brazil faced Galloping Inflation in the range of 50 to 700 per cent. 
    2. After the disintegration of the ex-USSR in the early 1990s, the Russian economy faced such inflation.

4 . Hyperinflation Inflation

  • In Hyperinflation, annual inflation rates are in million or even trillion. Prices of goods shoot up overnight.
  • Examples
    1. Germany during Great Depression when Deutsche Mark became worthless. 
    2. In recent times, Zimbabwe and Venezuela faced Hyperinflation.


Some definitions

1. Deflation

  • Persistent fall in the level of prices of goods and services.

2. Disinflation

  • Reduction in rate of inflation.

3. Stagflation

  • Stagflation is the combination of inflation & unemployment due to recession. 
  • Stagflation is the economic construct developed post the first oil shock of the early seventies when US inflation had soared to 11.5 per cent, even as the unemployment rate spiked to 9 per cent.

4. Reflation

  • Attempt to raise the price to counteract deflationary pressures.

5. Skewflation

  • Episodic price rises in one or a small group of commodities while inflation in the remaining goods and services remains the same. E.g., the episodic rise in the price of onions or tomatoes or pulses.

Impacts of Inflation

Inflation hurts following groups

Inflation hurts following groups
  • People on fixed income, pensioners and bondholders suffer because their income remains fixed while money’s purchasing power is reduced due to inflation.
  • Consumers suffer because price rise means more money being paid by consumers for what they buy. 
  • Lenders suffer because the money they will get back will have less purchasing power. (Note – Inflation favours the Debtors over the Lenders).
  • Importers suffer because inflation leads to currency depreciation, increasing the cost of imports. 
  • Taxpayers suffer as they have to pay more direct and indirect taxes. As indirect taxes are imposed ad valorem (on value), increased prices of goods make taxpayers pay increased indirect taxes. Similarly, the direct tax increases due to inflation as the taxpayer’s gross income moves to the upward slabs of tax brackets.

Inflation benefits following groups

Inflation benefits following groups
  • Businessmen make huge profits because the final product price rises faster than the price of raw materials.
  • Borrowers benefit as they have to return the same money, but it has less purchasing power. 
  • Government is the biggest beneficiary as it is the biggest borrower. Due to inflation, they have to pay back lesser in real terms.
  • Exporters benefit because the depreciation of currency leads to cheaper exports. 

Is inflation good or bad?

Controlled inflation (between 2 to 6% for India) is desirable & good for economy. Producers & traders make reasonable profits encouraging them to invest. But inflation above safe levels, i.e. 6% for India, hurt the economy negatively.


Philip’s Curve

  • It is a graphic curve showing a relationship between inflation and unemployment
  • Economist William Philips said there is a ‘trade off’ between inflation and unemployment.
    • When inflation increases correspondingly, unemployment decreases. 
    • When inflation decreases, unemployment increases. 
Philip's Curve
  • This idea became popular in the early 1960s when economists started to argue that unemployment could be checked forever at the cost of slightly higher inflation. Central Banks around the world began to make monetary policies accordingly. 
  • But in the 1970s, this idea was challenged because countries that followed the above policies suffered high inflation as well as unemployment in the long run. American economists Milton Friedman and Edmund Phelps argued that the trade-off between inflation and unemployment was only short-term. Once people expect higher inflation, they start to demand higher wages, and thus unemployment will rise back to its ‘natural rate’.

Index Theory

  • Inflation means a general rise in the price of goods and services. But rise against what? There should be some Base Year for that against which increase in prices of goods and services are measured. 
Index Theory of Inflation
  • The relative importance of all the goods and services is not the same. We cant equate rice and onion with shoes. Shoes are bought once in a while, but eatables are bought frequently, and their price rise hurts more. Hence, according to their relative importance, weight has to be assigned to all goods and services. 
  • Hence, the Laspeyres formula is used to calculate WPI, CPI and IIP index, which is a weighted arithmetic mean of a basket of commodities that tracks price/production level against the base year.
Laspeyres formula  in calculating Inflation
  • The inflation rate is calculated using change in Laspeyres Index in a particular month of the year compared to that of the same month of the previous year.
 Laspeyres Index in INflation

Base Years

Base Years for different Indexes are different

  Base Year Who
CPI 2012 NSO (under MoSPI)
WPI 2011 Economic Advisor, DPIIT
IIP 2011  NSO
Side Note: GDP 2011 NSO


Index 1: Consumer Price Index (CPI)

  • CPI measures inflation using the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
  • There are different types of CPIs released by various agencies, as given below.
  Released by Base Year
CPI
(1) Rural 2) Urban 3) All India)
NSO 2012
Consumer Food Price Index (CFPI) NSO 2012
CPI (Industrial Worker) Labour Ministry 2016
CPI (Agricultural Labourer) Labour Ministry 1986
CPI (Rural Labourer) Labour Ministry 1986

CPI (All India)

  • CPI (All India) is released by NSO with the base year of 2012.
  • It is the headline CPI inflation of India. 
  • Monetary Policy Committee uses CPI (All India) under its Inflation Targeting Mechanism.

CPI (Rural) and CPI (Urban)

  • Since the basket of goods used by people living in rural and urban areas differ, NSO also releases CPI (Rural) and CPI (Urban) to show the inflation in these areas separately.
  • These are also released by NSO, with 2012 as the base year. But, weightage assigned to different goods varies in accordance with the relative importance of goods used in these areas.

Basket of Goods and Weightage assigned

Component CPI (All India) weight CPI (Rural) weight CPI (Urban) weight
Food and beverages 45.86 34.18 36.29
Pan, tobacco and intoxicants 2.35 3.26 1.36
Clothing and Footwear 6.53 7.36 5.57
Housing 10.07  —- 21.67
Fuel and Light 6.84 7.94 5.50
Miscellaneous 28.32 27.26 29.53
Total 100 100 100

Consumer Food Price Index (CFPI)

  • If only the Food Component is seen, we get Consumer Food Price Index (CFPI).

Core Inflation

  • CPI minus Food and Fuel component is called Core Inflation.

Trends in CPI in recent times

Trends in CPI

CPI Old Indexes

1 . CPI-IW

  • It is Consumer Price Index for Industrial Workers
  • It is compiled by the Ministry of Labour
  • The base year of CPI (IW) is 2016. 
  • The basket of goods includes 370 goods. 
  • Use: It is used as the cost of living index in the organised sector. Dearness Allowance (DA) is calculated using this.

2 . CPI-AL

  • It is Consumer Price Index for Agricultural Labourers.
  • It is compiled by the Ministry of Labour
  • The base year of CPI (AL) is 1986 (the plan is to change it to 2019). 
  • The basket of goods includes 60 goods. 
  • Use: MNREGA wages are indexed to this.

3 . CPI – RL

  • It is Consumer Price Index for Rural labourers.
  • It is compiled by the Ministry of Labour
  • The base year of CPI (AL) is 1986 (the plan is to change it to 2019). 

Side Topic: Price Stabilization Fund

  • The government started the Price Stabilisation Fund with the corpus of ₹500 Crore in 2015 to fight Food Inflation.
  • Under this, Union gives interest-free advances to states to buy onion, potatoes, pulses etc., from farmers and maintain their supply in urban areas to stabilise prices. 


Thalinomics: Economics of a plate of food in India

Thalinomics
  • Thalinomics refers to the economics of a plate of food in India.
  • According to Economic Survey (2020), the price of Thali has reduced across all regions for both vegetarian and non-vegetarian thalis from 2015 to 2018. Hence, Thali’s affordability has increased for low-income families. The average yearly gain to the household of 5 individuals due to reduced prices is around Rs. 11,000.
  • The affordability of Thalis vis-à-vis a day’s worker’s pay has improved over time, indicating improved welfare of the ordinary person.
  • The decrease in the price is due to various reform measures taken in 2015 and afterwards, such as Pradhan Mantri Annadata Aay SanraksHan Abhiyan (PM-AASHA), Pradhan Mantri Krishi Sinchai Yojana (PMKSY), Pradhan Mantri Fasal Bima Yojana (PMFBY), Soil Health Card, e-NAM, National Food Security Mission (NFSM) and National Food Security Act (NFSA).


Index 2: Wholesale Price Index

  • The wholesale Price Index (WPI) is the price of a representative basket of wholesale goods. It reflects changes in the average prices of goods at the wholesale level — commodities sold in bulk and traded between businesses or entities rather than goods bought by consumers. 
  • It is released by Economic Advisor to the Department for Promotion of Industry and Internal Trade (DPIIT) under the Commerce Ministry. 
  • In 2017, the Base year was changed to 2011 (earlier was 2004). 
  • The basket of goods and the weight assigned to them while calculating WPI is as follows 
Component Weightage
Manufactured Products 64.23
Primary Articles 22.62
Fuel and Power 13.15
  • Earlier, indirect taxes were also counted in price while calculating the price. Other countries ignore indirect tax and transportation while measuring Producers Price Index (PPI). But in India, by including Indirect Taxes, we get inflation wrt wholesale buyers and not producers. In 2017, India fixed this anomaly, and now, while calculating WPI, the price without indirect tax is taken into consideration (although the Cost of Transportation is still there).

Trends in WPI in recent times

Trends in WPI


CPI-WPI Divergence

Recently, CPI and WPI have seen large divergence, as shown in the following graph. This divergence can be explained as follows

CPI-WPI Divergence

Index 3: Index of Industrial Production (IIP)

  • IIP is a monthly index prepared by NSO that tracks manufacturing activity in different sectors of an economy.
  • Its Base Year is 2011.
  • Various components and the weight assigned to them are as follows 
Manufacturing 78%
Mining 14%
Electricity 8%
  • Another way in which IIP is categorised is USE BASED CATEGORISATION. Weightage given to different categories in this is as follows
Primary goods 34.22%
Intermediate goods 17.22%
Capital goods 8.22%
Infrastructure goods 12.34%
Consumer durables 12.84%
Consumer nondurables 15.33%

Index of 8 Core Industries

  • Within  IIP , 8 industries are considered as core industries because they impact all other economic activities .
  • Eight Core Industries comprise 40.27 % of the weight of items included in the IIP.
  • It comprises of eight industries as follows 
    • Coal (weight: 10.33%)
    • Crude Oil (weight: 8.98 %)
    • Cement (weight: 5.37%)
    • Fertilizer (weight: 2.63 %)
    • Electricity (weight: 19.85%),
    • Refinery Products (weight: 28.04%)
    • Natural Gas (weight: 6.88 %)
    • Steel (weight: 17.92%)


Other Indexes

1. Producer Price Index

  • It measures the prices of goods and services as they are sold to the wholesaler by producers.
  • It is measured from the perspective of the producer, while WPI is measured from the perspective of the wholesaler.  
  • It covers both goods and services. (WPI only covers goods)
  • It is a better indicator than CPI because CPI includes subsidies provided by the government. Hence, it doesn’t give a clear trajectory of prices of factors of production. 
  • Abhijit Sen Committee has recommended the introduction of PPI in India.

2. Service Performance  Indices

  • Any of the above indexes do not implicitly measure inflation of the service sector.
  • Chandrasekhar Committee suggested starting Service Performance Indices. As a result, the following indices have been started
Railways SPIs Measures Inflation in freight and passenger services
Banking SPIs Measures Inflation in services for which banks charge fees, commissions, brokerage, etc.
Postal SPIs Measures Inflation in services provided by  Department of Posts  (private postal services are not taken in account)
Telecom SPIs Inflation in cellular services on the basis of TRAI report.

3. Residex

  • Residex is released by the National Housing Bank (NHB).
  • It has 2017-18 as its base and data is released on a quarterly basis.
  • It measures inflation in Housing prices in 26 cities.

4. Baltic Dry Index

  • Baltic Dry Index is released by London Stock Exchange.
  • It measures the cost to transport raw material by sea.
  • Conclusions that can be drawn from it are
    • Increase = World Economy will grow.
    • Decrease = World Economy will slowdown.