Inflation

Inflation means a peristent 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 1 to 5percent a year. Creeping inflation of 3 to 5 percent erodes the purchasing power of money when continued over many years, but it is "manageble". 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 universallly 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
reflation, which is an attempt to raise prices to counteract deflationary pressures.
Measures of inflation
GDP 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 the 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 price subsidization, profits, and taxes, mainly. Producer price inflation measures the price pressure due to increase in the costs of raw materials. It may absorbed by them or made up by increases in productivity or passed on 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 sles taxes. These are very similar to the Producer Price Indexes.
CPI
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 or industrial workers etc as in India.
Types of inflation based on causes
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 2006 and 2007, 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 refered 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 the first half of the decade saw rates come down and easy and cheap credit pushed up prices as demand grew.
Cost-push inflation: It is also refered 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 persistnt inflation caused by deficiencies in certain conditions in the economy such as a backward agricultural sector that is unable to respond to people'sincreased demand for food, inefficient distribution and storage facilities leading to artificial shortages of goods, and production of some goods controlled by some people.
High Inflation hurts
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 th 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 a wage 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 innvovation. 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 of deflation which is fall in average prices that 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 through zero rate of inflation is never preferred for the reasons cited elsewhere in the lesson.
Fiscal measures include reduction inn 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 availabe-import of wheat in India.
Administrative measures include implementation of dehoarding and anto-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. 3 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 of 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 1993-94. Wholesale prices of the products in the basket with their respective weightages in that year add upto "100". If, in 1993-94. the wholesale price of gur was Rs 2 a kg, and rose by 50 paise the following year, it would mean that the wholesale price index for gur would rise to 125 in 1994-95. But the movement of an index is based on the average of price movement of all the goods in the basket. Different base years are used for different price indices due to convenience, data availability, logistics etc.
WPI
The wholesale Price Index
The WPI, published weekly by the Ministry of Commerce and industry, with a two week lag, tracks the wholesale traded price of 435 items that include agricultural commodities (such as rice, tea, raw cotton, groundnut oil seed), industrial commodities (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 an indicator. designed to measure the changes in the price levels of commodities that flow into the wholesale trade. The index is a vital guide in economic analysis and policy formulation. WPI covers primary goods, power/fuel and manufactured goods.
The WPI is not intended to capture the effect of price rise on the consumer though it generally and broadly indicates it.
The Wholesale Price Index Series with 1993-94 base year
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 economy.
With a view to reflecting adequately the changes that have taken place in the economy since 1981-82 (the earlier base year), the Government shifted the base year to 1993-94. The new series with 1993-94 as the base took effect from 1-4-2000. To reflect the structural changes in the economy that have taken place over a decade, a large number of commodities have been added and a few with diminished importance have been dropped. In the revised series, there are 435 items in the commodity basket. "Primary Articles" contribute 98 items, "Fuel, Power, Light and Lubricants" 19 items, and "Manufactured Products" provide 318 items. The number of price quotations is 1918 quotations.
WPI is compiled on weekly basis with a time lag of two weeks. 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 year.
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.
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.
Generally, the WPI and the CPI move together except when the food prices have moved fast when the CPI is more than the WPI as in India in 2009 in a pronounded manner when WPI is in negative territory and CPI is above 10%.
Limitations on WPI
According to a Government appointed committee that examined the WPI and submitted its report in 2008, the accuracy of WPI is unsatisfactory. The items that are considered for the WPI and their respective weights were fixed in 1999-2000 and have not been revised since then though there have been major changes in the economy over the last decade. Services such as rail and road transport, helth care, postal, banking and insurance, for example, are not part of the WPI basket. Neither are the products of the unorganised sector that are estimated to constitute about 32% 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. Many of the goods in the WPI basket are not used so much any more.
The practices surrounding the gathering of data and generation of the index are not satisfactory either. Two-thirds of the price quotations are sourced from only four metros. Price reporting by manufacturers is voluntary and often not forthcoming. Scrutiny of data by the collection agency is lax.
Government set up Abhijit Sen committee on revising the WPI and it proposed to almost treble the number of items in the wholesale price index (WPI) and modify the weights attached to different items in keeping with the changed structure of the economy. the base year is also to be brough forward to 2004-05.
CPI
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 commoditier; for Agricultural Labourers (CPL-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.
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 son or items the office-goer would buy.
The coverage of CPI IW is broa-qer than the other indices of CPI like the CPI for agricultural laborers (AL) and the CPI for urban non-manual employees (UNME).
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 is 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 Ckrived from national accounts data released by the Central Statistic 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 or over one year and hence has very limited use for the conduct of policy.
Difference between wholesale prices and consumer prices
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 urbaan) and also across cities according to the consumer preferences for certain products, supplies and purchasing power. Besides, taxes leview 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; figues 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 CPl indices. There could be two reasons for this differenceln 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 or commodities might have grown more sharply than the wholesale prIces. indicating that middlemen have taken a bigger share.
Services and price index
In a bid to obtain a 'true picture' of the effect of price changes on the economy. the Union Finance Ministry has proposed the inclusionof services in the Wholesale Price Index (WPI) which is used to measure point-to-point inflation.
While the WPI now does not include services, the two consumer price indices (CPI) categorised for urban non-manual employees and industrial workers, do unclude certain services such as medical care, education, recreation and amusement, transport and communication. On the other hand some services do not find a mention either in the WPI or in the CPIs.
In India, the services sector accounted for 54% of the GDP.
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 ro.rby the margins and other transport and distribution costs-
Inflation in India today
India's inflation rate went into negative figures and India entered into deflation for the time in 30 years in June 2009- inflation stood at minus 1.61% for the week ended June 6 . 2009. It is the continuation of the trend that started in August 2008 when inflation peaked at 13% on the WPI However, it is a statistical deflation as the high base on 2008 makes the price rise look negative. Also, average price rise is negative due to preponderance of industrial goods in WPI. But food prices are rising and the CPI is above 10%. Thus, the drop in the demand for industrial goods is captured by the WPI but not wage goods and food.
The drop in prices is attributed to
Slackening demand globally and nationally
Commodity prices fell since last year rude etc
Excise duty and.service tax rates came down
Job losses and decline in demand
Ideal level of Inflation
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% as an acceptable level of inflation on 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 on human terms nor growth terms.
'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 excuded form 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 good 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 inasmuch as these are supply shocks.
Inflation Targeting
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.
Philips's curve
The inverse relationship between rate of inflation and rate of unemployment is shown in the PhiIfips curve: price stabilityhas a trade-off against employment. Some level ofinflation could be considered desirable in order to minimize unemployment.
totential 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- institutiQIlal 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 GOP falls below its potential level , inflation will decelerate as suppliers attempt to use excess capacity by cutting prices.
Deflation
Deflation is a prolonged and widespread decline in prices that causes consumers and businesses to curb spending as they wait for prices to fall further. It is the opposite of inflation, when prices rise, and should not be confused with disinflation, which merely describes a slowdown in the rate of inflation.
Deflation occurs when an economy's annual headline inflation indicator-typically the consumer price index - entes negative territory.
Deflation is hard to deal with because it is self-reinforcing. Put simply, unless it is stopped early. deflation can breed deflation, leading to what is known as a deflationary spiral.
When an economy has .fallen into deflation, demand from businesses and consumers to buy products falls because they expect to pay less later as prices fall. But as producers struggle to sell and go bankrupt, unemployment rises, reducing demand further. That causes deflation to become more pronounced.
It makes it more expensive to service existing debts. This is as true of governments, who have borrowed trillions of dollars globally to prop up the financial sector, as it is for consumers.
As debt becomes more expensive to payoff, the risk of default and bankruptcy rises too, making banks more wary of lending. This reduces demand and further exacerbates the deflationary problem.
Remedy
Tax cuts to boost demand from consumers and businesses
Lowering central bank interest rates to encourage economic activity
Printing more currency to boost money supply
Capital injections into the banking system
Increase government spending on projects that boost the return on private investment
India did not face the threat of deflation as demand has not dropped so much. Also, food scarcity meant food prices did not fall. In fact they rose.