Inflation

The simplest definition is Inflation is “a rise in the general level of prices”. By the term general, we mean 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. The opposite of inflation is deflation which means a fall in the general level of prices.

Types of inflation on the basis of rising prices or rate of inflation

1. Creeping Inflation:

When prices are gently rising, it is referred as Creeping Inflation. It is the mildest form of inflation and also known as a Mild Inflation or Low Inflation. When prices rise by not more than (upto) 3% per annum (year), it is called Creeping Inflation.

2. Chronic Inflation:

If creeping inflation persist (continues to increase) for a longer period of time then it is often called as Chronic or Secular Inflation. Chronic Creeping Inflation can be either Continuous (which remains consistent without any downward movement) or Intermittent (which occurs at regular intervals). It is called chronic because if an inflation rate continues to grow for a longer period without any downturn, then it possibly leads to Hyperinflation.

3. Walking Inflation:

When the rate of rising prices is more than the Creeping Inflation, it is known as Walking Inflation. When prices rise by more than 3% but less than 10% per annum (i.e between 3% and 10% per annum), it is called as Walking Inflation. According to some economists, walking inflation must be taken seriously as it gives a cautionary signal for the occurrence of running inflation. Furthermore, if walking inflation is not checked in due time it can eventually result in Galloping inflation.

4. Moderate Inflation:

Concept of Creeping and Walking inflation clubbed together are called Moderate Inflation. When prices rise by less than 10% per annum (single digit inflation rate), it is known as Moderate Inflation. It is a stable inflation and not a serious economic problem.

5. Running Inflation:

A rapid acceleration in the rate of rising prices is referred as Running Inflation. When prices rise by more than 10% per annum, running inflation occurs. Though economists have not suggested a fixed range for measuring running inflation, we may consider price rise between 10% to 20% per annum (double digit inflation rate) as a running inflation.

6. Galloping Inflation:

If prices rise by double or triple digit inflation rates like 30% or 400% or 999% per annum, then the situation can be termed as Galloping Inflation. When prices rise by more than 20% but less than 1000% per annum (i.e. between 20% to 1000% per annum), galloping inflation occurs. It is also referred as jumping inflation. India has been witnessing galloping inflation since the second five year plan period.

7. Hyperinflation:

Hyperinflation refers to a situation where the prices rise at an alarming high rate. The prices rise so fast that it becomes very difficult to measure its magnitude. However, in quantitative terms, when prices rise above 1000% per annum (quadruple or four digit inflation rate), it is termed as Hyperinflation.
During a worst case scenario of hyperinflation, value of national currency (money) of an affected country reduces almost to zero. Paper money becomes worthless and people start trading either in gold and silver or sometimes even use the old barter system of commerce. Two worst examples of hyperinflation recorded in world history are of those experienced by Hungary in year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe’s regime.

Causes of Inflation

There is not a single, agreed-upon factor, but there are a variety of variables, all of which play

some role in inflation:

1. Demand-Pull Effect

The demand-pull effect states that as wages increase within an economic system (often the case in a growing economy with low unemployment), people will have more money to spend on consumer goods. This increase in liquidity and demand for consumer goods results in an increase in demand for products. As a result of the increased demand, companies will raise prices to the level the consumer will bear in order to balance supply and demand.
The Money Supply: Inflation is primarily caused by an increase in the money supply that outpaces economic growth. Ever since industrialized nations moved away from the gold standard during the past century, the value of money is determined by the amount of currency that is in circulation and the public’s perception of the value of that money. When the Federal bank of a country decides to put more money into circulation at a rate higher than the economy’s growth rate, the value of money can fall because of the changing public perception of the value of the underlying currency. As a result, this devaluation will force prices to rise due to the fact that each unit of currency is now worth less.
One way of looking at the money supply effect on inflation is the same way collectors value items. The rarer a specific item is the more valuable it must be. The same logic works for currency; the less currency there is in the money supply, the more valuable that currency will be. When a government decides to print new currency, they essentially water down the value of the money already in circulation. A more macroeconomic way of looking at the negative effects of an increased money supply is that there will be more dollars chasing the same amount of goods in an economy, which will inevitably lead to increased demand and therefore higher prices.
A reduction in direct or indirect taxation: If direct taxes are reduced consumers have more disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond potential GDP
Rising consumer confidence and an increase in the rate of growth of house prices.

2. Cost-Push Effect

Another factor in driving up prices of consumer goods and services is explained by an economic theory known as the cost-push effect. Essentially, this theory states that when companies are faced with increased input costs like raw goods and materials or wages, they will preserve their profitability by passing this increased cost of production onto the consumer in the form of higher prices. Cost push inflation can be caused by many factors.
Rising wages Rising wages are a key cause of cost push inflation because wages are the most significant cost for many firms. Higher wages may also contribute to rising demand.
Import prices.

Raw Material Prices.

Profit Push Inflation:

When firms push up prices to get higher rates of inflation. This is more likely to occur during strong economic growth.

Declining productivity:

If firms become less productive and allow costs to rise, this invariably leads to higher prices.
An increase in world oil prices is a major contribution in cost push in oil importing countries.

Higher taxes:

If the government put up taxes, such as VAT and Excise duty, this will lead to higher prices, and therefore CPI will increase.

3. Exchange Rates

Inflation can be made worse by Country’s increasing exposure to foreign marketplaces. When the exchange rate suffers such that the Rupees has become less valuable relative to foreign currency, this makes foreign commodities and goods more expensive to Indian consumers while simultaneously making Indian. goods, services, and exports cheaper to consumers overseas.
This exchange rate differential between a country’s economy and that of its trade partners can stimulate the sales and profitability of Indian corporations by increasing their profitability and competitiveness in overseas markets. But it also has the simultaneous effect of making imported goods, more expensive to consumers in the India.

4. The National Debt

A country in National debt has two options: they can either raise taxes or print more money to pay off the debt.
A rise in taxes will cause businesses to react by raising their prices to offset the increased corporate tax rate. Alternatively, should the government choose the latter option, printing more money will lead directly to an increase in the money supply, which will in turn lead to the devaluation of the currency and increased prices.

5. Other Reasons:

These are mostly local factors

• Lack of competition in the market between firms i.e monopoly power either being a single large firm or due to cartelization, will give price making ability. This will result in higher costs of other firms.
• Trade Unions one of the major contributor increase costs by demanding a wage increase without increasing productivity. As a result costs of production increase which increase price level further and a wage price spiral starts.
• During a boom too much profiteering by some large firms increase costs of production of other firms often referred as profit push inflation.
• Sometimes artificial shortage (hoarding) or genuine shortage of an essential good can create a generalized increase in costs.
• Demand pull inflation will lead to cost push inflation. If prices of factors of production increase due to demand pull it will push costs of the firms up.
• Failure of Monsoon in country.

Effects of Inflation :

1. Impact of Inflation on Savers/Borrowers:

•  Inflation encourages current consumption (buy goods and services now before prices rise) and discourages savings.
• People with savings suffer in times of inflation as the purchasing power of their savings decreases as price levels rise.
• The real rate of interest (nominal rate less the inflation rate) is reduced in times of inflation.
• Real interest rates may be negative if inflation rate is greater than the interest rate. If so the purchasing power of savings declines. This discourages savings.

People who have borrowed money benefit as the real value of loans decreases as price levels rise (loans are easier to repay in the future as prices and income rise over time).

• Borrowers benefit as inflation reduces the real value (the purchasing power) of the money they owe.
• People who have borrowed money benefit as the real value of loans decreases as price levels rise (loans are easier to repay in the future as prices and income rise over time).

2. Growth and Employment

High levels of inflation reduce confidence and increase uncertainty (difficult to predict the future).
This reduces investment, increases levels of imports, reduces exports, depreciates the value of the local currency, increases unemployment and reduces economic growth. (Increasing prices together with rising unemployment is referred to as “stagflation”.).

3. Business Planning and Investment:

Inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs – and this may reduce planned investment spending.

4. Damage to export competitiveness:

High rate of inflation will hit hard the export industry in the economy. The cost of production will rise and the exports will become less competitive in the international market. Thus, inflation has an adverse effect on the balance of payments.

5. Social unrest:

High rate of inflation leads to social unrest in the economy. There is increase dissatisfaction in among the workers as they demand higher wages to sustain their present living standard. Moreover, high rate of inflation leads to a general feeling of discomfort for the household as their purchasing power is consistently falling.

6. Market efficiency:

Inflation distorts the price signals to the market and causes inefficient allocation of resources.
Resources are often allocated to speculative assets (precious metals, shares on the stock market, antiques etc) whose nominal value rises with inflation, but do not add to the levels of output and employment in a country.

7. Interest rates:

The Central Bank might use monetary tools to control high inflation rate by increasing interest rates. This will increase the cost of borrowing and will have a negative effect on both consumption and investment.
8. Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those who borrow, this is similar to getting an interest-free loan.

9. Inflation leads to balance of payments problems. When domestic prices rise faster than prices in foreign countries, exports tend to lag behind imports. The, rate of exchange also tends to depreciate both on account of falling purchasing power of currency within the country and adverse balance of payments. In some cases, there may also be an outflow of capital. A developed country may be able to handle the problem of adverse balance of payments through structural adjustment, but a developing country is not able to do so easily because they suffer from large institutional and other rigidities.
10. Inflation distorts the financial system of the country. In its initial stages, the system is able to withstand its adverse effect because the financial institutions by their very nature tend to ignore the purchasing power of money and operate with reference to interest rates and maturity of financial instruments. However, when inflation gathers strength, the financial system cannot withstand it and collapses.

11. Hidden tax:

Inflation is a hidden tax as it leads to fall in purchasing power of money. It happens particularly when authorities resort to deficit spending when their tax receipts lag behind and their expenditure does not decrease. The taxpayers therefore lose on account of reduced purchasing power of their money incomes. In other words, the authorities are able to collect resources from the taxpayers without specifically levying additional taxes on them. When prices rise, the fixed income earners find that the purchasing power of their money incomes is falling while the real income of the profit earners is increasing. When inflation becomes still stronger, the holders of financial wealth also lose. This way, inflation is a hidden tax by entrepreneurs on consumers and on recipients of contractual incomes.

12. The Good Aspects of Inflation:

A healthy rate of inflation is considered to be approximately 2-3% per year. The goal is for inflation (which is measured by the Consumer Price Index, or CPI) to outpace the growth of the underlying economy (measured by Gross Domestic Product, or GDP) by a small amount per year.
A healthy rate of inflation is considered a positive because it results in increasing wages and corporate profitability and keeps capital flowing in a presumably growing economy. As long as things are moving in relative unison, inflation will not be detrimental.
Another way of looking at small amounts of inflation is that it encourages consumption. For example, if you wanted to buy a specific item, and knew that the price of it would rise by 2-3% in a year, you would be encouraged to buy it now. Thus, inflation can encourage consumption which can in turn further stimulate the economy and create more jobs

Trend in Inflation

Headline WPI inflation, which reflects prices of tradeables, has moderated in 2013-14 to 5.98 per cent, falling from between 7 and 9 per cent over the previous two years This is due to weak post-crisis global demand and lower international commodity prices, as well as a sharp seasonal correction in vegetable prices.
5 Food inflation has remained a major driver of inflation since 2011. Seasonal factors accentuated food inflation which rose to double digits in early 2013-14, before moderating to an average of 6.22 per cent (WPI) and 9.22 per cent (CPI-NS) in the last quarter, because of high growth in the agricultural sector and a normal and well-distributed monsoon. The divergence in WPI and CPI inflation is primarily on account of higher weightage given to food articles in the consumer price indices.
Retail inflation as reflected in consumer price index (CPI) inflation has remained persistently over 8 per cent since 2011, going up above 10 per cent in 2012-13. This trend is largely attributed to high and sustained food inflation, which has only moderated in Q4 2013-14 causing consumer inflation to fall marginally to between 9 and 10 per cent in late FY 2013-14.
The largest contribution to headline WPI inflation in India has been from food and fuel.
WPI food inflation has remained persistently high during 2013-14, reaching a peak of 11.95 per cent in Q3. This was led by high inflation in cereals, vegetables, and eggs, fish and meat. Spike in prices of fruits and vegetables was mainly owing to seasonal factors.
Inflation in non-food manufactured (NFM) commodities, i.e core inflation, remained benign at around 2.5-3.5 per cent throughout the year on account of lower international prices and growth slowdown. Unlike the inflation in food and fuel, inflation in NFM inched up partly on account of wearing off of base effect and inflationary pressure within the chemicals, machinery and textile groups.
Measures Taken and Proposed by the Government to Contain Price Rise :

1. Fiscal Measures

Import duties for wheat, onions, pulses, and crude palmolein were reduced to zero and 7.5 percent for refined vegetable & hydrogenated oils.
Duty-free import of white/raw sugar was extended up to 30 June 2012; presently the import duty has been fixed at 10 per cent.

2. Administrative Measures

Ban on exports of onions was imposed for short periods of time whenever required. Exports of onions were calibrated through the mechanism of minimum export prices (MEP).
Futures trading in rice, urad, tur, guar gum and guar seed was suspended.
Exports of edible oils (except coconut oil and forest-based oil) and edible oils in blended consumer packs up to 5 kg with a capacity of 20,000 tons per annum and pulses (except Kabuli chana and organic pulses and lentils up to a maximum of 10,000 tonnes per annum) were banned.
Stock limits were imposed from time to time in the case of select essential commodities such as pulses, edible oil, and edible oilseeds and in respect of paddy and rice up to 30 November 2013.

3. Measures to Insulate the Vulnerable Sections

The central issue prices (CIP) for rice (at Rs 5.65 per kg for below poverty line [BPL] and Rs 3 per kg for Antodaya Anna Yojana [AAY] families) and wheat (at Rs 4.15 per kg for BPL and Rs 2 per kg for AAY families) have been maintained since 2002.
Under the targeted PDS (TPDS) allocation of foodgrains is being made to 6.52 crore AAY and BPL families at 35 kg per family per month at a highly CIP.
The government has allocated rice and wheat under the Open Market Sales Scheme (OMSS).
The scheme for imports of pulses which envisaged imports for distribution to BPL households through the PDS with a subsidy of Rs 10 per kg operated from November 2008 to June 2012. The government has decided to implement a varied form with a subsidy element of Rs 20 per kg per month for BPL cardholders for the residual part of the current year. The targeted BPL cardholders will be as estimated by the Department of Food and Public Distribution.
The Scheme for Distribution of Subsidized Imported Edible Oils has been implemented since 2008-9 through state/union territory (UT) governments for distribution of 1 litre per ration card per month with a central subsidy of Rs 15 per kg. The scheme has been extended up to 30 September 2013.

4. Budgetary and other Measures

A number of measures were announced in Union Budget 2012-13 to augment supply and improve storage and warehousing facilities. The government launched a National Mission for Protein supplements in 2011-12 with an allocation of Rs 300 crore. To broaden the scope of production of fish to coastal aquaculture, apart from fresh water aquaculture, the outlay in 2012-13 was stepped up to Rs 500 crore. Recently the government permitted FDI in multibrand retail trading. This will help consumers and farmers as it will improve the selling and purchasing facilities.

5. Monetary Measures

The RBI had also taken suitable steps to contain inflation with 13 consecutive increases by 375 basis points (bps) in policy rates from March 2010 to October 2011.
Priorities before Government to Contain Inflation:
The strategy to control inflation has to take into account the following factors:
1. Move to market prices: It is important to be cognizant of the fact that deregulation of diesel prices, power–sector reforms, and generally the move from administered to market-determined prices will release suppressed inflation in the short run. Nevertheless, the consequent reduction in subsidy and fiscal deficit will have the salutary effect of reducing inflation
2. Improving efficiency of public programmes and breaking the wage-price spiral: The projects selected for schemes like the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) do not improve the productivity of the agricultural sector commensurately. The increasing wages under such schemes have reportedly created shortage of labour in the agricultural sector as well as caused a wage-price spiral. The solution lies in selection of productivity enhancing projects for ambitious public policy programmes like the MGNREGS.
3. Rationalization of government support to farmers: If the policy of supporting farmers through MSP and procurement is to continue, the MSP should be scrupulously linked to the cost of production. Procurement should not be open-ended, and the practice of some state governments of charging as high as 14-15 per cent mandi fee/tax and paying high bonuses over and above the MSP must be discouraged. Experience has shown that the Food Corporation of India (FCI) has not been able to release enough stocks in the market to soften cereal prices while recovering its economic cost. While farmers can be incentivized by gradually removing restrictions on exports, the FCI can learn to procure stocks from markets more efficiently and manage risks through the futures market.
4. Role of APMC Acts: The State Agricultural produce marketing committee (APMC) Acts have created monopolies and distributional inefficiencies. They constitute a major roadblock in the way of creating a national market for agricultural commodities. Apart from breaking the monopoly and dissuading state governments from treating the APMCs as liberal sources of revenue, substantive efforts have to be made to create alternative trading platforms in the private sector where it is possible to reduce the layers of intermediation. Since this may take time, fruits and vegetables should be taken out of the purview of the APMC Acts immediately. A processor should be able to buy directly from farmers without having to pay any mandi fee/tax to the APMC.
5. Role of public deficits: Fiscal deficit should be brought down by setting stringent time-bound targets under the Fiscal Responsibility and Budget Management (FRBM) Act.

Measurement of Inflation in India

In India, inflation is measured on two price indices, viz, wholesale price index (WPI) and consumer price index (CPI). WPI measures price rise or inflation at the level of seller or retailer who buy commodities in bulk or ‘whole sale’. CPI is also called retail inflation since it measures inflation at the retail or consumer level. In India, WPI is the basis for determining the inflation of the economy.

Wholesale Price Index (WPI)

WPI is measured on weekly basis. The first index of wholesale prices commenced in India for the week January 10, 1942. The base year of WPI is revised periodically. Till date, 5 revisions have take place. The current WPI base year is 2004-05 based on prices of 670 commodities.
For determining WPI, commodities are divided into three categories – Primary Articles (102 items), Fuel & Power (19 items), and Manufactured Products (555 items). As you can see, the weight assigned to manufacturing is highest at 82% followed by primary articles like fruits and vegetables.

Consumer Price Index (CPI)

Unlike WPI, there is not a single measure of CPI. In India, four CPI indices are used to determine inflation at the consumer level. These are: CPI-IW (Industrial Worker), CPI-UNME (Urban Non-Manual Employees), CPI-AL (Agricultural Labourers), and CPI-RL (Rural Labourers).
Unlike the WPI, the new series of CPI based on recommendations of Abhijit Sen committee assigns the highest weight to primary articles like food, beverages and tobacco (49%).