12th Aug, 2021

Inflation

• Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time.
• It refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc.
• Inflation is indicative of the decrease in the purchasing power of a unit of a country’s currency. This is measured in percentage.
• Inflation can be viewed positively or negatively depending on the individual viewpoint. Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets. People holding cash may not like inflation, as it erodes the value of their cash holdings.
• Ideally, an optimum level of inflation is required to promote spending to a certain extent instead of saving, thereby nurturing economic growth.
• Inflation and economy is related in the following way:

• RBI takes the necessary measures to keep inflation within permissible limits and keep the economy running smoothly.

• Deflation is a general decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing power of currency rises over time.
• Deflation benefits consumers because they can purchase more goods and services with the same nominal income over time.
• Disinflation is a temporary slowing of the pace of price inflation. It is used to describe instances when the inflation rate has reduced marginally over the short term.
• Stagflation is the combination of high unemployment with high inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices led to low growth.

Who measures Inflation in India?

• Inflation is measured by a central government authority, which is in charge of adopting measures to ensure the smooth running of the economy.
• In India, the Ministry of Statistics and Programme Implementation measures inflation.

Types of Inflation

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

1. Creeping Inflation

Creeping or mild inflation is when prices rise 3% a year or less. This kind of mild inflation makes consumers expect that prices will keep going up. That boosts demand. Consumers buy now to beat higher future prices. That’s how mild inflation drives economic expansion.

2. Walking Inflation

This type of strong, or pernicious, inflation is between 3-10% a year. It is harmful to the economy because it heats up economic growth too fast. People start to buy more than they need, just to avoid tomorrow’s much higher prices. This drives demand even further so that suppliers can’t keep up. More important, neither can wages. As a result, common goods and services are priced out of the reach of most people.

3. Galloping Inflation

When inflation rises to 10% or more, it wreaks absolute havoc on the economy. Money loses value so fast that business and employee income can’t keep up with costs and prices. Foreign investors avoid the country, depriving it of needed capital. The economy becomes unstable, and government leaders lose credibility. Galloping inflation must be prevented at all costs.

4. Hyperinflation

Hyperinflation is when prices skyrocket more than 50% a month. It is very rare. In fact, most examples of hyperinflation have occurred only when governments printed money to pay for wars. Examples of hyperinflation include Germany in the 1920s, Zimbabwe in the 2000s, and Venezuela in the 2010s. The last time America experienced hyperinflation was during its civil war.

5. Core Inflation

The core inflation rate measures rising prices in everything except food and energy. That’s because gas prices tend to escalate now and then. Higher gas costs increase the price of food and anything else that has large transportation costs.

Causes of Inflation

• In any economy, generally two sets of factors result in inflation — Demand-pull factors and Cost-push factors.

• Demand-pull factors may be those due to which there is an increase in the demand for goods and services in general leading to rising prices.
• On the other hand, cost-push factors are those due to which there may be shortfall in supply of goods/services and/or rise in the cost of production of goods/services.
• At any given point of time, inflation is attributed to both sets of factors. Sometimes one may be more potent than the other.

Measures to Contain Inflation

RBI takes monetary measures while the Government takes fiscal measures to contain inflation.

Monetary Measures

• As part of the monetary policy review, the RBI takes suitable measures to moderate demand to levels consistent with the capacity of the economy to maintain its growth without provoking price rise.
• It is generally agreed that high rates of inflation is caused by an excessive growth of the money supply.
• The RBI controls the money supply by its monetary policy via which it alters the interest rates and alters the banking reserve requirements to bring the inflation in its comfort zone.
• The key policy rates are Repo Rate, Reverse Repo Rate, Marginal Standing Facility and the key banking reserve requirements are SLR and CRR.
• When these rates are altered, the movements are passed on other prevailing interest rates in the economy which ultimately influences the borrowing costs for firms and households.

For example, when the interest rates go down, it becomes cheaper to borrow, so households are more willing to buy goods and services and firms are in a better position to purchase items to expand their businesses, such as property and equipment.

Fiscal Measures

• The government can take the following Fiscal Measures to contain inflation:

1. Reducing Import Duties
2. Allowing imports of the commodities which are scarce in market.
3. Removing levy obligations in case of sugar
4. Banning exports of commodities such rice and oils.
5. Imposing minimum export prices.
6. Suspending or banning the futures trading is come commodities.
7. Raising the stock limit of some commodities.
8. Making available the commodities via various organizations such as NAFED and NCCF.

Measurement of Inflation

• There are several ways to measure inflation.
• On the basis of population coverage, the inflation indices are developed to understand the levels of inflation for certain sets of population such as consumers, producers, retailers, wholesalers etc. Such indices are called Consumer Price Index (CPI), Producer Price Index (PPI), and Wholesale Price Index (WPI) etc.
• On the basis of items, the inflation indices are developed to understand the levels of inflation for certain sets/baskets of items. Since the prices of some items are more volatile than others like food and fuel, it might give conflicting signals to policymakers as the overall inflation could change because of a selected few goods. Hence, separate indices can be developed separating the volatile items from the main index.  This gives rise to concepts of Headline inflation and core inflation whereby, the Headline inflation includes all the items and core inflation usually excludes food and fuel items.

Inflation Indices

In India, Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are two major indices for measuring inflation. In the United States, CPI and PPI (Producer Price Index) are two major indices.

The Wholesale Price Index (WPI) was the main index for measurement of inflation in India till April 2014 when RBI adopted the new Consumer Price Index (CPI) (combined) as the key measure of inflation.

Wholesale Price Index

The wholesale Price Index (WPI) is computed by the Office of the Economic Adviser in the Ministry of Commerce & Industry, Government of India. It was earlier released on weekly basis for Primary Articles and Fuel Group. However, since 2012, this practice has been discontinued. Currently, WPI is released monthly.

Salient notes on WPI are as follows:

Base Year

The current WPI Base year is 2004-05=100. It’s worth note that the base year for CPI is 2012 currently. This is one reason for the increasing difference between CPI and WPI in recent times.

Consumer Price Index

Consumer Price Indices (CPI) released at the national level are:

1. CPI for Industrial Workers (IW)
2. CPI for Agricultural Laborers (AL)/ Rural Laborers (RL)
3. CPI (Rural/Urban/Combined)

While the first two are compiled and released by the Labor Bureau in the Ministry of Labor and Employment, the third is by the Central Statistics Office (CSO) in the Ministry of Statistics and Programme Implementation.

In India, RBI uses CPI (combined) released by CSO for inflation purposes. Important notes on this index are as follows:

Base Year

The base year for CPI (Rural, Urban, and Combined) is 2012=100.

Key differences between WPI & CPI

• Primary use of WPI is to have inflationary trend in the economy as a whole. However, CPI is used for adjusting income and expenditure streams for changes in the cost of living.
• WPI is based on wholesale prices for primary articles, administered prices for fuel items and ex-factory prices for manufactured products. On the other hand, CPI is based on retail prices, which include all distribution costs and taxes.
• Prices for WPI are collected on voluntary basis while price data for CPI are collected by investigators by visiting markets.
• CPI covers only consumer goods and consumer services while WPI covers all goods including intermediate goods transacted in the economy.
• WPI weights primarily based on national accounts and enterprise survey data and CPI weights are derived from consumer expenditure survey data.

Index of Industrial Production (IIP)

• Index of Industrial Production data or IIP as it is commonly called is an index that tracks manufacturing activity in different sectors of an economy.
• The IIP number measures the industrial production for the period under review, usually a month, as against the reference period.
• IIP is a key economic indicator of the manufacturing sector of the economy.
• There is a lag of six weeks in the publication of the IIP index data after the reference month ends.
• IIP index is currently calculated using 2011-2012 as the base year.

IIP Index Components:

• Mining, manufacturing, and electricity are the three broad sectors in which IIP constituents fall.
• The relative weights of these three sectors are 77.6% (manufacturing), 14.4% (mining) and 8% (electricity).
• Electricity, crude oil, coal, cement, steel, refinery products, natural gas, and fertilizers are the eight core industries that comprise about 40 per cent of the weight of items included in the IIP.

Basket of products

There are 6 sub-categories:

1. Primary Goods (consisting of mining, electricity, fuels and fertilizers)
2. Capital Goods (e.g. machinery items)
3. Intermediate Goods (e.g. yarns, chemicals, semi-finished steel items, etc)
4. Infrastructure Goods (e.g. paints, cement, cables, bricks and tiles, rail materials, etc)
5. Consumer Durables (e.g. garments, telephones, passenger vehicles, etc)
6. Consumer Non-durables (e.g. food items, medicines, toiletries, etc)

Who releases IIP data?

• The IIP data is compiled and published by CSO every month.
• CSO or Central Statistical Organization operates under the Ministry of Statistics and Programme Implementation (MoSPI).
• The IIP index data, once released, is also available on the PIB website.

GDP Deflator

The most comprehensive measure is GDP deflator which is measured as the ratio of GDP (Gross Domestic Product) at current prices to GDP at constant prices. Since it encompasses the entire spectrum of economic activities including services, the scope and coverage of the national income deflator is wider than any other measure. This data is released by the Central Statistical Organization (CSO) but is not used as it comes quarterly and with a 2-month lag.

What is Inflation targeting?

• Inflation targeting involves using monetary policy to keep inflation close to the agreed target.
• RBI and Government of India signed a Monetary Policy Framework Agreement in February 2015.
• As per terms of the agreement, the objective of monetary policy framework would be primarily to maintain price stability (inflation targeting), while keeping in mind the objective of growth.
• According to the agreement, RBI would aim to contain consumer price inflation within 4% with a band of (+/-) 2% for all subsequent years.

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