Inflation and inflation rate

Inflation is a sustained increase in the overall

level of prices.
Since price stability is a key objective of
monetary policy, central banks are obviously
concerned with inflation.
Inflation is calculated using price indicesweighted average of prices of of many individual
products
The rate of inflation is the percentage change of
price level =( pt-pt-1)/pt-1*100 (price level for
period t and pt-1 is price level for period t-1).

Three strains of Inflation

Low, Galloping and Hyper.
Low is single digit inflation( average
inflation of India 5.5 percent during
the previous decade i.e. 2000s)
Galloping -double digit inflation( Latin
American countries)
Hyper very large change. May be
billion times( Germany hyper
inflation)

Economic impact of Inflation

Prices of specific goods or services may go up or down relative to
the prices of others reflecting changes in productivity or demand
and supply conditions.
But when the overall price level rises, it erodes the purchasing
power of income, raises the cost of living and lowers the real value
of savings.
Savers, investors and financial intermediaries track closely the
link between inflation and interest rate.
The level of inflation is also critical in terms of maintaining
competitiveness of domestic industry in a liberalised trading and
market determined exchange rate regime.
More importantly, it is the poor who are most vulnerable to
inflation as they do not have any effective hedge against inflation.
As Keynes said, "Inflation is the form of taxation which the public
find hardest to evade."

Why is inflation a concern?

It is a cause of concern for public policy because of the associated costs, especially
when a large part of the population has no hedge against inflation.
First, inflation erodes the purchasing power of money. Fixed-income earners and
pensioners see a decline in their disposable income and standard of living.
Second, there is diminution of real value of savings as real interest rates turn negative
and return on savings does not fully compensate for price rise.
Third, economic agents base their consumption and investment decisions on their
current and expected future income as well as their expectations on future inflation
rates. Persistent high inflation alters inflationary expectations and apprehension
arising from price uncertainty does lead to cut in spending by individuals and
slowdown in investment by corporates which hurts economic growth in the long run.
Fourth, if the inflation rate is increasing faster than those in other countries then
domestic products become less competitive which has adverse impact on growth,
employment andthe balance of payments.
Fifth, high inflation worsens inequality due to arbitrary redistribution of income where
the poor suffer the most as the rich can hedge against inflation.
Finally, the policy measures for reducing inflation have their externalities and
associated costs in terms of reduction in aggregate demand in the short to medium
run.

Demand pull and cost push inflation

Inflation caused by change in aggregate demand (When aggregate demand rises more
rapidly than the productive potential of the economy )is demand pull inflation.
Important factor behind demand inflation is money supply growth. Increase in money supply
increase in aggregate demand and increase in inflation.

In Indian context, an empirical exercise by RBI based on annual data for the 57 year period,
1952-53 to 2009-10, shows that there is a co-integrating long-term equilibrium relationship
among inflation, non-agricultural GDP and money supply
First, non-agricultural GDP has a highly significant and negative relationship with inflation,
which implies that an increase in non-agricultural GDP representing improved supply
condition will decrease inflation.
Second, money supply has a highly significant and positive relationship with inflation. One
per cent increase in money supply in absence of any increase in non-agricultural GDP could
lead to 0.9 per cent increase in inflation.
Third, alongside increase in money supply by one percent, if non-agricultural GDP also
increases by one per cent it will have a dampening effect on inflation. But still inflation could
go up by 0.15 per cent in the long-run.
Fourth, deviation from the long-run equilibrium is statistically significant and the adjustment
towards the long-run equilibrium is faster through changes in the non-agricultural GDP.
Fifth, there is a two way causal relationship between money supply and prices.

Demand pull and cost push

inflation(2)
Inflation arising from rising cost or
supply shocks is called cost push
inflation.
Generally, cost push inflation periods
were coincident with episodes of oil
price surge and drought conditions

Inertial Inflation
Inertial inflation is when inflation rate persists at
the same rate. Economists compare inertial
inflation with a lazy dog. If the dog is not
shocked by the push of a foot or the pull of cat.
1990s inflation rate in USA rose steadily around
3 per cent and most people came to expect that
3 percent is the inflation rate for USA. Similarly,
in India single digit inflation is inertial inflation.
During 2004-08 the inflation rate was 5- 5.5 %
the inflation expectation became 5%

Inflation expectations
Prolonged high inflation even if originating from supply
side would give rise to increased inflation expectations
and cause general prices to rise.
Poorly anchored inflation expectations make long-term
financial planning more complex with potential adverse
effects on investment and growth.
Moreover, high inflation is the most regressive form of
taxation, particularly on the poor.
It is, therefore, important to contain inflation and keep
inflation expectations anchored so that consumers do
not mark up their long-run inflation expectations by
reacting to a short period of higher-than-expected
inflation.

Measurement of inflation:
India

India has a rich tradition of collection and dissemination of price statistics

dating back to 1861 when the Index of Indian Prices was released.
We had four different primary measures of inflation - the Wholesale Price
Index (WPI) and three measures of the Consumer Price Index (CPI).
In addition, Gross Domestic Product (GDP) deflator and Private Final
Consumption Expenditure (PFCE) deflator from the National Accounts
Statistics (NAS) provide implicit economy-wide inflation estimate.
The WPI was considered as the headline inflation measure because of its
availability at high frequency, until recently, national coverage and
availability of disaggregated data which facilitate better analysis of
inflation.
While the WPI does not cover prices of services, CPIs are meant to reflect
the cost of living conditions for a homogeneous group of consumers based
on retail prices. Among the three measures of CPI, the CPI for Industrial
workers (IW) has a broader coverage than the others - the CPI for
agricultural labourers (AL), rural labourers (RL) In the organised sector,
CPI-IW was used as a cost of living index.
Since 2012, the CPI-New Series is reported, which tracks CPI for
urban and rural Households.

Measurement of inflation:
India

GDP Deflator, on the other hand, is a comprehensive measure of inflation,

implicitly derived from national accounts data as a ratio of GDP at current
prices to constant prices.
While it encompasses the entire spectrum of economic activities including
services, it is available on a quarterly basis with a lag of two months since
1996.
Moreover, national income aggregates extensively use WPI for deflating
nominal price estimates to derive real price estimates.

Decadal Average
Inflation Decades

WPI
1971-72
to
1980-81 10.3

CPI-IW

8.3

GDP Deflator

PFCE Deflator

8.8

1981-82
to
1990-91 7.1 9.0
8.7
1991-92
to
2000-01 7.8 8.7
8.1
2001-02
to
2008-09 5.2 5.3
4.6
Long-term Trend
7.7 8.0
(1971-72 to 2008-09)
Source: RBI

8.4

8.3

8.5

4.4
7.7

7.6

Divergence between WPI and CPI

Why do WPI and CPIs differ?
They differ in terms of their weighting pattern.
First, food has a larger weight in CPI ranging from 46 per
cent in CPI-IW to 69 per cent in CPI-AL whereas it has a
weight of only 27 per cent in WPI. The CPIs are, therefore,
more sensitive to changes in prices of food items.
Second, the fuel group has a much higher weight in the
WPI (14.2 per cent) than the CPIs (5.5 to 8.4 per cent). As
a result, movement in international crude prices has a
greater bearing on WPI than on the CPIs.
Third, services are not covered under WPI while they are,
to different degrees, covered under CPIs. Consequently,
service price inflation has a greater influence on CPIs.

Reasons for the Divergence since

2008

Since 2008, there has been a divergence between CPI and WPI.
Why?
This could be attributed to the following factors.
First, the price of minerals and metals went up sharply during MayJune 2008 and then fell precipitously reflecting global trends. Since
metals and alloys do not form a part of the CPI group, this
accentuated the divergence between CPI and WPI.
Second, there was a similar trend as metals in crude prices which had
a larger influence on WPI than CPI.
Third, price of services - such as, medical care, education, recreation
and amusement, transport and communication and personal care and
effects - in CPI-IW showed a significant inflation of over 8 per cent.
It may, however, be indicated that CPIs recorded very similar trends
as the food component of WPI despite the divergence of the overall
indices during the recent period.

Components of WPI Inflation

WPI has three components viz;
Primary article with a weight of
20.12; Fuel and Power with a weight
of 14.91 and Manufactured Products
with a weight of 64.97
In the primary article and
manufactured there is the
component food inflation having a
weight of around 24 per cent.

Core Inflation
The inflation rate covering all the components of WPI is Headline
inflation. Normally the analysis of inflation takes into account Head line
Inflation
Another way to analyse inflation data is by looking at core inflation,
which is generally a chosen measure of inflation that excludes the more
volatile categories like food and energy prices. 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.
In Indian context, the derivation of core inflation by exclusion of food and
energy from CPI/WPI discards a substantial portion of the commodity
basket. So the price movement of the remaining commodities may not be
representative of the underlying inflationary trend. Although these prices
have substantial effects on the overall index, they often are quickly
reversed. But the reversal of volatile prices sometimes is not short-lived.
Therefore, determining when to use a core inflation measure versus an
overall inflation measure remains a complex issue.

Producer Price Index

Even when we have a revised WPI, we would still not have a Producer Price Index (PPI).
The PPI covers price changes faced by the producers on primary, intermediate and
finished goods and services ready for the market.
WPI includes only goods(including intermediate goods) and no svs. It can be interpreted
as an index of prices paid by producers for their inputs. Relevant price is the wholesale
price.
The primary difference between the WPI and the PPI is, in addition to the coverage, that
the WPI reflects changes in the average cost of production including mark-ups and taxes,
while the PPI measures price changes of transacted goods at the gate excluding taxes.
The purpose of the PPI is to provide a measure of prices received by producers of
commodities. The PPI usually covers the industrial (manufacturing) sector as well as
public utilities (electricity, gas and communications). Some countries also include
agriculture, mining, transportation, and business services. Most of the countries replaced
WPIs with PPIs in the 1970s and 1980s.
For analytical purposes, it would be desirable to initiate the process of compilation of PPI
for India

Inflation Dynamics

Milton Friedman famously said, inflation is always and everywhere a

monetary
phenomenon.
It is believed that short-run inflation dynamics is largely dependent on
supply demand conditions and monetary expansion influences inflationary
condition in the long-run.
Monetary expansion could be caused by persistence of high fiscal deficit
and the need to finance the same by monetisation. Consequently, high
monetary growth could lead to continued excess demand for a prolonged
period without matching increase in output and productivity.
On the other hand, supply conditions have strong influence on the inflation
dynamics in the short run.In a rapidly growing developing economy like
ours, both structural and idiosyncratic factors could play a significant role
in the determination of inflation. In the recent years, the inward looking
nature of Indian economy has been changing. Activities in almost all the
sectors in varying degrees are influenced by global factors, be it trade in
commodities, provision of services, financing conditions, or consumer
taste. Now domestic prices are more influenced by changes in global
commodity prices for a wide range of goods a sea change from the 1970s
and 1980s when crude prices were major global influencing factors

Threshold inflation
Threshold inflation is the inflation rate the
country will sustain not having an adverse
impact on growth.
In Indian context the threshold inflation has
been discussed and the agreement is that 56 percent inflation rate is acceptable.
The RBI has a mandated objective in its
monetary policy for price stability. The long
term objective is 3-4 per cent inflation rate.

Shaping inflations path

Five factors will shape the inflation trajectory. The first is the
trend in domestic food prices.
Second, global commodity prices and, particularly, crude oil
prices will have an impact on overall inflation.
Third, on the demand side, there is a need to shift aggregate
demand away from consumption towards investment, to
augment the potential output of the economy
Fourth, the level of the fiscal deficit and the quality of
government expenditure have significant influence on inflation.
Fifth, the stance of monetary policy and its ability to anchor
inflationary expectations will affect how inflation evolves in
future. The level of the policy interest rate should be such that
it is neither too stimulative nor too tight.