You are on page 1of 33

INFLATION

INFLATION
Inflation is no stranger to the Indian economy. In fact,
till the early nineties Indians were used to double-
digit inflation and its attendant consequences. But,
since the mid-nineties controlling inflation has
become a priority for policy framers.

The natural fallout of this has been that we, as a nation,


have become virtually intolerant to inflation. While
inflation till the early nineties was primarily caused
by domestic factors (supply usually was unable to
meet demand, resulting in the classical definition of
inflation of too much money chasing too few goods),
today the situation has changed significantly.
INFLATION
Inflation today is caused more by global rather
than by domestic factors.

Naturally, as the Indian economy undergoes


structural changes, the causes of domestic
inflation too have undergone changes.
INFLATION

Inflation is defined as a sustained increase in the


general level of prices for goods and services.

It is measured as an annual percentage increase

As inflation rises, the value of currency goes down.


Thus the purchasing power of the currency, i.e. the
goods and services that can be bought in a unit of
currency, too goes down.
Measurement of Inflation
Measuring inflation is a difficult task. To do so a
number of goods that are representative of the
economy are put together into what is referred as a
"market basket."

inflation rising because of price rise in essential


commodities? Or was it because of the
'erroneous method' of calculating inflation?

Some economists assert that India's method of


calculating inflation is wrong as there are serious
flaws in the methodologies used by the government.
Measurement of Inflation
So how does India calculate inflation? And how
is it calculated in developed countries?

India uses the Wholesale Price Index (WPI) to


calculate and then decide the inflation rate in
the economy.
Most developed countries use the Consumer
Price Index (CPI) to calculate inflation.
Wholesale Price Index (WPI)

WPI was first published in 1902, and was one of the more
economic indicators available to policy makers until it was
replaced by most developed countries by the Consumer Price
Index in the 1970s.

WPI is the index that is used to measure the change in the


average price level of goods traded in wholesale market. In
India, a total of 435 commodities data on price level is tracked
through WPI which is an indicator of movement in prices of
commodities in all trade and transactions. It is also the price
index which is available on a weekly basis with the shortest
possible time lag only two weeks. The Indian government has
taken WPI as an indicator of the rate of inflation in the
economy.
Consumer Price Index (CPI)
CPI is a statistical time-series measure of a weighted
average of prices of a specified set of goods and
services purchased by consumers. It is a price index
that tracks the prices of a specified basket of
consumer goods and services, providing a measure of
inflation.

India is the only major country that uses a wholesale


index to measure inflation. Most countries use the
CPI as a measure of inflation, as this actually
measures the increase in price that a consumer will
ultimately have to pay for.
Measurement of Inflation
It pointed out that WPI does not properly measure the
exact price rise an end-consumer will experience
because, as the same suggests, it is at the wholesale
level.

Economists says WPI is supposed to measure impact of


prices on business. "But we use it to measure the
impact on consumers. Many commodities not
consumed by consumers get calculated in the index.
And it does not factor in services which have
assumed so much importance in the economy".
But why is India not switching over to
the CPI method of calculating
Inflation?
Finance ministry officials point out that there are many
intricate problems from shifting from WPI to CPI model.
First of all, they say, in India, there are four different types
of CPI indices, and that makes switching over to the
Index from WPI fairly 'risky and unwieldy.'
The four CPI series are:
 CPI Industrial Workers;
 CPI Urban Non-Manual Employees;
 CPI Agricultural labourers; and
 CPI Rural labour.
But why is India not switching over
to the CPI method of calculating
Inflation?
Secondly, officials say the CPI cannot be used in
India because there is too much of a lag in
reporting CPI numbers. In fact, as of May 21,
the latest CPI number reported is for March
2006.
The WPI is published on a weekly basis and the
CPI, on a monthly basis.
And in India, inflation is calculated on a weekly
basis.
INFLATION INDEX
Anual Inflation Rate

14
12.63
12
10.65
10 10.25
9.15
Percentage

8 8.09 2006­07
6.61 2007­08
6.26 6.37 6.36
6 5.68 2008­09
5.46 5.38 5.51 5.50
5.12 4.83 5.12
4.73 4.53 4.71
4 3.86 4.14
3.51 3.25 3.60
3.11
2

0
ly
ay

ne

st
r il

ry

h
ry
r

r
Ju

r
e

be

arc
gu
M

be
Ju

e
Ap

ua

rua
tob

mb

em
Au

tem

M
Jan

b
Oc

ve

Fe
p

De
No
Se

Months
CAUSES FOR INFLATION IN
INDIA
The government of India has always been under the
impression that:
(b) Some inflationary rise in prices is inherent in rapid
economic development- and GDP growth has been
around 7-8 per cent.

(d) RBI has always given the impression that by using


monetary policy of rate of interest and CRR, it
could control the volume of money supply and
volume of demand so as to maintain the annual
rate of inflation around 5.5%- such a rate of
inflation is permissible and manageable in the
context of economic growth.
CAUSES FOR INFLATION IN
INDIA
 The current rise in inflation has its roots in supply-side factors.
 There was shortfall in domestic production vis-a-vis domestic
demand and
 Hardening of international prices, prices of primary
commodities, mainly food items. Wheat, pulses, edible oils, fruits
and vegetables, and condiments and spices have been the major
contributors to the higher inflation rate of primary articles.
 The inflation was also accompanied by buoyant growth of money
and credit.
 While the GDP growth zoomed to 9.0 per cent per annum, the
broad money (M3) grew by more than 20 per cent.
 Demand for nearly everything from housing to fast moving
consumer goods is outpacing supply in part because white-collar
salaries are rising faster in India than anywhere else in Asia
CAUSES FOR INFLATION IN
INDIA
It would be too simplistic to hold any one factor
responsible for inflationary rise in prices in India in
recent years.

Actually, all of them collectively have contributed to the


price situation in India in recent years.

All the factors responsible for the rise in general prices


can be categorized as
(F) Demand-Pull Factors
(G) Cost-Push Factors
(H) Other Factors
Demand-Pull Factors
Mounting Govt. Expenditure:

Year Expenditure (Rs. Crores)

1950-51 740
1980-81 37,000
2004-05 9,02,300

The annual average rate of investment by the


government under ‘five year plans’ has risen from
Es. 1,000 crores in the 1950’s to Rs. 30, 000 crores
in the 1980’s and to over Rs. 80, 000 crores during
the 1990’s and Rs. 3,08,550 during the 10th five
year plan (2002-07)
Demand-Pull Factors
(2) Deficit Financing and Increase in Money Supply:

Money Supply and Monetary


Deficit Financing in India Since Resources (Rs. In Crores)
1981-82 (% of GDP) Money Supply Average
Revenue Fiscal With the Monetary
Year resources
Year deficit deficit Public
(M3)
(M1)
1981-92 0.2 5.4
1990-91 3.3 6.6 1970-71 7,340 10,960
2000-01 4.0 5.6 1980-81 23,120 55,360
2006-07 2.0 3.7 1990-91 92,890 2,65,830
2005-06 8,25,260 27,29,540
Economic Survey-2006-07

RBI Bulletin, April 2007


Demand-Pull Factors

(3) Role of Black Money:


It is well known that there is huge accumulation of
unaccounted money in the hands of tax evaders,
smugglers, builders and corrupt politicians and
government servants.

The black-money was estimated to be Rs.


6,00,000 crores in 1997-98 and nearly
25,00,000 crores in 2006-07
Demand-Pull Factors

(4) Growth of Population:

“Increase in population by 18-19 million


every year –it used to be 14-15 million two
decades ago”.
Cost-Push Factors
(1) Fluctuations in Out-put and Supply
Ex: Food Grains Production (in tonnes)

Year Production
1964-65 89 million
1965-66 72 million (fall 17 million)

2001-02 212 million (peak)


2002-03 174 million (decline of 38 million)
Cost-Push Factors

(2) Hike in oil Prices and Global inflation:


Serious inflationary pressures were also created
because of the sharp hike in the prices of crude
oil since September 1973 and the consequent
upward revision of the prices of oil and oil-based
products.

In 1980 alone there was 130 per cent increase in


fuel prices. It reached $148 during 2007-08.
Other Factors
Failure of government policies on the price front at
various times was a serious factor in the
inflationary rise in prices.

- Nationalization of wholesale wheat trade (1973)


- Failure to procure adequate food grains and
import
- Support prices
Consequences of Inflation
- Effects on production

- Effects on the distribution of Income

- Effects on fixed income earners


Is India Overheating? Eight
Myths About Inflation
The debate on inflation has given rise to eight
myths about inflation in India.

It is useful to examine each of these myths so


as to gain a clearer view of the issues - and
the appropriate policy response.
Eight Myths About Inflation

It's all about food prices.

Inflation stripped of food and energy, or other


volatile components, is still rising. For
example, between March 2006 and March
2007, year-on-year wholesale price index
inflation excluding food and energy rose from
2 per cent to 7.9 per cent.
Eight Myths About Inflation
The pickup in inflation is all due to base
effects from last year's low inflation.

The notion is that depressed inflation in early


2006 exaggerates the rise in inflation during
early 2007 on a year-on-year basis. But the
three-month moving average of month-on-
month, seasonally adjusted inflation has risen
by about 3 percentage points over the past year
- the same as year-on-year inflation.
Eight Myths About Inflation
Inflation will fall back to a normal range on its own.

Leading indicators of inflation point one way:

Continued price pressures.


Excess capacity has shrunk to a 14-year low, according to
the NCAER.
In addition, there are signs of overheating in real estate and
labour markets, with surveys showing the salaries of skilled
workers rising by around 15 per cent annually.
Broad money growth has hardly slowed, still registering
about 20 per cent year-on-year. With nominal GDP growing
at about 14 per cent, this seems a classic case of too much
money chasing too few goods - a recipe for inflation.
Eight Myths About Inflation
Fresh capacity will come on stream soon and
alleviate constraints (or, what we really need are
reforms to encourage supply).

Investment and reforms are welcome - not just to


combat inflation, but to generate growth and
employment that can alleviate poverty and raise
living standards. However, they take too long to
come on-stream to dampen inflation now. Indeed,
inflation has risen despite double-digit growth in
private fixed capital formation over 2002/03-
2005/06, accompanied by an 8.5 percentage point
rise in the ratio of overall investment to GDP.
Eight Myths About Inflation
Monetary tightening will kill the expansion

Keeping inflation under control, in fact, is key to


sustaining the expansion. Waiting until inflation
rises to higher levels will only make the job of
stabilizing prices harder. The international
experience on this score is clear: When inflation
expectations get entrenched at high levels, central
banks have to tighten even more sharply to get
inflation down.
Eight Myths About Inflation
 A stronger rupee does nothing to control inflation

Astronger rupee helps reduce inflation because it lowers the


import prices of oil, other raw materials and capital goods
and this, in turn, lowers the cost of production. It also
reduces the prices of import-competing goods, like steel.

A related myth is that a strong rupee will kill the economy


by hurting exporters. A stronger rupee does reduce the
rupee value of export earnings - but it also reduces the cost
of imported inputs, and to the extent that it dampens
inflation, it limits the need for interest-rate hikes. Moreover,
exporters are in a robust position now: Among 808
companies surveyed according to a study, net profits rose 67
percent in the October-December quarter.
Eight Myths About Inflation
 Policy tightening will deny credit to small businesses and the
common man, as well as hurt the poor.

It is true that small businesses and the common man have only limited access to
credit. This is a serious problem, but not one that can be solved through easy
monetary policy.

The poor, meanwhile, not only have limited access to credit, but live on fixed
incomes and have few or no assets to hedge against inflation - so that high
inflation hurts them more than higher interest rates. Consistent with this idea,
research by William Easterly and Stanley Fischer has shown that in a range of
countries, higher inflation is associated with a lower share of national income
accruing to the poor, a higher poverty rate, and a lower inflation-adjusted
minimum wage.

In light of these realities, the RBI is right to have taken steps to rein in inflation.
Compared with many other emerging countries, India has an admirable record of
price stability. Maintaining this track record will pay benefits in terms of
sustained growth with macroeconomic stability, and it will protect the most
vulnerable Indians from the ravages of inflation.
Thank You

You might also like