Inflation Demystified

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For those of you who follow the economy section of the news and newspapers, the word that attracts all eyes, and captivates all ears is INFLATION‘. It is very important to know what exactly inflation is and how does it affect the economy. Inflation is one of the most essential and talked about factor that drives a nation’s basic banking policy and also its economy. Here is a detailed description for you:

WHAT IS INFLATION?

It is necessary to be clear with the basic meaning of inflation. A layman definition of inflation is a sustained increase in the general price level of goods”. Simple it is to comprehend but a few things should be noted:

  1. It is a sustained increase in price, i.e. the prices of goods keep on increasing over a period of time. For example: usually during the months of July-September, there is a sustained increase in the price of onions, this can be termed as inflation. On the other hand, there are times when the price of goods increase for a day or two due to a sudden surge in demand, for ex.: during festivals there is a huge demand of milk near temples and holy places, so the local vendors sell the same quality at a higher price for that day, however they return to the standard price from next day onwards. Here, the price rise lasts for a day and thus, cannot be called inflation.
  2. There are two factors of inflation, one is MONEY, as and when the money supply increases in an economy, people demand more and hence, the prices of goods go up, causing inflation. Second is DEMAND, sometimes, demand for certain goods go up without any change in the money supply of the economy and hence, prices of goods go up, thus causing inflation. Both the schools of thought have been explained in detail below.
  3. Another term that is encountered often is deflation, which is sustained decrease in the level of prices over a period of time, often cause by imbalances in money supply or demand.

TYPES OF INFLATION:

  1. Low inflation: This is a slow and predictable inflation. Also called as creeping inflation, the increase in price is small and gradual.
  2. Galloping inflation: This type of inflation is usually abysmally high and reaches double or triple digit over a year.
  3. Hyper-inflation: Large and accelerating inflation. This type of inflation covers a long range in a short period of time.
  4. Bottleneck inflation: This type of inflation is caused due to supply side hazards or because of some malfunctioning in the supply chain.
  5. Core inflation: Core inflation measures inflation of the eight core manufacturing industries which are responsible for supplying raw material to other industries. These eight industries are: Coal, Refining, Fertiliser, Electricity, Crude Oil, Natural Gas, Steel, and Cement. Any increase in inflation in these industries has a trickle-down effect on the economy at large. Ex: If the prices of oil keep on increasing over a period time, then, the effects trickle down into the economy and everything else also becomes expensive.

CAUSES OF INFLATION:

There are two primary schools of thought which describe the causes of inflation. They are:

KEYNESIAN IDEA: As per the Keynesian theory, average demand has a bigger role in increasing inflation than increase of money in the economy i.e. inflation increases when the average demand increases. For them, money is only one determinant of demand. As money supply increases, people have more disposable income and demand more and because of this inflation creeps in. However, according to Keynes, if money supply increases but does not affect the demand in anyway, i.e. people earn more but start saving that extra income without changing the pattern of demand then, inflation will stay the same.

MONETARIST SCHOOL: As per the Monetarist school of thought, money supply is the factor that controls inflation in an economy. According to their theory, if money supply increases then inflation will increase. They advocate that, more money simply means more purchasing power and thus, higher demand, for them no other factor can increase demand as much as money and hence, inflation increases.

While the Keynesian idea was being followed till 1970, the world at large has accepted the monetarist idea since 1970 and most of the policies to control inflation actually control the money supply in an economy.

HOW TO MEASURE INFLATION?

Inflation in India is measured on two scales:

  1. WHOLESALE PRICE INDEX: Wholesale price index is an index that measures inflation based on the changes in wholesale price of a basket of 676 articles, which include:

(a) Manufactured products chemicals, metal and food

(b)  Primary articles like food (cereals, pulses, milk etc.), non- food articles (oilseeds, flowers etc.) and minerals (crude oil, petrol)

  • Fuel category i.e. cost of production of electricity, coal, mineral oil, LPG

Each category has a weight assigned to it and makes respective contribution in the final number. Manufacturing has the highest weight followed by primary articles and fuel.

Manufactured products>Primary articles> Fuel category

 These categories have internal weights too:

Manufacture products: Chemicals>Metal>Food

Primary articles: Food>Non -food>Mineral

Fuel: Mineral oil>Electricity>Coal

The following illustration will make it easier to remember:

wholesale

Also another thing to be noted is, WPI used to be India’s national parameter for inflation till 2014, however on the recommendations of the Urjit Patel Committee CPI (Rural+Urban) became the new national inflation indicator as it covers inflation from the consumer’s point of view and also accounts for the service sector variations which WPI doesn’t.

  1. CONSUMER PRICE INDEX: Consumer Price Index inflation or CPI is India’s national inflation indicator from 2014 onwards; also the base year for the calculation of the same has been revised to 2012 from 2010 i.e. calculations for CPI are done with respect to the inflation in 2012.

CPI is calculated in three different ways: (1) Rural (2) Urban (3) Combined (R+U)

The components are (from highest to lowest weight):

food

The number that you get from the combined average of these is Headline CPI and,

Headline (food+fuel) = Core CPI

With the change in the base year another change that was incorporated based on the consumer expenditure survey is that, weightage of food items was reduced and non-food was increased, however, food items still top the list.

Latest CPI numbers look like this: [provisional data for January 2016]

  1. Rural 6.48
  2. Urban 4.81
  3. Combined 5.69
  1. CONSUMER FOOD PRICE INDEX – A third type of index is the consumer food price index, which measures inflation in food in rural and urban areas. This index also has three parts: Rural, Urban and Combined.

The food price index basket consists of:

  • Cereals and products (Highest weight)
  • Milk and products
  • Vegetables
  • Oils and fats
  • Egg, fish and meat
  • Pulse and products
  • Sugar etc.
  • Fruits
  • Condiments and spices

If you look at the above list carefully, this is nothing but the first factor i.e. food of CPI. So, what exactly happens is along with CPI, a separate data for food from within the CPI is also released to keep a separate track of food inflation. This accounts for 52% of the CPI.

A look at the provision data available for January 2016 [provisional data for January 2016]

  1. Rural 6.93
  2. Urban 6.50
  3. Combined 6.85

 

Apart from this, there is also some additional information that should be kept in mind while going for exams:

  1. The formula used to calculate inflation in all the three indexes is called Laspayer’s formula, in which weighted average of the products is taken to arrive at the final answer.
  2. Secondly, base year for CPI and CFPI is 2012, whereas for WPI it still is 2004.
  3. The numbers for CPI and CFPI are released by the Central Statistics Office (CSO) under the Ministry of Statistics and Program Implementation

For WPI, the data is released by the Economic Adviser, Department of Industrial Policy and Promotion (DIPP) under the Ministry of Commerce.

MISCELLANEOUS INFORMATION ON INFLATION:

  1. Demand Pull Inflation: Demand-pull inflation is a term used inKeynesian economics to describe the scenario that occurs when price levels rise because of an imbalance in the aggregate supply and demand,e. this is a situation wherein demand increases and supply remains the same, because of which the general level of prices of good increase. A very relatable example of the same would be rise in the prices of onion during the months of July-September.
  2. Cost Push Inflation: Cost-push inflation is a phenomenon in which the generalprice levels rise (inflation) due to increase in the cost of wages and raw materials. this is a situation in which the general balance between supply and demand remains the same, but, there is a rise in the prices of single or few components of the supply chain, and thus, the price of the end product also rises. Any increase in the wages of the employees will also have an effect on the price of goods.
  3. Disinflation: Disinflation is the rate of change of inflation over a period of time. For example: If India registered an inflation of 5% in January of a particular year and 4% in March, then the country is said to be experiencing disinflation in that quarter. This is not to be confused with deflation which is a general drop in the prices of goods over a period of time.
  4. Stagflation: Stagflation is a condition of slow economic growth and relatively high rate of unemployment (economic stagnation). Usually accompanied by rising prices (inflation), or a decline in GDP (Gross Domestic Product).
  5. Recession: Recession is a significant decline in the activities of an economy lasting for more than a few months. It is visible in industry, employment, real income and wholesale retail trade. The technical indicator of recession is two consecutive quarters of negative economic growth as measured by the country’s GDP.
  6. Depression: Severe and prolonged downturn in an economy. Also defined as extreme recession that lasts for more than two years. It is characterised by: sustainable increase in unemployment, drop in available credit, diminishing output, bankruptcy, sustained volatility in currency prices and reduced trade and commerce. In times of depression, consumer confidence and investments reduce, causing the economy to shut down.

CURRENT TREND:

  1. The current trend is that the WPI numbers are continuously decreasing and are in the negative growth from the last one year. CPI on the other hand is increasing gradually.
  2. Secondly, on a whole inflation in India has been under control owing to a lot of factors like:
  • Heavy downfall in the international crude oil prices
  • Increase in food and agricultural production as reported by FAO
  • FCI’s open sale of grains has helped in maintaining proper stock and transparent allocation
  • Stockholding has reduced
  • Tight monetary policy was followed by RBI throughout the year

Let us conclude by saying that inflation is a necessary evil. While abnormally high inflation harms the economy and economic activities slowdown indicating a very high price rise and resulting in lower demand, abysmally low inflation (also called deflation) too is bad for the economy and is considered to be an indicator of a dying economy. Deflation indicates dying demand either due to collapse in supply chain or scarcity of free flow of money in the market. And, that is why even the Urjit Patel Committee recommended that for India to grow at 10%, inflation should stay within the bracket of 2-6%.

 
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