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MEB (2024-25) Handout 06 (Inflation)

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MEB (2024-25) Handout 06 (Inflation)

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chandru .A
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MEB (2024-25) Handout 06

INFLATION IN INDIA: MEASUREMENT, CAUSES, EFFECTS AND CONTROL MEASURES

INTRODUCTION
 Inflation is defined as the rate of increase in the general level of prices. In a broader sense, a persistent
and appreciable rise in the general price level is considered as inflation.
 Disinflation is a decline in the rate of inflation or the rate of increase in the general price level.
 Deflation is a negative inflation rate, i.e., the decline in the general price level.

Important Price Indices used in India to measure price changes


 Wholesale Price Index (WPI)
 New indices
o Consumer Price Index – Rural (CPI-Rural)
o Consumer Price Index – Urban (CPI-Urban)
o Consumer Price Index – Combined (CPI-Combined)
Measurement of Inflation:
 The inflation rate is measured as the percentage change in the price index. The Price Index is a number
that shows the weighted average of prices of goods and services and is used to compare price changes
from a particular base year with a price index of 100.
 Inflation Rate = 100 * [(PINt – PINt-1)/PINt-1]; where PIN is Price Index Number, ‘t’ is the period for
which the inflation rate is being calculated, and ‘t-1’ is the period in the previous year.
 Two types of price indices are used in India for inflation calculation and reporting:
 Wholesale Price Index (WPI): WPI is the weighted average prices of a specified basket of goods
(697 commodities) traded in the wholesale market. WPI (the base year 2011-12 = 100) is used for
calculating the following two types of inflation:
o Headline inflation. It is based on the change in the price of all 697 commodities included in
the basket of commodities for WPI.
o Core Inflation: It is non-food and non-fuel inflation. Food and fuel items are excluded
because they are volatile items experiencing wide price fluctuations. Such fluctuations may
be short-term.
 Consumer Price Index (CPI): CPI (the base year 2011-2012 = 100) is the weighted average of
prices of a specified basket of goods and services (299 items) that are purchased by consumers.
Presently, CPI-Combined is used for the following two types of inflation:
o Retail inflation: It is based on the change in the price of all 299 commodities included in the
basket of commodities for CPI-Combined. The three major subgroups of retail inflation (base
year 2011-2012=100) are food, beverages, and tobacco (weight =45.86); fuel and light (6.84);
and others, including clothing and footwear, housing, household goods, and services, health,
education, transport and communication, recreation and amusement and personal care
(47.30).
o Core CPI inflation: Inflation in the non-food –nonfuel group is called Core CPI inflation.
 RBI has used headline CPI-Combined inflation as the nominal anchor for monetary policy
formulation for inflation targeting since April 2014. Before that, WPI was used as the monetary
policy's nominal anchor.
 Inflation may also be measured by GDP deflator:
GDP deflator = 100 * (Nominal GDP /Real GDP)
1
GDP deflator reflects the average rise in price of all goods and services included in the GDP regarding
the base year. Thus, it is more comprehensive. The GDP Deflator in India was 117.80 Index Points in
2015 and 114.40 Index Points in 2014.

Causes of Inflation
 Demand-pull factors (factors leading to an increase in aggregate demand). The increase in
aggregate demand is caused by:
o Increased demand from the household sector caused by increased income
o Increased demand from the government sector caused by increased government expenditure.
Increased government expenditure will also lead to an increase in the income of the
household sector, which will lead to increased demand from the household sector
o Increased demand from the business sector caused by new investments or expansion by the
business sector. The positive outlook perceived by businesses may cause such increases.
o However, all the above factors will cause inflation only when aggregate supply is either fixed
or is lower than the increase in aggregate demand.
 Cost-push factors (factors leading to an increase in the cost of production forcing
businesses/enterprises to raise prices)
o Wage-push inflation: for example, when trade unions force rises in wage rate, irrespective of
demand for and supply of labor situations.
o Profit-push inflation: when businesses/enterprises command some/absolute degree of
monopoly power and increase the price to get more profit, irrespective of demand and supply
situations.
o Import-price push inflation: when prices of imported inputs increase, the cost of production
increases, and businesses are forced to increase the output price. The impact of this factor
depends on the import intensity of different businesses/enterprises/sectors
 Supply shock: A sudden decline in aggregate supply caused by unforeseen contingencies such as
monsoon failure, natural calamities, etc. Aggregate demand exceeds aggregate supply, leading to a
rise in general prices.
 Expectations and Inflation:
o If consumers expect prices to rise in the future, they may increase their current
consumption/demand, leading to price rise (inflation)
o If prices are expected to rise, hoarding may take place, which reduces current supply, leading
to a price rise in the current period
o If prices are expected to rise, businesses may increase their inventories of raw materials as
well as finished products leading to price rise.
Effects of Inflation
 Adverse impact on people's real income (purchasing power), especially those dependent on fixed
income sources.
 Increased prices may lower down demand, which will have an adverse impact on business
profitability
 Inflation makes export prices less competitive in the international market and imports cheaper in the
domestic market, which may lead to a decrease in exports and an increase in imports. This will have
an adverse impact on the balance of payments and, hence, economic growth.
 Inflation affects economic growth:

2
o Moderate inflation is conducive to growth. In the economy, wages lag behind prices. This
results in high-profit margins during moderate inflation and promotes economic activity.
o Since inflation redistributes income in favor of the rich, APS increases aggregate savings and
investment in the economy.
o However, very high hyperinflation may discourage savings and thus affect economic growth
adversely. High inflation may lead to wage increases, causing a wage-price spiral in the
economy.
 Inflation affects the distribution of income: inflation increases gap between rich and poor
o The gainers from inflation are the manufacturers, traders, and farmers whose income is
derived from profits; those investing in equities and physical assets; and debtors as the real
interest rate goes down (real interest rate = nominal rate – inflation rate)
o The losers from inflation are fixed-income earners such as agricultural labor or receivers of
rent, investors of bonds and term deposits, and creditors because the real interest rate goes
down during inflation.
Control of Inflation
Various possible steps that reduce excess aggregate demand and increase aggregate supply will help in
controlling inflation. Measures may include the following:
 Fiscal policy measures
o Reduce government expenditure
o Increase direct taxes so that people’s disposable income decreases, which will reduce demand
o Encouragement of savings or introduction of compulsory savings schemes
o Rationalization of excise and import duties on essential commodities
 Monetary policy measures
o Increase CRR/SLR, which will reduce credit creation by banks and the flow of credit to
household and business sectors. It will lead to a reduction in demand.
o Increase interest rates (through increasing the Repo rate), which reduces demand for credit
and hence reduces the demand in the economy
 Effective supply-demand management of sensitive items through liberal tariff and trade policies
o Increasing output or increasing imports and decreasing exports to increase the availability of
goods in short supply
o Controlling money wages to keep down the costs
o Price control and rationing

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