Inflation

Inflation generally mean Rise in Prices.

Inflation is an increase in price of a basket of goods and services that is Representative of
economy as a whole
It is persistance and substantial rise in general level of prices after full employment level of
output.
Measures
Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price
Index. The Consumer Price Index measures prices of a selection of goods and services purchased by a
"typical consumer". The inflation rate is the percentage rate of change of a price index over time

For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008
it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over
the course of 2007 is

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general
level of prices for typical U.S. consumers rose by approximately four percent in 2007.

How India Calculates Inflation ?

India Uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the
economy

WPI – 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 at price level is tracked
through WPI which is an indicator of movement in prices of commodities in all trade and
transactions.

Other widely used price indices for calculating price inflation include the following:

 Producer price indices (PPIs) which measures average changes in prices received by
domestic producers for their output. This differs from the CPI in that price subsidization,
profits, and taxes may cause the amount received by the producer to differ from what
the consumer paid. There is also typically a delay between an increase in the PPI and
any eventual increase in the CPI. Producer price index measures the pressure being put
on producers by the costs of their raw materials. This could be "passed on" to
consumers, or it could be absorbed by profits, or offset by increasing productivity. In
India and the United States, an earlier version of the PPI was called the Wholesale Price
Index.
  Commodity price indices, which measure the price of a selection of commodities. In the
present commodity price indices are weighted by the relative importance of the
components to the "all in" cost of an employee.
 Core price indices: because food and oil prices can change quickly due to changes in
supply and demand conditions in the food and oil markets, it can be difficult to detect
the long run trend in price levels when those prices are included. Therefore most
statistical agencies also report a measure of 'core inflation', which removes the most
volatile components (such as food and oil) from a broad price index like the CPI. Because
core inflation is less affected by short run supply and demand conditions in specific
markets, central banks rely on it to better measure the inflationary impact of current
monetary policy.

Other common measures of inflation are:

 GDP deflator is a measure of the price of all the goods and services included in gross
domestic product (GDP). The US Commerce Department publishes a deflator series for
US GDP, defined as its nominal GDP measure divided by its real GDP measure.
 Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down
to different regions of the US.
 Historical inflation Before collecting consistent econometric data became standard for
governments, and for the purpose of comparing absolute, rather than relative standards
of living, various economists have calculated imputed inflation figures. Most inflation
data before the early 20th century is imputed based on the known costs of goods,
rather than compiled at the time. It is also used to adjust for the differences in real
standard of living for the presence of technology.
 Asset price inflation is an undue increase in the prices of real or financial assets, such as
stock (equity) and real estate. While there is no widely accepted index of this type, some
central bankers have suggested that it would be better to aim at stabilizing a wider
general price level inflation measure that includes some asset prices, instead of
stabilizing CPI or core inflation only. The reason is that by raising interest rates when
stock prices or real estate prices rise, and lowering them when these asset prices fall,
central banks might be more successful in avoiding bubbles and crashes in asset prices.

Types Of Inflations :
On the Basis of Rate of Inflation :-
Creeping Inflation – Rise in the price at very low rate, or Snail’s pace, around 2-3% per annum
is reffered as Creeping Inflation or Mild Inflation.
Walking inflation – A sustained price rise of 3 to 7 % or below 10 % is termed as Walking
Inflation
Running Inflation - A sustained price rise of 10 to 20 % per Annum is termed as Running
Inflation
Hyperinflation - Running Inflation if not controlled turns into Hyperinflation which is also known
as galloping or Jumping Inflation.
Open Inflation – Continous rise in price without any interruption and control from the
government or any other authority is known as Open Inflation
Suppressed Inflation – When price level in an economy is not rise (though condition exist for
rise) through the use of government policies like price controls and rationing, it is known as
Suppressed Inflation

Causes of Inflation

Different schools of thought provide different views on what actually causes inflation. However,
there is a general agreement amongst economists that economic inflation may be caused by
either an increase in the money supply or a decrease in the quantity of goods being
supplied.The proponents of the Demand Pull theory attribute a rise in prices to an increase in
demand in excess of the supplies available. An increase in the quantity of money in circulation
relative to the ability of the economy to supply leads to increased demand, thereby fuelling
prices. The case is of too much money chasing too few goods. An increase in demand could also
be a result of declining interest rates, a cut in tax rates or increased consumer confidence.

The Cost Push theory, on the other hand, states that inflation occurs when the cost of
producing rises and the increase is passed on to consumers. The cost of production can rise
because of rising labor costs or when the producing firm is a monopoly or oligopoly and raises
prices, cost of imported raw material rises due to exchange rate changes, and external factors,
such as natural calamities or an increase in the economic power of a certain country.

An increase in indirect taxes can also lead to increased production costs. A classic example of
cost-push or supply-shock inflation is the oil crisis that occurred in the 1970s, after the OPEC
raised oil prices. The US saw double digit inflation levels during this period. Since oil is used in
every industry, a sharp rise in the price of oil leads to an increase in the prices of all
commodities.

While money growth is considered to be a principal long-term determinant of inflation, non-

monetary sources, such as an increase in commodity prices, have played a key role in triggering
inflation in the past four decades.

Demand-Pull Inflation

The Inflation taking palce due to demand pressures is known as Demand –Pull Inflation.
Increase in quantity of money.
Increase in business outlays or government expenditure
Foreign Expenditure on goods and services.
Cost-Push Inflation

Increase in the overall price level due to cost pressures is known as Cost-Push or Supply Side
inflation.
Higher wage rates
Higher Profit margins
Higher Taxes
Higher prices of Input

Effects of Inlation :

An increase in the general level of prices implies a decrease in the purchasing power of the currency.
That is, when the general level of prices rises, each monetary unit buys fewer goods and services. The
effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs
to some and benefits to others from this decrease in the purchasing power of money.
Increases in the price level (inflation) erode the real value of money (the functional currency) and other
items with an underlying monetary nature (e.g. loans and bonds).
Negative Effect of Inflation –
High or unpredictable inflation rates are regarded as harmful to an overall economy. They add
inefficiencies in the market, and make it difficult for companies to budget or plan long-term.
Inflation can act as a drag on productivity as companies are forced to shift resources away from
products and services in order to focus on profit and losses from currency inflation. Uncertainty
about the future purchasing power of money discourages investment and saving. And inflation
can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax
rates unless the tax brackets are indexed to inflation.

With high inflation, purchasing power is redistributed from those on fixed nominal incomes,
such as some pensioners whose pensions are not indexed to the price level, towards those with
variable incomes whose earnings may better keep pace with the inflation. This redistribution of
purchasing power will also occur between international trading partners. Where fixed exchange
rates are imposed, higher inflation in one economy than another will cause the first economy's
exports to become more expensive and affect the balance of trade. There can also be negative
impacts to trade from an increased instability in currency exchange prices caused by
unpredictable inflation.

Cost-push inflation
High inflation can prompt employees to demand rapid wage increases, to keep up with
consumer prices. In the cost-push theory of inflation, rising wages in turn can help fuel
inflation. In the case of collective bargaining, wage growth will be set as a function of
inflationary expectations, which will be higher when inflation is high. This can cause a
wage spiral. In a sense, inflation begets further inflationary expectations, which beget
further inflation.
Hoarding
People buy durable and/or non-perishable commodities and other goods as stores of
wealth, to avoid the losses expected from the declining purchasing power of money,
creating shortages of the hoarded goods.
Social unrest and revolts
Inflation can lead to massive demonstrations and revolutions. For example, inflation and
in particular food inflation is considered as one of the main reasons that caused the
2010–2011 Tunisian revolution[33] and the 2011 Egyptian revolution, according to many
observators including Robert Zoellick, president of the World Bank. Tunisian president
Zine El Abidine Ben Ali was ousted, Egyptian President Hosni Mubarak was also ousted
after only 18 days of demonstrations, and protests soon spread in many countries of
North Africa and Middle East.
Hyperinflation
If inflation gets totally out of control (in the upward direction), it can grossly interfere
with the normal workings of the economy, hurting its ability to supply goods.
Hyperinflation can lead to the abandonment of the use of the country's currency,
leading to the inefficiencies of barter.
Allocative efficiency
A change in the supply or demand for a good will normally cause its relative price to
change, signaling to buyers and sellers that they should re-allocate resources in
response to the new market conditions. But when prices are constantly changing due to
inflation, price changes due to genuine relative price signals are difficult to distinguish
from price changes due to general inflation, so agents are slow to respond to them. The
result is a loss of allocative efficiency.
Shoe leather cost
High inflation increases the opportunity cost of holding cash balances and can induce
people to hold a greater portion of their assets in interest paying accounts. However,
since cash is still needed in order to carry out transactions this means that more "trips to
the bank" are necessary in order to make withdrawals, proverbially wearing out the
"shoe leather" with each trip.
Menu costs
With high inflation, firms must change their prices often in order to keep up with
economy-wide changes. But often changing prices is itself a costly activity whether
explicitly, as with the need to print new menus, or implicitly.
Business cycles
According to the Austrian Business Cycle Theory, inflation sets off the business cycle.
Austrian economists hold this to be the most damaging effect of inflation. According to
Austrian theory, artificially low interest rates and the associated increase in the money
supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments,
which eventually have to be liquidated as they become unsustainable.
Control of inflation :
The Different policy meaures are used for controlling inflation depending upon source, causes
and intensity of inflation.

Monetary Measures –
Monetary measures are designed and implemented by the central bank of the country.
Monetary measures include quantitative and qualitative control measures that tries to restrict
the aggregate demand for goods and services in the economy by restricting the supply of
money in the economy.
Quantitative Measures:
1) Bank Rate
2) Open Market Operation (OMO)
3) Variable Reserve Ratio

Fiscal Policy –
Government Expenditure, Taxtaion and debt policies can be used to curb the inflationary
pressures in economy.
Since the government spending has become an important component of the aggregate
spending to almost all countries – developed and underdeveloped- by the changing its
expenditure in relation to its tax receipts, the government can exert a powerful effect on the
flow of money, aggregate demand and economic activity.

Selective Control Measures –

Regulating Customer credit.
Higher margin Requirements.
Directives, moral suasion, publicity and direct action.

Inflation in India

Inflation is caused due to several economic factors:

 When the government of a country print money in excess, prices increase to keep up
with the increase in currency, leading to inflation.
 Increase in production and labor costs, have a direct impact on the price of the final
product, resulting in inflation.
 When countries borrow money, they have to cope with the interest burden. This
interest burden results in inflation.
 High taxes on consumer products, can also lead to inflation.
 Demands pull inflation, wherein the economy demands more goods and services than
what is produced.
 Cost push inflation or supply shock inflation, wherein non availability of a commodity
would lead to increase in prices.
Problems

The problems due to inflation would be:

 When the balance between supply and demand goes out of control, consumers could
change their buying habits, forcing manufacturers to cut down production.
 The mortgage crisis of 2007 in USA could best illustrate the ill effects of inflation.
Housing prices increases substantially from 2002 onwards, resulting in a dramatic
decrease in demand.
 Inflation can create major problems in the economy. Price increase can worsen the
poverty affecting low income household,
 Inflation creates economic uncertainty and is a dampener to the investment climate
slowing growth and finally it reduce savings and thereby consumption.
 The producers would not be able to control the cost of raw material and labor and
hence the price of the final product. This could result in less profit or in some extreme
case no profit, forcing them out of business.
 Manufacturers would not have an incentive to invest in new equipment and new
technology.
 Uncertainty would force people to withdraw money from the bank and convert it into
product with long lasting value like gold, artifacts.

Inflation in India Economy

India after independence has had a more stable record with respect to inflation than most
other developing countries. Since 1950, the inflation in Indian economy has been in single digits
for most of the years

Between 1950-1960
The inflation on an average was at 2.00%

Between 1960-1970
The inflation on an average was at 7.2%

Between 1970-1980
The inflation on an average was at 8.5%.

Inflation At Present
Inflation in India a menace a few years ago is at a 30 year low. The inflation ended at a low of
0.61% in the week ended May 9, 2009 this after reaching a 16 year high of 12.91 % in August
2008, bringing in a sigh of relief to policymakers.