Inflation

INFLATION

INFLATION Inflation is no stranger to the Indian economy. In fact, till the early nineties Indians were used to doubledigit 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

10.25 9.15 8.09

4

3.86

5.46 4.73

5.12 4.53

5.12 4.14

4.83 4.71

5.38 3.51

5.51

5.50

5.68

3.11

3.25

3.60

em be

6

6.26

r

8

6.37

6.36

2

Months

h arc M

ry rua

Fe b

ua ry Jan

r

De c

mb e

r No ve

Oc tob e

be r tem

Se p

Au gu st

Ju ly

Ju ne

M

ay

0 Ap r il

Percentage

10

10.65

6.61

2006­07 2007­08 2008­09

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 1950-51 1980-81 2004-05

Expenditure 740 37,000 9,02,300

(Rs. Crores)

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:

Deficit Financing in India Since 1981-82 (% of GDP) Year

Revenue deficit

Fiscal deficit

Money Supply and Monetary Resources (Rs. In Crores)

Year

Money Supply With the Public (M1)

Average Monetary resources (M3)

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 1964-65 1965-66

Production 89 million 72 million (fall 17 million)

2001-02 2002-03

212 million (peak) 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-onmonth, 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 2002/032005/06, 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.

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