Do you know about inflation and current trends? we will explain the Inflation and current trends, This article will tell you about current trends. Kamal went to a stationary shop and purchased a diary. The shop owner asked him to pay Rs. 100 for it. Kamal looked at the shop owner and asked, “Why are you charging me extra money? Only last month you charged me Rs. 80, for exactly the same diary.” The shop owner replied,” I am not charging you extra money, I am also getting the supply at increased prices. It is because inflation is rising, prices of everything have increased.” Kamal returned the diary to the shop owner because he was short of money and was getting Rs. 80 as his pocket money. Now he was not able to purchase a diary by his pocket money. Kamal left the shop with several questions in mind. The same thing happened with the mother of Kamal, Anita. She went to the vegetable mandi and asked for a few vegetables on her list, that she used to purchase from the same shop. Shop owner packed the items and gave them to the Anita. When she asked for the bill, the shop owner asked her to pay Rs. 300. Anita only brought Rs. 250 with her because she bought the same list of vegetable for Rs. 230 last week. Anita told the shop owner that she only paid Rs. 230 for the same list of vegetables last week. The shop owner replied,” Madam, it is because inflation is rising, we are also getting the supplies on the increased prices.” Anita returned some of the vegetable items and took rest with her and returned with many questions in her mind. With several questions in mind, they both went to Mohan, father of Kamal, who is a teacher of economics in a college. They told him about the incidents and asked him to tell them about inflation. So, Mohan asked them to ask questions so that they could understand everything they have in mind. Kamal asked that,
What is inflation?
Definition of Inflation is very simple and straight forward. Inflation is an increase in the general level of prices in an economy that is sustained over time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. It is measured as an annual percentage increase and also defined as the percentage decrease in purchasing power capacity.
What causes inflation?
As given in the above picture, inflation can be caused by excess demand, pushing costs upwards, or due to some steps taken by the government. Kamal and his mother: Okay, so now we know about the causes of inflation. So does the inflation only affects consumers like us or are there any other effects of it? Mohan: Yes, consumers would definitely be affected by inflation, but there are several other effects of it. Let’s know about all of the effects of inflation.
Effects of inflation
Decreasing purchasing power: Inflation reduces the purchasing power of money. It would be able to buy a lesser quantity of goods compared to earlier. For example The vicious circle of inflation: Inflation itself create further inflationary pressure. High inflation can cause employees to demand more wages to match the increasing prices. It will increase their purchasing power and push inflation at a high level. Black marketing and hoarding: Due to fear of decreasing value of money, inflation may motivate some elements to hoard non-perishable and durable commodities, so that they can sell that at a higher price later. It creates an artificial shortage of that particular commodity in the market. Financial market: It leads to the redistribution of wealth from lenders to borrowers. It benefits borrowers. E.g. A has borrowed Rs. 1 lakh from Z to repay it within 5 years. Next year inflation rose at 6%. It means that the value of money has reduced by 6%. Now even if A payback loan in full next year, Z will bear a loss due to reduced Present value of money. Expenditures: Increased prices make our consumption levels fall as goods and services we buy get costlier. People tend to cut their consumption levels, aimed at neutralizing the impact of price rise. Currency: Inflation depreciates the currency of the economy, because it reduces the value of currency for the purpose of purchasing goods and services. Wages: Inflation increases the nominal (face) value of wages, while their real value falls. That is why there is a negative impact of inflation on the purchasing power and living standard of wage employees. To neutralize this negative impact the Indian government provides dearness allowance to its employees twice a year.
Investment: Investment in the economy is boosted by inflation (in the short-run) because of two reasons:
- Higher inflation indicates higher demand and suggests entrepreneurs expand their production level, and
- Higher the inflation, lower the cost of the loan
Savings: As the Present value of money start to decline during inflationary periods, holding money does not remain an intelligent economic decision. It leads to increased deposits in the banks in order to earn interest on that. But depositing money involves ‘shoe-leather cost’ Because it consumes the precious time of the people visiting the bank frequently tagging their shoe. Imports: Inflation gives an economy the advantage of lower imports and import-substitution as foreign goods become costlier. Employment: Inflation increases employment in the short-run, but becomes neutral or even negative in the long run. Phillips curve shows the relationship between the inflation rate and the unemployment rate. A.W. Phillips was one of the first economists to present compelling evidence of the inverse relationship between unemployment and wage inflation. The curve suggests that lower inflation, higher unemployment, and higher inflation. Criticism of the Philips Curve: The theory states that economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.
Types of Inflation
Depending upon the range of increase, and its severity, inflation may be classified into three broad categories as
- Low Inflation
- Galloping Inflation
Low Inflation or Creeping Inflation
- Such inflation is slow and on predictable lines, which might be called small or gradual.
- Low inflation takes place in a longer period and the range of increase is usually in ‘single-digit’.
- Such inflation has also been called ‘creeping inflation’.
- Technically, Creeping or mild inflation is when prices rise 3 percent a year or less.
- This kind of mild inflation makes consumers expect that prices will keep going up. That boosts demand. Consumers buy now to beat higher future prices.
- That's how mild inflation drives economic expansion
- Galloping Inflation
- This is a ‘very high inflation’ running in the range of double-digit or triple-digit (i.e., 20 percent, 100 percent or 200 percent in a year).
- It is known also by other names as hopping inflation, jumping inflation and running or runaway inflation.
- Technically, when inflation rises to 10 percent or more, it wreaks absolute havoc on the economy.
- Money loses value so fast that business and employee income can't keep up with costs and prices.
- Foreign investors avoid the country, depriving it of needed capital. The economy becomes unstable, and government leaders lose credibility. Galloping inflation must be prevented at all costs.
- When the general level of prices is falling over a period of time into the negative zone01 this is deflation, the opposite situation of inflation. In other words, when inflation turns negative it turns into deflation.
- If rapidly rising prices are bad for the economy, is the opposite, or falling prices, good?
- When prices are falling, consumers delay making purchases if they can, anticipating lower prices in the future.
- For the economy, this means less economic activity, less income generated by producers, and lower economic growth.
- It's caused when an asset bubble bursts.
- That's what happened in housing in 2006. Deflation in housing prices trapped those who bought their homes in 2005.
- Financial Authorities worry about overall deflation during the recession.
- That's because deflation can turn a recession into a depression. During the Great Depression of 1929, prices dropped 10 percent a year. Once deflation starts, it is harder to stop than inflation.
- Japan is one country with a long period of nearly no economic growth largely because of deflation.
- Hence, it turns out that deflation is not desirable either.
- Disinflation is when inflation rate slows down but not below zero. Inflation will remain positive but at a very low level.
- Disinflation is positive when inflation is high. The closer the inflation rate is to zero, however, markets will become increasingly uncomfortable with disinflation as it approaches the possibility of deflation.
- During healthy economic times when the economy is experiencing neither inflation nor deflation, a term like a price stability might describe the economic pricing environment at the time.
The best example of hyperinflation that economists cite is of Germany after the First World War—in the early 1920s. Such inflation quickly leads to a complete loss of confidence in the domestic currency and people start opting for other forms of money, as for example physical assets, gold and foreign currency (also known as ‘inflation-proof’ assets) and people might switch to barter exchange. Stagflation
- Stagflation is a situation in an economy when inflation and unemployment both are at higher levels.
- Stagflation is when economic growth is stagnant but there still is price inflation. This seems contradictory, if not impossible. Why would prices go up when there isn't enough demand to stoke economic growth?
- It happened in the 1970s when the United States abandoned the gold standard. Once the dollar's value was no longer tied to gold, it plummeted. At the same time, the price of gold skyrocketed.
- Stagflation didn't end until Federal Reserve Chairman Paul Volcker raised the fed funds rate to the double-digits.
- He kept it there long enough to dispel expectations of further inflation. Because it was such an unusual situation, stagflation probably won't happen again.
- When the economy is passing through the cycle of stagnation (i.e., long period of low aggregate demand in relation to its productive capacity) and the government shuffles with the economic policy, a sudden and temporary price rise is seen in some of the goods—such inflation is also known as stagflation.
- Stagflation is basically a combination of high inflation and low growth.
Okay great! That was nice info about the inflation but we would also like to know that how is it measured or calculated specifically in India so that at least we can understand that general price level has risen to a certain level.
Calculation of Inflation
Inflation is calculated by comparing the prices of standard goods across time. To measure inflation Data for months, years and decades can be compared. The formula for calculating the Inflation rate is: (Current CPI – Historical CPI) * 100 / Current CPI For example, if current CPI is 20 and historical CPI was 18, then (20 – 18) * 100/20 = 10% inflation This 10% means that now the money of everyone is worth 10% less compared to the year of comparison. If the number is negative then it will be counted as deflation.
Inflation in India
The rate of inflation is measured on the basis of price indices. A price index is a measure of the average level of prices, which means that it does not show the exact price rise or fall of a single good. There are two main sets of inflation indices for measuring price level changes in India –
- The Wholesale Price Index (WPI)
- The Consumer Price Index (CPI)
Other available indices include the GDP deflator and Private Final Consumption Expenditure (PFCE) deflator from the National Accounts Statistics (NAS). The GDP deflator is a complete measure of inflation defined as a ratio of GDP at current prices to GDP at constant prices.
Wholesale Price Index (WPI)
The WPI is calculated by the Ministry of Commerce and Industry. WPI measures the prices at the wholesale level. WPI is the price of a representative basket of wholesale goods. It takes a basket of 697 items into account and shows the combined prices. The basket used in WPI is composed of three groups: Manufactured Products (65 percent of total weight), Primary Articles like food, etc. (20.1 percent), and Fuel and Power (14.9 percent). WPI used by the Reserve Bank of India till 2014 to make its monetary policy. The present base year of WPI is 2011-12.
Consumer Price Index
The Central Statistics Office (CSO), Ministry of Statistics and Programme Implementation prepares CPI. Consumer prices measure the retail prices of goods consumed by the consumer in the economy. In the case of CPI (prices quoted from retailers), there are several indices to measure it:
- CPI for industrial laborers (CPI-IL),
- CPI for agricultural laborers (CPI-AL)
- CPI for rural laborers (CPI-RL)
- All India CPI
Inflation is measured ‘point-to-point’. It means that the reference dates for the annual inflation are January 1 to January 1 of two consecutive years (not or January 1 to December 31 of the concerned year). Similarly, the weekly rate of inflation is the change in one week reference being the two consecutive last days of the week (i.e., 5 p.m. of two Fridays in India).
From WPI to CPI
Although the WPI has traditionally been the most widely used measure for assessing inflationary pressures, the Reserve Bank of India (RBI) in 2014 conducted a review of its monetary policy framework, which recommended adopting a flexible inflation-targeting regime, based on headline CPI inflation. On taking office in September 2013, the new RBI Governor, Dr. Raghuram Rajan highlighted the importance of ‘low and stable expectations of inflation’. Furthermore, Dr. Rajan announced a review into the RBI's monetary policy framework, led by Dr. Urjit Patel (Deputy Governor of the RBI), which subsequently recommended the adoption of a flexible inflation-targeting regime based on headline consumer price inflation. This contrasted with previous monetary policy statements that had focused on the WPI and had even cited targets for WPI inflation.
What are the differences between CPI vs. WPI?
- The CPI places a much larger weight on food items than the WPI since it is weighted on the basis of household expenditure.
- Food, beverages, and tobacco have a combined weight of nearly 50 percent (compared with around 25 percent in the WPI).
- Also, the CPI includes components such as services (classified under the ‘miscellaneous’ category) and housing, which are notable omissions from the WPI.
Index Agency Base Year WPI Office of Economic affairs Ministry of Commerce & Industry 2004-05 CPI-All India Central Statistics Office Ministry of Statistics & Programme Implementation 2012 CPI-Urban CPI-Rural CPI-Al Labour Bureau Ministry of Labour and Employment 1986-87 CPI-RL 1986-87 CPI-IW 2001
Why RBI started using CPI instead of WPI?
In recommending that the RBI target headline CPI inflation, the Patel Committee cited a number of reasons:
- First, the fact that prices in the wholesale market are not purely producer prices or consumer prices makes the WPI difficult to interpret. Indeed, to the extent that there are significant variations in-retailer mark-ups, wholesale prices may not provide a reliable gauge of aggregate inflation.
- Second, the WPI does not capture movements in the prices of services, which constitute about 60 percent of gross value added in the Indian economy.
- Third, the use of the CPI in wage contracts and negotiations, and as a reference for the provision of welfare benefits, means that it is relatively well known to the public and therefore more likely than wholesale prices to guide the formation of inflation expectations of workers and consumers.
- Finally, as it provides a measure of the cost of living, the CPI more appropriately captures the welfare implications of price changes.
Consumer Food Price Indices (CFPI)
CFPI is a measure of the change in the retail prices of food products. The Central Statistics Office (CSO), Ministry of Statistics and Programme Implementation (MOSPI) started releasing Consumer Food Price Indices (CFPI) for three categories -rural, urban and combined - separately on an all India basis with effect from May 2014. The base year presently used is 2012. The CSO revised the Base Year of the CPI and CFPI from 2010=100 to 2012=100 with effect from the release of indices for the month of January 2015.
This is the ratio between GDP at Current Prices and GDP at Constant Prices. If GDP at Current Prices is equal to the GDP at Constant Prices, GDP deflator will be 1, implying no change in the price level. If GDP deflator is found to be 2, it implies a rise in price level by a factor of 2, and if GDP deflator is found to be 4, it implies a rise in price level by a factor of 4. The GDP deflator is acclaimed as a better measure of price behavior because it covers all goods and services produced in the country (because the weight of services has not been equitably accounted in the Indian ‘headline inflation’, i.e., inflation at WPI).
Headline inflation and core inflation
- This nomenclature is based on the inclusion or exclusion of the goods and services while calculating inflation.
- Popular in western economies, core inflation shows a price rise in all goods and services excluding energy and food articles.
- This measure of inflation excludes these items because their prices are much more volatile. It is most often calculated using the consumer price index (CPI), which is a measure of prices for goods and services.
- In India, it was first time used in the financial year 2000–01 when the government expressed that it was under control—it means the prices of manufactured goods were under control.
Core inflation = Headline inflation – (Food and Fuel articles)
Headline inflation is a measure of the total inflation within an economy, including commodities such as food and energy prices (e.g., oil and gas), which tend to be much more volatile and prone to inflationary spikes. Headline inflation may not present an accurate picture of an economy's inflationary trend since sector-specific inflationary spikes are unlikely to persist.
Positives of core inflation over headline inflation
If temporary price shocks are taken into account, they may affect the estimated overall inflation numbers in such a way that they are different from actual inflation. To eliminate this possibility, core inflation is calculated to gauge the actual inflation apart from temporary shocks and volatility. Food prices can be affected by factors outside of those attributed to the economy, such as environmental shifts that cause issues in the growth of crops. Energy costs, such as oil production, can be affected by forces outside of traditional supply and demand, such as political dissent. As it is less volatile to temporary shocks, Core inflation represents the trends inflation drives the future path of overall inflation. Hence, even when food and fuel inflation moderates over time, persistently high inflation in non-food, non-fuel components pose an upward risk to overall future inflation, creating challenges to monetary policy. In short core, inflation has become important because high core inflation today carries the seeds of high future inflation.
Negatives of core inflation over headline inflation
- This was criticized by experts on account of excluding food articles and energy out of the inflation and feeling satisfied on the inflation front.
- Basically, in the western economies, food and energy are not the problems for the masses, while in India these two segments are of most vital importance for the common people.
- Non-food manufacturing inflation is not published, although it can be estimated using the published WPI indices and weights.
- A measure of core CPI inflation can be compiled by excluding the food and fuel components.
- However, this only leaves around 40 percent of the consumption basket, making it a rather narrow measure of consumer price inflation.
- A further drawback is that, according to the RBI's estimates, shocks to the food and fuel components have larger and longer-lasting effects on inflation expectations than shocks to the other components.
- Therefore, a measure of core inflation that has a weak relationship with inflation expectations may be of limited usefulness for policymakers.
Current trends of inflation (Economic survey 2018-19)
- Headline CPI-C inflation has remained below 4.0 percent for two consecutive years. During FY 2018-19, WPI inflation stood at 4.3 percent.
- Headline inflation based on Consumer Price Index – Combined (CPI-C) has been declining continuously for the last 5 years.
- It has declined to 3.4 percent in 2018-19 from 3.6 percent in 2017-18, 4.5 percent in 2016-17, 4.9 percent in 2015-16 and 5.9 percent in 2014-15.
- The major reason for the decline in headline inflation in the FY 2018-19 was mainly due to low food inflation which ranged between (-)2.6 to 3.1 percent.
Food inflation based on the Consumer Food Price Index (CFPI) declined to 1.8 percent in 2017-18 from 4.2 percent in 2016-17, 4.9 percent in 201516 and 6.4 percent in 2014-15. This decline has been attributed to:
- The deflation in vegetables, fruits, pulses and products, sugar & confectionery, and eggs, which together account for 13.1 percent weight in overall CPI-C.
Food inflation based on Wholesale Price Index (WPI) too declined over the last two financial years due to:
- The deflation in pulses, vegetables, fruits, and sugar, which together account for 5.2 percent weight in the overall WPI basket.
It is a type of inflation that is measured by excluding the highly volatile components like and fuel items from the headline inflation. Core inflation captures the underlying trend of inflation and is, therefore, more stable. Unlike the non-core component of inflation, core inflation is not affected by temporary shocks. CPI-C based core inflation, which equals CPI excluding the food and fuel group, has remained above 4 percent since the start of the new series of CPI-C. However, it has declined from 5.7 percent in November 2018 to 4.5 percent in April 2019. Refined core inflation, which equals CPI excluding food and fuel group, petrol & diesel, too has moved closely with core inflation; it was 5.7 percent in 2018-19 as compared to 4.6 percent in 2017-18 and stood at 4.8 percent in April 2019.
DRIVERS OF INFLATION
CPI-C inflation during FY 2018-19 was driven mainly by the miscellaneous group followed by housing as well as fuel and light group. Goods inflation, which accounts for a weight of 76.6 percent in CPI-C, was 2.6 percent during FY 2018-19 as compared to 3.2 percent during FY 2017-18. In contrast, services inflation, which accounts for a weight of 23.4 percent, was 6.3 percent during FY 2018-19 when compared to 5.0 percent during 2017-18. 40 items of services account for 23.37 percent weight in CPI-C. Housing has the highest weight amongst services which is (10.07 percent), followed by transport and communication (4.59 percent), education (3.51 percent) and health (1.82 percent). Services inflation has been higher than goods inflation and the gap between the two is growing. Kamal and his mother: Great! Now we know all about inflation, but still, we have one question in mind when inflation is that important and effects economy in that significant way then why the government has not taken any step to contain it? Mohan: No, it is not like that, the government has taken various remedial and preventive steps to contain inflation. I will explain them to you both now.
Government efforts to contain inflation
The announcement of an official target range for inflation is known as inflation targeting. It is done by the Central Bank in an economy as a part of their monetary policy to realize the objective of a stable rate of inflation (the Government of India asked the RBI to perform this function in the early 1970s). India commenced inflation targeting ‘formally’ in February 2015 when an agreement between the GoI and the RBI was signed related to it—the Agreement on Monetary Policy Framework. The agreement provides the aim of inflation targeting in this way—it is essential to have a modern monetary framework to meet the challenge of an increasingly complex economy. Whereas the objective of monetary policy is to primarily maintain price stability while keeping in mind the objective of growth.’ Now, the new monthly CPI (C), is taken as the measure of headline inflation and is tracked by the RBI to anchor its monetary policy. Accordingly, the Central Government has notified in the Official Gazette 4 percent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6 percent and the lower tolerance limit of 2 percent.
Why RBI has taken headline inflation instead of core inflation?
Headline inflation reflects the prices of essential consumer goods. Inflation in these prices hurts people in lower-income groups more as they spend a higher proportion of their incomes on these items. Since the objective of monetary policy is to maintain price stability so as to protect ordinary citizens from the bouts of inflation, targeting headline inflation is the appropriate choice. The headline inflation measure demonstrates overall inflation in the economy. Other Efforts to contain inflation (Economic survey 2018-19)
- First, advisories are being issued, as and when required, to State Governments to take strict action against hoarding & black marketing, especially for commodities in short supply. These measures are taken to effectively enforce the Essential Commodities Act, 1955 & the Prevention of Black-marketing and Maintenance of Supplies of Essential Commodities Act, 1980.
- Second, regular review meetings on prices and availability of key commodities are held at the highest level, including at the level of Ministers, Committee of Secretaries, Inter-Ministerial Committees.
- Higher Minimum Support Price (MSP) for pulses and other crops has been announced so as to incentivize production and thereby enhance the availability of food items, which may help moderate prices.
- Government has set up Price Stabilization Fund (PSF) for procurement of agri-horticultural commodities including potatoes, onions, and pulses for its release during the lean period to improve availability and moderate their prices.
Short term measures
- During lean periods of 2017-18 and 2018-19, to control the rise in onion prices, onions were released at reasonable prices from the stock procured under Price Stabilization Fund (PSF).
- Pulses from the buffer are utilized for strategic market intervention for price management, meeting institutional requirements like supplies to State Governments/UTs for Mid-Day Meal Scheme (MDM), Integrated Child Development Services (ICDS) Scheme, and Public Distribution System (PDS), and through Open Market Sale, etc.
- Prohibition on export has been withdrawn in April 2018 on all varieties of edible oils, except mustard oil. Export of mustard oil in branded consumer packs of up to 5 kgs is permitted with a Minimum Export Price (MEP) of United States Dollar (USD) 900 per million ton (MT).
- the order empowering States/ UTs to impose controls including Stock Limits on Edible Oils and Edible Oilseeds has been withdrawn vide Notification dated June 13, 2018.
Measures available to control inflation
The main aim of every measure is to reduce the inflow of cash in the economy or reduce the liquidity in the market.
- Monetary Measures:
- Monetary policy is one of the most commonly used measures taken by the government to control inflation.
- In monetary policy, the central bank increases the rate of interest on borrowings for commercial banks.
- As a result, commercial banks increase their rate of interests on credit for the public.
- In such a situation, individuals prefer to save money instead of investing in new ventures.
- This would reduce money supply in the market, which, in turn, controls inflation.
- Apart from this, the central bank reduces the credit creation capacity of commercial banks to control inflation.
The monetary policy of a country involves the following: (a) The rise in Bank Rate: The main reasons for the reduction in the total expenditure of individuals are as follows; (i) Making the borrowing of money costlier (ii) Creating adverse situations for businesses (iii) Increasing the propensity to save (b) Direct Control on Credit Creation: The central bank directly reduces the credit-control capacity of commercial banks by using the following methods: (i) Performing Open Market Operations (OMO) (ii) Changing Reserve Ratios
- Fiscal Measures:
- The two main components of fiscal policy are government revenue and government expenditure.
- In fiscal policy, the government controls inflation either by reducing private spending or by decreasing government expenditure or by using both.
- It reduces private spending by increasing taxes on private businesses.
- When private spending is more, the government reduces its expenditure to control inflation.
- Besides this, government expenditures are essential for other areas, such as defense, health, education, and law and order.
- In such a case, reducing private spending is more preferable rather than decreasing government expenditure.
- When the government reduces private spending by increasing taxes, individuals decrease their total expenditure.
- For example, if direct taxes on profits increase, the total disposable income would reduce.
As a result, the total spending of individuals decreases, which, in turn, reduces money supply in the market. Therefore, at the time of inflation, the government reduces its expenditure and increases taxes for dropping private spending.
- Price Control:
- Another method for ceasing inflation is preventing any further rise in the prices of goods and services.
- In this method, inflation is suppressed by price control, but cannot be controlled for the long term.
- In such a case, the basic inflationary pressure in the economy is not exhibited in the form of rising in prices for a short time. Such inflation is termed as suppressed inflation.
- The historical evidence has shown that price control alone cannot control inflation, but only reduces the extent of inflation.
- For example, at the time of wars, the government of different countries-imposed price controls to prevent any further rise in the prices.
- Therefore, it can be said inflation cannot be ceased unless its cause is determined.
Hope you all understand the inflation and current trends.
Some Important Links:
UPSC Prelims 2019 Question Paper pdf Article 300A
Instruments of Capital Market Capital Market Instruments
Parliamentary form of Government in India Explain the Current Trends in Inflation
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Environmental Clearance Process in India Constitutional Values