What is inflation?
Inflation refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc. Inflation measures the average price change in a basket of commodities and services over time. Inflation is indicative of the decrease in the purchasing power of a unit of a country’s currency. This is measured in percentage.
Types of inflation
Based on rate of rise in Prices
Creeping inflation: Price rise at a very slow rate (less than 3 percent) like that of a snail or creeper is called creeping inflation. It is regarded safe and essential for economic growth.
Walking or Trotting inflation: Price rise moderately at the rate of 3 to 7 percent or less than 10 percent is called walking or Trotting inflation. It is a warning signal to the government to be prepared to control inflation.
Running inflation: It means price rise rapidly like the running of a horse at a rate of 10-20 percent. It affects the economy adversely.
Hyperinflation or Runway or Galloping inflation: the price rise at very fast at double or triple digit rate from 20-100 percent or more. Such a situation brings total collapse of the monetary system because of the continuous fall in the purchasing power of money.
Based on causes
Demand Pull Inflation: Demand pull inflation arises when aggregate demand in the economy becomes more than aggregate supply.
Cost push Inflation: when there is decrease in aggregate supply of goods and services results into increase in cost of production.
Factors causing inflation
Demand Side inflation is caused by
- high demand and low production or supply of multiple commodities create a demand-supply gap, which leads to a hike in prices due to increase in consumption;
- Increase in exports which undervalues rupee;
- The excess circulation of money leads to inflation as money loses its purchasing power with people having more money, they also tend to spend more, which causes increased demand.
- Increase in government expenditure over its income, the demand for consumption and capital goods and services.
- The repayment of public debt borrowed by government to public leaves people with more money. It induces people to spend more, hence more demand.
Supply side inflation is caused by
- Shortage of factors of production like labour, land, capital etc.
- Due to artificial scarcity created due to hoarding.
- Natural calamities like earthquake, land slide etc., affect production and supply of goods and services.
- Increase in Exports of a particular commodity leads to shortage of goods in domestic market.
Indictor used to measure inflation
In India, inflation is primarily measured by two main indices — WPI (Wholesale Price Index) and CPI (Consumer Price Index)
CPI: measures the average change in prices paid by ultimate consumers for a particular basket of goods and services over a period of time.
Four types of CPI are as follows:
- CPI for Industrial Workers (IW).
- CPI for Agricultural Labourer (AL).
- CPI for Rural Labourer (RL).
- CPI (Rural/Urban/Combined).
Of these, the first three are compiled by the Labour Bureau in the Ministry of Labour and Employment. Fourth is compiled by the NSO in the Ministry of Statistics and Programme Implementation.
Base Year for CPI is 2012.
Recently, the Ministry of Labour and Employment released the new series of consumer price Index for Industrial Worker (CPI-IW) with base year 2016.
WPI: It measures the change in the price of commodities supplied to wholesale market. Indirect taxes are excluded from the price.
Published by the Office of Economic Adviser, Ministry of Commerce and Industry.
The base year of All-India WPI is 2011-12.
In India, both WPI (Wholesale Price Index) and CPI (Consumer Price Index) are used to measure inflation, so these two are called the Head-line inflation.
Inflation target is set by the Government of India, in consultation with the Reserve Bank, once in every five years.
Inflation is measured by a central government authority, which is in charge of adopting measures to ensure the smooth running of the economy. Ministry of Statistics and Programme Implementation measures inflation.
RBI through its Monitory Policy Committee Controls Inflation with its tools to control Money supply in the market. RBI targets to CPI (combined).
The Central Government has notified 4 per cent Consumer Price Index (CPI) inflation as the target for 1st April, 2021 to 31st March, 2026 under the Reserve Bank of India Act 1934, with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.
Effects of inflation
- Redistribution of income and wealth
- Debtors Vs Creditors: debtor is gainer and Creditor is loser.
- Producers Vs Consumers: the producers stand to gain and consumers stand to lose. The purchasing power of money held by consumer falls.
- Flexible income group Vs Fixed income group: the flexible income groups like sellers, self-employed and employees of private concerns whose salary is adjusted according to inflation do not get affected, but fixed income groups like daily wage earners lose as the purchasing power of their income diminishes.
- Debentures or Bond holders and Savers Vs Equity holders: the Debentures or Bond holders and Savers receive fixed periodical income from their financial assets. The bond issuers gain, the bond holders lose. Equity holder stand at gain.
- Effects on production and Consumption: There is less production and consumption
- Balance of Payment (BoP): High price reduces the amount of export and increase import from other countries where goods are available at cheaper rate. It results in unfavourable balance of payment.
- Exchange Rate: High import and low export means high demand for foreign currencies compared to domestic currency. This depreciates domestic currency.
- Social and Political: Higher rate of inflation leads to social and political tension. People call for strike, hartals and stage dharnas.
Measures to control inflation
- Monetary measures: Monetary policy is one of the most commonly used measures taken by the RBI to control inflation. It uses tools like – Bank rate, Repo Rate, Open market operations, etc.
- 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.
- Price Control: In this method, inflation is suppressed by price control, but cannot be controlled for the long term. The historical evidences have shown that price control alone cannot control inflation, but only reduces the extent of inflation.
Deflation: it is opposite to that of inflation. The persistent fall in the general level of prices is called as deflation. The rate of change of price index is negative. The effects, causes and measures are also in the opposite direction.
Reflation: deliberate action of government to increase rate of inflation to stimulate the economy.
Disinflation: the rate of inflation at a slower rate is called disinflation.
Philips curve: it shows the relationship between rate of inflation and rate of unemployment. It shows that the relationship is negative. That is at high rate of inflation the unemployment rate is low.
Stagflation: It is situation of co-existence of stagnation and inflation in the economy. Stagnation means low National Income growth and high unemployment. Stagflation proves contrary to Philips curve.
Core inflation: It is measure of price rise in the economy excluding the price rise of very volatile and temporary in nature. Example for these products is fruits and vegetable.