Lecture 12: Inflation (Part-2) Misc. Topics

Misc. Topics

Lecture 12: Inflation (Part-2)

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INFLATION OTHER IMPORTANT TERMS: INFLATION TAX

▪ It is not a legal tax, rather it is the degree of decrease in the value of cash and is termed as the

inflation tax for the way it punishes people who hold assets in cash, which tend to be lower-and

middle-class wage earners.

▪ To quote Milton Friedman, “inflation is taxation without legislation”.

INFLATIONARY SPIRAL

▪ A self-sustaining upward trend in general price levels fuelled by the reinforcing feedback of a vicious circle.

▪ Such situations continue until radical measures are instituted to break the cycle, otherwise the currency is rendered almost worthless as a medium of exchange (as it happened in Germany in the 1920s, in Brazil in the 1980s, and in Argentina in the 1990s) and has to be replaced with new monetary units (currency).

▪ The wage price spiral is a typical example of an inflationary spiral.

Wage-Price Spiral The wage-price spiral is a macroeconomic theory used to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. The wage-price spiral suggests that rising wages increase disposable income raising the demand for goods and causing prices to rise. Rising prices increase demand for higher wages, which leads to higher production costs and further upward pressure on prices creating a conceptual spiral.

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INFLATION PREMIUM

▪ The bonus brought by inflation to the borrowers is known as the inflation premium. The interest

banks charge on their lending is known as the nominal interest rate, which might not be the real cost

of borrowing paid by the borrower to the banks.

▪ To calculate the real cost a borrower is paying on its loan, the nominal rate of interest is adjusted

with the effect of inflation and thus the interest rate we get is known as the real interest rate. Real

interest is always lower than the nominal interest rate, if the inflation is taking place—the difference

is the inflation premium

PHILIPS CURVE

▪ The Phillips curve is an economic concept developed by A. W. Phillips. It is a graphic curve which

advocates a relationship between inflation and unemployment in an economy. As per the curve there

is a ‘trade off’ between inflation and unemployment, i.e., an inverse relationship between them.

▪ The curve suggests that lower the inflation, higher the unemployment and higher the inflation, lower

the unemployment. The theory claims that with economic growth comes inflation, which in turn

should lead to more jobs and less unemployment.

REFLATION

▪ When the economy is crossing through the cycle of recession (low inflation, high unemployment, low

demand, etc.) and government takes some economic policy decisions (higher public expenditures,

tax cuts, interest rate cuts, etc.) to revive the economy from recession, certain goods see sudden and

temporary increase in their prices, such price rise is also known as reflation.

STAGFLATION

▪ Stagflation is a situation in an economy when inflation and unemployment both are at higher levels,

contrary to conventional belief. Such a situation first arose in the 1970s in the US economy (average

unemployment rate above 6 per cent and the average rate of inflation above 7 per cent) and in many

Euro-American economies. Stagflation is basically a combination of high inflation and low growth.





SKEWFLATION

▪ Economists usually distinguish between inflation and a relative price increase. ‘Inflation’ refers to a

sustained, across-the-board price increase, whereas ‘a relative price increase’ is a reference to an

episodic price rise pertaining to one or a small group of commodities.

▪ This leaves a third phenomenon, namely one in which there is a price rise of one or a small group of

commodities over a sustained period of time, without a traditional designation. ‘Skewflation’ is a

relatively new term to describe this third category of price rise. E.g. sustained price rise of edible oils

in India.

DEFLATION

▪ When the overall price level decreases so that inflation rate becomes negative, it is called deflation.

It is the opposite of the often-encountered inflation.

DISINFLATION

▪ It is a situation where inflation is still positive but rate of inflation is decreasing.

EFFECTS OF INFLATION

▪ Creditors (lenders) lose and debtors (borrowers) gain under inflation.

▪ Inflation hurts savers since worth of money declines.

▪ Workers whose salaries are not indexed are hurt.

▪ Exports loose competitiveness.

▪ Hurts macroeconomic stability.

INFLATION IN INDIA

Every economy calculates its inflation for efficient financial administration as the multidimensional effects

of inflation make it necessary. India calculates its inflation on two price indices, i.e., the wholesale price index

(WPI) and the consumer price index (CPI).

WHOLESALE PRICE INDEX

The WPI is average change of prices of a fixed basket of goods at the first point of bulk sale in the domestic

market over a given period of time

Features of WPI

▪ WPI measures the inflation at wholesale level.

▪ The present base year of WPI is 2011-12

▪ Nodal Office for Compilation and release of WPI is the Office of Economic Adviser, Department for

Promotion of Industry and Internal Trade, Ministry of Commerce and Industry.

▪ WPI figures are published on a monthly basis.

▪ Services are not covered under WPI.





Base revision in May 2017

▪ The Base Year for WPI was changed from 2004-05 to 2011-12 in May 2017.

▪ Some of the important new features of WPI with Base 2011-12 are

o The number of items in the basket has been increased from 676 to 697.

o New definition of wholesale price index does not include taxes in order to remove the impact of

fiscal policy. This also brings new WPI series closer to the Producer Price Index and is in consonance

with the global practices.

o The item level indices are being compiled based on statistically robust Geometric mean as compared

to Arithmetic mean used in the WPI 2004-05 series.

o As a part of the revised WPI series, a separate WPI Food Index has been launched. WPI food index

measures the changes in prices of food items at the level of producers. WPI Food Index along with

CPI Food Price Index would help monitor the food inflation effectively in India.

Components of WPI

▪ The WPI comprises of three major groups:

1. Primary Articles (eg- Food Articles, Vegetables, Milk, Minerals etc)

2. Fuel and Power (eg- LPG, Petrol etc)

3. Manufactured Products (eg- manufacture of food products, sugar, manufacture of textiles

etc)

▪ The weights of the three major group of items in WPI are shown Below

Major Group Weights

Base year-2011-12

Primary Articles 22.62

Fuel & Power 13.15

Manufactured Products 64.23

All Commodities 100.00

▪ Thus we can say that in WPI the weightage in decreasing order looks like:

o Manufactured Product >> Primary Article >> Fuel & Power

Use of WPI

1. It provides estimates of inflation at the wholesale transactions level for the economy as a whole. This

helps in timely intervention by the Government to check inflation, in particular inflation in essential

commodities, before the price increase spills over to retail prices.





2. WPI is used as a deflator for many sectors of the economy for estimating GDP by CSO.

3. WPI is also used for indexation by users in business contracts.

4. Global investors also track WPI as one of the key macro indicators for their investment decisions.

5. The WPI based inflation estimates also serve as an important determinant, in formulation of trade,

fiscal and other economic policies by the Government.

6. WPI is also used for the purpose of escalation clauses in the supply of raw materials, machinery and

construction work. Business firms in search of effective methods for coping with changes in prices

often employ price adjustment (escalation) clauses in long-term sales and purchase contracts.

Latest WPI data The annual rate of inflation is 11.16% (Provisional) for the month of July, 2021 (over July, 2020) as compared

to (-0.25%) in July, 2020. The high rate of inflation in July 2021 is primarily due to low base effect and rise

in prices of crude petroleum & natural gas; mineral oils; manufactured products like basic metals; food

products; textiles; chemicals and chemical products etc as compared the corresponding month of the

previous year.

CONSUMER PRICE INDEX

▪ CPI measures the average change in prices of fixed baskets of goods and services that households

purchase for the purpose of consumption. It is also called Retail Inflation.

▪ Earlier, there were segment specific CPIs which were compiled regularly. The four major segments

were

1. Consumer Price Index for Industrial Workers CPI (IW)

2. Consumer Price Index for Agricultural labour CPI (AL)

Base Effect The base effect refers to the effect that the choice of a basis of comparison or reference can have on the result of the comparison between data points. Using a different reference or base for comparison can lead to a large variation in ratio or percentage comparisons between data points. The base effect can lead to distortion in comparisons and deceptive results, or, if well understood and accounted for, can be used to improve our understanding of data and the underlying processes that generate them.





3. Consumer Price Index for Rural Labourers CPI (RL)

4. Consumer Price Index for Urban Non Manual Employees CPI(UNME)

▪ All these above-mentioned indices depict change in the level of average retail prices of goods and

services consumed by specific segments of population, which they refer to. (They are partial indices

only and do not present a true picture of consumption of the general population. For example – CPI

(RL) – depict price change for Rural labourers only.)

▪ Thus they do not provide a true picture of price fluctuations of various goods and services consumed

by the general population in the country over a period of time.

▪ The Central Statistical Organization (CSO) started compiling CPI (rural, urban and combined) on Base

2010=100 with effect from January 2011.

▪ The basket of items and weighing diagrams for this series of CPI was based on Consumer Expenditure

Survey (CES) 2004-05. Thus there was a gap of six years between the weight reference year (2004-

05) and Price Reference Year (i.e Base year = 2010).

▪ It is desirable to have a minimum gap between these two reference years so that prices are collected

of those items which belong to the basket of consumers in true sense.

▪ The base year has been accordingly revised from 2010 to 2012, and the revised series is released

w.e.f. January, 2015.

▪ So, the latest standard for CPI is:

o Base Year – the current Base Year for CPI (R), CPI(U) CPI (C) is 2012.

o Nodal office for compilation of CPI - The CPI (rural, urban and combined) is released by the

National Statistical Office (NSO) (CSO is part of NSO), Ministry of Statistics and Program

Implementation.

o Publication - CPI figures are released on a monthly basis.

▪ At present the following CPIs are published:

CPI(RL) - Released by Labour bureau, Ministry of Labour &

Employment

CPI(R), CPI(U), CPI(C) -released by NSO

CPI(AL) - Released by Labour bureau, Ministry of Labour &

Employment; used for calculation of rural employment wages

CPI(IW) - Released by Labour bureau, Ministry of Labour &

Employment; used for calculation of Dearness

Allowance

CPI





Components of CPI

▪ The major component in CPI (C) are as follows (along with their weights)

1. Food and Beverages – 45.86

2. Housing – 10.07

3. Fuel and Light – 6.84

4. Clothing and Footwear – 6.53

5. Pan, tobacco and intoxicants – 2.38

6. Miscellaneous – 28.32

Significance of CPI

▪ Since, RBI has adopted Inflation Targeting, CPI (C) is used as nominal anchor for conduct of monetary

policy in India. [Monetary Policy Committee is mandated to keep CPI (C) in range 2% – 6%. So CPI is

used for inflation targeting].

▪ CPI is also used as deflators in the National Accounts.

▪ CPI is also used for calculating Dearness Allowance

DIFFERENCE BETWEEN WPI AND CPI

CONTEXT WPI CPI

Definition Amounts to the average change in prices of commodities at the wholesale level.

Indicates the average change in the prices of commodities at the retail level.

Publishing office Office of Economic Advisor (Ministry of Commerce & Industry)

Central Statistics Office/NSO (Ministry of Statistics and Programme Implementation) & Labour Bureau

Commodities Goods only Goods and Services both

Inflation Measurement

First stage of a transaction Final stage of a transaction

Prices paid by Manufacturers and wholesalers Consumers

Types of Commodities covered

Manufacturing inputs and intermediate goods like minerals, machinery basic metals, etc.

Education, communication, transportation, recreation, apparel, foods and beverages, housing and medical care

Base Year 2011-12 2012

Latest CPI data All India Inflation rates (on point to point basis i.e. current month over same month of last year, i.e.

June 2021 over June 2020), based on General Indices and CFPIs are given as follows:





Note: CFPI is Consumer Food Price Index

▪ Consumer Food Price Index (CFPI) is a measure of change in retail prices of food products consumed by

a defined population group in a given area with reference to a base year.

▪ The Central Statistics Office (CSO), Ministry of Statistics and Programme Implementation (MOSPI)

started releasing CFPI for three categories - rural, urban and combined - separately on an all India basis

with effect from May, 2014.

▪ Like CPI, the CFPI is also calculated on a monthly basis and methodology remains the same as CPI. 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.

PRODUCERS PRICE INDEX

▪ Producer Price Index (PPI) measures the average change in the price of goods and services either as they leave the place of production, called output PPI or as they enter the production process, called input PPI.

▪ PPI estimates the change in average prices that a producer receives.

PRODUCER PRICE INDEX (PPI) VS CONSUMER PRICE INDEX (CPI)

Producer Price Index (PPI) Consumer Price Index (CPI)

PPI is an estimate of the change in average prices that the producer receives which are not always what the consumer pays for it.

Consumer Price Index (CPI) measures the change in average prices that the consumer pays to the retailer.

PRODUCER PRICE INDEX (PPI) VS WHOLESALE PRICE INDEX (WPI)

Producer Price Index (PPI) Wholesale Price Index (WPI)

The Producer Price Index or PPI is an index that measures the average price change received by the producer excluding the indirect taxes.

The Wholesale Price Index represents the price change of a basket of goods and includes some taxes levied. The distribution costs are also considered in WPI.

It tracks price change in both the goods and the services sector, giving a clear picture of the inflation in the country.

The services sector which contributes to 60% of the GDP is not included in WPI.





IS INFLATION GOOD/BAD FOR ECONOMY? ▪ Inflation is a relative concept, the utility of which varies from economy to economy.

▪ Lower inflation means lower aggregate demand in an economy. Due to lower demand in these

developed economies, they are not witnessing growth. Hence they are targeting for higher inflation.

▪ Under normal circumstances, ‘moderate’ inflation is good for any economy. Since inflation simply

means Demand is greater than Supply, which means the overall consumption in an economy is rising.

▪ Rise in demand will cause increase in production. Because of which profits of companies would

increase (more sales=more profits). When companies would earn more profits, there will also be hike

in wages of workers as incentive. Hence standard of living of workers will improve. Which ultimately

means the economy is prospering.

▪ However, extreme situations are detrimental for any economy. Neither excessive inflation is good nor

deflation (fall in prices) is good.

▪ When there is excessive inflation, which means that goods are getting very expensive, this will reduce

aggregate demand for products in the economy. This will cause fall in profits of companies (or even

losses).

▪ Because of which there might be reduction in wages of workers or even layoffs. Which will cause the

economy to shrink.

▪ On the other hand, deflation has similar effect. Deflation looks good from consumer’s point of view.

▪ However, that is not so. There is deflation in an economy when Supply is greater than Demand.

Because of lack of demand, companies will not produce goods, which will cause fall in wages &

ultimately reduction in aggregate demand (since purchasing power of people will fall because of fall in

wages). This again causes shrinking of economy.

So, to conclude, every economy strives to achieve ‘moderate’ inflation. Inflation might be good or bad

depending on economic scenario of that country.





SUMMARY

➢ Inflation - sustained increase in the general price level of goods and services.

➢ Types of Inflation

➢ Other Important Terms

CREEPING INFLATION rise in prices is very slow

TROTTING INFLATION prices rise moderately and the annual inflation rate is in single digit

RUNNING INFLATION prices rise rapidly at a rate of 10% – 20% per annum

GALLOPING INFLATION prices rise at double- or triple-digit rates, such as 30 % or 100 % per year

HYPER-INFLATION/ RUNAWAY INFLATION very high and accelerating inflation rate

BOTTLENECK INFLATION supply falls drastically and the demand remains at the same level

HEADLINE INFLATION measures the change in prices of a wide range of commodities including those which have price volatility, like food and oil

CORE INFLATION Core inflation = Headline inflation – (Food and Fuel) inflation

INFLATION TAX degree of decrease in the value of cash and is termed as the inflation tax for the way it punishes people who hold assets in cash

INFLATIONARY SPIRAL A self-sustaining upward trend in general price levels fuelled by the

reinforcing feedback of a vicious circle.

INFLATION PREMIUM The bonus brought by inflation to the borrowers

REFLATION sudden and temporary increase in the prices of some goods due to government intervention to revive economy

STAGFLATION combination of high inflation and low growth

SKEWFLATION there is a price rise of one or a small group of commodities over a sustained period of time

DEFLATION When the overall price level decreases so that inflation rate becomes negative

DISINFLATION situation where inflation is still positive but rate of inflation is decreasing

Demand Side Inflation aggregate demand>aggregate supply Causes: o Increased liquidity in the

economy. o Increase in income levels and

purchasing power of households. o Growth in population and increase

in demand for goods and services. o Changing consumer behaviour

Supply Side Inflation Cost of production increases w.r.t demand for goods Causes: o Rising nominal wages of labour. o Depreciation of exchange rates. o Rising food and energy prices. o Rising oil prices. o Higher production tax. o Structural rigidities





Effects of Inflation ▪ Creditors (lenders) lose and debtors

(borrowers) gain under inflation.

▪ Inflation hurts savers since worth of

money declines.

▪ Workers whose salaries are not

indexed are hurt.

▪ Exports loose competitiveness.

▪ Hurts macroeconomic stability.

WHOLESALE PRICE INDEX ▪ Measures the inflation at wholesale level.

▪ Base year of WPI is 2011-12

▪ Nodal Office for Compilation and release of

WPI is the Office of Economic Adviser,

Department for Promotion of Industry and

Internal Trade, Ministry of Commerce and

Industry.

▪ WPI figures are published on a monthly

basis.

▪ Services are not covered under WPI.

▪ Manufactured Product >> Primary Article

>> Fuel & Power.

CONSUMER PRICE INDEX ▪ Indicates the average change in the prices of

commodities at the retail level. ▪ Published by Central Statistics Office/NSO

(Ministry of Statistics and Programme Implementation)-CPI(R), CPI(U) & CPI(C) and Labour Bureau – CPI(IW), CPI(RL), CPI(AL)

▪ Goods and Services both ▪ Consumers, Education, communication,

transportation, recreation, apparel, foods and beverages, housing and medical care are major commodities covered

▪ Base Year is 2012

PRODUCER PRICE INDEX ▪ measures the average change in the

price of goods and services either as they leave the place of production, called output PPI or as they enter the production process, called input PPI.

▪ Includes both goods and services





MCQS FOR PRACTICE

Q1. Which one of the following statements is an appropriate description of deflation? [UPSC-2010] (a) It is a sudden fall in the value of a

currency against other currencies (b) It is a persistent recession in both the

financial and real sectors of economy (c) It is a persistent fall in the general price

level of goods and services (d) It is a fall in the rate of inflation over a

period of time Answer: C

Q2. A rise in general level of prices may be caused by [UPSC-2013] 1. an increase in the money supply 2. a decrease in the aggregate level of output 3. an increase in the effective demand Select the correct answer using the codes given below: (a) 1 only (b) 1 and 2 only (c) 2 and 3 only (d) 1, 2 and 3 Answer: D

Q3. Which of the following brings out the 'Consumer Price Index Number for Industrial Workers'? [UPSC-2015] (a) The Reserve Bank of India (b) The Department of Economic Affairs (c) The Labour Bureau (d) None of the above. Answer: C

Q4. A rapid increase in the rate of inflation is sometimes attributed to the “base effect”. What is “base effect”? [UPSC-2011] (a) It is the impact of drastic deficiency in

supply due to failure of crops (b) It is the impact of the surge in demand

due to rapid economic growth (c) It is the impact of the price levels of

previous year on the calculation of inflation rate

(d) None of the statements (a), (b) and (c) given above is correct in this context

Answer: C

Q5. Economic growth is usually coupled with [UPSC-2011] (a) Deflation (b) Inflation (c) Stagflation (d) Hyperinflation Answer: B

Q6. With respect to economy, which of the following correctly describes the term skewflation? (a) It is a rise in the price of one or a small group of commodities over a sustained period of time. (b) It means declining rate of inflation over the last four economic quarters of a financial year. (c) It means declining inflation due to huge imports over a period of time. (d) It is a measure of increasing prices particularly for the service sector. Ans. A





MAINS QUESTIONS FOR PRACTICE Q1. Differentiate between demand side and supply side inflation. Q2. Moderate inflation is good for the economy. Discuss. Q3. What are the effects of inflation on various stakeholders of economy. Q.4. Elaborate on the differences between wholesale price index and consumer price index. Q5. Explain the term ‘Inflationary Spiral’ and ‘Skewflation’.



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Lecture 12: Inflation (Part-2) Misc. Topics