Inflation

What is inflation?
 In economics, inflation is a general rise in the price level of an economy over a period of
time. When the general price level rises, each unit of currency buys fewer goods and
services; consequently, inflation reflects a reduction in the purchasing power per unit of
money.
 Inflation is measured on a yearly basis.
 The relation between economic growth and inflation is directly proportional.

Types of inflation -

Creeping inflation -
 Also called mild or crawling inflation.
 When the price level of goods in an economy continues to rise very slowly, it is called
creeping inflation.
 In this case, commodity prices rise between 2 to 4%.
 It is considered good for the economy as producers and traders make reasonable
profits which encourage them to invest more. This inflation is manageable.

Walking inflation -
 Also called - Trolling inflation.
 When the rate of rising prices is more than creeping inflation then it is called walking
inflation.
 In this case, commodity prices rise between 4 to 10%.
 This inflation must be taken seriously as this is a warning for the occurrence of running
or galloping inflation.

Galloping inflation -
 Also called - Hopping inflation & Running Inflation.
 When the inflation occurs for more than 10% and up to 50% it refers to galloping
inflation.
 Investors, even foreign investors, are discouraged from investing in such unbalanced
economies.

Hyperinflation -
 When inflation in an economy increases by more than 50% per month, it is called
hyperinflation.
 It is an extreme form of inflation.
 Hyperinflation occurs when there is a large increase in money supply.
  In these situations, the value of national currency is reduced to almost ‘Zero’ and paper
money becomes worthless.

Important terms related to inflation -

Open inflation -
 A situation where the price level rises without any price control measures by the
government.

Suppressed inflation -
 When the government takes various measures to prevent inflation, such as controlling
the demand for goods, controlling prices, etc., when the price level of goods cannot rise
unhindered, this type of inflation is called suppressed inflation.

Structural inflation -
 Inflation that occurs in an economy when the supply of goods decreases substantially
while demand remains the same is called structural inflation or bottleneck inflation.
 Such inflation is observed when production of agricultural commodities is low or due to
lack of storage of commodities, or distribution problems.

Disinflation -
 When inflation persists but the rate of inflation decreases, it is called disinflation.

Deflation -
 Deflation refers to a state of disequilibrium when commodity prices continue to decline.
 The price level continues to fall when the overall demand for a commodity falls short of
its supply in the country. This is called deflation.

Reflation -
 Refletion is a phenomenon when inflation returns after a spell of deflation, thereby
indicating that the economic growth is back in the economy.

Stagflation -
 Generally during inflation employment increases and unemployment decreases.
 But sometimes high inflation is accompanied by rising unemployment and slowing
economic growth.
 In other words, economic expansion does not occur in this situation but inflation occurs.
 This type of situation is seen mainly in developing and underdeveloped economies.

Skewflation -
 It occurs when there is inflation in some communities and deflation in others.
Core inflation -
 Based on those items whose prices are non-volatile.

Headline inflation -
 All commodities are covered in this.

Types of inflation (Based on causes) -

Demand-pull inflation -
 According to economists, if the aggregate supply of goods is unchanged or if the supply
of goods is completely inelastic in the short run, when the demand for goods increases,
the prices of goods rise or inflation occurs.

Causes -
 Increase in purchasing power.
 Population growth.
 Increase in public expenditure.
 Lower rate of savings by
households.
 Low unemployment rate.
 Increase in money supply and bank
credit.
 Lower rate of tax.
 This leads to increased disposable
income in the hands of households,
thereby resulting in increases in
the aggregate demand with no change in aggregate supply.
 To check this inflation, the supplies need to be increased to match the increased
demand, hence relieving the economy from higher levels of inflation.

Cost-pull inflation -
 It is also called “supply shock inflation”.
 If the cost of production inputs increases (labour wages, raw material costs) the cost of
production increases. According to economists, due to increase in production cost, the
price level of goods increases or inflation occurs.
Cost pull inflation is also caused by –
 Increased in indirect tax
 Increase in import prices
 Higher cost of capital and interest
rate.

Structural inflation -
 In this case inflation persists for a
longer period due to deficiencies
existing in the economy, such as -
 Insufficient distribution and storage
facilities and many more.
 Backward agriculture sector (poor productivity).
 It can be handled through major structural reforms.

Methods to measure inflation -

1. Wholesale price index.
2. Consumer price index.
3. GDP deflator.

What is the base year?

 Base year is the year on the ‘basis’ of which we compute inflation of an economy, i.e.,
percentage change in prices.

Criteria for deciding a particular financial year as base year -

 There should not be much gap between base year chosen and current year.
 Year with no major natural calamity, drought or famine.
 That Year should not have inflation at alarming rates.
 Year with less monsoon deficit.
 Unstable years in terms of economic activity are not considered as base years.

Wholesale price index (WPI) -

 The price index number that shows how much the prices of commodities in the
wholesale market have changed in the current year with respect to the base year is
called the wholesale price index.
 It measures on a monthly basis previously it was weekly basis.
 Current base year is 2011-2012 = 100 as base.
 Wholesale price index was first published in the year 1942 in India.
 Presently “the department of industrial policy and promotion” under “the Ministry of
Commerce and industry” compiles and publishes WPI.
  The Wholesale Price Index measures the wholesale prices of 697 goods but excludes
any services.
 In other words, it takes into account prices of commodities before they reach
consumers. Therefore, indirect taxes are not included in the prices considered for WPI
computation and as a result WPI-based inflation is not affected by any change in the
fiscal policy by the government.
 Rate of WPI-based inflation is always low compared to CPI-based inflation.
 Food items have laser weights in WPI.
 WPI measures inflation at each stage of production.
 WPI takes low time and data is available relatively quicker.

Consumer price index (CPI) -

 The price index number that shows how much the retail price of goods consumed by the
consumer has changed in the current year compared to the base year is called the
consumer price index.
 It measures on a monthly basis.
 It is released every month on the 12th day.
 It focuses on homogeneous group of consumers, i.e., consumers with the same liking in
terms of commodity basket. Presently it takes into consideration homogeneous groups:
ruler households and urban households.
 It reflects the cost of living of the two concerned categories of consumer.
 CPI takes into accounts both goods and services.
 Food items have greater weight in CPI.
 CPI measures inflation only at the final stage of production.
 It takes a long time to avail data.
 CPI is a better measure of inflation as compared to WPI and is more reliable for
monetary policy decisions.

CPI Rural, CPI Urban, CPI (Combined) -

 Base year of CPI is 2012; previously it was 2010.
 It covers 448 items in the rural basket and 460 items in the urban basket.
 For computing dearness allowance CPI is used.
 Housing component is not included under CPI rural.
 Weight of food and beverage is more in case of CPI rural compared to CPI urban.

GDP deflator -
 It refers to the ratio between GDP at current prices and GDP at constant prices.

GDP at current prices

GDP at constant prices

 If GDP deflator is 1, it implies no change in general price level.

  If GDP deflator is more than 1, it implies an increase in the general price level.
 GDP deflator is a better Measure of inflation as compared to WPI and CPI. But still it
is not used to frame short term inflation.

Core price index or core inflation -

 This measure is computed by policy makers to analyse inflation data, which excludes the
more volatile categories like food items and energy (fuel and power) products.
 Core inflation is calculated using CPI by excluding the aforesaid categories of
commodities to remove the impact of temporary and short-term shocks.

Producer price index (PPI) -

 It measures price changes from the perspective of the producer. It is a measure of the
average change in the selling prices over time received by domestic producers for their
output.