MBA
Education
&
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areers
32 August 2007
INFLATION
Definition, Causes, Effects
I
nflation is the sustained rise in the general
price level as a result of an increase in
demand without a corresponding increase in
supply.
Price instability is a common feature in any
economy developed, developing or
underdeveloped. Fluctuations in prices lead to an
uncertain and unfavourable economic
atmosphere. Such an atmosphere does not lend
itself to any kind of development activity. Stability
in prices is an important condition for efficient
and stable economic activity.
Causes of inflation
While inflation is a common feature, there is no
single cause or theory that explains it. Some
economists attribute inflation to the excess in
money supply which is a direct consequence of
ever increasing deficit financing (see below)
and rise in demand for goods and services.
Some others believe that inflation arises from
supply inflexibilities, macroeconomic structural
constraints and imbalances, etc. In India,
inflation is seen as a result of a combination all
these factors. Let us elaborate on a few of them.
Demand pull factors
There has been a sustained rise in government
expenditure over the past five decades. From a
few thousand crores in the 1950s, the
governments expenditure now runs into a few
lakh crore rupees. Continuous increase in
expenditure has the effect of placing more money
in the hands of the general public. This, in turn,
leads to a rise in purchasing power which drives
up the demand for goods and services. In the short
run, supply will not increase in proportion to
demand, due to structural imbalances. Thus, the
shortage in supply of goods in proportion to
demand results in a rise in price level i.e. inflation.
Also, increasing government expenditure
financed, in part, through deficits (also called
deficit financing) directly pushes up the money
supply. The huge increase in money supply in the
economy i.e. with the general public, has a direct
bearing on demand for goods and services and
therefore on price level. The amount of money
supply was Rs.23,120 crore in 1980-81. It has
now increased to about Rs.16,00,000 crore.
Two other major demand pull factors include
pressure of a rapidly rising population (which
translates into a higher effective demand), and
widespread speculation and hoarding in the case of
many essential goods (leading to shortage in supply).
Cost-push factors
Some economists attribute inflation to cost-push
factors like volatile fluctuations in output (as in
foodgrain production), upward revision of
administered prices (as for LPG, kerosene), and
external factors like oil prices and global inflation.
In a developing economy like ours, supply shocks
in terms of changes in output and supply play an
important role in exacerbating the cost-push
inflation. Two other factors which could be
mentioned here are: (a) continuously rising prices
of imports, and (b) increasing tax rates, especially
indirect taxation. When the cost of imports rise
(like a rise in oil import bill because of an increase
in global oil prices), the cost of production also
rises, pushing up the price level. Secondly, the
MBA
Education
&
C
areers
August 2007 33
ECO FUNDAS FOR YOU: INFLATION
M & C E
government has increasingly come to rely on
indirect taxes to mop up its revenues. Indirect
taxes (like service tax) give an opportunity to
business firms to raise prices.
How does inflation effect the common man?
Rapidly rising inflation leads to a fall in the
purchasing power of money. In other words,
the value of money comes down during an
inflationary situation.
For e.g., lets say you have Rs.50. You go to the
market to buy a kilogram of apples. You find
that a kilogram of apples cost you Rs.50. You
buy a kilogram of apples. A week later, with
another Rs.50 in your pocket, you go to the
market. This time the apples are priced at Rs.75
a kg. Now what quantity will you be able to buy
with Rs.50? Obviously, 2/3 kg or 670 grams.
While your Rs.50 could have bought one kg of
apples a week ago, now it is able help you buy
only 2/3 kg or 670 grams. Simply put, the
money value (in this case) has fallen by 33%.
Wholesale Price Index & Consumer Price Index
The Wholesale Price Index (WPI) is prepared by the
Central Statistical Organisation and includes all the
important and price-sensitive goods which are traded
in the wholesale markets throughout India. The
articles which enter into WPI consist of major
foodstuffs, raw materials, semi-manufactured goods
and manufactures. The purpose of WPI is to measure
the general purchasing power of the rupee in India.
The base year of the WPI is 1993-94. The new series
of index numbers of wholesale prices (base1993-94
= 100) was introduced from April 1, 2000. This
series has 435 distinct commodities as against 447
commodities in the old series (base 1981-82 = 100).
The index number of retail prices is used to
measure the value of the rupee with reference to
final consumption goods which are bought and
sold in the retail markets. The retail price index
reflects the purchasing power of the rupee as far
as the consumers are concerned. The real
difficulty in the construction of such an index lies
in the fact that retail prices may not be available
for the same goods and for continuous periods.
Accordingly, the Government of India has been
constructing three types of consumer price index
(CPI) numbers viz., for industrial workers, for
urban non-manual employees, and for agricultural
labourers.
The first two consumer price indices are prepared
for important towns in the country and for the
country as a whole, and the third one viz., CPI for
agricultural labourers, is prepared for all the states
separately and for the country as a whole. Only
those goods and services which are generally
consumed by the particular groups are included and
the prices of these goods and services are collected
from those localities where workers live and from
those shops which are frequented by the workers.
The CPI helps study the movement of consumer
goods prices and to measure the value of the rupee
with special reference to the working classes in
urban and rural areas.
The CPI for industrial workers and CPI for urban
non-manual employees are of great practical
significance, as they represent the movement of
the cost of living to the working classes.
The level of wages - or more correctly, the
dearness allowances - are linked to the cost of
living index in such a way that whenever the CPI
rises by a certain number of points, the money
wages or dearness allowance of the workers will
have to be raised by a certain amount.
The base year of the CPI for industrial workers is
1982 (base 1982 =100) and for urban non-manual
employees is 1984-85 (base 1984-85 = 100).
