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HareshPandyaWHATISINFLATION,MEASUREMENT,TYPESANDEFFECTS...

WHATISINFLATION,MEASUREMENT,TYPESANDEFFECTSOFINFLATION
OneofthefavouritetopicsfromIndianEconomyinPrelimsandMainsisInflation.Sinceinflationaffects
everycitizenofthecountry,howeverrichorpoor,itisacrucialdeterminantofacountryseconomicand
socialprogress.Nowonder,yourinflationrelatedconceptsshouldbeclear.Inthispost,wewilldiscussthe
definitionofInflation,howitisdeterminedandlistthedifferenttypesofinflation.Thenwediscussthe
effectsofinflationsincequestionsareoftenaskedinPrelimsontheeffectsofinflationondifferent
economicsegments.
DefinitionofInflation
ThesimplestdefinitionisInflationisariseinthegenerallevelofprices.Bythetermgeneral,wemeanif
thepriceofonegoodhasgoneupitisnotinflation,itisinflationonlyifthepricesofmostgoodshavegone
up.Theoppositeofinflationisdeflationwhichmeansafallinthegenerallevelofprices.
HowisInflationMeasuredinIndia
InIndia,inflationismeasuredontwopriceindices,viz,wholesalepriceindex(WPI)andconsumerprice
index(CPI).WPImeasurespriceriseorinflationatthelevelofsellerorretailerwhobuycommoditiesin
bulkorwholesale.CPIisalsocalledretailinflationsinceitmeasuresinflationattheretailorconsumer
level.InIndia,WPIisthebasisfordeterminingtheinflationoftheeconomy.
AboutWholesalePriceIndex(WPI)
WPIismeasuredonweeklybasis.ThefirstindexofwholesalepricescommencedinIndiafortheweek
January10,1942.ThebaseyearofWPIisrevisedperiodically.Tilldate,5revisionshavetakeplace.The
currentWPIbaseyearis200405basedonpricesof670commodities.
Recently,aWorkingGroupwassetupunderchairmanshipofProf.AbhijitSentorecommendnewseries
ofWPI.Thecommitteerecommendationshavebeenacceptedbythegovt.
FordeterminingWPI,commoditiesaredividedintothreecategoriesPrimaryArticles(102items),Fuel&
Power(19items),andManufacturedProducts(555items).Asyoucansee,theweightassignedto
manufacturingishighestat82%followedbyprimaryarticleslikefruitsandvegetables.
AboutConsumerPriceIndex(CPI)
UnlikeWPI,thereisnotasinglemeasureofCPI.InIndia,fourCPIindicesareusedtodetermineinflation
attheconsumerlevel.Theseare:CPIIW(IndustrialWorker),CPIUNME(UrbanNonManualEmployees),
CPIAL(AgriculturalLabourers),andCPIRL(RuralLabourers).
UnliketheWPI,thenewseriesofCPIbasedonrecommendationsofAbhijitSencommitteeassignsthe
highestweighttoprimaryarticleslikefood,beveragesandtobacco(49%).
CausesofInflation
Therearetwomaincausesofinflation:costpushanddemandpull.
CostPushInflationoccurswhengeneralpricesofcommoditiesincreasesduetoincreaseinproduction
cost.DemandPullInflationistheresultofmismatchbetweendemandandsupply.Eitherthedemand
increasesoverthesamelevelofsupplyorthesupplydecreaseswiththesamelevelofdemand.
TypesofInflation
Inflationmaybeclassifiedintothreemaincategories.
LowInflation
Suchinflationisslowandonpredictablelineswhichmightbecalledsmallorgradual.Itissometimesalso
calledcreepinginflation.Forexamplemonthlyinflationthatincreasesinsingledigitslike2.3%,2.8%,
3.2%,3.5%etc.
GallopingInflation
Thisisveryhighinflationrunningindoubleortripledigitslike20%,100%or200%ayear.Suchkindof
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inflationwasobservedincertainLatinAmericancountrieslikeArgentina.
HyperInflation
Thisformofinflationislargeandacceleratingwhichmighthaveannualratesinmillionoreventrillion.
SuchrateofinflationwasrecentlyobservedinZimbabwe.Insuchinflationnotonlyrangeofincreaseis
verylargebuttheincreasetakesplaceinaveryshortspanoftimeandpricesshootupovernight.
EffectsofInflation
Inflationhasmultidimensionaleffectsonaneconomy.Effectsofinflationondifferentsectorsand
segmentsisexplainedbelow.
OnCreditorsandDebtors
Inflationredistributeswealthfromcreditorstodebtorsi.e.lenderssufferandborrowersbenefitfrom
inflation.Thisistrueassumingthatsalarieswouldalsoincreaseduetopricerise.Thisresultsinrepaying
thesameamountofmoneywithextramoneyathandduetowagehikeorincreaseinDearnessAllowance
(DAforgovernmentemployees).
OnAggregateDemand
Risingpricesusuallyresultsinhigherdemandasitcomparativelylowersupply.Howeverifinflationresults
fromhigherinputcosts(costpush),aggregatemaydemandmayormaynotincreasecomparativetoprice
rise.
OnInvestment
Inflationincreasestheinvestmentinaneconomyintheshortrunasitencouragesproducerstoexpandor
increaseproduction.Also,intheshortrun,highertheinflationloweristhecostofloan.
OnSaving
Intheshortrun,risingpricesencouragespeopletodepositcashinhandwithbanksasmoneylosesvalue
soholdingitdoesnotmuchsense.Howeverinthelongrun,risingpricesdepletesthesavingrateinan
economy.
OnExchangeRate
Risingpricesgenerallyleadstodepreciationofthecurrencywhichimpliesthatthecurrencylosesits
exchangevalueinfrontofaforeigncurrency.Butthisisrelativetothepressureontheforeigncurrency
againstwhichtheexchangerateiscompared.Forinstance,from2013tillmid2014,eventhoughthere
wasrelativelyhighinflationinIndia,stillitdidnotlosemuchvaluevisavistheUSdollarsincethedollar
wasalsounderinflationarypressure.
OnExport
Withinflation,exportableitemsofaneconomygaincompetitivepricesintheworldmarket.Thisboosta
countrysexports.Thishappenssincevalueofcurrencyfallssoitmakesitcheaperforimportingcountries
tobuytheexportingcountriesproduce.
OnImports
Inflationgivesaneconomyadvantageoflowerimportsandimportsubstitutionasforeigngoodsbecome
costlier.
OnWages
Inflationincreasesthenominalorfacevalueofthewageswhileitsrealvaluefalls.Simplyput,eventhough
wagesmayincreasetooffsetinflationtheactualvalueofmoneyfalls.
INFLATIONTERMSANDINFLATIONMANAGEMENT
InthefirstpartonInflation,wehaveunderstoodthedefinitionofinflation,itsmeasurementandeffects.
Now,wewillunderstandsomeimportanttermsassociatedwithinflationthatareaskedinPrelimsand
Mains.AlsowewillunderstandhowinflationismanagedorcontrolledinIndianeconomy.
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InflationTerms
OftensometermsassociatedwithinflationareaskedinPrelimsorMains(2and5markers).Letssee
whicharethesetermsandwhatdotheymean.
PointtoPointInflation:ItmeansthatthereferencedatesfortheannualinflationisJanuary1toJanuary1
oftwoconsecutiveyearsandnotforJanuary1toDecember31oftheconcernedyear.Similarly,weekly
inflationmeasurementreferstoinflationmeasuredonsameweekoftwoconsecutiveyears.InIndia,thisis
measuredontwoconsecutivelastdaysoftheweek.(i.e.5PMoftwoFridaysinIndia).
InflationaryGap:Theexcessoftotalgovernmentspendingabovethenationalincome(i.e.fiscaldeficit)is
knownastheinflationarygap.
InflationTax:
Inflationtaxisnotanactuallegaltaxpaidtoagovernmentinsteadinflationtaxreferstothepenaltyfor
holdingcashatatimeofhighinflation.Whenthegovernmentprintsmoremoneyorreducesinterestrates,
itfloodsthemarketwithcash,whichraisesinflationinthelongrun.Ifaninvestorisholdingsecurities,real
estateorotherassets,theeffectofinflationmaybenegligible.Ifapersonisholdingcash,though,this
cashisworthlessafterinflationhasrisen.Thedegreeofdecreaseinthevalueofcashistermedthe
inflationtaxforthewayitpunishespeoplewhoholdassetsincash,whichtendtobelowerandmiddle
classwageearners.(Source)
InflationSpiral:Asituationwhenwagespushpricesupandpricespullwagesupisknownasthe
inflationaryspiral.Itisalsoknownaswagepricespiral.
InflationAccounting:Profitsofcompaniesgetoverstatedduetoincreaseininflation.Whenafirm
calculatesitsprofitsafteradjustingtheeffectsofcurrentlevelofinflation,thisprocessisknownasinflation
accounting.
Reflation:Itisanactofstimulatingtheeconomy(economicgrowth)byhighergovernmentexpenditure,tax
andinterestratecuts,reducingtaxratesetc.MajorworldeconomieslikeUSA,UKwentforreflationary
measurestoemergefromtheeconomicrecessionthathadsetinsince2008followingthesubprimecrisis.
Stagflation:Itisacombinationofhighinflationandloworstagnantgrowth(stagnantgrowth+inflation=
stagflation).Insuchasituation,inflationandunemploymentbothareathigherlevels.
PhillipsCurve:Itisagraphiccurvedepictinganinverserelationshipbetweeninflationandunemployment
inaneconomy.Thecurvesuggeststhatlowertheinflationhighertheunemploymentandviceversa.
InflationTargeting:Everygovernmentaimsforastablelevelorcomfortzoneofinflationaimstotarget
inflationratewithinthisrange.TheReserveBankofIndia(RBI)hassetainflationtargetof45%forthe
Indianeconomy.Ofcourse,thistargetisnotfixedforalltimesbutisrevisedasperneedsoftheeconomy.
Skewflation:Skewflationreferstoskewedorlopsidedinflationwherethereissustainedpriceriseinasmall
groupofcommoditieseventhoughpricesofothercommoditiesremainsrelativelystable.Forinstance,in
India,foodpricesrosesteadilyduring2009and2010eventhoughpricesofnonfooditemscontinuedto
bestable.
InflationManagement
Asmentionedabove,theaiminIndiaistomaintaininflationwithinthecomfortzoneof45%.Forthis
inflationistobemanagedorcontrolledproperly.Formanaginginflation,threesetofpolicymeasuresare
availableviz.fiscalpolicy,administrativepolicyandmonetarypolicy.Thegovernmentadministersthefiscal
andadministrativepolicieswhiletheReserveBankofIndia(RBI)administersthemonetarypolicy.Letus
seesomeofthemeasurestakenineachcategorytocontrolinflationinIndiarecently.
FiscalPolicyMeasures
Reducedimportdutiestozeroforrice,wheat,onion,pulses,edibleoilstobringdowncostofessentialfood
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items
Permittedimportof50,000tonnesofskimmedmilkpowderandwholemilkpowder
AdministrativeMeasures
Removedlevyobligationinrespectofallimportedrawsugarandwhite/refinedsugar
Bannedexportofedibleoilsandpulsestoincreaseavailabilityoftheseessentialitemsinthecountryand
thusmanagedemand
Imposedbanonexportofnonbasmatiriceandwheatforashortperiodoftime
Suspensionoffuturestradinginrice,uradandtur
Banonexportofonionforshortperiod
MonetaryMeasures
MonetarypolicyisadoptedbyRBItocontrolsupplyofmoneyintheeconomybytargeting,mostly,the
interestrateofcreditinthecountry.ThechieftoolsofmonetarypolicyareCashReserveRatio(CRR),
BankRate,RepoandReverseRepoRateandopenmarketoperations.
CRRistheportionofbankdepositskeptwithRBI.IfRBIwantstosuckmoneyoutofthesystemit
increasesCRRusuallyby0.25%or0.5%pointssobankshavelessmoneytolendsincetheykeepalarger
portionoftheirdepositswithRBI.
BankRateistherateatwhichtheRBIlendscredittocommercialbanks.Again,ifRBIwantstoreducethe
moneysupply,itincreasestheBankRatesoloansbecomecostlierduetoincreasedinterestrates.
Openmarketoperationsincludebuyingandsellingofgovernmentsecuritiestomopuporincreasemoney
supplyintheeconomy.WhentheRBIfeelsthereisexcessliquidityinthemarket,itresortstosaleof
securitiestherebysuckingouttherupeeliquidity.Similarly,whentheliquidityconditionsaretight,theRBI
willbuysecuritiesfromthemarket,therebyreleasingliquidityintothemarket.
Repomeansrepurchaseoptions.ReporateistherateatwhichtheRBIlendsshottermmoneytothe
banksagainstsecurities.WhenthereporateincreasesborrowingfromRBIbecomesmoreexpensive.
Therefore,wecansaythatincase,RBIwantstomakeitmoreexpensiveforthebankstoborrowmoney,it
increasesthereporatesimilarly,ifitwantstomakeitcheaperforbankstoborrowmoney,itreducesthe
reporate.
ReverseReporateistherateatwhichbanksparktheirshorttermexcessliquiditywiththeRBI.Thebanks
usethistoolwhentheyfeelthattheyarestuckwithexcessfundsandarenotabletoinvestanywherefor
reasonablereturns.AnincreaseinthereversereporatemeansthattheRBIisreadytoborrowmoney
fromthebanksatahigherrateofinterest.Asaresult,bankswouldprefertokeepmoreandmoresurplus
fundswithRBI.
Thus,wecanconcludethatRepoRatesignifiestherateatwhichliquidityisinjectedinthebankingsystem
byRBI,whereasReversereporatesignifiestherateatwhichthecentralbankabsorbsliquidityfromthe
banks.

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