Banking Article, Banking Finance 2022, Banking Finance September, 2022

Inflation – Concept, Causes & Control Measures

  1. Concept

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. It is indicative of the decrease in the purchasing power of a unit of a country’s currency. This is measured in percentage.

Sudden rise of prices is not inflation.  It is called as price rise.  If it happens more often, then it is called as inflation. Inflation is proof of growth.  When unchecked, this becomes expensive, purchasing power of money gets reduced.  It affects the poor most, because major portion of their earnings goes to meet inflation.  Inflation pushes interest rates up, dampens investment and leads to depreciation of currency.

Economists categorized three separate factors that cause a rise or fall in the price of goods:

  • A change in the value or production costs of the commodity,
  • A change in the value of money which then was usually a fluctuation in the commodity price of the metallic content in the currency, and
  • Currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency.
  1. Effects of Inflation

The purchasing power of a currency unit decreases as the commodities and services get dearer. This also impacts the cost of living in a country. When inflation is high, the cost of living gets higher as well, which ultimately leads to a deceleration in economic growth.

  1. Types of inflation

Creeping inflation: It is a condition where the inflation in a country increases slowly but continuously over a period of time and the effect of inflation is noticed after a long period of time.  It is a general price increase say up to 4% a year.  It reduces the purchasing power, but this type of inflation is manageable.

Trotting inflation: If the creeping inflation increases a few more hundreds of basis points, it is called as trotting inflation.  It causes little more pain than the creeping inflation.

Galloping inflation: If trotting inflation is not controlled and if the rate of inflation is between 8 to 10% per year, such inflation is called as galloping inflation.

Runaway inflation:  If the inflation becomes uncontrollable and when the galloping inflation aggravates, it leads to runaway inflation.

Hyperinflation: When prices are out of control – monthly inflation rate of  20-30% or more – an inflammatory cycle without any tendency towards equilibrium.

Demand-pull inflation: This type of inflation is caused by increase in aggregate demand due to increased private and government spending, etc.  Demand inflation encourages economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.

Cost-push inflation: This type of inflation also called “supply shock inflation,” is caused by a drop in aggregate supply (potential output).  This may be due to natural disasters, or increased prices of inputs.  For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation.  Producers for whom oil is a part of their costs could then pass this on to consumer in the form of increased prices.

Built-in inflation: Built-in inflation is a type of inflation that results from past events and persists in the present. Built-in-inflation is one of three major determinants of the current inflation rate.

Asset Inflation: Rising prices in assets like housing, gold, or stocks etc.

Other related concepts

Deflation: Persistent general fall in the level of prices.  Quite opposite to inflation.

Disinflation: It is a decrease in the rate of inflation – a slowdown in the rate of increase in general price level of goods and services in a nation’s GDP over time.  It is quite opposite to inflation. Simply put, it is reduction in the rate of inflation.

Stagflation: It is a combination of inflation and rising unemployment/recession.  It is the situation where inflation rate is high, the economic growth rate is slow and unemployment remains steadily high.    Stagflation makes it difficult for the people to buy the goods they intend to buy and find new economic opportunities.  Simply put it is a combination of inflation and rising unemployment/recession.

Relation: A situation where inflation returns after a spell of recession and deflation. Growth will be back in such situation.

Core inflation: Core inflation refers to the rise in prices of goods and services other than energy and food.  Energy (fuel & power) and food are highly volatile in prices, and hence kept out of core inflation.  Core inflation is considered as the prime indicator of underlying long-term inflation.

Headline inflation: A measure of the total inflation within an economy, including commodities such as food and energy prices, which tend to be much more volatile and prone to inflationary spikes.

  1. Causes of inflation

The main causes of inflation in India have been subject to considerable debates and discussions. These are some of the chief reasons for the increase in prices:

  • High demand and low production or supply of multiple commodities create a demand-supply gap, which leads to a hike in prices.
  • 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.
  • Spurt in production prices of certain commodities also causes inflation as the price of the final product increases. This is called cost-push inflation.
  • Increase in the prices of goods and services is also a factor to consider as the involved labour also expects and demands more costs/wages to maintain their cost of living. This spirals to further increase in the prices of goods.
  • A connection between inflation and unemployment has been drawn since the emergence of large scale unemployment in the 19th century, and connections continue to be drawn today. However, the unemployment rate generally affects inflation in the short-term but not in the long-term.  In the long-term, the velocity of money is far more predictive of inflation than low unemployment.

 

  1. Why deflation is worse than inflation

Deflation is worse because interest rates can only be lowered to zero.  As businesses and people feel less wealthy, they spend less, reducing demand further.  Prices drop in response, giving companies less profit.  Once people expect price declines, they delay purchases as long as possible.  They know the longer they wait, the lower the price will be.  This further decreases demand, causing business to slash prices even more.  It is a vicious, downward spiral.

  1. Indices of inflation

Wholesale Price Index (WPI)

The wholesale Price Index (WPI) is the price of a representative basket of wholesale goods.  Some countries uses WPI changes as a central measure of inflation.  WPI is calculated on the base year and WPI for the base year is assumed to be 100.  In this way individual WPI values for the remaining 400+ commodities are calculated and then the weighted average of individual WPI figures are found out to arrive at the overall Wholesale Price Index.

WPI is computed by the Office of the Economic Adviser in the Ministry of Commerce & Industry, Govt. of India.  Currently WPI is released monthly.

Consumer Price Index (CPI)

The inflation measured by Consumer Price Index (CPI) is defined as the change in the prices of a basket of goods and services that are typically purchased by specific groups of households.  In 2013, the consumer price index replaced the wholesale price index (WPI) as a main measure of inflation in India.  CPI Used to index real values of wages, salaries, pensions, for regulating prices.

CPI for Industrial Workers (CPI-IW)

Consumer Price Index Numbers for Industrial Workers (Base 1982=100) is designed to measure a change over time in prices of a given basket of goods and services consumed by a defined population, i.e. industrial workers. This index is compiled for industrial workers resides in 70 centers of industrial importance in the country.

Cost Inflation Index (CII)

Cost Inflation Index (CII) is used for calculating the estimated increase in the prices of goods and assets by year-by-year due to inflation.  Cost inflation index is calculated to match the prices to the inflation rate.  In simple words, an increase in the inflation rate over a period of time will lead to an increase in the prices.  Central Government specified the cost inflation index.  The CII for the financial year 2019-20 has been notified by the Ministry of Finance and has been set as 289.

CPI for Agricultural Labourers (CPI-AL)-and Rural Labourers (CPI-RL)

These indices were prepared taking 1986-87 year as the base year. The labour bureau has now started work taking 2018-19 as the new base year.  It may also include the new consumption patterns of the workers.  These indices may be used to fix the national minimum wage.

  1. Growth-inflation trade-off

Inflation control calls for curbing excess aggregate demand, and need not necessarily rein in the real growth rate.  Tightening of monetary policy will be generally aimed at containing speculation and enhancing the productive capacity of the economy and thus the potential growth rate.   Also, domestic inflation hurts the price competitiveness of Indian exports, particularly in the presence of the upward pressure exerted by buoyant capital inflows on the nominal exchange rate.  The RBI is buying foreign exchange to prevent the rupee from rising, and it had no option but to sterilise the liquidity so introduced into the system through an offsetting rise in the reserve rations.  But always, growth inflation trade-off is a challenge for the policy makers.

  1. Measures to control inflation:

There are broadly two ways of controlling inflation in an economy:

1). Monetary measures and

2). Fiscal measures

  1. I) Monetary Measures

The most important and commonly used method to control inflation is monetary policy of the Central Bank. Most central banks use high interest rates as the traditional way to fight or prevent inflation.

Monetary measures used to control inflation include:

(i) Bank rate policy

(ii) Cash reserve ratio and

(iii) Open market operations.

Bank rate policy is used as the main instrument of monetary control during the period of inflation. When the central bank raises the bank rate, it is said to have adopted a dear money policy. The increase in bank rate increases the cost of borrowing which reduces commercial banks borrowing from the central bank. Consequently, the flow of money from the commercial banks to the public gets reduced. Therefore, inflation is controlled to the extent it is caused by the bank credit.

Cash Reserve Ratio (CRR): To control inflation, the central bank raises the CRR which reduces the lending capacity of the commercial banks. Consequently, flow of money from commercial banks to public decreases. In the process, it halts the rise in prices to the extent it is caused by banks credits to the public.

Open Market Operations: Open market operations refer to sale and purchase of government securities and bonds by the central bank. To control inflation, central bank sells the government securities to the public through the banks. This results in transfer of a part of bank deposits to central bank account and reduces credit creation capacity of the commercial banks.

  1. II) Fiscal Measures

Fiscal measures to control inflation include taxation, government expenditure and public borrowings. The government can also take some protectionist measures (such as banning the export of essential items such as pulses, cereals and oils to support the domestic consumption, encourage imports by lowering duties on import items etc.).

  1. The bottom line

Inflation exists when prices rise but purchasing power falls over a certain period. There are two main causes that determine the type: cost-pull and demand-pull. Some consider built-in inflation as a third cause.Wholesale Price Index (WPI) and Consumer Price Index (CPI) are indices used to measure inflation rates. Using monetary policies, the Reserve Bank of India tries to keep the annual core inflation rate at 4% within the tolerable limit of 6% and a lower limit of 2%.

The most powerful way to protect ourselves from inflation is to increase the earning ability and income.  One more way of seeking protection is to invest in securities and other assets that give returns which are at least equivalent to the rate of inflation.

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