Inflation and its types
Since 1983, when “Inflation” was first made a part of American parlance, it has undergone a tremendous change. While in 1983 Webster explained Inflation as a cause rather than effect defining it as “Inflation is increase in supply of money that causes increase in price” in 2000 it was defined as “A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services”,
Following are some of the causal factors of inflation:
Supply of money goes up Or Demand for money goes down
Supply of goods goes down Or Demand for goods goes up
Following different types of inflation are also discussed:
Cost-Push/ Supply-Shock Inflation: This type of inflation mainly occurs when the cost of goods and services increases beyond control.
Demand-Pull- This type of inflation occurs when too much money is chasing few goods.
Pricing Power/ Oligopolistic- This type of inflation occurs when some business firms decide to raise the price of their products inorder to increase their profit margin. However it is not done when the economy is undergoing a downturn or suffering from a financial breakdown.
Sectoral- This type of inflation occurs when the increase in price of product of a particular sector leads to the inflation in all the sectors that are directly or indirectly dependent on it.
Fiscal- This type of inflation occurs when the government carries out uncontrolled and exorbitant expenditure pattern, spending too much on the non-development activities and finally putting itselt into vicious circle of debt and payments.
Hyperinflation- This type of inflation occurs when the price level is totally out of control and every day the price level is increasing by 10-15%, this type of inflation occurs specially when people have lost faith in their government and its money.
Various instruments used for measuring inflation are also discussed:
Consumer Price Index- A measure of price changes in consumer goods and services The CPI measures price change from the perspective of the purchaser.
Producer Price Index- A family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller.
Wholesale Price Index- A price index which monitors change in price of a basket of consumables
India Inflation Rate
From 1969 until 2010, the average inflation rate in India was 7.99 percent reaching an historical high of 34.68 percent in September of 1974 and a record low of -11.31 percent in May of 1976.
* The table above displays the monthly average.
New Series on WPI Inflation
WPI inflation is taken as the headline inflation in India. At the start of this year, government of India released the new series on the Wholesale Price Index (WPI) changing the base year from 1993-94 to 2004-05. There is not much difference in average inflation rate between the new series and the old series which is about 5.5 percent.
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Changes in the new series captures the current structure of the economy, consistent with the consumption pattern and the price trends at a disaggregate level. Notwithstanding a significant reduction in weightage, the food inflation in the new series is higher than in the old series. This is because of change in the consumption basket in favour of protein-rich items such as egg, meat and fish where price rise has been high apart from milk and pulses.
The non-food manufactured products inflation is lower in the new series than in the old series. This is because of a substantial overhauling of the basket with the introduction of a number of new items. The new series has 417 new commodities of which 406 are new manufactured products.
High Inflation Episodes
Going by the current experience of 5-6 months of double digit inflation as high, one can trace 9 such episodes in the last 56 years. Out of these 9 episodes, double digit inflation lasting beyond a year occurred on 5 occasions. The most prolonged one lasted for 30 months during October 1972 to March 1975. The last such high inflation was in the mid-1990s which lasted 15 months between March 1994 and May 1995.
Agricultural Output & Food Inflation
Fluctuations around the trend are determined more by the severity of supply shocks and the nature of policy response. One of the recurrent supply shocks influencing inflation conditions in India emanates from the agricultural sector due to drought conditions. Food inflation, which has always been a major source of fluctuation in the headline inflation, has a significant negative correlation (-) 0.5 with 2-year average growth in agricultural GDP.
Causes of Inflation
Among the general causes of inflation, a detailed analysis of the factors which affected the inflation of India in recent past has been studied. The analysis was as follows:
Supply-Shock Inflation: Two major components were discussed under this heading:-
A detailed trend of the food inflation in India was analyzed , peculiarities’ such as ,even when the general inflation(WPI) has been low, the food inflation was always been high, in double digits (10.37 present) ,have been discussed and factors causing this, like inadequate monsoon, poor distribution system, inadequate food security etc were discussed :
Monsoon: Since a big part of Indian cultivation is still based on natural rains due to insufficient or fluctuating monsoon both Rabi and kharif crops like rice, wheat, sugarcane etc suffer production loss.
Poor Distribution System: With the deregulation of food market, involvement of public distribution system has been continuously discouraged, due to which a systematic reliable system of food distribution seems to be absent.
Inadequate food security: About 50% of vegetables and fruits are wasted every year due to lack of proper cold storage facility.
Marketing margin- Initially, when the distribution of food items was regulated by government, the food products were directly supplied from farmers to the retailers and then to the consumers and hence the only margin above the cost of farmers was that of retailers and now in the deregulated market apart from the retail margins the marketing margins are also coming into picture because of which the final price is increasing and thus causing inflation.
General causes for industrial inadequacy:
Low manufacturing capacity – This cannot be the reason for inflation in Industrial sector of India because Indian manufacturing units at average are having capacity of about 95% which is sufficient to be excluded from the inflationary discussion
Low growth rate- Though this is true, but the reason is different from the normal, in India Industries are growing at low rate not because they are not capable of moving at faster pace but because the legal issues are crippling the pace, For Ex: For a single expansion of manufacturing process, the industries are supposed to get clearance from more than 100+ legal authorities which is both cumbersome and time consuming process. This resulting in unwanted low growth rate
Increased cost of raw materials- This could be illustrated best from the example of infrastructure growth of the country. While government has chalked out a huge amount of Rs.5400 crores for the development of infrastructure, this could be possible only when the steel companies are capable of supplying the sufficient steel required for the purpose. But it appears that the steel sector of country is failing in helping in achieving the goal, not because of technological reasons, but because of the high cost of raw materials, coke which is one of the raw materials is exported from other countries and its cost seems to be continuously increasing, thus causing increase in price of steel.
Sectoral Inflation: This type of inflation is basically caused due to rise of price of product of particular sector which in turn causes rise in price of all the dependent products and services. Ex: In India which exports crude oil from Saudi Arabia and other oil rich countries the continuous increase in oil price has led to increase in price level of transportation and aviation sector and other energy sources.
Fiscal Inflation: We know that productivity of GDP of country is given by:
Where Y= Output, C=Consumption, G= Government Expenditure, NX= Net Exports
But in this equation in the G component one important factor that is transfer payment is not taken into consideration, but in case of India it cannot be neglected because the transfer payments which account for the government expenditure over non-developmental activities like interest payment, subsidies are so high that they are adversely affecting the amount which must be dedicated toward activities which lead to development. Every year India takes an amount from IMF or World Bank to repay its previous debt and further development and fails to achieve both of them and goes into further debts and hence loans and the cycle goes on continuously with our interest payment rising year after year showing no sign of respite. This in turn is affecting other development activities and thus adding up to the inflation.
Measures to control inflation and their effect:
Raises the bank rates
Sells securities in the open market
Raises the reserve ratio
selective credit control measures
Not effective in cost push inflation
Effective in Demand pull inflation
Demonetization of Currency:
However, one of the monetary measures is to demonetize currency of higher denominations. Such a measure is usually adopted when there is abundance of black money in the country.
Issue of New Currency:
The most extreme monetary measure is the issue o f new currency in place of the old currency. Under this system, one new note is exchanged for a number of notes of the old currency. The value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of notes is hyperinflation in the country.
Fiscal Measures :
Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented by fiscal measures. Fiscal measures are highly effective for controlling government expenditure, personal consumption expenditure, and private and public investment. The principal fiscal measures are the following:
Reduction in Unnecessary Expenditure:
The government should reduce unnecessary expenditure on non-development activities in order to curb inflation. This will also put a check on private expenditure which is dependent upon government demand for goods and services.
Increase in Taxes:
To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes should be raised and even new taxes should be levied, but the rates of taxes should not be so high as to discourage saving, investment and production.
Increase in Savings:
Another measure is to increase savings on the part of the people. This will tend to reduce disposable income with the people, and hence personal consumption expenditure.
An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the government should give up deficit financing and instead have surplus budgets. It means collecting more in revenues and spending less.
At the same time, it should stop repayment of public debt and postpone it to some future date till inflationary pressures are controlled within the economy. Instead, the government should borrow more to reduce money supply with the public.
The other types of measures are those which aim at increasing aggregate supply and reducing aggregate demand directly.
To Increase Production:
One of the foremost measures to control inflation is to increase the production of essential consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc. If there is need, raw materials for such products may be imported on preferential basis to increase the production of essential commodities.
Rational Wage Policy:
Another important measure is to adopt a rational wage and income policy. Under hyperinflation, there is a wage-price spiral. To control this, the government should freeze wages, incomes, profits, dividends, bonus, etc. But such a drastic measure can only be adopted for a short period and by antagonizing both workers and industrialists. Therefore, the best course is to link increase in wages to increase in productivity. This will have a dual effect. It will control wage and at the same time increase productivity, and hence production of goods in the economy.
Price control and rationing is another measure of direct control to check inflation. Price control means fixing an upper limit for the prices of essential consumer goods. They are the maximum prices fixed by law and anybody charging more than these prices is punished by law. But it is difficult to administer price control.
Rationing aims at distributing consumption of scarce goods so as to make them available to a large number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene oil, etc. But it is very inconvenient for consumers because it leads to queues, artificial shortages, corruption and black marketing.
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Effects of measures taken by RBI:
Repo rate increase: When RBI increases Repo rate, the funds banks borrow from RBI becomes costly and hence they tend to increase the lending rates. Hence loans for common man become costly as well and hence they avoid taking loans. Hence the cash supply in the market reduces resulting in reduction in demand. This leads to reduction in prices of goods and services thus lowering inflation.
Reverse repo rate increase: When RBI increases the reverse repo rate, banks tend to give more loans to RBI as this is a very safe investment and they gain larger profit by doing this. Hence extra cash is extracted out of the market thus reducing money in market, leading to reduction in consumption and demand in the market thus lowering inflation.
OPEN MARKET OPERATIONS: RBI can sell securities to banks which will extract the excess cash from the market and the market will adjust itself for equilibrium.
Cash to Reserve Ratio Increase: When RBI increases cash to reserve ratio, banks have to keep higher amount of cash with RBI and hence the available money with the banks for lending reduces considerably. Hence banks increase the lending rates which reduce no. of loans given to people and less money is there in the market. Hence there is a decrease in demand and consumption.
Statutory Liquidity Ratio increase: When RBI increases SLR, banks have to spend higher amount in buying bonds and securities and hence the available money with the banks for lending reduces considerably. Hence banks increase the lending rates which reduce no. of loans given to people and less money is there in the market. Hence there is a decrease in demand and consumption.
EFFECT ON LM CURVE: The LM curve shifts upward on decreasing money supply which results in increase in interest rates as shown in diagram below.
Effect of Fiscal Measures
Reduction in unnecessary expenditure
Since government spending has become an important component of the aggregate spending, by changing its expenditure in relation to the tax receipts, the government can exert a powerful effect on the flow of money, aggregate demand and economic activity.
Increase in savings
Reduce disposable income -> reduce personal consumption expenditure
The payment of public debt can be delayed by the government as due to inflationary pressures fiscal deficit increases and government subsidies need to be increased. Hence by delaying payment of public debt there will be breathing space.
Increase in taxes:
Increase in taxes leads to increase in budget surplus and reduces the personal disposable income of an individual thereby decreasing consumption and demand, thus reducing prices of goods and services thereby reducing inflation.
Surplus budgets mean increase in revenues and decrease in spending. In both cases the liquidity in market will decrease
Increasing production is used to tackle supply side inflation
This leads to making necessary things available at a lower cost to help fight the social effects of inflation
Rational Wage Policy
Control Measures by RBI
The RBI has been given the mandate to rein in Inflation, but it is not well equipped to handle inflation. RBI can only influence the Monetary Policy, which has been not so successful in bringing down the Inflation in recent times in India. The reasons for this are manifold:
Monetary tools are more effective in economies with greater financial inclusion. In India the majority of the population still has no access to banks. The increasing cost of funds and rising interest rates are of little consequence in the economic life of a financially excluded population. The ratio of deposit accounts to total adult population is only 59 per cent in India.
The nature of the inflation is more of a “supply driven” nature and not demand driven. And tighter monetary controls are aimed at lowering the demand.
When credit is made costlier, it doesn’t distinguish between the credit for consumption or production.
Interest rate is one tool to influence inflation, but exchange rates are even stronger tool to influence inflation.
Domestic Inflation connected with the rise of global commodity prices. Commodities such as edible oil, pulses that India exports are directly affected by the international rates and sometimes due to a bad monsoon even the staples like wheat, sugar etc had to be imported.
What the RBI has been doing so far is only trying to control the credit availability in the market by rising the CRR, Repo Rate, and SLR etc. This makes the funds more costly for the commercial banks and in turn they are forced to increase the Prime Lending Rate (PLR). The increase in PLR increases the cost of credit for business and reduces the investment in the production sector. The high PLR means that no SME could get loan for working capital for less than 12% – 15%. This then sometimes leads to a recession (smaller magnitude). Infact in most of the times more inflationary pressures appear on the economy due to less production. Whereas at the same time in rest of Asia the interest rates are very low (Real Interest Rates in China: -2.64 %, South Korea: 3%, Thailand: 1.45%). So the Indian business interest would be hurt if only credit control measures are taken to control inflation.
Also high interest rates have become a magnet for foreign portfolio funds; which tends to appreciate the Rupee. But the RBI here again steps in to stop the Rupee from appreciating by infusing domestic currency into the economy, which again leads to more inflation.
The ability of the RBI to influence the WPI is limited; it is the price index that is heavily influenced by international commodity price. Here the exchange-rate management offers the best hope for controlling inflation. Roughly speaking, a 1% appreciation of the rupee yields a 0.2% reduction in the WPI. Today India has around $300 billion of foreign reserves (well beyond what is required to assure stability). This reserves build-up has contributed to inflation because rupees had to be pumped into the economy when the central bank purchased dollars. So selling the reserves would have three benefits:
An exchange rate appreciation would combat inflation, because there would be then an increase in the purchasing power of money.
The implicit and explicit fiscal costs of holding reserves would decline.
And it would support the monetary tightening that helps fight inflation. The RBI would be able to mop up the excess domestic currency from the economy.
But here the appreciation of the Rupee would hurt Indian exports and so a tradeoff has to be made. In China whose government controlled banks absorb the “sterilization bonds” that keeps domestic currency devalued at the same time decreases the currency in the economy (so less inflation). But in Indian the sterilization bonds are not very favored by the banks and they sell them in exchange for money.
Recommendation & Conclusion
The RBI can look at another aspect to tackle inflation, the Supply side of inflation. The strengthening of the supply side would require infrastructure development, planning, large scale investments etc. These are generally accomplished by the Government through Fiscal policies etc. But even the RBI has some tools to play a significant role here. The RBI already regularly issues master circulars, through which they direct various aspects of banking and certain corporate matters. It also regulates and governs matters regarding inflow of foreign funds, foreign institutional investment (FII) into India, Utilization of External Commercial Borrowings etc. So for the purpose of bolstering agricultural growth, development of infrastructure and all other avenues, it may lay down regulations to direct money either directly or indirectly with special importance to these sectors. And through this carefully routed capital, there may be an access to the required finance for the farmers & SMEs notwithstanding the high interest rate (which the RBI would then be able to maintain in the economy).
Eventhough in the short-run the RBI credit policy measure has been creating pain and might even push the economy into a small recession. However, it gives the creditability of the Central Bank to fight interest rate expectations and trying to control inflationary expectation within its mandate, so in medium-run it will definitely enhance the creditability of Indian economic environment.
Also if we look at the broader picture, another reason for inflation might be the economic status and mindsets of the people of India, which are advancing. The Indian consumer today demands products and services which were earlier not available to him/her. This is an indicator of an improved standard of living. And this should be considered as a good sign. Therefore the RBI instead of trying to artificially push demand down should give more attention to the supply factors for controlling inflation.