CASE STUDY ON INFLATION IN INDIA

RESEARCH DONE BYAKASH KAMAL(828) AAKRTI SARASWAT(543) ABHIUDAYA VERMA(804) CHANDRA PRAKASH(949) VARUN VERMA(525) AMIT KUMAR(864)

Table of Contents
Knowing Inflation ................................................................................................................................. 3 Inflation in Indian Context .................................................................................................................. 4 Defining Causes of Inflation ............................................................................................................... 5 Demand-pull inflation ................................................................................................................. 5 Cost-push inflation ...................................................................................................................... 5 Imported Inflation ....................................................................................................................... 5 Other Causes ............................................................................................................................... 6

Measuring Inflation .............................................................................................................................. 7 Problems of Inflation ........................................................................................................................... 8 Curbing Inflation ................................................................................................................................ 10 As individuals what can we do to stop Inflation?........................................................................... 13

Knowing Inflation
Inflation generally means rise in prices. To be more correct inflation is persistent rise in the general price level rather than a once-for-all rise in it, while deflation is persistent falling price level. A situation is described as inflationary when either the prices or the supply of money are rising, but in practice both will rise together. These days economies of all countries whether underdeveloped, developing as well developed suffers from inflation. Inflation or persistent rising prices are major problem today in the world. Because of many reasons, the rate of inflation in these days are much higher than earlier days. Inflation in these days coexists with high rate of unemployment, which is a new phenomenon and made it difficult to control inflation. An inflationary situation is where there is too much money chasing too few goods. As products and services are scarce in relation to the money available in the hands of the buyers, prices of the products and services rise to adjust for the larger quantum of money chasing them.

Inflation in Indian Context

Inflation is no stranger to the Indian economy. The Indian economy has been registering stupendous growth after the liberalization of Indian economy. In fact, till the early nineties, Indians were used to ignore inflation. But, since the mid-nineties controlling inflation has become a priority. The natural fallout of this has been that we, as a nation, have become virtually intolerant to inflation. The opening up of the Indian economy in the early 1990s had increased Indias industrial output and consequently has raised the Indian Inflation Rate. While inflation was primarily caused by domestic factors (supply usually was unable to meet demand, resulting in the classical definition of inflation of too much money chasing too few goods), today the situation has changed significantly. Inflation today is caused more by global rather than by domestic factors. Naturally, as the Indian economy undergoes structural changes, the causes of domestic inflation too have undergone tectonic changes. The main cause of rise in the rate of inflation rate in India is the pricing disparity of agricultural products between the producer and consumers in the Indian market. Moreover, the sky-rocketing of prices of food products, manufacturing products, and essential commodities have also catapulted the inflation rate in India. Furthermore, the unstable international crude oil prices have worsened the situation.

Defining Causes of Inflation

What exactly is the nature of the inflation which has the nation in its grip? The different causes of inflation, which are experienced in the Indian economy in a large proportion would be:-

Demand-pull inflation: This

is basically when the aggregate

demand in an economy exceeds the aggregate supply. It is also defined as `too much money chasing too few goods. Bare-boned, it means that a country is capable of producing only 100 items but the demand is for 105 items. Its a very simple demand-supply issue. The more demand the item has, the costlier it becomes. In the same way, the real estate in the country is rising.

Cost-push inflation: This

is caused when there is a supply

shock. This represents the condition where, even though there is no increase in Aggregate Demand, prices may still rise. I.e. non availability of a commodity would lead to increase in prices. This may happen if the costs of manufacturing, especially the cost of wages would rise.

Imported Inflation: This

is inflation due to increase in the

prices of imported goods and services. Te increase in the prices of imported final products directly affect any expenditure-based measure of inflation. They play an important role in driving the rise in domestic prices. The rise in the global prices of crude oil and agricultural commodities, including food grains, and industrial products, and setbacks to global economy resulting from sub-prime mortgage disaster and the US recession have contributed to Indias inflation.

Other Causes:
When the government of a country print money in excess, prices increase to keep up with the increase in currency, leading to inflation. Increase in production and labour costs has a direct impact on the price of the final product, resulting in inflation. When countries borrow money, they have to cope up with the interest burden. This interest burden results in inflation. High taxes on consumer products, can also lead to inflation. An increase in the indirect taxes can also lead to increased production costs. Inflation can artificially be created through a circular increase in wage earners demands and then the subsequent increase in producer costs which will drive up the prices of their goods and services. This will then translate back into higher prices for the wage earners or consumers. As demands go higher from each side, inflation continues to rise. Debt, war and other issues that cause a drastic financial burden can also cause the inflation.

Measuring Inflation
Inflation in India is mainly estimated on the basis of fluctuations in the wholesale price index (WPI). The wholesale price index comprises of the following indices: Domestic Wholesale Price Index (DWPI) Export Price Index (EPI) Import Price Index (IPI) Overall Wholesale Price Index (OWPI) The WPI consists of about 435 items and has three broad categories. They are:Primary Articles (weight of 22.0253) 22% Index Fuel, Power, Light, and Lubricants (weight of 14.2262) - 14% Index Manufactured Products (weight of 63.7485) 64% Index The base year of the WPI is 1993-94. The base year usually chosen is one where there has been fairly less volatility. The Indian WPI figure is released weekly on every Thursday. But recently the government has approved the proposal to release a wholesale price based inflation data on a monthly basis, instead of every week. The new series of WPI based inflation with 2004-05 as the base year has been launched. The move is aimed at improving the accuracy of the inflation data. The monthly release of WPI is a widely-followed international practice and it is expected to improve the quality of data. Collection of price data of manufactured goods will, accordingly, have a monthly frequency consistent with the practice of release of WPI. The new series of WPI based inflation with 2004-05 as the base year has since been launched. However, the government will continue to release a weekly index for primary articles, and commodities in the fuel, power, light and lubricants groups. The weekly index will facilitate monitoring of the prices of agricultural commodities and petroleum products, which are sensitive in nature.

Problems of Inflation
It has been reported that the manufacturing capacity in India is running at around 95 per cent of its capacity, which usually means it is running at full capacity. Therefore, when the prices of manufactured goods are increasing, the demand is usually higher than supply of goods and services, which is a clear case of demand-pull inflation. On the primary goods front, which consists of fruits, vegetables, food-grains etc, it is not that straight-forward. It has certainly been all over the news that the prices of fruits and vegetables are increasing and a trip to the supermarket or local grocery shop will testify the same. Although, it is a clear case of demand-pull inflation, on the other hand, it is also a case of a supply shock when one considers the fact that there is an abnormally high percentage of fruits and vegetables that goes to waste because of the lack of cold-storage facilities. Some estimates say 50 per cent of the produce goes to waste and that is a conservative figure. The fuel price hike is a straight example of cost push inflation. When OPEC (The Organization of the Petroleum Exporting Countries) was formed, it squeezed the supply of oil and this caused oil prices to rise, contributing to higher inflation. Since oil is used in every industry, a sharp rise in the price of oil led to an increase in the prices of all commodities. The problems due to inflation would be: When the balance between supply and demand goes out of control, consumers could change their buying habits, forcing manufacturers to cut down production. Inflation can create major problems in the economy. Price increase can worsen the poverty affecting low income for the household. Inflation creates economic uncertainty and is a dampener to the investment climate slowing growth and finally it reduce savings and thereby consumption.

The producers would not be able to control the cost of raw materials and labour. Hence they would not be able to control prices of the final products. This could result in less profit or in some extreme cases no profit, forcing them to go out of the business. Manufacturers would not have any incentive to invest in new equipment and new technology. Uncertainty would force people to withdraw money from the banks and convert it into product with long lasting value like gold, artefacts. The inflation created imbalances in the Indian economy. It has created a new rich class in social and political circles, who are corrupt themselves and also corrupt the overall society. The increased prices reduced the capacity to save and people preferred present consumption to future consumption. It has provided protection and subsidies to the industries, which bred inefficiency. It has lead to wrong allocation of resources due to distortion of relative prices and finally redistribution of wealth from the poor to the rich. It disturbs balance of payments.

Curbing Inflation
There are several reasons why we should worry about the spike in the inflation rate. Inflation is a tax on the poor and long-term lenders. Inflation is already too high, though it is definitely not at economy-wrecking levels. But its best to be serious about the threat it poses. Inflation has emerged as the biggest risk to the global outlook, having risen to very high levels across the world, levels that have not been generally seen for a couple of decades. Currently, in India, we go through boom-and-bust cycles; sometimes GDP growth rates are very high and sometimes GDP growth rates drop sharply. This boom-and-bust cycle is unpleasant for every household. There is a powerful international consensus that stabilizing inflation reduces this boom-and-bust cycle of GDP growth. India is facing the problem of inflationary pressure because of the increase in Aggregate Demand while Aggregate Supply is respectively constant. The inflationary pressure faced by the Indian Economy is due to Demand-Pull inflation i.e. Aggregate Demand > Aggregate Supply. To curb inflation, we need to fill the gap between Aggregate Demand and Aggregate Supply. For this, either we need to increase Aggregate Supply or decrease Aggregate Demand that can hamper economic development. To increase Aggregate Supply, either there is a need to increase production capacity of all current production units or to build new production plants/units. But as quoted in a survey done by the Reserve Bank of India (RBI) that all the production plants are running at their full production capacity. All resources are fully employed. The other way is to build new plants, but to do so will take at least 18 months to 2 years. In this situation, we need to decrease Money Supply, which is opted by RBI, in order to control in the ongoing inflation. Increasing production of useful goods and services is what India should focus on.

In the short run, it is not possible to meet the gap between Aggregate Demand and Aggregate Supply. Hence, the RBI, in recent monetary policy review on 29th October, 2013, raised the rates (Repo rates) by 0.25 basis with a view to quell the inflation. RBI planned that Liquidity from the market can be drained by decreasing money supply and to do so, it is increasing CRR, repo rate, reverse repo rate and taking other measure like that. CRR i.e. Cash Reserve Ratio (Liquidity Ratio) is the percentage of deposit that a commercial bank needs to keep with RBI by which RBI control liquidity in the market and create Money Supply. Repo Rate is the rate at which RBI lends money to other commercial Banks. The Reserve Bank said that such decisions had been taken to curb inflation in India. RBI is taking positive steps to reduce the inflation since inflations rates are going up week by week. By raising the reserve rate, a deflationary pressure can be put on the economy, since the money multiplier has been reduced. People will therefore save more. But in this hike, there is negative impact in terms of higher interest rates and personal loans, vehicle loans and other loans become costly. RBI may hike the rate to reduce the money circulation in the country but it also decreased the sales of all loan items and further it reduces the manufacturing activity of many industries. Now the public and private sector banks may raise the interest rate at which they lend money to borrowers. India needs to produce more exports than imports from another country, then the countrys money deflates with respect to that currency. Exporting becomes a problem because buyers from outside feel that the goods are expensive so they prefer buying some other countrys goods with cheaper rates. Thus money does not come in the same way. When public has more money, they may buy foreign goods, thus money goes out, which is bad. There is a need to encourage people to purchase goods produced within the country.

It is important for the policy makers to make credible announcements and decrease interest rates. Private agents must believe that these announcements will reflect actual future policy. Any announcement of low level inflation target is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumers demand (demand pull inflation) and a firms costs (cost push inflation), so inflation rises. Hence, if a policy makers announcements regarding monetary policy are not credible, policy will not have the desired effect. Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand as well as by using monetary policy. Supply side economists advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a return to the gold standard. All of these policies are achieved in practice through a process of open market operations.

As individuals what can we do to stop Inflation?

Firstly we should save more and more. As much of our money as possible should be saved. This will reduce the demand on the economy and hopefully reduce inflation. We should not overuse daily essentials like cooking gas, electricity etc. We should cut down on non-essentials, when buying groceries. We should look for cheaper alternatives to products that you normally buy. We should keep roads, highways, sidewalks, etc., beautified to help attract tourists and bring additional money into a growing economy. We should stop illegal immigration. Illegal activities reap the benefits of the country but dont pay taxes. Government-backed investment schemes such as Post Office Savings Schemes, Public Provident Funds (PPF) and National Savings Certificates (NSC) are best to invest in when inflation is slowly inching up and we are only looking at safety, not returns. Invest in short term deposits and funds, commodities and property. This will help us to slowly reach our financial goals while safeguarding our hard-earned money. *****