INFLATION

A PRESENTATION BY GROUP 1 Piyush Malhotra 135 Ishan Adlakha 136 Anand Kumar 137 Anu Lall 138 Russel Nayyar 139 Kanika Monga 140

FLOW OF PRESENTATION
What is Inflation? Effects of Inflation Types of Inflation Inflation In India Cost Push Demand Pull Philips Curve WPI & CPI Measures To Control Inflation Impact of Inflation

WHAT IS INFLATION?

Inflation is the rate at which the general level of prices for goods and services is rising and subsequently the purchasing power is falling. It is a situation where the aggregate demand of goods and services exceeds the available supply and due to this there is increase in price level which is sustained in a economy for a period of time. Whenever a product is bought or sold beyond its real price for its worth, then inflation of money occurs.

WHAT IS INFLATION?

General price level increases

Each unit of currency buys fewer goods/ services

Erosion in purchasing power of money

MEASURING INFLATION
Inflation is rate of change in the price level. If the price level in the current year is P1 and in the previous year P0. The inflation for the current year is

[(P1 - P0) / P0] x 100

EFFECTS OF INFLATION

Positive Effects Includes ensuring central banks can adjust nominal interest rates. Encouraging investment in non-monitory capital projects. Less unemployment

Negative Effects Includes a decrease in the real value of money and other monetary items over time. Uncertainty over future inflation may discourage investments and savings. Rapid inflation may leads to shortage of goods out of concern that prices may increase in future.

TYPES OF INFLATION

Inflation can be classified in terms of the rate at which prices increase

Creeping Inflation
There is a marginal increase in prices. If it persists over a period of time without and monetary control, it may lead to running inflation

Running Inflation
The inflation rate is between 8 and 10%. There is an urgent need to control inflation. Persistent running inflation reduces savings and results in a slowdown.

Hyperinflation
It occurs when inflation touches the double digit mark. Hyperinflation can hamper the ability of an economy to supply goods and can lead to the abandonment of the use of a countrys currency.

HIGH INFLATION MAY LEAD THE COUNTRY TO LOWER ECONOMIC GROWTH

INFLATION IN INDIA

Between 1950-1960 Between 1960-1970

The inflation on an average was at 2.00%

The inflation on an average was at 7.2%
Between 1970-1980

The inflation on an average was at 8.5%.

WHOLESALE PRICE INDEX BASED INFLATION RATE IN INDIA ON YEAR-ON-YEAR BASIS

Inflation Jan'11-Sep'12
10 9 8 7 6 5

4
3 2 1 0

CURRENT SCENARIO OF INFLATION IN INDIA

Indias headline inflation was lowest for July12 which was 6.87 %. The monthly inflation, based on wholesale price index (WPI), was 9.36 %.during the corresponding month of the previous year. Food articles have a 14.3 % share in the WPI basket and Food inflation had re-entered the double-digit zone after a gap of six months in April, 2012 and only dropped to below 10% in Aug12

Pulses became costlier by 28.26 %. Milk became costlier by 8.01 %. Prices of eggs, meat and fish rose by 16.00 %. Y-O-Y July12.

CURRENT SCENARIO OF INFLATION IN INDIA

Recent factory data showed that India continued to face the problem of high inflationary pressure and a slow rate of growth. Data released by the Central Statistics Office recently, Indias industrial output increased by 2.7 % in Sep12.

Petrol as an item has lower weightage in the WPI of about 1.09 basis points and does not primary impact the headline inflation.

INFLATION IN INDIA

Inflation accelerated to a 10-month high in September mainly due to increase in fuel prices, wheat and fruits.

RBI reduced the cash reserve ratio, by 25 basis points releasing over Rs 16,000 cr. The decline in the exchange rate value of the rupee makes imports expensive.

INFLATION IN INDIA

In India, even as the growth has come down, our inflation has not come down. Rupee devaluation is due to widening trade and current account deficits and slowdown in portfolio flows on account of escalation in euro crisis.

Demand Pull Inflation

Demand pull inflation occurs when aggregate demand and output is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap. When there is excess demand in the economy, producers are able to raise prices and achieve bigger profit margins because they know that demand is running ahead of supply. Typically, demand-pull inflation becomes a threat when an economy has experienced a strong boom with GDP rising faster than the long run trend growth of potential GDP. This results in the increase in the prices

Demand Pull Inflation

The general rise in price level is because the demand for goods and services is in excess of the available supply at existing prices. The reasons for the shift in AD curve can Y AS be either real or monetary factors. It is due to: P
Price Level

The real factors The monetary factors

P0 AD AD O Y Y
0 2 0 1

Y
1

Demand pull inflation can be shown in a diagram such as the one below.

Causes of Demand Pull Inflation

Possible causes of demand pull inflation A growing economy: people will get better jobs and will spend more A depreciation of the exchange rate
Exports are more competitive in overseas markets leading to an injection of fresh demand into the circular flow and a rise in national and demand for factor resources there may also be a positive multiplier effect on the level of demand and output arising from the initial boost to export sales

Technological innovation

Causes of Demand Pull Inflation

Reduction in direct or indirect taxation by the government
If direct taxes are reduced, consumers will have more disposable income causing demand to rise. Higher government spending and increased borrowing feeds through directly into extra demand in the circular flow.

Monetary stimulus to the economy

A fall in interest rates may stimulate too much demand for example in raising demand for loans or in causing rise in house price inflation

Causes of Demand Pull Inflation

Faster economic growth in other countries providing a boost to UK exports overseas.
Improved business confidence which prompts firms to raise prices and achieve better profit margins Demand pull inflation is most likely to occur when an economy is becoming stretched and is said to be danger of over-heating. This is often seen towards the end of a boom when output is expanding beyond the economys usual capacity to supply, the result being higher prices and also a larger trade deficit (imports act as a kind of safety valve to take away some of the excess AD).

Cost push theory of inflation

Cost-push inflation occurs when businesses respond to rising costs, by increasing their prices to protect profit margins. This creates a wide gap between the aggregate demand and aggregate supply.

Cost push theory of inflation

Cost push theory of inflation explains the causes of inflation origination from the supply side.

Cost push inflation depends on:

Price Level

AS1

Wage push inflation Profit push inflation Supply shock inflation

AS0

P1 P0 AD O

Q
1

Q
0

Quantity

Cost push theory of inflation

Wage push inflation: Created by labor unions
and workers who are often able to increase their wages faster than their productivity Profit push inflation: Business firms pricing the goods and services on sole basis of their direct cost of materials and labor. In other words, aggressively motivated towards profit margin Supply Shock inflation: the basic concept of supply-shock inflation has to do with a considerable increase in the cost of goods and services that are considered to be essential and somewhat difficult to substitute.

Cost push theory of inflation

Cost push theory of inflation

Cost-push inflation occurs when businesses respond to rising costs, by increasing their prices to protect profit margins. There are many reasons why costs might rise: Component costs: e.g. an increase in the prices of raw materials and components. This might be because of a rise in global commodity prices such as oil, gas copper and agricultural products used in food processing a good recent example is the surge in the world price of wheat. Rising labour costs - caused by wage increases that exceed improvements in productivity. Wage and salary costs often rise when unemployment is low (creating labour shortages) and when people expect inflation so they bid for higher pay in order to protect their real incomes. Higher indirect taxes imposed by the government for example a rise in the duty on alcohol, cigarettes and petrol/diesel or a rise in the standard rate of Value Added Tax. Depending on the price elasticity of demand and supply, suppliers may pass on the burden of the tax onto consumers.

Cost push theory of inflation

A fall in the exchange rate this can cause cost push inflation because it normally leads to an increase in the prices of imported products. For example during 2007-08 the pound fell heavily against the Euro leading to a jump in the prices of imported materials from Euro Zone countries. Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of GDP together with a rise in the level of prices. One of the risks of cost-push inflation is that it can lead to stagflation. Important note: Many of the causes of cost-push inflation come from external economic shocks e.g. unexpected volatility in the prices of internationally traded commodities and large-scale movements in variables such as the exchange rate. A country can also import cost-push inflation from another country that is suffering from rising inflation of its own.

Demand pull vs Cost Push Inflation

One difference between the demand pull and cost push inflations is the unemployment level. In demand pull inflation the unemployment level remains low, whereas in the cost push inflation the unemployment level is on rise.

 If demand pull inflation is correct the government must bear the cost of excessive spending and monetary authorities are to be blamed for cheap money policy On the contrary, if cost push is the real cause for inflation then the trade union are to blamed for excessive wage claim, industries for acceding them and business firms for marking-up profits aggressively.

Demand pull vs Cost Push Inflation

THE PHILLIPS CURVE

Phillips Curve by A.W. Phillips shows that there is a inverse relationship between the rate of money wage increases and the rate of unemployment of the labor force.

CHARACTERISTICS OF PHILLIPS CURVE

Its a downward sloping curve towards the right. The decline in the rate of unemployment from U1 to U2 would increase the rate of wage increase from P1 to P2 which in turn causes inflation to increase. If the wage push inflation is to be kept under control , the society should be willing to accept certain amount of unemployment. The increase in the rate of unemployment would reduce the rate of wage increases leading to price stability.

EXPLANATIONS OF PHILLIPS CURVE RELATIONSHIP

In terms of Behaviour of Organised Labour : When unemployment rate is low and labour market is tight, the demands for good is high and hence producers make good profits. Thus the wages of the labour increases under such conditions. When unemployment rate is high , due to the market conditions the demand is low hence profits are low. The wages of labor are not increased .

IN TERMS OF EXCESS DEMAND FOR LABOUR:

R.G Lipsey shows at at point W3, the supply of labour is equal to the demand of the labour . This implies that unemployment is not zero but the number of unemployed workers is exactly same as the number of jobs lying vacant. The rate of wage increases directly with the amount of the excess demand of labour. Unemployment varies inversely with the amount of excess demand. Hence wage rate varies inversely with unemployment rate.

Below the point W3 there is an excess demand for labour which means a lower unemployment rate and also a higher rate of wage increase. Vice versa for above W3

MEASURING INFLATION
Inflation is usually measured based on certain indices. Broadly, there are two categories of indices for measuring inflation Wholesale Prices and Consumer Prices. An Index number is a single figure that shows how the whole set of related variables has changed over time or from one place to another. In particular, a price index reflects the overall change in a set of prices paid by a consumer or a producer, and is conventionally known as a Cost-of-Living index or Producer's Price Index as the case may be.

WHOLESALE PRICE INDEX (WPI)

The Wholesale Price Index is an indicator designed to measure the changes in the price levels of commodities that flow into the wholesale trade intermediaries. In India about 676 items were used for calculating the WPI in base year. It is also the price index which is available on a weekly basis with the shortest possible time lag only two weeks.

WHOLESALE PRICE INDEX (WPI)

The index is a vital guide in economic analysis and policy formulation. It is a basis for price adjustments in business contracts and projects. It is also intended to serve as an additional source of information for comparisons on the international front.

CONSUMER PRICE INDEX (CPI)

CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. Under CPI, an index is scaled so that it is equal to 100 at a chosen point in time, so that all other values of the index are a percentage relative to this one.

CONSUMER PRICE INDEX (CPI)

It shows the cost of living of the group. It is based on the changes in the retail prices of goods or services. Based on their incomes, consumer spends money on these particular set of goods and services. There are different consumer price indices. Each index tracks the changes in the retail prices for different set of consumers. The reason for the different indices is the differing pattern of consumers.

WRT INDIA.

India is the only major country that uses a wholesale index to measure inflation. Most countries use the CPI as a measure of inflation, as this actually measures the increase in price that a consumer will ultimately have to pay for.

WPI does not properly measure the exact price rise an end-consumer will experience because, as the same suggests, it is at the wholesale level. The WPI doesnt take the price of services into consideration, which now accounts for 55% percent of the GDP.

WRT INDIA.
Take, for example, a commodity like coarse grains that go into making of livestock feed. This commodity is insignificant, but continues to be considered while measuring inflation. WPI is supposed to measure impact of prices on business. But we use it to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index.

WHY INDIA IS NOT SWITCHING OVER TO THE CPI METHOD OF CALCULATING INFLATION?

Finance ministry officials pointed out that there are many intricate problems from shifting from WPI to CPI model. First of all, they say, in India, there are four different types of CPI indices, and that makes switching over to the Index from WPI fairly 'risky and unwieldy.' The four CPI series are: CPI Industrial Workers; CPI Urban Non-Manual Employees; CPI Agricultural labourers; and

WHY INDIA IS NOT SWITCHING OVER TO THE CPI METHOD OF CALCULATING INFLATION?
Secondly, officials say the CPI cannot be used in India because there is too much of a lag in reporting CPI numbers. The WPI is published on a weekly basis and the CPI, on a monthly basis. And in India, inflation is calculated on a weekly basis.

THE CHANGE..

The Consumer Price Index (CPI), was introduced a year ago, and it will exist alongside the prevailing Wholesale Price Index (WPI). The CPI rate was introduced keeping in mind that demand-side pricing would be a better indicator of inflation than the WPI, which focuses on prices from the producers' side. The CPI data tracks retail prices in five major groups, food, fuel, clothing, housing and education across rural and urban India, providing a comprehensive reference point for policymakers.

THE CHANGE..
The CPI also reflects price movements in the services sector, which makes up about 55 per cent of India's economy but is not included in the WPI. The index, which uses 2010 as the base year, was introduced by the Ministry of Statistics in January 2011. Indias first ever annual inflation rate, based on the consumer price index (CPI), was 7.65 per cent for the month of January 2012

ISSUES

India now has three consumer indices CPI for industrial workers (IW), for agricultural labourers (AL) and rural labourers (RL) to reflect price increases for three different segments. This makes it difficult for the Indian government to adopt CPI in calculating inflation Then, there is too much of a lag in reporting of CPI numbers. India calculates inflation on weekly basis, whereas CPI figures are available on monthly basis. Thus, the economists are sure that it would take lot of time for Indian government to eventually have one CPI index incorporating all indices.

ISSUES
Given a choice, even Indian policymakers would want to shift to the wide and comprehensive index as it better reflects the demand-side pressures, an important ingredient in making policy to tackle inflation The RBI governor D Subbarao, too had recently said that the central bank has opted for WPI over CPI as a second-best choice. Although the CPI is the most representative of the price situation in the country, experts expect RBI will not abandon WPI as the primary inflation source anytime soon.

MEASURES TO CONTROL INFLATION

There are various measures by which the inflation can be controlled. These measures can be classified into -

Monetary measures,
Fiscal measures and Other measures.

MONETORY MEASURES
Monetory Policy refers to the policy measures that affect the economic variables viz. output, prices, etc through change in money supply RBI The monetory policy includes a range of instruments :(i) Cash Reserve Ratio (CRR) (ii) Statutory Liquid Ratio (SLR)

(iii) Bank Rate

(iv) Open Market Operations

MONETORY MEASURES TO CONTROL INFLATION IN INDIA

(i)

Other monetory policy measures: Modifications in SLR and restoring it to 23% of net demand and time liabilities (NDTL) of the banks. Bank Rate: Decreased from 9.50% to 9.00% which was continuing since 13/02/2012 CRR: Decreased from 4.50%which was continuing since 22/09/2012 SLR: Decreased from 24% which was continuing since 18/12/2010

(ii)

(iii)

(iv)

FISCAL MEASURES

The fiscal policy covers the policy of the Government relating to its expenditure and revenues and includes instruments like

(i) taxation,
(ii) subsidies, (iii) public expenditure

FISCAL MEASURES
Measures taken by the government to control inflation.

Decrease in public expenditure- One of the main reasons of inflation is excess public expenditure like building of roads ,bridges etc. Government should drastically scale down its non essential expenditure . Delay in payment of old debts: Payment of old debts that fall due should be postponed for sometime so that people may not acquire extra purchasing power. Increase in taxes : Government should levy some new direct taxes and raise rates of old taxes. Over valuation of money : To control the over valuation of money it is

AMINISTRATIVE MEASURE

Apart from monetory and fiscal policies certain administrative policies like rationing, price control, opening fair price shops, check on hoarding etc help to augment market supply and reduce inflationary prices

AMINISTRATIVE MEASURE TO CONTROL INFLATION IN INDIA

i. ii.

Public Distribution System (PDS)

To help people purchase wheat, rice, etc at reasonable price the govt has opened around 4.47 lakh fair price shops It ensures that the common people are assured of the supply of neccesary goods at lower prices

i.

Checking Hoarding
Govt must unearth hoardings and punish hoarders and speculators to ease pressure on prices

i. ii. iii.

Other Measures :
Ban on export of non basmati rice, edible oils and pulses. Increasing minimum support prices (MSPs) with a view to encourage acreage under food crops, increased production and more procurement. Distribution of imported pulses through PDS at subsidised rates.

OTHER MEASURES:
1. Other measures primarily include price control and rationing and

wage policy. Government sometimes puts temporary freeze on the earnings of the workers and employees, so that the purchasing power can be curbed. Example: Government of India imposed, temporary freeze on the leave travel Concession (LTC) for its employees.

2. Increase in the production- One of the major causes of the inflation is the excess of demand over supply ,so those goods should be produced more whose prices are likely to rise rapidly .In order to increase production public sector should be expanded and private sector should be given more incentives.

3. Proper commercial policy- Those goods which are in scarcity should be imported as much as possible from other countries and their export should be discouraged.
4. Encouragement to savings During inflation government should come out with attractive saving schemes. It may issue 5 or 10 year bonds in order to attract savings.

IMPACT OF INFLATION

Right from the beginning, inflation adds to inequalities of income and wealth. Every economy needs a continuous addition to its productive capacity for which it should encourage capital formation. Inflation makes consumption more attractive than saving.

When domestic prices rise faster than prices in foreign countries, exports tend to lag behind imports then rate of exchanges depreciates.

IMPACT OF INFLATION

High inflation distorts economic incentives by diverting resources away from productive investment to speculative activities.

Inflation reduces households saving leading to fall in overall investment in the economy which reduces its growth potential.
Nominal interest rates tend to be higher than they would have been under low and stable

IMPACT OF INFLATION

It affects external competitiveness through appreciation of the real exchange rate. It leads to an increase in unemployment and a fall in output. High inflation can prompt employees to demand rapid wage increases, to keep up with consumer prices.(Cost-push inflation) People buy durable and/or non-perishable commodities and other goods as stores of wealth.(Hoarding)

IMPACT OF INFLATION

Debtors and Creditors :As a result of the inflation the real value of money comes down. While paying back the loans taken, debtors do not consider the reduction in the value of money as a result of the inflation. Hence, debtors gain as a result of the inflation, whereas, creditors stand at the loosing end.

ANY SUGGESTIONS OR QUERIES ARE MOST WELCOME