Economics for Every One –

Inflation: Impact on the

Nation Prof. M. Guruprasad, Aicar Business School / Mumbai Jun 30, 2008 14:00

The graph of inflation and that of the blood pressure of the United Progressive Alliance ministers have
become highly positively correlated, what with national election not very far away.

The issue

The graph of inflation and that of the blood pressure of the United Progressive Alliance ministers have
become highly positively correlated, what with national election not very far away.

Not surprisingly, we are witness to a flurry of frantic actions and threat of even more frantic fanatic
actions to show to the whole world (electorates) that the fight against inflation is very much on.

And, whenever that fails, one can always fall back on the tried and tested formula of blaming the global
phenomenon having engendered the local problem.

Not that this attribution is baseless. There is indeed no gainsaying the fact that inflation has indeed
taken a global hue with food and oil prices running amok all over the world. And, the rise in food and oil
prices is more a reflection of runaway commodity prices.

Inflation rate grew by a faster 7.60 per cent in May from 7.14 per cent in the previous month, on higher
prices of food items, including jaggery and fish.
The RBI Governor recently admitted that inflation in India's food prices is much higher than the country's
'tolerance limit' necessitating a comprehensive review of the situation." We anticipated some
inflationary pressures but it turned out to be more intense and we have to examine all aspects of the
situation, both global and domestic,

Rising prices have forced India's United Progressive Alliance government to take urgent measures -- like
banning export of non-basmati rice, pulses, edible oil and cement -- to rein in runaway inflation. High
inflation rate has taken a political colour in the country with the opposition Bharatiya Janata Party and
Left allies accusing the government of its failure to address the aam aadmi's woes.
According to India Inc, however, the highest point in inflation is yet to hit India. A new survey says that
nearly two-thirds of the executives in India expect prices to flare up in the next six months. The report --
Economic and Hiring Outlook, First Quarter 2008: A McKinsey Global Survey -- states that as many as 64
per cent of Indian executives expect the rate of inflation to rise in the next six month, while only 20 per
cent expect a decline in the rate of price rise.

Among the products primarily responsible for the current inflation are food products of different kinds,
including cereals, intermediates like metals and the universal intermediate, oil.

Some of the reasons for the spurt in prices of various commodities:

Impact of high oil prices: High crude oil prices affect agricultural costs directly because of the
significance of energy as an input in the cultivation process as well as in the transportation of food.

Increase use of bio-fuels: Many Western countries have promoted bio-fuels as an alternative to
petroleum. This has led to significant shifts in acreage as well as use of certain food grains. For example,
Brazil uses sugarcane to make bio-fuel and the European Union uses imported vegetable oils to make
bio-fuel. This has reduced the available land for producing food the world over. As global food and
commodity prices rise, the impact is felt by India too.

Neglect of agriculture: The prolonged agrarian crisis in many parts of the developing world; excessive
use of groundwater and inadequate attention to preserving or regenerating land and soil quality; lack of
attention to relevant agricultural research and extension; overuse of chemical inputs that have long-run
implications for both safety and productivity have cumulatively led to inflation.

Reversing these processes will take time and substantial public investment. Until then, global supply
conditions will remain problematic.

A change in market structure: This allows for greater international speculation in commodities. It is often
assumed that rising food prices automatically benefit farmers, but this is far from the case, especially as
the global food trade has become more concentrated and vertically integrated.

Individual households claim to have opted for major cuts in their daily budget. "If the government
doesn't do anything to address your woes, we are left with no option but to choose a lower standard of
living," they say in unison.

Some of the largest increases in food prices have been in Mumbai. Here food is brought over long
distances by truckers who are now paying much more for fuel as the government has passed part of the
increase in world oil prices on to the consumers.

Wholesale price index has accelerated to 6 per cent from 4 per cent in January. Consumer price indexes
have risen nearly 7 per cent in urban areas over the past year and almost 9 per cent in rural areas,
where more than two-thirds of the population lives and where higher food prices are having the worst
effect.

According to small and medium level traders, they have been doubly hit. Rising prices are eating into the
volume of import of products; an increase in sales price tags is barring the entry of more consumers. "As
a result, they can import less and can sell even lesser amount of products," With prices of essentials
going through the roof, it has been extremely difficult for them to accumulate capital. As a result, they
can procure fewer amounts of goods and can sell even fewer products. Inflation is directly gnawing at
their very existence."

What is alarming is that small and medium businessmen are not backed by enough capital on which they
can fall back in a crisis and if this situation does not improve in a month or two, some like them will be
forced to wind up their business.

Life for the aam aadmi is becoming increasingly difficult because of all-round price rise across the
country, biting into the real incomes of the people.

Essential commodities are getting out of the reach of the poor and the middle class. The rate of inflation
reached beyond 7% per cent (week ended March), the highest in the last 13 months.

The situation has worsened by rounds of price hikes of petroleum products, which has had a cascading
impact on the prices of several commodities.

While economists think slow growth in farm output and rising demand are fuelling the prices, food
consumption by fast-growing China and bio-fuel demand are also pushing up prices, says the Reserve
Bank of India.

While the central government says it has taken various measures to try to boost food supply in the
longer term, there seems to be no short-term fix to bring prices down.

Data from the Price Monitoring Cell of the Department of Consumer Affairs of the Union government,
which collects data on 15 essential commodities from 18 centers across the country, show that prices of
most of the essential commodities monitored by the cell have experienced 20 to 40 per cent rise over
the last few years.

The fast growing developing economies, especially China and India, have been industrializing rapidly on
the back of still energy intensive technologies while growing incomes of a greater part of the population
is stimulating food demand. However, it does seem that price increases are not merely because of
demand supply mismatch.

The fact that commodity prices are still rising despite perceived threat of global growth slowdown
including that of Indian and China makes one believe that speculative activity is at play, especially in a
commodity like oil which has seen substantial built-up in speculative demand.

This is not surprising. With a slowdown in equity markets, there seems to have been a shift in asset class
in favour of commodities, leading to some speculative influence.

Question, however, is should global phenomenon be treated as a villain in the piece especially given the
fact that galloping food prices is a nightmare for any government facing inflation?

The Theory

An issue which has been causing grave concern to monetary authorities both in developed and in
developing economies in recent years has been the phenomenon of inflation. Inflation can be described
as a situation marked by a continuous increase in price level. The situation begins to cause worry when
this increase in price level exceeds a tolerable limit. When prices increase they do not affect all sections
of the society uniformly. When prices rise, some sections of society gain while other sections lose. The
persistence of inflation also causes permanent damage to society. It diverts investment into channels
like acquisition of land and other assets, which yield quick capital gains. When inflation continues over a
period of time it also erodes the motivation for saving. However. In controlling inflation the authorities
must not only identify the causes but also must evaluate other side effects that may arise as a result of
the pursuit of anti- inflationary policies.

Base on the source of inflationary pressures, it has been customary to distinguish three types of
inflation, demand pull, cost push and structural.

Demand Pull Inflation

Inflation, which is caused by excess demand, is described as demand-pull. When an attempt is made to
raise the level of aggregate demand from an existing level, it caused the price level to rise.

A shift in the aggregate demand curve can arise as a result of an increase in private as well as
government expenditures. Very often it is caused by an increase in government expenditure, which is
facilitated, by an increase in money supply.

Cost Push Inflation:

The main cause of inflation is traced to the shift in the aggregate supply curve. The shift in the aggregate
supply curve can occur as a result of the result of the rise in the wage rate. The cost-push inflation is
very often a case of wage push inflation.

Structural Inflation

The structural inflation thesis emphasis the possibility that even when there is no excess aggregate
demand, price level rises may rise because of excess demand situations in specific sectors.

Indicators and Measurement

Price Indices

Movements in prices have two aspects. One is the change in relative prices, which affect microeconomic
resource allocation and the other in the overall price level, which affect the purchasing power of money
over goods and services in general.

A variety of price indices are devised to capture this second aspect. IT is easy to measure changes in the
prices of individual commodities, but how does one work out the overall price increase in a whole
basket of commodities? This is what a price index does. There are three types of price indices viz., the
Wholesale Price Index ( WPI), the Consumer Price Index (CPI), and the GDP deflator.

The Wholesale Price Index ( WPI)

Measures changes in wholesale prices, it reflects producer inflation - the inflation facing producers in
terms of inputs

And

Consumer Price Index (CPI)

Measures changes in retail prices and hence inflation as it affects the consumer.

GDP deflator
It is defined as the ratio of current price GDP to constant price GDP.

To construct the index for a given year, with reference to a base year we need

Consumption basket in the base year

Prices of the items in the basket in the base year and
Price relatives for each item in the given year.
From (i) and (ii) we can get the weights w1…wn.

The Wholesale Price Index ( WPI)

In India the inflation rate, that is the rate at which the price level is increasing, is commonly measured by
the movements in the wholesale price index ( WPI). The index is a basket of 447 commodities and the
base year taken for giving weights to individual commodities is 1993- 94.
There are two WPIs. The first is called a point-to-point annual rate, which tells us what the rate of
change in wholesale prices is in a particular week of day in one year as compared to its level in the same
week or day the previous year. The other is what is called the annual average WPI rate, which is a 52
week average.

The items included in WPI are quite different. They include items like fertilizers, minerals, industrial raw
materials and semi- finished goods, machinery and equipments etc., apart from items in the food group
and in the fuel, light and power group. The WPI can be interpreted as an index of prices paid by
producers for their inputs.

Wholesale prices rather than retail prices are used. Thus for minerals ex-mine prices, for manufactured
products ex-factory prices, for agricultural commodities the first wholesaler’s prices etc., are used.

Weights are based on value of transaction in the various items in the base year. For manufactured
products it is the value of production, for agricultural products the value of marketable surplus etc.

The main groups of items are:

Primary Articles: food (Rice, wheat etc.), Non- food (raw cotton, jute etc.), Minerals (iron ore,
manganese ore etc.) In all 80 primary articles are covered.

Manufactured Articles: 270 items.

Fuel, Power, Light and Lubricants: 10 items

Wholesale price indices for individual commodities, commodity groups and the overall WPI are
published monthly by the Office of the Economic Advisor to the Government of India. They are reported
in number of other publications.

Consumer Price Index (CPI)

Before dealing with the CPI let us understand another commonly used term viz., the Cost of Living Index
( CLI). Changes in a true CLI would reflect changes in the money outlay required to maintain a given
standard of living for a representative family from a specified group such as ‘ urban wage earners’. Now
standard of living is a rather vague term.

In the microeconomic theory of consumer behaviour it is taken to mean a given level of ‘utility’ or
‘satisfaction’. A consumer can attain a given level of utility with a variety of combination of goods and
services. Which combination will actually be purchased depends upon the tastes of the consumer and
the relative prices of goods. We can only observe the actual purchases and not the level of satisfaction
attained by the consumer. Hence it is very difficult if not impossible to operationalise the concept of true
CLI.
CPI is a compromise. Instead of a given standard of living, we compare, over time, the money outlays
required to purchase a given basket of consumption goods and services. The basket represents the
actual consumption pattern of a typical family from a specific group for which the CPI is being
constructed. Since tastes vary across families and relative prices can also vary geographically, a separate
CPI is constructed for each of a few well-defined population groups. Typical groupings are ‘ urban
industrial workers’, agricultural labourers’, ‘urban non-manual employees’ etc.

The rationale for differentiating between these three groups is that the basket of goods consumed by
each group will differ significantly from that consumed by the others. For example, the CPI for AL will
typically attach a higher weight to food groups, especially cereals, as it is assumed that agricultural
labourers will spend a higher proportion of their wages on food than on, say, commuting. Conversely,
the weight attached to transport costs would typically be higher in CPI-UNME than it would be in CPI-AL.
Also, certain commodities consumed by one class may simply not be available, wholly or partly, to the
consumption basket of another class of consumers.

The preliminary to constructing a CPI for any class of consumers would be to identify the items, which
form a major part of the consumption basket of the class as a whole. This can only be achieved by
means of a household survey. Next, each item would be assigned a weight in the overall index in
proportion to its share in total expenditure. The index reflects nothing but the weighted average of each
commodity's price. An appropriate base year is selected, in which the price of each commodity, and
hence the overall index, is equated to 100. This base is then used as a benchmark for future prices.

Thus, if potatoes cost, say, Rs 10 per kg in the base year and Rs 20 in a subsequent year, the potato
index for the later year would be 200. What the weights do is to assign degrees of importance to
different commodities. Thus, if house rent has a 25% weight in the CPI-UNME, and rents increase by
20%, this will lead to a 5% increase in the overall CPI-UNME, other things remaining the same. On the
other hand, if watches have a weight of only 1%, even if their prices were to double, this would affect
the overall index by only 1%.

It is indeed true that consumption patterns change over time. If the CPI for a particular class is to remain
relevant, it must be constantly updated. This means a fresh survey leading to a new set of commodities
and weights, and hence an all-new base. This apart, you could have situations where the commodity
used in the basket has been replaced by a somewhat superior version, the original one no longer being
available. For instance, mechanical watches may disappear altogether, to be replaced by quartz
watches. It would clearly be misleading to disregard this change. This is taken into account by what is
called 'splicing'. The new prices are adjusted for the fact that the item in question is superior to the
original one.

The CSO (Central Statistical Organization) is now considering constructing a general CPI, not taking into
account different consumer groups. So far, macro-economic analysis typically uses the WPI, which may
not be an accurate indicator of inflation faced by end-consumers, as wholesale and retail prices can be
substantially different. A general CPI would be more relevant in this regard.

In practice it is not feasible to include each and every consumption item individually. Items are grouped
together into a small number of groups e.g. ‘food’,’pan, supari, tobacco and intoxicants’,’fuel and
light’,’housing’,’vegetables and fruits’ etc. with further sub grouping e.g. within food we can have
‘cereals’, ‘pulses and products’, ‘oils and fats’ etc.

The consumer price index ( CPI) put out monthly by the Ministry of Labour. Three CPIs are published -
for individual workers (CPI-IW) for urban non-manual employees (CPI- UNME) and for agricultural labour
( CPI- AL). The CPI that is watched with greatest interest is the CPI -IW, since it is used to calculate the
dearness allowance (DA) to be paid to the employees in the organized sector. Its base is 1982 and it
covers 260 commodities. Data is collected form 70 centers around the country.

However, to sustain low inflation, the syndrome of what economists call "high long- term inflationary
expectations" has to be addressed.

The WPI which uses 1993-94 as the base year and covers 435 items is called the "headline" rate of
inflation since it is the rate that captures news every Monday.

A current inflation rate has both a permanent and transient segment. Transient components arise from
sudden shocks - like when the prices of onions or crude oil shoot up or when the prices of edible oils
come crashing down. According to economists the permanent component is known as the " Core
Inflation". It is the future underlying rate of inflation anticipated by economic agents that does not
change with changes in output - either up or down.

Both inflationary expectation and inflationary experience need to be tackled.

Core inflation refers to the systemic inflation in the economy. It is a measure of inflation that adjusts for
the impact of supply shocks or any other specific factors related to inflation in particular items. It is a
refined measure of inflation looked at by the central bankers, since it bears a greater correlation with
the money supply and liquidity than the usual measures of inflation.

There are mainly two methods of computing core inflation. In the trimmed average method, the items
that have the maximum variation in prices on both sides (increase as well as decline) are ignored and
the inflation rate for the remaining basket of items is computed. Thus, this method ignores the impact of
items, whose prices are reflecting the item-specific movements.

In the second method, those groups / items are excluded (on a-priori basis) whose prices are believed to
be usually responding to the supply-side factors. The fuels group and perishable agricultural
commodities are typically excluded in such a measure. In India, the inflation rate for the manufactured
products' group is largely considered to be the core inflation prevailing in the economy. More refined
estimates of core inflation - based on the trimmed average method - are occasionally declared by the
Reserve Bank.