What is inflation?

Inflation is the increase in prices of baskets of goods and services that represents economy as a whole. It is measured as an annual percentage increase. For e.g. We all love to watch movies; there was a time when movie ticket was for Rs 50 and now its cost Rs 100, the prices have doubled, this is how inflation affects us. Take another e.g. suppose with Rs 100 you can buy only 6kg of groceries , the same amount of money can only buy 6/ ( 1+I) kg of groceries next year , where I refers to rate of inflation beyond today. Thus if the rate of inflation is 5%, other things being equal you can buy only 6/1.05 worth of groceries. Well all of us know what is inflation and what are its causes..so I wont be going much in to it.

Measurement scale of inflation Inflation can be measured by the following 2 ways: Inflation based on changes in consumer prices for specific baskets of goods known as consumer price index (CPI). Inflation based on changes in average prices of goods traded in wholesale market called as wholesale price index (WPI) In India inflation is calculated on the basis of WPI. WPI is calculated on weekly basis unlikely CPI that is calculated on monthly basis. WPI in India includes a total of 435 commodities and tracks the change of prices in these commodities. These goods can be classified as under: Primary articles ( food articles non-food articles and minerals) Fuel ,power ,light ,lubricants and manufactured products like food products , beverages , tobacco , textiles ,leather and leather products). Now with one eg ill show how WPI is calculated WPI is calculated on base year and WPI base year is assumed to be 100

Lets calculate the WPI for year 2007: assume that price of kilogram wheat in 2007 is Rs 7 and for 1993-94 kilogram wheat costs Rs 5 Therefore the WPI of year 2007 is: Price of wheat in 2007 price of wheat in 1994 / price of wheat in 1994 *100 7-5 /5*100 = 40 Since WPI for base year is assumed to be 100, WPI for 2007 will become 100+40 =140.

Calculation of rate of inflation If we have the WPI values of two time zones, say, beginning and end of year, the inflation rate for the year will be:

(WPI of end of year WPI of beginning of year)/WPI of beginning of year x 100) For e.g. WPI on 1st January 2007 are 141.2 and on January 2008 are 144.4, then inflation rate for year 2008 is,

144.4-141.2 / 141.2 *100 = 2.26 %, therefore we can conclude inflation rate for the year 2008 is 2.26% (I know this number seems to be unbelievable but its just an e.g.)

INFLATION A sustained rise in the prices of commodities that leads to a fall in the purchasing
power of a nation is called inflation. Although inflation is part of the normal economic phenomena of any country, any increase in inflation above a predetermined level is a cause of concern. High levels of inflation distort economic performance, making it mandatory to identify the causing factors. Several internal and external factors, such as the printing of more money by the government, a rise in production and labor costs, high lending levels, a drop in the exchange rate, increased taxes or wars, can cause inflation. Different schools of thought provide different views on what actually causes inflation. However, there is a general agreement amongst economists that economic inflation may be caused by either an increase in the money supply or a decrease in the quantity of goods being supplied.The proponents of the

Demand Pull theory attribute a rise in prices to an increase in demand in excess of the supplies available. An increase in the quantity of money in circulation relative to the ability of the economy to supply leads to increased demand, thereby fuelling prices. The case is of too much money chasing too few goods. An increase in demand could also be a result of declining interest rates, a cut in tax rates or increased consumer confidence. The Cost Push theory, on the other hand, states that inflation occurs when the cost of producing rises and the increase is passed on to consumers. The cost of production can rise because of rising labor costs or when the producing firm is a monopoly or oligopoly and raises prices, cost of imported raw material rises due to exchange rate changes, and external factors, such as natural calamities or an increase in the economic power of a certain country. An increase in indirect taxes can also lead to increased production costs. A classic example of cost-push or supply-shock inflation is the oil crisis that occurred in the 1970s, after the OPEC raised oil prices. The US saw double digit inflation levels during this period. Since oil is used in every industry, a sharp rise in the price of oil leads to an increase in the prices of all commodities. While money growth is considered to be a principal long-term determinant of inflation, non-monetary sources, such as an increase in commodity prices, have played a key role in triggering inflation in the past four decades. Inflation has become a major concern worldwide in 2008, with global prices rises in oil, food, steel and other commodities being the culprit.

Factors of Inflation Inflation is defined as the rate (%) at which the general price level of goods and services is rising, causing purchasing power to fall. This is different from a rise and fall in the price of a particular good or service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or preferences and changing costs. So if the cost of one item, say a particular model car, increases because demand for it is high, this is not considered inflation. Inflation occurs when most prices are rising by some degree across the whole economy. This is caused by four possible factors, each of which is related to basic economic principles of changes in supply and demand: Increase in the money supply. Decrease in the demand for money. Decrease in the aggregate supply of goods and services. Increase in the aggregate demand for goods and services.

In this look at what inflation is and how it works, we will ignore the effects of money supply on inflation and concentrate specifically on the effects of aggregate supply and demand: cost-push and demand-pull inflation.

Cost-Push Inflation
Aggregate supply is the total volume of goods and services produced by an economy at a given price level. When there is a decrease in the aggregate supply of goods and services stemming from an increase in the cost of production, we have cost-push inflation. Cost-push inflation basically means that prices have been pushed up by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when companies are already running at full production capacity. With higher production costs and productivity maximized, companies cannot maintain profit margins by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise in the general price level (inflation).

Production Costs To understand better their effect on inflation, lets take a look into how and why production costs can change. A company may need to increases wages if laborers demand higher salaries (due to increasing prices and thus cost of living) or if labor becomes more specialized. If the cost of labor, a factor of production, increases, the company has to allocate more resources to pay for the creation of its goods or services. To continue to maintain (or increase) profit margins, the company passes the increased costs of production on to the consumer, making retail prices higher. Along with increasing sales, increasing prices is a way for companies to constantly increase their bottom lines and essentially grow. Another factor that can cause increases in production costs is a rise in the price of raw materials. This could occur because of scarcity of raw materials, an increase in the cost of labor and/or an increase in the cost of importing raw materials and labor (if the they are overseas), which is caused by a depreciation in their home currency. The government may also increase taxes to cover higher fuel and energy costs, forcing companies to allocate more resources to paying taxes.

Putting It Together To visualize how cost-push inflation works, we can use a simple price-quantity graph showing what happens to shifts in aggregate supply. The graph below shows the level of output that can be achieved at each price level. As production costs increase, aggregate supply decreases from AS1 to AS2 (given production is at full capacity), causing an increase in the price level from P1 to P2. The rationale behind this increase is that, for companies to maintain (or increase) profit margins, they will need to raise the retail price paid by consumers, thereby causing inflation.

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Demand-Pull Inflation
Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments and foreign buyers. When these four sectors concurrently want to purchase more output than the economy can produce, they compete to purchase limited amounts of goods and services. Buyers in essence bid prices up, again, causing inflation. This excessive demand, also referred to as too much money chasing too few goods, usually occurs in an expanding economy.

Factors Pulling Prices Up

The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, an increase in government purchases can increase aggregate demand, thus pulling up prices. Another factor can be the depreciation of local exchange rates, which raises the price of imports and, for foreigners, reduces the price of exports. As a result, the purchasing of imports decreases while the buying of exports by foreigners increases, thereby raising the overall level of aggregate demand (we are assuming aggregate supply cannot keep up with aggregate demand as a result of full employment in the economy). Rapid overseas growth can also ignite an increase in demand as more exports are consumed by foreigners. Finally, if government reduces taxes, households are left with more disposable income in their pockets. This in turn leads to increased consumer spending, thus increasing aggregate demand and eventually causing demand-pull inflation. The results of reduced taxes can lead also to growing consumer confidence in the local economy, which further increases aggregate demand.

Putting It Together Demand-pull inflation is a product of an increase in aggregate demand that is faster than the corresponding increase in aggregate supply. When aggregate demand increases without a change in aggregate supply, the quantity supplied will increase (given production is not at full capacity). Looking again at the price-quantity graph, we can see the relationship between aggregate supply and demand. If aggregate demand increases from AD1 to AD2, in the short run, this will not change (shift) aggregate supply, but cause a change in the quantity supplied as represented by a movement along the AS curve. The rationale behind this lack of shift in aggregate supply is that aggregate demand tends to react faster

to changes in economic conditions than aggregate supply.

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Conclusion
Inflation is not simply a matter of rising prices. There are endemic and perhaps diverse reasons at the root of inflation. Cost-push inflation is a result of decreased aggregate supply as well as increased costs of production, itself a result of different factors. The increase in aggregate supply causing demand-pull inflation can be the result of many factors, including increases in government spending and depreciation of the local exchange rate. If an economy identifies what type of inflation is occurring (cost-push or demand-pull), then the economy may be better able to rectify (if necessary) rising prices and the loss of purchasing power

Question: What is the difference between GDP deflator and CPI?

Two differences: 1) GDP Deflator reflects prices of all goods and services produced within the country, whereas CPI reflects the prices of a representative basket of goods and services purchased by the consumers. 2) CPI uses a fixed basket of goods and services whereas the GDP deflator compared the price of currently produced goods relative to price of goods in the base year.

WPI vs CPI
Now as we have seen how inflation is calcualated with WPI , its now time to analyze wthether WPI is a good measure of inflation or not.

Most of the major economies like US, UK, Japan, France, Singapore and even our arch rival China have selected CPI as its official barometer to weigh its inflation. But our country, India, is amongst few countries of the world, which selected WPI as its official scale to measure the inflation in the economy.

The main difference between WPI and CPI is that wholesale price index measures inflation at each stage of production while consumer price index measures inflation only at final stage of production.

In last post we discussed about WPI, now lets have a better understanding of CPI and how its better from WPI:

CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. CPI is a fixed quantity price index and considered by some a cost of living index. 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.

In use of WPI there are certain problems which have been encountered. Economists say that main problem with WPI is that more than 100 out of 435 commodities included in the index have abstained to be important from consumption point of view. 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 measures general level of price changes either at level of wholesaler or at the producer and does not take into account the retail margins. Therefore we see here that WPI does give the true picture of inflation. In present day service sector plays a key role in indian economy. Consumers are spending loads of money on services like education and health. And these services are not incorpated in calculation of WPI. Moreover the inflation figures that we get on Friday hardly makes a differnce to consumers, as the commodites on which inflation is calculated are not part individual consumers budget. Therefore in order to know what exact number of inflation is affecting your budget , it is advisible you should do your own calculation. You can compare your expenditure for previous years and with present scenario

required to maitain your lifestyle and you ill come to know that increase in expenditure would be a few times higher than the official inflation figure.

But it is not easy for country like india to adopt to CPI , as 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 CPI Rural labour. Apart from this official staements say that there is too much of lag in reporting of CPI numbers, which makes it difficult for india to calcualte inflation based on CPI figures. India calcualtes inflation on weekly basis , whereas CPI figures are available on monthly basis. So all this give little ground for indian government to adopt CPI in calculating inflation.