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INFLATION

Inflation means long term continuous rise in general price level of a country. General
price level here means a weighted average of prices of various things bought and
sold in an economy during a period by consumers producers etc. Weighted average
means an average which is calculated taking into count the proportional relevance of
each component rather than treating all the components equally.

Example –

India uses 435 commodities for its general price level calculation. On a broader level, the
435 commodities are grouped into,
1. Primary Articles
2. Fuel, Power, Light & Lubricants
3. Manufactured Products

,Primary articles have a weighatage of 22.02%. Fuel, Power, Light & Lubricants, which
has a group weightage of 14.2%. Manufactured products have a weightage of 63.75 %.

In India inflation rate data is reported every week by MOSPI ( Ministry of Statistics
and Programme Implementation ). The data is reported on Thursday.

INFLATION RATE

Inflation rate is used to know the severness of price rise in an economy. Inflation
rate is calculated as below –

Inflation rate = Price in final period- Price in base period/ Price in base period. Since
inflation rate is always calculated in percentage terms the above formula is to be
multiplied by 100.

If a particular item has a higher weight and its price rises, it will have a greater effect
on the inflation rate. At the end of the day it depends on how much weight a
particular item is assigned.

For example in the case of India a small rise in the price of manufactured items will
have more effect on inflation rate because these item have higher weightage.

Inflation rate can be calculated using either the average retail price of commodities (
called Consumer Price Index) or average price of commodities used by wholesalers
( called Wholesale Price Index)

Most countries use a consumer price index (CPI) while India uses a wholesale price
index (WPI). As their names suggest, the CPI pertains to a set of items that a
consumer consumes while the WPI is a basket particular to the wholesale market. In
calculating average price level on the basis of CPI more weightage is given to food
item in WPI these items have low weightage. IN WPI services are not included in
CPI services like education fee, doctor’s fee, personal care fee etc. are included. In
cae of WPI base year is 1993-94 in case of CPI base year is 1982.

HEADLINE INFLATION

Weekly inflation data reported in newpapers.

CORE INFLATION

Core inflation is a measure of inflation which excludes certain items that face volatile
price movements e.g. food products and energy.

Causes Of Inflation

Inflation may be caused by reasons in the real sector or the monetary sector of the
economy. In the real sector inflation may result either from the reasons operating
on the demand side ( demand pull) of the economy or reasons operating on the
supply side ( reasons which operate through cost) of the economy. Wage spiral,
inflationary expectations, mark-up are some other reasons which may happen
through the supply side.

Monetary sector inflation may be caused by rise increase in the supply of money.

1. Demand-pull inflation refers to the idea that the economy actual demands
more goods and services than available. This shortage of supply enables
sellers to raise prices until an equilibrium is put in place between supply and
demand.
2. The cost-push ( cost push inflation is called commodity inflation) theory , also
known as "supply shock inflation", suggests that shortages or shocks to the
available supply of a certain good or product will cause a ripple effect through
the economy by raising prices through the supply chain from the producer to
the consumer. You can readily see this in oil markets. When OPEC reduces oil
supply, prices are artificially driven up and result in higher prices at the pump.

3. Inflationary Expectation – Milton Freidman emphasized the important of


inflationary expectation in creating more inflation. The theory works like this. In the
late 1960s, Friedman argued that if the price rise was expected, unions would have
demanded higher wages, so wages and prices would go up in unison. The effect of
inflationary expectation hen in the 1970s, the nightmare scenario that Friedman’s
theory seemed to predict, came true. Inflation expectations were so deeply
embedded, that in order to give a boost to jobs, prices had to rise by more than
normal. This extra rise then became expected – and an upward spiral of ever-rising
prices occurred, and so sophisticated did our expectations become, that
unemployment actually started to rise. It was called stagflation. on inflation can
work in various other ways also.
4. Wage Spiral.Even if wage earners do not expect any inflation 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 is also called wage spiral). This will then translate
back into higher prices for the wage earners or consumers. As demands go
higher from each side, inflation will continue to rise. Labour unionism causes
such kind of inflationary pressure to happen. In India after 1920s with the birth
of the Communist Party of India labour unionism has been on rise. The report of
acceptance of the report of the Sixth Pay Commission by the government of
India is expected to create pressure on inflation.

5.. Base Effect. A semblance of inflation can be created only if inflation rate is
calculated with a base year in which prices were low. This is called base effect.
This may not be real inflation.

6.Money supply plays a large role in inflationary pressure as well. Monetarist


economists like Freidman feel that inflation is dominantly a monetary
phenomenon. (He said: "Inflation is always and everywhere a monetary
phenomenon.") Monetary inflation was most famously seen in Weimar Germany
during the 1920s, when the German government went crazy with the printing presses
to the point where it took billions of marks to equal one dollar. This wiped out the
savings of the middle class, most members of which were compensated with
(worthless) "million mark" notes, and eventually led to the rise of Hitler

Monetary inflation is better advocated utilizing the equation of exchange and the
quantity theory of money, the former, which is MV=PT (money supply x velocity of
circulation = price levels x total transactions) and the latter, explains that the velocity
of circulation be will equal to the level of transactions, therefore after removing them
from the equation, only M=P remains, hence saying that any change in the money
supply will bring about a change in the level of prices.

TYPES OF INFLATION

On the basis of rate inflation is categorized in the following –

1. Moderate inflation – a. creeping inflation ( less than 10 % per annum). B.


walking inflation 10 % per annum)
2. Running inflation. ( more than 10 % up to 20% per annum)
3. Galloping inflation. ( more than 20% up to triple digit per annum)
4. Hyper inflation. ( more than 1000% per annum). Hyperinflation notably took
place in Germany in 1920-1923. The German price index rose from 1 to
10,00,000,000 during January 1922 to November 1923. Zimbabwe these
days is facing the same problem.

The above categorization of inflation is provided by Samuelson.


Effects of Inflation

Consumers and businesses on fixed incomes will lose out. Many pensioners are on fixed pensions so
inflation reduces the real value of their income year on year. The effects of inflation can be brutal
for the elderly who are looking to retire on a fixed income. The money that they
expect to retire with will be worth less and less as time goes on and inflation goes
higher.

Inflation can also cause a disruption of business planning – uncertainty about the future makes planning
difficult and this may have an adverse effect on the level of planned capital investment. Example – rise in
the price of steel can have an effect on the price of Nano and it may not remain a one lakh car as planned.

Rise in inflation rate may cause higher interest rates and this may compel businessmen to keep their
investment plans on hold. This mean that investment rate in the economy may fall this damages long-run
economic growth and productivity.

Cost-push inflation usually leads to a slower growth of company profits which can then feed through into
business investment decisions.

Inflation distorts the operation of the price mechanism and can result in an inefficient allocation of
resources. When inflation is volatile, consumers and firms are unlikely to have sufficient information on
relative price levels to make informed choices about which products to supply and purchase.

Two further costs of inflation are often mentioned in the textbooks:

Shoe leather costs - when prices are unstable there will be an increase in search times to discover more
about prices. Inflation increases the opportunity cost of holding money, so people make more visits to their
banks and building societies (wearing out their shoe leather!).

Menu costs –menu costs are the costs to firms of updating menus, price lists, brochures,
and other materials when prices change in an economy. Volatile inflation may cause
menu cost to rise . This can be important for companies who rely on bulky catalogues to send price
information to customers.

Rise in inflation leads to erosion of savings because saved money loses value if the
interest it earns is lower than the rate of inflation.

Example- An investment of 1000 Rs done in a bank will turn into 1080 if the bank is
giving you 8% per annum. In the same period if the rate of inflation in the
econonmy is 12.34 percent it means that the value of Rs 1000 Rs has fallen by Rs
120.34 Rs thus on net basis you have a loss of 1080- 1120.34 = 40.34 Rs per
annum per 1000 Rs. This means that if you have made an investment of 1 lakh in
bank you lose 4034 Rs per lakh per annum.

How to Limit the Effects of Inflation on Your Savings


The money that is not earning interest is exposed to inflation. Inflation can and
usually does rise every year. For instance, 1% or even 3% rise in inflation can occur
and does occur from time to time. This is the reason that prices go up and a rupee in
1970 bought much more than it does today. By saving money that doesn't earn
interest, you are possibly losing several percentage points of its value each year.

In order to fight the effects of inflation, any money that you save should be invested.
When you invest money, you earn interest. While no investment is 100% secure,
saving money in a savings account, certificate of deposit or investing it in the stock
market for the most part will grow your money. The more secure the investment, the
lower the growth, but also the lower the risk.

In order to beat inflation, choose financial tools that will more than likely beat the
effects of inflations such as a certificate of deposit, bonds, money market, etc.
Another important tip to beat inflation year after year is to choose investments
where the interest rate is not fixed or where money can be easily turned into liquid
and invested elsewhere. For instance, investing in stocks is usually a good choice due
to the fact that a stock is not limited in its growth, where a bank account has a fixed
rate of return. If there is a jump in inflation, over the amount of your fixed interest
rate, you will actually be losing money. But , the main problem with stocks and
inflation is that a company's returns tend to be overstated. In times of high inflation,
a company may look like it's prospering, when really inflation is the reason behind
the growth. When analyzing financial statements, it's also important to remember
that inflation can wreak havoc on earnings depending on what technique the
company is using to value inventory.

Fixed-income investors are the hardest hit by inflation. Suppose that a year ago you
invested Rs1,000 in a Treasury bill with a 10% yield. Now that you are about to
collect the Rs1,100 owed to you, is your Rs100 (10%) return real? Of course not!
Assuming inflation was positive for the year, your purchasing power has fallen and,
therefore, so has your real return. We have to take into account the chunk inflation
has taken out of your return. If inflation was 4%, then your return is really 6%.

This example highlights the difference between nominal interest rates and real
interest rates. The nominal interest rate is the growth rate of your money, while the
real interest rate is the growth of your purchasing power. In other words, the real
rate of interest is the nominal rate reduced by the rate of inflation. In our example,
the nominal rate is 10% and the real rate is 6% (10% - 4% = 6%).

Inflation-Indexed Bonds

There are securities that offer investors the guarantee that returns will not be eaten
up by inflation. Treasury inflation-protected securities (TIPS), are a special type of
Treasury note or bond. TIPS are like any other Treasury, except that the principal and
coupon payments are tied to the CPI and increase to compensate for any inflation.

Inflation crossing 8% already and reports say will hit 9-10% soon. In other words,
bad news for investments. Increasing inflation affects your purchasing power and can
deal a body blow to your financial goals. Here's how you can inflation proof your
investments.
• Gold : Gold is the traditional hedge against inflation since the price of gold
goes up as inflation hits a high. Says Arvind Rao, certified financial planner,
"In order to tackle inflation head on, invest 10%-15% of your portfolio in
gold. While gold will not help you rake in 40%-50% returns like equities, you
can be sure of 10%-12% in the long run".
• Real estate : Investment in real estate is lucrative but liquidity is a
major issue. If you're an NRI, monitoring your property here in India can get
difficult. Yet, around 25% to 30% of your portfolio should constitute real
estate as a hedge against inflation.
• Mutual funds: Depending on your risk profile, 50% of your portfolio should
constitute equities. "To make the most, invest in banking and infrastructure
sectors as also gold mining funds. Note that around 10% of your portfolio
should constitute debt in order to cushion the ups and downs of the market
and rake in the most out of your money.

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. It is time that we think about a
revaluation of the Indian Rupee as a policy response to the complex issue of
managing inflation, while simultaneously address the constraints on the supply side
on food grains through increase in domestic production.

HOW TO CONTROL INFLATION

There are two broad ways in which governments try to control inflation. These are-

1. Fiscal measures.
2. Monetary measures.

The first involves reducing government spending and the second involves regulating
the supply of money by adjusting monetary variables like CRR, repo rates etc. This is
done by the central bank. India’s central bank is called the Reserve Bank of India.