BEE (2019-20) Handout 06

INFLATION IN INDIA: MEASUREMENT, CAUSES, EFFECTS AND CONTROL MEASURES

INTRODUCTION
 Inflation is defined as the rate of increase in general level of prices. In broader sense, a persistent and appreciable rise in
general price level is considered as inflation.
 Disinflation is a decline in the rate of inflation or the rate of increase in general price level.
 Deflation is a negative rate of inflation, i.e., decline in general price level.

Important Price Indices used in India to measure price changes

 Wholesale Price Index (WPI)
 New indices
o Consumer Price Index – Rural (CPI-Rural)
o Consumer Price Index – Urban (CPI-Urban)
o Consumer Price Index – Combined (CPI-Combined)
Measurement of Inflation:
 Inflation rate is measured as the percentage change in the price index. Price Index is a number which shows weighted average
of prices of goods and services and is used to compare price changes from a particular base year with price index as 100.
 Inflation Rate = 100 * [(PINt – PINt-1)/PINt-1]; where PIN is Price Index Number, and ‘t’ is the period for which inflation rate
is being calculated and ‘t-1’ is the period in previous year.
 Two types of price indices are used in India for inflation calculation and reporting:
 Wholesale Price Index (WPI): WPI is the weighted average of prices of a specified basket of goods (697 commodities)
which are traded in the wholesale market. WPI (base year 2011-12 = 100) is used for calculating following 2 types of
inflation:
o Headline inflation. It is based on change in price of all 697 commodities included in the basket of commodities
for WPI.
o Core Inflation: It is non-food and non-fuel inflation. Food and fuel items are excluded because these are volatile
items experiencing wide fluctuations in their prices. Such fluctuations may be short-term.
 Consumer Price Index (CPI): CPI (base year 2012 = 100) is the weighted average of prices of a specified basket of
goods and services (299 items), which are purchased by consumers. Presently, CPI-Combined is used for following 2
types of inflation:
o Retail inflation: It is based on change in price of all 299 commodities included in the basket of commodities for
CPI-Combined. The three major subgroups of retail inflation (base year 2012=100) are, food, beverages and
tobacco (weight =45.86); fuel and light (6.84); and others including clothing and footwear, housing, household
goods and services, health, education, transport and communication, recreation and amusement and personal
care (47.30).
o Core CPI inflation: Inflation in non-food –non fuel group is called Core CPI inflation.
 RBI has been using headline CPI-Combined inflation as the nominal anchor for monetary policy formulation for inflation
targeting since April 2014. Before that, WPI was being used as the nominal anchor for the monetary policy.
 Inflation may also be measured by GDP deflator:
GDP deflator = 100 * (Nominal GDP /Real GDP)
GDP deflator reflects the average rise in price of all goods and services included in the GDP with reference to the base year.
Thus it is more comprehensive. GDP Deflator in India was 117.80 Index Points in 2015 and 114.40 Index Points in 2014.

Causes of Inflation
 Demand-pull factors (factors leading to increase in aggregate demand). Increase in aggregate demand is caused by:
o Increased demand from household sector caused by increased income
o Increased demand from government sector caused by increased government expenditure. Increased government
expenditure will also lead to increase in income of household sector which will lead to increased demand from
household sector
o Increased demand from business sector caused by new investments or expansion by business sector. Such
increases may be caused by positive outlook perceived by businesses.
o However, all above factors will cause inflation only when aggregate supply is either fixed or is lower than the
increase in aggregate demand.
 Cost-push factors (factors leading to increase in cost of production forcing businesses/enterprises to raise prices)
o Wage-push inflation: for example, when trade unions force rise in wage rate, irrespective of demand for and
supply of labour situations.
 o Profit-push inflation: when businesses/enterprises command some/absolute degree of monopoly power and
increase price to get more profit, irrespective of demand and supply situations.
o Import-price push inflation: when prices of imported inputs increase, cost of production increases and
businesses are forced to increase the price of output. Impact of this factor depend on the import intensity of
different businesses/enterprises/sectors
 Supply shock: When there is sudden decline in aggregate supply caused by unforeseen contingencies such as monsoon
failure, natural calamities, etc. Aggregate demand exceeds aggregate supply leading to the rise in general prices.
 Expectations and Inflation:
o If consumers expect prices to rise in future, they may increase their current consumption/demand leading to
price rise (inflation)
o If prices are expected to rise, hoarding may take place which reduces current supply leading to price rise in
current period
o If prices are expected to rise, businesses may increase their inventories of raw materials as well as finished
products leading to price rise.
Effects of Inflation
 Adverse impact on real income (purchasing power) of people, especially those who are dependent on fixed income
sources.
 Increased prices may lower down demand which will have adverse impact on business profitability
 Inflation makes export price less competitive in international market and imports cheaper in domestic market which may
lead to decrease in exports and increase in imports. It will result into adverse impact on balance of payments and hence
economic growth.
 Inflation affects economic growth:
o Moderate inflation is conducive for growth. In the economy generally, wages lag behind prices. This results in
high profit margins during moderate inflation and promotes economic activity.
o Since inflation redistributes income in favour of rich, APS increases thereby increasing aggregate savings and
investment in the economy.
o However, very high or hyper inflation may discourage savings and thus affect economic growth adversely. High
inflation may lead to increase in wages causing wage-price spiral in the economy.
 Inflation affects distribution of income: inflation increases gap between rich and poor
o The gainers from inflation are the manufacturers, traders and farmers whose income is derived from profits;
those investing in equities and physical assets; and debtors as real interest rate goes down (real interest rate =
nominal rate – inflation rate)
o The losers from inflation are fixed income earners such as agricultural labor or receivers of rent; investors of
bonds and term deposits and creditors because the real interest rate goes down during inflation.
Control of Inflation
Various possible steps, which reduce excess aggregate demand and increase aggregate supply, will help in controlling inflation.
Measures may include following:
 Fiscal policy measures
o Reduce government expenditure
o Increase direct taxes so that people’s disposable income decreases which will reduce demand
o Encouragement of savings or introduction of compulsory savings schemes
o Rationalization of excise and import duties on essential commodities
 Monetary policy measures
o Increase CRR/SLR, which will lead to reduction in credit creation by banks and flow of credit to household and
business sectors. It will lead to reduction in demand.
o Increase interest rates (through increasing Repo rate) which reduce demand for credit and hence reduce the
demand in the economy
 Effective supply-demand management of sensitive items through liberal tariff and trade policies
o Increasing output or increasing imports and decreasing exports so as to increase the availability of goods in short
supply
o Controlling money wages to keep down the costs
o Price control and rationing