ECONOMICS FOR EVERYONE- PRICENOMICS- Sailing towards Stagflation (Recession and

Inflation)
Prof.M.Guruprasad, UNIVERSAL BUSINESS SCHOOL

“An Inflation proceeds and tbe real value of the currency fluctuates wildly from month to month, all
permanent relations between debtors and creditors, which form the ultimate foundation of capitalism.,
become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates
into a game and a lottery.”

- Lord John Maynard Keynes

The rising graph of inflation has the power to increase the pulse rate and blood pressure across the length
and breadth of the society, be it an ordinary Citizen or policy makers.

Inflation is often considered as an economic challenge. Inflation refers to the general rise in the price level
in an economy. An increase in inflation leads to a fall in the purchasing power of a currency as the
commodities and prices gets dearer. In simple terms, we would be able to purchase only fewer items for
the same money.

An issue which has been causing grave concern to monetary authorities both in developed and in
developing economies in since ages 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.

The impact would be far greater when rising inflation is accompanied with a stagnant output. In such a
scenario, the economy would be facing the situation called ‘Stagflation’.

At present, the debate is whether the Covid-19 induced economic crisis would push the major economies
to a stagflationary shock. The debate is getting stronger in India, with the release of GDP data for the first
quarter of FY21. The Indian economy contracted 23.9 per cent in Q1FY21. The major components of
GDP -- via consumption demand and investment demand – contracted 27 per cent and 47 per cent,
respectively. Now, we know that in the second quarters (Q2), the Economy contracts 7.5%, officially/
technically India is into Recession.
Learning Point 1: The decline in the GDP in two successive quarters is called recession.

Economists determine the amount of business activity in the economy by looking at things like
employment, industrial production, real income and wholesale-retail sales. They define a recession as the
time when business activity has reached its peak and starts to fall until the time when business activity
bottoms out. When the business activity starts to rise again it's called an expansionary period.

What are the factors, which cause income, employment, investment, etc., fluctuate in a regular cyclical
pattern? To explain these factors, a large number of theories have been put forward by various
economists. A variety of factors such as fluctuations in money supply and bank credit, under
consumption, overinvestment, clustering of innovations, interaction of the principles of the multiplier and
accelerator, peoples expectation about the future etc., have been emphasized by different theories for
explaining business cycles.

Various theories (factors) of business cycles can be broadly divided into two categories, external theories
(factors) and internal theories (factors). In external factors, the basic cause of business cycles is found in
events or factors outside the economic system like wars, revolutions, political events, pandemic(an
epidemic occurring worldwide), growth and fluctuations in population, discoveries of new lands and
resources, and finally scientific and technological innovations. The internal factors theorems emphasis on
mechanisms or factors within the economic system such as money supply, over investment, under
consumption, changes in consumption propensities and inducement to invest, etc.,

Many economists today agree that occurrence of business cycles is ideally explained, not by a single
theory, but by a combination of theories, or more appropriately, but by a combination of external and
internal theories.

On the other hand, the inflation rate as measured by Consumer Price Index (CPI) breached the upper band
of 6 per cent for the fifth consecutive month at 6.69 per cent in August. The major contributor to the
rising inflation rate was the surge in food prices. Food inflation rate registered a growth rate of around 9
per cent in August. Similarly, core inflation i.e., inflation excluding food and fuel also remained high at
5.4 per cent, despite the falling demand in the economy. The contraction of GDP along with the rising
inflation rate ignites the fear of stagflation in the Indian economy.

Learning Point 2: Consumer Price Index (CPI) measures changes in retail prices and hence
inflation as it affects the consumer.

According to experts, even before the outbreak, the Indian economy was grappling with inherent
problems of low economic growth and high unemployment. In 2019-20, the economic growth was at a
decadal low (4.2 percent) while in Q4 2019-20 it was the lowest in the past 44 quarters owing to the
nation-wide lockdown announced towards March-end halting economic activities. The pandemic and
subsequent nation-wide lockdown for nearly two months dragged the economic growth to a historic low
of -23.9 percent in Q1 2020-21. It was the steepest contraction for the quarter among all the major global
economies. Such a deep contraction has abated expectations of early economic recovery.

Source: THE HINDU

According to some experts, what we see now is a recession combined with inflation. As we observe, the
economy was on continuous decline for the last two quarters i.e. six months along with the rise in price
levels.

Learning Point 3: “Continued increase in inflation combined with stagnant demand and high
unemployment will lead to what Economists term as 'stagflation', a dangerous territory from which
it becomes very hard for large economies to recover”.

Former Indian Prime Minister and renowned economist Dr.Manmohan Singh (In November 2019,
he raised the possibility of India facing stagflation).
Impact on Economy/Society:

The impact is heavy. Life for ordinary is becoming increasingly difficult because of all-round price rise
across the country, biting into the real incomes of the people. With the combination of reducing income,
loss of jobs, low business and the lingering pandemic, the present crisis is affecting every section of the
society be it businessmen,traders,factory workers or people in services. The situation is has further
worsened by the global Oil Prices.

Learning Point 4:

Now, let us understand some of the theory, concepts associated with Inflation such as

Theory and Basics of Inflation Measurement

Types of Inflation

Inflation, broadly can be classified into four types, Walking inflation, Creeping inflation, Galloping
inflation and Hyperinflation and of course Stagflation. A situation of declining prices is also known as
deflation.

Creeping Inflation: This is also known as mild inflation or moderate inflation. This type of inflation
occurs when the price level persistently rises over a period of time at a mild rate. When the rate of
inflation is less than 10 per cent annually, or it is a single digit inflation rate, it is considered to be a
moderate inflation.

Galloping Inflation: If mild inflation is not checked and if it is uncontrollable, it may assume the character
of galloping inflation. Inflation in the double or triple digit range of 20, 100 or 200 percent a year is called
galloping inflation. Many Latin American countries such as Argentina, Brazil had inflation rates of 50 to
700 percent per year in the 1970s and 1980s.

Hyperinflation: It is a stage of very high rate of inflation. While economies seem to survive under
galloping inflation, a third and deadly strain takes hold when the cancer of hyperinflation strikes. Nothing
good can be said about a market economy in which prices are rising a million or even a trillion percent
per year. Hyperinflation occurs when the prices go out of control and the monetary authorities are unable
to impose any check on it. Germany had witnessed hyperinflation in 1920’s and recent years in
Venezuela.

Stagflation: It is an economic situation in which inflation and economic stagnation or recession occur
simultaneously and remain unchecked for a period of time. Stagflation was witnessed by developed
countries in 1970s, when world oil prices rose dramatically.

Deflation: Deflation is the reverse of inflation. It refers to a sustained decline in the price level of goods
and services. It occurs when the annual inflation rate falls below zero percent (a negative inflation rate),
resulting in an increase in the real value of money. Japan suffered from deflation for almost a decade in
1990s.

(Indiainfoline)

Walking inflation occurs when prices rise moderately and annual inflation rate is a single digit. ...
Inflation of this rate is a warning signal for the government to control it before it turns into running
inflation.

Causes of present crisis:

According to some economists, the current set of data showing high retail inflation and a contraction in
growth. This is akin to the phenomenon of stagflation. But, the current situation has also worsened due to
the impact of pandemic and is more cyclical in nature. The local lockdowns have especially been cited as
a key factor for the supply side disruptions, particularly for perishable agricultural products which have
massively contributed to the rise in inflation of certain food items (known as Food Inflation). Some
experts view that, the Headline CPI inflation will likely be below 4 per cent by year-end with rebalancing
of effective demand-supply dynamics, sharply widening output gap and favourable base effect.
Source: Business Today

But some experts believe that the demand slump, given higher unemployment and lower wage growth,
will ensure that high inflation does not sustain for a long time. They say inflation fuelled by supply-side
constraints will be negated by slump in demand in the medium term. The risk of a second Covid-19 wave
could also keep inflation high. "There is a risk that in the current situation, if rising infections force
further extension of localised lockdowns, supply disruptions could worsen, preventing a fall in inflation
and recovery in output. This could result in a stagflation-like situation. Economists point out, points at
demand collapse due to slow growth given that there is every reason to expect higher unemployment and
lower wage growth. He says we are seeing supply-side inflation induced by response to the health crisis in
the form of lockdowns and not due to, say, a sharp fundamentally driven rise in oil prices.

Learning Point 5:

Causes of Inflation:

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.

Most economic research firms and rating agencies predict 10-12 per cent GDP contraction in FY21. With
growth unlikely to come back in a hurry, inflation trajectory will decide the period India remains under
the damaging influence of stagflation. The RBI, in its monetary policy statement on August 6, had
predicted that headline inflation may remain high in second quarter of FY21 but moderate in second half
of the financial year.
Positive Factors:

Some Economists feel that the situation is not that bad. The spike in inflation has been driven mainly by
seasonal food inflation which is likely to cool down. October to February is typically the period where
there is the pressure of food prices and the RBI is mandated to target headline inflation, which includes
food. They suspect the month of January will see another round of high inflation but once again, it will
only be due to an upsurge in two or three vegetable prices — say Onion (Onionomics?) and others. If you
remove these three from the equation, inflation is really less than 5 per cent.

Also, they feel core inflation continues to be subdued reflecting weak demand. They don’t see much
spillover from food to non-food inflation. Therefore, according to them, we are not strictly facing
stagflation. Another factor is the wholesale price index (WPI) has been in the negative territory since the
start of Pandemic before climbing to 0.16 per cent in August. In January 2020, when retail inflation rate
was high at 7.5 per cent, wholesale inflation rate stood at 3.5 per cent. Thus, in the current scenario, there
is inflationary pressure only at the retail level, and not at the wholesale level. And, this could be attributed
to the supply-side disruptions caused by lockdowns. They are hopeful that, once the restrictions are eased,
there could be some cool off in the inflation rate. Of course, the spread of Covid remains a challenge.

Learning Point 6:

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.
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 Wholesale Price Index (WPI) –

Measures changes in wholesale prices, it reflects producer inflation - the inflation facing producers in
terms of inputs. 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) (also an indicator of Headline
Inflation).
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 equipment 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.

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.

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.

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.

One of the reasons where we used to hear from the Government/ Media, that inflation is going
down (basically Headline inflation), but never feel the same in our neighborhood shop.
The divergence between the CPI and WPI is not surprising as they differ in composition. Food
items have a share of almost 40% in the CPI basket. This is just 24% for WPI. Therefore food price
hikes generate stronger tailwinds for CPI. But the food components of CPI and WPI actually move
very closely with each other

The CSO (Central Statistical Organization) is has considered constructing a general CPI, not taking into
account different consumer groups. In India, Consumer Price Index (CPI) and Wholesale Price Index
(WPI) are two major indices for measuring inflation. In United States, CPI and PPI (Producer Price
Index) are two major indices.
The Wholesale Price Index (WPI) was main index for measurement of inflation in India till April 2014
when RBI adopted new Consumer Price Index (CPI) (combined) as the key measure of inflation
Wholesale Price Index (WPI) is computed by the Office of the Economic Adviser in Ministry of
commerce & Industry, Government of India. It was earlier released on weekly basis for Primary Articles
and Fuel Group. However, since 2012, this practice has been discontinued. Currently, WPI is released
monthly.

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

According to economists, unless food inflation is controlled in the short term, such an environment may
set in where monetary and fiscal policies may not easily be effective, aggravating the challenge for the
policy makers. Consequently, the rise in retail inflation in the short term led the RBI's MPC (Monetary
Policy Committee) to hold the interest rates in August.

What impact does monetary policy have on the different interest rates in the economy and what effects it
has got on the inflation rate? The RBI doesn't directly control these interest rates but in general a tighter
monetary policy leads to higher interest rates. So how do interest rates affect the rise and fall of inflation?
Higher interest rates put less borrowing power in the hands of consumers (business).Thus consumers
spend less; the demand slows down, thereby controlling inflation. In general it is perceived that prices
raise when more money chases few goods. Thus one of the key task in controlling the inflation rate is to
control the excessive money supply in the economy. The central bank's target for retail inflation is set
within a band of +/-2 per cent.

If the RBI decides that the economy is slowing down -that demand is slowing down-then it can reduce
interest rates, increasing the amount of cash entering the economy (consumers/business). In simple terms
by increasing the interest rates say reverse repo and repo (as in the current case), the RBI aims to increase
the cost of borrowing money there by reducing the supply of money. This would impact (reduce) money
that is spent by consumers and businesses. This would slow down the inflation.

But with the rising Inflation rates, the policy measures is to control the inflationary tendency by
increasing the interest rates. What happens now, where the economy is slowing down but the
inflation rate is going up? Huge challenge for the government and the RBI.

One of the major challenges for the government is to push the consumption, private investment. The
impact of recent measures of government (AatmaNirbhar Bharat) are yet to be seen. Some experts feel,
Food inflation is responsible for the spike in inflation and while there is an element of seasonality to it,
given that the data is year-on-year, it is not the only factor. But, some experts point out that there is high
stock of food grains which are yet to be released by the government and supply constraints will be solved
once this stock is released in the markets. With the recent debate of Farm reforms and Labour reforms
proposals the issue is becoming more challenging. So economists feel that, Monetary measures will not
adequately solve the problem because the current inflation is largely food inflation-driven where
monetary policy has little role. Also, some economists feel that Liquidity is not the reason for the
recession. According to them, the economy was decelerating even before the crisis but after the pandemic
struck, there is a decline in GDP or contraction in the economy. This is mainly due to the lockdown which
has caused both the demand and supply to contract. Some experts suggest, Liquidity injection is required
to ensure that the businesses have adequate working capital when the capacity utilisation increases as the
lockdown is relaxed.

Though it is early to say of the economy has entered a phase of stagflation, many economists fee that the
growth-inflation conundrum will surely get more prominent in India in the days ahead.

Learning Point: 7
Key differences between WPI & CPI
Primary use of WPI is to have inflationary trend in the economy as a whole. However, CPI is used for
adjusting income and expenditure streams for changes in the cost of living.
WPI is based on wholesale prices for primary articles, administered prices for fuel items and ex-factory
prices for manufactured products. On the other hand, CPI is based on retail prices, which include all
distribution costs and taxes.
Prices for WPI are collected on voluntary basis while price data for CPI are collected by investigators by
visiting markets.
CPI covers only consumer goods and consumer services while WPI covers all goods including
intermediate goods transacted in the economy.
WPI weights primarily based on national accounts and enterprise survey data and CPI weights are derived
from consumer expenditure survey data.

• Base Year
• Current WPI Base year is 2004-05=100. It’s worth note that the base year for CPI is 2012
currently. This is one reason for increasing difference between CPI and WPI in recent times.
• Items
• There are total 676 items in WPI and inflation is computed taking 5482 Price quotations. These
items are divided into three broad categories viz. (1) Primary Articles (2) Fuel & power and (3)
Manufactured Products.
WPI
CPI

Item Group Weight-age

Food and beverages 54.18

Pan, Tobacco and Intoxicants 3.26

Clothing & Footwear 7.36

Fuel & Light 7.94

Miscellaneous 27.26

Total 100

Learning Point: 8

Philips Curve:

The Phillips curve is an economic concept developed by A. W. Phillips stating that inflation and
unemployment have a stable and inverse relationship. The theory claims that with economic growth
comes inflation, which in turn should lead to more jobs and less unemployment.
But during Stagflation, it is observed that this factor work differently, as the falling economy is fueled by
a rising inflation.

Sources:

- Economics for Everyone - Interest Rates and Inflation - by Prof.M.Guruprasad,

Indiainfoline.

https://www.indiainfoline.com/article/b-school-reports-guru-
gyan/economics-for-everyone-interest-rates-and-inflation-
114031000535_1.html

- ECONOMICS FOR EVERYONE –INFLATION - IMPACT ON THE NATION- by

Prof.M.Guruprasad, Indiainfoline.

- Economics for Everyone – Onionomics- by Prof.M.Guruprasad, Indiainfoline.

https://www.indiainfoline.com/article/news-top-story/economics-for-everyone-
%E2%80%93-onionomics-114020500194_1.html

- Economics for everyone: Recession and its reasons- by Prof.M.Guruprasad,

Indiainfoline.

https://www.indiainfoline.com/article/b-school-reports-guru-gyan/economics-
for-everyone-recession-and-its-reasons-114031000445_1.html

- Prof.M.Guruprasad, UNIVERSAL BUSINESS SCHOOL