Inflation

1
 What is Inflation
• Inflation occurs when the general level of prices is rising. In other words, if
there is persistent rise in price level of a basket of commodities over a
period of time, then we can say it inflation. The opposite of inflation is
called deflation. When there is persistent fall in price level of basket of
commodities during a year.
• Dis inflation-Disinflation occurs when price inflation slows down
temporarily. Unlike deflation, this is not harmful to the economy because
the inflation rate is reduced marginally over a short-term period.

• Who controls inflation in India?

The Reserve Bank of India(RBI) and Government
• Who publish inflation data in India
Central Statistical Organization(CSO) for Consumer Price Index (CPI) and
Office of economic advisor for Wholesale Price Index(WPI)

2
3
 Inflation decreases the value of
money(Purchasing power decreases)

4
  How inflation is calculated in India
In India inflation is calculated through WPI and CPI.
 Whether Inflation is a leading or lagging indicator
Both WPI and CPI are lagging indicator. I mean to say one month lag.
 When inflation data is released
Every month inflation data is released during 13 to 15th at 12 noon. WPI data
releases 14th of every month. If that day is not a working day then next
day they release the data.
 How frequency is inflation data
Inflation data is available on monthly and yearly basis. Since 2012 weekly
inflation data is not available.
 How many commodities are in WPI basket

Base Year Number of Commodities

1993-94 435

2004-05 676

2011-2012 697

5
 How many commodities are in CPI Basket
The number of commodities in rural basket is 448 and the number of
commodities in urban basket is 460
CPI provides inflation data on rural, urban and combined. In addition
consumer food price index of urban, rural and combined figures are given.

 Do you think that all commodities have equal weight?

The weight varies from commodities to commodities

 What is the Current CPI and WPI base year

The base year is 2012 for CPI and 2011-12 for WPI
 How can we calculate inflation?
CPI or WPI inflation is calculated on point to point basis (Dec 2020 data is
compared with Dec 2019 data).
𝑃 −𝑃
( 𝑡 𝑡−1)*100
𝑃𝑡−1
(𝑃𝑡 - 𝑃𝑡−1 )/(𝑃𝑡 -1))*100
𝑃𝑡 stands the price level of current year
𝑃𝑡−1 is the price level of the previous year
6
Inflation is calculated as year on year(YoY) basis.
For the Month of October 2020, the WPI inflation is 1.48% compared to
1.32% a year back. It is visible that WPI inflation has increased. Now we
need to see what contributed to increase in inflation. WPI has 3
components(1) Primary article (2) Fuel power (3) Manufactured products.
The weight of primary article, fuel power and manufactured products are
22.6%, 13.2% and 64.2%. Note: the sum of the wt is equal to 100. We can
conclude that WPI gives more weightage to manufactured products, followed
by primary article and fuel , power .
WPI data.pdf

7
 Figure 1: WPI inflation is 1.56% for the Month of November 2020 and it
accelerated from 1.48%
8
6
4
2 1.56
0
May-15
May-13

May-14

May-16

May-17

May-18

May-19

May-20
Aug-13

Aug-14

Aug-15

Aug-16

Aug-17

Aug-18

Aug-19

Aug-20
Nov-13

Nov-14

Nov-15

Nov-16

Nov-17

Nov-18

Nov-19

Nov-20
Feb-14

Feb-15

Feb-16

Feb-17

Feb-18

Feb-19

Feb-20
-2
-4
-6
-8

The WPI inflation has accelerated from 1.48% in October 2020 to 1.56% in November
2020 . Now we will see why WPI inflation has increased. Lets see their components8
 Figure 2: The increase in inflation is because of
Manufactured product (2.12% in October and increased to
2.97% in Nov)
30

20

10

2.7
0 2.97
Feb-14

Feb-15

Feb-16

Feb-17

Feb-18

Feb-19

Feb-20
Nov-14

Aug-17
May-13
Aug-13
Nov-13

May-14
Aug-14

May-15
Aug-15
Nov-15

May-16
Aug-16
Nov-16

May-17

Nov-17

May-18
Aug-18
Nov-18

May-19
Aug-19
Nov-19

May-20
Aug-20
-10 -9.8

I PRIMARY ARTICLES
-20
II FUEL & POWER
III MANUFACTURED PRODUCTS
-30 9
 CPI Inflation
The CPI(General) inflation for the month of November 2020 is 7.20%
(Rural), 6.73% (Urban) and 6.93% % combined inflation.

CPI inflation was 7.75%(Rural) In October 2020, 7.33% (Urban) in October

2020 and Combined CPI for the month of November is 7.61%.
The combined CPI inflation is 6.93% in November 2020 as compared to
7.61% a year back. We can say inflation has decelerated from 7.61% to
6.93%. Then you need to analyse why inflation has come down.

10
 Differences between WPI and CPI
They differ in terms of their weighting pattern.
 WPI takes into account the wholesale prices. WPI is based on the price
prevailing in the wholesale markets or the price at which bulk transactions
are made. It is easier to acquire these prices because the goods that are
traded in the wholesale market are quite few. Where as CPI takes into
account the retail price. In other words CPI is based on the final price of
goods prevail in the retail markets.
 Services are not covered under WPI while they are, to different degree,
covered under CPI. WPI does not capture the price movements in the
service sector which has a larger and increasing share of GDP.

• CPI gives more weight to food items where as WPI gives more weight to
manufactured products. Therefore CPI is more sensitive to change in the
price of food items
• The fuel group has a much higher weight in WPI(13.15%) than the CPI
(7.94%). As a result movement in the international crude prices has a
greater bearing on WPI than on the CPI.
• CPI relates to different segment of the population and entire population
where as WPI deals with entire population only.
11
Different Categories/Types of Inflation
• We can classify inflation into 3 broad categories. 1. Low
inflation 2. Galloping inflation 3. Hyper inflation
Low inflation: Low inflation is characterized by prices that rise
slowly and predictably. We might define this as single digit
annual inflation rate. In this case the prices are relatively
stable. People trust money because it remains its value from
month to month and year to year. People can go for long term
contract

12
Galloping inflation: Inflation in the double digit or triple
digit range of 20, 100 or 200 percent per year is called
galloping inflation or “very high inflation”. In galloping
inflation the prices will rise million or trillion percent per
year. Galloping inflation is relatively common
particularly in countries suffering from weak
governments, war or revaluations. Many Latin American
countries, such as Argentina, Chile and Brazil had
inflation rates 50 to 700 percent per year 1970 to 1980.

Hyper Inflation: While economies seems to survive under

galloping inflation, but it is very difficult to survive in
hyper inflation.

13
 Hyper Inflation
• We used to go to the stores with money in our pockets and
come back with food in our baskets. Now we go with money
in baskets and return with food in our pockets. Everything is
scarce except money. Prices are chaotic and production dis
organized. People were seen running from store to store,
dumping their money like hot potatoes, before they get
burned by moneys loss of value.

14
Flabbergasted

15
Hyper Inflation in Zimbabwe

16
17
 Headline VS. Core inflation
Headline inflation is the raw inflation figure reported through the Consumer
Price Index. Headline inflation is not adjusted to remove highly volatile
figures such as food and energy products. Headline inflation is often closely
related to shifts in the cost of living, which provides useful information to
consumers. The headline figure is not adjusted for seasonality or for the
often-volatile elements of food and energy prices, which are removed in the
core Consumer Price Index (CPI).

18
 Anticipated Vs. Unanticipated
Inflation
Unanticipated inflation creates more problem
than the anticipated inflation.

19
 Causes of Inflation

Inflation arises because of several macro economic factors. All the factors
can be categorized into two broad categories such as demand pull
inflation and cost push inflation. In the presence of demand pull inflation
or cost push inflation price level increases.

Demand Pull inflation:

• Demand pull inflation occurs when too much money(spending) chases too
few goods
• Demand pull inflation occurs when aggregate demand rises more rapidly
than the aggregate supply (economy’s productive potential), pulling prices
up to equilibrate supply and demand.
• Put it simply, demand pull inflation occurs when AD> AS. As a result,
price level increases which causes inflation.

For simplicity, take an example. 5 movie ticket is available and 20 people

wants to buy the movie ticket. As a movie ticket seller, I will increase the
ticket price. Here, what movie ticket price increases because of increase in
aggregate demand
20
Demand Pull Inflation

21
 Demand Pull Inflation factors
• Increase in foreign demand
• Increase in domestic demand
• Structural Changes in consumption pattern
• Increase in money supply
• More credit is available to the customer
• Increase in population
• Increase in consumer optimism(consumer confidence index)
• Reduction of tax
• Increase in government expenditure
• Increase in GDP
• Increase in employment
• Speculation relating to increase in price level
• 7th pay commission(Increase in salary)
• Increase in wealth

22
Demand Pull Inflation

Note: In
demand
pull
E’
inflation,
AD
E
increases
and AS
remains
the same

23
 Demand Pull Inflation Continues..
In order to see the demand pull inflation, we require Aggregate demand and
aggregate supply curve. X axis represents aggregate output and Y axis
represents price level. The aggregate demand curve shows the relationship
between the aggregate price level and the quantity of aggregate output
demanded by households, businesses, and the government during a period of
time. The aggregate supply curve indicates the quantity of aggregate output
that producers are willing and able to supply at each possible price level. Both
AD and AS curve intersects with each other at point E and determine
equilibrium price level and output. At point E, AD=AS. What will happen if
AD> AS? . Lets assume that AS remains constant and there is increase in
AD. Now aggregate demand curve shifts from AD to AD’ . Now new
equilibrium point is E’ where AD’ and AS intersect with each other and price
level is OP’. Price level has increased from OP to OP’ and that is because of
increase in AD . This is called as demand pull inflation. Note: If increase in
price level is due to increase in AD, then it is called as Demand pull inflation.

Note: A sustained rise in the price level caused by rightward shift of the
aggregate demand curve is called demand pull inflation.
24
 Causes of Inflation Continues..
Cost push Inflation
We see today that inflation sometimes rises because of increase in cost of
production rather than increases in aggregate demand. This phenomenon is
called as cost push or supply shocks inflation. In 1973, 1978, 1999 and 2000
oil price rose sharply, business cost of production increased, and a sharp burst
of cost push inflation followed. These situations can be seen as an upward shift
in the aggregate supply curve.

Cost push inflation arises because of increase in cost of production( Increase in

Wage rate, salary, cost of raw material, rentals of the lease plant, crude oil
price, interest rate). As a result business is not profitable. If business is not
profitable, businessmen will is pessimistic about their return which will force
them to produce less. If businessmen will produce less output, then there will
be shortage of output in our economy which will tend to increase the price
level.

25
Cost Push Inflation: Inflation is high because of increase in cost

26
 Cost push Inflation Continues(Increase in Cost of
production)
 Increase in crude oil price
 Increase in transportation cost
 Increase in wage rate
 Labour strike/Farmer strike
 Natural calamities
 Increase in seed and fertilizer price
 Increase in interest rate
 Increase in cost of raw material
 War
 Poor rainfall/ heavy rainfall
 Decrease in AS
 Increase in tax

27
Cost Push Inflation

E’

28
 Cost Push Inflation
In order to see the cost push inflation, we require Aggregate demand and
aggregate supply curve. X axis represents aggregate output and Y axis
represents price level. The aggregate demand curve shows the relationship
between the aggregate price level and the quantity of aggregate output
demanded by households, businesses, and the government during a period of
time. The aggregate supply curve indicates the quantity of aggregate output
that producers are willing and able to supply at each possible price level. Both
AD and AS curve intersects with each other at point E and determine
equilibrium price level and output. At point E, AD=AS. What will happen if
cost of production increases and as a result producers are forceful to produce
less output. In this scenario, aggregate supply reduces which will shit the
aggregate supply curve to AS’. Note: AD curve remains the same and AS
curve shifted to AS’. Both AD and AS’ intersects with each other at point E’.
Now equilibrium point changes from E to E’. At E’, price level is OP’ and
output is OQ’. Here there is increase in price level from OP to OP’ and that
increase in price level is due to increase in cost of production and not because
of increase in aggregate demand. This is called as cost push inflation.
29
Note: A sustained rise in the price level caused
by leftward shift of the aggregate supply curve
is called cost push inflation.

30
 Effects of Inflation
Here we will discuss, how inflation affects household(consumer),
producers(firms) and government and the economy in general.
• Erodes Purchasing Power-Inflation indicates the loss of purchasing power of
the consumer. The same unit of currency will buy less amount of goods and
services as their prices increase. This is the loss of purchasing power of the
currency of a country.
• Household Consumption adversely affected:-The person most affected by
rising inflation is the final consumer of goods. The prices of goods and
services are constantly rising. But the salaries and income of consumer do not
rise proportionately, there is a lag. So, the goods and services become less
affordable to these final consumers. And the population in the lowest income
group are the most affected. They cannot even afford basic necessities.
• Household Savings decreases: If household will spend more money to buy
the product, then, their savings will be affected (comedown). Because of
inflation, standard of living of the people decreases.
• Inequality between rich and poor increases-Because of inflation, poor
people cant able to afford the product for consumption purpose whereas rich
people can. Without proper food, poor people will become physically week
and job loss. As a results poor become poorer and inequality between 31rich
and poor increases.
32
 Effects of Inflation Continues..
• Government expenditure increases-Because of inflation,
government expenditure increases(DA increase) which may force
the government for borrowing.
• Fixed income-earners-Fixed income-earners (such as salaried
people, rent-earners, landlords, pensioners, etc.), suffer greatly
because inflation reduces the value of their earnings.
• Industrial Sector: The rising prices mean that the factors of
production like labor and raw materials have also become expensive.
The profit margins of the companies are decreasing. And after an
extent, the companies pass on the burden of these additional
expenses to the final consumer. And the entire economy suffers.
• Inflation and economic growth- Inflation has negative impact on
economic growth. Because of inflation price level increases as a
result AD falls which further deteoriate the economic growth.

33
 Effects of Inflation Continues..

• Investments: One of the major results of inflation in an economy is the

general slowdown of the economy. When this happens unemployment
rates rise, the purchasing power of the consumer decreases, credit
becomes expensive. All these cause a strain on the entire financial system
of the country. It discourages heavy investment in the economy by both
domestic and international players.
• Creditor(Lender) and debtor(borrowers): During inflation borrowers is the
always gainer and lender is the always looser. Because of inflation value
of money falls. As a result, lender is the looser.
• Real estate
• Gems and jewelry
• Aviation industry
• GDP decreases: Inflation makes the product very expensive as a result AD
falls. Once AD falls means producers will be forceful to produce less. As a
result GDP falls in an economy.

34
 How Inflation kills an Economy
•

35
 Can inflation have a positive impact on the
economy?

Yes, inflation can have a positive impact on the economy. If it is creeping

inflation of about 2%, then it promotes economic growth and has an overall
positive impact on a nation’s economy. The threshold level of inflation is 4 to
5 % and it is treated as good for the economy. Anything above it, inflation is
generally considered bad.

36
 Measures to Check Inflation
Controlling inflation is not a simple task. The rise in prices is a result of many
factors like aggregate demand, increasing the supply of money, etc. There are
different measures to check inflation. You know inflation can be demand pull
inflation or cost push inflation.
Lets assume that demand pull inflation persists. How RBI and
Government controls demand pull inflation. You know demand pool inflation
arises when too much money chases too few goods and AD> AS. When AD
will be more. When people have money with them.
How Government control demand pull inflation?: Government can control
demand pull inflation by increasing taxes( Tax can be direct and indirect tax).
If government will increase the tax, consumer and producer need to pay more
money to Government. Money will transfer from consumer and producer to
Government. Less money means less demand. As a result, inflation will come
down. Note: government has one instrument that is tax.
Government: Increasing taxes and reduces government expenditure to control
inflation. Reducing government expenditure is not the best scenario as it may
delay important social welfare programmes related to education, healthcare
and other such important aspects of the society.
37
How Central bank(RBI in India) control demand pull inflation?:
If RBI came to know that inflation is demand driven (People are having lots
of money, as a result, they are demanding more goods and services). Because
of it prices are increasing and inflation occurs. Here RBI objective is how to
take money from the public for which people have less money for which they
will demand less. In order to do so, RBI will increase interest rate(Saving
interest rate). That will tempt people to save more money in the bank. Now
they have less money. You know once people have less money then they will
demand less and inflation will come down.

38
 Measures to Check Inflation Continues..

Let’s assume that cost push inflation occur.

How RBI and Government controls the cost push inflation. Cost push
inflation arises due to increase in cost of production as a result As affected in
the economy
How Government responds to cost push inflation?
Government came to know that inflation is due to increase in cost of
production. Here Government objective is to control inflation by reducing
cost. How Government will reduce cost?. By reducing the tax rate and
providing subsidy to firms. As a results prices will fall and inflation will
come down
How Central Bank(RBI in India) responds to cost push inflation
RBI came to know that inflation is due to increase in cost of production.
Here, RBI objective is to control inflation by reducing the cost. How RBI will
reduce cost?. RBI will reduce cost by reducing interest rate. As a result cost
of production will come down and inflation as well.

39
How Central Bank controls Inflation

40
 Short run Phillips Curve
Short run Phillips Curve shows the relationship between inflation and
unemployment. We can say there exists an inverse relationship between
inflation and unemployment. Note: Employment and unemployment are
opposite side of the same coin. Employment rate is high means
unemployment rate is low and vice versa. In this figure, when inflation is
12%, the unemployment rate is 4%. Inflation will be high when more people
are in the workforce( Employed). More people are in the workforce means
their income will be more and hence AD will be more. On the contrary, when
inflation is low it means AD is low. When AD will be low?. AD will be low
when less people are in the workforce(in other words more people are
unemployed) .

41
Thank You

42