52 Macroeconomic Policy Environment The difference can be ascribed to the differences in the weights assigned to different commodity groups in these two price indices. These are shown below: CPI (IW) WPI Commodity Groups | Weights | Commodity Groups | Weights Food Group 46.2 Primary Food 154 Pan, Supari, Tobacco, | 7.5 | Manufactured Food | 1.54 Fuel & Light 64 _| Other Primary Goods | 6.63 Other Manufactured Housing 15.3 Goods 52.2 Clothing 6.6 Fuel 14.24 Miscellaneous Group | 23.3 Total 100 All 100 From the above it can be seen that in CPI, the weight assigned to food group is much higher than in WPI. In WPI the predominant commodity group is manufactured products. Now, if food prices rise faster than others those will show up much more prominently in CPI than in WPI. The price of the same food items will be rising almost equally sharply in WPI as well, but their weights being low in the overall basket, the overall impact on WPI may still be moderate. The reverse is also true. If manufactured goods prices rise faster than others that will show up much more prominently in WPI than in CPI. The rapid rise in inflation based on CPI in India today can thus be explained by a very sharp rise in the prices of food products which have a much larger weight in CPI compared to WPI. Not very far back, however, it was the opposite. Inflation rate based on WPI was higher than CPI inflation, This was because of a sharp rise in raw material prices which impacted the prices of manufactured products more than others. 2.6 INFLATION: THE Basics Inflation refers to a continuous rise in general price level.'* In India, we estimate inflation based on the movement in WPI, which is reported every i6There is also a term called ‘core inflation’, defined as year-to-year change in prices, excluding the price of food and energy and, pethaps, administered prices. The exclusion of these prices is done because they are subject to fluctuations beyond the control of the monetaryGDP. General Price Level and Related Concepts 53 week with a two-week lag.”” CPI is used to arrive at cost of living changes and for the calculation of deamess allowance or cost of living allowance. In many other countries, inflation is derived from movements in CPI. Inno country, GDP deflator is used as a measure of inflation because, the long lag of over one year and other measurement problems do not render it useful for the formulation of policy. 2.6.1 What Causes Inflation? Inflation can be caused by demand factors, referred to as “demand-pull” inflation or by cost factors, referred to as “cost-push” inflation. Demand-pull inflation can be caused by an increase in any of the components of aggregate demand, ie., consumer demand (C), investment demand (I), government demand (G) or net foreigners’ demand (X - M) or some combination of the above. Usually, however, it is an increase in G, which is the primary cause of demand-pull inflation. When the demand increases, the extent of price increase depends on the supply situation. At one extreme, let us assume that there is massive excess capacity all around the economy and the suppliers in the economy can meet the excess demand for goods and services without resorting to increase in prices, then we may not see any rise in prices consequent to an increase in demand. At the other extreme, let us assume that the economy is operating at its full capacity and there is no scope for increasing production. In that case, the entire increase in demand will be dissipated by way of a rise in prices. In real life, however, we neither encounter economy-wide massive excess capacity nor do we come across a situation where output cannot be increased at all. In real life, as demand increases, prices and output both increase; when the economy is closer to capacity output, price rise is steeper and, vice versa, when there is some excess capacity in the economy. Cost-push inflation is driven by an increase in costs, independently of demand. The logic underlying this phenomenon is as follows. Conceptually, the contribittion that a factor of production, say, labour, makes to the revenue ofa fitm is the additional output that the firm gets by employing that labour times the price of the output. The wage that the labour gets, therefore, is supposed to reflect this. Now, if, because of union pressures wages are policy, such as, random fluctuations in weather or, OPEC decisions. Core inflation, thus, focuses on the more persistent movements in inflation and, thereby, helps understand policy effectiveness better. '7 Starting November 14, 2009, WPI is being released on a monthly basis. The government, however, continues to provide weekly data on prices of primary articles and fuels.54 Macroeconomic Policy Environment pushed up, without any increase in the worker's contribution to the output, per unit cost of production goes up at each level of output. If firms face a rise in costs, they will respond partly by raising prices and passing the cost on to their consumers and partly by cutting back on production. Note that unlike demand-pull inflation where both prices and output go up, cost- push inflation results in a rise in prices and a fall in output. We have taken the example of labour costs here, but costs could also go up because of an increase in material costs, import costs, due to increase in oil prices, strong bargaining power of producers. In short, any increase in costs or money gain, greater productivity will result in increase in prices. Demand-pull and cost-push are, of course, convenient starting points for explaining what causes inflation. Beyond a stage the distinction between the two gets blurred. What may have started as a demand pull- inflation may turn into a cost-push inflation as workers demand higher wages, suppliers want higher prices for raw materials. Again, cost-push inflation may turn into a demand-pull inflation if the government (‘G’ is a component of aggregate demand) ends up spending more to give more dearness allowance to its staff, or bail out some units adversely affected by cost-push inflation. The rule of thumb is that if output and prices are both increasing, demand side factors predominate. On the other hand, if a rise in prices is accompanied by a fall in output, it is the cost factors which are more important. Inflation can, also, be expectation driven. If people expect inflation to be say, x%, then based on this expectation, people will revise prices and actually take the inflation to x%. Expectations are formed based on past inflation rates. Policy challenge, under the circumstances, lies in finding ways to douse the expectations. The key is policy credibility. Otherwise, expected inflation may drive actual inflation. Inflation and Money Supply Inflation, as we have defined, refers to a continuous rise in prices. A one shot increase in prices does not fit into our definition of inflation, though Ptice levels may be higher than before. Let us say government spends more money as a result of increased demand for goods and services. In other words, there is a demand-pull. This will lead to an increase in prices and the extent of price rise, as we have discussed earlier, will depend on the supply capacity of the economy. Now, consider the GDP identity: Y = C +GDP General Price Level and Related Concepts 55 1+G+X~-M. The left hand side of the equation is the actual output and the right hand side of the equation is the total spending, or aggregate demand. Let us, for analytical convenience, assume that we have reached a stage where actual output (Y) is constant and cannot be increased any further. Then an ever growing government expenditure (G) must crowd out I, C and X-M, eventually reaching a point where all production is purchased by the government. When this happens there is no further scope for increase in G and no further rise in prices. But this is not inflation, which we have defined as continuous rise in prices. We will say that there was a rise in price level but that has fizzled out, as the government has no more money to spend. Now consider cost push. Let us say there is an increase in the price of petrol. Petrol being such an important product, all other prices will most certainly go up in the economy. Unless our incomes increase or we chose to save less, we will probably cut down our expenditure somewhere else to meet the increased cost of petrol. So there will be increase in prices in some sectors along with a downward pressure in prices in sectors where demand for goods and services have fallen. And, the economy will, in course of time, settle at a new general price level, which, on balance, may settle roughly where it began. So, where is the continuous rise in prices? The question we are asking is: what makes price rise continuous, which is the definition of inflation? The answer is that while the initial increase in prices, whether driven by demand-pull or cost-push factors may take some time to get fully absorbed by the economy, and therefore, one may observe rising prices for some time, such a rise in prices cannot be sustained for long, unless there is further spending of money, In other words, if money supply is held constant, then, beyond a stage, there is no scope for further spending of money and inflation will fizzle out. However, the central bank may have to increase the money supply to meet the growing demand for government spending to pay additional dearness allowance to its employees who have been hit by an increase in the price level or for meeting other commitments. This makes the price rise continuous. By implication, then, what we are saying is that a continuous rise in prices is possible only if it is accommodated by an increase in money supply. Indeed, inflation, in the long run, is a monetary phenomenon. It is sustained by an increase in money supply.® This relationship draws from our discussion on money in Section 2.2. You may like to refresh Section 2.2. Note that in arriving at this relationship between money supply and prices, we are assuming that the number of times money changes hands in an year is stable,56 Macroeconomic Policy Environment Inflation and Interest Rates Our focus in this section is on the relationship between inflation and nominal interest rate. The discussion is in broad terms; nevertheless, it will be useful to grasp the basics. Let us begin by drawing from our previous learning in Section 2.3 where we discussed the basics of interest rates. We said that real interest rate is equal to nominal interest rate minus expected inflation. We also said that because of difficulties in arriving at expected inflation, actual inflation is sometimes used as a proxy. Symbolically 7 = i — n® where r is the real interest rate, i is the nominal interest rate and n° is the expected inflation. Now, let us rewrite the equation as: i = r + n*. This says that nominal interest rate is equal to real interest rate plus inflationary expectations. And, as before, actual inflation can be used as a proxy for inflationary expectations. Let us now give an economic interpretation to the concept of real interest rate. Real interest rate is nothing but the return on the stock of capital or, roughly, investment. For the economy as a whole the return on the stock of capital over time is given by the real GDP growth. Therefore, GDP growth sets the limit for real interest rate. Or r can be roughly used as a proxy for real GDP growth. Now, consider the equation: i = r + m*. In a period of slowdown as GDP growth slows down, we have seen, expected inflation will be low and so will be nominal interest rate i. In a booming economy, as GDP growth accelerates, expected inflation will be higher and so will be the nominal interest rate. Finally, if we say that real interest rate, which is capturing the real GDP growth, is constant, there exists a relationship between expected inflation and nominal interest rates. Intuitively, whatwearesayingjs thatonereason why interest rate (nominal) exists is inflation. People who lend money would like to be compensated for the loss of purchasing power of what they lend. Interest rates, therefore, will be low if inflationary expectations are low. Since inflationary expectations are formed based on current inflation rates, interest rates are low when inflation rate is Idw and interest rates are high when inflation rate is high. Costs of Inflation If we all knew with certainty what the annual price rise would be, we would all make adjustments accordingly such that the costs of inflation would be minimum. However, inflation tends to be unanticipated. And, unanticipated inflation can be costly.GDP General Price Level and Related Concepts 57 The first set of costs is what is known as distribution costs. Inflation penalizes people with fixed income. With inflation, the value of the money these people earn, goes down. Thus inflation redistributes incomes away from this group in favour of those, whose incomes keep pace with inflation. Similarly, inflation also redistributes income between the lender and the borrower. Lender loses because of a fail in the real value of financial assets, he gets back while the borrower gains because the real value of the monetary assets, he returns has, come down. Also, while inflation means, generally, rising prices, all prices do not rise at the same rate. Some prices rise more and some by less than the overall. This creates changes in relative prices and can be a source of uncertainty to business. Aside from the above, unanticipated inflation can also affect growth. A high inflation rate diverts financial savings, which support investment demand and thereby growth to non-investible resources like gold, land, and commodities that usually have a tendency to keep pace with inflation but do not contribute towards growth. Inflation can also lead to a flight of capital from the country, thus, further reducing economy's access to investible resources. Last but not least, inflation can also slow down external sector demand for domestically produced goods and services. As we discussed in Section 2.4, if the domestic inflation rate is higher than other trading partners’ inflation rate, our goods and services become less competitive compared to that of our trading partners. Management of Inflation What is a manageable rate of inflation? There is a general agreement among economists that inflation should be relatively low and stable but there is no consensus on the rate. An acceptable rate will depend on a host of factors, including economic growth and social justice objectives and also political considerations. In India, an acceptable rate of inflation can be considered as between 5% and 6%" per annum. In other countries, it may be less. The important thing is that the inflation rate should be stable. If the inflation is triggered by demand-pull, at least theoretically, the problem is amenable to macro policy management. Assume that inflation ® Rangarajan, C., “The Changing Context of Monetary Policy” in indian Economy, Essays on Money and Finance, UBS Publishers’ Distributors Ltd, 1998. -58 Macroeconomic Policy Environment has overshot the desirable level as a result of demand-pull factors. Recall that when there is a demand-pull inflation, with prices, output also rises. A contractionary fiscal or monetary policy (lower G, higher taxes, higher interest rates) can be used to slow down the economy till both output and inflation are brought back to the original level. However, if the overshooting of inflation is due to cost-push factors, policy makers have a more difficult job at hand. This is because, in case of cost-push inflation, with inflation, output also falls. Now, if you follow a contractionary fiscal or monetary policy and slow down the economy, prices will fall because of lesser demand for goods and services, but also the output would fall. If on the other hand, you want to target output, by following expansionary fiscal and monetary policies, you cannot bring down prices. In other words, in case of cost-push inflation, it is very difficult to get back to the original output and price combination by use of conventional macroeconomic Policy tools. In this situation, therefore, the solution has to be found not from the demand but from the supply side that has caused the cost-push inflation. Conventional macroeconomic policies do not offer a readymade solution to cost-push inflation (Box 2.2). To the extent, real life inflation is a combination of both demand- pull and a cost-push factor, in addition to being driven by expectations, actual management of inflation is not an easy task. The problem is one of identification. If the rise in prices is due to one-time factors like increase in oil prices or upward revision of administered prices, the central bank may not like to slowdown the economy to tame prices. On the other hand, if the inflation is due to a sustained rise in demand, the central bank may need to take a more decisive step in terms of containing demand. But then does the central bank know for sure what is causing the price rise? If not, can it dampen expectations? These are some of the dilemmas the central banker is faced with in the conduct of monetary policy. | Box 2.2 More on Why is Supply Side Inflation More Difficult to Manage? The difficulty the policy makers face in controlling supply side inflation can be explained with a set of demand and supply curves. In the following diagrams, AD refers to aggregate demand for goods and services in an economy in a given period of time and AS refers to | aggregate supply of goods and services produced in an economy inGDP, General Price Level and Related Concepts 59 a given period of time. P refers to general price level. The aggregate demand curve (AD) is downward sloping because as the general price level (P) increases, the value of money that we have to spend on goods and services comes down and with that reduced value of money we buy less goods and services. The aggregate supply curve (AS) is upward sloping because the producer needs to be given an incentive to produce more, in response to rising demand, because increasing production at the margin costs more. The y-axis measures the general price level (P), which is a weighted average price of all goods and services produced in the economy. And the x-axis measures GDP (Y). The point of intersection between AD and AS gives us the equilibrium level of GDP (e.g., Y, Y,) and equilibrium level of price (e.g., P, P,) 12 Demand Sie imation 1 Supply Sie Inflation Let us consider demand side inflation first. Assume 'Y, represents 9% GDP growth and P, 5% inflation. Since these numbers are consistent with India’s growth and price stability objectives (Chapter 1), the policy maker would like to stay at point A. Now, for some reason, AD goes up and the AD curve moves to the right to ADI. Asa result, GDP growth increases from Y, to Y, (> 9%) but so does inflation from P, to P, © 5%). Since inflation is out of line with price stability objective, the policy maker would like to revert back to A. A contractionary macroeconomic policy will be followed (e.g. signaling a rise in the interest rates by RBI), and in normal times, AD1 will move back to point A. The time it takes to move back to point A is the policy lag. (contd.)60 Macroeconomic Policy Environment The pointis that if the disturbance originates from the demand side, which usually is the case, macroeconomic policies, which are geared towards handling demand side disturbances, can take the economy back to the desirable point with a predictable lag. However, this is not so if the inflation originates from the supply side. Ina supply side inflation, as can be seen from the second diagram, the inflation is caused not by a rightward shift in the AD curve but by a leftward shift in the AS curve. And, when that happens, we end up in a situation where a higher inflation exists simultaneously with a slower growth of GDP. A leftward shift in the AS can be caused by an increase in commodity prices (oil, steel, cement, aluminum), which are important ingredients in the production process. As a result, the cost of production goes up; producers reflect this increase by charging a higher output price; higher output price lowers demand and at the end of the day the economy ends up with higher prices and slower growth of output. A leftward shift in the AS can also be caused by a crop failure consequent to an inclement weather. Here, supply falls short of demand and prices rise to bring the market to equilibrium. If the problem originates from the supply side how does one get back to point A? A little reflection will show that policies like fiscal and monetary policies, which are geared towards addressing disturbances arising from demand side, cannot bring the economy back to point A, at least, not in a short period of time. If an expansionary set of macroeconomic policies are followed, the AD will shift to AD,. The point where AD, touches AS, will be the new point of equilibrium. And it can be seen that at that point the economy will be able to reach the desired level of GDP growth Y, but at a rate of inflation which is even higher than P,. Similarly, if a contractionary set of policies are followed, AD shifts to AD,, the point where it intersects AS, is the new point of equilibrium. At this point, the economy can have the desired level of inflation (P,) but at slower growth of output compared to Y,. Either way, point A will not be reached. The solution to a supply side disturbance is to shift AS, back to AS. One way to do it is to augment domestic production, but that can be time-consuming; the other way is to increase imports, but the feasibility of that will depend on global prices vis-i-vis domestic prices; finally, one can think of institutional mechanism to manage available suppliesGDP, General Price Level and Related Concepts 61 through controls; but that may interfere with market signals and may not be sustainable. Usually, therefore, a supply side disturbance is less amenable to policy correction. In the event of a supply side disturbance, the policy maker is in a dilemma. Should it target growth (Y,) or Inflation (P,) since it cannot target both simultaneously? If it targets growth, price stability objective will have to be compromised with®, if it targets inflation, growth may suffer. A practicing manager is worried about this situation because, given this choice; the policy maker usually goes for price stability. 2.7 SUMMING Up In this chapter, we have attempted to familiarize the readers with certain key concepts in macroeconomics, which affect business bottom lines. A set of demand variables, captured by GDP and related measures, which are crucial to revenue growth have been introduced first. Then, the discussion shifted to cost variables like interest rates, exchange rates and prices. So far, the familiarization has been mostly at a conceptual level. Now, we will apply these concepts to see how they affect the business environment and how macroeconomic policies address business concerns. Chapter 2 is an important chapter. The reader should carefully grasp the concepts introduced in this chapter. The rest of the book will build on the foundation laid out in this chapter. Many of the basic concepts covered in this chapter will be assumed as known, or at best, a quick refresher will be provided, in subsequent discussions. The reader will be well advised to go through this chapter each time he/she moves to a new chapter. REVIEW QUESTIONS 1, Why should a manager monitor GDP growth? Explain clearly what GDP growth does and does not signal to the manager. 2. Why doweconsider/z«a/ goods and services while estimating GDP? ‘Suppose the reference period is the calendar year and on December 31, ® Supply side inflation may further spillover to the demand side because of growth and it may be difficult to contain inflationary expectations.