INFLATION

Introduction
In economics, inflation is a rise in the general level of prices of goods and services in an
economy over a period of time. When the price level rises, each unit of currency buys fewer
goods and services; consequently, inflation is also degradation in the purchasing power of
money. A chief measure of price inflation is the inflation rate, the annualized percentage
change in a general price index over time. Inflation's effects on an economy are manifold and
can be simultaneously positive and negative. Negative effects of inflation include a decrease in
the real value of money and other monetary items over time, uncertainty over future inflation
may discourage investment and savings, and high inflation may lead to shortages of goods if
consumers begin hoarding out of concern that prices will increase in the future. Positive effects
include a mitigation of economic recessions and debt relief by reducing the real level of debt.

Definition
Many definitions of inflation can be read from the books of economics, but a general definition of
inflation is given below as:-

Inflation is an increase in the price of a basket of goods and services that is representative of the
economy as a whole.

A similar definition of inflation can be found in economics by Parkin and Bade which can be
easily understood by a layman as:-

“Inflation is an upward movement in the average level of prices. Its opposite is deflation, a
downward movement in the average level of prices. The boundary between inflation and
deflation is price stability.”

In order to understand the concept of inflation and its opposite deflation let us take an example

For instance imagine we have only two commodities: Oranges picked from orange trees, and
paper money printed by the government. In a year where there is a drought and oranges are
scarce, we'd expect to see the price of oranges rise, as there will be more Rupees chasing very
few oranges. Conversely, if there's a record crop or oranges, we'd expect to see the price of
oranges fall, as orange sellers will need to reduce their prices in order to clear their inventory.
Here few Rupees will be chasing many oranges. These scenarios are inflation and deflation.
Above picture shows inflation rates around the world in 2009

Above graph shows inflation rates of India over the last decade
Calculation
Inflation is usually estimated by calculating the inflation rate of a price index, usually the
Consumer Price Index. The Consumer Price Index measures prices of a selection of goods and
services purchased by a consumer. The inflation rate is the percentage rate of change of a price
index over time.

But before we proceed further let us understand what is consumer price index or price index?

Consumer price index or price index:

A consumer price index (CPI) measures changes through time in the price level of consumer
goods and services purchased by households. It is a statistical estimate constructed using the
prices of a sample of representative items whose prices are collected periodically.

Now we will calculate inflation:

For instance, in January 2009, in India Consumer Price Index was 202.416, and in January 2010
it is 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the
course of 2009 is

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general
level of prices for typical Indian consumers rose by approximately four percent in 2010.

Fallacy in above method of calculation

Let us understand the flaw in it by taking example of Nokia N-97 handset and FMCG product
say edible oil. Within one year price of edible oil mushroomed by more than 10-15% whereas
the price of Nokia N-97 has come down from Rs 8500 to Rs 5000 approx. As per above
calculation in 2010 prices of both Nokia N-97 and edible oil should rise by 4.28%which is
actually not happening. This means that above calculation is not showing the actual picture of
economy. The above calculation only shows a general overview and not a particular sector of the
economy.
Types of inflation
Economists have suggested four types of inflations which are mentioned as follows:

Wage Inflation: Wage inflation is also called as demand-pull or excess demand inflation. This type of
inflation occurs when total demand for goods and services in an economy exceeds the supply of the
same. When the supply is less, the prices of these goods and services would rise, leading to a situation
called as demand-pull inflation. This type of inflation affects the market economy adversely during the
wartime.

Cost-push Inflation: From the name it means, if there is increase in the cost of production of goods and
services, there is likely to be a forceful increase in the prices of finished goods and services. For instance,
a rise in the wages of laborers would raise the unit costs of production and this would lead to rise in
prices for the related end product.

Pricing Power Inflation: Pricing power inflation is more often called as administered price inflation. This
type of inflation occurs when the business houses and industries decide to increase the price of their
respective goods and services to increase their profit margins. A point noteworthy is pricing power
inflation does not occur at the time of financial crises and economic depression, or when there is a
downturn in the economy.

Sectoral Inflation: This is the fourth major type of inflation. The sectoral inflation takes place when there
is an increase in the price of the goods and services produced by a certain sector of industries. For
instance, an increase in the cost of crude oil would directly affect all the other sectors, which are directly
related to the oil industry. Take the example of aviation industry. When the price of oil increases, the
ticket fares would also go up. This would lead to a widespread inflation throughout the economy, even
though it had originated in one basic sector. If this situation occurs when there is a recession in the
economy, there would be layoffs and it would adversely affect the work force and the economy in turn.

Other Types of Inflation

Fiscal Inflation: Fiscal Inflation occurs when there is excess government spending. This occurs when
there is a deficit budget. For instance, Fiscal inflation originated in the US in 1960s at the time President
Lydon Baines Johnson. America is also facing fiscal type of inflation under the Presidentship of George
W. Bush due to excess spending in the defense sector.

Hyperinflation: Hyperinflation is also known as runaway inflation or galloping inflation. This type of
inflation occurs during or soon after a war. This can usually lead to the complete breakdown of a
country’s monetary system. However, this type of inflation is short-lived. In 1923, in Germany, inflation
rate touched approximately 322 percent per month with October being the month of highest inflation.
Causes of inflation
There are a few different reasons that can account for the inflation in our goods and services;
let's review a few of them:

 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.

 This can be easily understood from the Indian context where the population is
increasing by approx. 1.2% annually and on the other hand cultivable land is
declining day by day in the name of industrialization, infrastructure development
etc. This leads to more demand and less supply which ultimately leads to
demand pull inflation. From the data table and graph given below it is evident
that in spite of having record growth, prices of various commodities is increasing
year by year.

 The cost-push 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.

 The most practical example of cost push theory is oil market. Whenever OPEC
reduces oil supply, prices are artificially driven up and result in higher prices of
the oil.
 
 Money supply plays a large role in inflationary pressure as well. Monetarist economists
believe that if the Federal Reserve does not control the money supply adequately, it
 may actually grow at a rate faster than that of the potential output in the economy, or
real GDP. The belief is that this will drive up prices and hence, inflation. Low interest
rates correspond with a high levels of money supply and allow for more investment in
big business and new ideas which eventually leads to unsustainable levels of inflation as
cheap money is available.

 The credit crisis of 2008-09 is a very good example of this. As a result of cheap
lower interest rates many prominent banks like Lehman Brothers, Citibank, Bank
of America etc went bankrupt in the year 2008.
 
 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 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.
Effects of inflation

Effects of inflation are negative, and can hurt individuals and companies alike, below are a list
of effects of inflation:

1. Hoarding --people will try to get rid of cash before it is devalued, by hoarding food and
other commodities creating shortages of the hoarded objects.
2. Distortion of relative prices-- usually the prices of goods goes higher, especially the
prices of commodities.
3. Increased risk -- uncertainties in business always exist, but with inflation risks are very
high, because of the instability of prices.
4. Existing creditors will be hurt --because the value of the money they will receive from
their borrowers later will be lower than the money they gave before.
5. Fixed income recipients will be hurt --because while inflation increases, their income
doesn’t increase, and therefore their income will have less value over time.
6. Increased consumption ratio at the early stages of inflation --people will be consuming
more because money is more abundant and its value is not lowered yet.
7. Lowers national saving --when there is a high inflation, saving money would mean
watching your cash decrease in value day after day, so people tend to spend the cash on
something else.
8. Causes business cycles --many companies will have to go out of business because of the
losses they incurred from inflation and its effects.
9. Currency debasement --which lowers the value of a currency, and sometimes cause a new
currency to be born.
10. Rising prices of imports --if the currency is destabilized, then its purchasing power in the
international market is lower.
Steps taken by Government of India to control inflation

To maintain sufficient cash flow in the market

RBI increased its repo rate, reverse repo to 5.25% and 3.75% respectively while the Cash Reserve Ratio
to 6% .

Let us try to understand repo rate, reverse repo rate and cash reserve ratio step by step:

Repo rate: Repo rate is the rate at which banks borrow rupees from RBI. A reduction in the repo
rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from
RBI becomes more expensive.

Reverse Repo rate: Reverse repo rate is the rate at which Reserve Bank of India (RBI) borrows
money from banks. It can be used to take the money to be drawn out of the banking system.

Cash Reserve Ratio: Cash reserve ratio is a bank regulation that sets the minimum reserves each
bank must hold to customer deposits and notes. If RBI decides to increase the percent of this, the
available amount with the banks comes down. RBI is using this method (increase of CRR rate),
to drain out the excessive money from the banks.

From the above definitions it is clear that in order to have sufficient money in the banking
system and to keep the inflation under check these rates have to be changed from time to time.

Steps taken to control food prices

 For paddy, MSP has moved from Rs.560 to Rs.1000 per quintal.
 The new Nutrient Based Fertilizer Policy is being implemented by the government to
boost agricultural output.
 To increase production of pulses during Kharif 2010-11, the MSP of Tur, Urad and
Moong has been increased substantially. For Tur, it has been raised from Rs.2300 to
Rs.3000 per quintal, for Urad from Rs.2520 to Rs.2900 per quintal, Moong from Rs.2760
to Rs.3170 per quintal.
 Government has given an additional incentive of Rs.5 per kg for these pulses sold during
the harvest/arrival period of two months to designated procurement agencies.
 Government has amended the The Income Tax Act 1961 to encourage construction of
more warehousing facilities by giving tax exemptions to those contributing for the same.
 The CIP(central issue price) for rice is fixed at Rs 5.65 per kg for BPL(below poverty
line) and Rs 3 per kg for AAY (Antyodaya anna yojna)and while wheat is at Rs 4.15 per
kg for BPL and Rs 2 per kg for AAY.

 Antyodaya Anna Yojna was launched in 2000 to provide food based assistance to
poor households. These households are given special ration cards (Antyodaya
card). Each household is entitled to receive food grains at a highly subsidized
price. Subsidized prices are wheat at Rs 2 per kg and rice at Rs 3 per kg from fair
price shop and no FPS dealer can charge extra under any circumstances.

 For pulses and edible oils, the Government of India is bearing a subsidy of Rs 10 per kg
and Rs 15 per kg respectively for distribution of these items through PDS/Fair price
shops.
 Government has also given an additional allocation of 4.57 lakh tonnes of food grains
per month for APL (above poverty line) families.
 Reducing import duties to zero – for rice, wheat, pulses, edible oils (crude), sugar and
maize.
 Reducing import duties on refined & hydrogenated oils & vegetable oils from 9.0% to
7.5%.

Inflation of India for the week ended 28 August 2010 was recorded 11.45%
 Group – One
Name: Alok Shakya
Topic: Inflation
College: National School of Business
Section: B
Roll number: 02

Submitted on 15 September 2010