Inflation

INFLATION

  • Definition: Persistent rise in the price of goods and services (G&S).

Types of Inflation:

  1. Creeping Inflation: General price increase up to 4% a year; considered a welcome inflation.
  2. Trotting or Walking Inflation: Price increase by a few hundred basis points beyond creeping inflation.
  3. Galloping Inflation: Price increase at 8-10% annually.
  4. Runaway Inflation: Rapid and uncontrollable price rise.
  5. Hyperinflation: Monthly price increase of 20-30%, with no tendency toward equilibrium.

Other Concepts:

  • Deflation: Fall in prices; can lead to a self-reinforcing deflationary spiral if unchecked, requiring Keynesian stimulus.
  • Disinflation: Reduced rate of inflation.
  • Stagflation: Combination of inflation and unemployment.
  • Reflation: Deliberate government action to stimulate the economy, often when inflation returns after deflation and recession.
  • Skewflation: Price rise of a small group of commodities over a sustained period.
  • Headline Inflation:
  • Measured using the Consumer Price Index (CPI).
  • Reflects inflation experienced by consumers and includes primary, fuel, and manufacturing inflation.
  • Core or Underlying Inflation:
  • Excludes transitory effects to focus on demand-side factors.
  • Excludes food, fuel, and food processing manufacturing.

RECESSION

  • Definition: Decline in macroeconomic indicators with rising unemployment.
  • Technical Definition: Negative growth rate for two consecutive quarters.
  • Double-Dip Recession: A recession followed by a short recovery, then another recession.

DEPRESSION

  • Definition: An extreme form of recession.
  • Characteristics:
  • Prolonged duration.
  • High unemployment.
  • Credit unavailability.
  • Shrinking output.
  • Bankruptcies.
  • Reduced trade volume.
  • High currency volatility.

Types of Inflation Based on Causes

  1. Demand-Pull Inflation: Occurs when demand outpaces supply or there’s an inverse relationship between the two.
  2. Cost-Push Inflation: Results from supply shocks, such as increased input costs.
  3. Structural Inflation: Arises from deficiencies in the economy, like backward agriculture or inefficient distribution.
  4. Cartelization: Producers collude to push prices up.
  5. Hoarding: Accumulation of large quantities of goods.
  6. Imported Inflation: High import prices due to overdependency on imports.

Impact of High Inflation

  1. Investment:
  • Short Run: Boosts investment due to:
    • High inflation → High demand → Entrepreneurs expand production levels.
    • Higher inflation reduces the real cost of loans, encouraging borrowing.
  1. Savings:
  • Short Run: Savings may increase.
  • Long Run: Savings decrease as inflation erodes purchasing power.
  1. Bracket Creep:
  • Nominal value of gross tax revenue increases as taxpayers move into higher tax brackets without real income growth.
  1. Exchange Rates:
  • Inflation often leads to currency depreciation.
  1. Trade Balance:
  • Developed Economies: Inflation may improve the trade balance.
  • Developing Economies: Inflation worsens the trade balance due to the composition of foreign trade.
  1. Employment:
  • Short Run: Employment rises as demand increases.
  • Long Run: Employment may decrease or become neutral.
  1. Wages:
  • Nominal Wages: Increase.
  • Real Wages: Fall, negatively affecting purchasing power and living standards.
  1. Banking System:
  • Faces pressure from higher lending.
  • Banks often do not revise nominal interest rates quickly, as the real cost of borrowing (Nominal Interest – Inflation) falls.
  • Notes:
    • Nominal Interest Rate: Actual price paid by borrowers to lenders, not adjusted for inflation.
    • Real Interest Rate: Adjusted for inflation (Nominal Interest – Inflation).

Gainers vs. Losers During High Inflation

GainersLosers
DebtorsCreditors
ProducersConsumers
Flexible income groupsFixed income groups
Bond issuersBond holders
Debenture holders or savers with fixed interest rates (gain only if interest > inflation).

Monetary Policy Framework Agreement (2015)

  1. RBI targets CPI (Combined) inflation within 4% ± 2%.
  2. Inflation targeting:
  • Government of India (GoI) sets the inflation target in consultation with RBI.
  • RBI is responsible for achieving the target.

Urjit Patel Committee Recommendations (2014)

  1. Set the inflation target at 4% ± 2%.
  2. Define the nominal anchor in terms of Headline CPI.
  3. Ensure fiscal deficit is reduced to 3% by 2016-17.
  4. Establish the Monetary Policy Committee (MPC) for decision-making.
  5. RBI to independently fix the inflation target.

Monetary Policy Committee (MPC)

  • Introduced under the Monetary Policy Framework Agreement (2015).
  • Finance Act 2016: Amended the RBI Act, 1934, providing statutory backing to the MPC.
  • Composition:
  • Governor of RBI (Chairperson).
  • Deputy Governor in charge of monetary policy.
  • One RBI official.
  • Three members nominated by the Central Government.
  • Key Features:
  • Members are not eligible for reappointment.
  • Decisions are binding on RBI.
  • Publishes a Monetary Policy Report every six months.
  • Meets four times a year.

Indices for Calculation of Inflation

1. Wholesale Price Index (WPI)

  • Definition: Measures inflation at the wholesale transaction level for the economy as a whole.
  • Published By: Economic Advisor, DIPP, Ministry of Commerce, on a monthly basis with a one-month lag.
  • Commodities Categories:
  1. Primary Articles
  2. Fuel and Power
  3. Manufactured Goods
  • Limitations: Does not include services and the unorganized sector.
  • New All-India WPI:
  1. Base Year: 2011-12.
  2. Excludes indirect taxes to eliminate the impact of fiscal policy, making it closer to the Producer Price Index (PPI) and reflecting production-side inflation.
  3. Introduced a separate WPI Food Index, combining food articles under primary articles and food products under manufactured products.

2. Producer Price Index (PPI)

  • Definition: Measures the price received by producers for their goods.
  • Development:
  • 2014: Goldar Committee set up to develop PPI.
  • 2019: Government commission established to transition from WPI to PPI as the deflator in GVA/GDP calculations.

3. Consumer Price Index (CPI)

  • Definition: Tracks changes in the price of a basket of goods and services purchased by households.
  • Published By:
  1. Ministry of Labour: CPI for Industrial Workers (IW) and Rural Labourers (RL).
  2. CSO: CPI (Urban, Rural, Combined).
  3. base year 2012
  • Components: Consumer Price Index has 6 main components with differing weights
    • Food and beverages (45% weight overall with Cereals accounting for 9.67% of the total)
    • Pan, tobacco, and intoxicants (2.38%)
    • Clothing and footwear(6.53%) 
    • Housing  (10.07%)
    • Fuel and light (6.84%)
    • Miscellaneous (services such as education, health care etc.) (28.32%)

4. Consumer Food Price Index (CFPI)

  • Definition: Measures changes in the retail prices of food products.
  • Introduced By: CSO at the all-India level in 2014.

5. Services and Price Index (SPI)

  • Committee: Established by DIPP on the advice of C.P. Chandrashekhar.

6. Housing Price Index (HPI)

  • Published By: RBI.
  • Frequency: Quarterly.
  • Coverage: Tracks housing price changes across 10 major cities.

7. Index of Industrial Production (IIP)

  • Definition: Measures industrial growth and assists in estimating GDP growth.
  • Industry Classification:
  1. Manufacturing (77%).
  2. Mining (14%).
  3. Electricity (7%).
  • Published By: CSO on a monthly basis.

8. Purchasing Manager’s Index (PMI)

  • Definition: Predicts levels of industrial production in advance, covering both manufacturing and services.
  • Published By: HSBC and Markit (Nikkei).
  • Interpretation:
  • Above 50: Expansion in industrial production.
  • Below 50: Contraction in industrial production.

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