Home General Knowledge GK SPECIAL TOPIC : INFLATION
GK SPECIAL TOPIC : INFLATION
Written by Administrator   
Friday, 18 July 2014 07:43


 



INFLATION

Recently the CSO adopted a new method to measure the price index in India. In the following section few basic issues and measurements of inflation are discussed.

Inflation is an economic term that is used for addressing the measure for price rise for commodities. There are two types of inflation demand pull and cost pull inflation. While the demand pull refers to the increase in prices which happens as a result of increase in demand that may occur due to increase in disposable income, change in tastes, technological obsolescence, substitutionary effect or complementary effects. The cost pull inflation occurs mainly on account of change in prices due to change in factor supply price that in turn may occur due to increase in wages, increase in taxes paid by producers, increase in prices of other input cost, increase in transportation cost etc. There are various method adopted to measure the change in prices. The method in which the inflation is measured is through the index numbers. Apart from this distinction the inflation is categorized as real and nominal inflation. Real inflation is defined in terms of prices that are adjusted for interest rate inflation or increases in monetary values.

Apart from general inflation that arise because of deficit in supply and increasing demand the factors that affect inflation are due to structural problems in the economy. Under developed countries are marked with supply side bottlenecks, lack of resources, infrastructural lacunae, market imperfections and lack of skilled resources. Despite labor abundance and economy operating much below the full employment equilibrium, the aforementioned factors create friction in meeting the demands as it limits the production capacities.

The most prevalent is the Wholesale Price Index (WPI) in India. WPI is measured on the basis of wholesale prices provided by the wholesale traders and government units. These are compiled on weekly basis and an average record is computed for the month to arrive at monthly average. Various products and commodities are classified under different categories broadly classified as under primary articles, manufactured products and other non primary articles. The other method of measuring inflation is with the help of Consumer Price Index (CPI) that are compiled for various consumer categories. These are computed for the prices paid by agricultural laborers, industrial workers, self employed etc. In India the CPI is measured with a three month lag on monthly basis. Different weights are accorded to different commodities based on usages of the products. Central Statistical Organization (CSO) is responsible for the collection of data on inflation in India.

Before the economic liberalization and price deregulation introduced in India the country faced high inflation rate. The main reasons cited were the fixation of agricultural minimum prices that increased the prices of primary products in India and related food products both processed and unprocessed. The primary products prices were given substantial weightage in earlier methods that were adopted for calculation of the price index.

INFLATION-1

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money.

As for example

If we were able to buy 1kg of rice at say Rs.50 but due to price rise same amount is costing Rs.70. The price rise of the commodities over a period of time is inflation that is affecting the purchasing power of the people. This in turn reduces the value of money as for each commodity we have to spend more than the previous one.

TYPES OF INFLATION

1. Demand pull 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.

As for example

High prices of onions: Due to the crop failure the supply of onions decreased but the demand among the masses remained the same. Thus as a result prices increased drastically reached around Rs.80. The government had imported the onions from Pakistan. As the supply increases in the market the prices automatically decrease. Thus this is demand pull inflation. The vicious circle of demand and supply controls the prices.

2. Cost-push Inflation: If there is increase in the cost of production of goods and services, due to increase of wages and raw materials cost, there is likely to be a consequent increase in the prices of finished goods and services.

As for example

High petrol prices: ongoing increase in the prices of petrol is resulting in high inflation rate. Since petroleum is so important to developing economies, a large increase in its price can lead to the increase in the price of most products, raising the inflation rate.

3. 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 crisis and economic depression, or when there is a downturn in the economy. This type of inflation is also called as oligopolistic inflation because oligopolies have the power of pricing their goods and services.

As for example

Increment in prices of cars: due to increase in cost of steel, plastic etc and to maintain profit margins the price of cars have to be increased.

4. Sectoral 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. Thus, the ever-increasing price of fuel has become an important issue related to the economy all over the world.

As for example

Increment in airfare: In Aviation industry when the price of oil increases, the ticket fares also go up.

INFLATION-2

1. Stagflation: It is a situation in which the inflation rate is high and the economic growth rate is low. It raises a dilemma for economic policy since actions designed to lower inflation may worsen economic growth and vice versa.

There can be two reasons for stagflation:

Firstly, stagflation can result when the productive capacity of an economy is reduced by an unfavorable supply shock, such as an increase in the price of oil for an oil importing country. Such an unfavorable supply shock tends to raise prices and slows the economy by making production more costly and less profitable.

Secondly, stagflation can result due to inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply and the government can cause stagnation by excessive regulation of goods markets and labour market.

2. Reflation: It is the act of stimulating the economy by increasing the money supply or by reducing taxes. It is an act of pumping money in the market to increase the circulation so that economy can be stipulated again.

As in U.S to increase the growth rate government has announced special bailout packages for the companies thus trying to pump economy out of recession.

3. Disinflation: It is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services in a nation's gross domestic product over time.

4. Deflation: It is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). This should not be confused with disinflation which is a slow-down in the inflation rate (i.e. when inflation declines to lower levels).

5. Hyper inflation: It is the extremely rapid escalation of prices (typically more than 50% per month) for goods and services. The most famous hyperinflation of the modern era occurred in Germany in 1920-1923 when the government began printing money to make up for revenue lost. The German hyperinflation resulted in a percentage increase in prices in the millions per month. Other cases of hyperinflation (Greece, Hungary) following World War II were even more extreme.

The root cause of hyperinflation tends to be the excessive printing of currency by the monetary authority. Hyperinflation is extremely disruptive by making savings worthless very quickly, thus encouraging workers to spend money as fast as it is earned.

6. Recession: A significant decline in activity across the economy, lasting longer than a few months is recession. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP).

Depression: It is a sustained, long-term downturn in economic activity in one or more economies. A depression is characterized by its length, by abnormally large increases in unemployment, falls in the availability of credit— often due to some kind of banking or financial crisis, shrinking output—as buyers dry up and suppliers cut back on production, and investment, large number of bankruptcies—including sovereign debt defaults, significantly reduced amounts of trade and commerce—especially international, as well as highly volatile relative currency value fluctuations—most often due to devaluations.

INFLATION-3

HOW INFLATION IS MEASURED

Inflation is measured using two price indexes CONSUMER PRICE INDEX and WHOLESALE PRICE INDEX.

A price index is a normalized weighted average of prices for a given class of goods or services in a given region, during a given interval of time. It is a statistic designed to help to compare how these prices, taken as a whole, differ between time periods

Price indices have several potential uses. For particularly broad indices, the index can be said to measure the economy's price level or a cost of living.

A price index is selected and its index is assumed as 100 and on this basis price index for the current year is calculated. If index is below 100 it indicates deflation whereas if high then inflation.

• CONSUMER PRICE INDEX

A consumer price index (CPI) measures changes in the price level of consumer goods and services purchased by households. It is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.

In India CPI is calculated in different fields as:

* CPI-IW i.e. Consumer Price Index for Industrial Workers (BASE YEAR IS 2001)

* CPI-AL i.e. Consumer Price Index for Agricultural Labour ( BASE YEAR IS 1986-87)

* CPI-RL i.e. Consumer Price Index for Rural Labours (BASE YEAR IS 1986-87)

• WHOLESALE PRICE INDEX

The Wholesale Price Index or WPI is the price of a representative basket of wholesale goods. The Indian WPI figure is released monthly and influences stock and fixed price markets. The Wholesale Price Index focuses on the price of goods traded between corporations, rather than goods bought by consumers, which is measured by the Consumer Price Index. The purpose of the WPI is to monitor price movements that reflect supply and demand in industry, manufacturing and construction. This helps in analyzing both macroeconomic and microeconomic conditions.

The limitations of WPI are related to

(a) Non-inclusion of services;

(b) following a fixed weighting scheme while the economy is undergoing major structural changes, and

(c) use of gross transactions data rather than data on final purchases.

Base year for WPI is 2004-05

INFLATION-4

Monetary measures to control inflation (given by RBI)

• Cash reserve ratio: Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the per cent 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.

Effect on inflation

The foremost reason of inflation is increment in money supply in the market. Cash reserve ratio is the amount kept by banks in RBI. If for example the bank has 100000 rupees and CRR is 10% then 10% of 100000 has to be kept with RBI i.e. 10000 rupees. Now if the CRR increased to 12% then banks has to kept 12% of 100000 i.e. 12000 with RBI. Hence the money with the banks decreases as CRR increases and thus money supply in the market decreases too and hence the inflation decreases.

• Statutory liquidity ratio: Statutory Liquidity Ratio is the amount of liquid assets, such as cash, precious metals or other approved securities, that a financial institution must maintain as reserves other than the Cash with the Central Bank

Effect on inflation

As we have understood that the foremost reason of inflation is increment in money supply in the market. SLR is the amount of assets maintained by a bank. If for example the bank has 1000000 rupees and SLR is 20% then 20% of 1000000 have to be maintained by banks i.e. 200000 rupees in form of gold, securities etc. Now if the SLR increased to 30% then banks has to kept 30% of 1000000 i.e. 300000. Hence the money with the banks decreases as SLR increases and thus money supply in the market decreases too and hence the inflation decreases.

• Bank rate: This is the rate at which central bank (RBI) lends money to other banks or financial institutions.   If the bank rate goes up, long-term interest rates also tend to move up, and vice-versa. Thus, it can said that in case bank rate  is hiked,  in all likelihood banks will hikes their own lending rates to ensure and they continue to make a profit.

Effect on inflation

When the private or public banks are in need of money, they borrow from RBI. RBI lends them at a rate known a bank rate (simply the interest at which money is given).

As for example if the bank rate increases interest given by banks to RBI increases thus banks money circulation decreases. Decrement in money circulation decreases inflation.

• Repo rate and reverse repo rate: A repurchase agreement is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively representing interest, called the repo rate. The party that originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest.

A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a "repo", while the buyer in the same transaction would describe it a "reverse repo". So "repo" and "reverse repo" are exactly the same kind of transaction, just described from opposite viewpoints. The term "reverse repo and sale" is commonly used to describe the creation of a short position in a debt instrument where the buyer in the repo transaction immediately sells the security provided by the seller on the open market.

Effect on inflation

A reduction in the repo rate will help banks to get Money at a cheaper rate. When the repo rate increases borrowing from the central bank becomes more expensive. In order to increase the liquidity in the market, the central bank increases or decreases the rate. Thus inflation get automatically controlled.



 



 

Add comment


Security code
Refresh

Articles
Newsletter Subscription
Fill the form below to subscribe for recieving email alerts from rosemaryinstitute.com