Prof.R.Srinivasan Department of Management Studies, Indian Institute of Science,Bangalore.

Increase in the general level of prices in an economy that is sustained over a period of time is called inflation  Inflation is measured for a basket of goods and services 

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Distribution of income and wealth The rich get richer and poor get poorer Loss to fixed income earners Gains to profit earners Gains to the debtors Loss to the creditor Loss to wage earners Government Economic growth Employment

Why is it bad?  

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Losses to savers: Inflation erodes the purchasing power of the amount saved. Losses to people with fixed incomes: People with fixed incomes (such as the interest on a fixed deposit, or a fixed salary) find that the purchasing power of their income diminishes over time. Losses to taxpayers: If your salary increases in line with inflation, and no adjustments are made to income tax, you will shift into a higher tax bracket and end up paying a larger share of your salary to the taxman. Contd.

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Confusing price signals to producers and slower expansion of businesses: In times of inflation, an increase in the price of a product can occur either simply as part of the regular inflation related adjustments to prices, or because the demand for that product has risen permanently. Entrepreneurs, not knowing which of the two kinds of price increases have occurred, may wait much longer before expanding their businesses and employing more resources in reaction to a permanent increase in demand.

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Speculation crowding out production: An environment of high inflation and financial instability leads to more entrepreneurship and other resources being devoted to speculation in existing assets such as real estate, and less to expansion of production and employment.

What causes Inflation?  an

increase in international oil prices;  a fall in the exchange rate;  a nationwide excessive salary and wage hike; or  an increase in food prices and commodities etc.

 The

first and the comprehensive theory of inflation was propounded by Irving Fisher in 1911  According to classical theory inflation occurs in direct proportion to increase in money supply, given level of output

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Inflationary gap is explained as the planned expenditure in excess of output available at full employment level The inflationary gap is so called because it causes only inflation, without increasing the level of output The inflationary gap generates only money income without creating matching real output because the economy is in full employment equilibrium

 The

general level of prices rises only due to an increase in the money supply  Inflation is always a monetary phenomenon …. and can be produced only by a more rapid increase in the quantity of money than in output  Proportionate relationship is not propounded

Aggregate price level of commodities determined by the aggregate demand and aggregate supply  Inflation is caused by both demand and supply side factors  Demand side factors are called demand pull factors  Supply side factors are called supply side or cost push factors Demand pull factors - monetary factors - Increase in government spending, given tax revenue - Cut in tax rate without change in government expenditure - Upward shift in investment function - Downward shift in saving function - Upward shift in export function - Downward shift in import function Cost Push Inflation - wage push 

Inflation In India    

Inflation is measured by the Wholesale Price Index (WPI) and not by Consumer Price Index (CPI). WPI is the measure of headline inflation in India. Most developed countries use the Consumer Price Index (CPI) to calculate inflation. WPI preferred to CPI -wider commodity coverage -available on weekly basis -computed at all-India basis

Wholesale Price Index (WPI) WPI was first published in 1902, and was one of the more economic indicators available to policy makers until it was replaced by most developed countries by the Consumer Price Index in the 1970s.  WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions.  It is also the price index which is available on a weekly basis with the shortest possible time lag only two weeks. The Indian government has taken WPI as an indicator of the rate of inflation in the economy. 

Composition of WPI(in India) Wholesale price index (weight=100): Primary articles (wt.=22.0) cereals, pulses, Fruits and vegetables, egg, oil etc. 

Fuel power,Light and Lubricants (wt.=14.2) Mineral Oil, Electricity,Coal Mining 

Manufactured Products (wt.63.8) Sugar, edible oils, textiles, chemicals, iron & steel, machinery, transport equipment, etc 

Consumer Price Index (CPI)  CPI

is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation.  CPI is a fixed quantity price index and considered by some as cost of living index.

Which method does India use?  India

is the only major country that uses a wholesale index to measure inflation. Most countries use the CPI as a measure of inflation, as this actually measures the increase in price that a consumer will ultimately have to pay for.

Drawbacks of using WPI 

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WPI does not properly measure the exact price rise an endconsumer will experience because, as the same suggests, it is at the wholesale level. More than 100 out of the 435 commodities included in the Index have ceased to be important from the consumption point of view. For example, a commodity like coarse grains that go into making of livestock feed. This commodity is insignificant, but continues to be considered while measuring inflation. WPI is supposed to measure impact of prices on business but it is used in India to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index. And it does not factor in services which have assumed so much importance in the economy

Why is India not switching over to the CPI method of calculating inflation? In India, there are four different types of CPI indices, and that makes switching over to the Index from WPI fairly 'risky and unwieldy.' The four CPI series are: CPI Industrial Workers; CPI Urban Non-Manual Employees; CPI Agricultural labourers; and CPI Rural labour.  CPI cannot be used in India because there is too much of a lag in reporting CPI numbers.  The WPI is published on a weekly basis and the CPI, on a monthly basis.  And in India, inflation is calculated on a weekly basis. 

Monetary Measures - Bank rate policy - Variable reserve ratio - Open market operation - Statutory liquidity ratios - Moral persuasion - Selective credit controls Fiscal Measures - Cut down in public expenditure Tax policy Price and Wage Control - Price control - Wage control - Indexation

Role of RBI during inflationary time  The RBI raises the repo rate (rate at which at RBI    

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borrows from banks- bank rate is the rate at which banks borrow from RBI) Banks then usually raise their lending and deposit rates. When people face higher lending rates, they buy fewer goods on credit. This causes less credit to be used and less money to end up with shopkeepers. With less money, credit and expenditure in the economy, it becomes more difficult to raise prices and wages. Therefore, inflation is reduced.

Few thoughts on rising inflation in India over last few months 

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Between July 2007 and June 2008,global food grain prices had gone up 45%;in India they had risen only 6%. World oil prices had risen 93%,domestic oil prices a fraction of that.

The commodities that led world inflation were not the ones that led inflation in India. Food grain prices had risen in India, but had nothing to do with inflation measured by wholesale price index; share of food grains in WPI was small. Contd.

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The only commodities whose domestic prices had gone up in tandem with global prices were edible oils, whose global prices had risen 96%. Half of the rise in WPI was due to minerals. Iron ore prices had shot up owing to global shortage, while India is an important exporter. The rise in Iron ore prices along with coal and oil prices had positive impact on rise of Steel prices. Minerals thus accounted for a half of the rise in WPI;along with oil and steel they contributed to two thirds of rise. Contd.

 Thus

Inflation calculated according to WPI over last few months is irrelevant to people’s cost of living.  Inflation according to consumer price index for the industrial workers went up to 7.9% in March,2008 from 5.5% in February,2008 and is stable at that level.

Thus, when every week RBI announces fresh figure for inflation which seems to increase every week there is real no great reason to worry for us.

Thank you