Inflation ( Cause and Effect )
Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Inflation can also be described as a decline in the real value of money—a loss of purchasing power in the medium of exchange which is also the monetary unit of account and the monetary store of wealth. When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time.
Funny instance – “Son, in our time we use to take money (paisa) in pockets and carry goods to home in bags. But in your age you will carry money (rupees) in bags and carry goods to home in your pocket”. He was so right! This is inflation –which reduces the purchasing power of common man.
Measuring Inflation
In major economies, inflation is measured by CPI, which is Consumer Price Index. CPI is a measure of the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation. Two basic types of data are needed to construct the CPI: price data and weighting data. The price data are collected for a sample of goods and services from a sample of sales outlets in a sample of locations for a sample of times. The weighting data are estimates of the shares of the different types of expenditure as fractions of the total expenditure covered by the index. These weights are usually based upon expenditure data obtained for sampled periods from a sample of households.
In major economies, inflation is measured by CPI, which is Consumer Price Index. CPI is a measure of the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation. Two basic types of data are needed to construct the CPI: price data and weighting data. The price data are collected for a sample of goods and services from a sample of sales outlets in a sample of locations for a sample of times. The weighting data are estimates of the shares of the different types of expenditure as fractions of the total expenditure covered by the index. These weights are usually based upon expenditure data obtained for sampled periods from a sample of households.
In other words, Inflation is calculated as percentage change in CPI in two periods. Hence,
Inflation (%) = (CPI2- CPI1)*100/CPI1
Where, CPI1 = CPI in the previous period and CPI2 = CPI in the current period
Inflation (%) = (CPI2- CPI1)*100/CPI1
Where, CPI1 = CPI in the previous period and CPI2 = CPI in the current period
India uses a different price index called the Wholesale Price Index (WPI) to calculate the rate of inflation in our economy. It is quite similar to Consumer Price Index, but uses whole sale prices instead of retail consumer prices. WPI is the index used to measure changes in the average price levels in the wholesale market. Data on 435 commodities is tracked through WPI, in India, which is an indicator of movement in prices. I share the common view of other economists who believe WPI, as a measure of inflation, is flawed. India should switch to CPI, which has been adopted by most developed countries.
There are several other ways of measuring inflation as well. They are GDP price deflator, Producer Price Indices and Commodity Price Indices. However, they are not commonly used.
Flaws of WPI
Former RBI governor once explained why India does not use CPI as a measure of inflation. The CPI data is not released as frequently as WPI data. WPI data is released almost weekly and sometimes at most biweekly, where as CPI data is released once in a month. There is also a lot of lag in collating all the CPI data. There is another problem with the CPI data in India. We don’t have a single CPI data, but four different CPI figures relating to agriculture goods, urban manual labor and non-urban labor etc. There is no discipline in when these different figures are released and with what frequency. So government of India has a genuine reason in not going for CPI based inflation.
Former RBI governor once explained why India does not use CPI as a measure of inflation. The CPI data is not released as frequently as WPI data. WPI data is released almost weekly and sometimes at most biweekly, where as CPI data is released once in a month. There is also a lot of lag in collating all the CPI data. There is another problem with the CPI data in India. We don’t have a single CPI data, but four different CPI figures relating to agriculture goods, urban manual labor and non-urban labor etc. There is no discipline in when these different figures are released and with what frequency. So government of India has a genuine reason in not going for CPI based inflation.
WPI based calculation is full of flaws. WPI is supposed to measure impact of prices on business. But we use it to measure the impact on consumers. The WPI that was constituted in 1993-94 has virtually remained unchanged since then, and it has lost quite a bit of its relevance while calculating inflation. Some of the WPI commodities include coarse grains that go into making of livestock feed but they continue to be considered while measuring inflation. The sole reason why many unimportant commodities continue to remain included is possibly because data on their prices was available!
Causes of Inflation
Let’s get back to our discussion on the fundamentals of inflation. Economists believe that inflation is a monetary phenomenon. However, in the short and medium term inflation may be affected by supply and demand pressures inthe economy, and influenced by the relative elasticity of wages, prices and interest rates.
1. Over-expansion of money supply i.e. excess liquidity in the economy leads to inflation because “too many money would be chasing too few goods”.
2. Expansion of Bank Credit Rapid expansion of bank credit is also responsible for the inflationary trend in a country.
3. Deficit Financing: The high doses of deficit financing which may cause reckless spending, may also contribute to the growth of the inflationary spiral in a country.
4. A high population growth leads to increase in demand and money income and cause a high price rise.
5. Excessive increase in the price of fuel or food products due to political, economic or natural reasons will lead to inflation for short- as well as long-term.
Let’s get back to our discussion on the fundamentals of inflation. Economists believe that inflation is a monetary phenomenon. However, in the short and medium term inflation may be affected by supply and demand pressures inthe economy, and influenced by the relative elasticity of wages, prices and interest rates.
1. Over-expansion of money supply i.e. excess liquidity in the economy leads to inflation because “too many money would be chasing too few goods”.
2. Expansion of Bank Credit Rapid expansion of bank credit is also responsible for the inflationary trend in a country.
3. Deficit Financing: The high doses of deficit financing which may cause reckless spending, may also contribute to the growth of the inflationary spiral in a country.
4. A high population growth leads to increase in demand and money income and cause a high price rise.
5. Excessive increase in the price of fuel or food products due to political, economic or natural reasons will lead to inflation for short- as well as long-term.
For example – We all remember that price of crude went up from $50 to $140 within two years. Almost every industry including agriculture, transportation and manufacturing depends on crude for its operation. Any excessive increase in the price of crude leads to increase in cost of good and services i.e. inflation.
Another example – China and India consist of almost 34% of the world’s population. As the economy in these two countries are growing at a rate of over 9%, people are consuming more and more goods due to increased income and better life. Demand for those goods and services has led to a high inflationary environment in these countries.
Another example – China and India consist of almost 34% of the world’s population. As the economy in these two countries are growing at a rate of over 9%, people are consuming more and more goods due to increased income and better life. Demand for those goods and services has led to a high inflationary environment in these countries.
States of Inflation
There are different states of inflation which is characterized based on its value as well as variation from the previous value.
There are different states of inflation which is characterized based on its value as well as variation from the previous value.
1. Hyperinflation – It is a very high rate of inflation, usually a rate in excess of 50%. History has some excellent examples of hyperinflation. In Germany, inflation exceeded 1 million % in 1923. It was said that a horse cart full of money would not buy even a newspaper. Right now, Zimbabwe is having an inflation of 1 million %. They have to issue currency of $500 Million dollar (I am not kidding!!) which could only buy a lunch at McDonalds.
2. Deflation – It is the decrease in the general price level of goods and services only when annual inflation is below 0% resulting in the real value of money. Hence, it is sometimes called “negative inflation”. Japan suffered from deflation for almost a decade in 1990s. To control recession and Central Bank of Japan was forced to have a negative interest rate on deposit for over a decade.
3. Disinflation – It refers to a time when the rate of change of prices is falling while the inflation rate is positive. For example – if the inflation rate comes down from 3% to 2%, we would say it is disinflation. In India, we have a disinflation because inflation has come down from a high of 13% to 6% and it is still dropping.
4. Stagflation – It is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time. Stagflation can result when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.
Effects of Inflation on economy
As we know Inflation is the increase in the price of general goods and service. Thus, food, commodities and other services become expensive for consumption. Inflation can cause both short-term and long-term damages to the economy; most importantly it causes slow down in the economy.
As we know Inflation is the increase in the price of general goods and service. Thus, food, commodities and other services become expensive for consumption. Inflation can cause both short-term and long-term damages to the economy; most importantly it causes slow down in the economy.
1. People start consuming or buying less of these goods and services as their income is limited. This leads to slowdown not only in consumption but also production. This is because manufactures will produce fewer goods due to high costs and anticipated lower demand.
2. Banks will increase interest rates as inflation increases otherwise real interest rate will be negative. (Real interest ~ Nominal interest rate – inflation). This makes borrowing costly for both consumers and corporate. Thus people will buy fewer automobiles, houses and other goods. Industries will not borrow money from banks to invest in capacity expansion because borrowing rates are high.
3. Higher interest rates lead to slowdown in the economy. This leads to increase in unemployment because companies start focusing on cost cutting and reduces hiring. Remember Jet Airways lay off over 1000 employees to save cost.
4. Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation.
5. Inflation affects the productivity of companies. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation.
2. Banks will increase interest rates as inflation increases otherwise real interest rate will be negative. (Real interest ~ Nominal interest rate – inflation). This makes borrowing costly for both consumers and corporate. Thus people will buy fewer automobiles, houses and other goods. Industries will not borrow money from banks to invest in capacity expansion because borrowing rates are high.
3. Higher interest rates lead to slowdown in the economy. This leads to increase in unemployment because companies start focusing on cost cutting and reduces hiring. Remember Jet Airways lay off over 1000 employees to save cost.
4. Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation.
5. Inflation affects the productivity of companies. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation.
Inflation Targeting
There are various ways of controlling inflation in an economy. I will discuss two main ways of doing so:
There are various ways of controlling inflation in an economy. I will discuss two main ways of doing so:
Monetary Policy
The most important and commonly used method is monetary policy. Most central banks use high interest rates and slow growth of the money supply as the traditional ways to fight or prevent inflation. RBI raised CRR, Repo rate and Reverse repo rate to reduce money supply in the economy to fight inflation which was hovering in double digit. High interest rates make borrowing expensive and hence, people as well as corporate borrow less money from banks. This reduced the demand for goods and services such as real estate, automobiles and others.
Fixed Interest Rate
As we know high inflation reduced the value of money. A number of smaller countries who do not have sophisticated banking system rely on tying their currency with that of a developed country. Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-à-vis the currency it is pegged to.
As we know high inflation reduced the value of money. A number of smaller countries who do not have sophisticated banking system rely on tying their currency with that of a developed country. Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-à-vis the currency it is pegged to.
Government Measures
Apart from these two broad methods, government takes some protectionist measures as well to fight inflation. Government may ban export of essential items such as pulses, cereals and oils to support the domestic consumption and hence reduced their prices. Also, government may lower duties on the import of similar items which are having less supply in the economy.
Apart from these two broad methods, government takes some protectionist measures as well to fight inflation. Government may ban export of essential items such as pulses, cereals and oils to support the domestic consumption and hence reduced their prices. Also, government may lower duties on the import of similar items which are having less supply in the economy.
Positive side of inflation
You may be wondering how come inflation is good for economy. A little bit of inflation is not a bad thing. It implies the possibility of higher prices and profits in the future. To the worker, a little bit of inflation may imply rising wages in the future. What I am trying to say is that they are based more on “psychology” than “economics”.
You may be wondering how come inflation is good for economy. A little bit of inflation is not a bad thing. It implies the possibility of higher prices and profits in the future. To the worker, a little bit of inflation may imply rising wages in the future. What I am trying to say is that they are based more on “psychology” than “economics”.
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