✅ Chapter 07 - Inflation

Introduction

PYQP Sample

Inflation

Inflation Refers to a General and Persistent Increase in Prices of Goods and Services

Inflation should be Broad Based - Meaning Prices of Most of the Goods and Services should increase, not few !

Increase in price of a few commodity like Onion or Potato cannot be considered as Inflation

Persistent - On Continuous Basis it should Increase

Inflation is Measured in Terms of Percentage

For India it should be (4% +_ 2)

Point to Point Inflation

Point to Point Inflation is also called as Year on Year Inflation

Inflation is 4% wrt the Price of Commodity → in the Corresponding Month of Previous Year

Types of Inflation (Based on Rates)

Creeping Inflation ( Low to Moderate ROF )

For India its 2 to 4

Trotting Inflation (Not Moderate = Higher)

For India - 5 to 10

Galloping Inflation (Highest)

For India 10 to 20

Hyperinflation (Uncontrollable)

Greater than 20%

Examples

Historical Germany

Had Hyper Inflation After World War 1 Treaty of Versailles

Zimbabwe

Annual Rate of Inflation - 8 Lac Crores

Daily Rate of Inflation - 100%

A Loaf of Bread Costed - 55 Million USD

Iran

Iran was put under Economic Sanctions by US

Iran wasn't allowed to export crude oil to other countries

Hence, Dollar Inflow Into Iran Reduced - Thus the Iranian Currency got Reduced

Depreciated Due to → 1 $ = 41,000 Riyal

Imports into Iran Became Costly

Example: 1 Loaf of Bread was around 40,000 Riyal

What Did Iranian Central Bank → Issued a New Currency called Toman

Where 1 Toman = 40,000 Riyal

This Measure was Temporary

This is called as Redenomination

WPI & CPI

Inflation at Wholesale Level - WPI

Inflation at Consumer Level - CPI

PS: There is Generally Divergence Between WPI & CPI ; but in theory they should go up and down together

Terms Related to Inflation

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Inflation, Deflation, Disinflation, Reflation

A High Rate of Inflation and Zero Rate of Inflation are Equally Bad

Ideal Rate of Inflation for India is 4%

Current Rate of Inflation in India is : CPI 5.72%

Base Effect

Comparison wrt to Base or a Reference may distort the Reality is called Base Effect

Rate of Inflation = (Current Year Prices - Previous Year Prices) / Previous Year Prices

Here Previous Year Prices is the Base Year

as PYP is in Denominator →

If PYP is High - Rate of Inflation would be Lower → This is called as High Base Effect
if PYP is Low - Rate of Inflation would be Higher → This is called as Low Base Effect

Example

Phillips Curve

Phillips Curve Shows Relationship Between Inflation & Unemployment Rate

Before 1970’s - According to Phillips Curve

This will fail in Hyper Inflation. It is Possible only in Short Term.

Long Term Curve Says - In Any Country Unemployment is Independent from Rate of Inflation

No Matter How Low or High Rate of Inflation in a Country is - There will always be some unemployment → Hence it is called as Natural Rate of Unemployment

Natural Rate of Unemployment

Structural Unemployment: Form of Unemployment due to miss match between skill set of person and demand of Job

When Skill Set is Lower than Demand of the Job

Example: in 1990’s People were expert in typewriters, after introduction of computer, demand of job increased, people not knowing computer but knew how to typewrite

Example: Due to Machines, people in car manufacturing industry may be reduced

Example: Tesla Replacing Driver

Example: IT Engineers that don't have new Skills

Under Employment: Skill Set is Higher than Demand of the Job

Example: Engineer employed in BPO Sector

Frictional Unemployment : A Temporary Form of Unemployment, when a person is switching Job, Hence he is Unemployed for a Particular Time Period

Stagflation

Stagflation is combination of Stagnation & Inflation

It Means

GDP is Going Down
Inflation is High
Unemployment is High

Inflation Tax

It is a Penalty and it is nowhere related to Taxation System

It is a Kind of Penalty which people face due to holding of cash, during inflation

Holding of Cash, Leads to Decrease in Purchasing Power of Rupee

Hence, this Decreased Purchasing Power is called as Tax or rather Inflation Tax

Due to Inflation Tax, Investments in Speculative Investment Increases

Shoe Leather Cost

Menu Cost

Inconvenience caused to the Manufacturers in changing prices !!

Skewflation & Shrinkflation

Skewflation: Prices of Only Few Commodities Increase

Shrinkflation: Reducing the Quantity being Given to the Customer

Causes of Inflation

It is caused due to Demand Supply Mismatch

Price could increase due to - Two Independent Reasons

Demand for Apple Increases → Demand Pull Inflation
Supply of Apple Decreases → Supply Side Inflation / Cost Push Inflation
If Demand Increased & Supply Decreased → Look Which one is the Dominant Factor

Hence, If Demand Increases by 20% or Supply Reduces by 10% - It will be called as Demand Pull Inflation

Also, If Demand Increases by 10% or Supply Reduces by 20% - It will be called as Cost Push Inflation

Factors that can lead to Increase in Demand in Indian Economy

Lower RoI → Injected Money in Indian Economy by RBI → Recession Based Injection
A Condition where a Demand of a Commodity Increases because of Its Need
Price of Commodity may increase in Future
Increase in Number of Consumer or Increase in Population
Borrows More Money → Higher Fiscal Deficit → Money Circulation in Economy Increases
Increased Salary of People

What Happens when Export Increases - Is it Demand Side or Supply Side Inflation ?

It will lead to Demand Pull Inflation in India

It will lead to Cost Push Inflation as well, where the Supply in India will decrease

In UPSC Mark it as: Demand Pull Inflation

Aggregate Demand

PFCE → Private Final Consumption Expenditure
GFCE → Government Final Consumption Expenditure
GCF → Over All Investment in an Economy
Net Exports → Total Exports from India - Total Imports into India

Since Export is Part of Aggregate Demand in an Economy, According to Keynes it's a part of Demand Pull Inflation

Inflation Index Wages

CPI AL - Consumer Price Index - Agriculture Labour

Demand Only Increases with Surplus Money. Hence in case of Inflation Index Wages there is increase in the Income but it is not surplus as the prices of Goods & Services have increased by the Same Margin

Now, When Labour Cost is Increasing → Cost Push Inflation

Factors Contributing to Inflation - Demand Side / Supply Side

Demand Side and Supply Side Factors

Higher GDP - High Income Level - More Surplus - More Demand

Protein Based Inflation

Farmers Generally Produce - rice & wheat

but due to increase in Per Capita Income - People want more Protein Based Food

Types of Fiscal and Monetary Policy

Fiscal Policy is the Policy of Government that deals with

How Much Tax Should it collect - Income

How Much Should it spend - Expense

Fiscal and Monetary Policy

List of Factors

Like in Exports → increase in MSP can lead to Demand Pull & Cost Push Inflation

Dekhna Kaise Hai ki Kaun Sa Inflation Hua Hai

Demand Pull Inflation

Uska Demand Badha Hai
Generally Due to Surplus Money or Increased Money Supply

Cost Push Inflation / Supply Side Inflation →

Dekho ki Yaa toh Supply Decrease Hui
Ya toh uska Price Badha Hai

Structural Inflation

It occurs due to certain structural deficiency of the economy. this deficiency can be due to both or either of demand or supply side

For Example Structural Deficiency in Indian Agri is

Protein Based Inflation
Rain Fed Agriculture (52% Dependence)
Poor Storage Infra - Like Godowns & Poor Infra
Fragmented Land Holdings - 86% Small & Marginal Farmers

Some Common Structural Deficiencies in an Economy

Dominance of Monopolistic Companies in an Economy
Poor Logistics
Lack of Adequate Forex Reserve

Example: Pakistan, Bangladesh & Sri Lanka

Problem wrt Public Finance

Poor & Developing Companies - Revenue Lower & Expenditure Higher → Increased Government Borrowing → Higher Fiscal Deficit → Borrow More → More Money in Economy Injected by Govt → Creates Conducive Env for Pvt Sectors and Other Investments → Thus Increasing the Crowding Effect

Lack of Natural Resources
Lack of Human Capital or Old Human Capital

Inflationary & Deflationary Gap

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Supply Pe Control Nahi Hota Hai → Isliye Demand pe Control Karte Hain Hence, We Can't Increase the Aggregate Supply

Measurement of Inflation in India

Basket of Commodities

Inflation is always measured in a Basket of Commodities

This Basket of Commodity is fixed by the Entity which is Publishing this Index

WPI - Office of Economic Advisor, Ministry of Commerce & Industry → 697 Commodities
CPI - National Statistics Office, Under Ministry of Statistics → 299 Commodities

Weightage

Commodities which have recurring demand have more weightage in calculation

As Compared to Refrigerator and Apple. Apple has more weightage as it has more recurring demand

All the Weightages are assigned as such that it is total to 100

Base Year

The Year in Which Prices of Commodity were Relatively Stable like in 2012 for WPI

Prior to 2012, the Base Year was 2004-05

The Frequency at which it changes is decided by the agency which publishes it

No Fixed Limit of time for change

Laspeyres Formula → Relative Price & Rate of Inflation → For Both WPI & CPI

Formula: Relative Price = Current Year Prices / Base Year Prices

Rate of Inflation

Rate of Inflation = { (RP of Current Year - RP of Previous Year) / RP of Previous Year }* 100

For Base Year 2012

Relative Price for Base Year will be 1

Relative Price * Weight = 1 * 100 = 100

For Year 2013

Relative Price = Current Year Price (Rs 110) / Base Year Price (Rs 100) = 1.1

Relative Price * Weight = 1.1 * 100 = 110

Here Inflation is → 110 - 100 * 100 = 10

For Year 2014

Relative Price = Current Year Price (Rs 121) / Base Year Price (Rs 100) = 1.21

Relative Price * Weight = 1.21 * 100 = 121

Here Inflation is → 121 - 110 * 100 = 10

Important Note

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Relative Price is Measured wrt Base Year Rate of Inflation is Measured wrt the Previous Year

Types of Measurement of Inflation - PPI, WPI, CPI

PPI

Paid By : Change in cost of Raw Material for a Producer : Input PPI

Received By : Change in Selling Price for Producer : Output PPI

Chand Committee : Transition from WPI to PPI

Indirect Taxes : Example is GST

Service is Always at Retail Level and Not at Wholesale Level, Isliye WPI main Included Nahin Hai Services

WPI - By Economic Adviser in the Ministry of Commerce and Industry

Pros

Comprehensive as it has 697 Items

No Indirect Tax Included

Cons

Does Not Cover Service - Service is 55% of GDP

Leads to Double Accounting → Product counted as a Primary Item (Orange) is also included in Manufactured Product (Orange Juice)

CPI - By The National Statistical Office (NSO), Ministry of Statistics and Programme Implementation (MoSPI)

It is Targeted by RBI

Difference Between WPI & PPI

Understanding WPI - 697 Commodities

Published by Office of Economic Advisor from Ministry of Commerce & Industry on Monthly Basis

WPI is Pub wrt to month of Previous Year

Components of WPI

Primary Food Articles - Grains
Primary Non Food Article

Raw Materials for Industry
Crude Petroleum and Natural Gas

Manufactured

Man Food Prod
Man Non Food Prod

Fuel & Power

Petrol Diesel Electricity

Understanding CPI - 299 Commodities

Miscellaneous: Service Like Education, Health, Telecommunication, Transportation ( Including Petrol Diesel)

Note : Fuel and Light Does Not have Petrol and Diesel

Difference Between WPI & CPI

Inflation Expectation is controlled not the Inflation Per Say

CFPI - Consumer Food Price Index

Covers 10 Commodities Table of Food & beverage - 2 Commodities = Table of CFPI

Types of Inflation - Headline, Core, Refined Core

ONLY FOOD & FUEL is considered to be VOLATILE

Headline Inflation

WPI : All 697 Commodities
CPI : All 299 Commodities
If not Said anything, only Headline then CPI

Core Inflation

Excludes Volatile Commodities like Food and Fuel
WPI - Food & Fuel → WPI Core Inflation
CPI - Food & Fuel → CPI Core Inflation
Suggestions on Core Inflation should be Targeted by RBI
Here Miscellaneous Categories is Included

Refined Core Inflation

Further Removes Component of Petrol and Diesel from Miscellaneous

Other Varieties of CPI

CPI AL: Agricultural Labour - NREGA is Linked

Mahendra Dev Verman Committee Suggested that MGNREGA Should be Linked to CPI RL Rather than CPI AL

CPI RL: Rural Labour

CPI IW: Industrial Workers → Linked to Inflation INdex Wages → Mehangai Bhatta

CPI Rural: Does not take into account changes in rental prices of housing - as in rural people own houses and don't rent

CPI Urban: Inflation in Urban Areas

CPI Combined: Average of CPI Rural and Urban

Other Types of Indexes

FAO - Food Price Index

International Level → Published by FAO - Food and Agricultural Organisation

Housing Price INdex - By RBI

RESIDEX - by NHB

Understanding Variation in CPI

60% of Edible Oil & 99% of Palm Oil is Imported

Understanding Variation in WPI

Divergence Between CPI & WPI

Weightage of food in WPI and CPI

in WPI - 24%
in CPI - 45%

Weightage of Manufactured in WPI and CPI

in WPI - 55%
in CPI - Lower than WPI

Concept of GDP Deflator

Nominal GDP and Real GDP

Nominal GDP - GDP at Current Market Prices
Real GDP - GDP at Base Year Price or Constant Prices

Concept of GDP Deflator

Issue with GDP Deflator

WPI CPI is Every Month where as GDP Deflator is calculated Quarterly
There is No Explicit Weightage - Because Qty is Removed
Imports are NOT Included

Difference between CPI & GDP Deflator

Effect of Inflation Summary

Effect of Inflation on Exports and Imports

Inflation Increases & Rupee Value Depreciates

In Imports and Exports we take into consideration Immediate Effect of Inflation

Effect of Inflation on Bonds

Effect of Inflation on Creditor and Debtor

Creditor - Jo Paisa Deta Hai - Nuksan

Debtor - Jo Paise Leta Hai / Jisne Debt Liya Hai - Fayda - Pays Less in terms of Real Value

Paisa Same aa raha hai, par paise ka purchasing capacity kam ho gaya hai

Concept of Bracket Creep and Fiscal Drag

Progressive Tax Slabs

Increase in Wages → Inflation Indexed Wages

Increased Income Level Does Not Impact Purchasing Power

Bracket Creep - Shifting of People from Low Tax Bracket to High Tax Bracket

Fiscal Drag - When an Increase in Tax Collection by Govt, People have less money to Spend and hence there is a Reduced Demand, Decreased Inflations and Hampers GDP Growth Rate is called Fiscal Drag

Bracket Creep and Fiscal Drag are Long Term Phenomenon of 2 to 3 Years Normally

Measures to Check Volatility in Prices

by Consumer Affairs Ministry
Control Prices of Onion, Potato and Pulses
SFAC - Small Farmers Agri Business Consortium
E-NAM - National Agricultural Market
During Bumper Production - SFAC Procures and Creates Buffer - During Increased Price, It releases the Buffer to Control the Price

MSP - Minimum Support Price is for 23 Items
By Ministry of Consumer Affairs
FCI - Food Corporation of India
MIS Covers Horticultures and Perishable Commodities like Fruits and Vegetables
MIS is implemented only in the request of State Govt where as MSP is implemented every year
Loss Faced by MIS Implementation is Equally Shared between Centre and State