Inflation in India

SUBMITTED TO- SUBMITTED BY-

Dr. Tilak Raj Jaspreet Raghu
MBA GEN (B)
ROLL NO. - 15
 Introduction
Plenty of us have, at some point or another, heard a grandparent talk about the
days of their childhood when a candy bar cost barely anything. A chocolate bar
which used to cost rupee one now costs 20 rupees. How does such a massive
increase happen? Inflation, the rise in the price of goods and services over a
period of time. Inflationrefers to a signi cant rise in the general price level in a
country over a long period of time. It is the opposite of price stability. In
economics, price stability is not used in a rigid sense to mean price xity. A
modest increase of 2 to 3 per cent per annum in the price level is a compatible,
sometimes even desirable, in the context of economic development. However,
when the general price rise appreciates (say in double-digit gure) and is
experienced over a long period of time, it gets the dreaded name of in ation.
For the common person, there is something threatening about the phenomenon
of in ation, especially on those occasions when the rise in prices of goods is
not matched by an equivalent rise in the prices of labor.

“Inflation poses a serious threat to the growth momentum. Whatever be the

cause, the fact remains that inflation is something which needs to be tackled
with great urgency …”

[Dr. Manmohan Singh, Prime Minister of India, February 4, 2011, New Delhi]

Over the last decade, inflation has emerged as a leading concern of

India’s economic policymakers and citizens. Worries grew as the inflation rate
(measured as the twelve-month change in the consumer price index) rose from
3.7% to 12.1% over 2001-2010. The inflation rate has since fallen to 5.2% in
early 2015, leading to a debate about whether this moderation is likely to endure
or inflation will rise again.

What explains the movements in India’s inflation rate? Economists,

policymakers, and journalists have proposed a variety of answers to this
question. Many emphasize the effects of rises and falls in food price inflation,
especially for certain staples such as milk, fruits, and vegetables. These price
increases are in turn explained by factors including shifting dietary patterns,
rising rural wages, and a myriad of government policies such as price supports
and the rural unemployment guarantee scheme. Some suggest that the monetary
and fiscal stimulus following the crisis led to higher inflation, while others cite
supply side constraints arising from policy bottlenecks.

Many, including RBI Governor Rajan, fear that high levels of inflation
may become embedded in the expectations of price setters, creating a self-
sustaining “inflationary spiral” .The role of monetary policy is controversial,
with media reports and analysts debating the role of interest-rate increases in
explaining the recent fall in inflation, and more generally the RBI’s ability to
control inflation and the effects on the real economy .The debates about inflation
in India are reminiscent of debates that have been going on for decades in
advanced economies--especially debates about the 1970s and 1980s, when
inflation in the U.S. and Europe reached double-digit rates, like India more
recently.

But the thing that has confused economist is the trend of Indian inflation
related to rest of the developing countries

Figure 1: Comparison of inflation in India with other developing countries

.
 The Reserve Bank of India (RBI) tightened monetary policy to contain
inflation, raising the repo rate by 3.75 percentage points between March 2010 and
October 2011. However, inflation as measured by the Consumer Price Index
(CPI)—the RBI’s preferred price gauge—remained close to 10% from 2008 to
2013, only falling to 6.0% in 2014 following the crash in commodity prices. Such
was the concern over high inflation that India’s former finance minister blamed it
for his party’s defeat in the last Parliamentary election in 2014 (Press Trust of
India 2015).

Instead of questioning the efficacy of a strategy that had failed to contain

inflation, the RBI doubled down on it. In February 2015, it formally adopted
inflation targeting, with the target for consumer-price inflation set at 6% for 2016,
and at 4% with a two-percentage-points tolerance band for subsequent years
(Ministry of Finance, Government of India and RBI 2015). The move was seen as
a historic shift in the monetary policy of the RBI to a sole focus on inflation from
the previous “multi-indicator approach” under which the central bank considered
various other variables, such as economic growth and the exchange rate, while
framing its monetary policy stance (Nam and Kumar 2015).

Literature Review
To say that inflation is a complex and controversial phenomena would be a
truism. But as a result of this complexity, research on inflation approach the
subject from a number of different theoretical angles, and some of the more
empiricist work doesn’t explicitly state a theoretical framework. To try to make
sense of this maze of research approaches, this section will classify the literature
on inflation in India into demand-pull and cost-push categories. This approach is
inspired by Vernengo (2007: 490-492) and Hagger (1964). Some authors classify
the literature on inflation in India into monetarist and structuralist categories. eg.
Sahu (2013), Ghatak (1995), Balakrishnan (1994). However, such a categorization
ignores the currently dominant New Keynesian approach which is distinct from the
monetarist approach, although both come under the demand-pull school.
Monetarists such as Milton Friedman, who favoured money-supply targeting,
expressed doubts about the efficacy of inflation targeting on the grounds that the
link between interest-rate changes and price changes in the short term is not
precisely known (Goodfriend and King 1997: 273).

Machlup (as cited in Hagger (1964:117)) defines demand-pull inflation as

when “autonomous expansions of demand (government spending, business
spending, consumer spending) are followed by responsive (competitive) price
increases”, while cost-push inflation is said to have occurred when “aggressive
increases of wage rates and/or material prices are followed by induced and/or
supportive (compensatory) demand expansions”. To be sure, demand-pull
approaches take account of supply-side factors, while cost-push factors consider
demand-side factors. According to Solow and Samuelson, it is difficult in practice
to distinguish between demand-pull and cost-push inflation, not least because it is
hard to tell whether a price increase or cost increase came first (as cited in Forder
(2010: 12)). However, it is possible to identify differences in the theoretical
approaches of the two camps. The key difference between the two categories is
whether they see demand as what Nicholas (1988: 34-35) calls a “causal” factor or
a “propagating” factor of inflation. The other point of difference is the belief of
most demand-pull proponents in the existence of a “natural” or equilibrium state of
the economy characterized by a natural level of output, a natural rate of
unemployment.

Joshi V. K. (2012) in his study based on the impact of monetary policy of India
in inflation found that the thrust of monetary policy was on reducing the annual
inflationrate. In the study period from 2009-11, he found that the inflation has
crossed the historical records reached upto a level of 14%. Based on the study he
concluded that CRR is most important measure by which RBI can combat
inflation. In the last six months the inflation has dropped from a level of 7.17 in
January 2015 to 4.36 in July 2015. In the last decade Inflation range between 4-
14% with highest in 2009. The RBI revises CRR and the repo rate in their
quarterly and mid-quarter policy reviews to maintain a balance between growth
and inflation.
Bhattacharya K. and Bhattarcharyya I. (2001) in their paper examined the
transmission mechanism of an increase in oil prices on prices of other
commodities and output in India using monthly data from April 1994 to
December 2000. The paper specified a four equation VAR model to study the
interaction of inflation in oil with non-oil inflation and growth in money and
output.

OBJECTIVES
The objective of this assignment is to do an in depth analysis of factors that
have fuelled inflation in India in the past few years.

1. To provide a theoretical background of Inflation and to discuss the

historical experience of India with respect to inflation.

2. To ascertain the causes and the effect of inflation on Indian economy.

INDIA'S INFLATIONARY
EXPERIENCES
India's inflationary experiences can broadly be divided into two periods: Pre-
reform Period and Post reform period.

4.1 Pre-Reform Period (1950-51 to 1990-91)

Inflation during the pre-reform period was generally on an upward trend with
few years of negative inflation in between. Both domestic and foreign factors
played a crucial role in determining inflation rates over these years. Some of
the major events that affected inflation during this period were wars of 1962
and 1965, low agricultural production in 1965-66, and oil price shocks in early
and late 1970s.
Period: 1953-54 to 1961-62

The average inflation during this period was 2.69, but it showed significant
variations annually. During this period, India witnessed negative inflation of -
6.8 and -5.2 percent in 1954-55 and 1955-56 respectively. This was followed
by highest inflation recorded during this period of about 14 percent in 1956-
57. This was observed mainly due to increase in demand pressures,
particularly investment demand in light of the thrust on industrialization in
second five-year plan. Post this, inflation lied between 3 to 7 percent in the
next four years.

Period: 1961-62 to 1970-71

Average inflation jumped to 6.9 percent during this period and annual
variations were lesser than the previous period. It varied from -1.1 to 13.9
percent. Years 1966-67 and 1967-68 witnessed high inflation of 13.9 and 11.6
percent respectively. This was primarily seen as the impact of impact of the
Pakistan war in 1965 and the famine experienced during 1965-66. 1968-69
experienced deflation of around 1 percent due to great harvest in the previous
year. In the following two years, inflation was between 3 to 6 percent.

Period: 1970-71 to 1981-82

This period was marked by extreme fluctuations in inflation. The average

inflation was 10.1, ranging from -1.1 to 25 percent. Early 1970s experienced
high rates of inflation with years 1973-74 and 1974-75 witnessing above 20
percent inflation in India for the first time since independence. In fact, 1974-75
recorded 25 percent inflation which is the highest ever till date for India. This
was seen as a result of supply shock originating from poor agricultural
production and increase in oil prices. The following year witnessed slight
deflation. This was followed by in low inflation periods till 1978-79. Inflation
was again high at 17.1 and 18.2 percent in the next two years. This was again
due to low agricultural productivity and rise in oil prices. Referring to the
severity in in ation, particularly that of agricultural commodities in 1972-73
and 1973-74, the RBI Annual Report 1974-75 observed that “even the seasonal
decline in prices, particularly agricultural commodity prices, to which the
Indian economy is traditionally accustomed, did not take place during the last
two years”.

Period: 1981-82 to 1990-91

Average inflation during this period was 7.2 percent. Variations were less
relative to previous periods. Inflation varied between 4.4 per cent in 1985-86
and 10.1 per cent in 1990-9112.

Table 1: Inflation rates during pre-reform period

2 Post-Reform period (1991-92 to 2012-13)

Price levels have been persistently rising in the post-reform period with no year
experiencing deflation.

Period: 1991-92 to 2000-01

By March, 1991 rupee depreciated by nearly 37 percent with respect to dollar

and this added to the inflationary pressures in the economy. Sustained rise in
fuel prices combined with the phased opening of Indian economy during this
period also added to the inflation. As a result a sharp increase in inflation was
witnessed during 1992-96. From 1995-96 onwards, there has been a continuous
deceleration and the average inflation for the period 1996-97 to 2000-01 was
the lowest since the mid 1950s in terms of the 52 week average.

Period 2000-01 to 2009-10

During this period inflation varied from as low as 3.3 percent in 1999-2000 to
as high as 7.2 percent in 2000-01. However, after this inflation witnessed a
decelerating trend and remained at about 3.4 percent in 2002-03. In 2004-05,
spurt in domestic food prices due to deficient monsoon coupled a spurt in the
international oil prices again drove up domestic prices. Inflation began to ease
in the second half of 2004-05 under the impact of a combination of fiscal and
monetary measures. In 2005-06, WPI inflation eased to 4.3 per cent as
compared to 6.5 per cent a year earlier.

In this decade 2000-01, 2003-04, 2004-05, 2006- 07, and 2008-09 had higher
inflation relative to the decadal average of 5.4 percent. The years 2003-04,
2004-05, 2006-07, and 2008-09 also witnessed high inflation in manufactured
products mainly on account of high prices of raw materials. Major drivers of
inflation in 2008-09 were high international fuel and commodity prices. Year
2009-10 was marked by global slowdown and unfavorable monsoon, average
inflation during this period was 3.6 percent.

Period 2010-13

This period is very peculiar in India's experiences of inflation. This is period is

marked by high inflation resulting from elevated inflationary expectations, hike
in vegetable prices due to unseasonal rains post monsoon and rising global
commodity prices. Food products have been the major drivers of inflation
during this period. The financial year started with a headline inflation of 9.7 per
cent which briefly touched double digit in September 2011 before coming down
to 6.6 per cent in January 2012. It was expected that decline in growth during
the period 2011-12 will ease the pressure on core inflation but the extent of
moderation was constrained by depreciating rupee and high global commodity
prices.

Primary food articles inflation declined sharply during November 2011–January

2012, largely reflecting a seasonal decline in the prices of vegetables. However,
prices rebounded significantly subsequently, resulting in food inflation
reverting to double-digit levels by April 2012. As per mid-year analysis 2012-
13, inflation as measured by WPI averaged 8.9 per cent for 2011-12. In the first
half of 2012-13, it decelerated to 7.7 percent. It fall to 7.32 per cent in October
2012, 7.24 per cent in November, 7.18 per cent December 2012 and stood at
6.62 (provisional) for the month of January 2013.
Recent Trends

The Economic Survey 2016-2017 highlighted that the retail inflation is likely to
be below 5% in the current fiscal year as demonetisation would discourage ant
price headwind. According to the survey the new inflation targeting approach
by the Monetary Policy Committee (MPC) and gains from macro-economic
stability will help India consolidate gains on price control, meaning prices will
be less susceptible of individual whims and caprice of governments. In the year
2016, retail inflation stabilised around 5 per cent, while wholesale price-based
inflation averaged around 2.9 per cent during April-December, 2016.

Inflation in the fiscal year 2016-17 has been characterized by two distinctive
features. The Consumer Price Index during April-December, 2016, averaged 4.9
per cent and displayed a downward trend since July when it became apparent
that kharif agricultural production in general, and pulses in particular would be
bountiful. The decline in pulses prices has contributed substantially to the
decline in CPI inflation which reached 3.4 percent at end-December. On the On
wholesale-price front, a reversal trend was observed from a trough of (-) 5.1 per
cent in August 2015 to 3.4 per cent at the end of December 2016 due to rising
international crude prices. The average inflation based on the wholesale price
index (WPI) also declined to (-) 2.5 per cent in 2015-16 from 2.0 per cent in
2014- 15. The downward trend however reversed during the current financial
year partly due to impact of rise in global commodity prices and partly owing to
adverse base effect. The global commodity and energy prices have increased by
18 per cent and 23 per cent respectively in the first eleven months of 2016 as
per IMF price indices. The wedge between CPI and WPI inflation, which had
serious implications for the measurement of GDP has narrowed considerably.
Core inflation has, however, been more stable, hovering around 4.5 percent to 5
percent for the year so far. India has managed to maintain export
competitiveness despite capital inflows and inflation that has been greater than
in trading partners. Reflecting this, India's global market share in manufacturing
exports has risen between 2010 and 2015. Inflation hardened during the first
few months of 2016-17, mainly due to upward pressure on the prices of pulses
and vegetables. It dipped to two-year low of 3.4 per cent in December 2016 as a
result of lower prices especially of food items.

CAUSES & EFFECTS OF FLATION IN INDIA

CAUSES OF INFLATION

There are a number of factors that might impact inflation in India. One of them
is supply factors. India is an agrarian society with close to 52% of the
workforce employed in agriculture. Droughts, foods, inadequate methods for
the storage of grains lead to a lower amount of output being produced. This
decreases the supply at each price level, but the demand remains the same.
Thus excess demand leads to increase in price level. Since 2006-07 there have
been a series of adverse supply shocks. The shocks arose from a shortfall in
food-grain and non-food grain commodities (vegetables, fruits, protein-based
foods - pulses, milk, eggs, meat).

Another factor might be demand factors as rising incomes have drastically

increased the purchasing power of the population, further increasing consumption
demand. This surge in demand has triggered inflationary pressures, particularly in
sectors where supply has lagged behind. As public policy continued to spur
growth in consumption demand and wages, inflation became a common
phenomenon. Supply shocks can trigger sudden and sharp inflationary pressures,
but the pressures diminish when supplies revive. In India, the constant inflation
stems, instead, from government policies that spurred consumption demand by
increasing wages and salaries but did not do enough to remove supply-side
bottlenecks. Within the framework of such fiscal policies that boosted
consumption, supply shocks had a larger effect on inflationary pressures. In India,
an expansionary fiscal policy has boosted consumption demand in recent years. A
sharp increase in the international prices of fuels has also acted as a trigger for
inflation.

Figure2 : Fuel price rise

There are domestic factors that have a role to play. India is a developing
country where the markets and the inter linkages between markets are not
perfectly established and are underdeveloped. This means that when there is
an increase in money supply, there is no corresponding change in production
of goods. The supply of goods takes a longer time to adjust and hence it leads
to inflation. Other important domestic factors include the practice of hoarding.
Hoarding is stockpiling of items when a shortage is expected or it may be
strategic in order to decrease supply and hence increase the market price.

There have been wage increases by the government, which more than
compensated for inflation, but had no established link to productivity
improvement. Such a growth in wages without an improvement in
productivity is a source of inflation. The wages of a large section of workers
in the economy rise in line with inflation as they may be linked to inflation
like the linking of wages to inflation under NREGA. This linkage between
wages and inflation through MGNREGA has the potential to spread a wage-
price spiral across various sections of the economy. It is important to link
wage increases to productivity, to increase supply in line with rising demand.
Despite monetary tightening, inflationary pressures have continued. The RBI
has attempted to reign in demand, which the higher fiscal deficit fired by
consumption-oriented spending, through interest rate hikes. The nature and
quantum of fiscal spending has thus muted the effectiveness of the monetary
policy. Political instability in the country makes investors wary of investing
in India. This reduced investment decreases growth opportunities and causes
supply bottlenecks thus further fuelling supply shortage and price increase.

EFFECTS OF INFLATION

High and persistent inflation is bound to have certain adverse effects on the
economy and the major casualty of inflation is growth. Some part the recent
decline in growth rate and a massive decline in industrial production can be
attributed to high inflation India has faced in the last 3-4 years.

Balance of Payments

India for long has been facing an import-export mismatch. As the prices of
goods in India have increased, their relative cost for international customers
have increased as a result of which there has been a decline in exports. On the
other hand, since imports have become relatively cheaper, demand of imports
have increased, further worsening the current account of the country. This ratio
has continually been increasing and it is expected to increase further this
financial year. As of June, 2013 India's current account deficit already stands at
staggering $ -18.1 B.
Industries
Industries and economic activity all over India has also been adversely
affected. Inflation has led to the increase in the costs of inputs such as raw
materials and labor to some extent. This increase in costs has led to the
decline in margins. There is some extent up to which industries can bear these
added expenses resulting from inflation, once these increased prices are
passed on to the customers, it further adds to inflation. According to a CRISIL
research, EBITDA margins, which touched 5-year lows in 2012-13, are
expected to remain under pressure, as input costs escalate and demand
remains weak.
Figure 3: Effect of inflation on economic growth

Consumer

The section of the society that is most affected by inflation is the consumer. As
the salaries and income of the individual's increases with a lag, there is always
a time when prices of good are increasing and they are becoming less and less
affordable because income is stagnant. Fixed wage earners are most affected by
it as it takes more time for their wages to adjust to rising inflation. If the
inflation is high and persistent, the lag between price rise and wage rise
increases. Population at the lower end on the spectrum is most affected by
inflation.
Investment

Inflation has distorted the financial system of the country. In its initial stages,
the system was able to withstand its adverse effect because the financial
institutions by their very nature tend to ignore the purchasing power of money
and operate with reference to interest rates and maturity of financial
instruments. However, as inflation has gathered strength, the financial system is
not able to withstand it. As the inflation has crossed its earlier phases, strain on
the financial system, speculation, and expectations of further price rise and
similar other forces have lead to an increase in unemployment and a fall in
output. Eventually, in the final phase of inflation, the output and employment
levels may fall to abysmally low levels. Fluctuating prices generate opposite
effects on debtors and creditors. Rising prices have proved beneficial for
debtors at the expense of creditors. Thus, inflation has discouraged people to
invest in financial assets. All this has been coupled by the decline in foreign
investment in the country because of decline in investor confidence. Overseas
investors have pulled out a massive Rs 44,162 crores from the Indian capital
market in the month of June, 2013 itself.

Equality and Poverty

Although inflation erodes the wealth of each and every individual equally, its
effects are more pronounced on poor people rather than rich. The people that are
already living at subsistence level are most affected by it. In terms of capability
deprivation, inflation has not only led to an increase in inequality but also to
increase in poverty.
Currency depreciation
Weakening of Indian rupee is both the cause and effect of inflation. As the
domestic inflation has increased, imports have become cheaper leading to the
increased demand of dollars, thus depreciation the currency. A depreciated
currency, on the other hand, has now increased the cost of imported goods too
further fuelling inflation. A weak Indian rupee has increased the cost of oil and
petroleum which is a major input in many industries and seriously affected the
profitability of many industries.
From the above discussion, we can easily make out the effect of inflation on the
overall growth of the economy. As shown in the figure India's GDP growth has
declined from 9.4% to 4.7% in 2013 and much of the can be attributed to the
adverse effects of inflation on economic growth.

Figure 4: India GDP Growth

CONCLUSION

There might be positive relation between growth and inflation in the short run
because as the demand of goods and services increases with economic growth,
inflation is bound to increase. But in the longer run, relation between inflation and
growth turns negative. Long and persistent inflation reduces the economic growth.
Thus, there is an urgent need to address these issues of Inflation. RBI and
government are very much aware of all these effects have taken certain measure to
tackle inflation. But what effect these measures will have on growth is a
contentious issue. For example, increase in interest rates may reduce inflation but
will also reduce investment and thus, growth.