INFLATION www.edutap.co.in Learn anytime, anywhere. xs HEY cap cin ‘wr rh wordpress.comContents 1 WHATIS INFLATION. 2 CAUSESOF INFLATION... 2 DEMAND PULL INFLATION. 22 cOSTPUSHINFLATION. 23. MONETARY INFLATION. 3 EFFECTS OF INFLATION... 4 Someimportant TERMS. 4A OISINFLATION DEFLATION. 42 43, Hyperintation. 44 STAGFLATION 45° REFATION... 5 THEBOTTOMUNE, {6 Measures to CONTROL INFLATION ow 7 How do we MEASURE INFLATION? 7.1 WPI (WHOLESALE PRICE INDEX). 7.2 CONSUMER PRICE INDEX CP. {8 WHAT IS HEADLINE INFLATION 9 WHAT SCORE INFLATION... HET oe ccap cin ‘wr ra wordpress.com1 WHATIS INFLATION Inflation is the rate at which the general level of prices for goods and services is rising and, ‘consequently, the purchasing power of currency is falling. ‘As a result of inflation, the purchasing power of a unit of currency falls. For example, if the inflation rate is 2%, then a pack of gum that costs Rs 1 in a given year will cost Rs 1.02 the next year. In other words, inflation is the GENERAL RISE in the prices of goods and services in an ‘economy OVER A PERIOD OF TIME. Rate of Inflation is calculated as = (Prices in current year/ Prices in the base year) x 100 2 CAUSES OF INFLATION There is no single theory for the cause of inflation that is universally agreed upon by economists and academics, but there are a few hypotheses that are commonly held. 2. DEMAND PULLINFLATION Demand pull inflation is caused by the overall increase in demand for goods and services, which bids up their prices. ‘This theory can be summarized as "too much money chasing too few goods" In other words, if demand is growing faster than supply, prices will increase. This usually ‘occurs in rapidly growing economies. This theory is often promoted by the Keynesian school of economics. Itis generally good for the economy (in manageable figures) as it stimulates expansion in the long run 2.2. COST PUSH INFLATION Inflation is caused when companies’ costs of production go up. When this happens, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of natural resources or imports. Itcan be caused by increase in wages, increase in ries of raw material sun dsater etc HEB oe e22p0.in ‘wr rah opresscom2.3. MONETARY INFLATION Inflation is caused by an oversupply of moneyin the economy. Just like any other ‘commodity, the prices of things are determined by their supply and demand. If there is too much supply, the price of that thing goes down. If that thing is money, and too much supply of money makes its value go down, the result is that the prices of everything else priced in dollars must go up! This theory is often promoted by the “"Monetarist” school of economics. 3. EFFECTS OF INFLATION Inflation affects different people in different ways, with some benefiting from its effects at the expense of some who lose out. Here is a brief account of the typical winners and losers from inflation: '* Creditors (lenders) lose and debtors (borrowers) gain under inflation. ‘+ Inflation hurts savers since a rupee saved will be worth less in the future. Unless the money is saved in an account that pays an interest rate at or above the rate of inflation, the purchasing power of savings will erode. This phenomenon is sometimes called "cash-drag.” ‘+ Workers with fixed salaries or contracts that do not adjust with inflation will be hurt ‘as the buying power of their incomes stay the same relative to rising prices. 4.1. DISINELATION Disinflation is a condition where inflation is still positive, but the rate of inflation is decreasing = - for example from 8% to 42%. HEY or c22apcin ‘wr ra wordpress.com4.2 DEFLATION Deflation is when the general level of prices are falling, It is the opposite effect of inflation. Deflation tends to occur more rarely and for shorter periods of time than inflation. Deflation occurs typically during times of recession or economic crisis and can lead to deep economic crses including depression. The reason for ths isthe so-called deflationary spiral when prices are going down, why would you spend your money today, when each rupee will be more valuable tomorrow? And why spend tomorrow when each rupee can buy more the day after? The result is that people stop spending and hoard their money in anticipation of prices falling even further. If money is being hoarded, it isn’t being spent, so business profits collapse and people are laid off. Increasing unemployment leaves the economy with even less spending, and the spiral continues. 43° Hyperinflation Hyperinflation is unusually rapid inflation, typically more than 50% in a single month. In extreme cases, this inflation gone awry can lead to the breakdown of a nation's monetary system or even its economy. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month! Likewise, in Zimbabwe, hyperinflation led to Z$100 trillion bills being printed that were worth only a few U.S. dollars. Hyperinflations have also famously occurred in Hungary and Argentina in the 20" century. 44, STAGFLATION Stagflation is the rare combination of high unemployment and economic stagnation along with high rates of inflation. ‘A combination of stagnation and inflation EE oe e222p0.in ‘wr ra wordpress.comIt is 2 situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high. 4,5 REFLATION Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes, seeking to bring the economy in a growth mode. 5 THE BOTTOMLINE ‘The bottomline is that people often complain when prices go up, but they often ignore the fact that wages should be rising as well. The question shouldn't be whether inflation is rising, but whether it's rising at a quicker pace than your wages. A modest inflation is a sign that an economy is growing. In some situations, little Inflation can be just as bad as high inflation. The lack of inflation may be an indication that the economy is weakening. As you can see, it's not so easy to label inflation as either good or bad ~ it depends on the overall ‘economy as well as your personal situation. 6 Measures to CONTROLINFLATION VCO) \ ea FSA Vann REGULATES DEMAND SIDE FACTORS * QUANTITATIVE TOOLS NV] \slu)s) ss) * QUALITATIVE TOOLS ‘© REGULATES SUPPLY SIDE FACTORS is | SCAL * ALTERING TAXATION POLICY iV) | SANS 0) 8) Sis)» ALTERING EXPENDITURE POLICY LET US RECAP THE MONETARY MEASURES HS cap coin ‘wr ra wordpress.comMONEY SUPPLY Increase in Money Supply Purchasing power wl ‘Money ith the Banks rosense iirc Constant co | __o 4 Demand wil increase Interest rate wl sense snfiation Investment will increase Growth wilinerease MONEY SUPPLY Decrease in Money Supply Purchasing power wit | {Maney wih the banks cewree waildeceese cae 4 4 Demand will decrease Inflation wil fol HET oe cctap cin Investment will cocroase {Growth wif wor slgradeb wordpress.com+ To ARREST INFLATION/ REDUCE INFLATION, we have to REDUCE THE MONEY SUPPLY + To INDUCE INFLATION / REDUCE DISINFLATION/ REDUCE DEFLATION, we have to INCREASE THE MONEY SUPPLY RR INCREASE DECREASE. SLR INCREASE DECREASE REPO RATE INCREASE DECREASE. REVERSE REPO INCREASE DECREASE MSF INCREASE DECREASE. OPEN MARKET RBI SELLS G SECS RBI BUYS G SECS OPERATIONS. EXAMPLES OF FISCAL MEASURES ‘+ Banning the export of commodities that are scarce in the country ig available essential commodities like kerosene, pulses, etc INFLATION INDEXED BONDS. Inflation Indexed Bond (IIB) is @ bond issued by the Sovereign, which provides the investor @ constant return irrespective of the level of inflation in the economy. The main objective of Inflation Indexed Bonds is to provide 2 hedge and to safeguard the investor against macroeconomic risks in an economy. HEY oe ccap cin ‘wr ah wodpresscomIssue of lIBs has assumed significance in the context of high level of inflation experienced in the Emerging Market and Developing Economies during the recent years, as the value of money loses rapidly in an environment of high inflation In the indian context, inflation was one of the major macroeconomic concerns of the ‘economy during the period 2008-2013 where real interest rates were consistently negative. The period also was noted for the high current account deficit (CAD), which saw huge Investment in the alternate instrument ~ gold - by the households, necessitating heavy import of gold. In order to reduce the attractiveness of gold for investment and reduce the CAD, the Government of India launched Inflation indexed bonds (IIB) on 4 June 2013 The Reserve Bank of India auctioned its first tranche, linking to Wholesale Price Index (WPI) inflation, as WP! headline inflation was then used as the key measure of inflation by RBI. UIB bonds were issued on monthly basis (on last Tuesday of each month) till December 2013, These bonds offered annual return of 1.44% (through half yearly coupon) over and ‘above the headline inflation (WPI). Over the time, IIB bonds lost its attractiveness, as there has been significant moderation in inflation since 2014-15. ‘The IIB bonds turned highly illiquid, as WPI inflation remained negative for consecutive 15 months (as on Feb 2015) since November 2014. With a view to improve the liquidity in G Secs market, Government decided to buy back the IIB bonds. ‘The Government of India announced the repurchase of 1.44% Inflation government stocks 2023 in February 2016 through reverse auction for an aggregate amount of Rs. 6500 crore (face value). The repurchase was undertaken as an adhoc measure to redeem the government stock prematurely by utilizing surplus cash balance. ‘Since April 2014, RBI adopted consumer price index (CPI combined) as the key measure of inflation for its monetary policy stance. In case RBI issues new IIB bonds in the near future, it would be based on CPI, as CPI (combined) has been accepted by RBI as the key measure of inflation for its monetary policy stance, since 2014. A predecessor of Inflation Indexed Bonds (IIBs) was Capital Indexed Bonds (CIBs) issued HEY or c22apccin ‘wr ah wodresscom| during 1997. However, the CiBs issued in 1997 provided inflation protection only to principal and not to interest payment. IIBs provide inflation protection to both principal and interest payments. 7 How do we MEASURE INFLATION? ‘There are 2 most common indicators to measure inflation 1, WPI i.e WHOLESALE PRICE INDEX 2. €Pli.e, CONSUMER PRICE INDEX 7-1. WPI (WHOLESALE PRICE INDEX) + The Wholesale Price Index (WP) is the price of a representative basket of wholesale goods + Ite ists of 3 categories: (IN DECREASING ORDER OF WEIGHT) 1, Manufacturing (64.97%) 2. Primary articles (20.12%) 3. Fuel and power (14.91%) Note that WPI contains NO SERVICES = Prd etsy cue MANUFACTURING| + The basket of WPI has 676 items ‘+The BASE YEAR is 2004.05 HE cap cin ‘wr ra wordpress.com+ The data for WPI is released by the OFFICE OF ECONOMIC ADVISOR, Dept of Industrial Policy and Promotion, Ministry of Commerce and Industry Below graph dey ‘the trend of WPI: _asohtinnnnlll porate arts came jan? 7.2. CONSUMER PRICE INDEX (CPI) + CPI measures changes in the price level of a basket of consumer goods and services purchased by households + [thas 6 categories (earlier 5) 1. Food and beverages 2. Miscellaneous (SERVICES like health, education, etc) 3. Housing 4, Fuel and light 5, Clothing and footwear 6. Pan, tobacco and intoxicants BEY row ccutap.coin wor slgradeb wordpress.comled] a ei] CPI RURAL CPI URBAN COMBINED ‘+ The BASE YEAR is 2011-12 (has been recently changed from 2008-10) + The number of items in CPI (Combined) basket are 908 (448 for Rural and 460 for Urban) + The data for CPs released by Central Statistics Office (CSO) under MOSPI (Ministry of Statistics and Programme Implementation) +The Reserve Bank of India (RBI) has started using CPI-combined as the sole inflation measure for the purpose of monetary policy. ‘+ As per the agreement on Monetary Policy Framework between the Government and the RBI dated February 20, 2015 the sole of objective of RBI is price stability and a target is set for inflation as measured by the Consumer Price Index-Combined. ‘CHANGES IN CPI SERIES ‘© The base year has been changed from 2009-10 to 2011-12 The overall weight of households, food and fuel expenditure has gone down and that of non food expenditure has gone up ‘© The weights have been assigned according to Consumer Expenditure Survey 2011 8 WHATIS HEADLINE INFLATION It is the OVERALL inflation figure obtained by t respective indices. into account all the categories of the For example, if we take all 3 categories of WPI (Primary articles, fuel and manufacturing) and calculate WPI, what we obtain is headline WPI HEE oe ccap cin ‘wr ra wordpress.com9 WHAT IS COREINFLATION It is the rate of inflation calculated to exclude certain items that are subject to sudden and. short-lived price movements, mainly food and energy/fuel. Core inflation is considered a better indicator of overall long-term than un-adjusted headline inflation as it excludes the volatile articles from the calculation which may distort the overall inflation figures. Note: ‘The latest data near to the examination date would be the most crucial for all aspirants, we shall cover that through our MCQs on current affairs for Phase 2. HE oe cctap cin ‘wr ra wordpress.com