Indian

Economy
Telegram Link by
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@kapillive 11th Edition
By Kapil Sikka
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 Chapter 7

Inflation and Business Cycle

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Contents of Chapter
• Base Effect

• Effects of Inflation

• Inflation in India

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Phillips Curve
• The Phillips curve is an economic concept developed by A. W. Phillips
stating that inflation and unemployment have a stable and inverse
relationship.

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Natural Rate of Unemployment
• Many consider a 4% to 5% unemployment rate to be full employment
and not particularly concerning.

• The natural rate of unemployment represents the lowest

unemployment rate whereby inflation is stable or the unemployment
rate that exists with non-accelerating inflation

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NAIRU
• The non-accelerating inflation rate of unemployment (NAIRU) is the specific
level of unemployment that is evident in an economy that does not cause
inflation to increase.

• In other words, if unemployment is at the NAIRU level, inflation is constant.

• NAIRU often represents the equilibrium between the state of the economy
and the labor market.

• We may say that the NAIRU is the lowest unemployment rate that an
economy can sustain without any upward pressure on inflation rate.

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GDP Deflator
• The GDP price deflator is also known as the GDP deflator or the
implicit price deflator
• It measures the changes in prices for all of the goods and services
produced in an economy.
• It helps economists compare the levels of real economic activity from
one year to another.
• The GDP deflator is a more comprehensive inflation measure than
the CPI index because it isn't based on a fixed basket of goods.

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• Since the deflator covers the entire range of goods and services
produced in the economy — as against the limited commodity
baskets for the wholesale or consumer price indices — it is seen as a
more comprehensive measure of inflation.

• As a result, nominal GDP will most often be higher than real GDP in
an expanding economy.
• The formula to find the GDP price deflator:
• GDP price deflator = (nominal GDP ÷ real GDP) x 100

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• If GDP at Current Prices is equal to the GDP at Constant Prices, GDP
deflator will be 1, implying no change in price level.

• If GDP deflator is found to be 2, it implies rise in price level by a

factor of 2, and if GDP deflator is found to be 4, it implies a rise in
price level by a factor of 4.

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Base Effect
• Price rise with regard to previous

• Current Inflation Rate = [(Current Price Index – Last year’s Price

Index)] ÷ Last year’s Price Index] × 100

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Effects on Inflation
• On Creditors and Debtors
• On Lending
• On Aggregate Demand
• On Investment
• On Income
• On Saving (Shoe leather cost)

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Effects on Inflation
• On Tax (Direct and Indirect)
• Bracket creep
• The extent to which tax collections of the government are concerned, inflation
increases the nominal value of the gross tax revenue but real value decreases

• On Exchange Rate

• On Exports

• On Imports (Essential Goods vs Normal Goods)

• Trade Balance issues

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Effects on Inflation
• On Employment

• On Wages

• On Self Employed

• On the Economy

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Inflation in India
• Wholesale Price Index

• Consumer Price Index

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WPI
• Since 1942
• widely used inflation indicator in India.
• Published by the Office of Economic Adviser, Ministry of Commerce
and Industry.
• All transactions at the first point of bulk sale in the domestic market
are included.
• Major criticism for this index is that the general public does not buy
products at wholesale price.
• The base year of All-India WPI has been revised from 2004-05 to
2011-12 in 2017.
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WPI
• Primary Articles, Fuel and Power, and Manufactured Products

• The prices used for compilation do not include indirect taxes in order
to remove impact of fiscal policy.

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CPI
• It measures price changes from the perspective of a retail buyer.
• It measures changes over time in the level of retail prices of selected
goods and services on which consumers of a defined group spend
their incomes.

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CPI
• Inflation at consumer level
• CPI (IW): Used for pay revisions
• CPI (UNME) Urban non manual employees- Employees of Foreign
Companies, used for capital gains purpose (Discontinued from 2011)
• CPI (AL) – Agri Labour : Basket majorly comprises of Food
• CPI (RL)- Rural Labour (earlier dropped then revived again)

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New CPI
• CPI (Rural)
• CPI (Urban)
• CPI (R) + (U) = CPI (Combined)
• CPI(C) = Monthly Basis, tracked by RBI (Since 2015)

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Trends in Inflation
• Decadal Inflation

• Headline Inflation

• Core Inflation

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• The headline inflation measure demonstrates overall inflation in the
economy.
• Conversely, the core inflation measure strips the prices of highly
volatile food and fuel components to distinguish the inflation signal
from transitory noise.

• Core CPI =Headline CPI - (food and fuel components.)

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Structural Inflation

• Problem of Developing Economies

• Rising Demand but Low Supply

• Supply Side Mismatch

• Low growth, Higher Inflation

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Inflation Targeting in India
• Done by Central Bank of Country

• Policies are adopted keeping in mind the liquidity requirements

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Agreement on Monetary Policy Framework
• The RBI will be responsible for containing inflation targets at 4% (with
a standard deviation of 2%) in the medium term
• The central bank will be deemed to have missed its target if
consumer inflation is at more than 6 percent or at less than 2 percent
for three consecutive quarters starting in the 2015/16 fiscal year.
• If the central bank misses the inflation target, it will send a report to
the government citing reasons and remedial actions.
• The central bank will also need to give an estimated time-period
within which it expects to return to the target level

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• Healthy range of Inflation 2-6%

• Every six months, the RBI to publish a document explaining:

• Source of inflation;
• Forecasts of inflation (6-18 Months)

• In case of Failure RBI has to give

• remedial actions proposed to be taken by the RBI; and
• an estimate of the time-period within which the target would be achieved
pursuant to timely implementation of proposed remedial actions.

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Various Committees
• Chakrvarty Committee : 4% is normal

• GoI (1997-98): 4-6%

• Tarapore Committee: 3-5% by 2000

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What is PPI then?
• Producers Price Index
• The government has set up a working group under Niti Aayog
member Ramesh Chand to revise the current series of Wholesale
Price Index (WPI) with base 2011-12 and devise a new Producer Price
Index (PPI).

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Housing Price Index
• RESIDEX is a housing price index (HPI) formulated and developed by
the National Housing Bank, a wholly owned subsidiary of the RBI.
• RESIDEX currently measures price change in residential housing
across 50 cities in India and is slated to capture data from over 100
cities, including all state capitals and ‘smart cities’.
• RESIDEX will not only help guide decisions within the sectors of real
estate and real-estate finance, but will also enable more accurate
tracking of national and regional economic performance.

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Service Price Index
• Tertiary Sector contribution

• OECD-Eurosat Report of 2005

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Q1. Which of the following will happen if inflation increases?
1. lenders will suffer and borrowers will benefit
2. the currency of the economy appreciates
3. tax-payers suffer while paying their direct and indirect taxes
Select the INCORRECT statement(s) using the codes given below
a) 2 Only
b) 1 and 2
c) 3 Only
d) None of the above
Ans: a

Explanation:
•Only statement 2 is incorrect.
•Statement 2: With every inflation the currency of the economy depreciates (loses its
exchange value in front of a foreign currency) provided it follows the flexible
currency regime.
•Tax-payers suffer while paying their direct and indirect taxes. As indirect taxes are
imposed ad valorem (on value), increased prices of goods make tax-payers to pay
increased indirect taxes (like cenvat, vat, etc., in India).
Q2 With regard to the Export-Import, consider the following statements
1. Increase in inflation led exportable items of an economy gain competitive prices in
the world market
2. In the case of compulsory imports Inflation causes more profit to the economy
Select the CORRECT statement(s) using the codes given below
a) 1 Only
b) 2 Only
c) Both 1 and 2
d) None of the above
Ans: a

Explanation:
•Only statement 1 is correct.
•Statement 2: Inflation gives an economy the advantage of lower imports and import-substitution as
foreign goods become costlier.
•But in the case of compulsory imports (i.e., oil, technology, drugs, etc.) the economy does not get this
benefit and loses more foreign currency instead of saving it.
Q3. GDP Deflator is the ratio between:
a) Inflationary tax and rate of GDP
b) GDP at Current Prices and GDP at Constant Prices
c) Increasing rate of GDP and increasing rate of GNP
d) None of the above
Ans: b

Explanation:
•GDP deflator is the ratio between GDP at Current Prices and GDP at Constant Prices.
•If GDP at Current Prices is equal to the GDP at Constant Prices, GDP deflator will be 1, implying no
change in price level.
•GDP deflator is acclaimed as a better measure of price behaviour because it covers all goods and
services produced in the country.
Q4. Phillips curve is a graphic curve which advocates a relationship between inflation
and:
a) Tax rates
b) Unemployment
c) Growth
d) None of the above
Ans: b

Explanation:
•Philips Curve It is a graphic curve which advocates a relationship between inflation and unemployment
in an economy.
•According to it there is a inverse relation between the inflation and unemployment.
•The curve suggests that lower the inflation, higher the unemployment and higher the inflation, lower
the unemployment.
Q5 Consider the following statements regarding the method of measuring inflation
1. The rate of inflation is measured on the basis of price indices – WPI and CPI
2. It is measured ‘point-to-point’
3. A price index does not show the exact price rise or fall of a single good
Select the CORRECT statement(s) using the codes given below
a) 1 Only
b) 1 and 3
c) 2 and 3
d) 1, 2 and 3
Ans: d

Explanation:
•All statements are correct.
•The rate of inflation is measured on the basis of price indices which are of two kinds—Wholesale
Price Index (WPI) and Consumer Price Index (CPI).
•A price index is a measure of the average level of prices, which means that it does not show the
exact price rise or fall of a single good.
•Formula: Rate of inflation (year x) = Price level (year x) –Price level (year x-1) / Price level (year x-
1)×100
•Inflation is measured ‘point-to-point’. It means that the reference dates for the annual inflation is
January 1 to January 1 of two consecutive years.
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