SEBI Grade A 2020: ECONOMICS: INFLATION

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 SEBI Grade A 2020: ECONOMICS: INFLATION
Table of Contents
INFLATION ................................................................................................................... 4
What is ‘Inflation’? ............................................................................................................................................. 4
Inflation Rate .................................................................................................................................................. 4
Causes of Inflation .............................................................................................................................................. 4
1. Demand-Pull Inflation ................................................................................................................................ 4
2. Cost-Push Inflation ..................................................................................................................................... 5
3. Built-In Inflation ......................................................................................................................................... 6
4. The Money Supply ...................................................................................................................................... 7
5. The National Debt ....................................................................................................................................... 8
6. Exchange Rates ........................................................................................................................................... 8
Types of Inflation ................................................................................................................................................ 8
Creeping Inflation ........................................................................................................................................... 8
Walking Inflation ............................................................................................................................................ 8
Galloping Inflation .......................................................................................................................................... 8
Hyperinflation ................................................................................................................................................. 8
Stagflation ....................................................................................................................................................... 8
Core Inflation .................................................................................................................................................. 9
Deflation ......................................................................................................................................................... 9
Wage Inflation ................................................................................................................................................ 9
Asset Inflation ................................................................................................................................................. 9
Effects of Inflation .............................................................................................................................................. 9
1. Effects on Distribution of Income and Wealth: .......................................................................................... 9
Effects on Production:................................................................................................................................... 10
Effects on Income and Employment: ............................................................................................................ 10
Effects on Business and Trade: ..................................................................................................................... 10
Effects on the Government Finance:............................................................................................................. 10
Effects on Growth: ........................................................................................................................................ 10
How does inflation affect interest rates? ........................................................................................................... 11
Measurement of Inflation in India .................................................................................................................... 11
GDP Deflator ................................................................................................................................................ 11
Consumer Price Index ................................................................................................................................... 11
Difference between the various CPIs ............................................................................................................ 12
The Wholesale Price Index (WPI) ................................................................................................................ 12
Headline and Core inflation .......................................................................................................................... 12
Important Measures to Control Inflation .......................................................................................................... 13
Monetary Measures:...................................................................................................................................... 13
Fiscal Measures:............................................................................................................................................ 14

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 SEBI Grade A 2020: ECONOMICS: INFLATION
Other Measures: ............................................................................................................................................ 14
Deflation ........................................................................................................................................................... 15
Causes of Deflation ....................................................................................................................................... 16
Deflation Changes Debt and Equity Financing ............................................................................................ 16

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 SEBI Grade A 2020: ECONOMICS: INFLATION
INFLATION
What is ‘Inflation’?
Inflation is a quantitative measure of the rate at which the average price level of a basket of selected
goods and services in an economy increases over some period of time. It is the rise in the general level
of prices where a unit of currency effectively buys less than it did in prior periods.
• Often expressed as a percentage, inflation thus indicates a decrease in the purchasing power of a nation’s
currency. Inflation can be contrasted with deflation, which occurs when prices instead decline.
• As prices rise, a single unit of currency loses value as it buys fewer goods and services. This loss of
purchasing power impacts the general cost of living for the common public which ultimately leads to a
deceleration in economic growth. The consensus view among economists is that sustained inflation
occurs when a nation's money supply growth outpaces economic growth.
• To combat this, a country's appropriate monetary authority, like the central bank, then takes the
necessary measures to keep inflation within permissible limits and keep the economy running smoothly.

• Inflation is measured in a variety of ways depending upon the types of goods and services considered
and is the opposite of deflation which indicates a general decline occurring in prices for goods and
services when the inflation rate falls below 0%.

Inflation Rate
• The inflation rate is the percentage increase or decrease in prices during a specified period, usually a
month or a year.
• The percentage tells you how quickly prices rose during the period. For example, if the inflation rate for
a gallon of gas is 2% per year, then gas prices will be 2% higher next year. That means a gallon of gas
that costs Rs 200 this year will cost Rs 204 next year.
• If the inflation rate is more than 50% in a month, that's hyperinflation.
• If inflation occurs at the same time as a recession, that's stagflation.
• Rising prices in assets like housing, gold, or stocks are called asset inflation.
• The inflation rate is a critical component of the misery index, which is an economic indicator that helps
to determine an average citizen's financial health. The other component is the unemployment rate.
• When the misery index is higher than 10%, it means people are either suffering from a recession,
galloping inflation, or both. In other words, either inflation or unemployment is greater than 10%.

Causes of Inflation
Rising prices are the root of inflation, though this can be attributed to different factors. In the context of
causes, inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In
inflation.

1. Demand-Pull Inflation
Demand-pull inflation is the upward pressure on prices that follows a shortage in supply. Economists
describe it as "too many rupees chasing too few goods."
• Demand-pull inflation is a tenet of Keynesian economics that describes the effects of an imbalance
in aggregate supply and demand.
• When the aggregate demand in an economy strongly outweighs the aggregate supply, prices go up.
• This is the most common cause of inflation.

• The term demand-pull inflation usually describes a widespread phenomenon. That is, when consumer
demand outpaces the available supply of many types of consumer goods, demand-pull inflation sets in,
forcing an overall increase in the cost of living.
• In Keynesian economic theory, an increase in employment leads to an increase in aggregate demand for
consumer goods. In response to the demand, companies hire more people so that they can increase
their output. The more people firms hire, the more employment increases. Eventually, the demand for
consumer goods outpaces the ability of manufacturers to supply them.

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Causes of Demand-Pull Inflation
There are five causes for demand-pull inflation:
• A growing economy. When consumers feel confident, they spend more and take on more debt. This
leads to a steady increase in demand, which means higher prices.
• Asset inflation. A sudden rise in exports forces an undervaluation of the currencies involved.
• Government spending. When the government spends more freely, prices go up.
• Inflation expectations. Companies may increase their prices in expectation of inflation in the near future.
• More money in the system. An expansion of the money supply with too few goods to buy makes prices
increase.
Demand-Pull Inflation Vs. Cost-Push Inflation
Cost-push inflation occurs when money is transferred from one economic sector to another. Specifically, an
increase in production costs such as raw materials and wages inevitably is passed on to consumers in the
form of higher prices for finished goods.
• In good times, companies hire more. But, eventually, higher consumer demand may outpace production
capacity, causing inflation.
• Demand-pull and cost-push move in practically the same way but they work on a different aspect of the
system. Demand-pull inflation demonstrates the causes of price increases. Cost-push inflation shows
how inflation, once it begins, is difficult to stops.

Example of Demand-Pull Inflation

• Say the economy is in a boom period, and the unemployment rate falls to a new low. Interest rates are
at a low point, too. The federal government, seeking to get more gas-guzzling cars off the road, initiates
a special tax credit for buyers of fuel-efficient cars. The big auto companies are thrilled, although they
didn't anticipate such a confluence of upbeat factors all at once.
• Demand for many models of cars goes through the roof, but the manufacturers literally can't make them
fast enough. The prices of the most popular models rise, and bargains are rare. The result is an increase
in the average price of a new car.
• It's not just cars that are affected, though. With almost everyone gainfully employed and borrowing
rates at a low, consumer spending on many goods increases beyond the available supply.
• That's demand-pull inflation in action.

2. Cost-Push Inflation
Cost-push inflation occurs when overall prices increase (inflation) due to increases in the cost of wages
and raw materials. Higher costs of production can decrease the aggregate supply (the amount of total
production) in the economy. Since the demand for goods hasn't changed, the price increases from
production are passed onto consumers creating cost-push inflation.

• The most common cause of cost-push inflation starts with an increase in the cost of production, which
may be expected or unexpected. For example, the cost of raw materials or inventory used in production
might increase, leading to higher costs.
• Inflation is a measure of the rate of price increases in an economy for a basket of selected goods and
services. Inflation can erode a consumer's purchasing power if wages haven't increased enough or kept
up with rising prices. If a company's production costs rise, the company's executive management might
try to pass the additional costs onto consumers by raising the prices for their products. If the company
doesn't raise prices, while production costs increase, the company's profits will decrease.
• For cost-push inflation to take place, demand for the affected product must remain constant during the
time the production cost changes are occurring. To compensate for the increased cost of production,
producers raise the price to the consumer to maintain profit levels while keeping pace with expected
demand.

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Causes of Cost-Push Inflation
• As stated earlier, an increase in the cost of input goods used in manufacturing, such as raw materials.
For example, if companies use copper in the manufacturing process and the price of the metal suddenly
rises, companies might pass those increase on to their customers.
• Increased labor costs can create cost-push inflation such as when mandatory wage increases for
production employees due to an increase in minimum the wage per worker. A worker strike due to stalled
to contract negotiations might lead to a decline in production and as a result, higher prices ensue for the
scare product.
• Unexpected causes of cost-push inflation are often natural disasters, which can include floods,
earthquakes, fires, or tornadoes. If a large disaster causes unexpected damage to a production facility
and results in a shutdown or partial disruption of the production chain, higher production costs are likely
to follow. A company might have no choice but to increase prices to help recoup some of the losses from
a disaster. Although not all natural disasters result in higher production costs and therefore, wouldn't
lead to cost-push inflation.
• Other events might qualify if they lead to higher production costs, such as a sudden change in
government that affects the country’s ability to maintain its previous output. However, government-
induced increases in production costs are more often seen in developing nations.
• Government regulations and changes in current laws, although usually anticipated, may cause costs to
rise for businesses because they have no way to compensate for the increased costs associated with
them. For example, the government might mandate that healthcare be provided, driving up the cost of
employees or labor.

Cost-Push vs. Demand-Pull

Rising prices caused by consumers is called demand-pull inflation. Demand-pull inflation includes times
when an increase in demand is so great that production can't keep up, which typically results in higher
prices. In short, cost-push inflation is driven by supply costs while demand-pull inflation is driven by
consumer demand—while both lead to higher prices passed onto consumers.

Example of Cost-Push Inflation

The Organization of the Petroleum Exporting Countries (OPEC) is a cartel that consists of 14 member
countries that both produce and export oil. In the early 1970s, due to geopolitical events, OPEC imposed an
oil embargo on the United States and other countries. OPEC banned oil exports to targeted countries and
also imposed oil production cuts.
What followed was a supply shock and a quadrupling of the price of oil from approximately $3 to $12 per
barrel. Cost-push inflation ensued since there was no increase in demand for the commodity. The impact of
the supply cut led to a surge in gas prices as well as higher production costs for companies that used
petroleum products.

3. Built-In Inflation
Built-in inflation is the third cause that links to adaptive expectations. As the price of goods and services
rises, labor expects and demands more costs/wages to maintain their cost of living. Their increased wages
result in higher cost of goods and services, and this wage-price spiral continues as one factor induces the
other and vice-versa.
• As an economic concept of significance, Built-in Inflation is that kind of inflation which evolve from the
past events and continues to affect the current economical conditions of a nation. Built-in Inflation that
it may also be termed as Hangover Inflation

Nature of Built-in Inflation:

At one particular point of time, Built-in Inflation acts as one of the 3 principal determinants of the current
rate of inflation. This very nature of Built-in Inflation can be well-illustrated by the Triangle Model of
Inflation, as propounded by Robert J. Gordon.
Gordon's Triangle Model of Inflation says that the current rate of inflation is equivalent to the
the summation of the Supply-Shock Inflation, Demand-Pull Inflation and Built-in Inflation.
Origin of Built-in Inflation:
The condition of Built-in Inflation one finds today, originated in the past under the continuous influence of
a Supply-Shock (Cost Push) Inflation or Demand Pull Inflation.

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• The built-in inflation originates from either persistent demand-pull or large cost-push (supply-shock)
inflation in the past. It then becomes a "normal" aspect of the economy, via inflationary expectations
and the price/wage spiral.
Inflationary expectations
• Inflationary expectations play a role because if workers and employers expect inflation to persist in the
future, they will increase their (nominal) wages and prices now. This means that inflation happens now
simply because of subjective views about what may happen in the future. Following the generally
accepted theory of adaptive expectations, such inflationary expectations arise because of persistent past
experience with inflation.

Price/Wage Spiral
• Workers and employers usually do not get together to agree on the value of real wages. Instead, workers
attempt to protect their real wages from falling in response to inflation (or to attain a target real wage)
by pushing for higher money (nominal) wages.
• Thus, if they expect price inflation – or have experienced price inflation in the past – they push for higher
nominal wages. If they are successful, this raises the costs faced by their employers.
• To protect the real value of their profits (or to attain a target profit rate or rate of return on investment),
employers then pass the higher costs on to consumers in the form of higher prices.
• This encourages workers to push for higher nominal wages because these price rises raise their cost of
living; so the inflationary cycle reinforces itself.

• In the end, built-in inflation involves a vicious circle of both subjective and objective elements, so that
inflation encourages inflation to persist. It means that the standard methods of fighting inflation using
monetary policy or fiscal policy to induce a recession are extremely expensive, i.e. they can cause large
rises in unemployment and large falls in real gross domestic product. This suggests that alternative
methods such as wage and price controls (incomes policies) may also be needed in the fight against
inflation.

There are some more casues of inflation

4. The Money Supply

Inflation is primarily caused by an increase in the money supply that outpaces economic growth. Ever since
industrialized nations moved away from the gold standard during the past century, the value of money is
determined by the amount of currency that is in circulation and the public’s perception of the value of that
money.

• When the RBI decides to put more money into circulation at a rate higher than the economy’s growth
rate, the value of money can fall because of the changing public perception of the value of the underlying
currency. As a result, this devaluation will force prices to rise due to the fact that each unit of currency
is now worth less.
• One way of looking at the money supply effect on inflation is the same way collectors value items. The
rarer a specific item is, the more valuable it must be. The same logic works for currency; the less
currency there is in the money supply, the more valuable that currency will be. When a government
decides to print new currency, they essentially water down the value of the money already in circulation.
A more macroeconomic way of looking at the negative effects of an increased money supply is that there
will be more dollars chasing the same amount of goods in an economy, which will inevitably lead to
increased demand and therefore higher prices.

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5. The National Debt
We all know that high national debt in the India is a bad thing, but did you know that it can actually drive
inflation to higher levels over time?
• The reason for this is that as a country’s debt increases, the government has two options: they can
either raise taxes or print more money to pay off the debt.
• A rise in taxes will cause businesses to react by raising their prices to offset the increased corporate tax
rate. Alternatively, should the government choose the latter option, printing more money will lead
directly to an increase in the money supply, which will in turn lead to the devaluation of the currency
and increased prices (as discussed above).

6. Exchange Rates
Inflation can be made worse by our increasing exposure to foreign marketplaces. In India, we function on
a basis of the value of the Rupee. On a day-to-day basis, we as consumers may not care what the exchange
rates between our foreign trade partners are, but in an increasingly global economy, exchange rates are
one of the most important factors in determining our rate of inflation.
• When the exchange rate suffers such that the Indian currency has become less valuable relative to
foreign currency, this makes foreign commodities and goods more expensive to Indian consumers while
simultaneously making Indian goods, services, and exports cheaper to consumers overseas.
• This exchange rate differential between our economy and that of our trade partners can stimulate the
sales and profitability of Indian corporations by increasing their profitability and competitiveness in
overseas markets. But it also has the simultaneous effect of making imported goods (which make up
the majority of consumer products in India), more expensive to consumers in the India.

Types of Inflation
Major types of Inflation are discussed below:

Creeping Inflation
Creeping or mild inflation is when prices rise 3-4% a year or less. When prices increase 2% or less it
benefits economic growth. This kind of mild inflation makes consumers expect that prices will keep going
up. That boosts demand. Consumers buy now to beat higher future prices. That's how mild inflation drives
economic expansion. For that reason, the RBI sets 4% as its target inflation rate.

Walking Inflation
This type of strong, or pernicious, inflation is between 3-10% a year. It is harmful to the economy because
it heats up economic growth too fast. People start to buy more than they need, just to avoid tomorrow's
much higher prices. This drives demand even further so that suppliers can't keep up, neither can wages. As
a result, common goods and services are priced out of the reach of most people.

Galloping Inflation
Galloping inflation occurred during WWII. When inflation rises to 10% or more, it wreaks absolute havoc
on the economy. Money loses value so fast that business and employee income can't keep up with costs
and prices. Foreign investors avoid the country, depriving it of needed capital. The economy becomes
unstable, and government leaders lose credibility. Galloping inflation must be prevented at all costs.

Hyperinflation
Hyperinflation is when prices skyrocket more than 50% a month. It is very rare. In fact, most examples
of hyperinflation have occurred only when governments printed money to pay for wars.
• Examples of hyperinflation include Germany in the 1920s, Zimbabwe in the 2000s, and Venezuela in the
2010s. The last time America experienced hyperinflation was during its civil war.

Stagflation
Stagflation is when economic growth is stagnant but there still is price inflation. In economics, stagflation,
or recession-inflation, is a situation in which the inflation rate is high, the economic growth rate slows, and
unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to
lower inflation may exacerbate unemployment.

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Core Inflation
Food prices are not included in the core inflation rate. The core inflation rate measures rising prices in
everything except food and energy. That's because fuel prices tend to escalate every summer. Families use
more fuel to go on vacation. Higher fuel costs increase the price of food and anything else that has large
transportation costs.

Deflation
Deflation seems good at first, but it has terrible consequences for businesses and homeowners. Deflation is
the opposite of inflation. It's when prices fall. In economics, deflation is a decrease in the general price level
of goods and services. Deflation occurs when the inflation rate falls below 0%. Inflation reduces the value
of currency over time, but sudden deflation increases it.

Wage Inflation
Wage inflation is when workers' pay rises faster than the cost of living. This occurs in three situations. First,
is when there is a shortage of workers. Second, is when labor unions negotiate ever-higher wages. Third is
when workers effectively control their own pay.

Asset Inflation
An asset bubble, or asset inflation, occurs in one asset class. Good examples are housing, oil and gold. Asset
price inflation is an economic phenomenon denoting a rise in price of assets, as opposed to ordinary goods
and services. Typical assets are financial instruments such as bonds, shares, and their derivatives, as well
as real estate and other capital goods.

Effects of Inflation
The following points highlight the six major effects of inflation. The effects are:
1. Effects on Distribution of Income and Wealth
2. Effects on Production
3. Effects on Income and Employment
4. Effects on Business and Trade
5. Effects on the Government Finance
6. Effects on Growth

1. Effects on Distribution of Income and Wealth:

The impact of inflation is felt unevenly by the different groups of individuals within the national economy—
some groups of people gain by making big fortune and some others lose.
We may now explain in detail the effects of inflation on different groups of people:

Creditors and debtors:

During inflation creditors lose because they receive in effect less in goods and services than if they had
received the repayments during a period of low prices. Debtors, on other hand, as a group gain during
inflation, since they repay their debts in currency that has lost its value (i.e., the same currency unit will
now buy less goods and services).

Producers and workers:

Producers gain because they get higher prices and thus more profits from the sale of their products. As the
rise in prices is usually higher than the increase in costs, producers can earn more during inflation. But,
workers lose as they find a fall in their real wages as their money wages do not usually rise proportionately
with the increase in prices. They, as a class, however, gain because they get more employment during
inflation.

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Fixed income-earners:
Fixed income-earners like the salaried people, rent-earners, landlords, pensioners, etc., suffer greatly
because inflation reduces the value of their earnings.

Investors:
The investors in equity shares gain as they get dividends at higher rates because of larger corporate profits
and as they find the value of their shareholdings appreciated. But the bondholders lose as they get a fixed
interest the real value of which has already fallen.

Traders, speculators, businesspeople and black-marketers:

They gain because they make more profits from the persistent rise in prices.

Farmers:
Farmers also gain because the rise in the prices of agricultural products is usually higher than the increase
in the prices of other goods.
Thus, inflation brings a shift in the pattern of distribution of income and wealth in the country, usually
making the rich richer and the poor poorer. Thus during inflation there is more and more inequality in the
distribution of income.

Effects on Production:
The rising prices stimulate the production of all goods—both of consumption and of capital goods. As
producers get more and more profit, they try to produce more and more by utilising all the available
resources at their disposal.
• But, after the stage of full employment the production cannot increase as all the resources are fully
employed. Moreover, the producers and the farmers would increase their stock in the expectation of a
further rise in prices. As a result hoarding and cornering of commodities will increase.
• But such favourable effects of inflation upon production are not always found. Sometimes, production
may come to a standstill position despite rising prices, as was found in recent years in developing
countries like India, Thailand and Bangladesh. This situation is described as stagflation.

Effects on Income and Employment:

Inflation tends to increase the aggregate money income (i.e., national income) of the community as a whole
on account of larger spending and greater production. Similarly, the volume of employment increases under
the impact of increased production. But the real income of the people fails to increase proportionately due
to a fall in the purchasing power of money.

Effects on Business and Trade:

The aggregate volume of internal trade tends to increase during inflation due to higher incomes, greater
production and larger spending. But the export trade is likely to suffer on account of a rise in the prices of
domestic goods. However, the business firms expand their businesses to make larger profits.
During most inflation since costs do not rise as fast as prices profits soar. But wages do not increase
proportionate with prices, causing hardships to workers and making more and more inequality. As the old
saying goes, during inflation prices move in escalator and wages in stairs.

Effects on the Government Finance:

During inflation, the government revenue increases as it gets more revenue from income tax, sales tax,
excise duties, etc. Similarly, public expenditure increases as the government is required to spend more and
more for administrative and other purposes. But the rising prices reduce the real burden of public debt
because a fix sum has to be paid in instalment per period.

Effects on Growth:
A mild inflation promotes economic growth, but a runaway inflation obstructs economic growth as it raises
cost of development projects. Although a mild dose of inflation is inevitable and desirable in a developing
economy, a high rate of inflation tends to lower the growth rate by slowing down the rate of capital formation
and creating uncertainty.

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How does inflation affect interest rates?

Inflation is an important concept for small business because it affects interest rates, which impacts how
much it costs to borrow money. At the heart of the relationship between inflation and interest rates are real
and nominal interest rates.
• Nominal interest rates are the interest rates advertised by your bank. They are, for example, the interest
accrued on your savings in your savings account. The real interest rate is the nominal interest rate
adjusted for inflation.

• In an economic scenario where there is 3% inflation and you have a variable rate interest loan at 10%
interest that's adjusted for inflation, the real interest rate you will pay is 13%. In other words, inflation
can end up costing you more money.

Measurement of Inflation in India

There are two main set of inflation indices for measuring price level changes in India – the Wholesale Price
Index (WPI) and the Consumer Price Index (CPI).

• The WPI, where prices are quoted from wholesalers, is constructed by Office of Economic Affairs, Ministry
of Commerce and Industries.

• In the case of CPI (prices quoted from retailers), there are several indices to measure it: CPI for industrial
labourers (CPI-IL), agricultural labourers (CPI-AL) and rural labourers (CPI-RL) besides an all India CPI.

• In addition, Gross Domestic Product (GDP) deflator and Private Final Consumption Expenditure (PFCE)
deflator from the National Accounts Statistics (NAS) provide an implicit economy-wide inflation estimate.

GDP Deflator
• The most comprehensive measure of Inflation is GDP deflator which is measured as ratio of GDP (Gross
Domestic Product) at current prices to GDP at constant prices. Since it encompasses the entire spectrum
of economic activities including services, the scope and coverage of national income deflator is wider
than any other measure. This data is released by the Central Statistical Organisation (CSO) but is not
used as it comes quarterly and with a 2 month lag.

Consumer Price Index

Two Ministries – Ministry of Statistics and Programme Implementation (MOSPI) and Ministry of Labour and
Employment (MOLE) are engaged in the construction of different CPIs for different groups/sectors.

• CPI inflation is also called as retail inflation as the prices are quoted from retailers. Following are the
various CPIs.
o CPI for all India or CPI combined.
o CPI for Agricultural Labourers (AL)
o CPI for Rural Labourers (RL); and
o CPI for Industrial Workers (IW)

CPI by MOSPI (CSO)

The CSO, which comes under MOSPI, is constructing the rural, urban and the combined CPIs. They are
published from 2011 onwards. Of these, the CPI combined is the most important of all the CPIs as it is
relevant for all categories of people.

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In April 2014, the RBI has selected the all India CPI (of CSO) as the inflation index to target inflation under
its new inflation targeting monetary policy framework. RBI’s decision has made the CPI as the prime inflation
index.

CPIs by MOLE (Labour Bureau)

The Labour Bureau, Ministry of Labour and Employment (MOLE) is preparing different indices for various
categories of people. These were CPI for Rural Laborares (CPI-RL), CPI for Agricultural Laborares (CPI-AL)
and CPI for Industrial Workers (CPI-IW).

• There was a CPI For Urban Non-Manual Employees (CPI-UME), but it was discontinued from April 2010.
• Since these CPIs were for specific categories of workers, it lacked the quality of an all India index.
• On the other hand, the first three indices are for specific occupational categories.
• The CPI compiled and released at national level by MOLE reflect fluctuations in retail prices relating to
specific segments of population in the country like industrial Workers (CPI-IW), agricultural laborers
(CPI-AL) and rural labourers (CPI-RL)

Difference between the various CPIs

Difference between the various CPIs is not just that they measure price level changes for different sectors
or groups. In addition to such a sector specific price level measurement; these indices differ in terms of
their geographical coverage, commodities included, weights assigned to the different commodity groups and
the base year on the basis of which price level changes are compared.

The Wholesale Price Index (WPI)

The WPI is published by the Office of Economic Adviser, Ministry of Commerce and Industry. It is in use
since 1942 and is being published from 1947 regularly.
• It has a long history for serving as the nationwide inflation indicator till the emergence of the combined
CPI in 2011.
• An important feature of the WPI which separate it from the CPI is that prices are collected from
wholesalers.

Table : Different price indices in India

Number of
Index Agency Base Year
Commodities

Office of Economic Affairs, Ministry of Commerce

WPI 2011-12 697
and Industries

CPI All India, CPI CSO, Ministry of Statistics and Programme 448 (rural)
2012
-Urban and Rural Implementation 460 (urban)

CPI-AL 1986-87

CPI-RL Labour Bureau, Ministry of Labour and 1986-87

Employment
CPI-IW 2001

Headline and Core inflation

Headline inflation:
Headline inflation is the raw inflation figure as reported through the Consumer Price Index (CPI) that is
released monthly by the Bureau of Labor Statistics. The CPI calculates the cost to purchase a fixed basket

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of goods, as a way of determining how much inflation is occurring in the broad economy. The CPI uses a
base year and indexes the current year's prices according to the base year's values

Core Inflation:
Core inflation removes the CPI components that can exhibit large amounts of volatility from month to month,
which can cause unwanted distortion to the headline figure. The most removed factors are those relating to
the cost of food and energy. Food prices can be affected by factors outside of those attributed to the
economy, such as environmental shifts that cause issues in the growth of crops. Energy costs, such as oil
production, can be affected by forces outside of traditional supply and demand, such as political dissent.

Headline v/s Core inflation

• Headline inflation is a measure of the total inflation within an economy, including commodities such as
food and energy prices (e.g., oil and gas), which tend to be much more volatile and prone to inflationary
spikes .
• On the other hand, "core inflation " (also non-food-manufacturing or underlying inflation) is calculated
from a price index minus the volatile food and energy components.
• Headline inflation may not present an accurate picture of an economy's inflationary trend since sector-
specific inflationary spikes are unlikely to persist.
• Core inflation represents the long run trend in the price level.
• In measuring long run inflation, transitory price changes should be excluded.
• One way of accomplishing this is by excluding items frequently subject to volatile prices, like food and
energy.

Important Measures to Control Inflation

Some of the important measures to control inflation are as follows:
1. Monetary Measures
2. Fiscal Measures
3. Other Measures

• Inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand. Inflation
can, therefore, be controlled by increasing the supplies of goods and services and reducing money
incomes in order to control aggregate demand.
• The various methods are usually grouped under three heads: monetary measures, fiscal measures and
other measures.

Monetary Measures:
Monetary measures aim at reducing money incomes.
Credit Control:
One of the important monetary measures is monetary policy. The central bank of the country adopts a
number of methods to control the quantity and quality of credit. For this purpose, it raises the bank rates,
sells securities in the open market, raises the reserve ratio, and adopts a number of selective credit control
measures, such as raising margin requirements and regulating consumer credit. Monetary policy may not
be effective in controlling inflation, if inflation is due to cost-push factors. Monetary policy can only be helpful
in controlling inflation due to demand-pull factors.
Demonetisation of Currency:
However, one of the monetary measures is to demonetise currency of higher denominations. Such a
measure is usually adopted when there is abundance of black money in the country.

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Issue of New Currency:
The most extreme monetary measure is the issue of new currency in place of the old currency. Under this
system, one new note is exchanged for a number of notes of the old currency. The value of bank deposits
is also fixed accordingly. Such a measure is adopted when there is an excessive issue of notes and there is
hyperinflation in the country. It is a very effective measure. But is inequitable for it hurts the small depositors
the most.

Fiscal Measures:
Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented by fiscal
measures. Fiscal measures are highly effective for controlling government expenditure, personal
consumption expenditure, and private and public investment.

The principal fiscal measures are the following:

Reduction in Unnecessary Expenditure:

The government should reduce unnecessary expenditure on non-development activities in order to curb
inflation. This will also put a check on private expenditure which is dependent upon government demand for
goods and services. But it is not easy to cut government expenditure. Though this measure is always
welcome but it becomes difficult to distinguish between essential and non-essential expenditure. Therefore,
this measure should be supplemented by taxation.
Increase in Taxes:
To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes should be
raised and even new taxes should be levied, but the rates of taxes should not be so high as to discourage
saving, investment and production. Rather, the tax system should provide larger incentives to those who
save, invest and produce more.
Further, to bring more revenue into the tax-net, the government should penalise the tax evaders by
imposing heavy fines. Such measures are bound to be effective in controlling inflation. To increase the
supply of goods within the country, the government should reduce import duties and increase export duties.
Increase in Savings:
Another measure is to increase savings on the part of the people. This will tend to reduce disposable income
with the people, and hence personal consumption expenditure. But due to the rising cost of living, people
are not in a position to save much voluntarily.
Keynes, therefore, advocated compulsory savings or what he called ‘deferred payment’ where the saver
gets his money back after some years. For this purpose, the government should float public loans carrying
high rates of interest, start saving schemes with prize money, or lottery for long periods, etc. It should also
introduce compulsory provident fund, provident fund-cum-pension schemes, etc. All such measures increase
savings and are likely to be effective in controlling inflation.
Surplus Budgets:
An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the government
should give up deficit financing and instead have surplus budgets. It means collecting more in revenues and
spending less.
Public Debt:
At the same time, it should stop repayment of public debt and postpone it to some future date till inflationary
pressures are controlled within the economy. Instead, the government should borrow more to reduce money
supply with the public.
Like monetary measures, fiscal measures alone cannot help in controlling inflation. They should be
supplemented by monetary, non-monetary and non-fiscal measures.

Other Measures:
The other types of measures are those which aim at increasing aggregate supply and reducing aggregate
demand directly.

To Increase Production:
The following measures should be adopted to increase production:
1. One of the foremost measures to control inflation is to increase the production of essential consumer
goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.

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2. If there is a need, raw materials for such products may be imported on preferential basis to increase the
production of essential commodities,
3. Efforts should also be made to increase productivity. For this purpose, industrial peace should be
maintained through agreements with trade unions, binding them not to resort to strikes for some time,
4. The policy of rationalisation of industries should be adopted as a long-term measure. Rationalisation
increases productivity and production of industries through the use of brain, brawn and bullion,
5. All possible help in the form of latest technology, raw materials, financial help, subsidies, etc. should be
provided to different consumer goods sectors to increase production.

Rational Wage Policy:

Another important measure is to adopt a rational wage and income policy. Under hyperinflation, there is a
wage-price spiral. To control this, the government should freeze wages, incomes, profits, dividends, bonus,
etc.
But such a drastic measure can only be adopted for a short period as it is likely to antagonise both workers
and industrialists. Therefore, the best course is to link increase in wages to increase in productivity. This
will have a dual effect. It will control wages and at the same time increase productivity, and hence raise
production of goods in the economy.

Price Control:
Price control and rationing is another measure of direct control to check inflation. Price control means fixing
an upper limit for the prices of essential consumer goods. They are the maximum prices fixed by law and
anybody charging more than these prices is punished by law. But it is difficult to administer price control.

Rationing:
Rationing aims at distributing consumption of scarce goods so as to make them available to a large number
of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is
meant to stabilise the prices of necessaries and assure distributive justice. But it is very inconvenient for
consumers because it leads to queues, artificial shortages, corruption and black marketing. Keynes did not
favour rationing for it “involves a great deal of waste, both of resources and of employment.”
From the various monetary, fiscal and other measures discussed above, it becomes clear that to control
inflation, the government should adopt all measures simultaneously. Inflation is like a hydra- headed
monster which should be fought by using all the weapons at the command of the government.

Deflation
Deflation is a general decline in prices for goods and services, typically associated with a contraction in the
supply of money and credit in the economy. During deflation, the purchasing power of currency rises over
time.
• Deflation causes the nominal costs of capital, labor, goods, and services to fall, though their relative
prices may be unchanged. Deflation has been a popular concern among economists for decades. On its
face, deflation benefits consumers because they can purchase more goods and services with the same
nominal income over time.
• However, not everyone wins from lower prices and economists are often concerned about the
consequences of falling prices on various sectors of the economy, especially in financial matters. In
particular, deflation can harm borrowers, who can be bound to pay their debts in money that is worth
more than the money they borrowed, as well as any financial market participants who invest or speculate
on the prospect of rising prices.

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Causes of Deflation
• By definition, monetary deflation can only be caused by a decrease in the supply of money or financial
instruments redeemable in money.
• In modern times, the money supply is most influenced by central banks, such as the Federal Reserve.
When the supply of money and credit falls, without a corresponding decrease in economic output, then
the prices of all goods tend to fall. Periods of deflation most commonly occur after long periods of artificial
monetary expansion.

Deflation Changes Debt and Equity Financing

• Deflation makes it less economical for governments, businesses, and consumers to use debt financing.
However, deflation increases the economic power of savings-based equity financing.
• From an investor's point of view, companies that accumulate large cash reserves or that have relatively
little debt are more attractive under deflation.
• The opposite is true of highly indebted businesses with little cash holdings. Deflation also encourages
rising yields and increases the necessary risk premium on securities.

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