• What is Inflation?

• Inflation refers to the rise in the prices of most goods and

services of daily or common use, such as food, clothing, housing,
recreation, transport, consumer staples, etc.
• Inflation measures the average price change in a basket of
commodities and services over time.
• Inflation is indicative of the decrease in the purchasing power of
a unit of a country’s currency.
• This could ultimately lead to a deceleration in economic growth.
• However, a moderate level of inflation is required in the
economy to ensure that production is promoted.
• In India, inflation is primarily measured by two main indices —
WPI & CPI which measure wholesale and retail-level price
changes, respectively.
• What is the Wholesale Price Index?
• It measures the changes in the prices of goods sold and
traded in bulk by wholesale businesses to other businesses.
• Published by the Office of Economic Adviser, Ministry of
Commerce and Industry.
• It is the most widely used inflation indicator in India.
• 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.
What is the Consumer Price Index?
• It measures price changes from the perspective of a retail buyer. It
is released by the National Statistical Office (NSO).
• The CPI calculates the difference in the price of commodities and
services such as food, medical care, education, electronics etc,
which Indian consumers buy for use.
• The CPI has several sub-groups including food and beverages, fuel
and light, housing and clothing, bedding and footwear.
• Base Year for CPI is 2012.
• The Monetary Policy Committee (MPC) uses CPI data to control
inflation. In April 2014, the Reserve Bank of India (RBI) had adopted
the CPI as its key measure of inflation.
• What is the difference between CPI and WPI?
• WPI tracks inflation at the producer level and CPI captures
changes in prices levels at the consumer level.
• WPI does not capture changes in the prices of services, which
CPI does.
• In WPI, more weightage is given to manufactured goods, while
in CPI, more weightage is given to food items.
Hence, Inflation is a persistent and an appreciable rise in the general level of prices.
In India, we estimate inflation by a movement in the Wholesale Price Index (WPI), which is reported every week with
a two-week lag.
The Cost of Living Index (CPI) is used to arrive at cost of living changes and for the calculation of dearness allowance or
cost of living allowance.

Reasons for Increasing Inflation in India Lately

•Cost push inflation:
• Disruptions due to global supply chain: The high rate of inflation in 2022 is primarily due to rise in prices of
crude petroleum and natural gas, mineral oils, basic metals, etc. owing to disruption in the global supply chain
caused by the Russia-Ukraine conflict.
• As per the CPI data, inflation in 'oils and fats' in March soared to 18.79% as the geopolitical crisis due to
the Russia-Ukraine war pushed edible oil prices higher. Ukraine is a major exporter of sunflower oil.
• Increasing the import cost: The sharp rise in commodity prices across the world is a major reason behind the
inflation spike in India. This is increasing the import cost for some of the crucial consumables, pushing inflation
higher.
• Cascading effect: When prices of oil and fertilizer increase, there is bound to be a cascading effect on all other prices
— which eventually the customer has to pay for.

•Abundance of liquidity:
• The excessive liquidity parked by central banks and the spending done by various governments to curb the effects of the
pandemic. This was about $9 trillion and slowly it was excessive money chasing too few goods thus stoking inflation. Probably the
urge to recover from the lows of the pandemic impelled the global economies to go overboard on monetary and fiscal support. The
result was runaway inflation in most global economies.
• Excessive liquidity has callused runaway inflation in India as the rate is above 4% for over 35 months and above the tolerance limit of
6% for 6 out of the last 12 months.
• Failure of Keynesian multiplier theory: After the advent of Covid-19, the major concern of policymakers all over the world was to
revive demand. This was sought to be achieved by raising government expenditure. This is the standard Keynesian prescription. The
severe lockdowns imposed to prevent the spread of Covid-19 restricted the mobility of people, goods and services. Thus, the
expansion in government expenditure did not immediately result in increased production in countries where the lockdown was
taken seriously.
• What causes inflation?
• Inflation can be caused by demand factors referred to as demand
pull inflation or by cost factors, referred to as cost pull inflation.
• Demand-pull inflation
• One of the major shocks to inflation is a change in aggregate demand.
Demand-pull inflation can be caused by an increase in any of the components
of aggregate demand, ie. Consumer demand(C), Investment demand (I),
Government demand (G) or net foreigner’s demand (X-M) or some
combination of the above. Usually, however, it is an increase in G, which is the
primary cause of demand-pull inflation. When the demand increases, the
extent of price increase depends on the supply situation.

• Whatever the reason, demand-pull inflation occurs when aggregate demand

rises more rapidly than the economy’s productive potential, pulling prices up to
equilibrate aggregate supply and demand. In effect, demand dollars are
competing for the limited supply of commodities and bid up their prices. As
unemployment falls and workers become scarce, wages are bid up and the
inflationary process accelerates.

• A particularly damaging form of demand-pull inflation occurs when

governments engage in deficit spending and rely on the monetary printing
press to finance their deficits. The large deficits and the rapid money growth
increase aggregate demand, which in turn increases the price level.
 Cost push inflation
• Today inflation sometimes increases because of increases in costs rather than
because of increases in demand. This phenomenon is known as cost-push or
supply-shock inflation. Often, it leads to an economic slowdown and to a
syndrome called “stagflation”, or stagnation with inflation.
• In 1973, 1978, 1999, and again in the late 2000s, countries were minding their
macroeconomic business when severe shortages occurred in oil markets. Oil
prices rise sharply, business costs of production increased, and a sharp burst
of cost-push inflation followed. These situations can be seen as an upward
shift in the AS curve. Equilibrium output falls while prices and inflation rise.
• Stagflation poses a major dilemma for policymakers. They can use monetary
and fiscal policies to change aggregate demand. However, AD shifts cannot
simultaneously increase output and lower prices and inflation. An outward
shift in AD curve would through monetary expansion would offset the decline
in output but raises prices further. Inflation resulting from rising costs during
periods of high unemployment and slack resource utilization is called
supply-shock inflation. It can lead to the policy dilemma of stagflation when
output declines at the same time as inflation is rising.
 Unemployment

• A person is unemployed if he is out of work and (1) has been actively

looking for work during the previous four weeks, or (2) is waiting to be
called back to a job after having been laid off.
• Unemployment = Labour force – Number of people employed
• Unemployment rate= Labour force – Number of people employed
Labour force
The duration of unemployment indicates whether unemployment is short
run or long run.
• About Unemployment: Unemployment occurs when a person who
is actively searching for employment is unable to find work.
• Unemployment is often used as a measure of the health of the economy.
• The most frequent measure of unemployment is the unemployment
rate, which is the number of unemployed people divided by the
number of people in the labour force.
• Types of Unemployment in India:
• Disguised Unemployment: It is a phenomenon wherein more people are
employed than actually needed.
• It is primarily traced in the agricultural and the unorganised sectors of India.
• Seasonal Unemployment: It is an unemployment that occurs during certain
seasons of the year.
• Agricultural labourers in India rarely have work throughout the year.
• Structural Unemployment: It is a category of unemployment arising from
the mismatch between the jobs available in the market and the skills of the
available workers in the market.
• Many people in India do not get jobs due to lack of requisite skills and due to poor
education level, it becomes difficult to train them.
• Cyclical Unemployment: It is a result of the business cycle,
where unemployment rises during recessions and declines with economic
growth.
• Cyclical unemployment figures in India are negligible. It is a phenomenon that is mostly
found in capitalist economies.
• Technological Unemployment: It is the loss of jobs due to changes in
technology.
• In 2016, World Bank data predicted that the proportion of jobs threatened by automation
in India is 69% year-on-year.
• Frictional Unemployment: The Frictional Unemployment also called
as Search Unemployment, refers to the time lag between the jobs when an
individual is searching for a new job or is switching between the jobs.
• In other words, an employee requires time for searching a new job or shifting from the
existing to a new job, this inevitable time delay causes frictional unemployment.
• It is often considered as voluntary unemployment because it is not caused due to the
shortage of job, but in fact, the workers themselves quit their jobs in search of better
opportunities.
• Vulnerable Employment: This means, people working informally, without
proper job contracts and thus sans any legal protection.
• These persons are deemed ‘unemployed’ since records of their work are never
maintained.
• It is one of the main types of unemployment in India.
• Causes of Unemployment in India:
• Social Factors: In India the caste system is prevalent. The work is prohibited for
specific castes in some areas.
• In big joint families having big business, many such persons will be available who do not do any
work and depend on the joint income of the family.
• Rapid Growth of Population: Constant increase in population has been a big
problem in India.
• It is one of the main causes of unemployment.
• Dominance of Agriculture: Still in India nearly half of the workforce is dependent on
Agriculture.
• However, Agriculture is underdeveloped in India.
• Also, it provides seasonal employment.
• Fall of Cottage and Small industries: The industrial development had adverse
effects on cottage and small industries.
• The production of cottage industries began to fall and many artisans became unemployed.
• Immobility of Labour: Mobility of labour in India is low. Due to attachment to the
family, people do not go to far off areas for jobs.
• Factors like language, religion, and climate are also responsible for low mobility.
• Defects in Education System: Jobs in the capitalist world have become highly
specialised but India’s education system does not provide the right training and
specialisation needed for these jobs.
• Thus many people who are willing to work become unemployed due to lack of skills.
• Natural rate of unemployment is the average rate of unemployment around which any economy
fluctuates in the long run.

• Policies aimed at reducing the natural unemployment

• 1. Unemployment benefits should be reduced as they reduce the urgency for an unemployed
person to take up a job.
• 2. Minimum wages should be reduced.
• 3. Incentives should be given to workers to take up technical training. This will make the workers
more productive and side by side reduce the natural rate of unemployment.
• 4. Efforts should be made to control recession.

• Frictional Unemployment- It is the unemployment which arises due to the time gap it takes for the
workers to search for a job that best suits their individual skills and tastes, when the economy is at
full employment. It can be reduced through collecting information on the workers’ profile to
match jobs and workers through retraining programmes.
• Costs of unemployment- Loss in production: According to Okun’s
law, a downward sloping curve shows an inverse relationship
between unemployment and the real GDP. According to this law, 1
extra point of unemployment costs 2 percent of GDP.
• An undesirable effect on income distribution and the human costs of
unemployment.
Phillips curve- Relationship between inflation
and unemployment
• The curve shows the relationship between the unemployment rate
and inflation. The basic idea is that when output is high and
unemployment is low, wages and prices tend to rise more rapidly.
This occurs because workers and unions can press more strongly for
wage increases when jobs are plentiful and firms can more easily
raise prices when sales are brisk. The converse also holds- high
unemployment tends to slow inflation.
• A short-run Phillips curve shows the inverse relationship between
inflation and unemployment. The right hand vertical scale shows
the rate of money-wage inflation.
• Say that labour productivity rises at a steady rate of 1 percent each
year. If wages are rising at 4 percent and productivity is rising at 1
percent, then average labour costs will rise at 3 percent.
Consequently, prices will also rise at 3 percent.

• Rate of inflation= Rate of wage growth – Rate of productivity growth

• The non-accelerating inflation rate of unemployment (or NAIRU) is
that unemployment rate consistent with a constant inflation rate. At
the NAIRU, upward and downward forces on price and wage inflation
are in balance, so there is no tendency for inflation to change.
The long-run vertical Phillips curve
 Long-run Phillips curve

• In the long-run, the Phillips curve is vertical, implying that the rate of
unemployment is independent of the rate of inflation.
• Period 1- Unemployment is at NAIRU. There are no demand or supply surprises and
the economy is at point A on the lower short run Phillips curve.
• Period 2- Next, suppose there is an economic expansion which lowers the
unemployment rate. As unemployment declines, firms recruit workers more
vigorously, giving large wage increases than formerly. As output approaches
capacity, price markups rise. Wages and prices begin to accelerate. The economy
moves to point B on its short run Phillips curve. The lower unemployment rate
raises inflation during the short period.
• Period 3- Because inflation has risen, firms and workers are surprised and they
revise upward their inflationary expectations. The result is a shift in the short-run
Phillips curve. The new short-run Phillips curve lies above the original Phillips
curve, reflecting the higher expected rate of inflation.
• Thus the conventional conclusion of a trade-off between the
unemployment rate and inflation rate dose not hold in the long run.
The actual unemployment rate has a tendency to ultimately gravitate
towards the equilibrium rate of unemployment, which Friedman calls
the natural rate of unemployment, at which the demand for labour is
equal to the supply of labour. The long-run Phillips curve is vertical at
the natural employment rate.

• According to the Phillips curve, policy makers could make a choice

between different combinations of the rate of inflation and the rate of
unemployment. In reality, even if there is a trade-off, it exists only in
the short-run. There is no permanent inflation-unemployment
trade-off and policy-makers can make a choice between different
combinations of unemployment and inflation.
 Sacrifice ratio
• The sacrifice ratio is the percentage of output which is lost for a one
point decrease in the inflation rate. This ratio also depends on the
time, place and methods which are used to reduce the inflation.
Available estimates show a sacrifice ratio ranging from 1 to 10. Thus
in the short run, the government can reduce inflation but only at the
cost of increasing the unemployment and reducing the level of
output.

• According to Okun’s law, a downward sloping curve shows an

inverse relationship between unemployment and the real GDP.
According to this law, 1 extra point of unemployment costs 2
percent of GDP.