Notes Inflation

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INFLATION

Table of Contents
INFLATION .................................................................................................................... 1
What is Inflation? ............................................................................................................ 2
Causes of Inflation ................................................................................................................... 2
Types of Inflation ..................................................................................................................... 3
Cost-Push Inflation ........................................................................................................................................ 4
Demand-Pull Inflation ................................................................................................................................... 4

Deflation Vs. Disinflation .................................................................................................. 5

Headline Inflation Vs. Core Inflation ................................................................................. 5
Imported Inflation ............................................................................................................ 6
What is Imported Inflation? .......................................................................................................................... 6
What Causes Imported Inflation? .................................................................................................................. 6

Stagflation ....................................................................................................................... 7
What is Stagflation? ...................................................................................................................................... 7
Causes of Stagflation .................................................................................................................................... 7
Stagflation – Current Situation in India ........................................................................................................ 8

Inflation Indices ................................................................................................................ 8

Consumer Price Index (CPI) ...................................................................................................... 8
Types of CPI ................................................................................................................................................. 10
Wholesale Price Index (WPI) .................................................................................................. 10
Reasons for Divergence between CPI and WPI: ....................................................................... 12
Producer Price Index (PPI) ...................................................................................................... 13
Measure of Inflation in India........................................................................................... 13
Misery Index................................................................................................................... 13
Role of RBI in Controlling Inflation .................................................................................. 14
Interest Rate ................................................................................................................................................ 14
Reserve Ratios............................................................................................................................................. 14
Open Market Operations ............................................................................................................................. 15
Selective Credit Control .............................................................................................................................. 15
Flexible Inflation Targeting Framework (FITF) ................................................................... 15

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What is Inflation?

• Inflation is a general increase in the prices of goods and services in an economy.

• When the general price level rises, each unit of currency buys fewer goods and services;
consequently, inflation corresponds to a reduction in the purchasing power of money.
• The rate at which purchasing power drops can be reflected in the average price increase
of a basket of selected goods and services over some period of time.
• The rise in prices, which is often expressed as a percentage, means that a unit of
currency effectively buys less than it did in prior periods.
• Inflation can be contrasted with deflation, which occurs when prices decline and
purchasing power increases.

Causes of Inflation

Inflation can be caused by multiple factors, such as –

1. Increase in Money Supply:

• Excess currency (money) supply in an economy is one of the primary cause of inflation.
• This happens when the money supply/circulation in a nation grows above the economic
growth, therefore reducing the value of the currency.

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2. Deficit Financing:
• Deficit financing means generating funds to finance the deficit which results from
excess of expenditure over revenue.
• The deficit is often funded through borrowings or printing new currency notes.
• Printing new currency notes increases the flow of money in the economy. This leads to
increase in inflationary pressures which leads to rise of prices of goods and services in
the country.

3. Increase in Government Expenditure:

• Government expenditure would increase money supply within an economy.
• For example, when government spends heavily on public goods such as construction of
roads, schools, parks, etc. it leads to an increase in employment. This, in turn, leads to
an increase in purchasing power, thereby causing inflation.

4. Rise in Administered Prices:

• There are a number of important commodities, both agricultural and industrial, for
which the price level is administered by the government.
• The government keeps on raising prices from time to time in order to cover up losses
in the public sector.
• The upward revision of administered prices of coal, iron and steel, electricity and
fertilisers are made at regular intervals.
• Once the administered prices are raised, it is a signal for other prices to go up, thus,
leading to inflation.

5. Rising Import Prices:

• Inflation is a global phenomenon.
• International inflation gets imported into the country through major imports like
fertilisers, edible oil, steel, cement, chemicals, and machinery.
• For example, the rate of inflation was particularly high in March, 2022, primarily due
to rise in prices of crude petroleum and natural gas, mineral oils, etc., owing to
disruption in the global supply chain caused by the Russia-Ukraine conflict.

Types of Inflation

Inflation can be divided into two types – (i) cost-push inflation; and (ii) demand-pull inflation.

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Cost-Push Inflation

• Cost-push inflation occurs when overall prices increase due to increases in the cost of
wages and raw materials.
• Cost-push inflation can occur when higher costs of production 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.
• Cost-push inflation is usually associated with an unexpected external event like a
natural disaster or the depletion of natural resources, monopoly, government regulation,
government taxation, and changes in exchange rates.
• Inflation that occurred due to rising oil prices and increased raw materials prices due to
the breakdown of the supply chain during the COVID-19 Pandemic, is an example of
cost-push inflation.

Demand-Pull Inflation

• Demand-pull inflation is the upward pressure on prices that follows a shortage in

supply, a condition that economists describe as "too many dollars chasing too few
goods."
• The major cause of demand-pull inflation is a rise in aggregate demand.
• The increase in aggregate demand is primarily due to an increase in government
spending or an increase in household and business spending.
• In March of 2020, the global economy shut down due to the COVID-19 pandemic.
• After the global economy shut down in March 2020, due to the pandemic. With the
advent of a number of vaccines in late 2020, the economy began to slowly open up.
• This lead to an increase in demand for goods and services that weren’t readily available
for close to a year.
• Inventories started depleting, as consumers started demanding more food, household
items, and fuel. This increased demand “pulled” up prices, thus, causing inflation.

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Deflation Vs. Disinflation

Deflation Vs. Disinflation

Deflation Disinflation
Deflation is the drop in general price levels Disinflation occurs when price inflation
in an economy. slows down temporarily.
Deflation can be caused by a drop in the Disinflation can be caused by a recession or
money supply, government spending, when a central bank tightens its monetary
consumer spending, and corporate policy.
investment.
Deflation continues to occur until the rate of Disinflation continues to occur until the rate
inflation becomes positive or zero. of inflation becomes zero.

Headline Inflation Vs. Core Inflation

Headline Inflation Vs. Core Inflation

Headline Inflation Core Inflation
Headline inflation is the total inflation of an Core inflation is headline inflation less
economy over a specified period of time. inflation contributed by volatile
commodities such as food, energy, etc.
Headline inflation is primarily used to Core inflation is primarily used to measure
measure the short-term impact of inflation on the long-term impact of inflation on the
the economy. economy.
It reflects the impact of inflation on retail It reflects the impact of inflation on
consumers. production of goods and services.
Headline inflation is useful for medium- to Core inflation is useful for short-term
long-term monetary policy formulation. monetary policy formulation.

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Imported Inflation

What is Imported Inflation?

• When the general price level rises in a country because of the rise in prices of imported
commodities, inflation is termed as imported.
• The two key contributors to India's imports are Crude Oil and Gold. A rise in prices of
these two products leads to a rise in the import bill of the country.
• Inflation may also rise due to the depreciation of the domestic currency, which pushes
up the rupee cost of imported items.
• For example, when 1 USD = INR 50, India is importing $100 worth of goods. Thus, in
rupee terms, India is spending INR 5,000 to purchase the imported goods. When INR
depreciates against USD and the exchange rate is 1 USD = INR 60, India spends INR
6,000 to purchase $ 100 worth of goods as earlier. Although, price level remains the
same at $100, the outflow of money has increased in rupee terms after the depreciation
of INR against USD.

What Causes Imported Inflation?

• Imported inflation is caused by a decline in the value of a country's currency.

• The more a currency depreciates on the foreign exchange market, the higher the price
of imports. Effectively, more money is needed to buy goods and services from outside
the country.
• With imported inflation, production costs are higher for companies. These companies
most often reflect this increase in the selling price of the goods and services sold.

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• As a result, prices within the country rise.

Stagflation

What is Stagflation?

• Stagflation or recession-inflation is a situation in which the inflation rate is high or

increasing, the economic growth rate slows, and unemployment remains steadily high.
• Stagflation can be a dilemma for governments since most actions designed to lower
inflation may raise unemployment levels, and policies designed to decrease
unemployment may worsen inflation.

Causes of Stagflation

• There is no consensus among economists on the causes of stagflation. Each economics

school offers its own view on its origins. However, two main theories may be derived:
supply shock and poor economic policies.
• The supply shock theory suggests that stagflation occurs when an economy faces a
sudden increase or decrease in the supply of a commodity or service (supply shock),
such as a rapid increase in the price of oil. In such a situation, prices surge, making
production costlier and less profitable, thus slowing economic growth.
• A second theory states that stagflation can be a result of a poorly made economic policy.
For example, the government can create a policy that harms industries while growing
the money supply too quickly. The simultaneous occurrence of these policies can lead
to slower economic growth and higher inflation.

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Stagflation – Current Situation in India

• As per the RBI, India’s economy is better placed than many other countries to avoid
the risk of potential stagflation, owing to its prudent stabilization policies.
• With most constituents of the GDP surpassing pre-pandemic levels, domestic economic
activity is gaining strength.
• In order to check price rise, the monetary policy committee (MPC) on two occasions,
in May 2022 and in June 2022, raised the repo rate by 40 basis points (bps) and 50 bps,
respectively.
• The recovery remained broadly on track. This demonstrates the resilience of the
economy in the face of multiple shocks and the innate strength of macro fundamentals
as India strives to regain a sustainable high growth trajectory.

Inflation Indices

• The government measures inflation by comparing the current prices of a set of goods
and services to previous prices.
• The different types of price indices used to measure inflation are –
▪ Consumer Price Index (CPI)
▪ Wholesale Price Index (WPI)
▪ Producer Price Index (PPI)

Consumer Price Index (CPI)

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What is CPI?

• The Consumer Price Index (CPI) measures the change in the prices of goods and
services from the perspective of the consumer.
• The change in this index over a period of time is called CPI inflation.
• The Central Bank pays very close attention to this figure in its role of maintaining price
stability.
• The Price Statistics Division (PSD) of the National Statistical Office (NSO), Ministry
of Statistics and Programme Implementation (MoSPI) started compiling Consumer
Price Index (CPI) separately for rural, urban, and combined sectors on monthly basis
with Base Year (2010=100) for all India and States/UTs with effect from January 2011.
• The Base Year of the CPI was revised from 2010=100 to 2012=100, with effect from
January, 2015.
• The formula for calculating CPI is Laspeyres Index, which is measured as follows:
[Total cost of a fixed basket of goods and services in the current period * 100]
divided by Total cost of the same basket in the base period

Components of CPI

Food and
Beverages

Pan,
Miscellaneo Tobacco
us and
Intoxicants

Component
s of CPI

Clothing
Fuel and
and
Light
Footwear

Housing

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CPI Components with Weights

Components Rural Urban Combined
Food & Beverages 54.18 36.29 45.86
Pan, Tobacco & Intoxicants 3.26 1.36 2.38
Clothing & Footwear 7.36 5.57 6.53
Housing 0.00 21.67 10.07
Fuel and Light 7.94 5.58 6.84
Miscellaneous 27.26 29.53 28.32

Types of CPI

1. CPI for Industrial Workers (CPI-IW):

• The Labour Bureau compiles CPI-IW to quantify changes in the pricing of a fixed
basket of products and services used by Industrial Workers over time.
• A typical working-class family from any of these seven economic sectors, ranging from
industries, mines, plantations, motor transport, port, railways, and energy generation
and distribution, would be the target demographic.
• It is used for wage indexation and fixation of dearness allowance for government
employees.
• The present base of CPI-IW is 2016=100.

2. CPI for Agricultural Laborers (CPI-AL):

• The Labour Bureau compiles CPI-AL to help fix and revise minimum wages
for agricultural labour in different States.
• The present base of CPI-AL is 1986-87=100.

3. CPI for Rural Labourer (CPI-RL):

• The Labour Bureau compiles CPI-RL to help fix and revise minimum wages for rural
and unskilled labour in different States.
• The present base of CPI-RL is 1986-87=100.

Wholesale Price Index (WPI)

What is WPI?

• WPI measures the changes in the prices of goods sold and traded in bulk by wholesale
businesses to other businesses.
• WPI is released by the Office of the Economic Adviser, Ministry of Commerce &
Industry.

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• The new series of WPI with Base year 2011-12=100 became effective from April 2017.
Earlier the base year was 2004-05.
• The prices tracked are ex-factory price for manufactured products, agri-market (mandi)
price for agricultural commodities and ex-mines prices for minerals.
• Weights given to each commodity covered in the WPI basket is based on the value of
production adjusted for net imports.
• WPI covers prices of products/commodities only pertaining to four sectors namely
agriculture, mining, manufacturing and electricity.
• The WPI basket does not cover services.

Components of WPI

Components of WPI
Primary Articles Manufactured Products Fuel & Power
▪ Food articles ▪ Textiles ▪ Coal
▪ Non-food articles ▪ Chemicals & chemical ▪ Mineral oils (petrol,
▪ Minerals products diesel)
▪ Crude Petroleum ▪ Food products ▪ Electricity etc.
▪ Natural gas ▪ Paper & paper products
▪ Rubber and plastic
products
▪ Basic metals
▪ Machinery & machine
tools, etc.

WPI Food Index

• The WPI Food Index measures and tracks the changes in the price of all food related
goods in the stages before the retail level.

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• The WPI Food index is compiled by taking the aggregate of WPI for “Food Products”
under “Manufacture Products” and “Food Articles” under “Primary Article” using
weighted arithmetic mean.

Reasons for Divergence between CPI and WPI:

Reasons CPI WPI

WPI is more sensitive to

cost push inflation. Higher
cost of production due to
higher fuel costs in
Cost push inflation
transport and
(high WPI)
communication will
increase cost push inflation.
(64% weightage of
manufactured group)

Fuel and light

includes household
domestic fuel items like
electricity, LPG, kerosene,
cooking fuel. (7%
Retail Core Inflation
weightage)
(inflation excluding
Fuel and Power - 13%
“Food and Beverages”
Transport and weightage
and “Fuel and Light”)
communication fuel
(High WPI)
includes diesel & petrol
(this comes under
miscellaneous group and
included in core inflation)
(7% weightage)

Reasons CPI WPI

Food Inflation (Low CPI) Low food inflation due to

robust supply and good agri 24% weightage of food
growth resulted in low CPI, and beverages
Effective PDS.
46% weightage of food and
beverages

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Producer Price Index (PPI)

• The Producer Price Index or PPI is an index that measures the average price change of
goods and services.
• It can be calculated either when the goods leave the place of production or as they enter
the production process.
• In the case where the goods leave the production place, it is known as Output PPI.
• Similarly, Input PPI is when goods enter the production process.
• The PPI measures price movements from the seller's point of view.
• The PPI hasn't been in use in India yet, but Niti Aayog has created a roadmap to
introduce it soon.

Measure of Inflation in India

• In 2014, RBI adopted the new CPI (Combined) as the key measure of headline inflation
based on recommendations of Urjit Patel Committee.
• Earlier, RBI had given more weightage to Wholesale Price Index (WPI) than CPI as
the key measure of headline inflation for all policy purposes.
• CPI or inflation target set by RBI = 4% ± 2% (Inflation target of 4%, with a tolerance
band of +/- 2 percentage points.)

Misery Index

• The misery index is an economic indicator, created by economist Arthur Okun.

• The index helps determining how the average citizen is doing economically.
• Misery index is calculated by adding the unemployment rate to the inflation rate.
• It is also called “Economic Discomfort Index (EDI)”.
• The misery index indicates the rate that people without work cannot afford the items
they need or want.
• A healthy economy will produce a misery index of between 6% and 7%. This is also
known as a Goldilocks Economy, where the ideal rate of growth is 2%-3%.

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Role of RBI in Controlling Inflation

The RBI has adopted several policies through which it decreases or increases certain rates to
control inflation in the economy.

Interest Rate

1. Repo Rate:
• Repo rate is the rate at which RBI buys government securities with an agreement of
repossession, from the commercial banks.
• It is a short term borrowing from the central bank, against securities, to inject money to
meet the gap between the demand for money (loans) and deposits in the bank.

2. Reverse Repo Rate:

• It is the rate at which the RBI borrows money from the commercial banks.
• Banks deposit money in RBI when there is no other profitable option to invest the short
term excess liquidity or when there is uncertainty in the market for a significant period
of time.

3. Bank Rate:
• Bank rate is the rate at which the RBI allows finance to the domestic banks
• Unlike, Repo rate, there are no securities to be kept against the finance.
• But, in policies designed to control inflation, Bank rates are seldom revised.

Increase in these interest rates means that the RBI is making it expensive for the commercial
banks to borrow money (in case of reverse repo rate, lucrative to keep the deposits in RBI),
thus limiting the injection of money the market. RBI does this to decrease the liquidity in the
market.

Reserve Ratios

1. Cash Reserve Ratio (CRR):

• Banks are required to keep a fraction of deposit liabilities in the form of liquid cash, as
CRR, with the RBI to ensure safety and liquidity of the deposits.

2. Statutory Liquidity Ratio (SLR):

• Every bank in India has to maintain a minimum proportion of their net demand and
time deposits as liquid assets in the form of cash, gold, precious and semiprecious
stones.

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If there is increase in the reserve ratios, the total amount of deposits left with commercial banks
which it can give as commercial loans decreases and hence there is reduction in the loan
granting capacity of the banks. RBI uses this instrument for credit control in the market.

Open Market Operations

• The RBI can purchase or sell Government securities from or to the public.
• To control inflation, the RBI sells the securities in the money market which sucks out
excess liquidity from the market.
• As the amount of liquid cash decreases, demand goes down.
• This part of monetary policy is called the open market operation.

Selective Credit Control

• The Banking Regulation Act empowers the RBI to control the level and pattern of
advances given by banks, selectively.
• The RBI has been operating selective credit control to contain inflation of goods that
are short in supply or sensitive goods like food grains, vegetables, pulses, oilseeds,
cotton, sugar, etc., which are of mass consumption.
• The selective credit control policy, therefore, is to discourage advances given by banks
against these essential commodities.

Flexible Inflation Targeting Framework (FITF)

• The Flexible Inflation Targeting Framework (FITF) was introduced in India post the
amendment of the Reserve Bank of India (RBI) Act, 1934 in 2016.
• In accordance with the RBI Act, the Government of India sets the inflation target every
5 years after consultation with the RBI.
• While the inflation target for the period between 5 August 2016 and 31 March 2021
was determined to be 4% of the Consumer Price Index (CPI), the Central Government
announced that the upper tolerance limit for the same will be 6% and the lower tolerance
limit can be 2% for the same.
• Inflation Targeting is a central banking policy that focuses on altering monetary policy
to attain a set annual inflation rate.
• Inflation targeting is founded on the assumption that preserving price stability, which
is achieved by managing inflation, is the greatest way to generate long-term economic
growth.

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• New Zealand was the first country to embrace inflation targeting, and since then, a large
number of nations, including India, have chosen it as their primary monetary policy
tool.

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