Inflation,-Fiscal and Monetary Policies.

Dr. Seema Singh

PhaseofInflation

Beyondaleveloffullemployment,increaseindemand

orriseininvestmentmayleadtoincreasedpressureon
resources.
Distortcostcalculation,leadstoinflation.

Measurement of Inflation
Wholesale Price Index (WPI)
Consumer Price Index (CPI)

Measurement of Inflation
Wholesale Price Index (WPI) : This index is the most
widely used inflation indicator in India. This is published
by the Office of Economic Adviser, Ministry of Commerce
and Industry.
WPI captures price movements in a most comprehensive
way.
Important monetary and fiscal policy changes are linked
to WPI movements.
It is in use since 1939 and is being published since 1947
regularly.

Whole sale Price Index

We are well aware that with the changing times, the economies
too undergo structural changes. Thus, there is a need for
revisiting such indices from time to time and new set of articles
/ commodities are required to be included based on current
economic scenarios. Thus, since 1939, the base year of WPI
has been revised on number of occasions. The current series
of Wholesale Price Index has 2004-05 as the base year. Latest
revision of WPI has been done by shifting base year from 199394 to 2004-05 on the recommendations of the Working Group
set up with Prof Abhijit Sen,, Member, Planning Commission as
Chairman for revision of WPI series. This new series with base
year 2004-05 has been launched on 14th September, 2010.

Limitation of Whole sale Price Index

The important limitations relate to
(a) non-inclusion of services
(b)following a fixed weighting scheme while the economy
is undergoing major structural changes, and
(c) use of gross transactions data rather than data on final
purchases.

A brief on the historical development of this

WPI is given below : Base year

Year of
Introduction

No of Items
in Index

No of Price
Quotations

Week ended
19th August
1939

1942

23

23

End August
1939

1947

78

215

112

1952-53 (194849 as weight

base)

1952

1961-62

July 1969

139

774

1970-71

January 1977

350

1295

1981-82

July 1989

447

2371

1993-94

April 2000

435

1918

2004-05

September 2010

676

5482

555

Consumer Price Index

The CPI measures price change from the perspective of the retail
buyer. It reflects the actual inflation that is borne by the
individual. CPI is designed to measure changes over time in the
level of retail prices of selected goods and services on which
consumers of a defined group spend their incomes. Till January
2012, in India there were only following four CPIs compiled and
released on national level. (In some countries like UK, Malaysia,
Poland it is also known as Retail Price Index). That was (1)
Industrial Workers (IW) (base 2001), (2) Agricultural Labourer (AL)
(base 1986-87) , (3) Rural (RL) (base 1986-87) (4) Urban NonManual Employees (UNME) (base 1984-85). However, a new series
has started from 2012 which compile, CPI (rural); CPI (Urban) and
CPI (Rural+ Urban).

ClassificationofInflationI
DemandPullInflation

DecreaseinInterestrate anincreaseintheinvestmentintheeconomy
anincreaseinmoneyofthefactorsofproduction increaseinthe
expenditureonconsumptiongoods willleadtodemandinflation.
CostPushInflation
Anincreaseinwage, Anincreaseinprofitmargin,and
impositionofheavycommoditytaxes.

ClassificationofInflationII.a(onthebasisof
rateofinterest)

CreepingInflationpricesincreasesupto3%withoutincrease

insupply.
WalkingInflationisbetween03%to09%perannum.
Prof.Samuelsonhasclubbedthemtogetherasmoderate
inflation.
Infactonedigitinflationinconsideredgoodforadeveloping
country.

ClassificationofInflationII.b(onthebasisof
rateofreturn)
1020%/annumisreferredasrunninginflation
Ifitexceedsthatfigure,maybedescribedas
gallopinginflation
Hyperinflationisdifficulttomeasurebutin
quantitativeterms,rateofpriceriseisabove1000%
perannum.

Worldwide Experience of Inflation

Indian economy has
experienced some spate of
running and galloping
inflation (not exceeding 25%)
since second five year plan.
Argentina, Brazil and Israel has
experience inflation over 100%
during eighties.
Impact of galloping inflation is
disastrous but even running
inflation has very serious
implication.

Hungry in the year 1996 and

Zimbabwe during 2004-09 has
experienced Hyper inflation.
Value of national currency
reduces almost to zero.

Deflation-I
Deflation is a situation where there is decrease in
the general price level of goods and services.
During deflation, the inflationary rate falls below
0% (a negative inflation rate) while real value of
money increases. There may be fall in aggregate
level of demand so, consumers delay purchases
until prices fall further leads to increase in idle
capacity, unemployment, and lower disposable
income. Further, it may lead to recession and lead
to deflationary spiral.

Difference between Inflation and

Deflation
Inflation is rise in prices.
Inflation distorts the
distribution of income between
different group of people in the
country in a way that rich gain
at the expense of the poor; but
it does not reduce the real
income of the society.

Deflation reduces national

income through contraction of
production and increases
unemployment.
Each segment of the society is
adversely affected.
In he last five decades, there is
hardly any country which has
passed through a period of
persistent fall in the general
level of prices.

Stagflation-I
A situation in which stagnant economy is
coupled with rising prices.
Both stagflation and inflation can result from
inappropriate macroeconomic policies. For
example, central bank can cause inflation by
permitting excessive growth of the money
supply and the government can cause
stagflation by excessive regulation in good and
labour market.

Stagflation-II
Excessive growth of money supply taken to such an
extreme that it must be reversed abruptly can clearly
be a cause.
Both types of explanations was discussed for the global
stagflation of the 1970s.
It began with a huge rise in oil prices, but then
continued as central banks used excessively
stimulating monetary policy to counteract the resulting
recession, causing a runaway price/ wage spiral.

Control of Inflation
Monetary Policy

Fiscal Policy

Repo rate is a rate at which banks

borrow from RBI for short periods up to
7 or 14 days but predominantly
overnight. RBI manages this repo rate
which is the cost of credit for the bank.
This becomes a floor below which the
short-term interest rates dont go.
Higher the repo rate means the cost of
short-term money is very high. Lower
the repo rate means the cost of shortterm rate is low which means at higher
repo rates the economy growth may
slowdown whereas at lower repo rate
economy growth may get enhanced.

Reduction in Unnecessary
Expenditure or Unproductive
expenditure should be curtail by
the Government
Further, to bring more revenue into the
tax-net, the government should
penalise the tax evaders by imposing
heavy fines.
To increase the supply of goods within
the country, the government should
reduce import duties and increase
export duties.

Control of Inflation
Monetary Policy

Fiscal Policy

Reverse repo rate is the rate at

which the central bank of a
country (Reserve Bank of India
in case of India) borrows
money from commercial banks
within the country.

To cut 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, it should provide larger
incentives to those who save,
invest and produce more.

Control of Inflation
Monetary Policy

Fiscal Policy

Under CRR , a certain percentage of

the total bank deposits has to be
kept in the current account with RBI
which means banks do not have
access to that much amount for any
economic activity or commercial
activity. Banks cant lend the money
to corporates or individual
borrowers, banks cant use that
money for investment purposes. So,
that CRR remains in current account
and banks dont earn anything on
that.

Increase in Savings
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.

Control of Inflation
Monetary Policy
Statutory liquidity ratio (SLR)
is the Indian government term for
reserve requirement that the
commercial banks in India require
to maintain in the form of certain
specified securities predominantly
central government and state
government securities. It means
the banks earn some amount of
interest on that investment under
SLR as against CRR where it earns
zero.

Fiscal Policy

Surplus Budgets
the government should give
up deficit financing and instead
have surplus budgets.

Difference between Depreciation and

Devaluation
Depreciation

Devaluation

Depreciation happens in countries with a

floating exchange rate. A floating exchange
rate means that the global investment
market determines the value of a country's
currency. The exchange rate among various
currencies changes every day as investors
reevaluate new information. While a
country's government and central bank can
try to influence its exchange rate relative to
other currencies, in the end it is the free
market that determines the exchange rate.
As of 2012, all major economies use a
floating exchange rate. Depreciation occurs
when a country's exchange rate goes down in
the market. The country's money has less
purchasing power in other countries because
of the depreciation.

Devaluation happens in countries with a fixed

exchange rate. In a fixed-rate economy, the
government decides what its currency should
be worth compared with that of other
countries. The government pledges to buy and
sell as much of its currency as needed to keep
its exchange rate the same. The exchange
rate can change only when the government
decides to change it. If a government decides
to make its currency less valuable, the change
is called devaluation. Fixed exchange rates
were popular before the Great Depression but
have largely been abandoned for the more
flexible floating rates. China was the last major
economy to openly use a fixed exchange rate.
It switched to a floating system in 2005.

Phillips Curve
In economics, Phillipss curve
represented the average relationship
between unemployment and wage
behavior over the business cycle.
Since its discovery by British
economist AW Phillips, it has become
an essential tool to analyse macroeconomic policy. It showed the rate of
wage inflation that would result if a
particular level of unemployment
persisted for some time. Stated
simply, decreased unemployment,
(i.e., increased levels of employment)
in an economy will correlate with
higher rates of inflation.

Criticism
At the height of the Phillips curves popularity, Edmund Phelps and
Milton Friedman independently challenged its theoretical
underpinnings. They argued that well-informed, rational employers
and workers would pay attention only to real wagesthe inflationadjusted purchasing power of money wages. In their view, real
wages would adjust to make the supply of labor equal to the
demand for labor, and the unemployment rate would then stand at
a level uniquely associated with that real wagethe natural rate
of unemployment.

NAIRU (Non Accelerating inflation Rate of

Unemployment)
Now economists prefer to talk about NAIRU the lowest rate of unemployment
at which inflation does not accelerate.
The lowest rate of unemployment at which the jobs market can be in stable
equilibrium.
When unemployment is above this rate, demand can potentially be
increased to bring it to the natural rate, but attempting to even it further will
only cause inflation to accelerate.
In order to reduce inflation by 1%, we must hold unemployment above the
natural rate two to 2 and a half percentage points.

Thanks