Inflation: Causes, Types, Measurement and Policy Responses

Inflation: Causes, Types, Measurement and Policy Responses #

Inflation: Causes and Implications in India #

It is the rise in prices of goods and services within a particular economy wherein, the purchasing power of consumers decreases, and the value of the cash holdings erode.
In India, the Ministry of Statistics and Programme Implementation (MoSPI) measures inflation.
Some causes that lead to inflation are: Increase in demand, reduction in supply, demand-supply gap, excess circulation of money, increase in input costs, devaluation of currency, rise in wages, among others.

How Inflation is measured?

In India, inflation is primarily measured by two main indices — WPI (Wholesale Price Index) and CPI (Consumer Price Index), which measure wholesale and retail-level price changes, respectively.
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.
On the other hand, the goods or services sold by businesses to smaller businesses for selling further are captured by the WPI.
In India, both WPI (Wholesale Price Index) and CPI (Consumer Price Index) are used to measure price increases.

Types of Inflation: Causes, Speed and Variants #

Based On Causation	Based On Speed	Others
Demand Pull Inflation Cost Push Monetary Built In Headline/Core Profit Induced Structural Inflation	Creeping Walking Running Galloping or Hyperinflation	Skew flation Stagflation

Inflation based on Causes and Categories #

Demand-Pull Inflation: Causes and Economic Implications #

“Too much money chasing too few goods”.
The overall output of the economy does not fall in this case.
CAUSES–
When aggregate demand in an economy outpaces aggregate supply.
Deficit financing by the government and fiscal stimulus.
Depreciation of rupee and Increase in Forex reserve.
Lower interest rates- causes a rise in consumer spending and higher investment. This boost to demand causes a rise in AD and inflationary pressures.
Rising real wages. For example, union’s bargaining for higher wage rates.

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Cost-Push Inflation: Factors, Effects, and Economic Dynamics #

When prices increase due to the rising cost of inputs like wage increase, high transport price, unavailability of raw materials. With an increase in prices, the output level of the economy also falls.

Built-In Inflation: Cycle of Rising Prices and Labor Costs #

Firms pass the higher labour costs on to their customers as higher prices. It becomes a vicious cycle of higher price-higher labour cost-higher price.

Monetary Inflation: Impact of Money Supply Expansion on Economic Stability #

RBI printing more and more money (deficit financing) can cause inflation. Monetary inflation is a sustained increase in the money supply of a country (or currency area).

Structural Inflation: Challenges in Developing Economies and Market Dynamics #

Due to the weak structure of the institutions and markets in the economies, mostly the developing and low-income ones. Example- Artificial shortage of foods/ goods due to hoarding and Poor agriculture produce due to poor monsoons, inadequate irrigation facilities etc.

Profit-Induced Inflation: Market Power and Price Dynamics #

If the producers, due to their monopoly position, tend to mark-up their profit margin, it will lead to profit-induced inflation.

Reflation Strategies: Stimulating Economic Growth during contraction #

Reflation is the act of stimulating the economy after a period of economic slowdown or contraction. The goal is to expand output, stimulate spending and curb the effects of deflation. Policies include tax cuts, infrastructure spending, increasing the money supply and lowering interest rates.

Skewflation(Skew + flation): Price Disparities and Economic Impacts #

It is the skewed rise in the price of some items while remaining item prices remain the same. E.g. Seasonal rise in the price of onions.

Stagflation: Balancing Rising Prices, Recession, and Economic Growth #

The situation of rising prices along with falling growth and employment, is called stagflation. Inflation accompanied by an economic recession.

What defines Full Employment and its impact on Economic Potential? #

A situation where all the resources in the economy are fully employed and operating at the maximum potential.

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CORE INFLATION

HEADLINE INFLATION

Core inflation is the change in the costs of goods and services but does not include those from the food and energy sectors. This measure of price increases excludes these items because their prices are much more volatile. It is most often calculated using the consumer price index (CPI), which is a measure of prices for goods and services.
Core Inflation is a reflection of a long-term inflationary trend in the economy.

A measure of the total price increases 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.
Headline inflation may not present an accurate picture of an economy’s price increases trend since sector-specific inflationary spikes are unlikely to persist.

Spectrum of Inflation Speed #

Creeping (1-4%)	When the rate of price increases slowly rises over time. For example, the price increases from 2% to 3%, to 4% a year.
Walking (2-10%)	When it is in single digits – less than 10%.Central Banks will be increasingly concerned.
Running (10-20%)	When it starts to rise at a significant rate. It is usually defined as a rate between 10% and 20% a year.
Galloping (20%-1000%)	This is an inflation rate of between 20% up to 1000%. At this rapid rate of price increases, it is a serious problem and will be challenging to bring under control.
Hyper-inflation	Inflation rising at a very fast rate, can lead to a total collapse of the currency and economic crisis. E.g., Venezuela is experiencing hyperinflation due to poor economic policies and weak government.

Economic Trends: Deflation, Disinflation, Inflation, Reflation and Depression #

Deflation	It is the general fall in the price level over a period of time
Disinflation	It is the fall in the rate of price increase or a slower rate of inflation. Example: a fall in the inflation rate from 8% to 6%.
Inflation	It is the rise in prices of goods and services within a particular economy wherein, the purchasing power of consumers decreases, and the value of the cash holdings erode
Reflation	Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes, seeking to bring the economy back up to the long-term trend, following a dip in the business cycle. It is the opposite of disinflation.
Depression	It is Economic depression is a sustained, long-term downturn in economic activity

Economic Disparities: Inflationary and Deflationary Gaps #

INFLATIONARY GAP	DEFLATIONARY GAP
The Inflationary gap is a situation when Aggregate demand exceeds the Aggregate supply at the full employment level	The Deflationary Gap is when Aggregate demand is lower than Aggregate Supply at the full employment level
Overemployment	Underemployment
Excess of Aggregate demand	Lack of aggregate demand
Need for restrictive fiscal and monetary policies like lesser government spending, more taxes and higher interest rates	Need for more expansionary fiscal and monetary Policies like More government spending, less taxes, lower interest rates.

BASE EFFECT– The impact of the last year’s inflation over the corresponding rise in the current inflation. The base can make inflation high or low, even if prices are the same in the period.

Inflation Targeting: Central Bank Strategies and Monetary Policy Goals #

It is a monetary policy where the central bank sets a specific inflation rate as its goal and adjusts its monetary policy to achieve that rate.

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Monetary Policy Mechanisms and Economic Indicators #

The MPC is a statutory and institutionalized framework under the RBI Act, 1934, for maintaining price stability, while keeping in mind the objective of growth. It was created in 2016.
It was created to bring transparency and accountability in deciding monetary policy.
MPC determines the policy interest rate required to achieve the price increases target.
Committee comprises six members where Governor RBI acts as an ex-officio chairman. Three members are from RBI and three are selected by the government. The price increase target is to be set once every five years. It is set by the Government of India, in consultation with the Reserve Bank of India.
Current inflation target is pegged at 4% with -2/+2 tolerance till March 31, 2021.

GDP Deflator And Implicit Price Deflator:	It is a comprehensive measure of inflation. GDP price deflator = (nominal GDP ÷ real GDP) x 100 It covers the entire range of goods and services produced in the economy This reflects the extent to which the increase in the gross domestic product has happened on account of higher prices rather than an increase in output.
Phillips Curve:	Inverse relationship between unemployment and inflation.
Producer Price Index:	Producer Price Index (PPI) measures the average change in the price of goods and services either as they leave the place of production, called output PPI or as they enter the production process, called input PPI. PPI estimates the change in average prices that a producer receives.
Laspeyre Index:	By German economist Etienne Laspeyres ,Used for calculation of WPI,CPI,IIP.
Paasche Index:	By German economist Hermann Paasche – Tells about what today’s basket of commodities would have cost @ base year.
Fisher Index:	American Economist Irving Fisher-The Fisher Index is a consumer price index used to measure the increase in prices of goods and services over a period of time and is calculated as the geometric mean of the Laspeyres Index and the Paasche Price Index.

Differences Between PPI and WPI #

WPI captures the price changes at the point of bulk transactions and may include some taxes levied and distribution costs up to the stage of wholesale transactions. PPI measures the average change in prices received by the producer and excludes indirect taxes.
Weight of an item in WPI is based on net traded value whereas in PPI weights are derived from Supply
PPI removes the multiple counting bias, which is inherent in WPI.
WPI does not cover services, whereas PPI includes services.

Comparing PPI and CPI Methodologies #

PPI estimates the change in average prices that a producer receives while CPI measures the change in average prices that a consumer pays. The prices received by the producers differ from the prices paid by the consumers on account of various factors such as taxes, trade and transport margin, distribution cost etc..
Weights of items in CPI are derived from Consumer Expenditure Surveys whereas for PPI it is calculated on the basis of Supply.

Benefits and Disadvantages of Rising Inflation #

BENEFITS	DISADVANTAGES
It lowers the interest rate	Lenders suffer as real purchasing power declines
Debtors benefit.	Fixed income people like pensioners and salaried people suffer. Uncertainty in the economy so less investment
Currency depreciates	Imports suffer as they become costlier due to depreciation of the currency
Exports benefit majorly due to the depreciation of the currency	Real wages decrease.
Businesspeople gain profits.	Rupee purchasing power declines.
Savings, investment, and employment rise in the short term	Fall in real value of savings.
Nominal wage increases.	Decline in competitiveness.

Comparing Inflation Indices: WPI, CPI, and IIP – Methodologies and Applications #

WHOLESALE PRICE INDEX (WPI)	CONSUMER PRICE INDEX (CPI)	Index of Industrial Production (IIP)
BASE YEAR- 2011-12	2011-12	2011-12
Measures the average change in the prices of commodities for bulk sale before the retail level. Most widely used inflation indicator.	Measures the change in the retail price of goods and services with reference to a base year. RBI has adopted CPI (Combined: Rural + Urban) as its key measure of price increases.	Measures the growth rates in different industry groups of the economy. It is a key economic indicator of the manufacturing sector of the economy. Index of 8 core industries are- Refinery Products > Electricity > Steel > Coal > Crude Oil > Natural Gas > Cement > Fertilizers. These 8 industries command 40.27% weight in the overall IIP.
Covers only goods	Both goods and services	Different Sectors
Manufactured products (64%) > Primary Articles (23%) > Fuel and Power (13%)	Food and Beverage 45.86 Miscellaneous 28.32 Housing 10.07 Fuel and light 6.84 Clothing and Footwear 6.53 Pan, tobacco and intoxicants 2.38	Manufacturing (77.63%) > Mining (14.37%) > Electricity (7.9%)
Published by Office of Economic Adviser (OEA), Ministry of Commerce and Industry	CPI for Industrial Workers (IW) by the Ministry of Labour and Employment. The base year for CPI (IW) is changed from 2001 to 2016 Agricultural Labourer (AL) by the Ministry of Labour and Employment. CPI for Rural Labourer (RL) by the Ministry of Labour and Employment. The Consumer Price Index for agricultural workers (CPI-AL) and rural workers (CPI-RL) base year is 1986-87 CPI (Rural/Urban/Combined) by National Statistics Office (NSO), Ministry of Statistics and Programme Implementation.	The IIP index is computed and published by the Central Statistical Organisation (CSO) on a monthly basis.

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Strategies to Combat Inflation #

MONETARY POLICY MEASURES	FISCAL POLICY MEASURES	OTHER MEASURES
Increase of the Bank rate.	Reduces the private spending by increasing taxes	Price control by government as a short -term measure
Make borrowing costly by increasing interest rates.	Reduces the government spending	Import controls imposed by the government.
Increasing the propensity to save	Bringing more people under tax coverage	Restricting the wage increase by companies
Controlling the credit-creation	Introducing new taxes and cess
Conducting open market operations Increasing the Cash reserve ratio, statutory liquid ratio etc and other policy rates

Urjit Patel Committee Recommendations: Reforming Monetary Policy with Inflation Targeting #

The committee suggested that inflation should be the nominal anchor for the monetary policy framework. The nominal anchor or the target for price increases should be set at 4 percent with a band of +/- 2 percent around it. Monetary policy decision making should be vested in a Monetary Policy Committee (MPC) that should be headed by the Governor.

Interplay of Inflation, Fiscal Policy, and Monetary Policy #

Inflation is controlled by the Govt. through Fiscal policy and By RBI through Monetary policy.

What is monetary policy?

Monetary policy is the process by which the monetary authority of a country, generally the central bank, controls the supply of money in the economy by its control over interest rates in order to maintain price stability and achieve high economic growth.
In India, the central monetary authority is the Reserve Bank of India (RBI). It is designed to maintain the price stability in the economy.

What is fiscal policy ?

fiscal policy is the use of government revenue collection (taxes or tax cuts) and expenditure (spending) to influence a country’s economy.
Changes in the level and composition of taxation and government spending can affect macroeconomic variables, including:

1. Aggregate demand and the level of economic activity

2. Saving and investment

3. Income distribution

4. Allocation of resources.

Difference between fiscal and monetary policy

Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by a government department; while monetary policy deals with the money supply, interest rates and is often administered by a country’s central bank.
Both fiscal and monetary policies influence a country’s economic performance.

Fiscal Stimulus: Strategies to Boost Economic Activity #

In economics, stimulus refers to attempts to use monetary or fiscal policy (or stabilization policy in general) to stimulate the economy. Stimulus can also refer to monetary policies like lowering interest rates and quantitative easing. A stimulus is sometimes colloquially referred to as “priming the pump” or “pump priming“.

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Inflation tax/Seigniorage

Inflation tax is not an actual legal tax paid to a government; instead “inflation tax” refers to the penalty for holding cash at a time of high price increases. When the government prints more money or reduces interest rates, it floods the market with cash, which raises price increases in the long run. If an investor is holding securities, real estate or other assets, the effect of price increases may be negligible.
This is a situation of sustaining government expenditure at the cost of people’s income. This looks as if the rise in prices is working as a tax. That is how the term inflation tax is also known as seigniorage. It means, they are always the level to which the government may go for deficit financing – level of deficit financing is directly reflected by the rate of price increases.

Inflation Premium

The bonus brought by inflation to the borrowers is known as the inflation premium.
It is the benefit a borrower gets on his borrowings from lending institutions at the time of price increases in the economy .

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