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?
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Types of Inflation: Causes, Speed and Variants
| Based On Causation | Based On Speed | Others |
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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.
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.
| CORE INFLATION | HEADLINE INFLATION |
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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.
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: |
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| Phillips Curve: |
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| Producer Price Index: |
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| Laspeyre Index: |
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| Paasche Index: |
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| Fisher Index: |
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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) |
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| Covers only goods | Both goods and services | Different Sectors |
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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? |
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| What is fiscal policy ? |
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 |
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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“.
RELATED CONCEPTS
| Inflation tax/Seigniorage
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Inflation Premium
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