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Banking in India - Part 8 ( Inflation)

Bankers Corner

Inflation

  • Inflation is the rate of increase in prices for goods and services. During periods of inflation, there is an increase of the money supply.
  • Salient features of inflation are as follows :
    1. Inflation is always accompanied by a rise in prices and it is, in fact, uninterrupted increase in prices.
    2. Inflation is essentially an economic phenomenon as it originates within the economic system and is fed by the action and interaction of economic forces.
    3. Inflation is a dynamic process which can be observed more or less over a long period
    4. A cyclical movement should not be confused with inflation.
    5. Inflation is a monetary phenomenon as it is generally caused by excessive money supply.
    6. Pure inflation start after full-employment.
  • Inflation is caused due to a mismatch between demand and supply, i.e. when demand exceeds supply. Thus, inflation can occur due to changes in the demand side or the supply side or both.
  • Demand-Pull Inflation: It emerges when the aggregate demand exceeds the level of full employment output. Consumers and investors seek to buy more than the total amount of output that can be produced. This type of inflation is also known as excess demand inflation. Some of the factors which influence Demand-Pull Inflation are:
    1. Increase in public expenditure, especially by the government operating large fiscal deficits.
    2. Loose monetary policy of the Central Bank, which leads to low-interest rates and thus higher consumption.
    3. Rapid GDP growth, which leads to more employment, higher wages and thus higher inflation.
    4. Increase in population.
    5. Depreciation of exchange rate, which reduces imports, increases exports and thus pulls up demand.
    6. Reduction in direct taxes, which puts more money in the hands of households.
    7. Speculation in commodities market etc.
  • Cost-Push Inflation: Cost-push inflation happens when the demand for goods increases because the cost of production costs rises to the point where fewer goods can be produced. Some of the factors which influences Cost-Push Inflation are:
    1. Backward agricultural sector, which is not able to produce enough food.
    2. Inefficient storage, transportation and marketing infrastructure, which leads to wastage and reduction in supplies.
    3. Hoarding by traders of essential items, artificially reduces supply and causes inflation.
    4. Rise in the prices of crude oil, fertilizers etc.
    5. Rise in labour costs.
    6. Higher cost of imported materials.
    7. Higher cost of capital due to squeezing of credit by the Central Bank.
    8. Cartelisation by a few big suppliers to fix prices arbitrarily to make undue profits.
    9. Monopoly of a single supplier in the market, enabling him to set arbitrary prices.
    10. Pushing up of profits by the management of a company by increasing the prices also leads to inflation.

Effects of Inflation

  • Effects of inflation on different communities are different. Some of them gains while some loses. Effect of inflation on:
    1. Debtors and Creditors: Debtors borrow from creditors to repay with interest at some future date. Changes in the price level effect them differently at different time periods. During inflation when the prices rise (and the real value of money goes down), the debtors pay back less in real terms than what they had borrowed and thus, to that extent they are gainers. On the other hand, the creditors get less in terms of goods and services than what they had lent and lose to that extent.
    2. Investors: The effect of inflation on savers and investors is that they lose purchasing power. However, investors in equities benefit because more dividend is yielded on account of high profit made by joint-stock companies during inflation.
    3. Business community: During inflation this groups are in profit as the value of their inventories and stock of goods rises in money terms.
    4. Farmers: During inflation prices of agricultural produce increases and hence farmers usually gains during inflation.
    5. Government: In a mixed economy, the public sector is affected by fluctuations in price level. As prices rise, the Government has to spend more on goods and services, including raw materials, for carrying through their projects. Estimates are revised and taxes are raised.
    6. The entrepreneurs: Entrepreneurs stand to gain more than wage earners or fixed income groups. Speculators, hoarders, black marketers and smugglers gain on account of wind fall profits. Changes in the value of money also result in the redistribution of wealth, partly because during inflation there is no uniform rise in prices and partly because debts are expressed in terms of money. Inflation is a kind of hidden tax, highly harmful to the poorer sections of society. Thus, poor become poorer.
    7. Middle class and salaried persons: The hardest hit are the persons who receive fixed incomes, usually called the middle chss. Persons who live on past savings, fixed interest or rent, pensions, salaries, etc., suffer during periods of rising prices as their incomes remain fixed.
    8. Wage earners: Wage earners generally suffer during inflation, despite the fact that they obtain a wage rise to counter the rise in the cost of living. However, wages do not rise as much as the rise in prices of those commodities which the workers consume.
    9. Public morale: Inflation results in arbitrary redistribution of wealth favouring businessmen and debtors, and hurting consumers, creditors, petty shopkeepers, small investors and fixed income earners. This lowers the public morale. The ethical standards and the public morale fall to miserably low levels during the period of hyper-inflation.

Measures of Inflation

  • There are two main set of inflation indices for measuring price level changes in India –
    1. Wholesale Price Index (WPI) and
    2. The Consumer Price Index (CPI)

Wholesale Price Index (WPI)

  • Wholesale Price Index (WPI) is a price index which represents the wholesale price of a basket of goods over time. Fiscal and monetary policy changes are greatly influenced by changes in WPI. The wholesale price index (WPI) is based on the wholesale price of a few relevant commodities of over 240 commodities available. The commodities chosen for the calculation are based on their importance in the region and the point of time the WPI is employed. In preparing the Wholesale Price Index, higher weightage is accorded to the manufacturing products than the others. Precisely, 65 % weightage is accorded to manufactured products, 20 % to primary articles and 15 % to fuel and lubricants.
  • Since 2009, WPI has been computed on a monthly basis, similar to other price indices. The Reserve Bank of India (RBI) primarily used WPI inflation for the formulation of monetary policy under monetary targeting framework as well as under multiple indicator approach (MIA)— although inflation measured by other indices was also monitored/ analysed.
  • Urjit Patel Committee recommendations, the RBI Act has been amended and flexible inflation targeting (FIT) has been put in place with CPI inflation as the nominal anchor.
  • Under the FIT, as the RBI has been mandated to achieve price stability measured in terms of CPI inflation, the use of WPI inflation has been completely done away with. All projections relating to inflation are currently done in terms of CPI. As of now, WPI is predominantly used for converting GDP/GVA at current prices to the same at constant prices. 
  • The Government periodically reviews and revises the base year of the macroeconomic indicators as a regular exercise to capture structural changes in the economy and improve the quality,  coverage, and representativeness of the indices.    In  this direction, the base year  of All-India  WPI has been revised  from  2004-05  to   2011-12 by the  Office of  Economic  Advisor (OEA),  Department of Industrial Policy and Promotion,  Ministry of Commerce and Industry to  align it with the base year of other  macroeconomic indicators  like  the  Gross Domestic Product (GDP) and  Index of Industrial Production (IIP).

New WPI computation

  • While the base year of the current GDP series is 2011-12, the base year for the WPI series has till recently been 2004-05. Since April 2017, this anomaly has been overcome following revision in the base year of WPI from 2004-05 to 2011-12 to align it with the base year of other macroeconomic indicators. The new base 2011-12 is already five years old. The next revision of base year is being discussed. In this context, a general suggestion would be to switch over to the chain-based method.
  • One of the striking features of the new WPI series is that the item level averaging is being done by using geometric mean, instead of the arithmetic mean used earlier. This is as per international best practice and similar to the practice adopted for the CPI.
  • To remove the influence of fiscal policy, indirect taxes have been excluded from the quotations used to compute new WPI. This will make the new WPI conceptually closer to the producers’ price index. Exclusion of excise duty from the computation of WPI has also partly contributed to lower WPI inflation during recent years, which in turn has pushed real GDP up to some extent.
  • TheWholesale Price Index (WPI) series in India has undergone six revisions in 1952-53, 1961-62, 1970-71, 1981-82, 1993-94 and 2004-05 so far. The current series is the seventh revision. 
  • Inthe revised series, WPI will continue to constitute three Major Groups namely  Primary  Articles, Fuel & Power and Manufactured  Products. Highlights  of  the  changes  introduced in the  new series are summarized below:
  • Increase in a number of items from  676 to  697.   In all 199 new items have been added and  146  old items have been dropped.
  • The new series is more representative with an increase in number of quotations from 5482  to 8331, an increase by 2849 quotations (52%).

Measures to check inflation

  • The various measures to check inflation can be studied under heads –
    1. Monetary measures.
    2. Fiscal measures.
  • Monetary measures: These measures come under the purview of Reserve Bank of India. These measures are used to check the supply of money and credit. They consist of:
    1. Quantitative measures: open market operations, statutory reserve requirements and bank rates
    2. Qualitative measures: margin requirements, moral suasion, etc.
  • Through the Monetary Policy review, RBI tries to control price rise and maintain economic growth and financial stability.

Fiscal Measures

  • Fiscal measures to control inflation include taxation, government expenditure and public borrowings.
  • With Fiscal Measures Government fights with supply constraint by reducing import duties to supply inflated materials from foreign countries to Indian market. Hence reducing demand pull inflation. The government can also take some protectionist measures such as banning the export of essential items such as pulses, cereals and oils to support the domestic consumption encourage imports by lowering duties on import items etc. In India, fiscal tools are often used to control inflation.

Philips Curve

  • Phillips curve is an economic concept that serves as the linchpin for central bankers across the world. Developed by New Zealand economist A.W.H. Phillips, it states that there is an inverse relationship between inflation and unemployment in any economy. Phillips studied price and employment data in the United Kingdom from 1861 to 1957 to arrive at this interesting conclusion.
  • The underlying logic behind the Phillips curve is that wages are inflexible, in a market economy, so unemployment is bound to shoot up whenever workers refuse to accept lower wages. Inflation, which increases nominal but not real wages, is assumed to trick workers into accepting a lower remuneration for their services; it is thus an indirect wage cut that helps prevent an increase in unemployment.
  • Central bank chiefs thus keep a very close eye on inflation and unemployment data of the overall economy to plan monetary policy accordingly. They try to maintain the level of unemployment at the non-accelerating inflation rate of unemployment, which is the unemployment rate at which inflation too is just under control.
  • Whenever inflation is too low and unemployment too high, central banks increase the money supply to encourage greater employment. When this causes inflation to shoot up too high, they reduce the money supply, which results in lower inflation but also slightly higher unemployment.

Role of RBI to curb inflation

  • Reserve Bank of India is armed with monetary policy with three objectives; Controlling inflation, encouraging growth and financial stability.
  • Monetary policy instruments to curb inflation consist of Repo-Rate, The Cash Reserve Ratio, SLR and some other occasional interventions, like Open Savings Bank Interest Rate policy.
  • RBI manages the exchange rates fluctuation to cope with the exchange rate sensitive inflation. When RBI wants to devalue the rupee they may intervene in the foreign exchange market by using rupee to buy up foreign currency or conversely, if they want to revalue the rupee, they may intervene by selling off foreign exchange reserves.

Some Definitions

  • Inflation: A sustained rise in general level of prices brought about by high rates of expansion in aggregate money supply.
  • Hyper or Galloping Inflation: An inflationary situation when prices rise every moment and there is no limit to the height to which the prices might rise.
  • Open Inflation: An inflationary situation when prices rise without any interruption.
  • Suppressed Inflation: Condition in which as a result of adoption of certain policies by the government, prices are prevented from rising.
  • Stagflation: It is an economic situation in which high inflation and economic stagnation or recession occur simultaneously and remain unchecked for a period of time. Stagflation was witnessed by developed countries in 1970s, when world oil prices rose dramatically. 
  • Deflation: Deflation is the reverse of inflation. It refers to a sustained decline in the price level of goods and services. It occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money. Japan suffered from deflation for almost a decade in 1990s.
  • Core Inflation: It is a measure of inflation that excludes the more volatile categories like food and energy prices. It reflects the inflation trend in an economy.

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