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Inflation

Study Material > Economics
  • 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 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:
    1. 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.
    2. Increase in public expenditure, especially by the government operating large fiscal deficits.
    3. Loose monetary policy of the Central Bank, which leads to low interest rates and thus higher consumption.
    4. Rapid GDP growth, which leads to more employment, higher wages and thus higher inflation.
    5. Increase in population.
    6. Depreciation of exchange rate, which reduces imports, increases exports and thus pulls up demand.
    7. Reduction in direct taxes, which puts more money in the hands of households.
    8. 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. 
  • In the 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 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 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 the 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: The 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.

Indian Currency System

  • Money is defined as anything that is generally accepted as payment for goods and services and repayment of debts. The main uses of money for us are as a medium of exchange, a unit of account, and a store of value.
  • Indian currency is called the Indian Rupee (INR) and the coins are called paise. One Rupee consists of 100 paise.
  • The word ‘rupee’ has been derived from the Sanskrit word rupyakam, meaning a silver coin. It owes its origin to rupiya, issued by Sher Shah Suri in 1540-45. Today, the Reserve Bank of India issues currency under the RBI Act 1934. 
  • During the rule of the slave dynasty, silver coins known as tanka and copper coins known as jital were introduced by Iltutmish.
  • Silver coin known as Rupiya were issued by Sher Shah Suri. It remained in use during the Mughal period, Maratha era and British India. 
  • Earliest paper rupees issued by Bank of Hindostan (1770– 1832), General Bank of Bengal and Bihar (1773–75), and Bengal Bank (1784–91). 
  • Earliest paper rupees issued by Bank of Hindostan (1770– 1832), General Bank of Bengal and Bihar (1773–75), and Bengal Bank (1784–91). 
  • The Reserve Bank of India was formally set up in 1935 and was empowered to issue Government of India notes.
  • The first paper currency issued by RBI was a 5 rupee note bearing King George VI’s portrait, in January 1938. The first banknote printed by independent India was a 1 rupee note.
  • On August 15, 1950, the new ‘anna system’ was introduced – the first coinage of the Republic of India. One rupee now consisted of 16 annas.
  • The 1955 Indian Coinage (Amendment) Act, which came into force on April 1, 1957, introduced a ‘decimal series’. The rupee was now divided into 100 paisa instead of 16 annas or 64 pice. The coins were initially called naye paise, meaning new paise, to distinguish them from the previous coins.
  • In order to aid the blind in the country, each coin had distinctly different shapes – the round 1 naya paisa, scalloped edge 2 naya paisa, the square 5 naya paisa, and the scalloped edge 10 naya paisa.
  • Our banknotes in the Mahatma Gandhi Series were introduced in 1996 and were issued in a phased manner in the denominations of Rs.5, Rs.10, Rs.20, Rs.50,Rs.100, Rs.500 and Rs.1000.
  • At present, our banknotes in India are issued in the denomination of Rs.10, Rs.20, Rs.50, Rs.100, Rs.500 and Rs.1000. These notes are called as banknotes as they are issued by the Reserve Bank of India. Our printing of notes in the denominations of Re.1, Rs. 2 and Rs.5 has been discontinued as these denominations have been coinised. However, such banknotes issued earlier are continued in circulation and continued to be legal tender for us.
  • The Reserve Bank can also issue banknotes in the denominations of five thousand rupees and ten thousand rupees, or any other denomination that the Central Government may specify. Though, there cannot be banknotes in denominations higher than ten thousand rupees in terms of the current provisions of the Reserve Bank of India of Act, 1934. Our coins can be issued up to the denomination of Rs.1000.
  • The language panel on the Indian rupee bank notes has 15 of the 22 national languages of India.
  • Coins are minted by the Government of India mints while the notes are printed by the Reserve Bank of India (RBI) and Government of India presses. We have four mints in India located at Kolkata, NOIDA, Mumbai and Hyderabad. Regarding note printing presses RBI has its Bharatiya Reserve Bank Note Mudran Private Limited (BRBNMPL) presses at Salboni in West Bengal which is about 200 kms from Kolkata and another one at Mysore in Karnatka. Government presses are located at Dewas in Madhya Pradesh and Nasik in Maharashtra.
  • The Reserve Bank derives its role in currency management from the Reserve Bank of India Act, 1934.The Reserve Bank manages currency in India. Our Government, on the advice of the Reserve Bank, decides on various denominations of banknotes to be issued. The Reserve Bank also co-ordinates with the Government in the designing of our banknotes, including the security features.
  • The responsibility for our coinage vests with the Government of India on the basis of the Coinage Act, 1906 as amended from time to time. The Government of India also attends to the designing and minting of our coins in various denominations.
  • The Government of India decides the quantity of our coins to be minted on the basis of indents received from the Reserve Bank.
  • The quantum of banknotes that needs to be printed, broadly depends on our requirement for meeting the demand for banknotes due to inflation, GDP growth, replacement of soiled banknotes and reserve stock requirements.
  • One rupee note are printed by Govt of India itself and signed by the Ministry of finance whereas other currencies are printed by Reserve Bank on behalf of Govt of India.

 Insurance in India

  • From ancient times insurance in various forms has been mentioned in the writings of Manu (Manusmrithi), Yagnavalkya(Dharmashastra) and Kautilya (Arthashastra). The fundamental basis of the historical reference to insurance in these ancient Indian texts is the same i.e. pooling of resources that could be re-distributed in times of calamities such as fire, floods, epidemics and famine. The early references to Insurance in these texts have reference to marine trade loans and carriers' contracts.
  • The history of Life Insurance Companies in India began with the establishment of Oriental Life Insurance Company in the year 1818 in Calcutta. 
  • The life insurance companies established during this period exclusively catered to the needs of the European community and Native Indian lives were not insured by these companies.
  • At the dawn of the twentieth century, many insurance companies were founded. The Swadeshi movement of 1905-1907 gave rise to many Indian insurance companies. The Indian Life Assurance Companies Act, 1912 was the first statutory measure to regulate the life insurance business.
  • Insurance in Indiarefers to the market for insurance in India which covers both the public and private sector organisations. It is listed in the Constitution of India in the Seventh Schedule as a Union List subject, meaning it can only be legislated by the Central government.
  • The insurance sector has gone through a number of phases by allowing private companies to solicit insurance and also allowing foreign direct investment. India allowed private companies in insurance sector in 2000, setting a limit on FDIto 26%, which was increased to 49% in 2014.
  • Insurance industry includes two sectors:
    1. Life Insurance and.
    2. General Insurance.
  • Insurance companies offer protection against losses. They deal in life insurance, marine insurance, vehicle insurance and so on.
  • The insurance companies collect the little savings of the investors and then reinvest those savings in the market.

Some major players in insurance sector are:

  1. Life Insurance Corporation of India (LIC)
  2. General Insurance Corporation (GIC)

Life Insurance Corporation of India (LIC)

  • Life Insurance Corporation of India(LIC) is an Indian state-owned insurance group and investment company headquartered in Mumbai. The Life Insurance Corporation of India was founded when the Parliament of India passed the Life Insurance of India Act on 19 jun 1956 that nationalised the private insurance industry in India. Over 245 insurance companies and provident societies were merged to create the state owned Life Insurance Corporation.
  • It is the largest insurance company in India. With eight zonal offices the most recent being at Patna.
  • LIC is also operating internationally through branch offices in Fiji, Mauritius and UK and through joint venture companies in Bahrain, Nepal, Sri – Lanka, Kenya and Saudi Arabia.
  • The LIC had monopoly till year 2000 when the Insurance sector was reopened to the private sector. Before that, the industry consisted of only two state insurers: Life Insurers (Life Insurance Corporation of India, LIC) and General Insurers (General Insurance Corporation of India, GIC). India allows private companies in insurance sector in 2000. Current FDI limit in Insurance sector is 49% under automatic route.
  • Slogan of LIC: LIC's slogan yogakshemam vahamyahais in Sanskrit language which translates in English as "Your welfare is our responsibility". This is derived from ancient Hindu text, the Bhagavad Gita’s 9th chapter, 22nd verse. The slogan can be seen in the logo, written in Devanagari script.
  • Objectives of LIC: The important objectives of LIC are as follows:
    1. To mobilise maximum savings of the people by making insured savings more attractive.
    2. To extend the sphere of life insurance and to cover every person eligible for insurance under insurance umbrella.
    3. To ensure economic use of resources collected from policy holders.

Function of LIC

  • The LIC subscribes to and underwrites the shares, bonds and debentures of several financial corporations and companies and grants term-loans.
  • It maintains a relationship with other financial institutions for coordination of its investment.
  • It is the single largest investor in the Country. It subscribes to the share capital of companies, both preference and equity and also to debentures and bonds.
  • It also extends assistance for development of infrastructure facilities like housing, rural electrification, water supply, sewerage, etc.
  • It extends resource support to other financial institutions such as IDBI, UTI, IFCI, etc. through subscription to their shares and bonds etc.

General Insurance Corporation (GIC)

  • The entire general insurance business in India was nationalised by General Insurance Business (Nationalisation) Act, 1972 (GIBNA).
  • The Government of India (GOI), through Nationalisation took over the shares of 55 Indian insurance companies and the undertakings of 52 insurers carrying on general insurance business.
  • It was incorporated on 22 November 1972 under the Companies Act, 1956 as a private company limited by shares.
  • GIC was formed for the purpose of superintending, controlling and carrying on the business of general insurance.
  • As soon as GIC was formed, GOI transferred all the shares it held of the general insurance companies to GIC.
  • In November 2000, GIC was renotified as the Indian Reinsurer
  • GIC had four subsidiary companies:-
    1. Oriental Insurance Company Limited
    2. New India Assurance Company Limited
    3. National Insurance Company Limited and 
    4. United India Insurance Company
  • With effect from December 2000, these subsidiaries have been de-linked from the parent company and were set up as independent insurance companies.
  • The ownership of the four erstwhile subsidiary companies and also of the General Insurance Corporation of India was vested with Government of India.
  • GIC Re is a wholly owned company of Government of India.

Insurance Regulatory and Development Authority of India (IRDAI)

  • The Insurance Regulatory and Development Authority of India(IRDAI) is an autonomous, statutory agency tasked with regulating and promoting the insurance and re-insurance industries in India.  
  • It was constituted by the Insurance Regulatory and Development Authority Act, 1999, by the Government of India for two significant reasons to safeguard the interest of the policy holders and for the upgradation of the entire insurance sector right from the approach adopted by the existing insurance companies towards their shareholders to the eradication of the shortcomings of the industry.
  • The agency's headquarters are in Hyderabad, Telangana, where it moved from Delhi in 2001.
  • IRDAI is a 10-member body including the chairman, five full-time and four part-time members appointed by the government of India.

Functions of IRDAI

  • It can issue, renew, modified, withdrawal, suspend or cancel registration of an insurance company in India.
  • It protects policyholder interests.
  • Promoting and regulating professional organisations connected with the insurance and reinsurance industry.
  • Promoting efficiency in the conduct of insurance business.
  • Levying fees and other charges for carrying out the purposes of this act.

Pension system

  • The National Pension System (NPS) was launched on 1st January, 2004 with the objective of providing retirement income to all the citizens. NPS aims to institute pension reforms and to inculcate the habit of saving for retirement amongst the citizens.
  • Initially, NPS was introduced for the new government recruits (except armed forces). With effect from 1st May, 2009, NPS has been provided for all citizens of the country including the unorganised sector workers on voluntary basis.
  • Additionally, to encourage people from the unorganised sector to voluntarily save for their retirement the Central Government launched a co-contributory pension scheme, 'Swavalamban Scheme’ in the Union Budget of 2010-11.
  • NPS offers following important feature to help subscriber save for retirement:
    1. The subscriber will be allotted a unique Permanent Retirement Account Number (PRAN). This unique account number will remain the same for the rest of subscriber's life. This unique PRAN can be used from any location in India.
  • PRANwill provide access to two personal accounts:
    1. Tier I Account: This is a non-withdrawable account meant for savings for retirement.
    2. Tier II Account: This is simply a voluntary savings facility. The subscriber is free to withdraw savings from this account whenever the subscriber wishes. No tax benefit is available on this account.

Swavalamban Scheme

  • Under Swavalamban Scheme the government will contribute a sum of 1,000 to each eligible NPSsubscriber who contributes a minimum of Rs.1,000 and maximum Rs.12,000 per annum. This scheme is presently applicable upto F.Y.2016-17.

Pension Fund Regulatory & Development Authority (PFRDA)

  • The Pension Fund Regulatory & Development Authority Act was passed on 19th September, 2013 and the same was notified on 1st February, 2014. PFRDA is regulating NPS, subscribed by employees of Government of India, State Governments and by employees of private institutions/organizations & unorganized sectors. The PFRDA is ensuring the orderly growth and development of pension market.
  • The Government of India had, in the year 1999, commissioned a national project titled “OASIS” (an acronym for old age social & income security) to examine policy related to old age income security in India. Based on the recommendations of the OASIS report, Government of India introduced a new Defined Contribution Pension System for the new entrants to Central/State Government service, except to Armed Forces, replacing the existing system of Defined Benefit Pension System.
  • On 23rd August, 2003, Interim Pension Fund Regulatory & Development Authority (PFRDA) was established through a resolution by the Government of India to promote, develop and regulate pension sector in India.  
  • The contributory pension system was notified by the Government of India on 22nd December, 2003, now named the National Pension System (NPS) with effect from the 1st January, 2004. The NPS was subsequently extended to all citizens of the country w.e.f. 1st May, 2009 including self employed professionals and others in the unorganized sector on a voluntary basis.
  • The National Securities Depositories Limited (NSDL) has been appointed as the Central Record Keeping Agency for the NPS.
  • The PFRDA appointed the GN Bajpai Committee to review the implementation of Informal Sector Pension in August, 2010.

 


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