Chapter 07 - Inflation

Prelims Syllabus

Introduction
PYQP Sample

Inflation
1. Inflation Refers to a General and Persistent Increase in Prices of Goods and Services
  
  Inflation should be Broad Based - Meaning Prices of Most of the Goods and Services should increase, not few !
  
  Increase in price of a few commodity like Onion or Potato cannot be considered as Inflation
  
  Persistent - On Continuous Basis it should Increase
2. Inflation is Measured in Terms of Percentage
  
  For India it should be (4% +_ 2)
Point to Point Inflation
1. Point to Point Inflation is also called as Year on Year Inflation
2. Inflation is 4% wrt the Price of Commodity → in the Corresponding Month of Previous Year
Types of Inflation (Based on Rates)
- Creeping Inflation ( Low to Moderate ROF )
  
  For India its 2 to 4
- Trotting Inflation (Not Moderate = Higher)
  
  For India - 5 to 10
- Galloping Inflation (Highest)
  
  For India 10 to 20
- Hyperinflation (Uncontrollable)
  
  Greater than 20%
  
  Examples
  - Historical Germany
    
    Had Hyper Inflation After World War 1 Treaty of Versailles
  - Zimbabwe
    1. Annual Rate of Inflation - 8 Lac Crores
    2. Daily Rate of Inflation - 100%
    3. A Loaf of Bread Costed - 55 Million USD
  - Iran
    1. Iran was put under Economic Sanctions by US
    2. Iran wasn't allowed to export crude oil to other countries
    3. Hence, Dollar Inflow Into Iran Reduced - Thus the Iranian Currency got Reduced
    4. Depreciated Due to → 1 $ = 41,000 Riyal
    5. Imports into Iran Became Costly
    6. Example: 1 Loaf of Bread was around 40,000 Riyal
    7. What Did Iranian Central Bank → Issued a New Currency called Toman
      
      Where 1 Toman = 40,000 Riyal
      
      This Measure was Temporary
      
      This is called as Redenomination
WPI & CPI

Inflation at Wholesale Level - WPI

Inflation at Consumer Level - CPI

PS: There is Generally Divergence Between WPI & CPI ; but in theory they should go up and down together

Terms Related to Inflation

💡 Inflation, Deflation, Disinflation, Reflation
1. A High Rate of Inflation and Zero Rate of Inflation are Equally Bad
2. Ideal Rate of Inflation for India is 4%
3. Current Rate of Inflation in India is : CPI 5.72%
Base Effect
1. Comparison wrt to Base or a Reference may distort the Reality is called Base Effect
2. Rate of Inflation = (Current Year Prices - Previous Year Prices) / Previous Year Prices
3. Here Previous Year Prices is the Base Year
4. as PYP is in Denominator →
  1. If PYP is High - Rate of Inflation would be Lower → This is called as High Base Effect
  2. if PYP is Low - Rate of Inflation would be Higher → This is called as Low Base Effect
5. Example
Phillips Curve
1. Phillips Curve Shows Relationship Between Inflation & Unemployment Rate
2. Before 1970’s - According to Phillips Curve
  
  This will fail in Hyper Inflation. It is Possible only in Short Term.
  
  Long Term Curve Says - In Any Country Unemployment is Independent from Rate of Inflation
  
  No Matter How Low or High Rate of Inflation in a Country is - There will always be some unemployment → Hence it is called as Natural Rate of Unemployment
3. Natural Rate of Unemployment
  1. Structural Unemployment: Form of Unemployment due to miss match between skill set of person and demand of Job
    
    When Skill Set is Lower than Demand of the Job
    
    Example: in 1990’s People were expert in typewriters, after introduction of computer, demand of job increased, people not knowing computer but knew how to typewrite
    
    Example: Due to Machines, people in car manufacturing industry may be reduced
    
    Example: Tesla Replacing Driver
    
    Example: IT Engineers that don't have new Skills
  2. Under Employment: Skill Set is Higher than Demand of the Job
    
    Example: Engineer employed in BPO Sector
  3. Frictional Unemployment : A Temporary Form of Unemployment, when a person is switching Job, Hence he is Unemployed for a Particular Time Period
Stagflation
1. Stagflation is combination of Stagnation & Inflation
2. It Means
  1. GDP is Going Down
  2. Inflation is High
  3. Unemployment is High
Inflation Tax
1. It is a Penalty and it is nowhere related to Taxation System
2. It is a Kind of Penalty which people face due to holding of cash, during inflation
  
  Holding of Cash, Leads to Decrease in Purchasing Power of Rupee
  
  Hence, this Decreased Purchasing Power is called as Tax or rather Inflation Tax
3. Due to Inflation Tax, Investments in Speculative Investment Increases
Shoe Leather Cost
Menu Cost

Inconvenience caused to the Manufacturers in changing prices !!
Skewflation & Shrinkflation
1. Skewflation: Prices of Only Few Commodities Increase
2. Shrinkflation: Reducing the Quantity being Given to the Customer

Causes of Inflation
1. It is caused due to Demand Supply Mismatch
2. Price could increase due to - Two Independent Reasons
  1. Demand for Apple Increases → Demand Pull Inflation
  2. Supply of Apple Decreases → Supply Side Inflation / Cost Push Inflation
  3. If Demand Increased & Supply Decreased → Look Which one is the Dominant Factor
    
    Hence, If Demand Increases by 20% or Supply Reduces by 10% - It will be called as Demand Pull Inflation
    
    Also, If Demand Increases by 10% or Supply Reduces by 20% - It will be called as Cost Push Inflation
3. Factors that can lead to Increase in Demand in Indian Economy
  1. Lower RoI → Injected Money in Indian Economy by RBI → Recession Based Injection
  2. A Condition where a Demand of a Commodity Increases because of Its Need
  3. Price of Commodity may increase in Future
  4. Increase in Number of Consumer or Increase in Population
  5. Borrows More Money → Higher Fiscal Deficit → Money Circulation in Economy Increases
  6. Increased Salary of People
4. What Happens when Export Increases - Is it Demand Side or Supply Side Inflation ?
  
  It will lead to Demand Pull Inflation in India
  
  It will lead to Cost Push Inflation as well, where the Supply in India will decrease
  
  In UPSC Mark it as: Demand Pull Inflation
5. Aggregate Demand
  1. PFCE → Private Final Consumption Expenditure
  2. GFCE → Government Final Consumption Expenditure
  3. GCF → Over All Investment in an Economy
  4. Net Exports → Total Exports from India - Total Imports into India
  Since Export is Part of Aggregate Demand in an Economy, According to Keynes it's a part of Demand Pull Inflation
Inflation Index Wages

CPI AL - Consumer Price Index - Agriculture Labour

Demand Only Increases with Surplus Money. Hence in case of Inflation Index Wages there is increase in the Income but it is not surplus as the prices of Goods & Services have increased by the Same Margin

Now, When Labour Cost is Increasing → Cost Push Inflation
Factors Contributing to Inflation - Demand Side / Supply Side

Demand Side and Supply Side Factors
1. Higher GDP - High Income Level - More Surplus - More Demand
2. Protein Based Inflation
  
  Farmers Generally Produce - rice & wheat
  
  but due to increase in Per Capita Income - People want more Protein Based Food
3. Types of Fiscal and Monetary Policy
  
  Fiscal Policy is the Policy of Government that deals with
  1. How Much Tax Should it collect - Income
  2. How Much Should it spend - Expense
4. Fiscal and Monetary Policy
5. List of Factors
  
  Like in Exports → increase in MSP can lead to Demand Pull & Cost Push Inflation
6. Dekhna Kaise Hai ki Kaun Sa Inflation Hua Hai
  1. Demand Pull Inflation
    1. Uska Demand Badha Hai
    2. Generally Due to Surplus Money or Increased Money Supply
  2. Cost Push Inflation / Supply Side Inflation →
    1. Dekho ki Yaa toh Supply Decrease Hui
    2. Ya toh uska Price Badha Hai
Structural Inflation
1. It occurs due to certain structural deficiency of the economy. this deficiency can be due to both or either of demand or supply side
2. For Example Structural Deficiency in Indian Agri is
  1. Protein Based Inflation
  2. Rain Fed Agriculture (52% Dependence)
  3. Poor Storage Infra - Like Godowns & Poor Infra
  4. Fragmented Land Holdings - 86% Small & Marginal Farmers
3. Some Common Structural Deficiencies in an Economy
  1. Dominance of Monopolistic Companies in an Economy
  2. Poor Logistics
  3. Lack of Adequate Forex Reserve
    
    Example: Pakistan, Bangladesh & Sri Lanka
  4. Problem wrt Public Finance
    
    Poor & Developing Companies - Revenue Lower & Expenditure Higher → Increased Government Borrowing → Higher Fiscal Deficit → Borrow More → More Money in Economy Injected by Govt → Creates Conducive Env for Pvt Sectors and Other Investments → Thus Increasing the Crowding Effect
  5. Lack of Natural Resources
  6. Lack of Human Capital or Old Human Capital
Inflationary & Deflationary Gap

💡 **Supply** Pe Control Nahi Hota Hai → Isliye **Demand** pe Control Karte Hain
Hence, We Can't Increase the Aggregate Supply
Measurement of Inflation in India
- Basket of Commodities
  1. Inflation is always measured in a Basket of Commodities
  2. This Basket of Commodity is fixed by the Entity which is Publishing this Index
    1. WPI - Office of Economic Advisor, Ministry of Commerce & Industry → 697 Commodities
    2. CPI - National Statistics Office, Under Ministry of Statistics → 299 Commodities
- Weightage
  1. Commodities which have recurring demand have more weightage in calculation
  2. As Compared to Refrigerator and Apple. Apple has more weightage as it has more recurring demand
  3. All the Weightages are assigned as such that it is total to 100
- Base Year
  1. The Year in Which Prices of Commodity were Relatively Stable like in 2012 for WPI
  2. Prior to 2012, the Base Year was 2004-05
  3. The Frequency at which it changes is decided by the agency which publishes it
  4. No Fixed Limit of time for change
- Laspeyres Formula → Relative Price & Rate of Inflation → For Both WPI & CPI
  1. Formula: Relative Price = Current Year Prices / Base Year Prices
    
    Rate of Inflation
    
    Rate of Inflation = { (RP of Current Year - RP of Previous Year) / RP of Previous Year }* 100
  2. For Base Year 2012
    
    Relative Price for Base Year will be 1
    
    Relative Price * Weight = 1 * 100 = 100
  3. For Year 2013
    
    Relative Price = Current Year Price (Rs 110) / Base Year Price (Rs 100) = 1.1
    
    Relative Price * Weight = 1.1 * 100 = 110
    
    Here Inflation is → 110 - 100 * 100 = 10
  4. For Year 2014
    
    Relative Price = Current Year Price (Rs 121) / Base Year Price (Rs 100) = 1.21
    
    Relative Price * Weight = 1.21 * 100 = 121
    
    Here Inflation is → 121 - 110 * 100 = 10
  5. Important Note
  💡 Relative Price is Measured wrt Base Year Rate of Inflation is Measured wrt the Previous Year

Types of Measurement of Inflation - PPI, WPI, CPI
- PPI
  
  Paid By : Change in cost of Raw Material for a Producer : Input PPI
  
  Received By : Change in Selling Price for Producer : Output PPI
  
  Chand Committee : Transition from WPI to PPI
  
  Indirect Taxes : Example is GST
  
  Service is Always at Retail Level and Not at Wholesale Level, Isliye WPI main Included Nahin Hai Services
- WPI - By Economic Adviser in the Ministry of Commerce and Industry
  
  Pros
  1. Comprehensive as it has 697 Items
  2. No Indirect Tax Included
  Cons
  1. Does Not Cover Service - Service is 55% of GDP
  2. Leads to Double Accounting → Product counted as a Primary Item (Orange) is also included in Manufactured Product (Orange Juice)
- CPI - By The National Statistical Office (NSO), Ministry of Statistics and Programme Implementation (MoSPI)
  
  It is Targeted by RBI
Difference Between WPI & PPI
Understanding WPI - 697 Commodities
1. Published by Office of Economic Advisor from Ministry of Commerce & Industry on Monthly Basis
2. WPI is Pub wrt to month of Previous Year
3. Components of WPI
  1. Primary Food Articles - Grains
  2. Primary Non Food Article
    1. Raw Materials for Industry
    2. Crude Petroleum and Natural Gas
  3. Manufactured
    1. Man Food Prod
    2. Man Non Food Prod
  4. Fuel & Power
    1. Petrol Diesel Electricity
Understanding CPI - 299 Commodities

Miscellaneous: Service Like Education, Health, Telecommunication, Transportation ( Including Petrol Diesel)

Note : Fuel and Light Does Not have Petrol and Diesel
Difference Between WPI & CPI

Inflation Expectation is controlled not the Inflation Per Say
CFPI - Consumer Food Price Index

Covers 10 Commodities Table of Food & beverage - 2 Commodities = Table of CFPI

Types of Inflation - Headline, Core, Refined Core

ONLY FOOD & FUEL is considered to be VOLATILE
1. Headline Inflation
  1. WPI : All 697 Commodities
  2. CPI : All 299 Commodities
  3. If not Said anything, only Headline then CPI
2. Core Inflation
  1. Excludes Volatile Commodities like Food and Fuel
  2. WPI - Food & Fuel → WPI Core Inflation
  3. CPI - Food & Fuel → CPI Core Inflation
  4. Suggestions on Core Inflation should be Targeted by RBI
  5. Here Miscellaneous Categories is Included
3. Refined Core Inflation
  1. Further Removes Component of Petrol and Diesel from Miscellaneous
Other Varieties of CPI
1. CPI AL: Agricultural Labour - NREGA is Linked
  
  Mahendra Dev Verman Committee Suggested that MGNREGA Should be Linked to CPI RL Rather than CPI AL
2. CPI RL: Rural Labour
3. CPI IW: Industrial Workers → Linked to Inflation INdex Wages → Mehangai Bhatta
4. CPI Rural: Does not take into account changes in rental prices of housing - as in rural people own houses and don't rent
5. CPI Urban: Inflation in Urban Areas
6. CPI Combined: Average of CPI Rural and Urban
Other Types of Indexes
- FAO - Food Price Index
  
  International Level → Published by FAO - Food and Agricultural Organisation
- Housing Price INdex - By RBI
- RESIDEX - by NHB

Understanding Variation in CPI

60% of Edible Oil & 99% of Palm Oil is Imported
Understanding Variation in WPI
Divergence Between CPI & WPI
1. Weightage of food in WPI and CPI
  1. in WPI - 24%
  2. in CPI - 45%
2. Weightage of Manufactured in WPI and CPI
  1. in WPI - 55%
  2. in CPI - Lower than WPI

Concept of GDP Deflator
1. Nominal GDP and Real GDP
  1. Nominal GDP - GDP at Current Market Prices
  2. Real GDP - GDP at Base Year Price or Constant Prices
2. Concept of GDP Deflator
3. Issue with GDP Deflator
  1. WPI CPI is Every Month where as GDP Deflator is calculated Quarterly
  2. There is No Explicit Weightage - Because Qty is Removed
  3. Imports are NOT Included
Difference between CPI & GDP Deflator

Effect of Inflation Summary
Effect of Inflation on Exports and Imports

Inflation Increases & Rupee Value Depreciates

In Imports and Exports we take into consideration Immediate Effect of Inflation
Effect of Inflation on Bonds
Effect of Inflation on Creditor and Debtor
1. Creditor - Jo Paisa Deta Hai - Nuksan
2. Debtor - Jo Paise Leta Hai / Jisne Debt Liya Hai - Fayda - Pays Less in terms of Real Value
3. Paisa Same aa raha hai, par paise ka purchasing capacity kam ho gaya hai

Concept of Bracket Creep and Fiscal Drag
- Progressive Tax Slabs
1. Increase in Wages → Inflation Indexed Wages
2. Increased Income Level Does Not Impact Purchasing Power
3. Bracket Creep - Shifting of People from Low Tax Bracket to High Tax Bracket
4. Fiscal Drag - When an Increase in Tax Collection by Govt, People have less money to Spend and hence there is a Reduced Demand, Decreased Inflations and Hampers GDP Growth Rate is called Fiscal Drag
5. Bracket Creep and Fiscal Drag are Long Term Phenomenon of 2 to 3 Years Normally
Measures to Check Volatility in Prices
1. PSF
  1. by Consumer Affairs Ministry
  2. Control Prices of Onion, Potato and Pulses
  3. SFAC - Small Farmers Agri Business Consortium
  4. E-NAM - National Agricultural Market
  5. During Bumper Production - SFAC Procures and Creates Buffer - During Increased Price, It releases the Buffer to Control the Price
2. MIS
  1. MSP - Minimum Support Price is for 23 Items
  2. By Ministry of Consumer Affairs
  3. FCI - Food Corporation of India
  4. MIS Covers Horticultures and Perishable Commodities like Fruits and Vegetables
  5. MIS is implemented only in the request of State Govt where as MSP is implemented every year
  6. Loss Faced by MIS Implementation is Equally Shared between Centre and State
3. Operation Greens
  1. Covers TOP Products - Tomato, Onion & Potato
  2. Implemented by Ministry of Food Processing Industry
  3. Govt has gone from TOP to TOTAL
Measures to Check Inflations
1. To Check Inflation we need to
  
  Reduce the Demand→ By Govt → Tax Increase and Reduce Exp
  
  Increase the Supply → By RBI → Policy Rates
2. Futures Trading in (Trading of Agri Commodities)
Cobweb Phenomenon in Pulses

Inflationary Momentum

Continuos Increase of Inflation in a momentum is called Inflationary Momentum
Inflationary Premium

Increase Rate of Interest on Loans due to Increase Inflation is called Inflation Premium