Inflation

By: Ashwin Thenappan.P Sakshi Dhawan

Inflation

Inflation is defined as a sustained increase in the general level of prices for goods and services . Subsequently Purchasing power is falling

Causes
Demand pull inflation Cost-push inflation(Supply shock -scarcity) Built-in inflation Printing more rupees Costly imports Insufficient rainfall

Effects of Inflation
Real rate of return becomes low Decline in growth Unemployment Domestic currency depreciates Spending less Hyperinflation Hoarding

Inflation Measurement
Inflation is the rate of change in prices, and the price level is the cumulative of past inflation. In an economy, the rate of inflation is measured by the percentage change in the Price Index. The average price movement for a fixed basket of goods and services over a period of time is referred to as the Price Index. Prices may be measured at the retail or wholesale level and the respective indexes are Consumer Price Index(CPI), Wholesale Price Index (WPI)

Consumer Price Index

The Consumer Price Index (CPI) is a weighted price index which measures the monthly change in the prices of goods and services.

CPI: An Example
Category
Food Alcohol & Tobacco Clothing Transport Housing Leisure Services

Price Index
104 110 96 108 106 102

Weighting
19 5 12 14 23 9

Price x Weight
1976 550 1152 1512 2438 918

Household Goods
Other Items

95
114

10
8 100

950
912 10408

 Weights are attached to each category and then these weights are multiplied to the price index for each item of spending for a given year. The price index for this year is: the sum of (price x weight) / sum of the weights So the price index for this year is 104.1 The rate of inflation is the % change in the price index from one year to another. So if in one year the price index is 104.1 and a year later the price index has risen to 112.5, then the annual rate of inflation = (112.5 104.1) divided by 104.1 x 100. Thus the rate of inflation = 8.07%

Wholesale Price Index

An index that measures and tracks the changes in price of goods in the stages before the retail level. Wholesale price indexes (WPIs) report monthly to show the average price changes of goods sold in bulk, and they are a group of the indicators that follow growth in the economy.

Steps involved in the compilation of WPI: 1. Finalization of base Year 2. Finalization of item Basket 3. Finalizing Classification Structure 4. Allocation of weights at majorgroups/groups/sub-group and item level 5. Finalization of item specification and Sources of collecting data for price 6. Collection of Price 7. Calculation of Index

Control Measures
There are broadly two ways of controlling inflation in an economy: 1. Monetary measures 2. Fiscal measures

Monetary Measures
The most important and commonly used method to control inflation is the Monetary Policy of the Central Bank. Most central banks use high interest rates as the traditional way to fight or prevent inflation. Monetary measures used to control inflation include:
i. bank rate policy ii. cash reserve ratio and iii. open market operations.

Fiscal Measures
Fiscal measures to control inflation include taxation, government expenditure and public borrowings. 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.).

Inflation and Interest Rates

Contrary to popular belief, excessive economic growth can very detrimental At one extreme, an economy that is growing too fast can experience hyperinflation At the other extreme, an economy with no inflation has essentially stagnated The right level of economic growth, and thus inflation, is somewhere in the middle

 It's the governments job to maintain that delicate balance An increase in interest rates, attempts to head off future inflation. A decrease in interest rates aims to spur on economic growth. While inflation is a major issue, it is not the only factor informing the governments decisions on interest rates. For example, the government might ease interest rates during a financial crisis to provide liquidity financial markets, thus preventing a market meltdown

Inflation and Unemployment

There is an inverse relation between rate of inflation and the rate of unemployment in an economy. The more the entrepreneur extends the employment opportunity the more he has to pay to that particular factor of production and the more payment to factor of production the increase in the cost of producing a unit will be observed and in order to maintain the profitability of the product the entrepreneur will inflate the price of that product.