Inflation

Inflation,-Fiscal and Monetary Policies.Dr. Seema SinghPhase of Inflation Beyond a level of full employment, increase in demand or rise in investment may lead to increased pressure on resources. Distort cost calculation, leads to inflation.

Measurement of Inflation Wholesale Price Index (WPI) Consumer Price Index (CPI)

Measurement of Inflation Wholesale Price Index (WPI) : This index is the most widely used inflation indicator in India. This is published by the Office of Economic Adviser, Ministry of Commerce and Industry. WPI captures price movements in a most comprehensive way. Important monetary and fiscal policy changes are linked to WPI movements. It is in use since 1939 and is being published since 1947 regularly.

Whole sale Price IndexWe are well aware that with the changing times, the economies too undergo structural changes. Thus, there is a need for revisiting such indices from time to time and new set of articles / commodities are required to be included based on current economic scenarios. Thus, since 1939, the base year of WPI has been revised on number of occasions. The current series of Wholesale Price Index has 2004-05 as the base year. Latest revision of WPI has been done by shifting base year from 1993-94 to 2004-05 on the recommendations of the Working Group set up with Prof Abhijit Sen,, Member, Planning Commission as Chairman for revision of WPI series. This new series with base year 2004-05 has been launched on 14th September, 2010.

Limitation of Whole sale Price IndexThe important limitations relate to non-inclusion of services following a fixed weighting scheme while the economy is undergoing major structural changes, and use of gross transactions data rather than data on final purchases.

A brief on the historical development of this WPI is given below : -

Base yearYear of IntroductionNo of Items in IndexNo of Price QuotationsWeek ended 19th August 193919422323End August 19391947782151952-53 (1948-49 as weight base)19521125551961-62July 19691397741970-71January 197735012951981-82July 198944723711993-94April 200043519182004-05September 20106765482Consumer Price IndexThe CPI measures price change from the perspective of the retail buyer. It reflects the actual inflation that is borne by the individual. CPI is designed to measure changes over time in the level of retail prices of selected goods and services on which consumers of a defined group spend their incomes. Till January 2012, in India there were only following four CPIs compiled and released on national level. (In some countries like UK, Malaysia, Poland it is also known as Retail Price Index). That was (1) Industrial Workers (IW) (base 2001), (2) Agricultural Labourer (AL) (base 1986-87) , (3) Rural (RL) (base 1986-87) (4) Urban Non-Manual Employees (UNME) (base 1984-85). However, a new series has started from 2012 which compile, CPI (rural); CPI (Urban) and CPI (Rural+ Urban).

Classification of Inflation-I Demand Pull InflationDecrease in Interest rate an increase in the investment in the economyan increase in money of the factors of production increase in the expenditure on consumption goods will lead to demand inflation. Cost Push InflationAn increase in wage, An increase in profit margin, and imposition of heavy commodity taxes.

Classification of Inflation-II.a (on the basis of rate of interest) Creeping Inflation- prices increases up to 3% without increase in supply. Walking Inflation is between 03% to 09% per annum. Prof. Samuelson has clubbed them together as moderate inflation. In fact one digit inflation in considered good for a developing country.

Classification of Inflation-II.b (on the basis of rate of return) 10-20% /annum is referred as running inflation If it exceeds that figure, may be described as galloping inflation Hyper inflation is difficult to measure but in quantitative terms, rate of price rise is above 1000% per annum.

Worldwide Experience of InflationIndian economy has experienced some spate of running and galloping inflation (not exceeding 25%) since second five year plan. Argentina, Brazil and Israel has experience inflation over 100% during eighties.Impact of galloping inflation is disastrous but even running inflation has very serious implication.Hungry in the year 1996 and Zimbabwe during 2004-09 has experienced Hyper inflation.Value of national currency reduces almost to zero.

Deflation-I Deflation is a situation where there is decrease in the general price level of goods and services. During deflation, the inflationary rate falls below 0% (a negative inflation rate) while real value of money increases. There may be fall in aggregate level of demand so, consumers delay purchases until prices fall further leads to increase in idle capacity, unemployment, and lower disposable income. Further, it may lead to recession and lead to deflationary spiral.

Difference between Inflation and DeflationInflation is rise in prices. Inflation distorts the distribution of income between different group of people in the country in a way that rich gain at the expense of the poor; but it does not reduce the real income of the society.Deflation reduces national income through contraction of production and increases unemployment. Each segment of the society is adversely affected.In he last five decades, there is hardly any country which has passed through a period of persistent fall in the general level of prices.Stagflation-I A situation in which stagnant economy is coupled with rising prices. Both stagflation and inflation can result from inappropriate macroeconomic policies. For example, central bank can cause inflation by permitting excessive growth of the money supply and the government can cause stagflation by excessive regulation in good and labour market.

Stagflation-II Excessive growth of money supply taken to such an extreme that it must be reversed abruptly can clearly be a cause. Both types of explanations was discussed for the global stagflation of the 1970s. It began with a huge rise in oil prices, but then continued as central banks used excessively stimulating monetary policy to counteract the resulting recession, causing a runaway price/ wage spiral.

Monetary PolicyRepo rate is a rate at which banks borrow from RBI for short periods up to 7 or 14 days but predominantly overnight. RBI manages this repo rate which is the cost of credit for the bank. This becomes a floor below which the short-term interest rates dont go. Higher the repo rate means the cost of short-term money is very high. Lower the repo rate means the cost of short-term rate is low which means at higher repo rates the economy growth may slowdown whereas at lower repo rate economy growth may get enhanced.Fiscal PolicyReduction in Unnecessary Expenditure or Unproductive expenditure should be curtail by the GovernmentFurther, to bring more revenue into the tax-net, the government should penalise the tax evaders by imposing heavy fines. To increase the supply of goods within the country, the government should reduce import duties and increase export duties.

Control of InflationMonetary PolicyReverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country.Fiscal PolicyTo cut consumption expenditure, the rates of personal, corporate and commodity taxes should be raised and even new taxes should be levied, but the rates of taxes should not be so high as to discourage saving, investment and production. Rather, it should provide larger incentives to those who save, invest and produce more.

Control of InflationMonetary PolicyUnder CRR , a certain percentage of the total bank deposits has to be kept in the current account with RBI which means banks do not have access to that much amount for any economic activity or commercial activity. Banks cant lend the money to corporates or individual borrowers, banks cant use that money for investment purposes. So, that CRR remains in current account and banks dont earn anything on that.Fiscal PolicyIncrease in SavingsDue to the rising cost of living, people are not in a position to save much voluntarily. Keynes, therefore, advocated compulsory savings or what he called deferred payment where the saver gets his money back after some years. For this purpose, the government should float public loans carrying high rates of interest, start saving schemes with prize money.Control of InflationMonetary PolicyStatutory liquidity ratio (SLR) is the Indian government term for reserve requirement that the commercial banks in India require to maintain in the form of certain specified securities predominantly central government and state government securities. It means the banks earn some amount of interest on that investment under SLR as against CRR where it earns zero.Fiscal PolicySurplus Budgets the government should give up deficit financing and instead have surplus budgets.

Control of InflationDifference between Depreciation and DevaluationDepreciationDepreciation happens in countries with a floating exchange rate. A floating exchange rate means that the global investment market determines the value of a country's currency. The exchange rate among various currencies changes every day as investors reevaluate new information. While a country's government and central bank can try to influence its exchange rate relative to other currencies, in the end it is the free market that determines the exchange rate. As of 2012, all major economies use a floating exchange rate. Depreciation occurs when a country's exchange rate goes down in the market. The country's money has less purchasing power in other countries because of the depreciation.

DevaluationDevaluation happens in countries with a fixed exchange rate. In a fixed-rate economy, the government decides what its currency should be worth compared with that of other countries. The government pledges to buy and sell as much of its currency as needed to keep its exchange rate the same. The exchange rate can change only when the government decides to change it. If a government decides to make its currency less valuable, the change is called devaluation. Fixed exchange rates were popular before the Great Depression but have largely been abandoned for the more flexible floating rates. China was the last major economy to openly use a fixed exchange rate. It switched to a floating system in 2005.

Phillips CurveIn economics, Phillipss curve represented the average relationship between unemployment and wage behavior over the business cycle. Since its discovery by British economist AW Phillips, it has become an essential tool to analyse macro-economic policy. It showed the rate of wage inflation that would result if a particular level of unemployment persisted for some time. Stated simply, decreased unemployment, (i.e., increased levels of employment) in an economy will correlate with higher rates of inflation.

CriticismAt the height of the Phillips curves popularity, Edmund Phelps and Milton Friedman independently challenged its theoretical underpinnings. They argued that well-informed, rational employers and workers would pay attention only to real wagesthe inflation-adjusted purchasing power of money wages. In their view, real wages would adjust to make the supply of labor equal to the demand for labor, and the unemployment rate would then stand at a level uniquely associated with that real wagethe natural rate of unemployment.NAIRU (Non Accelerating inflation Rate of Unemployment)Now economists prefer to talk about NAIRU the lowest rate of unemployment at which inflation does not accelerate.The lowest rate of unemployment at which the jobs market can be in stable equilibrium.When unemployment is above this rate, demand can potentially be increased to bring it to the natural rate, but attempting to even it further will only cause inflation to accelerate.In order to reduce inflation by 1%, we must hold unemployment above the natural rate two to 2 and a half percentage points.

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