1 Letter of Transmittal To, The Regional Director, Reserve Bank of India, Patna (Bihar) Report of Young Scholar, 2011 on ³Inflation Indices and the Common Man´ Dear sir, I have great pleasure submitting the report on ³Inflation Indices and the Common Man´. As the w orld economy has begun to stabilize in the aftermath of the g lobal crisis, inflation has re-emerged as a major concern particularly in the fast-recovering developing economies. Inflation is normally related with high prices which causes decline in the purchasing power or the value of money. Inflation or inflation rate is calculated as the percentage change of a certain price index. There are two ways forcalculating inflation rate .They are Consumer Price Index (CPI) and Wholesale Price Index (WPI). In this project, I have analyzed the measures that are used to calculate the inflation or inflation rate. Finally I am very thankful to RESERVE BANK OF INDIA for giving me this rare opportunity for which I would be highly indebted throughout my life. Yours sincerely, K.Satyanarayana Pintu Kumar Manager (Estate Dept.) RBI YOUNG SCHOLAR,2011 Guide
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Without a sound and effective banking system in India, it cannot have a healthy
economy. The banking system of India should not only be hassle free but it should beable to meet new challenges posed by the technology and any other external and
internal factors.
For the past three decades, India's banking system has several outstanding
achievements to its credit. The most striking is its extensive reach. It is no longer
confined to only metropolitans or cosmopolitans in India. In fact, Indian banking system
has reached even to the remote corners of the country. This is one of the main reasons
of India's growth process.
The government's regular policy for Indian bank since 1969 has paid richdividends with the nationalization of 14 major private banks of India.
Not long ago, an account holder had to wait for hours at the bank counters for
getting a draft or for withdrawing his own money. Today, he has a choice. Gone are
days when the most efficient bank transferred money from one branch to other in two
days. Now it is simple as instant messaging or dials a pizza. Money has become the
order of the day.
Banking in India originated in the last decades of the 18th century. The oldest
bank in existence in India is the State Bank of India, a government-owned bank that
traces its origins back to June 1806 and that is the largest commercial bank in the
country. Central banking is the responsibility of the Reserve Bank of India, which in
1935 formally took over these responsibilities from the then Imperial Bank of India,
relegating it to commercial banking functions. After India's independence in 1947, the
Reserve Bank was nationalized and given broader powers. In 1969 the government
nationalized the 14 largest commercial banks; the government nationalized the six next
In economics inflation is a rise in the general level of prices of goods and servicesin an economy over a period. When the general price level rises, each unit of currency
buys fewer goods and services. Consequently, inflation also reflects erosion in the
purchasing power of money ± a loss of real value in the internal medium of exchange
and unit of account in the economy. A chief measure of price inflation is the inflation rate
the annualized percentage change in a general price index.
Inflation or inflation rate is calculated as the percentage change of a certain price
index. There are two ways for calculating inflation rate .They are Consumer Price Index
(CPI) and Wholesale Price Index (WPI). A consumer price index measures changes in
the price level of consumer goods and services purchased by households. It is a priceindex that tracks the prices of a specified basket of consumer goods and services,
providing a measure of inflation. CPI is a fixed quantity price index and considered by
some a cost of living index. Under CPI, an index is scaled so that it is equal to 100 at a
chosen point in time, so that all other values of the index are a percentage relative to
this one. CPI is used by many countries to calculate inflation such as USA, UK, Japan,
France etc.
Wholesale price index is the index that is used to measure the change in the
average price level of goods traded in wholesale market. In India, a total of 676
commodities data on price level is tracked through WPI, which is an indicator of
movement in prices of commodities in all trade and transactions. It is also the price
index which is available on a weekly basis with the shortest possible time lag only two
weeks. The Indian government has taken WPI as an indicator of the rate of inflation in
the economy. Currently the base year on which inflation is calculated is 2004-05.
Inflation's effects on an economy are various and can be simultaneously
positive and negative. Negative effects of inflation include a decrease in the real value
of money and other monetary items over time, uncertainty over future inflation may
discourage investment and savings, and high inflation may lead to shortages of goods if
consumers begin hoarding out of concern that prices will increase in the future. Positive
effects include ensuring central banks can adjust nominal interest rates (intended to
mitigate recessions), and encouraging investment in non-monetary capital projects.
Economists generally agree that high rates of inflation and hyperinflation are
caused by an excessive growth of the money supply. Views on which factors determine
Increase in the quantity of money or in the overall money supply (or debasement of
the means of exchange) has occurred in many different societies throughout history,
changing with different forms of money used. For instance, when gold was used as
currency, the government could collect gold coins, melt them down, mix them with other
metals such as silver, copper or lead, and reissue them at the same nominal value. By
diluting the gold with other metals, the government could issue more coins without also
needing to increase the amount of gold used to make them. When the cost of each coin
is lowered in this way, the government profits from an increase in seigniorage. This
practice would increase the money supply but at the same time the relative value of each coin would be lowered. As the relative value of the coins becomes less,
consumers would need to give more coins in exchange for the same goods and
services as before. These goods and services would experience a price increase as the
value of each coin is reduced.
Historically, infusions of gold or silver into an economy have also led to inflation.
From the second half of the 15th century to the first half of the 17th, Western Europe
experienced a major inflationary cycle referred to as the "price revolution´, with prices
on average rising perhaps six fold over 150 years. This was largely caused by the
sudden influx of gold and silver from the New World into Habsburg Spain. The silver spread throughout a previously cash starved Europe, and caused widespread inflation.
By the nineteenth century, economists categorized three separate factors that
cause good, a change in the price of money which then was usually a fluctuation in the
commodity price of the metallic content in the currency, and currency depreciation
resulting from an increased supply of currency relative to the quantity of redeemable
metal backing the currency. Following the proliferation of private bank note currency
printed during the American Civil War, the term "inflation" started to appear as a direct
reference to the currency depreciation that occurred as the quantity of redeemable bank
notes outstripped the quantity of metal available for their redemption. The term inflation
then referred to the devaluation of the currency, and not to a rise in the price of goods.
Inflation is caused when the aggregate demand exceeds the aggregate supply
of goods and services. We analyze the factors which lead to increase in demand and
the shortage of supply.
Factors Affecting Demand
Both Keynesians and monetarists believe that inflation is caused by increase in the
aggregate demand. They point towards the following factors which raise it.
(1) Increase in money supply
Inflation is caused by an increase in the supply of money which leads to
increase in aggregate demand. The higher the growth rate of the nominal money
supply, the higher is the rate of inflation.
(2) Increase in Disposable Income
When the disposable income of the people increases, it raises their demand for goods and services. Disposable income may increase with the rise in national
income or reduction in taxes or reduction in the saving of the people.
(3) Increase in Government Expenditure
Government activities have been expanding much with the result that
government expenditure has also been increasing at a phenomenal rate, thereby
raising aggregate demand for goods and services. Governments of bothdeveloped and developing countries are providing more facilities under public
utilities and social services, and also nationalizing industries and starting public
enterprises with the result that they help in increasing aggregate demand.
Inflation can be controlled by increasing the supplies and reducing money
incomes in order to control aggregate demand. The various methods are usually
grouped under three heads: Monetary measures, fiscal measures and other measures.
Monetary Measures
Monetary measures aim at reducing money incomes.
(a) Monetary Policy:- One of the important monetary measures is monetary
policy. The central bank of the country adopts a number of methods to control
the quantity and quality of credit. For this purpose, it sells securities in the openmarket, raises the reserve ratio, and adopts a number of selective credit control
measures, such as raising margin requirements and regulating consumer credit.
Monetary policy may not be effective in controlling inflation, if inflation is due to
cost-push factors. Monetary policy can only be helpful in controlling inflation
due to demand-pull factors.
(b) Demonetization of Currency: - However, one of the monetary measures is
to demonetize currency of higher denominations. Such a measure is usually
adopted when there is abundance of black money in the country.
(c) Issue of new currency:- The most extreme monetary measure is the issue
of new currency in place of the old currency. Under this system, one new note is
exchanged for a number of notes of the old currency. The value of bank deposits
is also fixed accordingly. Such a measure is adopted when there is an excessive
issue of notes and there is hyperinflation in the country. It is very effective measure.
But is inequitable for its hurts the small depositors the most.
Monetary policy alone is incapable of controlling inflation. It should, therefore, be
supplemented by fiscal measures. Fiscal measures are highly effective for controlling
government expenditure, personal consumption expenditure, and private and public
investment. The principal fiscal measures are the following:
(a) Reduction in unnecessary expenditure:- The government should reduce
unnecessary expenditure on non-development activities in order to curb inflation. This
will also put a check on private expenditure which is dependent upon government
demand for goods and services. But it is not easy to cut government expenditure.
Though economy measures are always welcome but it becomes difficult to distinguish
between essential and non-essential expenditure. Therefore, this measure should be
supplemented by taxation.
(b) Increase in taxes:- To cut personal 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, the tax system should provide larger incentives to those who save,
invest and produce more. Further, to bring more revenue into the tax-net, the
government should penalize the tax evaders by imposing heavy fines. Such measures
are bound to be effective in controlling inflation. To increase the supply of goods within
the country, the government should reduce import duties and increase export duties.
(c) Increase in savings:- Another measure is to increase savings on the part of thepeople. This will tend to reduce disposable income with the people, and hence personal
consumption expenditure. But due 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 µdeferred 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, or lottery for long periods, etc. It should also
introduce compulsory provident fund, provident fund-cum-pension schemes, etc.
compulsorily. All such measures to increase savings are likely to be effective in
controlling inflation.
(d) Surplus Budget:- An important measure is to adopt anti-inflationary budgetary
policy. For this purpose, the government should give up deficit financing and instead
have surplus budgets. It means collecting more in revenues and spending less.
(e) Public Debt:- At the same time, it should stop repayment of public debt and
postpone it to some future date till inflationary pressures are controlled within the
economy. Instead, the government should borrow more to reduce money supply with
the public.
Like the monetary measures, fiscal measures alone cannot help in controlling
inflation. They should be supplemented by monetary, non-monetary and non fiscal
measures.
Other Measures
The other types of measures are those which aim at increasing aggregate supply
and reducing aggregate demand directly.
(a) To Increase Production:- The following measures should be adopted to increase
production:
(i) One of the foremost measures to control inflation is to increase the production of
essential consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) If there is need, raw materials for such products may be imported on preferential
basis to increase the production of essential commodities.
(iii) Efforts should also be made to increase productivity. For this purpose, industrial
peace should be maintained through agreements with trade unions, binding them not to
resort to strikes for some time.
(iv) The policy of rationalization of industries should be adopted as a long-term
measure. Rationalization increases productivity and production of industries through the
use of brain, brawn and bullion.
(v) All possible help in the form of latest technology, raw materials, financial help,
subsidies, etc. should be provided to different consumer goods sectors to increase
production.
(b) Rational Wage Policy :- Another important measure is to adopt a rational wageand income policy. Under hyperinflation, there is a wage-price spiral. To control this, the
government should freeze wages, incomes, profits, dividends, bonus, etc. But such a
drastic measure can only be adopted for a short period and by antagonizing both
workers and industrialists. Therefore, the best course is to link increase in wages to
increase in productivity. This will have a dual effect. It will control wage and at the same
time increase productivity, and hence production of goods in the economy.
(c) Price Control:- Price control and rationing is another measure of direct control to
check inflation. Price control means fixing an upper limit for the prices of essential
consumer goods. They are the maximum prices fixed by law and anybody charging
more than these prices is punished by law. But it is difficult to administer price control.
(d) Rationing:- Rationing aims at distributing consumption of scarce goods so as to
make them available to a large number of consumers. It is applied to essential
consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilize the
prices of necessaries and assure distributive justice. But it is very inconvenient for
consumers because it leads to queues, artificial shortages, corruption and black
marketing. Keynes did not favour rationing for it "involves a great deal of waste, both of
resources and of employment."
TYPES OF INFLATION
Demand-Pull Inflation:- This type of inflation occurs when total demand for goods and
services in an economy exceeds the supply of the same. When the supply is less, the
prices of these goods and services would rise, leading to a situation called as demand-
pull inflation. This type of inflation affects the market economy adversely during the
wartime.
Cost-Push Inflation:- As the name suggests, if there is increase in the cost of
production of goods and services, there is likely to be a forceful increase in the prices of
finished goods and services. This type of inflation may or may not occur in conjunction
with demand-pull inflation.
Hyper Inflation:- It is an extremely accelerated form of inflation, occurring when the
country imposing it is in desperate need of money-either to pay debts, fund
development and so on.
Stagflation:- This is the situation in which the inflation continues to rise although the
economy is in recession. This type of inflation can have disastrous effects but isgenerally a short lived form of inflation as it could potentially lead to a financial crisis.
Inflation rate is the rate at which prices of goods and services increase in its
economy. It is an indication of the rise in the general level of prices over time.
Mathematically, inflation or inflation rate is calculated as the percentage rate of change
of a certain price index. These indices are Wholesale Price Index and Consumer PriceIndex.
Wholesale Price Index
WPI was first published in 1902, and was one of the more economic indicators
available to policy makers until it was replaced by most developed countries by the
Consumer Price Index in the 1970s. WPI is the index that is used to measure the
change in the average price level of goods traded in wholesale market. In India, a totalof 676 commodities data on price level is tracked through WPI which is an indicator of
movement in prices of commodities in all trade and transactions. It is also the price
index which is available on a weekly basis with the shortest possible time lag only two
weeks. The Indian government has taken WPI as an indicator of the rate of inflation in
Criteria for selection of Wholesale Price Outlets The following criteria were used to determine the wholesale price outlets:
(1) Popularity of an establishment along the line of goods to be priced
(2) Consistency of the stock
(3) Permanency of the outlet
(4) Cooperativeness of the price informant
(5) Location Criteria for selection of commodities in the Market Basket The commodities in the market basket were selected according to the following criteria:
(1) Popularity of the variety of the commodity (implies representativeness with respect
to the commodity)
(2) Consistency of supply in the market (sustained availability of supply from the base
period to the present)
(3) Relatively high market share of the commodity.
Calculation of inflation rate by WPI
In this method, a set of 676 commodities and their price changes are used for the
calculation. The selected commodities are supposed to represent various strata of the
economy and are supposed to give a comprehensive WPI value for the economy.
WPI is calculated on a base year and WPI for the base year is assumed to be 100. To
show the calculation, let¶s assume the base year to be 1970. The data of wholesale
prices of all the 676 commodities in the base year and the time for which WPI is to becalculated is gathered.
Let's calculate WPI for the year 1980 for a particular commodity, say wheat.
Assume that the price of a kilogram of wheat in 1970 = Rs 5.75 and in 1980 = Rs 6.10
The WPI of wheat for the year 1980 is,
(Price of Wheat in 1980 ± Price of Wheat in 1970)/ Price of Wheat in 1970 x 100
i.e. (6.10 ± 5.75)/5.75 x 100 = 6.09
Since WPI for the base year is assumed as 100, WPI for 1980 will become 100 + 6.09 =
106.09.
In this way individual WPI values for the remaining 434 commodities arecalculated and then the weighted average of individual WPI figures are found out to
arrive at the overall Wholesale Price Index. Commodities are given weightage
depending upon its influence in the economy.
If we have the WPI values of two time zones, say, beginning and end of year, the
(1)WPI does not include services while they are the most essential part of an economy.
(2)WPI follows a fixed weightage of all the commodities while the economy is
undergoing many structural changes.
(3)The base year is chosen after a decade which is a very long time.
(4)The inflation rate is measured at the ³Intermediate demand level´ and not at the
³Final demand level´.
(5) Another problem is that the share of expenditure of commodities may change
overtime. For instance, the expenditure on computers, which were seldom available
before 1990s but now have a significant share in the expenditure of an urban Indian. So
the weights of these indices need to be changed over time.
Consumer Price Index
A Consumer Price Index (CPI) measures changes in the price level of consumer
goods and services purchased by households. The CPI is defined by the United States
Bureau of Labor Statistics as "a measure of the average change over time in the prices
paid by urban consumers for a market basket of consumer goods and services.´
The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. Sub-indexes and sub-sub-
indexes are computed for different categories and sub-categories of goods and
services, being combined to produce the overall index with weights reflecting their
shares in the total of the consumer expenditures covered by the index. CPI is a fixed
quantity price index and considered by some a cost of living index. Under CPI, an index
is scaled so that it is equal to 100 at a chosen point in time, so that all other values of
the index are a percentage relative to this one.
It is one of several price indices calculated by most national statistical agencies.
The annual percentage change in a CPI is used as a measure of inflation. A CPI can beused to index (i.e., adjust for the effect of inflation) the real value of wages, salaries,
pensions, for regulating prices and for deflating monetary magnitudes to show changes
in real values. In most countries, the CPI is, along with the population census and the
USA National Income and Product Accounts one of the most closely watched national
(1) WPI does not properly measure the exact price an end-consumer will experience
because it is at the wholesale level, whereas, CPI actually measures the increase in
price that a consumer will ultimately have to pay for.
(2) Many commodities included in WPI have ceased to be important from the consumer
point of view, whereas, CPI commodities are changed as the consumption pattern
follows.
(3) In CPI, the commodity basket is reviewed after every 4-5 years which is not in the
case of WPI.
(4) The WPI doesn¶t take the price of services into consideration, which now accounts
for 60 percent of the GDP. Also, it is too general and cannot be used for specific
purposes. For example, if an individual wants to know the trends in office stationery
products, then WPI may not capture the correct or complete picture.
(5) The WPI is compiled and published by Office of the Economic Advisor on a weekly
basis while the CPI is compiled and published by the Labour Bureau on a monthly basis
in India. The CPI is published for rural, agricultural and industrial workers.
(6) Wholesale price index measures inflation at each stage of production whileConsumer price index measures inflation only at final stage of production.
(7) Wholesale price index is the middle point of the sum of all the goods bought by the
traders whereas consumer price index is the middle point of the sum of all the goodsbought by consumers.
(8) There are only few countries that use WPI to calculate inflation rates whereas manynations have already shifted to using CPI.
(9) WPI is said to result an erroneous measure while CPI will describe actual cost of living and inflation rate more accurately.
(1) Wage and Salary Earners:- Wage and Salary Earners suffer a lot during inflation
because wages and salaries generally do not rise in the same proportion in which thecost of living rises. For example, the National Floor Level of Minimum Wage has
increased from Rs.80 to Rs.115 per day during the last 4-5 years but the inflation rate
during this period rose from 6.39% to 9.04%.So there is a time lag between these two. If
the workers and salary earners are well organized into power trade-unions, they may
not suffer much during inflation but if they are unorganized, they suffer very deeply.
(2) Pensioned-Income Groups:- These groups have the hardest hit as their incomes
are fixed which do not bear any relationship with the rising cost of living. They have tocut- off the consumption of some essential daily use products in order to meet up the
hike in prices.
(3) Entrepreneurs:- Inflation is welcomed by entrepreneurs and businessmen because
they stand to profit by rising prices. They find that the value of their inventories and
stock of goods is rising in money terms. They also find that prices are rising faster than
the costs of production, so that their profit is greatly enhanced.
(4) Farmers:- Farmers are generally the gainers during inflation. The prices of farm
products go up while the costs incurred by them do not go up to the same extent. But
there is a time-lag between rise in prices and the increase in costs. In this, the big
farmers who have huge investment earn more than the small farmers whose turnover is
low.
(5) Investors:- Those who invest in debentures and fixed-interest bearing securities,
bonds, etc, lose during inflation. However, investors in equities benefit because more
dividend is yielded on account of high profit made by joint-stock companies during
As the world economy has begun to stabilize in the aftermath of the global crisis,
inflation has re-emerged as a major concern particularly in the fast-recoveringdeveloping economies. At present, the major pressure on prices is emanating from the
food and energy sectors both at global and domestic levels. However, it has now also
advanced towards the core sector.
The Reserve Bank of India is trying to control inflation supportive of growth
momentum. This has to be seen in the context of more than expected inflation in the
recent past, relative stickiness of prices, especially of food and building of wider
inflationary expectations in the economy even as monetary policy tools are being used
proactively to manage demand and damper inflationary pressures in the economy.
Inflation has been elevated for over a year and RBI has responded by raising the reporate, or the rate at which it lends to banks, ten times. It has tried to bring down the
aggregate demand. Lower demand acts a check on rising prices. Inflationary pressures
in the economy are also emanating in part from supply-side constraints, especially in
food and other primary articles, as well as the transmission of higher global food, oil and
other commodity prices. These considerations therefore are complicating the issue in
the near term.
Therefore, it is important for the Reserve Bank of India to ensure a low
inflation environment as a pre-condition for sustained high growth.