Download Prof.R.Srinivasan Department of Management Studies, Indian

Prof.R.Srinivasan
Department of Management Studies,
Indian Institute of Science,Bangalore.
Increase in the general level of prices in
an economy that is sustained over a
period of time is called inflation
 Inflation is measured for a basket of
goods and services
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Distribution of income and wealth
The rich get richer and poor get poorer
Loss to fixed income earners
Gains to profit earners
Gains to the debtors
Loss to the creditor
Loss to wage earners
Government
Economic growth
Employment
Why is it bad?
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Losses to savers: Inflation erodes the
purchasing power of the amount saved.
Losses to people with fixed incomes: People
with fixed incomes (such as the interest on a
fixed deposit, or a fixed salary) find that the
purchasing power of their income diminishes
over time.
Losses to taxpayers: If your salary increases in
line with inflation, and no adjustments are
made to income tax, you will shift into a higher
tax bracket and end up paying a larger share of
your salary to the taxman.
Contd.
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Confusing price signals to producers and slower
expansion of businesses: In times of inflation, an
increase in the price of a product can occur either
simply as part of the regular inflation related
adjustments to prices, or because the demand for
that product has risen permanently.
Entrepreneurs, not knowing which of the two
kinds of price increases have occurred, may wait
much longer before expanding their businesses
and employing more resources in reaction to a
permanent increase in demand.
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Speculation crowding out production: An
environment of high inflation and financial
instability leads to more entrepreneurship and
other resources being devoted to speculation in
existing assets such as real estate, and less to
expansion of production and employment.
What causes Inflation?
 an
increase in international oil prices;
 a fall in the exchange rate;
 a nationwide excessive salary and
wage hike; or
 an increase in food prices and
commodities etc.
 The
first and the comprehensive
theory of inflation was propounded
by Irving Fisher in 1911
 According to classical theory inflation
occurs in direct proportion to
increase in money supply, given level
of output
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Inflationary gap is explained as the planned
expenditure in excess of output available at full
employment level
The inflationary gap is so called because it
causes only inflation, without increasing the
level of output
The inflationary gap generates only money
income without creating matching real output
because the economy is in full employment
equilibrium
 The
general level of prices rises only
due to an increase in the money
supply
 Inflation is always a monetary
phenomenon …. and can be
produced only by a more rapid
increase in the quantity of money
than in output
 Proportionate relationship is not
propounded
Aggregate price level of commodities determined by the
aggregate demand and aggregate supply
 Inflation is caused by both demand and supply side
factors
 Demand side factors are called demand pull factors
 Supply side factors are called supply side or cost push
factors
Demand pull factors
- monetary factors
- Increase in government spending, given tax revenue
- Cut in tax rate without change in government
expenditure
- Upward shift in investment function
- Downward shift in saving function
- Upward shift in export function
- Downward shift in import function
Cost Push Inflation
- wage push
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Inflation In India
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Inflation is measured by the Wholesale Price Index
(WPI) and not by Consumer Price Index (CPI).
WPI is the measure of headline inflation in India.
Most developed countries use the Consumer Price
Index (CPI) to calculate inflation.
WPI preferred to CPI
-wider commodity coverage
-available on weekly basis
-computed at all-India basis
Wholesale Price Index (WPI)
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 total of 435 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.
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Composition of WPI(in India)
Wholesale price index (weight=100):
Primary articles (wt.=22.0)
cereals, pulses, Fruits and vegetables, egg, oil
etc.
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Fuel power,Light and Lubricants (wt.=14.2)
Mineral Oil, Electricity,Coal Mining
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Manufactured Products (wt.63.8)
Sugar, edible oils, textiles, chemicals, iron &
steel, machinery, transport equipment, etc
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Consumer Price Index (CPI)
 CPI
is a statistical time-series
measure of a weighted average of
prices of a specified set of goods and
services purchased by consumers. It
is a price index 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 as cost of living
index.
Which method does India
use?
 India
is the only major country that
uses a wholesale index to measure
inflation. Most countries use the CPI
as a measure of inflation, as this
actually measures the increase in
price that a consumer will ultimately
have to pay for.
Drawbacks of using WPI
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WPI does not properly measure the exact price rise an endconsumer will experience because, as the same suggests, it
is at the wholesale level.
More than 100 out of the 435 commodities included in the
Index have ceased to be important from the consumption
point of view. For example, a commodity like coarse grains
that go into making of livestock feed. This commodity is
insignificant, but continues to be considered while
measuring inflation.
WPI is supposed to measure impact of prices on business
but it is used in India to measure the impact on consumers.
Many commodities not consumed by consumers get
calculated in the index. And it does not factor in services
which have assumed so much importance in the economy
Why is India not switching over to the
CPI method of calculating inflation?
In India, there are four different types of CPI
indices, and that makes switching over to the
Index from WPI fairly 'risky and unwieldy.' The
four CPI series are: CPI Industrial Workers; CPI
Urban Non-Manual Employees; CPI
Agricultural labourers; and CPI Rural labour.
 CPI cannot be used in India because there is
too much of a lag in reporting CPI numbers.
 The WPI is published on a weekly basis and
the CPI, on a monthly basis.
 And in India, inflation is calculated on a
weekly basis.
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Monetary Measures
- Bank rate policy
- Variable reserve ratio
- Open market operation
- Statutory liquidity ratios
- Moral persuasion
- Selective credit controls
Fiscal Measures
- Cut down in public expenditure
Tax policy
Price and Wage Control
- Price control
- Wage control
- Indexation
Role of RBI during inflationary
time
 The RBI raises the repo
rate (rate at which at RBI
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borrows from banks- bank rate is the rate at
which banks borrow from RBI)
Banks then usually raise their lending and deposit
rates.
When people face higher lending rates, they buy
fewer goods on credit.
This causes less credit to be used and less money
to end up with shopkeepers.
With less money, credit and expenditure in the
economy, it becomes more difficult to raise prices
and wages.
Therefore, inflation is reduced.
Few thoughts on rising inflation
in India over last few months
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Between July 2007 and June 2008,global food
grain prices had gone up 45%;in India they had
risen only 6%.
World oil prices had risen 93%,domestic oil prices
a fraction of that.
The commodities that led world inflation were not
the ones that led inflation in India.
Food grain prices had risen in India, but had nothing
to do with inflation measured by wholesale price
index; share of food grains in WPI was small.
Contd.
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The only commodities whose domestic prices had
gone up in tandem with global prices were edible
oils, whose global prices had risen 96%.
Half of the rise in WPI was due to minerals.
Iron ore prices had shot up owing to global
shortage, while India is an important exporter.
The rise in Iron ore prices along with coal and oil
prices had positive impact on rise of Steel prices.
Minerals thus accounted for a half of the rise in
WPI;along with oil and steel they contributed to
two thirds of rise.
Contd.
 Thus
Inflation calculated according to
WPI over last few months is irrelevant to
people’s cost of living.
 Inflation according to consumer price
index for the industrial workers went up
to 7.9% in March,2008 from 5.5% in
February,2008 and is stable at that
level.
Thus, when every week RBI announces
fresh figure for inflation which seems
to increase every week there is real
no great reason to worry for us.
Thank you