Inflation

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INTRODUCTION

Inflation means a persistent rise in the prices of goods and services. Inflation reduces the purchasing power of money. It hurts the poor more as a greater proportion of their incomes are needed to pay for their consumption. Inflation reduces savings, pushes the interest rates, dampens investments, and leads to depreciation of currency thus making imports costlier.

Types of inflation

  • creeping inflation

creeping inflation is a rate of general price increase of 1 to 5% a year. Creeping inflation of 3 to 5% erodes purchasing power of money when continued over many years, but it is manageable. Furthermore a low creeping inflation could be good for the economy as producers and traders make reasonable profits encouraging them to invest.

  • Trotting inflation

Trotting inflation is usually defined as 5 to 10% annual rate of increase in the general level of prices that, if not controlled might accelerate into a galloping inflation of 10 to 20% a year. If it aggravates, galloping inflation can worsen to a runaway inflation which may change into a hyperinflation.

  • Hyperinflation

Hyperinflation is the inflation that is out of control, a condition in which prices increases rapidly as currency loses its value. No definition of hyperinflation is universally accepted.
Other related concept

  • Deflation when there is a general fall in the level of prices
  • Disinflation which is the reduction of the rate of inflation.
  • Stagflation which is a combination of inflation and rising unemployment due to recession.
  • Reflation which is an attempt to raise prices to counteract deflationary pressures.

Measures of Inflation

  • GDP deflator

GDP stands for gross domestic product, the total value of all final goods and services produced within that economy during a specified period. GDP deflator is a measure of the change in prices of all new, domestically produced, final goods and services in an economy. The GDP deflator is not based on fixed market basket of goods and services but applies to all goods and services domestically produced.

  • Cost of living index

The cost of living is the cost of maintaining a certain standard of living. It is defined with reference to a basket of goods and services. When their cost goes up, cost of living is said to be dearer and the index will go up. It has a value of 100 in the base year. An index value of 105 indicates that the cost of living is 5% higher than in the base year.

  • Producer price index

Producer price index (PPI) measures the change in the prices received by a producer. The difference with the wholesale price index is countered for by logistics, profits taxes, mainly. Producer price inflation measures the price pressure due to increase in the costs of raw materials. It may be absorbed by them or made up by increases in productivity or passed on to the consumers. It depends on the market conditions.

  • Wholesale price indices

Wholesale price indices (WPI), which measures the change in price of a selection of goods at wholesale, prior to retail sales thus excluding sales taxes. These are very similar to the producer price indexes.

  • Consumer Price index

Consumer Price index (CPI) is a measure that changes in prices paid by the consumer at the retail level. It can be for the whole community or group specific for example CPI for industrial workers etc as in India.

Types of inflation based on causes
1. Demand pull inflation
Demand pull inflation is caused by increase in demand due to increased private and government spending etc. It involves inflation which is rising as real gross domestic product rises and unemployment falls. This is commonly described as “too much money chasing too few goods”. For example, India in 2010 when economy is said to have overheated and demand outstripped supply and prices rose.
2.Cost push inflation
It is also referred to as ”supply shock inflation” caused by reduced supplies due to increase prices of inputs. For example crude prices globally have gone up causing supply constraints which means higher costs of production and so higher prices. Crude and food prices shot up in 2008 July came down and again increased.
3. Structural inflation
Structural inflation is a type of persistent inflation caused by deficiencies in certain conditions in the economy such as a backward agricultural sector that is unable to respond to peoples increased demand for food, inefficient distribution and storage facilities leading to artificial shortages of goods, and production of some goods controlled by some people.

Problems with high rate of inflation in economy

  • people on a fixed income (eg. pensioners, students) will be worse off in real terms due to higher prices and equal income as before.
  • Low income groups are particularly hurt
  • Strikes can take place for higher wages which can cause a wage spiral. Also if strikes occur in an important industry which has a comparative advantage the nation may see a decrease in productivity, export and growth.
  • It will distribute income from those on fixed incomes, such as pensioners and shifts it to those who draw and inflation linked income and businesses.
  • Inflation tax happens. When a government borrows and spends, the cash held by people erodes in value due to inflation.
  • Inflation may discourage saving and thus hit investment. The savings pattern is also gets skewed in favor of unproductive assets like gold and inflation may be higher than interest rates and yield is negative.
  • Inflation can drag down to an investment climate turns bad due to instability and uncertainty and also and interest rates are raised and cost of credit increased.
  • Inflation discourages exports as domestic sales are attractive and BOP problems can be caused. Inflation may erode the external competitiveness of domestic products if it leads to higher production costs such as wage increases, higher interest rate and currency depreciation.

Majors to control inflation

  • dual pricing like in sugar
  • fiscal measures include reduction in indirect taxes
  • Monetary measures include rate and reserve requirements changes. Open market operations can establish prices under normal conditions also sterilization through, governmental bond transactions as in the case of MSBs.
  • supply-side actors include making goods available import of edible oil in India
  • Administrative measures include implementation of dehoarding and anti-black marketing measures. Wage and price controls can also be used.

Collection of statistics act, 2008
Collection of statistics at 2008 was made to bring in new rules aimed at improving data collection. Government will levy higher penalty for not sharing data and tougher punishment will be imposed in cases where manipulation of data is involved.
Under the new act people or companies not divulging data would have to pay a fine of Rs. 1000 and they would be given a 14 day notice prior to comply. If the information is not provided even after two weeks the penalty will rise to Rs. 5000 per day.

Phillips’s curve
The inverse relationship between rate of inflation and rate of unemployment is shown in the Phillips curve. Price stability has a trade off against employment. Some level of inflation could be considered desirable in order to minimize unemployment. Potential output sometimes called the natural gross domestic product is an important concept in relation to inflation. It is the level of GDP where the economy is at its optimal level of production given various constraints institutional and natural.

Governments steps to control inflation
The government has taken a number of short term and medium-term measures to improve domestic availability of essential commodities and moderate inflation.

  • Fiscal measures
  • Reduce import duties to zero for rice, wheat, onions, and edible oils and to 7.5% for refining and hydrogenated oils and vegetable oils.
  • Permitted national dairy development board (NDDB) to import 50, 0000 MT, of butter, butter oil, and anhydrous milk fat at zero duty under tariff rate quota.
  • Permitted the state trading Corporation of India (STC) /minerals and metals trading Corporation (MMTC)/Project equipment (PEC) and national agricultural cooperative marketing Federation of India (NAFED) to import duty-free white/refined sugar initially with a cap of 1 million tones. Later duty-free import was also allowed by other Central/State government agencies and private trade without any cap on quantity.
  • Administrative measures
  • removed levy obligation in respect of all imported raw sugar and white refined sugar
  • Banned export of edible oils (except coconut oil and forest based oil) and pulses (except kabuli chana and organic pulses).
  • Imposed ban on export of non-basmati rice and wheat for short period of time
  • Permitted export of edible oils in branded consumer packs of up to 5 kg subject to limit of 10,000 tones.
  • Prohibited export of milk powder (including skimmed milk powder, whole milk powder, dairy whitener and infant milk food) Casein and casein products.
  • Effected no change in tariff rate values of edible oils
  • Open inflation

When the government does not attempt to prevent price rise, inflation is said to be open. Thus inflation is open when prices rise without any interruption. In open inflation the free market mechanism is permitted to fulfill its historic function of rationing the short supply of goods and distribute them according to consumers ability to pay. Therefore the essential characteristics of an open inflation lie in the operation of the price mechanism as the sole distributing agent.

  • Monetary Measures

Repo rates were raised and CRR also went up to make credit dearer. (Note: CRR = Cash Reserve Ratio)

Represses inflation
When the government interrupts a price rise, there is a repressed or suppressed inflation. Thus it refers to those conditions in which price increases are prevented at the present time through an adoption of certain measures like price controls and rationing by the government but they are rise on the removal of such controls and rationing. The essential characteristic of repressed inflation, in contrast to inflation, is that the former seeks to prevent distribution through price rise under free-market mechanism and substitutes instead a distribution system based on controls.

Inflation tax
Price rise means more money being paid by the consumers for what they buy. Thus it is a type of tax, hence called as Inflation tax.

 
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