Economic Notes : Inflation in Economy – SSC CGL Tier 1
Economic Notes : Inflation in Economy – SSC CGL Tier 1
Inflation One of the most intricate challenges of our present times is the problem of rising Inflation. Its effect can be felt by each and every person to at least some degree, whether he is an engineer, doctor, lawyer, govt. servant or anybody. Inflation makes no partiality in choosing its innocent victims. So what exactly is inflation and how is it caused? Whether it originates in our home country or it is imported from abroad? What are our Economists doing to control Inflation? These are the questions that naturally arise in anyone’s mind.
Inflation is defined as a general rise in prices of all commodities. In the words of Samuelson, “by inflation we mean a time of generally rising prices for goods and factors of production – rising prices of bread, cakes, haircuts, rising wages, rents etc”. It is not the rise in the price of my favorite commodity e.g. McDonald’s Pizza, but the overall rise in the prices of all the goods and services manufactured and consumed within the territory of a nation. When we say that the monthly rate of Inflation is 12%, what it means is that on an average, the prices of all goods and services have increased by 12% in the period of last one month. The essence of inflation is disequilibrium between aggregate demand and aggregate supply, i.e. excess of demand over supply that keeps the price level rising over time.
Measures of Inflation-
In India, Inflation is measured using WPI (Wholesale Price Index). It is very tedious to track each and every commodity and calculate its price rise. Instead of that an Index of several goods and services is prepared. India’s WPI is a weighted-index of 435 commodities. It means price-rise of all commodities will not be treated equally. The price-rise of rice will have more weight-age than price-rise of a Maruti-car. That is because rice is consumed by a very large number of people compared to a Maruti car. The weight-age of a Mercedez car will be still lower in the WPI. So when this WPI increases from say 100 to 112, we say that the rate of inflation is 12%.
Many other countries like UK, USA, China, etc. use CPI (Consumer Price Index) to measure inflation. This is a more realistic measure because it computes the index based on the increase in actual price paid by the consumer. On the other hand, WPI considers the rise in the price by the Wholesalers of the goods and services.
Inflation wise, the past half a century can be divided into distinct phases, viz.,
- Period of relative price stability (1951-1956). The average annual rate of price rise or inflation was almost nil during this period. Within this period the price changes varied between negative to positive. The overall price stability, or even negative inflation rate was mainly the result of bumper agricultural production and tremendous success of the first plan. However pressures of high demand towards the beginning of Second Plan caused the prices to rise.
- Phase of Moderate Inflation (1956-1971). During the period 1956-1971, average annual inflation rate rose to 6.4 per cent. The price position during third five-year plan deteriorated badly. The average increase in prices was around 5.8 per cent. However there was a small decline (-1.1 per cent) during 1968-69 mainly due to the impact of a bumper crop in the year1966-67.
iii. Period of High Inflation Rate (1971-1981). During the decade 1971-81, the annual average inflation rate (rate of increase in price level) became still higher to reach 10 percent. The crop failure in 1972 and the oil shock of 1973 were the main factors behind the inflation. the average inflation rate which was higher at 12 per cent during 1971-72 to 1975-76 and slightly lower at 8.5 per cent during 1976-77 and 1980-81. Plan wise, the inflation rate which was high at around 9 percent during the fourth plan (1969-74) came down to 6.3 percent during the fifth plan 1974-79.
- Slowdown of Inflation (1981-1991). During this phase the annual inflation rate slightly came down to 8 per cent. The highest recorded price rise during this decade was 18 per cent in 1980-81 and lowest of 4.4 percent in 1985-86. But during the five- year period (seventh plan 1985-90) it rose to around 8 percent.
- Price situation in the Nineties. The 1991-1996 periods witnessed the revival of strong inflationary pressures. But 1996 onwards inflation declined and inflation rate has declined to moderate levels varying between 4 to 6 per cent. Since then, the inflationary situation came under control with a noticeable decline in the prices of primary food articles as well as manufactured food products.
Types of Inflation –
Open Inflation -: The rate where Costs rise due to Economic trends of spending product and services.
Suppressed Inflation -: Existing inflation disguised by government Price controls or other interferences in the economy such as subsidies. Such suppression, nevertheless, can only be temporary because no governmental measure can completely contain accelerating inflation in the long run. It is Also Called Repressed Inflation.
Galloping Inflation -: Very Rapid Inflation which is almost impossible to reduce.
Creeping Inflation -: Circumstance where the inflation of a nation increases gradually, but continually, over time. This tends to be a typically pattern for many nations. Although the increase is relatively small in the short-term, as it continues over time the effect will become greater and greater.
Hyper Inflation -: Hyperinflation is caused mainly by excessive deficit spending (financed by printing more money) by a government, some economists believe that social breakdown leads to hyperinflation (not vice versa), and that its roots lie in political rather than economic causes.
Causes of Rising Prices:
To understand the various causes that have contributed to the continuing price rise or inflation in India, we have to look into factors which have on one side, pulled the demand upwards and on the other side, prevented supply from keeping pace with this rising demand. Inflation is basically a combination of two types of phenomenon. Its causes could be nailed down to Cost-Push inflation and Demand-Pull inflation.
Cost-Push Inflation is caused by rise in the cost of factors of production. In classical economic theory, there used to be only three factors of production – land, labor and capital. However, in today’s complex world, infinite factors are required to produce a single product or commodity e.g. house-rent, electricity, admin-expenses, raw-materials, fuel (petroleum), steel, etc. The price rise in any one or more of these factors will increase the cost of production of the final product. The producer of the commodity (the businessman) will naturally shift this cost to his consumers by raising the cost of his final product. This phenomenon is called Cost-Push Inflation.
There are some of factors that have contributed to increase in cost of production are as follows:
- Fluctuation in output and supply.
- Increase in taxes i.e. taxation, as a factor in rising costs and prices.
- Changes in administered prices.
- Hike in oil prices and global inflation.
Let us take a simple example. Suppose a bakery owner produces bread by using several factors like wheat, flour, machines, labor, etc. The cost of production of one piece of bread comes to $8. He adds $2 as his profit-margin and sells it to consumers at $10. This continues for several days. Now suppose the price of wheat increases due to low production or crop failure. Now the owner recalculates his cost of production. It comes to $10. He now adds his margin of $2 and increases the cost of bread to $12. This directly results in 2% rise in the cost of bread, or in the bread component of the WPI.
Demand-Pull Inflation is another type of inflation. In this case, the cost of factors of production remains same. However, due to increase in the demand of the commodity by consumers in the market relative to its supply, the owner will naturally increase the prices. In this case, demand has increased, but supply has remained constant.
There are some factors behind rapid increase in demand and relatively slow growth over the past few decades. This is as follows:
- Increase in money supply.
- Massive increase in government expenditure.
- Rapid increase in population.
- Growth of black money.
Let us take a simple example, suppose the cost of production of one piece of bread remains constant at $8. He adds his margin of $2 and charges $10 to each consumer. Now suppose the preference of his bread increases among the consumers, as it becomes more popular. This results in an increased demand for bread (This is a simplified example, in real world demand and supply is more complex). So sensing more demand for his product, the owner increases the price to $12.
Liquidity: The term Liquidity is usually used to identify hard cash. In fact Liquidity just means money in any form. Liquidity is also referred to the ability and ease with which an asset could be converted to money. For e.g. cash is the most liquid asset. Savings-account deposit could also be called liquid asset. How is Liquidity related to Inflation you may ask? The answer is simple. It’s because of Demand-Pull Inflation. The demand for the commodity is directly influenced by the amount of money that people have. The Government or Central Bank can directly influence demand-pull inflation by controlling liquidity.
Inflation Rates in India
There are different indices in India like Wholesale Price Index (WPI), Consumer Price Index (CPI) etc. which measure inflation rates in India. But what we generally find in headlines as inflation rate in India is Inflation rate based on WPI. In the last 50 years, WPI based inflation rate shows an average inflation rate around 7-8%. The highest inflation rate observed in India was 34.68 Percent in September of 1974. The lowest rate touched was -11.31 Percent in May of 1976.
Headline Inflation vs Core Inflation
Having studied inflation rate measurement at different levels, now let’s focus on two terms related to inflation. They are Headline Inflation and Core Inflation.
- Headline Inflation –
Headline Inflation is the measure of total inflation within an economy. It includes price rise in food, fuel and all other commodities.
The inflation rate expressed in Wholesale Price Index (WPI) usually denotes the headline inflation. Though Consumer Price Index (CPI) values are often higher, WPI values traditionally make headlines.
- Core Inflation (Underline Inflation or Non-food Inflation) –
Core inflation is also a term used to denote the extend of inflation in an economy. But Core inflation does not consider the inflation in food and fuel. This is a concept derived from headline inflation. There is no index for direct measurement of core inflation and now it is measured by excluding food and fuel items from Wholesale Price Index (WPI) or Consumer Price Index (CPI).
Is inflation always bad for the economy?
Though a high rate of inflation is not good for the economy, a mild inflation, say under 3%, may turn, at times, useful for the economy. As we hinted in the beginning, inflation can occur because of high demand too. High demand on scarce resources will automatically increase prices. This is called demand pull inflation. But demand for a commodity is a good sign from the industry perspective. Industries now will try to produce more commodities to reap the benefit of high prices and demand. More production will trigger GDP growth.
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