Inflation

It is a persistent and appreciable rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is an erosion in the purchasing power of money � a loss of real value of money.

Inflationary Gap

The inflationary gap is the amount by which aggregate expenditure would exceed aggregate output at the full employment level of income. The index number of wholesale prices was published for the first time in India, from the week commencing January 10, 1942, with base week ended August 19, 1939 = 100. Since 1947 the index is being published regularly. In India the WPI is calculated on a weekly basis. The set of Wholesale Price Index numbers with base year 1993- 94 was introduced with effect from April, 2000. The number of commodities whose prices are considered for calculating WPI is approximately 430. Significant structural changes have taken place in the Indian economy since then. A new Working Group for the revision of the current series of the Wholesale Price Index Numbers (Base: 1993- 94= 100) was constituted under the Chairmanship of Prof. Abhijit Sen, of Jawahar Lal Nehru University.

Latest revision of WPI has been done by shifting base year from 1993-94 to 2004-05. A Working Group was set up with Prof. Abhijit Sen, Member, Planning Commission as Chairman for revision of WPI series. The Working Group submitted its Technical Report with a recommendation to change the base year from 1993-94 to 2004-05. Accordingly WPI of the new series [with base year 2004-05] was launched on 14th September, 2010. A representative commodity basket comprising 676 items has been selected and weighting diagram has been derived for the new series consistent with the structure of the economy.

Assignment of weights for constructing the general price index normally reflects the relative importance of the goods and services included. Thus, the general price index captures the overall magnitude of prices of the goods and services.

The WPI has been replaced in most countries by Producer Price Index (PPI) due to the broader coverage provided by the PPI in terms of products and industries and the conceptual concordance between the PPI and system the national account. For policy formulation and analytical purpose, measurement of price changes from producers and consumers prospective is considered far more relevant and technically superior compared to one at wholesale level.

Different Names of Inflation

Creeping Inflation

When inflation rate is less than 3% per annum; Walking or Trotting Inflation When rate of inflation is between 3-6%; Running Inflation When the sustained rise in prices is about 10% per annum;

Galloping or Hyper Inflation

When the inflation rate is more than 20% per annum.

Two Types of Inflation

The distinction between cost-push and demand-pull inflation is unworkable, irrelevant or meaning-less. The actual inflationary process contains some elements of both.

Demand-pull Inflation

It is a situation when �too many money chasing after too few goods�. An excess of aggregate demand over aggregate supply generates inflationary rise in prices. When money supply increases it creates more demand for goods but if supply of goods cannot be increased due to full employment or other reasons, demand-pull inflation is caused.

Cost-push inflation

Cost-push inflation is caused by wage increase enforced by labour unions, profit increase by the entrepreneurs and input price rise due to structural or external reasons.

Phillips Curve

Two goals of economic policymakers are low inflation and low unemployment, but often these goals are in conflict.�� Suppose, for instance, that policymakers were to use monetary or fiscal policy to expand aggregate demand. This policy would lead to higher output and a higher price level. Higher output means lower unemployment, because firms need more workers when they produce more. A higher price level means higher inflation. Thus, when policymakers move the economy up, they reduce the unemployment rate and raise the inflation rate. Conversely, when they contract aggregate demand and move the economy down, unemployment rises and inflation falls. This trade flow between inflation and unemployment, is called the Phillips curve.

The Phillips curve is named after New Zealand-born economist A. W. Phillips. In 1958, Phillips observed a negative relationship between the unemployment rate and the rate of wage inflation in data for the United Kingdom.

Social Costs of Inflation

  • Inflation imposes real costs on the economy.
  • First, inflation erodes the value of money. Although India is a moderate inflation country with the 62-year long-term average inflation rate being 6.7 per cent, yet during this period the overall price level has multiplied 45 times. This means that Rs.100 now is worth only Rs. 2.2 at 1950-51 prices.
  • Second, high and persistent inflation has significant socio-economic costs. Given that the burden of inflation is disproportionately large on the poor, and considering that India has a large informal sector, high inflation by itself can lead to distributional inequality.
  • Third, high inflation distorts economic incentives by diverting resources away from productive investment to speculative activities. Fixed-income earners and pensioners see a decline in their disposable income and standard of living.
  • Inflation reduces households� savings as they try to maintain the real value of their consumption. Consequent fall in overall investment in the economy reduces its potential growth.

Inflation Tax

Governments spend money for various purposes like building roads, raising armed forces, providing transfer payments to the poor and elderly, etc. The government can finance its spending in three ways. First, it can raise revenue through taxes, such as personal and corporate income taxes. Second, it can borrow from the public by selling government bonds. Third, it can print money. The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. As prices rise, the real value of the money in the hands of the people falls. In other words, money held by the public becomes less valuable. Printing money to raise revenue is, therefore, like imposing a tax which is called inflation tax. Inflation eats up a part of the value of money.

Fourth, economic agents base their consumption and investment decisions on their current and expected future income as well as their expectations on future inflation rates. Persistent high inflation alters inflationary expectations and apprehension arising from price uncertainty does lead to cut in spending by individuals and slowdown in investment by corporates which hurts economic growth in the long-run.

Fifth, as inflation rises and turns volatile, it raises the inflation risk premia in financial transactions. Hence, nominal interest rates tend to be higher than they would have been under low and stable inflation.

Sixth, if domestic inflation remains persistently higher than those of the trading partners, it affects external competitiveness through appreciation of the real exchange rate.

Finally, as inflation rises beyond a threshold, it has an adverse impact on overall growth. The Reserve Bank�s technical assessment suggests that the threshold level of inflation for India is in the range of 4 to 6 per cent. If inflation persists beyond this level, it could lower economic growth over the medium-term.

Written by princy

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