Case study: Inflation

What is causing Inflation?

Inflation is the rise in prices which occurs when the demand for goods and services exceeds their
available supply. In simpler terms, inflation is a situation where too much money chases too few
goods. In India, the wholesale price index (WPI), which was the main measure of the inflation rate
consisted of three main components - primary articles, which included food articles, constituting
22% of the index; fuel, constituting 14% of the index; and manufactured goods, which accounted for
the remaining 64% of the index.
For purposes of analysis and to measure more accurately the price levels for different sections of
society and as well for different regions, the RBI also kept track of consumer price indices. The
average annual GDP growth in the 2000s was about 6% and during the second quarter (July-
September) of fiscal 2006-2007, the growth rate was as high as 9.2%. All this growth was bound to
lead to higher demand for goods. However, the growth in the supply of goods, especially food
articles such as wheat and pulses, did not keep pace with the growth in demand. As a result, the
prices of food articles increased. According to Subir Gokarn, Executive Director and
Chief Economist, CRISIL, "The inflationary pressures have been particularly acute this time due to
supply side constraints [of food articles] which are a combination of temporary and structural
factors."

Measures Taken
In late 2006 and early 2007, the RBI announced some measures to control inflation. These measures
included increasing repo rates, the Cash Reserve Ratio (CRR) and reducing the rate of interest on
cash deposited by banks with the RBI. With the increase in the repo rates and bank rates, banks had
to pay a higher interest rate for the money they borrowed from the RBI. Consequently, the banks
increased the rate at which they lent to their customers. The increase in the CRR reduced the money
supply in the system because banks now had to keep more money as reserves. On December 08,
2006, the RBI again increased the CRR by 50 basis points to 5.5%. On January 31, 2007, the RBI
increased the repo rate by 25 basis points to 7.5%...

Some Perspectives
The RBI's and the government's response to the inflation witnessed in 2006-07 was said to be based
on 'traditional' anti-inflation measures. However, some economists argued that the steps taken by the
government to control inflation were not enough...

Outlook
Several analysts were of the view that the RBI could have handled the 2006-07 inflation without
tinkering with the interest rates, which according to them could slow down economic growth. Others
believed that high inflation was often seen by investors as a sign of economic mismanagement and
sustained high inflation would affect investor confidence in the economy.
However, the inflation rate in emerging economies was usually higher than developed economies

Questions:
Q1. Explain the concept of Inflation in Indian context.
Q2. Give out the ways of curbing inflation.
Your report must be presented as text format of 5 pages.

RBI has decided to reduce the Cash Reserve Ratio (CRR) for Scheduled Commercial Banks by 50
basis points from 5.50 per cent to 5.00 per cent and Repo Rate is 4.75% of their net demand with
effect from January 17, 2009.
Knowing Inflation…

By inflation one generally means rise in prices. To be more correct inflation is persistent rise in the
general price level rather than a once-for-all rise in it, while deflation is persistent falling price. A
situation is described as inflationary when either the prices or the supply of money are rising, but in
practice both will rise together. These days economies of all countries whether underdeveloped,
developing as well developed suffers from inflation. Inflation or persistent rising prices are major
problem today in world. Because of many reasons, first, the rate of inflation these years are much
high than experienced earlier periods. Second, Inflation in these years coexists with high rate of
unemployment, which is a new phenomenon and made it difficult to control inflation.

An inflationary situation is where there is 'too much money chasing too few goods'. As
products/services are scarce in relation to the money available in the hands of buyers, prices of the
products/services rise to adjust for the larger quantum of money chasing them. As someone once
said, "Inflation is when you pay Rs.15 for a Rs.10 haircut you used to get for Rs.5 when you had
hair."

Inflation in Indian Context…

Inflation is no stranger to the Indian economy. The Indian economy has been registering stupendous
growth after the liberalization of Indian economy. In fact, till the early nineties Indians were used to
ignore inflation. But, since the mid-nineties controlling inflation has become a priority. The natural
fallout of this has been that we, as a nation, have become virtually intolerant to inflation. The
opening up of the Indian economy in the early 1990s had increased India's industrial output and
consequently has raised the India Inflation Rate. While inflation was primarily caused by domestic
factors (supply usually was unable to meet demand, resulting in the classical definition of inflation
of too much money chasing too few goods), today the situation has changed significantly.

Inflation today is caused more by global rather than by domestic factors. Naturally, as the Indian
economy undergoes structural changes, the causes of domestic inflation too have undergone tectonic
changes. The main cause of rise in the rate of inflation rate in India is the pricing disparity of
agricultural products between the producer and consumers in the Indian market. Moreover, the sky-
rocketing of prices of food products, manufacturing products, and essential commodities have also
catapulted the inflation rate in India. Furthermore, the unstable international crude oil prices have
worsened the situation.
Defining causes of Inflation…

What exactly is the nature of this inflation which has the nation in its grip? The different causes of
inflation which are experienced in Indian economy in a large proportion would be:-

Demand-pull inflation: This is basically when the aggregate demand in an economy exceeds the
aggregate supply. It is also defined as `too much money chasing too few goods'. Bare-boned, it
means that a country is capable of producing only 100 items but the demand is for 105 items. It's a
very simple demand-supply issue. The more demand there is, the costlier it becomes. Much the same
as the way real estate in the country is rising.

Cost-push inflation: This is caused when there is a supply shock. This represents the condition
where, even though there is no increase in Aggregate Demand, prices may still rise. I.e. non
availability of a commodity would lead to increase in prices. This may happen if the costs of
especially wage cost rise.

Imported Inflation: This is inflation due to increases in the prices of imports. Increases in the prices
of imported final products directly affect any expenditure-based measure of inflation. They play an
important role in driving the rise in domestic prices. The rise in the global prices of crude oil and
agricultural commodities, including food grains, and industrial products, and setbacks to global
economy resulting from sub-prime mortgage disaster and US recession have contributed to India’s
inflation.

Other Causes:

• When the government of a country print money in excess, prices increase to keep up with the
increase in currency, leading to inflation.
• Increase in production and labor costs, have a direct impact on the price of the final product,
resulting in inflation.
• When countries borrow money, they have to cope with the interest burden. This interest
burden results in inflation.
• High taxes on consumer products, can also lead to inflation. An increase in indirect taxes can
also lead to increased production costs.
• Inflation can artificially be created through a circular increase in wage earners demands and
then the subsequent increase in producer costs which will drive up the prices of their goods
and services. This will then translate back into higher prices for the wage earners or
consumers. As demands go higher from each side, inflation will continue to rise.
• Debt, war and other issues that cause a drastic financial blunder can also cause the inflation.
Measuring Inflation…

Inflation in India is mainly estimated on the basis of fluctuations in the wholesale price index (WPI).
The wholesale price index comprises of the following indices:
 Domestic Wholesale Price Index (DWPI)
 Export Price Index (EPI)
 Import Price Index (IPI)
 Overall Wholesale Price Index (OWPI)

The WPI consists of about 435 items and has three broad categories. They are:-
 Primary Articles (weight of 22.0253) – 22% Index
 Fuel, Power, Light, and Lubricants (weight of 14.2262) - 14% Index
 Manufactured Products (weight of 63.7485) – 64% Index

The base year of the WPI is 1993-94. The base year usually chosen is one where there has been
fairly less volatility. The Indian WPI figure is released weekly on every Thursday. But recently the
government has approved the proposal to release a wholesale price based inflation data on a monthly
basis, instead of every week. The new series of WPI based inflation with 2004-05 as the base year
would be launched soon. The move is aimed at improving the accuracy of the inflation data.

The monthly release of WPI is a widely-followed international practice. And, it is expected to

improve the quality of data. Collection of price data of manufactured products will, accordingly,
have a monthly frequency consistent with the practice of release of WPI. The new series of WPI
based inflation with 2004-05 as the base year would be launched soon. However, the government
will continue to release a weekly index for primary articles, and commodities in the fuel, power,
light and lubricants groups. The weekly index will facilitate monitoring of prices of agricultural
commodities and petroleum products, which are sensitive in nature.

Problems of Inflation…
It has been reported that the manufacturing capacity in India is running around 95 per cent, which
usually means it is running at full capacity. Therefore, when the price of manufactured products is
increasing, it means that demand is usually higher than supply and that is a clear case of demand-pull
inflation.

On the primary goods front, which consists of fruits, vegetables, food-grains etc, it is not that
straight-forward. It has certainly been all over the news that the prices of fruits and vegetables are
increasing and a trip to the supermarket or local grocery shop will testify to that. Although it is a
clear case of demand-pull inflation, on the other, it is also a bit of a supply shock when one considers
the fact that there is an abnormally high percentage of fruits and vegetables that goes to waste
because of the lack of cold-storage facilities. Some estimates say 50 per cent of produce goes to
waste and that is a conservative number.

The fuel price hike is a straight example of cost push inflation. When OPEC (The Organization of
the Petroleum Exporting Countries) was formed, it squeezed the supply of oil and this caused oil
prices to rise, contributing to higher inflation. Since oil is used in every industry, a sharp rise in the
price of oil leads to an increase in the prices of all commodities.

The in depth problems due to inflation would be:

• When the balance between supply and demand goes out of control, consumers could change
their buying habits, forcing manufacturers to cut down production.
• Inflation can create major problems in the economy. Price increase can worsen the poverty
affecting low income household.
• Inflation creates economic uncertainty and is a dampener to the investment climate slowing
growth and finally it reduce savings and thereby consumption.
• The producers would not be able to control the cost of raw material and labor and hence the
price of the final product. This could result in less profit or in some extreme case no profit,
forcing them out of business.
• Manufacturers would not have an incentive to invest in new equipment and new technology.
• Uncertainty would force people to withdraw money from the bank and convert it into product
with long lasting value like gold, artifacts.

The imbalances inflation has created in the Indian economy:-

 • It has created a new rich class in social and political lives who are corrupt themselves and
also corrupt the overall society.
• The increased prices reduced the capacity to save and people preferred present consumption
to future consumption.
• It has provided protection and subsides to industries which bred inefficiency.
• It has lead to misallocation of resources due to distortion of relative prices and finally a
redistribution of wealth from the poor to the rich.
• It disturbs balance of payments.

A time where we were used to paying Rs 2 for a dozen bananas, have to shell out the same amount
for a single fruit now. A cup of coffee in a Grade III Udupi restaurant in Mumbai costs Rs 12,
against Rs 8 a year ago, due to the rise in prices of the ingredients. There is no index for the large
sections of single persons in big cities who depend on hotels for all their meals.

Curbing Inflation…

There are several reasons why we should worry about the spike in the inflation rate. Inflation is a tax
on the poor and long-term lenders. Inflation is already too high, though it is definitely not at
economy-wrecking levels. But it’s best to be serious about the threat it poses. Inflation has emerged
as the biggest risk to the global outlook, having risen to very high levels across the world, levels that
have not been generally seen for a couple of decades.

Currently, in India, we go through boom-and-bust cycles; sometimes GDP growth rates are very
high and sometimes GDP growth rates drop sharply. This boom-and-bust cycle is unpleasant for
every household. There is a powerful international consensus that stabilizing inflation reduces this
boom-and-bust cycle of GDP growth.

India is facing the problem of inflationary pressure because of the increase in Aggregate Demand
while Aggregate Supply is respectively constant. The inflationary pressure faced by Indian Economy
is due to Demand-Pull inflation i.e. Aggregate Demand > Aggregate Supply. Thus to curb inflation
need to fill the gap between Aggregate Demand and Aggregate Supply. For this either we need to
increase Aggregate Supply or decrease Aggregate Demand that can hamper economic development.
To increase Aggregate Supply either there is a need to increase production capacity of all current
production units or to build new production plants.

But as quoted in a survey done by RBI that all the production plants are running at their full
production capacity thus all resources are full employed. The other way is to build new plant but to
do this will take at least 18months to 2years. Thus meanwhile we need to decrease Money Supply,
which is opted by RBI. Increasing production of useful goods and services is what India should
focus on.

As in the short run it is not possible to meet the gap between Aggregate Demand and Aggregate
Supply thus RBI is planning to decrease liquidity by reducing Money Supply from the market. RBI
planned that Liquidity from the market can be drained by decreasing money supply and to do so it is
increasing CRR, repo rate, reverse repo rate and taking other measure like that.

CRR i.e. Cash Reserve Ratio (Liquidity Ratio) is the percentage of deposit that a commercial
bank needs to keep with RBI by which RBI control liquidity in the market and create Money Supply.
Repo Rate is the rate at which RBI lends money to other commercial Banks.

The Reserve Bank said that such decisions had been taken to curb inflation in India. RBI is taking
positive steps to reduce the inflation since inflations rates are going up week by week. By raising the
reserve rate, a deflationary pressure can be put on the economy, since the money multiplier has been
reduced. People will therefore save more. But in this hike, there is negative impact in terms of higher
interest rates and personal loans, vehicle loans and other loans become costly. RBI may hike the rate
to reduce the money circulation in the country but it also decreased the sales of all loan items and
further it reduces the manufacturing activity of many industries. Now the public and private
sector banks may raise the interest rate at which they lend money to borrowers.

Produce more exports than imports than another country, then your money deflates with respect to
that currency. Exporting becomes a problem cause buyers from outside feel that the goods are
expensive so they prefer buying some other country’s goods with cheaper rate. Thus money does not
come in. in the same way, when public has more money they buy foreign goods, thus money goes
out which is bad. There is a need to encourage people to purchase goods produced within the
country.

It is important for policymakers to make credible announcements and degrade interest rates. Private
agents must believe that these announcements will reflect actual future policy. If an announcement
about low-level inflation targets is made but not believed by private agents, wage-setting will
anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will
increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so
inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible,
policy will not have the desired effect.

Keynesians emphasize reducing demand in general, often through fiscal policy, using increased
taxation or reduced government spending to reduce demand as well as by using monetary policy.
Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency
and some reference currency such as gold. This would be a return to the gold standard. All of these
policies are achieved in practice through a process of open market operations.

As individuals what can we do to stop Inflation?

Firstly save!!! As much of your money as possible should be saved. This will reduce the demand on
the economy and hopefully reduce inflation. Do not overuse daily essentials like cooking gas,
electricity etc. Cut down on inessentials when buying groceries. Look for cheaper alternatives to
products that you normally buy.

Keep roads, highways, sidewalks, etc., beautified to help attract tourism and bring additional
monetary into a growing economy. Stop illegal immigration. Illegal activities reap the benefits of the
country but don't pay taxes. Government-backed investment schemes such as Post Office Savings
Schemes, Public Provident Funds (PPF) and National Savings Certificates (NSC) are best to invest
in when inflation is slowly inching up and you are only looking at safety, not returns. Invest in short
term deposits and funds, commodities and property. This will help you to slowly reach your
financial goals while safeguarding your hard-earned money.

Conclusion…

There is actually no methodology to erase inflation in a region, but there are prevention measures
that could be done. The government could predict threatening crisis and perhaps promote and open
up trade or tourism industry to keep suffice cash flowing in their country. This could fade off some
notorious effects of inflation. Inflation is like a toothache. It grows slowly, inexorably, and in the end
affects your efficiency. Just like for toothaches, tolerance levels vary for inflation too. Some
countries can tolerate higher levels of it without growth slowing down. For others, the threshold is
lower. Developed countries have lower inflation thresholds -- as usual the rich are softer -- and
developing countries have higher thresholds.