What is Inflation ?

Inflation is n Inflation is no stranger to the Indian economy.

In fact, till the early nineties Indians were used to double-digit
inflation and its attendant consequences. But, since the mid-
nineties controlling inflation has become a priority for policy
framers.
The natural fallout of this has been that we, as a nation,
have become virtually intolerant to inflation. While inflation till
the early nineties 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 dom

 Inflation is defined as a sustained increase in the

general level of prices for goods and services.

 It is measured as an annual percentage increase

 As inflation rises, the value of currency goes down. Thus the

purchasing power of the currency, i.e. the goods and
services that can be bought in a unit of currency, too goes
down.

Rising inflation level is a major issue worrying all the countries.

India’s inflation Rate.

The Indian economy has been registering stupendous growth

after the liberalization of Indian economy. 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.

The stupendous growth rate of industrial output and

employment has created enormous pressure on the inflation rate.
The Reserve Bank of India (the central bank) and the Ministry of
Finance, Government of India are concerned about the prevalent
and intermittent rise of the inflation rate. The present rise of
Inflation rate in India can be detrimental to the projected
growth of Indian economy. Thus, the Reserve Bank of India is
devising methods to arrest the rise of inflation by putting checks
and measures in place. Although the central bank has assured the
Indian business community and the general public about the
harmless inflationary rise, apprehensions still exist among the
business circles of India.

The main cause of rise of India Inflation Rate is the pricing

disparity of agricultural products between the producer and end-
consumer. Moreover, the meteoric rise of prices of food
products, manufacturing products, and essential commodities has
also catapulted the India Inflation Rate. As a result of this, the
Wholesale Prices Index (WPI) of India touched 6.1% as on 6th
January, 2007. Moreover, the Cash Reserve Ratio touched 5.5%
on the same day.
 To arrest the panic and discomfort amongst the Indian
business circles, the Reserve Bank of India, in its recently
drafted monetary policy, had given top priority to price stability.
It also sought to sustain the stupendous rate of economic growth
of India. The Reserve Bank of India has raised the Cash Reserve
Ratio in a continuous manner to arrest the rise of India Inflation
Rate.

The solution to this problem lies in rationalizing the pricing

disparity between the producer and the consumer. Only this will
ensure inflation stabilization and thus sustainable economic
growth of India.

Measures of Inflation
The inflation in the Indian economy can be measured in 3 ways:

1) National Income Deflator- This is defined as ratio of GDP at current

prices and GDP at Constant Prices. It is a comprehensive measure as it
encompasses all the goods and services produced in the economy. However,
its application is limited as it is released on a quarterly basis by CSO and
then it comes with a lag of 2 months (e.g. figures for quarter Jan-Mar 2008
quarter are released on 30 May, 2008). Further the GDP figures are subject
to revisions (though this applies to WPI as well) and together these factors
make it of little use for policymakers.

2) Based on Wholesale Price Index (WPI)- This is the most common

measure of inflation and is used for policy purposes.
3) Based on Consumer Price Indices- Within Consumer Price Indices, there
are four subindices that are based to capture price levels across different
types of consumers.
They are:
a. CPI - Industrial Workers
b. CPI- Urban Non-Manual Employees
c. CPI- Agricultural labor
d. CPI- Rural Labor
Long term trends in Inflation
! Long-term trends: Figure 1 shows overall inflation trends have
declined from 1970s levels. Inflation declines in 1980s, increases in 1990s
compared to 1980s level but again declines in 2000s. Inflation has nearly
halved in 2000s compared to 1970 levels and this is common across all
measures of inflation except WPI-Fuel. Apart from the absolute inflation
number, another important indicator is volatility in the overall inflation
trend. High volatility implies estimating inflation in future becomes difficult
and this makes anchoring inflation expectations very difficult.
 HOW INDIA CALCULATE INFLATION??

Rising inflation was the most recent ticklish political issue

that hit the Manmohan Singh government. But was inflation rising
because of price rise in essential commodities? Or was it because
of the 'erroneous method' of calculating inflation?

Some economists assert that India's method of calculating

inflation is wrong as there are serious flaws in the methodologies
used by the government.

Economists V Shunmugam and D G Prasad working with

India's largest commodity bourse -- the Multi Commodity
Exchange -- have come out with a research paper arguing that the
government urgently needs to shift the method of calculating
inflation.
Saying that there are serious flaws in the present method
of calculating inflation, the paper India should adopt
methodologies in developed economies.

So how does India calculate inflation? And how is it calculated in

developed countries ?

 India uses the Wholesale Price Index (WPI) to calculate

and then
decide the inflation rate in the economy.

 Most developed countries use the Consumer Price Index

(CPI) to calculate inflation.
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.

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 a

cost of living index. Under CPI, an index is scaled so that it is
equal to 100 at a chosen point in time, so that all other values of
the index are a percentage relative to this one.

Economists Shunmugam and Prasad say it is high time that India

abandoned WPI and adopted CPI to calculate inflation.
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.
"CPI is the official barometer of inflation in many countries
such as the United States, the United Kingdom, Japan, France,
Canada, Singapore and China. The governments there review the
commodity basket of CPI every 4-5 years to factor in changes in
consumption pattern," says their research paper.

It pointed out that WPI does not properly measure the exact
price rise an end-consumer will experience because, as the same
suggests, it is at the wholesale level.

The main problem with WPI calculation is that more than 100 out
of the 435 commodities included in the Index have ceased to be
important from the consumption point of view.

Take, 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.

India constituted the last WPI series of commodities in 1993-94;

but has not updated it till now that economists argue the Index
has lost relevance and can not be the barometer to calculate
inflation.
Shunmugam says WPI is supposed to measure impact of prices on
business. "But we use it 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," he pointed out.
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.
 CAUSES FOR INFLATION IN INDIA

The current rise in inflation has its roots in supply-side factors.

 There was shortfall in domestic production vis-a-vis

domestic demand and
 Hardening of international prices, prices of primary
Commodities, mainly food items. Wheat, pulses, edible oils,
fruits and vegetables, and condiments and spices have been
the major contributors to the higher inflation rate of
primary articles.
 The inflation was also accompanied by buoyant growth of
money and credit.
 While the GDP growth zoomed to 9.0 per cent per annum,
the broad money (M3) grew by more than 20 per cent.
 Demand for nearly everything from housing to fast moving
  consumer goods is outpacing supply in part because white-
collar
 salaries are rising faster in India than anywhere else in Asia

It would be too simplistic to hold any one factor responsible for

inflationary rise in prices in India in recent years.

Actually, all of them collectively have contributed to the price

situation in India in recent years.

All the factors responsible for the rise in general prices can be
categorized as
(*) Demand-Pull Factors
(*) Cost-Push Factors
(*) Other Factors

Consequences of Inflation

 Effects on production
 Effects on the distribution of Income
 Effects on fixed income earners
An Assignment of

Managerial Economics

On

Inflation Measures
in India

By,
D.Pradeep Kumar
Exe-MBA, IIPM, HYD