INFLATION

INFLATION
In ation

De nition: In ation is a continuous rise in the prices of goods and services in an economy, leading
to a decrease in purchasing power.

Example: If the price of bread increases from $1 to $1.10 over a year, it signi es in ation.

Causes of In ation

- Demand Pull In ation:

• Occurs when demand exceeds supply.
- Example: During a festive season like Diwali, the demand for sweets increases signi cantly,
causing their prices to rise.

- Cost Push In ation:

• Occurs when production costs rise, reducing supply.
- Example: If the cost of crude oil rises, making transportation more expensive, this can lead to
higher prices for goods like vegetables and electronics. For instance, if the cost of raw materials
for producing smartphones rises, the nal price of smartphones will also increase.

- Built-in In ation:
• Occurs due to past in ation and future in ation expectations.
- Example: If workers expect prices to rise, they may demand higher wages. If employees
anticipate a rise in living costs, they might negotiate higher salaries, leading businesses to
increase product prices to cover these costs.

De cit Financing and In ation Linkages

De nition: Governments often spend more than they earn, resulting in a de cit. This de cit can be
nanced by borrowing from the public or by the central bank printing more money.

• De cit Financing: Funding government spending through borrowing.

Example: If a government builds a new highway by borrowing money, it is engaging in de cit
nancing.

Impact on In ation:

• General De cit Financing: Can increase overall demand, leading to in ation.

Example: If the government borrows to fund a large-scale infrastructure project, it can boost
demand for construction materials and labor, pushing up their prices.
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 •
Monetization of De cit: This method, where the central bank prints more money, directly
increases the money supply and is highly in ationary.
Example: If the government prints money to nance its de cit, it can lead to an excessive amount
of money in circulation, driving up prices across the board.

In summary, in ation is a rise in prices caused by various factors such as increased demand, higher
production costs, and expectations of future price increases. De cit nancing, especially when it
involves printing more money, can exacerbate in ation.

Types of In ation: On the Basis of Pace

In ation can occur at different rates, each with unique economic implications. Here are the types of
in ation based on their pace:

In ation Rate/
Outcome Example
Type Pace

Creepin Low in ation, potentially bene cial for the Annual price increase of 2% in
< 4%
g economy. groceries.
Walking 4% - Manageable in ation, requires monitoring to Annual price increase of 5% in
/Mild 10% prevent escalation. housing.

Runnin 10% - Signi cant in ationary pressures, negatively Annual price increase of 15%
g 20% impacting savings. in healthcare.

Gallopi 20% - Severe, leads to loss of con dence in the Annual price increase of 30%
ng 50% currency. in electronics.

Extreme in ation, as de ned by Phillip Cagan; Monthly price increase of

Hyperin >
causes economic collapse and renders currency 100% in basic goods in post-
ation 50%
worthless. war Germany.
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 Other Types of In ation
1. Open In ation: Visible and measurable increase in prices without any attempt by the
government to control it.
◦ Example: Prices of consumer goods rising due to increased demand.
2. Suppressed/Repressed In ation: Occurs when prices are controlled by the government
despite increased demand.
◦ Example: Government-set price ceilings on essential goods, leading to shortages.
3. Structural In ation: Caused by changes in the structure of the economy, such as wage
increases or changes in production costs.
◦ Example: Increase in wages leading to higher production costs and thus higher
prices.
4. Re ation: Deliberate in ationary policy by the government to counteract de ation.
◦ Example: Government stimulus packages to boost spending.
5. Bi ation: Simultaneous in ation in some areas of the economy and de ation in others.
◦ Example: Rising healthcare costs alongside falling electronics prices.
6. Stag ation: Combination of stagnant economic growth and high in ation.
◦ Example: High unemployment rates combined with rising food prices.
7. Skew ation: In ation affecting only certain sectors of the economy, not the overall
economy.
◦ Example: Signi cant price increases in the housing market but stable prices
elsewhere.
8. Disin ation: Slowdown in the rate of in ation, still positive but declining.
◦ Example: In ation rate dropping from 5% to 3%.
9. De ation: Decrease in the general price level of goods and services.
◦ Example: Falling prices in the real estate market during a recession.
10. Shrink ation: Reduction in the size or quantity of products while maintaining the same
price.
◦ Example: Snack bags containing fewer chips but costing the same.
11. Skimp ation: Reduction in the quality of services provided while keeping prices the same.
◦ Example: Airlines offering fewer in- ight services without lowering ticket prices
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 Japani cation

Japani cation refers to a prolonged period of de ation, economic stagnation, declining property
markets, and nancial stress as households, companies, and governments struggle to deleverage
after excessive borrowing.

• Example: Japan's "Lost Decade" during the 1990s when the country faced economic
stagnation and de ation.
In ation Premium

An in ation premium is the additional interest rate charged by lenders to compensate for higher
expected in ation, pushing nominal interest rates higher.

• Example: Lenders increasing mortgage interest rates due to anticipated in ation.

In ationary and De ationary Gap

• In ationary Gap: Occurs when aggregate demand exceeds the level required to maintain
full employment, leading to rising prices.
◦ Example: Increased consumer spending during an economic boom leading to higher
prices.
• De ationary Gap: The shortfall of aggregate demand below the level required to maintain
full employment, resulting in falling prices.
◦ Example: Reduced consumer spending during a recession leading to lower prices.
Greed ation

Greed ation refers to in ation driven by corporate greed rather than an increase in production costs,
demand, or wages. It implies that companies exploit in ation to generate excessive pro ts.

Proponents' View:

•
Increased market dominance by corporations.
•
Calls to limit market power and prevent pro teering, sometimes advocating for a ban on
price hikes.
◦ Example: Large corporations increasing prices more than necessary to maximize
pro ts.
Opponents' View:

• Businesses set prices based on consumer willingness to pay.

• Seen as a political narrative rather than an actual explanation for in ation.
◦ Example: Economists arguing that market competition prevents arbitrary price
hikes.
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 Impacts of In ation

In ation affects various economic agents and variables differently, leading to both positive and
negative consequences:

Economic Agent/
Impacts Example
Variable
Borrowers
Borrowers gain as the real value of their debt decreases
Creditors and bene ting from
with in ation, while lenders lose as the purchasing
Debtors lower real debt
power of the repayment declines.
values.
Bondholders
Bond and Fixed interest income earners see a reduction in real
experiencing
Debenture income due to in ation eroding the purchasing power of
decreased real
Holders their earnings.
returns.
Shareholders
Investors in stocks may bene t as businesses can gaining from
Investors
potentially increase pro ts during in ationary periods. increased business
pro ts.
Wage earners
Individuals with xed incomes suffer as wage increases
Salaried People experiencing
often lag behind price rises, leading to a decline in real
and Wage Earners reduced purchasing
purchasing power.
power.
Pro t-Earners, Pro t-makers can bene t from in ation by raising prices Businesses pro ting
Speculators, and and generating higher pro ts, while speculators in from increased
Black Marketeers essential goods may exploit price volatility. product prices.
Savers facing
In ation reduces the real return on savings, effectively
diminished
Savers taxing savings as the nominal return fails to keep pace
purchasing power of
with rising prices.
savings.
Taxpayers
In ation can push individuals into higher tax brackets
experiencing
Taxpayers without a corresponding increase in real income,
bracket creep due to
increasing their tax burden.
in ation.
Currency
In ation can lead to currency depreciation, affecting
devaluation
Exchange Rate trade balances and the cost of imports, potentially
impacting export
contributing to imported in ation.
competitiveness.
These bonds provide investors a return adjusted for In ation Indexed
In ation Indexed
in ation, protecting their real returns in an in ationary Bonds ensuring
Bonds (IIBs)
environment. capital protection.
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 In ation Indexed Bonds (IIBs)

De nition: In ation Indexed Bonds (IIBs) are issued by governments to provide investors with
returns adjusted for in ation. They protect against the erosion of purchasing power caused by
in ation.

Features:

• Indexing: In India, IIBs are typically indexed to the Wholesale Price Index (WPI). At
redemption, investors receive the higher of the adjusted principal or the face value.
• Protection: They safeguard investors' capital from losing value due to in ation, ensuring
that their purchasing power is maintained.
Historical Context:

• Capital Indexed Bonds (CIBs): An earlier version issued in 1997 protected only the
principal against in ation, whereas IIBs protect both principal and interest payments.
Taxation: There are no special tax concessions for IIBs in India, but they serve as a hedge against
in ation's impact on investment returns.

By understanding these impacts and mechanisms like IIBs, individuals and institutions can better
navigate the challenges posed by in ation in their nancial planning and investment strategies.

Measuring In ation

In ation in an economy is assessed through various price indices that track changes in prices over
time across different sectors. Here are some key indices used to measure in ation:

1. Consumer Price Index (CPI)

◦ De nition: CPI measures the average change in prices paid by consumers for goods
and services over time. It re ects the cost of living for urban and rural populations.
◦ Types:
▪ CPI(Urban): Released by the National Statistical Of ce (NSO) for urban
areas.
▪ CPI(Rural): Also released by NSO, tracking rural area price changes.
▪ CPI(Combined): Aggregated CPI(Urban) and CPI(Rural) data by NSO.
▪ CPI(Agriculture Laborer), CPI(Rural Laborer), CPI(Industrial Workers):
Released by the Labor Bureau, speci c to different labor groups.
▪ Consumer Food Price Index: Measures changes in food prices within CPI
calculations.
◦ Example: An increase in CPI(Urban) indicates rising urban consumer prices,
impacting urban households' purchasing power.
2. Wholesale Price Index (WPI)

◦ De nition: WPI measures the average change in the prices of goods traded in bulk at
the wholesale level. It excludes services.
◦ Types:
▪ Headline WPI: Overall index for all commodities.
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 ▪
Food Index: Tracks changes speci cally in food prices.
◦ Example: A rise in WPI indicates increasing costs for producers, potentially leading
to higher retail prices over time.
3. Producer Price Index (PPI)

◦ De nition: PPI monitors changes in prices from the perspective of producers. It

tracks prices of goods and services before they reach consumers.
◦ Calculation: PPI excludes indirect taxes, transportation, and trade margins.
◦ Example: An increase in PPI suggests rising production costs, which may eventually
translate into higher consumer prices.
4. GDP De ator

◦ De nition: The GDP de ator measures the overall level of prices in an economy
relative to the base year. It re ects in ation within the economy as a whole.
◦ Calculation: GDP De ator = (Nominal GDP / Real GDP) * 100
◦ Example: A higher GDP de ator indicates in ationary pressures affecting the entire
economy's output.
5. Residex

◦ De nition: Residex is India's of cial Housing Price Index (HPI), managed by the
National Housing Bank (NHB). It tracks changes in residential property prices.
◦ Example: An increase in Residex signi es rising housing costs, impacting
affordability and real estate investments.
These indices provide critical insights into price movements across different sectors of the
economy, helping policymakers, businesses, and consumers anticipate and respond to in ationary
trends effectively.

Food In ation Scenario in India

In India, sustained high food in ation signi cantly impacts welfare, given that food makes up 45%
of the CPI consumption basket. Several factors contribute to this scenario:

1. Demand-Side Factors:

◦ Rising Income and Diversi cation of Diets: Increased income levels and dietary
diversi cation lead to higher demand for high-value food products like pulses, meat,
sh, eggs, milk, vegetables, and fruits.
◦ High Expenditure Elasticities: There is growing demand pressure for vitamin and
protein-rich commodities due to rising per capita income and changing consumption
patterns.
2. Example: As urbanization increases and incomes rise in India, there is a notable shift in
consumer diets towards protein-rich foods like meat and dairy products. This trend fuels
demand for these items, contributing to food in ation pressures.

3. Supply-Side Factors:

◦ Rising Input Costs: Increased prices of key inputs such as fuel and agricultural
wages contribute to higher production costs, in uencing food prices.
◦ Transportation Costs: Fuel in ation affects food in ation as it is essential for
transporting produce and powering agricultural machinery like tube wells and
tractors.
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 ◦ International Price Movements: Integration into international agricultural trade
exposes India to uctuations in global food prices, impacting domestic food
in ation.
4. Example: In recent years, uctuations in global crude oil prices have directly impacted
transportation costs in India. Higher fuel prices increase the cost of transporting food from
farms to markets, thereby raising overall food prices.

Policy Interventions for Containing Food In ation

To manage food in ation effectively, several policy interventions are crucial:

• Monetary Policy Actions:

◦ Conducting monetary policy to moderate demand pressures by adjusting interest

rates and managing money supply.
• Fiscal Policy Actions:

◦ Implementing scal policies to manage demand and increase supply, such as

controlling government expenditures, incentivizing savings, and possibly adjusting
tax rates.
• Administrative Policy Actions:

◦ Employing administrative measures like price controls, maintaining buffer stocks,

regulating speculation and hoarding, and managing commodity futures trading.
In ation Management Strategies

Maintaining low, predictable, and stable in ation is essential for economic stability:

• In ation Targeting Regime:

◦ Since 2015, the Reserve Bank of India (RBI) follows Flexible In ation Targeting
(FIT) under the Monetary Policy Framework Agreement (MPFA).
◦ Target: RBI aims to keep consumer price in ation within 4% with a tolerance band
of (+/-) 2%.
◦ Monetary Policy Committee (MPC): The MPC, chaired by the RBI Governor, uses
tools like the repo rate to achieve in ation targets.
◦ Statutory Backing: FIT regime is legally supported through amendments to the RBI
Act, 1934.
These strategies aim to ensure price stability, boost investor con dence, and foster sustainable
economic growth amid varying in ationary pressures.

Phillips Curve: Linkage between In ation and Unemployment

• Theory Overview

◦ The Phillips Curve posits an inverse relationship between in ation and

unemployment.
◦ It suggests that as unemployment decreases, in ation tends to
increase, and vice versa.
◦ Economic growth is often associated with higher in ation
rates.
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 • Evolution and Criticism

◦ Historical Context:
▪ The stable trade-off between in ation and unemployment broke down in the
1970s.
▪ Stag ation emerged, characterized by simultaneous high in ation and high
unemployment.
◦ RBI's Perspective:
▪ The RBI and its Monetary Policy Committee (MPC) historically did not
explicitly use unemployment in rate-setting decisions.
▪ A 2021 RBI paper indicated a revival of interest in the Phillips Curve post the
global nancial crisis.
Misery Index

• De nition

◦ The Misery Index was originally created by economist Arthur Okun to gauge
economic performance from the perspective of the average citizen.
◦ It combines the annual in ation rate with the seasonally adjusted unemployment rate.
• Modi ed Misery Index (Steve Hanke's Version)

◦ Components:
▪ Incorporates in ation, unemployment, and bank lending rates.
▪ Also includes the percentage change in real GDP per capita.
◦ Formula Misery Index =
Unemployment Rate
+
Inflation Rate
+
Bank Lending Rates
−
Percentage Change in Real GDP per Capita

Misery Index=Unemployment Rate+In ation Rate+Bank Lending Rates−Percentage

Change in Real GDP per Capita
◦ Purpose:
▪ Provides a comprehensive measure of economic distress and policy impact.
▪ Offers insights beyond traditional economic indicators, re ecting broader
economic well-being.
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