INFLATION
COST PUSH
OR DEMAND
PULL ?
MACROECONOMICSS :
GROUP 2
NAME ROLLNO
PGPBL/05/058
RAGHUL PALANISWAMY
PGPBL/05/037
ADITI BANERJEE
PGPBL/05/057
PRASHANT SRIVASTAVA
Inflation, the persistent rise in the general price level of goods and
services, is a critical economic phenomenon with profound
implications for nations, particularly developing economies such as
India.
FACT CHECK:
When India became a republic nation, the constitution of India came
into existence in 1952. At that time 1 USD was equal to 4.766 INR.
Compared to now as it is 1 USD = 83.4 INR.
As India's economic engine propels forward, the concurrent
challenges posed by inflation necessitate a thorough examination of
its root causes and the development of viable solutions.
Causes of Inflation:
1. Demand-Pull Factors: Population growth and rising urbanization
contributing to increased consumption
2. Cost-Push Factors: Escalating production costs, including wages,
raw materials, and energy
3. StructuraFactors: Inefficient agricultural practices, infrastructural
bottlenecks and inadequate investment in technology
4. Monetory Factors: Central bank actions affecting interest rate as
well as global economic conditions influencing capital flows
5. Fiscal policies: Excessive government spending without adequate
revenue and subsidies distorting market mechanisms
DEMAND PULL AND COST PUSH
INFLATION
Demand Pull Inflation
When concurrent demand for output exceeds what the economy can produce,
firms compete to purchase a limited amount of goods and services. The causes
of demand pull inflation are :
1. An increase in government spending can increase aggregate demand, thus
raising prices.
2. Depreciation of local exchange rates, which raises the price of imports and,
for foreigners, reduces the price of export.
3. •Rapid overseas growth can also ignite an increase in demand as more
exports are consumed by foreigners
4. • Reduction in taxes by government households leading to increase in
disposable income
Example: The financial institutions created an ever-growing pool of
MBS(mortgage-backed securities), driving huge and rapid gains in demand for
the securities among investors. As demand for MBS grew, it helped drive
housing prices to unsustainably high levels. When real estate prices collapsed,
the result was a deep recession.
Cost-Push Inflation
When the aggregate supply of goods and services decreases, often due to an
increase in production costs, it results in cost-push inflation. Production cost
may increase due to :
1. Increase in cost of the four factors of production—labor, capital, land, or
entrepreneurship
2. The price of raw materials due to scarcity of raw materials available
3. Increase in taxes by the government
4. The increase in cost is passed to the customers or can lead to decline in
supply causing cost push inflation.
Example:
The price of oil was increased by OPEC countries while demand for the
commodity remained the same. As the price continued to rise, the costs of
finished goods also increased, resulting in inflation
Effect of Inflation in the
Indian market
Inflation is a critical economic indicator that represents the rate at which the
general level of prices for goods and services rises, eroding purchasing power.
Inflation has significant and multifaceted impacts on the Indian market.
It influences various sectors and stakeholders in diverse ways, shaping economic
activities and consumer behaviors.
Understanding these effects is crucial for policymakers, businesses, and
consumers alike to navigate the complexities of an inflationary environment.
This overview delves into how inflation affects the Indian market, examining its
impact on consumer purchasing power, investment, business operations, and
overall economic stability.
Effect of Inflation in the
Indian market
GDP and Inflation Trend 2013-2023
GDP Growth
Year Inflation Rate (%)
Rate (%)
2013 6.39 9.13
2014 7.4 5.8
2015 8.2 4.9
2016 8.3 4.5
2017 7 3.3
2018 6.1 3.9
2019 4.2 4.8
2020 -6.6 6.2
2021 8.9 5.1
2022 6.9 6.7
2023 7.2 4.3
Effect of Inflation in the
Indian market
GDP and Inflation Trend 2013-2023
Source : Reserve Bank of India (RBI), Ministry of Statistics and Programme Implementation (MoSPI), and the World
Bank.
Short Term Effect Of Inflation
1. Consumer Purchasing Power:
In the short term, inflation reduces the purchasing power of consumers. As
prices rise, consumers can buy fewer goods and services with the same
amount of money, leading to a decline in the standard of living.
2. Cost of Living:
A spike in inflation leads to an immediate increase in the cost of living.
Essential commodities such as food, fuel, and housing become more
expensive, affecting household budgets, especially for the lower and middle
income groups.
3. Interest Rates:
The Reserve Bank of India (RBI) may increase interest rates to curb inflation.
Higher interest rates make borrowing more expensive, slowing down
consumer spending and business investments.
4. Stock Market Volatility:
Inflation can lead to increased volatility in the stock market. Higher inflation
rates often result in higher interest rates, which can negatively impact stock
prices as future corporate earnings are discounted at a higher rate.
5. Impact on Savings:
Inflation reduces the real value of savings. When inflation rates are higher
than the interest rates offered by banks, the real returns on savings become
negative, discouraging savings.
Long Term Effect Of Inflation
1. Economic Growth:
Prolonged inflation can hinder economic growth. High inflation creates uncertainty
about future prices, which can deter investment and long term planning. Businesses
may delay or reduce investments due to the unpredictability of costs and returns.
2. Income Redistribution:
Over the long term, inflation can lead to income redistribution. Fixed income
earners, such as pensioners and salaried employees, are disproportionately affected
as their income does not increase with inflation, leading to a decline in their
purchasing power.
3. Currency Devaluation:
Sustained high inflation can lead to the devaluation of the Indian rupee. As the
currency loses value, imports become more expensive, further exacerbating
inflationary pressures. Conversely, exports may become cheaper and more
competitive internationally.
4. Fiscal Deficit:
High inflation can impact government finances. The cost of public projects
increases, and the government may need to increase its expenditure to support
social welfare programs, leading to a higher fiscal deficit.
6. Wage Price Spiral:
If inflation persists, it can lead to a wage price spiral. Workers demand higher wages
to keep up with rising prices, which in turn leads to higher production costs and
further price increases, creating a self reinforcing cycle.
Is Inflation good or bad?
Aspect Why Is Inflation Bad? Why Is Inflation Good?
Erodes purchasing power, Encourages spending
Consumer
leading to reduced living before prices rise, boosting
Impact
standards. the economy.
Reduces the real value of Encourages investment in
Savings savings, discouraging long- assets that grow with
term savings. inflation.
Creates uncertainty, deterring A moderate level of inflation
Economic
investment and long-term indicates a growing
Stability
planning. economy.
Increases the cost of Reduces the real burden of
Debt
borrowing, reducing debt over time for
Management
consumption and investment. borrowers.
Analysis of CPI and its Factors
CPI Comparison with WPI and
Exchange Rate
CPI vs WPI - April 2014 to Feb 2024
CPI Vs Exchange Rate - April 2014 to Feb 2024
GDP Consumer Spending - April 2014 to Feb 2024
AR Model Fitting on CPI Data with Exogenous Variables
Chart Explanation:
Original CPI Data (Blue Line):
This line represents the actual historical data of the CPI inflation rate over time.
Fitted Values (Red Line):
This line represents the values predicted by the Auto Regressive model based on the
given CPI inflation rate data and exogenous variables (WPI inflation rate, exchange
rate, repo rate, and GDP consumer spending).
Model Accuracy:
The model appears to fit the data well, indicating that the chosen exogenous
variables (WPI inflation rate, exchange rate, repo rate, and GDP consumer
spending) significantly influence the CPI inflation rate.
Economic Implications:
The inclusion of these exogenous variables suggests that the CPI inflation rate is
influenced by both supply-side factors (WPI inflation rate) and demand-side factors
(GDP consumer spending), as well as monetary policy (repo rate) and external
factors (exchange rate).
VAR ( Vector Auto-Regression Model )
Impluse Response Function
Impulse Response Analysis: VAR enables the analysis of the effect of shocks to on
variable on others, providing insights into the transmission mechanisms of economi
policies and external shocks.
CPI Inflation Rate Response:
WPI Inflation Rate: A positive shock to the WPI inflation rate initially increases CPI
inflation, confirming WPI's strong influence on CPI.
Exchange Rate: A depreciation in the exchange rate slightly reduces CPI inflation,
aligning with the negative coefficient found earlier.
Repo Rate: An increase in the repo rate has a minimal and delayed impact on
reducing CPI inflation.
GDP Consumer Spending: A positive shock to consumer spending slightly increases
CPI inflation.
Variance Decomposition
The Forecast Error Variance Decomposition (FEVD) graph provides insights into how
each factor contributes to the forecast error variance of the CPI inflation rate over
time.
CPI Inflation Rate:
WPI Inflation Rate: Significantly impacts CPI inflation variance, indicating a strong
cost-push effect.
Exchange Rate: Moderate contribution, suggesting currency fluctuations affect CPI
but to a lesser extent.
Repo Rate: Minimal impact initially, but grows over time, indicating monetary
policy influence.
GDP Consumer Spending: Minor contribution, indicating weaker demand-pull
inflation effect.
Conclusion
Cost-Push Inflation :
WPI Inflation Rate ~ 50%
Exchange Rate ~ 20%
Demand-Pull Inflation :
Repo Rate ~ 20%
GDP Consumer Spending ~ 10%
Current Inflation in India is Cost-Push !
Summary
Based on the analysis, it is evident that the major contributing factors to CPI
inflation in India are the WPI inflation rate and the exchange rate, which together
account for 70% of the variation in CPI inflation. This indicates that cost-push
factors are significant drivers of inflation in India.
The repo rate and GDP consumer spending contribute less significantly but still
play important roles, with a combined contribution of 30%, indicating the
presence of demand-pull inflationary pressures as well.
Managerial Recommendations
Focus on Controlling Wholesale Prices: Since WPI inflation rate has the largest
impact on CPI, efforts should be made to control wholesale prices through effective
supply chain management, subsidies, and incentives for key sectors. Global factors,
like Ukrain-Russia conflict, Issues in MEA are one of the driving factors for supply
chain disruptions. India still spends 15% of GDP for logistics vs 10% US and Europe vs
9% for China.
Monitor and Manage Exchange Rates: Policies should aim to stabilize the exchange
rate to mitigate its impact on CPI inflation. This could involve using foreign
exchange reserves strategically and negotiating trade terms that minimize currency
volatility.
Monetary Policy Adjustments: The RBI should continue to use the repo rate
effectively to manage demand-pull inflation, ensuring that interest rates are
conducive to controlling inflation without stifling economic growth.
Stimulate Consumer Spending Prudently: While encouraging consumer spending
is important for economic growth, it should be managed in a way that does not lead
to excessive demand-pull inflation. This could involve targeted fiscal policies that
stimulate spending in strategic areas without overheating the economy.
References
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india/85983/1
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spending/#:~:text=Consumer%20spending%20across%
20India%20amounted,high%20during%20the%20recor
ded%20period.
[Link]
[Link]
and-not-demand-1824690-2021-07-06
Appendix
[Link] of Regression Results( VAR ( Vector Auto-Reg Model )
Appendix
