Og
Master notes
Indian
Economy
INFLATION
INFLATION
Inflation is a sustained increase in the general price level of goods and services in an economy over a
period of time. It reduces the purchasing power of money, meaning you need more money to buy the
same amount of goods or services as before.
1. Definition of Inflation
Inflation is the rate at which the general price level of goods and services rises, eroding purchasing
power. It is measured on a year-on-year basis. It is usually expressed as a rate as follows:
𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 =
For example:
If Maggi costs ₹12 this year and rises to ₹15 next year, the inflation rate is approximately 25%.
Similarly, with 100 rupees we could have bought 8 Maggie's earlier. Now, we can only buy 6
Maggies only. Hence, our purchasing power got reduced. Thus, increasing inflation reduces the
purchasing power.
However, inflation cannot be told only with increase in price of a single product. We need to measure
for a basket of products affecting different sections of the society to account for any rise or fall in
prices. It is measured through the Price Index (the concept of the Price Index is explained in detail in
the sections below).
2. Types of Inflation
It can be categorized on the basis of its rate as well as its causes.
Types of Inflation based on Rate
Depending on the rate of rise in prices, there are 4 types of inflation as explained below.
Creeping Inflation or Mild Inflation or Low Inflation
As the name suggests, this type of inflation creeps, which means that the rise in prices is slow but
continuous.
Generally, the rate of price rise between 2% - 3% is categorized as Creeping Inflation.
This inflation is manageable and is, generally, considered good for the growth of the economy.
At this rate of price rise (2 percent to 3 percent), the producers and traders make reasonable
profits, which encourages them to invest more.
Walking Inflation or Trotting Inflation
When the rate of rise in prices is more than that in Creeping Inflation, then it is called Walking
Inflation or Trotting Inflation.
Generally, the range of this inflation is between 3% - 10%.
It must be taken by the government as a wake-up call as, if not checked, it may lead to Running
Inflation or Galloping Inflation.
Galloping Inflation or Hopping Inflation or Running Inflation
When the rate of price rise is more than 10% and below 50%, it is known as Galloping Inflation.
Due to this high level of price rise, businesses and employees’ incomes cannot keep up with the
costs and prices.
Investors also refrain from investing in economies with this high level of inflation.
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Hyperinflation
It is an extreme form of inflation where the prices rise at an alarmingly high rate, usually more
than 50% per month.
Usually, it occurs when there is a large increase in the money supply.
Hyperinflation, in its extreme situations, means that the value of domestic
currency reduces to almost zero and even to buy a loaf of bread, one needs to carry money in big
bags.
Thus, money almost ceases to be a store of value as well as a medium of exchange.
The most recent phenomena of Hyperinflation are those in Zimbabwe during 2004-09 and in
Venezuela in 2019.
Types of Inflation based on Causes
Based on the underlying causes, inflation is, broadly, categorized into the following types.
Demand-Pull Inflation
A rise in prices of goods and services due to an increase in aggregate demand and consumption
is called Demand-Pull Inflation.
The underlying reason for this type of inflation is, usually, the increased disposable income in the
hands of households, thereby increasing their demands for goods and services.
This, in turn, means that while the aggregate supply of goods and services remains the same, their
aggregate demand increases sharply, thus raising their prices.
Cost-Push Inflation
A rise in prices of goods and services due to an increase in the cost of ‘factors of production’ i.e.
land, labor, capital, and entrepreneurs is called Cost-Push Inflation.
The underlying reason for this type of inflation is the increased cost of one or more inputs of
production (i.e. land, labor, capital, and entrepreneurs). For example, a rise in the wage of labor.
As a result of this, the overall cost of production of the good/service increases, and hence its price
in the market increases.
Supply-Shock Inflation
A rise in prices of goods and services due to either an unexpected or unforeseen sharp fall in the
supply of commodities is called Supply-Shock Inflation.
It is called “Supply-Shock” because its causal factors lie out of the control of either the firms or the
workers.
Structural Inflation or Bottleneck Inflation
A rise in prices of goods and services due to deficiencies existing in the economy such as
inefficient storage and distribution facilities, poor productivity, etc is called Structural or
Bottleneck Inflation.
These deficiencies lead to shortages of supply of the good/service, which, in turn, results in its
increased price.
The Government faces a tough time tackling this type of inflation.
Protein Inflation
It is generally caused by the changing dietary habits of the population of a country due to the
increase in income.
As more and more people include protein-rich items such as milk, pulses, meat, fish, etc., it
increases the demand and hence the prices of these items.
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3. Measures of Inflation
To effectively monitor and control the level of inflation in an economy, policymakers use various
kinds of instruments.
In India, inflation is mainly measured through two price indices – the Wholesale Price Index (WPI) and
the Consumer Price Index (CPI). Another measure of inflation frequently used across the world is –
GDP Deflator.
Price, Price Level, and Price Index
The price of a good or service is defined as the rate at which that good or service is exchanged for
money. In other words, the price of a good or service is the amount of money received for selling or,
paid for buying, one unit of that good or service.
The term Price Level refers to the average price or cost of all goods and services offered for sale
in an economy. Measurement of price level allows economists to monitor changes in prices over
a period of time.
A Price Index is a statistical measure that reflects the average change in prices over time for a basket
of goods and services. It is expressed with reference to a particular period, called the Base Year.
A base year is selected and its index is assumed as 100. On its basis, the price index for other periods
is calculated.
𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 =
Price Indices are used to measure the level of inflation.
Wholesale Price Index (WPI)
The Wholesale Price Index (WPI) measures the average change in the price of commodities traded in
the wholesale market.
In other words, the Wholesale Price Index (WPI) measures the average change in the prices of
commodities for bulk sale at the level of the early stage of transactions in the domestic markets of
India. It covers three commodity groups:
Primary Products
Fuel, and Power
Manufactured Products
Thus, the WPI basket does not cover Services.
The prices tracked are ex-factory prices for manufactured products, mandi prices for agricultural
commodities, and ex-mines prices for minerals. Weights given to each commodity covered in the
Wholesale Price Index (WPI) basket are based on the value of production adjusted for net imports.
It is compiled and released by the Office of Economic Advisor, Ministry of Commerce and Industry on
a monthly basis. The Base year for WPI is 2011-12.
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Consumer Price Index (CPI)
The Consumer Price Index (CPI) measures the average change in prices paid by final consumers
for a particular basket of goods and services over a period of time.
In other words, the Consumer Price Index (CPI) measures changes over time in the general level of
prices of goods and services that households acquire for the purpose of consumption. Because of the
different socioeconomic conditions of consumers, various types of Consumer Price Indices (CPIs) are
calculated in India.
CPI for Industrial Workers (CPI-IW)
CPI for Industrial Workers (CPI-IW) measures the change in the price of commodity basket
consumed by the industrial workers.
It is compiled and released by the Labor Bureau, Shimla, Ministry of Labor on a monthly basis.
Base Year for CPI-IW is 2016.
It is used for wage indexation in government and organized sectors.
CPI for Urban Non-Manual Employees (CPI-UNME)
CPI for Urban Non-Manual Employees (CPI-UNME) measures the change in the price of
commodity baskets consumed by non-manual employees like office goers.
Now, it has been discontinued.
It was compiled by the Central Statistical Organisation (CSO), Ministry of Statistics and Programme
Implementation on a monthly basis.
CPI for Rural Laborers and Agricultural Laborers (CPI-AL & RL)
CPI for Rural Laborers and Agricultural Laborers (CPI-AL & RL) measures the change in the price
of commodity baskets consumed by rural laborers.
It is compiled and released by the Labor Bureau, Shimla, Ministry of Labor on a monthly basis.
Base year for CPI-AL 1986-87.
It is used for revising minimum wages for agricultural laborers in different states.
New Consumer Price Indices (CPIs)
Old CPIs cover only a segment of the population such as agricultural laborers, industrial workers,
etc, and hence, do not give a nationwide picture.
Therefore, three new indices were introduced which cover all segments of the population of India.
These new CPIs are compiled and published by the Central Statistical Organisation (CSO) for the
All India Level as well as the State/UT Level.
Base year for these new CPIs is 2012.
The 3 new Indices have been described as follows:
CPI (Rural)
CPI (Rural) measures and tracks changes in the prices of goods and services consumed
specifically by people living in rural areas.
CPI (Urban)
CPI (Urban) measures and tracks changes in the prices of goods and services consumed
specifically by people living in urban areas.
CPI (Combined)
CPI (Combined) is computed by combining CPI (Rural) and CPI (Urban).
Based on the recommendations of the Urjit Patel Committee, the Reserve Bank of India (RBI) has
started using CPI (Combined) as the sole inflation measure for the purpose of monetary policy.
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Wholesale Price Index (WPI) Vs Consumer Price Index (CPI)
The difference between WPI and CPI can be understood through a comparative study between the
two.
Producer Price Index (PPI)
The Producer Price Index (PPI) measures the average change over time in the selling prices
received by domestic producers for their output.
While the Wholesale Price Index (WPI) and Consumer Price Index (CPI) measure price changes from
the perspective of buyers, the Producer Price Index (PPI) measures price changes from the
perspective of producers.
GDP Deflator
GDP Deflator refers to the ratio between GDP at Current Prices(Nominal) and GDP at Constant
Prices(Real).
By giving an idea about the changes in the level of prices, it acts as an indicator of the level of
price rise.
If the GDP Deflator = 1, it implies no change in the general price level.
If the GDP Deflator > 1, it implies an increase in the general price level.
If the GDP Deflator < 1, it implies a decrease in the general price level.
As compared to WPI and CPI, GDP Deflator is a better measure of inflation as it takes into account all
the goods and services of the economy. But, still, it is not used for short-term inflation targeting as
GDP-related data are not available on a monthly basis. Also, unlike CPI and WPI, GDP Deflator does
not include Imported goods as GDP measures goods and services produced inside the territory
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4. Effects of Inflation
Redistribution of Income and Wealth: It leads to the redistribution of income and wealth from one
hand to another. It results in loss to some group of people and gains to another group of people.
Borrower (Debtor) v/s Lender (Creditor): The borrower (debtor) is the gainer, lender (creditor) is
the loser.
For example, suppose the debtor borrows Rs. 100/- at the interest rate of 5% per annum.
So, he has to pay Rs. 105/- to the creditor next year. But, suppose inflation increases by more than 5%
in a year, then what Rs. 100/- could buy this year cannot be bought by 105/- in the next year. So, the
effective value of money for the creditor decreases.
Producer Vs Consumer: The purchasing power of money held by consumers falls. So, they have to
pay more money to producers for the same amount of goods and services.
Thus, the producer is the gainer, and the consumer is the loser.
Flexible Income Group v/s Fixed Income Group: Flexible income groups like sellers, self-employed
etc, whose salary is adjusted according to inflation don’t get affected. On the other hand, fixed-
income groups like daily-wage earners lose as the purchasing power of their fixed income falls.
Debentures or Bond Holders v/s Issuers: Bond Issuers(e.g. Government) gain, and the bond-
holders(e.g. G-Sec holders) lose. This is because the fixed rate paid for the bonds is not enough to
compensate for inflation.
Equity Holders: The income of equity holders depends on the profit of the company. In an
inflationary situation, companies earn more profit. So, equity holders also earn more income.
Effects on Production and Consumption
A rise in prices leads to a fall in demand for goods and services. As a result, it may force a cut
down in the production.
It may also lead to a shift in investment from other sectors to those in which price rise has taken
place. (as investors intend to make a higher profit)
Other Effects of Inflation
Savings: As inflation reduces the value of money, holding money is not a prudent economic
decision. So, people would like to deposit money in the banks to negate the effect of inflation(as
inflation increases, interest rates are increased by banks to motivate customers to save more and
de-motivate lenders to borrow less to bring down the money supply).
Growth and Employment: In the short run, an increase in inflation is usually accompanied by an
increase in economic growth and hence employment. But, in the long term, it does not necessarily
hold true (more explained by Phillips Curve).
Balance of Payment (BoP): High price reduces exports and increases imports from other countries
where goods are available at a cheaper rate. It results in an unfavorable Balance of Payment
(BoP).
Exchange Rate: A high import and low export mean high demand for foreign currencies vis-a-vis
domestic currency. This depreciates domestic currency.
Social and Political Impacts: High level of prices leads to social and political tensions like strikes,
dharnas, etc.
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5. Measures to Control Inflation
Monetary Measures
The RBI uses monetary tools to reduce the money supply in the market. It leads to a reduction in
demand, and hence prices.
In some extreme situations, Demonetization of Currency (i.e. declaring a currency of a particular
denomination as invalid) is done. It suddenly reduces the money supply in the market and hence
demand for goods and services.
Fiscal Measures
Reduction in government expenditure, which helps reduce demand and hence brings down the
price level.
The government resorts to increasing direct taxes like Income Tax. It reduces the disposable
income available to the people, thus leading to low demand and hence lower prices.
The government may also resort to decreasing indirect taxes like Excise Duty, Sales Tax, etc. It,
directly, brings down the prices of goods and services.
The government may also pass a surplus budget, which means less expenditure than receipts. This
reduces money supply and hence demand for goods and services.
Trade Measures
Various trade measures can be taken to tackle the shortage of goods in the domestic market, such
as the import of goods from foreign countries. The higher supply helps to bring down the prices.
Administrative Measures
A rational Wage Policy helps to bring the cost of production and hence prices of goods and
services under control.
At times, the government may resort to direct price control by fixing maximum price limits through
the Administered Price System or Subsidy Programs.
The method of rationing (i.e. fixing quota for consumption of a particular good) helps keep the
demand under control and hence reduces prices.
Inflation is an intricate part of the economic fabric influencing financial decisions and economic
policies. Its effective management requires a careful balance of monetary policy, fiscal policy, and
regulatory measures to maintain economic stability and promote sustained growth. By understanding
and anticipating its causes and effects, governments, businesses, and individuals can better prepare
and adapt to its inevitable challenges.
6. Other related concepts
Deflation
Deflation refers to a persistent fall in the general level of prices.
Thus, it is the opposite of Inflation.
In this case, the rate of change of the price index is negative(fall in current prices below the base
year prices).
It is bad if it leads to Purchasing delay in speculation for further price drop.
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Disinflation
It refers to a situation when the inflation occurs at a slowing pace.
For example, if the rate of price rise in the last month was 6% and it is 5% in the current month, it
will be called Disinflation.
Reflation
Reflation refers to the deliberate action of the government to increase the rate of inflation to
stimulate the economy.
It is usually done to redeem the economy from a deflationary situation
Core Inflation
It is the measure of persistent increase in the general level of prices of goods and services
excluding food and energy items (the items whose prices are very volatile and temporary in
nature).
Since it excludes the items that are volatile w.r.t. their prices, it gives the long-term trend in price rise.
Thus, it is helpful in framing the long-term policy.
Headline Inflation
It refers to the total inflation within an economy, including all items that consumers buy.
Thus, it reflects the rate of change in prices of all goods and services in an economy over a period
of time.
In the RBI’s newly adopted Flexible Inflation Targeting (FIT) framework, CPI (Combined) is used to
calculate the Headline Inflation.
Stagflation
The word ‘Stagflation’ is made up of two words, i.e., stagnation and inflation.
It refers to an economic situation in which both Stagnation (i.e. very low economic growth) as well
as price rise occur simultaneously.
Usually, in normal situations, a higher rate of inflation is accompanied by a higher rate of
economic growth.
But, Stagflation is a rare phenomenon and is an exception to the “Phillips Curve”.
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Inflationary Gap
It is also known as an expansionary gap.
It is the difference between the current level of real GDP and the anticipated GDP(or Potential
GDP) that would be experienced if an economy is at full employment(more work, more salary, more
demand).
In other words, it is the amount by which actual aggregate demand exceeds the level of
aggregate supply.
Opposite to this is the Deflationary Gap when aggregate supply is more than the aggregate
demand.
Inflation Spiral or Price Wage Spiral
It refers to a situation of a vicious circle wherein both wages and prices, reinforced by each other,
keep on increasing.
An increase in wages increases the demand and hence prices of goods and services. With
aggregate supply remaining the same, the increase in the prices again increases the wages due
to higher profits earned by entrepreneurs.
Thus, it works like a spiral where wages and prices reinforce each other.
Inflation Premium
It refers to an additional amount that investors require on the return of an investment to
compensate for the risk of inflation.
In order to negate the effect of inflation, investors calculate a “Real Interest Rate” by adjusting the
“Nominal Interest Rate” for inflation.
Accordingly, they charge the borrower on the real interest rate, and not on the nominal interest
rate.
Inflation Tax
It refers to an implicit tax caused by the effect of inflation on nominal assets, such as cash, bonds,
and savings accounts.
Printing and injecting more money into the market by the government creates an inflationary
situation, which reduces the purchasing power of the money held by individuals.
Thus, inflation acts like an explicit tax levied by the government as its effects are similar.
Phillips Curve
It represents the inverse relationship between the unemployment rate and inflation.
It says that there is an inverse relationship between the rate of inflation and the rate of
unemployment in an economy.
In other words, if unemployment decreases, inflation will increase and vice-versa.
This curve is named after the economist A.W. Phillips, who first put forward this theory in 1958.
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Note: Stagflation is an exception to the theory proposed by the Phillips Curve
Pro Tips for Solving MCQs on Inflation
1. Types of Inflation Based on Rate
Match percentages with types:
Creeping Inflation: <3%
Walking Inflation: 3-10%
Galloping Inflation: 10-50%
Hyperinflation: >50% per month.
Keywords like "manageable" or "economic disruption" often hint at the type.
2. Types of Inflation Based on Causes
Demand-Pull Inflation: High demand (look for rising income or fiscal stimulus).
Cost-Push Inflation: Rising wages or input costs.
Supply-Shock Inflation: Sudden supply constraints (e.g., natural disasters).
Structural Inflation: Persistent inefficiencies in production or logistics.
Tip: Identify whether demand or supply-side is discussed.
3. Measures of Inflation
Price Indices are key tools to measure inflation:
WPI: Excludes services; wholesale perspective.
CPI: Retail perspective; includes services.
GDP Deflator: Comprehensive but not for short-term analysis.
PPI: Tracks prices at the producer level.
Tip: Focus on base year and inclusions for each index
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4. Price, Price Level, and Price Index
Price: Cost of a single good/service.
Price Level: Average prices across the economy.
Price Index: Tracks changes in price level over time.
Tip: Questions often involve comparisons or trends.
5. Wholesale Price Index (WPI)
Excludes services; tracks price changes at the wholesale level.
Base year: 2011-12.
Tip: WPI questions usually focus on its scope (no services).
6. Consumer Price Index (CPI)
Retail perspective; includes services.
Types: CPI-IW, CPI-AL, CPI-RL, CPI-Combined.
Used by RBI for inflation targeting.
Tip: Know that CPI is more consumer-focused than WPI.
7. Producer Price Index (PPI)
Tracks price changes at the producer level (input costs).
More predictive for inflation trends.
Tip: PPI reflects production-side inflation.
8. GDP Deflator
Broadest measure, covering all goods/services produced domestically.
Tip: Not suitable for short-term inflation due to its annual nature.
9. Effects of Inflation
Redistribution Effects:
Borrowers benefit, lenders lose during inflation.
Fixed-income groups suffer; equity holders gain.
Economic Effects:
Savings decline as purchasing power decreases.
Investment increases with moderate inflation.
10. Measures to Control Inflation
Monetary Policy:
Increase interest rates (tight money supply).
Open market operations.
Fiscal Policy:
Reduce government spending or increase taxes.
Supply-Side Measures:
Boost production.
Tip: Match the measure to its policy category
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11. Deflation
Sustained decrease in price levels.
Reduces demand and investment, leading to recession.13. Disinflation
Decline in rate of inflation, but prices still rise.
Example: Inflation drops from 6% to 4%.
12. Reflation
Policies to increase prices or revive the economy during deflation.
13. Core Inflation
Excludes volatile items like food and fuel.
Used for policy decisions due to stability.
14. Headline Inflation
Includes all items, including food and fuel.
More reflective of public impact.
15. Stagflation
High inflation + High unemployment + Stagnant growth.
Tip: Often a result of supply shocks.
16. Skewflation
Uneven price rise in specific sectors (e.g., healthcare, housing).
17. Phillips Curve
Inverse relationship between inflation and unemployment (short-term).
Tip: Watch for exceptions in the long run(stagflation).
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