Inflation

and
Business Environment

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 Inflation and Business Environment
Main Points

• Movement in prices
• Inflation Measurement issues: Price Indices
• Features and uses of various price indices available in
India
• Criteria to describe inflationary scenario
• Rate of Inflation; Degree of Control; Causes;
Predictability of Inflation
• Impact of inflation
• Monetary and fiscal tools for controlling inflation
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 Presentation on 15th September
• Topic 10. Does stock market promotes economic
growth in India?
• Dhiren Goyal - 2014B3A8539P
Akshat Mechu - 2014B3TS952P
Madhav Gupta - 2014B3TS951P
Nitish Kundala -2014B3A4761P

• Topic: 17. Trends and Growth of FII/FPI to India

and its impact on Indian business
• Vaibhav 2014B3A1703P
• Ankit 2014B3A1687P
• Krishna 2014B3A4479P

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Ex- Reserve Bank Governor D. Subba Rao
cited his receding hairline and the high rates
for his hair cut to make a point on inflation.

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 Inflation
• He said he used to pay Rs 25 for a haircut 20
years ago which went up to Rs 50 even as his
hair thinned.
• "Now when I have virtually no hair left, I pay
Rs 150 for a haircut,“
• The Ex-Governor said : "I struggle to
determine how much of that is inflation, how
much is the premium I am paying to the
barber for the privilege of cutting the non-
existing hair".
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 Inflation: Definition

Rise in Price
• Persistent rise
• Substantial rise
• After full employment level of output

• It refers to an increase in the overall price level.

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One Time Increase in Prices Vs. Inflation

Price Level

300 C D

200

100 B
A

Time
0 1 2 3 4

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 Deflation
• Some countries may also face negative inflation
rate.
• Situation of persistent and substantial fall in the
overall price level below the full employment
level of output.
• The value of money keep on rising and price level
keep on falling.
• At the same time, there is fall in the output,
employment and income.

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 Movement in Inflation Rate over the Various
Phases of Business Cycles

Full
Rate of Slowdown employment
growth of C Disinflation output
National Expansion
Income, Inflation
D
Inflation/ F
B
Deflation Recession E
Deflation Recovery
Recovery Reflation
X
A Reflation
Depression
Deep deflation
No. of Years
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 Price Movements: Inflation, Disinflation,
Deflation, Reflation
Concept Price Level Economy below or
above full employment

Inflation Persistent and Above

substantial increase
Disinflation Deceleration in the Above
rate of increase
Deflation Absolute fall Below
Reflation Slow and steady Below
increase
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Inflation, Disinflation, Reflation and Deflation: An Hypothetical E.g
Example
Period Inflation Disinflation Deflation Reflation
Economy Above Economy Above Economy Below Economy Below
Full Employment Full Employment Full Employment Full Employment
Output Output Output Output
Price Rate of Price Rate of Price Rate of Price Rate of
Level Price Level Price Level Price Level Price
Change Change Change Change
2004 100.0 - 100.0 - 100.0 - 95.8

2005 110.0 10.0 120.0 20.0 90.0 -10.0 96.2 0.4

2006 125.0 13.6 142.0 18.3 78.0 -13.3 96.7 0.5

2007 145.0 16.0 165.0 16.2 65.0 -16.7 97.3 0.6

2008 170.0 17.2 190.0 15.2 54.0 -16.9 98.1 0.8

2009 200.0 17.6 215.0 13.2 44.0 -18.5 99.0 0.9

2010 240.0 20.0 240.0 11.6 35.0 -20.5 100.0 1.0

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 Countries experienced such situations
• Inflation
– Hungary after the end of World War II
– Yugoslavia in early 1990s
– Latin American Countries such as Bolivia, Peru, Mexico, and
Argentine in 1980s
– Brazil in the early 1990s
– African Nation Zimbabwe recently 2009.
• Deflation
– USA in early 1930s
– UK after World War I
– Hong Kong following East Asian Financial Crisis 1997
– Japan in early 1990s
• Stagflation
– UK in 1960s and 1970s
– USA in 1970s
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 Price Index

Basic Concepts
Index Number
Statistical device (measure) to express average
changes in the value of something in relation to
its value at the base period.
The value of an index at the base period is 100.
Price Index
Measures relative changes in average prices over
time
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 Price Index: Estimation
Price Relative (PR)
The ratio of the price of a single commodity in the current
period (P1) to its price in the base period (P0).
Symbolically PR = (P1/P0)
Assume that the country is producing only wheat
Then
PR = Pw1 / Pw 0
(The price of wheat in the current year / The price of
Wheat in the base year)

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 Price Index: Estimation
Weighted Price Index
Different commodities are produced in different
proportions
Hence, to estimate an overall price level
Each item is given a weight which is determined
on the basis of its importance in the selected basket
Ex: For two commodities (let it be wheat and cloth):
weighted index is
[( Pw1.Ww)  ( Pc1.Wc )]
[( Pw0.Ww)  ( Pc0.Wc )]

Where Ww + Wc = 1 16
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 Application of Price index

• There are 2 basic application of price index:

– 1) Changing the base of an index
– 2) Combining two or more overlapping

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 1) Changing the base of an Index
• Reasons for changing the base of an index number and
constructing a new index number based on a new base year
 1) The base year is either too old or distant from the
current year
 2) A comparison is to be made with a series of indexes
with a different base.
New index of any year =

100 x Old index of the period

Index of the new base period

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2) Combining two or more overlapping indexes

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3) Combining two or more overlapping indexes
• Splicing or Coupling of Indexes:
• The need to combine arises for maintaining
continuity in comparison because sometimes an
index is discontinued as the base becomes too
old.
• A series of indexes is constructed with recent
period as base by the same technique as used in
base shifting.
• It is only possible for splicing if the indexes are
constructed with the same items, and have an
overlapping year. 22
Measurement of Inflation Rate using Price Index

Inflation Rate

(Current Year’s Price Index – Last Year’s Price Index)

Last Year’s Price Index

(PINDt – PINDt-1) / PINDt-1

Multiplying this by 100 one gets % inflation rate

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 Point to Point Vs Average Inflation Rate
Point to Point Inflation Rate Average Inflation Rate
Estimation of inflation at the Average of inflation rate at
same point of time in two different points of a time during
different periods or years a given period

Example
Example
Inflation rate:
Price index First week = 5%,
31st March 2011: 127 Second Week = 6%,
31st March 2012: 135 Third Week = 7%
Inflation in 2012 Fourth Week = 8 %
= [(135 - 127) / 127] x 100 Inflation Rate in the month
= 6.3% = (5 + 6 + 7 + 8)/ 4 = 26 / 4 = 6

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 Point to Point Vs Average Inflation Rate

Point to Point
Inflation Rate Discounts the impact of seasonality
in price fluctuations

Average
Inflation Rate Moderate the large positive and/ or
negative shocks to the price levels
during a given time period / year

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 Types of Price Indices
• 1) Consumer Price Index (CPI)
• 2) Producer Price Index (PPI)
• 3) Wholesale Price Index (WPI)
• 4) GDP Deflators

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Consumer Price Index
(CPI)

• Captures movements in consumer or retail prices

• Measures the cost of living
• Most relevant price index for the consumers

Steps in the Estimation

• 1) Identification of the basket of goods
• 2) Determination of weights for each of the commodity
covered in the consumption basket
• 3) Regular monitoring of the prices
• 4) Determination of the base year

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Producer Price Index
(PPI)

• Captures the movements in producers prices

• Excludes taxes, trade margins and transport costs
• The most relevant price index for manufacturers.
• Ratio CPI / PPI indicates the extent of distribution cost
falling on the consumers.
• Signals the changes in the general price level as
measured by the CPI: thus, serves as a business cycle
leading indicator.
• Closely watched by the policy makers, and business
managers.
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Wholesale Price Index
(WPI)

• Captures the movements in the wholesale prices

• Very close to the PPI (Prices of raw materials, semi-finished
and finished goods + prices of imported tangible goods if they
are transacted at the wholesale level.
• Differs from the PPI to the extent of tax, wholesale margin
and transport cost from manufacturing units to wholesale
establishment
• If no distinction made between WPI and PPI, PPI is treated
as WPI.
• Many countries have switched over from the WPI to PPI
because the PPI can track price changes at primary and
intermediate stages before it gets built into the finished goods
stages
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 GDP Deflators
(Implicit Price Index )

• It captures the prices of all final goods produced in an

economy
• It is the most comprehensive measure of price index
•It is also used as a measure of real GDP
•The price index is not estimated directly.
•It is a variable weight index:
•Uses Paasche’s method
Estimation
GDP deflator = Nominal GDP / Real GDP
= GDP at current prices / GDP at constant
prices
Real GDP = Nominal GDP / GDP Deflator 31
 Price Indices in India
Price indices in India

WPI (Overall) CPI(new Series) Combined

(Rural + Urban)

Primary Fuel, Power Manufactured

Articles and Products
Old Series Overall New Series
Lubricants
not available Combined
(Rural + Urban)
CPI - IW CPI - RL CPI - AL

CPI - Rural CPI - Urban

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 WPI in India
• Published by the Office of Economic Adviser, Ministry of
Commerce and Industry.
• It is widely used by Government, banks, industry and
business circles.
• It is in use since 1939 and is being published since 1947
regularly.
• The latest WPI has a basket of 676 items.
• The major criticism for this index is that 'the general
public does not buy at the wholesale level', thus WPI
does not give the actual feeling of the amount of
pressure borne by the general public.
• However, the increase in wholesale prices does affect
the retail prices and as such give some feel of the
consumer prices.
•
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 CPI in India
• The CPI measures price change from the perspective of the
retail buyer.
• It is the real index for the common people. It reflects the
actual inflation that is borne by the individual.
• CPI is designed to measure changes over time in the level
of retail prices of selected goods and services on which
consumers of a defined group spend their incomes.
• Till January 2012, in India there were only following four
CPIs compiled and released on national level.

• (1) Industrial Workers (IW) (base 2001),

• (2) Agricultural Labourer (AL) (base 1986-87) and
• (3) Rural Labourer (RL) (base 1986-87)
• (4) Urban Non-Manual Employees (UNME) (base 1984-85),
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 CPI in India
• These four CPIs reflect the effect of price
fluctuations of various goods and services
consumed by specific segments of population in
the country.
• These indices did not encompass all the
segments of the population and thus, did not
reflect the true picture of the price behaviour in
the country as a whole.

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 CPI in India
• New Series of CPI Started in 2012 (with base year 2010)
• Thus, CSO of the MOSPI has started compiling a new
series of CPI for the
– (a) CPI for the entire urban population viz CPI (Urban);
– (b) CPI for the entire rural population viz CPI (Rural)
– (c) Consolidated CPI for Urban + Rural will also be
compiled based on above two CPIs
• These would reflect the changes in the price level of
various goods and services consumed by the Urban and
rural population.
• These new indices are now compiled at State / UT and all
India levels.
• The new series, also includes services, which is not the
case with the WPI series.
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 Inflation in India: Major Contributory Factors
• The inflation remained moderate during the last
decade: Average annual inflation rate: 5.3%
• Average annual inflation was the highest in fuel group
• During the last five years: Primary products registered
the highest rise
• Unlike the previous decadal average, Year 2010-11and
2011-12 witnessed a sharp rise in the inflation rate,
hovering around double digit figure.
• Inflation moderated in 2012-13, but remained above the

decadal average and above the comfort zone of the RBI.

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 Types of Inflation
Classification Criteria Types of Inflation
Rate of Inflation Creeping Inflation
Walking Inflation
Running Inflation
Hyperinflation
Degree of Control Open Inflation
Suppressed Inflation
Coverage Headline Inflation
Core Inflation
Causes Demand Pull Inflation
Cost Push Inflation
Predictability Anticipated Inflation
Unanticipated Inflation
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On the Basis of Rate
of Inflation

Creeping Inflation

• Very low rate of price increase 2 - 3 %

per annum
• Expected to be conducive for production
and investment activities:
• increasing profitability motivates the
business organizations to expand
• Preferred over the zero rate of inflation
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On the Basis of Rate
of Inflation

Walking Inflation
• Sustained price increase between 3-10%
• Along with the prices of various commodities the
prices of cost components – wages and
intermediate goods increase with a lag
• The lag in the prices of final commodities and the
cost components keep the profitability high
• Though not feared indicates the possibility of
running or hyper inflation if not controlled in time
• Signs of ensuing danger: strains the skills of policy
makers in combating inflation 41
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On the Basis of Rate
of Inflation

Running Inflation
• Sustained price increase between 10 - 20%
• Encourages speculation
• Along with the prices of final commodities the
prices of cost components increase
substantially
• Higher risk in business: Cases of business
failures
• Requires urgent policy attention: formulation
of strong fiscal and monetary measures42or
direct control measures 42
 On the Basis of Rate of Inflation

Hyper Inflation/ Galloping/ Jumping Inflation

Extremely high price increase between 20- 30% and
above
• Monetary authorities lose control over inflation
• Money ceases to be useful as a medium of exchange or a
store of value
• Large uncertainty in the environment
• Resources get diverted to speculative / hoarding activities
• Households spend money at a much faster rate: increase
in the velocity of circulation
• Govt. opt for deficit financing
•Worsening of the BOP: Depreciation of the domestic
currency
•Loss of the investors confidence: Flight of foreign 43
Zimbabwe: A Case of Hyperinflation
Year Inflation
Rate
2000 55.9
2001 71.9
2002 133.2
2003 365.0
2004 350.0
2005 237.8
2006 1016.7
2007 6723.7
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 Zimbabwe: A Case of Hyperinflation

Impact of Inflation
• Real Gross Domestic Product in Zimbabwe decreased
drastically
– Registered negative growth rate since 2000: - 5 % in
2001; -18% in 2003, -12.6% in 2008

• Became one of the poorest nations in the world with

– unemployment of more than 90%
– One fifth of the population infected with HIV/ AIDS

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 On the Basis of
Degree of Control

Open Inflation Suppressed Inflation

• Continuous rise in prices • If left for market forces, conditions /

potential exists for the rise in prices
• No interruption and control • The government controls the prices
from the government or and does not allow them to rise
any other authority • Markets are cleared through rationing
Creates many administrative problems

• Shifts resources from the productive

to unproductive uses

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 On the Basis of
Coverage
Headline Inflation Core Inflation

• As the name suggests: • It is defined as the overall WPI –

Appears in the headlines The prices of sensitive commodities
especially food and energy prices
• In India it is estimated on the • The prices of sensitive
basis of WPI as the overall commodities are netted out as
CPI was not available so far. these are temporary in nature and
do not reflect normal inflationary
environment

• Provides more stable inflation rate

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 On the Basis of Causes

Demand Pull Inflation Cost Push (Supply Side) Inflation

An autonomous increase in the any of An autonomous increase in the any of the
the demand components causes such cost components is passed on to the prices
inflation when supply is fixed of final goods and results in the cost push
inflation
For example:
• An increase in the quantity of money Reasons
• Increase in public expenditure • Higher wage rates
• Higher prices of basic inputs
Impact:
• Increases Prices, Output and Impact: Increases Prices, Reduces
Employment Output and employment

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 Demand Pull Vs Cost Push Inflation
Price Level
Price Level
AS1
AS0
AS0

P1
P1

P0
P0
AD1

AD0
AD0
Y0 Y1
Real Output Y1 Y0 Real Output

Demand Pull Inflation Cost Push Inflation

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 On the Basis of Predictability of Inflation
• Anticipated /Expected Inflation
• Unanticipated Inflation
• Based on expectations.
• This inflation is not expected
• On the basis of past and present
trend in price level. • Error in forecast of inflation leads
• Depend on forecasts made available to difference in anticipated and actual
from various reports and policy Inflation
documents and economic forecast
made available. • Redistributes the income from creditors
to debtors, fixed income earners to
• Closely watch the values of certain profit earners, from consumers to
economic variables that lead to producers
inflation.
• Leads to economic waste and social
• Laborers, consumers, producers disruption
make their decisions accordingly.

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 Effects of Inflation
Production and
Economic Activities

Mild Inflation
• Increases profitability
• Encourages producers to invest and produce more
Very High Inflation
• Generates uncertainty

• Diverts resources from the productive to speculative

activities
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 Effects of Inflation
Distribution of
Income

• Benefits: the producers, and debtors.

•
• Hurts: the consumers, creditors, fixed income earners

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 Measures to Contain Inflation In India
The following measures were initiated to contain inflationary pressures
Monetary Measures
The interest rates or other types of rates are increased.

Fiscal Measures:
1) To improve the overall supply
2) The import duty was reduced on several items including
rice, wheat, pulses, edible oils, sugar etc.
3) To restrict the outflow of essential items
Export of essential items like non-basmati rice,
edible oils, pulses, onions banned.
4)To incentivize farmers to augment supply by setting
minimum prices of various agricultural products.
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