Inflation: Prices on the Rise
According to the International Monetary Fund (IMF), inflation is the rate at which prices rise over a period. It can be a broad measure of overall price rise or a specific measure for certain goods and services.
It shows the rising cost of living and tells us how much more expensive a set of goods and/or services has become over a fixed period, usually a year. In India, inflation matters a lot more because of income inequality and a huge population.
What creates inflation?
Long-lasting inflation happens due to 3 main reasons:
1. Too much money in the market (Lax Monetary Policy):
When the government prints more money than the economy needs, the value of money falls. So, you need more money to buy the same thing, and prices rise. Economists call this the Quantity Theory of Money.
2. Demand and Supply Pressures:
Cost-Push (Supply Side): When supply is disrupted, prices rise. This can happen due to natural disasters, war, or costly raw materials like crude oil. The 2008 food and fuel inflation across the world is a perfect example.
Demand-Pull (Demand Side): When demand becomes more than what the economy can produce, prices rise. This happens when people have more money due to a stock market boom, low interest rates, or high government spending.
3. Expectations:
Inflation can become self-fulfilling. If people and companies expect prices to rise tomorrow, they will increase wages and prices today through rent agreements and salary negotiations. Once this happens, their expectation becomes reality, and inflation continues like inertia.
The Good and the Bad of Inflation
Inflation reduces purchasing power:
If your income does not rise as fast as prices, you become poorer in real terms because you can buy less. This fall in real income is the biggest cost of inflation. And prices don't rise equally; the price of petrol may rise daily, but your salary may rise only once a year. This uneven rise hurts consumers the most.
It creates winners and losers:
Inflation affects borrowers and lenders differently.
Losers: People with fixed incomes suffer. For example, if a pensioner gets a fixed 5% hike every year but inflation is 7%, his purchasing power falls.
Winners: Borrowers with fixed interest rates benefit. If you have a home loan at 5% and inflation is also 5%, your real interest rate becomes zero. If inflation is higher and your income also rises, repaying the loan becomes even easier.
Too much inflation is disastrous:
Many countries have suffered from hyperinflation, inflation of 1000% or more. In 2008, Zimbabwe saw inflation of 500 billion percent. Such high inflation destroys an economy, and governments must take very painful steps to control it, sometimes even giving up their own currency.
But falling prices (deflation) are also bad:
If prices keep falling, people will stop buying things thinking it will be cheaper tomorrow. This leads to less business, less income, and slow economic growth. Japan faced this for many years. That is why during the 2007 financial crisis, central banks like the US Federal Reserve kept interest rates very low to prevent deflation.
What is ideal then?
Most economists agree that low, stable, and predictable inflation is best. If inflation is low and predictable, people can plan better, and it also encourages people to buy now rather than later, which boosts economic activity. That is why most central banks, including the RBI, follow a policy of inflation targeting, keeping inflation low and stable.
Relevance of inflation:
| Price Stability: | A little bit of inflation is considered good for the economy. When people know that prices will rise slightly in the future, they tend to spend and invest now rather than keep money idle. |
| Central Bank Policy Tool: | Central banks like the US Federal Reserve, the European Central Bank, and India's Reserve Bank of India use inflation as a main tool. They set an inflation target and increase or decrease interest rates to achieve it. |
| Real Interest Rates: | Inflation helps us understand the real cost of money. The real interest rate is the nominal interest rate minus inflation. It tells us the actual cost of borrowing and the actual return on our savings. |
| Income Redistribution: | Inflation changes who gains and who loses. Borrowers benefit because they repay their loans with money that is now worth less. On the other hand, lenders lose because the money they get back has less purchasing power. This shifts wealth from one group to another. |
| Encouraging Investment: | Moderate inflation pushes people to invest. When prices are expected to go up, people and businesses prefer to spend and invest their money rather than hoarding it, hoping for better returns. |
| Nominal Wage Adjustments: | Inflation allows salaries to be adjusted in numbers. Even if the real buying power of your salary remains the same, the actual number can increase. This helps avoid the problem of sticky wages and keeps the job market flexible. |
Impact on Global Competitiveness:
If a country's inflation is higher than its trading partners, its products become more expensive in the world market. This can hurt its exports and global competitiveness.
Taxation Effects: Inflation also affects taxes. As prices and incomes rise, people may move into a higher tax bracket and pay more tax. If the government does not adjust tax brackets for inflation, people end up paying more tax even without any real increase in income. This is called "bracket creep."
What are the different ways to measure inflation in India?
The two primary indices used to measure inflation in India are the Consumer Price Index (CPI) and Wholesale Price Index (WPI).
| Consumer Price Index (CPI) | Wholesale Price Index (WPI) | Producer Price Index for Manufacturing (PPIM) |
|---|---|---|
| ▪️ It is a key indicator of inflation that measures changes in the average retail prices paid by consumers for a basket of goods and services over time. ○ The base year for CPI is 2024. ▪️ The Monetary Policy Committee (MPC) uses CPI data to control inflation. ▪️ In India there are different CPIs that cater to specific population groups: ○ CPI for Industrial Workers (CPI-IW) ○ CPI for Agricultural Laborers (CPI-AL) ○ CPI for Rural Laborers (CPI-RL) ○ CPI for Urban Non-Manual Employees (CPI-UNME) | ▪️ It measures the average change in the prices of goods at the wholesale level (from the perspective of producers and businesses). ▪️ It includes a broader range of goods than the CPI. ▪️ The WPI in India includes primary articles, fuel and power, and manufactured products. ▪️ The base year of All-India WPI has been revised from 2004-05 to 2011-12 in 2017. | ▪️ The PPIM is another index that measures the average change in the selling prices received by domestic producers for their output of manufactured goods. ▪️ It focuses specifically on the manufacturing sector. |
Different Ways to Contain Inflation in India:
| Monetary Policy (by RBI): | RBI controls inflation mainly by controlling money supply. It increases or decreases key interest rates like the repo rate to make loans costlier or cheaper. It also does Open Market Operations (OMO)—buying or selling government securities to control how much money is available in the market. |
| Fiscal Policy (by Government): | The government controls inflation through its spending and taxes. For example, increasing taxes reduces people's disposable income, so they spend less, which helps control inflation. |
| Food Price Management: | In India, food prices are a major driver of inflation. So the government uses the Minimum Support Price (MSP) to assure farmers a price and the Public Distribution System (PDS) to provide affordable food to people. |
| Buffer Stock Operations: | The government keeps a buffer stock of essential items like wheat and rice. When there is a shortage in the market, it releases stock to stabilize prices. The Price Support Scheme (PSS) for pulses and oilseeds should also be implemented properly with help from state governments. |
| Trade Policies: | The government regulates imports and exports to control domestic supply. For example, it can ban exports of onions or allow cheaper imports when domestic prices rise. A clear foreign trade policy helps in this. |
| Anti-Hoarding Measures: | To stop artificial price rises, the government conducts raids against hoarding and black marketing. The Essential Commodities Act, 1955, was made for this, though it has not been very effective. |
| Exchange Rate Management: | A stable exchange rate keeps import costs stable. If the rupee falls sharply, imports become expensive and push up inflation. The government should have a dedicated agency to manage public debt and exchange rates. |
| Financial Inclusion: | Schemes like Pradhan Mantri Jan Dhan Yojana (PMJDY) bring people's savings into the formal banking system. This gives banks more stable funds for investment and reduces inflationary pressure in the informal market. |
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