Inflation

WHAT IS INFLATION ?

Inflation is a rise in general level of prices of goods and services in the country over a period of time. As the cost of goods and services increase, the value of a currency declines because you won't be able to purchase as much with that currency as you could have last month or last year.

How is it Measured?
Consumer Price Index

CPI is a measure estimating the average price of consumer goods and services purchased by households. CPI measures a price change for a constant market basket of goods and services from one period to the next within the same area (city, region, or nation). It is a price index determined by measuring the price of a standard group of goods meant to represent the typical market basket of a typical urban consumer. The percent change in the CPI is a measure estimating inflation.

Wholesale Price Index

WPI was published in 1902,and was one of the economic indicators available to policy makers until it was replaced by most developed countries by the CPI market. index in the 1970. WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. Some countries (like India and The Philippines) use WPI changes as a central measure of inflation. However, India and the United States now report a producer price index instead.

EFFECTS OF INFLATION

Effect on Production
Mild inflation is beneficial to the economy. Hyperinflation disrupts the economy: discourages savings => capital accumulation falls. Drives out foreign capital already invested in the economy. Volume of production will fall not only on account of fall in capital accumulation, but also due to the uncertainty. Pattern of production may change. Sellers market (A market which has more buyers than sellers.
High prices result from this excess of demand over supply) =>

results in deterioration of the quality of goods produced. Give impetus to speculative activities. Most serious: disrupts the smooth functioning of the price mechanism.

Effect on Distribution
Results in redistribution of income and wealth. Debtors & Creditors: Debtors are gainers they borrowed when purchasing power of money was high and return the loans when pp of money is low due to rising prices. Creditors are losers receive less in real terms. Wage & Salary Earners: wages do not rise proportionally with rise in cost of living. If they are well organized in trade unions, they may not suffer much. Farmers: gain prices of farm products go up while costs incurred do not go up to the same extent time lag between rise in prices and costs. Farmers are generally debtors and can repay their debts in terms of less purchasing power.

 Fixed income groups: hardest hit persons who live on past savings, pensioners, interest and rent receivers suffer most during inflation. Entrepreneurs: Inflation is a boon whether manufacturers, traders, merchants and businessmen rising prices serve as a tonic for business enterprise experience windfall gains as the prices of their inventories (stocks) suddenly go up. Also gain as their costs (on wages, raw materials, etc) do not go up as rapidly as prices. Investors: of two types (a) Invest in equities (shares) Dividends on equities increase with increase in prices and corporate earnings. (b) Invest in fixed interest-yielding bonds and debentures income from bonds remain fixed and as such they have much to lose during inflation. Frequently, the value of their savings is largely, if not completely, wiped out as a result of depreciation in the value of money.

Causes of inflation

Demand pull Inflation :

Such inflation occurs when aggregate demand exceeds the aggregate supply i.e., economys productive potential.

Causes of Demand Pull Inflation :

*mounting government expenditure *Deficit Financing and increase in money supply *Increase in the disposable income. *Role of black money *Uncontrolled growth of population

COSTS PUSH INFLATION Cost push inflation occurs when the price of commodity increases as a result of the increase in cost of production. Cost of production increases due to : Increase in the wage level Rise in prices of imports Rise in taxes Rise in administered prices

Rise in oil prices and global inflation

MEASURES TO CONTROL INFLATION

Monetary Policy
Measures adopted by the Central Bank such as increase in re-discount rates: increases the cost of borrowing for business and consumer spending and discourages excessive activity based on borrowed funds sale of government securities in the open market: mops up excessive purchasing power from the public increase in reserve ratios: cash reserve ratio and statutory liquidity ratio; and adjustments in selective controls: consumer credit control and higher margin requirements, etc.

Fiscal Policy
Government Expenditure: during inflation, effective demand increases far too much due to unregulated private spending. To counteract this, the government should reduce its own expenditure to the minimum. Taxation: the problem is to reduce the size of the disposable income in the hands of the general public The rates of existing taxes should be increased while new taxes should be imposed. Public Borrowing: the objective is to take away from the public excess purchasing power. Public borrowing may be voluntary or compulsory.

 Debt Management: refers to public borrowing and repayment the government borrowing may assume the form of borrowing from non-bank public through sale of bonds and securities, which will curtail consumption and private investment. Overvaluation: of domestic currency in terms of foreign currencies will serve as an anti-inflationary measure as (i) it will discourage exports and thereby result in an increased availability of good and services at home, (ii) encourage imports add to domestic stock of goods and services, (iii) by lowering the price of foreign inputs, it will help in checking the upward cost-price spiral.

Galloping or Hyperinflation: Prices rise every minute and there is no upward limit to which it may rise in course of time. Lord Keynes has called it true inflation. This type invariably occurs after the point of full employment. Price rises by 16% and more. Examples are the Great Inflation of Germany after First World War, and Great Chinese Inflation after the Second World War.