Inflation Notes for UPSC
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Inflation Notes for UPSC

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Economics

Inflation Notes for UPSC

Inflation is a very important topic of Economics. It forms the basis o understand a number of other topics. That is why it becomes far more important to study and understand Inflation in detail. As far as Civil Services are concerned, a number of questions asked in UPSC, HCS, and UPPSC revolves around this topic. In the following article, you will find detailed notes covering each and every aspect of it.

Inflation Notes for UPSC

INFLATION

  • Inflation is defined as a rise in the general level of prices of goods and services in an economy over a period of time.
  • When the price of good rises, each unit of money buys fewer goods. Thus, Inflation also reflects an erosion in the purchasing power of money.
  • Inflation is measured as ‘point - to- point’. It means that the reference dates for the annual inflation are January 1 to January 1 of two consecutive years.

 

Types of inflation

  • Cause Based Inflation

      • Demand-Pull Inflation
      • Cost-Push Inflation
      • Pricing Power Inflation
      • Sectoral Inflation
  • Rate-Based Inflation

    • Creeping Inflation
    • Trotting Inflation
    • HyperInflation
    • Galloping Inflation

Read also: Introduction to Economics- Basic Concepts

CAUSE BASED INFLATION

Demand-Pull Inflation

  • This type of inflation occurs when:

(a) Total demand for goods and services in an economy exceeds the supply of the same.

(b) When supply is less, the price of these goods and services rises.

Cost-Push Inflation

  • When there is an increase in the cost of production of goods and services due to an increase in wages or an increase in the cost of raw materials required. Consequently, there will be an increase in the price of finished goods and services.

Pricing power Inflation

  • This type of inflation occurs when the business houses and industries decide to increase the price of their respective goods and services to increase their profit margins. 
  • It is called administered price inflation.
  • It does not occur at the time of financial crisis and economic depression or when there is a downturn in the economy.
  • It is also known as oligopolistic inflation because oligopolies have the power of pricing their goods and services.

Sectoral Inflation

  • It takes place when there is an increase in the price of goods and services produced by a certain sector of industries.
  • Ex., an increase in the price of crude oil would affect all the sectors that use crude oil as an input raw material.

If the price of one good has gone up, it is not inflation, it is only if the prices of most goods have gone up.

 

RATE BASED INFLATION

Creeping Inflation

  • It occurs when the inflation rate is in the range of 1% to 5%.
  • Such a type of inflation erodes the purchasing power of money but is referred to as manageable and inevitable in a growing economy.

Trotting Inflation

  • It occurs when the inflation rate is in the range of 5% to 10%.

Galloping Inflation

  • This is very high inflation running in the range of double or triple digits (i.e. 20% or 200% a year).
  • It is also known as hopping, jumping,  running, or runaway inflation.

HyperInflation

This form of inflation is large and accelerating which might have annual rates in million or even trillion.

  • In such inflation, the range of increase is very large and it takes place in a very short span of time.
  • Ex. After the first world war, Germany (1920 - 23) began printing money to make up for revenue loss.

Read also: Most relevant MCQ for Economics asked in UPSC, HCS exam

CAUSES OF DEMAND-PULL INFLATION

    • Increase in money supply
    • Increase in Government expenditure
    • Increase in black money
  • Population Pressure
  • Increase in Foreign Exchange Reserves (an increase in FOREX leads to an increase in the domestic money supply)
  • Rising Liquidity due to Public Finance tools
  • Increase in income of individuals

 

CAUSES OF COST-PUSH INFLATION

    • Increase in input costs such as an increase in wages
    • Increase in indirect tax 
    • Seasonal fluctuations in output and supply in the case of agriculture
    • Increase in Administered prices such as an increase in Minimum Support Price 
  • Infrastructural bottlenecks like shortage of power, transportation, etc.
  • Increase in import prices

 

MEASURES TO CHECK INFLATION

Monetary Policy Measure

This includes quantitative and qualitative measures like rising in cash reserve ratio, repo rate or adopting a dear monetary policy.

Fiscal Policy Measures

It implies the reduction of non-plan expenditure by the government and reducing indirect tax (GST).

Administrative Measures

It requires demand and supply management by improving distribution and availability rather than production.

 

IMPORTANT TERMS

Bottleneck Inflation

  • This inflation takes place when the supply falls drastically and the demand remains at the same level. 
  • Such situations arise due to supply-side accidents or mismanagement which is also known as ‘structural inflation.

Core Inflation

  • Core Inflation calculates the price of all the goods and services in the economy excluding the energy and food items.
  • Such a measure doesn’t include the volatile items, which may distort the true picture of inflation in the economy.
  • It is calculated by taking CPI and excluding energy and food items.
  • It is criticized on the ground that Food and energy are important in India and they are more sensitive to price changes.

Inflationary Gap

  • Excess of total government spending above the national income (i.e. fiscal deficit)
  • It is done to increase the production level which ultimately increases the price because of the extra-creation of money.

Deflationary Gap

  • The shortfall in total spending of the government (i.e. fiscal surplus) over the national income.
  • It is a situation of producing more than the demand.
  • It is also known as the output gap.

Inflation Spiral

  • It is an inflationary situation that results out of a process of wage and price interaction “when wages press prices up and prices pull wages up”.

Phillips curve

  • It is a graphic curve according to which there is an inverse relationship between inflation and unemployment.
  • The non-accelerating inflation rate of unemployment is the rate of unemployment at which inflation will stabilise. At this rate of unemployment, prices will rise at the same rate each year 

Inflation Notes for UPSC

Read also: 100 Most Important Multiple choice questions on Economics asked in various Competitive exams

Reflation

  • It is a situation often deliberately brought by the government to reduce unemployment and increase demand by going for higher levels of economic growth.
  • Government goes for higher public expenditure, tax cuts, interest rate cuts, etc.
  • Fiscal deficit rises, extra money is generally printed, wages increase and there is almost no improvement in unemployment.
  • When the economy is crossing a cycle of recession (low inflation, high unemployment, low demand etc) and the government takes some economic policy decisions to revive the economy from recession, certain goods see a sudden and temporary increase in their prices, such as price rise is also known as reflation.

Stagflation

  • It refers to a situation in an economy when inflation and unemployment both are at high levels.
  • When the economy is passing through the cycle of stagnation (i.e. long period of low aggregate demand in relation to its productive capacity) and the government shuffles with the economic policy, a sudden and temporary price rise is seen in some of the goods, such as inflation is also known as stagflation.
  • It is a combination of high inflation and low growth.

Inflation Targeting

  • It means that the central bank of a country targets to contain inflation at a certain level or between a certain range and uses its monetary policy to achieve that target within a particular time frame. The ‘healthy range of inflation’ is to be 2 - 6%.
  • After Urjit Patel Panel Report, there is an increasing debate on the role of inflation targeting as a framework for implementing monetary policy.
  • Some countries have adopted point targets, while others are following a more flexible approach to targeting inflation within a band.

Deflation

  • When some event leads to decrease in prices of goods and services.
  • It is the opposite of inflation.
  • Deflation occurs when the inflation rate falls below 0%.

Disinflation

  • It is defined as a slowdown in the inflation rate.
  • Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of deflation which did not end until the end of 2004.

GDP Deflator

  • It is the ratio between GDP at Current Prices and GDP at Constant Prices.
  • Value of ‘1’ implies that there is no change in the price level.
  • It is a better measure of price behavior because it covers all goods and services produced in the country.

Base Effect

  • It refers to the impact of the rise in the price level (i.e. last year’s inflation) in the previous year over the corresponding rise in the price levels in the current year (i.e. current inflation).

Base Year

  • A base year is a year used for comparison for the level of a particular economic index.
  • The base year is changed periodically in an economy and currently, the base year of India for GDP is 2011-12. But the Statistics Ministry is set to change the base year to 2017-18.
  • 2 criteria for selecting the base year:
    • It should not be too far or too near the current year.
    • It should be a normal year i.e. the year with fewer shocks.

Business Cycle

The ups and downs experienced by the economy in their performance is the business cycle.

4 Phases in a business cycle:

  • Trough - Bottom of the business cycle
  • Expansion/Recovery - The period in a business cycle when the output and employment rise (from trough up to a peak).
  • Peak - The highest point in a business cycle
  • Contraction/Recession - The period during which the output and employment fall (from the peak down to a trough).

Inflation Notes for UPSC

EFFECTS OF INFLATION

On Creditors and Debtors

During inflation, lenders suffer and borrowers benefit.

On Investment

During inflation investment in the country is boosted.

On Exchange Rate

With every inflation, the currency of the economy depreciates. 

On Imports and Exports

During inflation, the volume of exports increases, and the volume of imports decreases.

Read also: FAQs on Economics with Explanation - UPSC/HCS

VARIOUS INDICES TO MEASURE INFLATION

Wholesale Price Index (WPI)

  • It represents the price of various goods at a wholesale stage.
  • The base year of WPI has been changed to 2011-12 and the number of items has been increased to 697.
  • Office of the Economic Advisor in  Department of Industrial Policy & Promotion in Ministry of Commerce & Ministry is entrusted with the task of releasing this index.
  • Even though WPI was prepared on a weekly basis for a number of decades, India shifted to the monthly calculation of WPI in 2009.
  • Out of 697 items, 117 are primary articles (22.6%), 16 are fuel & power (13.1%) and 564 are manufactured products (64.2%).

Limitations of WPI

  • WPI does not take into account services such as Health, IT, Education, transport.
  • It does not account for the products of the unorganized sector in India, which constitutes about 35% of the manufactured output of the Indian economy.

 

Consumer Price Index

  • A Price Index computed using a bundle that is meant to represent the ‘market basket’ purchased by a typical consumer.
  • CPI is calculated by taking into account price changes for each item in the basket of goods and averaging them (monthly basis).
  • Majorly changes in CPI are used to access price changes associated with the cost of living.
  • In India, RBI uses CPI (combined) released by the Central Statistical Office, Ministry of Statistics and Programme Implementation with the base year as 2012.
  • The number of items in the CPI basket is 448 in rural and 460 in urban.

Series of CPI

  • CPI for Industrial Workers, CPI (IW)
  • CPI for Agricultural Labourers, CPI (AL)
  • CPI for Urban Non-Manual Employees, CPI (UNME)
  • CPI for Rural Workers, CPI (RW)

 

CPI (IW)

  • It has 260 items (plus the services) in its basket with 2001 as the base year. Its first base year was 1958-59.
  • The data is collected with one month’s frequency and the index has a time lag of 1 month.
  • This index specifies the government employees (apart from banks’ and embassies’ personnel).
  • The wages of the central government employees are revised on the basis of the changes occurring in this index, the Dearness Allowance is announced twice a year.
  • When pay commission recommends pay revisions, the base is CPI (IW).
  • It is compiled and released by the Labour Bureau in the Ministry of Labour and Employment.

 

CPI (UNME)

  • It has 1984-85 as the base year and 146- 365 commodities in the basket for which data is collected monthly with two weeks’ time lag.
  • It is basically used for determining the Dearness Allowances of employees of some foreign companies operating in India (i.e., airlines, communications, banking, insurance, embassies and other financial services).
  • It is used under the Income Tax Act to determine capital gains and by the Central Statistical Organisation for deflating selected service sector’s contribution to GDP at factor cost and current prices to calculate the corresponding figure at constant prices.

 

CPI (AL)

  • It has 1986-87 as its base year with 260 commodities in its basket. The data is collected with a monthly frequency and has three weeks time lag.
  • This index is used for revising minimum wages for agricultural labourers in different states.
  • It is compiled and released by the Labour Bureau in the Ministry of Labour and Employment.

 

CPI (RL)

  • It has 1983 as the base year, data is collected on a monthly frequency with three weeks’ time lag, and its basket contains 260 commodities.
  • It is compiled and released by the Labour Bureau in the Ministry of Labour and Employment.

 

New CPI Indices

    • A new CPI was launched in February 2011 called CPI (New). It has 2012 as its current base year.
  • CPI (New) is the average of CPI (Rural) and CPI (Urban), which is also prepared separately.
    • Three new indices are :
  • CPI (Urban)
  • CPI (Rural)
  • CPI (Combined)
  • It is compiled and released by the Central Statistics Office.

 

Analysis of WPI and CPI

  • WPI is purely a commodity index and does not take into account services for measuring inflation, whereas CPI (IW) includes both commodities and services, though the number of commodities covered by it is much smaller as compared to WPI.
  • CPI (IW) is based on retail prices and hence captures the impact of prices of selected essential goods and services on the household budget.
  • As compared to WPI, CPI has a much larger weightage of primary articles, which is as high as 57%. This implies that the impact of food inflation is reflected much more prominently in CPI than in WPI as WPI gives just 20% weightage to these articles. So, seasonal fluctuation in prices of these commodities has a relatively lesser influence on WPI.

 

Producer Price Index

  • It measures price change from the producers’ perspective as against the CPI, which measures price change from consumers’ perspective.
  • In PPI, only basic prices are used for compilation, while taxes, trade margins and transport costs are excluded.
  • PPI is better to measure inflation as price changes at crude and intermediate stages can be tracked before it creeps into the finished goods stage.

 

Service Price Index

  • Because of the increasing contribution to this sector to GDP, it is needed.
  • The office of Economic Adviser, Ministry of Commerce and Industry has been making an effort to develop a sector-specific service price index for the country with the technical assistance being received under the World Bank Assisted Economic Reforms Projects.

 

Real Estate Price Index

  • Fast urbanisation and rapid economic growth have resulted in an unprecedented increase in property values.

 

Why track the movement of residential House Prices?

  • It is important to facilitate the supply of affordable housing to people.
  • The necessity of designing the right mix of policy initiatives to encourage property acquisition.
  • Real estate asset is an important component of the wealth of the private sector and financial freedom allowed for acquiring this wealth.
  • The financial intermediaries lend for residential houses.

The authentic data on the real estate sector, development of a credible database on market-driven price trends and price index of market segments have emerged as a crucial element of market development.

 

NHB RESIDEX is an index of the National Housing Board to provide an index of residential prices in India across cities and over time.

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