Inflation

On February 26, 2021, the Reserve Bank of India (RBI) published its ‘Report on Currency and Finance (RCF) for the year 2020-21.’ The report with its theme, ‘Reviewing the Monetary Policy Framework’ assumes topical relevance in the context of the review of the inflation target by March 2021 against the backdrop of structural changes in the macroeconomic and financial landscape that have prompted several central banks to undertake policy framework reviews. The report also studied the flexible inflation targeting (FIT) framework in India.

As per a another report by the RBI, the annual retail inflation rate rose 6.30% year-on-year in May, up from 4.29% in April and sharply above analysts’ estimate of 5.30%. The wholesale price inflation rate rose 12.94%, its highest in at least two decades.

Hence, the topic, ‘Inflation’ becomes important for the IAS Exam.

What is Inflation? In economics, inflation (or less frequently, price inflation) is a general rise in the price level of an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.

As per RBI, an inflation target of 4 per cent with a +/-2 per cent tolerance band, is appropriate for the next five years (2021-2025).

Inflation (UPSC Notes):- Download PDF Here

Types of Inflation

The different types of inflation in an economy can be explained as follows:

Demand-Pull Inflation

This type of inflation is caused due to an increase in aggregate demand in the economy.

Causes of Demand-Pull Inflation:

  • A growing economy or increase in the supply of money – When consumers feel confident, they spend more and take on more debt. This leads to a steady increase in demand, which means higher prices.
  • Asset inflation or Increase in Forex reserves– A sudden rise in exports forces a depreciation of the currencies involved.
  • Government spending or Deficit financing by the government – When the government spends more freely, prices go up.
  • Due to fiscal stimulus.
  • Increased borrowing.
  • Depreciation of rupee.
  • Low unemployment rate.

Effects of Demand-Pull Inflation:

  • Shortage in supply
  • Increase in the prices of the goods (inflation).
  • The overall increase in the cost of living.

Cost-Push Inflation

This type of inflation is caused due to various reasons such as:

  • Increase in price of inputs
  • Hoarding and Speculation of commodities
  • Defective Supply chain
  • Increase in indirect taxes
  • Depreciation of Currency
  • Crude oil price fluctuation
  • Defective food supply chain
  • Low growth of Agricultural sector
  • Food Inflation
  • Interest rates increased by RBI

Cost pull inflation is considered bad among the two types of inflation. Because the National Income is reduced along with the reduction in supply in the Cost-push type of inflation.

Built-in Inflation

This type of inflation involves a high demand for wages by the workers which the firms address by increasing the cost of goods and services for the customers.

Also, read about Inflation Targeting in the linked article.

Remedies to Inflation

The different remedies to solve issues related to inflation can be stated as:

  • Monetary Policy (Contractionary policy)

The monetary policy of the Reserve Bank of India is aimed at managing the quantity of money in order to meet the requirements of different sectors of the economy and to boost economic growth.

This contractionary policy is manifested by decreasing bond prices and increasing interest rates. This helps in reducing expenses during inflation which ultimately helps halt economic growth and, in turn, the rate of inflation.

  • Fiscal Policy
    •  Monetary policy is often seen separate from fiscal policy which deals with taxation, spending by government and borrowing. Monetary policy is either contractionary or expansionary.
    • When the total money supply is increased rapidly than normal, it is called an expansionary policy while a slower increase or even a decrease of the same refers to a contractionary policy.
    • It deals with the Revenue and Expenditure policy of the government.

Tools of fiscal policy

  1. Direct Taxes and Indirect taxes – Direct taxes should be increased and indirect taxes should be reduced.
  2. Public Expenditure should be decreased (should borrow less from RBI and more from other financial institutions)

To know more about the Fiscal policy in India, refer to the linked article.

  • Supply Management measures
    • Import commodities that are in short supply
    • Decrease exports
    • Govt may put a check on hoarding and speculation
    • Distribution through Public Distribution System (PDS).

Measurement of Inflation

  1. Wholesale Price Index (WPI) – It is estimated by the Ministry of Commerce & Industry and measured on a monthly basis.
  2. Consumer Price Index (CPI) – It is calculated by taking price changes for each item in the predetermined lot of goods and averaging them.
  3. Producer Price Index – It is a measure of the average change in the selling prices over time received by domestic producers for their output.
  4. Commodity Price Indices – It is a fixed-weight index or (weighted) average of selected commodity prices, which may be based on spot or futures price
  5. Core Price Index – It measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices. It is a way to measure the underlying inflation trends.
  6. GDP deflator – It is a measure of general price inflation.

Know more about the Cash reserve ratio in this article.

Effect of Inflation on the Economy

The effect of inflation on the economy can be stated as:

  •  The effect of inflation is not distributed evenly in the economy. There are chances of hidden costs for different goods and services in the economy.
  • Sudden or unpredictable inflation rates are harmful to an overall economy. They lead to market instability and thereby make it difficult for companies to plan a budget for the long-term.
  • Inflation can act as a drag on productivity as companies are forced to mobilize resources away from products and services to handle the situations of profit and losses from inflation.
  • Moderate inflation enables labour markets to reach equilibrium at a faster pace.

Important Terms related to Inflation

  1. Disinflation: Reduction in the rate of inflation 
  2. Deflation: Persistent decrease in the price level (negative inflation) 
  3. Reflation: Price level increases when the economy recovers from recession based on value of inflation 
  4. Creeping inflation – If the rate of inflation is low (upto 3%)
  5. Walking/Trotting inflation – Rate of inflation is moderate (3-7%) 
  6. Running/Galloping inflation – Rate of inflation is high (>10%) 
  7. Runaway/Hyper Inflation – Rate of inflation is extreme
  8. Stagflation: Inflation + Recession (Unemployment) 
  9. Misery index: Rate of inflation + Rate of unemployment
  10. Inflationary gap: Aggregate demand > Aggregate supply (at full employment level) 
  11. Deflationary gap: Aggregate supply > Aggregate demand (at full employment level) 
  12. Suppressed / Repressed inflation: Aggregate demand > Aggregate supply. Here govt will not allow rising of prices. 
  13. Open inflation: A situation where price level rises without any price control measures by the government. 
  14. Core inflation: Based on those items whose prices are non-volatile.
  15. Headline inflation: All commodities are covered in this.
  16. Structural inflation: Due to structural problems like infrastructural bottlenecks.

Learn Important Economic terms for UPSC in the linked article.

Online Quiz 2021

Inflation (UPSC Notes):- Download PDF Here

FAQ about Inflation

Why is inflation bad for the economy?

Inflation erodes purchasing power of the people due to sustained increase in prices of goods and services within a period.

Who decides inflation rate in India?

The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. However, the Reserve Bank of India is the authority to control inflation through monetary policies which it does by increasing bank rates, repo rates, cash reserve ratio, buying dollars, regulating money supply and availability of credit.

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