Issues Relating to Inflation

ISSUES   RELATING TO INFLATION

By

G.THIMMAIAH

MEANING AND NATURE OF INFLATION 

1.      Inflation is an economic situation characterized by persisting general rise in the prices of goods and services.

2.      Inflation may be wholesale price inflation and/or retail price inflation.

3.      Inflation may be general rise in the prices of most of the goods and services and/or sectoral inflation like food inflation.

4.      Inflation may be structural, that is inherited from past policies of the government which cannot be reduced without reducing growth rate of GDP

5.      Inflation may be domestic inflation and/or global inflation.

TYPES   OF   INFLATION

1.      Wholesale inflation which reflects increase in the wholesale prices of commodities.

2.      Headline inflation which reflects increase in the prices of all groups of commodities.

3.      Core inflation which reflects increase in the prices of non- food (non- energy) manufactured goods.  

4.      Retail inflation which reflects increase in the prices of commodities at the retail trade level, which is in retail shops.

5.      Food inflation reflects increase in the prices of food articles.

RATES OF INFLATION IN INDIA

1.      Wholesale inflation rate increased by 7.55% as on May 12, 2012as against 7.23%as April 12, 2012.

2.      Retail inflation rate increased by 10.36% as on May 12, 2012.

3.      Core inflation has come down to below 5 % in May

4.      But Food inflation rate increased by 10.74% as on May 12, 2012. This is actually pushing up whole sale inflation

FOOD INFLATION IN INDIA

·         Food inflation rises to 9.13% on June 23, 2011

·         Food inflation hits 9.44% on July 14, 2011  

·         Food inflation rises to 8.04% on August 4, 2011

·         Food inflation rises to 10.05% on September 01, 2011

·         Food inflation rises by 0.79 % on December  11, 2011

·         Food Inflation declines by -0.68 %0n January 12, 2012

·         Food inflation increases to 6.12 %on February 12, 2012

·         Food inflation  increases to 10.11 % on March 12 ,2012

·         Food inflation increases to  10.49 % on April  12,2012

·         Food inflation increases to   10.74 % on May 12, 2012

Source: Reserve Bank of India

HOW TO MEASURE INFLATION?

1.      Price indices are constructed to measure inflation. Prices of sample items of goods are collected and their relative importance is used as weight and an index is prepared.

2.      In India Economic Adviser’s index of Wholesale price index is prepared and changes in wholes sale prices are measured every month with 2010-11 as base year. (There is also producers’ price index).

3.      Consumer Price Index for Industrial workers is constructed by Indian Labor Bueareau with 2001 as base year.

4.      India was also having consumer price index for agricultural laborers and consumer price index for non-manual employees. These have been discontinued.

5.      GDP deflator is also used to measure inflation as it is a more representative index. But it is not available for current periods. (GDP at current prices divided by GDP at constant prices).

CAUSES OF INFLATION

1.      Mismatch between supply and demand for goods and services at the sectoral and micro level.

2.      Aggregate demand exceeding aggregate supply at the macro level.

That is: (consumption+ investment+ government expenditure +exports)

= aggregate demand    EXCEEDING   (savings+ taxation+ imports) = aggregate supply

This is called demand pull inflation.

3.      Costs of inputs, (interest on credit, raw materials, wages, taxes and transport cost), rising faster than productivity. This is called cost-push inflation.

4.      Prices of imported inputs like petroleum products may contribute to domestic inflation through rise in energy cost. This is called globally transmitted inflation.

5.      Inflation is not merely and always a monetary phenomenon but more complex economic phenomenon.

    EFFECTS OF INFLATION

1.      Economic effects: a. Price effect. b. Income effect. c. Wealth effect.

·         When prices rise, price effect compels consumers to substitute superior goods by lower quality goods. This encourages spurious goods production and piracy.

·         When prices rise, people will be left with less income which is income effect. Thus inflation reduces income of poor people which adds to inequality.

·         When prices rise lenders lose real value of money and borrowers gain. This process redistributes income lenders to borrowers.

2.      Inflation adversely affects growth of GDP through monetary policy, expenditure policy and by creating economic uncertainty. It encourages speculation.

3.      Political effects: civil unrest, revolt, voting out a government and all such consequences will follow.

 ISSUES RELATING TO INFLATION (1)

1.      Has Globalization transmitted global inflation into India?

2.      Global inflation is transmitted through oil prices.

3.      It is transmitted through commodity prices

4.      It is transmitted through speculative food grains prices.

5.      Global capital flows into Indian stock market has pushed up share prices.

6.      Does inflation facilitate growth of GDP?

INFLATION   IN   USA

EUROPEAN   INFLATION

INFLATION IN BRIC COUNTRIES (BRIC)

ISSUES RELATING TO INFLATION (2)

1.      Can Monetary   Policy alone control Inflation?

2.      Monetary policy tools include: Interest rate Policy of the Central bank, Cash Reserve Ratio, Open Market Operations, and Directives (moral persuasion).

3.      Monetary policy will be able control inflation if inflation is caused by excess money supply. Otherwise it becomes ineffective.

4.      Monetary policy also becomes ineffective if fiscal policy measures are not coordinated and supportive to monetary policy.

INFLATION AND MONETARY POLICY IN CANADA

                INFLATION AND BANK OF CANADA’S INTEREST RATE

INFLATION AND MONETARY POLICY

                                  MONETARY POLICY IN SELECTED COUNTRIES

ISSUES RELATING TO INFLATION (3)

1.      Is the present inflation in India structural?

·         To some extent yes, because of persisting fiscal deficit.  (That is Government’s net borrowing).

         Association between fiscal deficit and inflation

                                  Fiscal Deficit            Rate of increase

Year                         as % of GDP            in Wholesale Inflation                                                                                  

2000-01                       -9.47                                3.5

2001-02                       -9.51                                3.0

2002-03                       -9.94                                3.8

2003-04                       -9.57                                3.6

2004-05                       -8.51                                8.7

2005-06                       -7.24                                4.2

2006-07                       -6.49                                6.4

2007-08                       -5.37                                5.8

2008-09                       -4.09                                6.7

2009-10                       -8.47                                7.5

2010-11                       -9.54                                10.5

Note: Fiscal Deficit includes that of the Union and of the state Governments.

Source: Reserve Bank of India

ISSUES RELATING TO INFLATION (4)

1.      Does inflation facilitate growth of GDP?

·         Ben Bernanke summarized the answer

o   Slow growth cures inflation

o   High growth fuels Inflation.

How?

ASSOCIATION BETWEEN INFLATION AND GROWTH

               Recent Trend of Real GDP Growth and Inflation in India

ISSUES RELATING TO INFLATION (5).

What is Threshold Inflation for India?

“High output growth and low inflation are among the most important objectives of macroeconomic policy. But there are perceived trade-offs between lowering inflation and achieving high growth. Empirical evidence emphasizes that the growth-inflation relationship depends on the level of inflation—at some low levels, inflation may be positively correlated with growth, but at higher levels inflation is likely to be harmful to growth. In other words, the relationship between inflation and output growth is nonlinear.”

Source:  RBI Working Paper

ISSUES RELATING TO INFLATION (6)

1.      Can India follow inflation targeting monetary strategy?

·         Inflation targeting means choosing a specific rate of inflation and using monetary policy measures to achieve it. Many countries do it.

·         Inflation targeting cannot be done in India because of multiple objectives imposed on RBI.

ISSUE RELATING TO INFLATION (7).

INFLATION TARGETING AND INFLATION INFLEXION

“It must be emphasized here that the concepts of inflation target and threshold are distinct. Inflation targeting is a construct of monetary policy making in which a central bank announces a ‘target’ and then steers its policy tools towards achieving that target. Inflation threshold is a point of inflexion for the growth-inflation trade-off.

Therefore, inflation threshold need not necessarily be the ‘target’ of monetary policy.”

Source: RBI Working Paper.

TREND IN INDIAN GDP GROWTH RATE

ISSUES RELATING TO INFLATION (8).

IS INDIAN ECONOMY ENTERING INTO STAGFLATION?

1.      Stagflation is an economic situation in which growth rate of GDP slows down and stagnates side by side general price level goes on increasing. Thus a combination of stagnation of GDP growth rate with rising inflation is ‘Stagflation’.

2.      The GDP figures released for the fourth quarter of 2012 and the entire financial year combined with resurgent headline inflation numbers appear to show that the Indian economy is entering into stagflation.

3.      Many western countries faced this economic situation in 1980’s and Japan has been facing it for last 15 years.

4.      Stagflation increases unemployment, poverty and economic inequality and people become desperate and lose faith in modern capitalism

NO   STAGFLATION   IN   INDIA

1.      It is true that the GDP growth rate has been slowing down but not declining as may be observed from the preceding table.

2.      It is however true that Indian economy is facing inflation, that is, persisting rise in general prices.

3.      In other words, Indian economy is facing inflation but not stagflation.

ISSUES RELATING TO INFLATION (9) .

RUPEE DEPRECIATION AND INFLATION IN INDIA

1.      External value of rupee is determined by the Reserve Bank of India in a fixed exchange rate regime. Periodically it is changed in response to the changes in the current account balance of the foreign trade.

2.      But the external value of the rupee was allowed to float in the market from March 1993 under the Liberalized Exchange Rate Management System and now it is determined by the supply and demand in India for US dollar which is the international reserve currency.

3.      In recent months, external value of the rupee started depreciating because of several reasons. One reason is the increase in the current account deficit of the country which reached 3.6 per cent of the GDP. Second reason is decline in our exports on account of economic slowdown in European countries and the USA and increase in imports mainly because of the increase in the price of crude oil in the Middle East countries. Third reason is that the External Commercial Loans, (ECBs), borrowed by Indian Corporate entities have become due now for repayment which has increased demand for dollar. On top of all these reasons, the FDI and FII inflows started declining because of certain tax provisions, (Retrospective Assessment and GAAR), announced in the Union budget for 2012-13 to plug the tax evasion. The cumulative effect of all these factors resulted in the rupee value depreciating to as low as Rs.57.35 per US dollar in the month of June this year.

DOES RUPEE DEPRECIATION LEAD TO INFLATION?

1.      When rupee depreciates, we have to pay more rupees for getting one dollar. This would mean we have to pay more for imports particularly for crude oil imports. Education and foreign travel cost more. Even though international prices of commodities have declined, rupee depreciation has offset that benefit. Thus rupee depreciation has led to import cost-push inflation

2.      But when rupee deprecates, it is like devaluation in a fixed exchange rate regime and should encourage our exports. But this is not happening because of the decline in demand for our exports because of the economic slowdown in European countries and in the USA. Slow growth of exports combined with high level of imports has resulted in current account deficit to increase to 3.6 per cent of GDP.

3.      In the context of slowdown in FDI and FII inflows, India is not able to finance the increased current account deficit.

4.      All these factors lead to further depreciation of Indian rupee which will push up both import cost push and export demand pull inflation.

5.      Thus Rupee depreciation in external value will lead and has led to increase in inflation.

ISSUES RELATING TO INFLATION (10).

DOES INFLATION LEAD TO DEPRECIATION OF RUPEE?

1.      When inflation persists or increases, our exports become costly and the demand for our exports will go down. This will reduce our foreign exchange earnings.

2.      In order offset the effect of inflation on our exports, we have to reduce the value of our rupee.  This is devaluation under fixed exchange regime.

3.      But since we have floating exchange regime, rupee automatically depreciates when our exports do not grow sufficient enough to finance our imports.

4.      So inflation becomes a double edged sword. It makes rupee to depreciate and rupee depreciation also leads to inflation.

IS INDIA GOING FOR ANOTHER ECONOMIC CRISIS?

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