Indian Economy, 5th edition (24 page)

Introduction

For a layman, inflation is just price rise. It becomes a matter of everyday discussion if the prices of daily or weekly items start rising. Whatever impact it might be having on other areas of economy, inflation might take an ugly turn and lead to a political crisis—at least in the developing economies. India has seen governments thrown out of power in elections due to price rise in daily-use items. This is not the case in the developed economies, but inflation takes its political toll there, too. In the developed economies more aware and informed voters get carried away by the greater impact of higher or lower inflations in the elections. In this chapter, we will try to examine the concept of inflation from all possible dimensions to have an overall understanding.

Definition

A rise in the general level of prices
1
; a sustained rise in the general level of prices
2
; persistent increases in the general level of prices
3
; an increase in the general level of prices in an economy that is sustained over time
4
; rising prices across the board
5
—is inflation. These are some of the most common academic definitions of inflation. If the price of one good has gone up, it is not inflation, it is inflation only if the prices of
most
goods have gone up.
6

When the general level of prices is falling over a period of time this is
deflation
, the opposite situation of inflation. It is also known as
disinflation
. But in contemporary economics, deflation or disinflation not used to indicate fall in prices. Instead, a price rise is termed a ‘rise in inflation’ and a price fall is termed a ‘fall in inflation’. The terms deflation or disinflation have become part of the macroeconomic policy of modern governments. In policy terms, the terms show a reduction in the level of national income and output, usually accompanied by a fall in the general price level. Such a policy is often deliberately brought about by the governments with the objective of reducing, inflation and improving the balance of payments (BoP) by reducing import demand. As instruments of deflation, any policy includes fiscal measures (as for example, tax increase) and monetary measures (as for example, increase in interest rate).

The rate of inflation is measured on the basis of price indices which are of two kinds—Wholesale Price Index (WPI) and Consumer Price Index (CPI). A price index is a measure of the average level of prices, which means that it does not show the exact price rise or fall of a single good. The rate of inflation is the rate of change of general price level which is measured as follows:

Rate of inflation (year x) = Price level (year x) –Price level (year x-1) / Price level (year x-1)×100

This rate shows up in percentage form (%), though inflation is also shown in
numbers
i.e.
digits
. A price index is a weighted average of the prices of a number of goods and services. In the index the total weight is taken as 100 at a particular year of the past (the
base year
), this when compared to the current year shows a rise or fall in the prices of current year, there is a rise or fall in the ‘100’ in comparison to the base year—and this inflation is measured in digits.

Inflation is measured ‘
point-to-point
’. It means that the reference dates for the annual inflation is January 1 to January 1 of two consecutive years (not for January 1 to December 31 of the concerned year). Similarly, the weekly rate of inflation is the change in one week reference being the two consecutive last days of the week (i.e., 5 p.m. of two Fridays in India).

Why inflation occurs

Economists have been giving different explanations throughout the 19
th
and 20
th
centuries for the occurrence of inflation—the debate still goes on. But the debate has certainly given us a clearer picture of inflation. We shall may see the reasons responsible for inflation in two parts—

I. Pre-1970s

Till the rise of the monetarist school, economists used to agree upon two reasons behind inflation:

(a) Demand-Pull Inflation

A mis-match between demand and supply pulls up prices. Either the demand increases over the same level of supply, or the supply decreases with the same level of demand and thus the situation of demand-pull inflation arise. This was a Keynesian idea. The Keynesian School suggests cuts in spending as the way of tackling excess demand mainly by increasing taxes and reducing government expenditure.

In practice, the governments keep tracking the demand-supply matrix to check such inflation. At times, the goods in short supply are imported, interest on loans increased, wages revised, depending upon the situation.

(b) Cost-Push Inflation

An increase in factor input costs (i.e. wages and raw materials) pushes up prices. The price rise which is the result of increase in the production cost is cost-push inflation. The Keynesian school suggested controls on prices and incomes as direct ways of checking such inflation and ‘moral suasions’ and measures to reduce the monopoly power of trade unions as the indirect measures (basically, cost-push inflations chiefly used to happen due to higher wage demanded by the trade unions during the era).

Today, the governments of the world use many tools to check such inflations—reducing excise and custom duties on raw materials, wage revisions, etc.

II. Post-1970s

After the rise of Monetaristic School of Economics in the early 1970s (
monetarism developed in opposition to post-1945 Keynesian idea of demand management
), the school provided monetarist explanation for inflation, the so-called ‘demand-pull’ or the ‘cost-push’ which is excessive creation of money in the economy.

(a) Demand-Pull Inflation

For the monetarists a demand-pull inflation is creation of extra purchasing power to the consumer over the same level of production (which happens due to wage revisions at micro level and deficit financing at the macro level). This is the typical case of creating extra money (either by printing or public borrowing) without equivalent creation in production/supply i.e., ‘too much money chasing too little output’—the ultimate source of demand-pull inflation.

(b) Cost-Push Inflation

Similarly for monetarists, ‘cost-push’ is not a truly independent theory of inflation—it has to be financed by some extra money (which is created by the government via wage revision, public borrowing, printing of currency, etc.). A price rise does not get automatically reciprocated by consumers’ purchasing. Basically, people must have got some extra purchasing power created that’s why they start purchasing at higher prices also. If this has not been the reason, people would have cut-down their consumption (i.e. overall demand) to the level of their purchasing capacity and the aggregate demand of goods would have gone down. But this does not happen. It means every cost-push inflation is a result of excessive creation of money—increasing money flow or money supply.

For monetarists, a particular level of money supply for a particular level of production is healthy for an economy. Extra creation of money over the same level of production causes inflation. They suggested proper monetary policy (money supply, interest rates, printing of currencies, public borrowing, etc.) to check the situations of inflationary pressure on the economy. Monetarists cancelled the Keynesian theory of inflation.

III. Measures to Check Inflation

From the above-given reasons for inflation and the measures to control it, which measure the governments of the world should apply in their policy making? In practice, governments around the world distanced themselves from this debate and have been taking recourse to all possible options while controlling inflation. The governments resort to following options to check rising inflation:

(i)
As a
supply side measure,
the government may go for the import of goods which are in short-supply—as a short-term measure (as happened in India in the case of ‘onion’
7
and meeting the buffer stock norm of wheat). As a long-term measure, governments go on to increase the production to matching the level of demand. Storage, transportation, distribution, hoarding are the other aspects of price management of this category.

(ii)
As a
cost side measure,
governments may try to cool down the price by cutting down the production cost of the goods showing price rise with the help of tax breaks—cuts in the excise and custom duties (as happened in June 2003 in India in the case of crude oil and steel
8
). This helps as a short-term measure. In the long-term, better production process, technological innovations, etc. are helpful. Increasing income of the people is the monetary measure to avoid the heat of such inflation.

(iii)
The governments may take recourse to tighter monetary policy to cool down either the demand-pull or the cost-push inflations. This is basically intended to cut down the money supply in the economy by siphoning out the extra money (as RBI increases the Cash Reserve Ratio of bank in India)
9
from the economy and by making money costlier (as RBI increases the Bank Rate or Repo Rate in India)
10
. This is a short-term measure. In the long-run, the best way is to increase production with the help of the best production practices.

Again, this measure does not work if the price rise is taking place in the items of everyday use such as salt, onion, wheat, etc. (because nobody purchases such goods by borrowing from the banks). This measure helps if the prices are rising due to extra demand of cement, iron and steel, etc.

The governments might utilise any of the above or all the three measures to check and manage inflation in their day to day price management policy making.

Types of Inflation

Depending upon the range of increase, and its severity, inflation may be classified into three broad categories:

I. Low Inflation

Such inflation is slow and on predictable
11
lines which might be called small or gradual
12
. This is a comparative term which puts it opposite to the faster, bigger and unpredictable inflations. Low inflation takes place in a longer period and the range of increase is usually in ‘single digit’. Such inflation has also been called as ‘
creeping inflation
’
12
. We may take an example of the monthly inflation rate of a country for six months being 2.3%, 2.6%, 2.7%, 2.9%, 3.1% and 3.4%. Here the range of change is of 1.1% and over a period of six months.

II. Galloping Inflation

This is a “
very high inflation
” running in the range of double-digit or triple digit (i.e. 20%, 100% or 200% a year)
13
. In the decades of 1970s and 1980s, many Latin American countries such as Argentina, Chile, and Brazil had such rates of inflation—in the range of 50 to 700 per cent. The Russian economy did show such inflation after the disintegration of the ex-USSR in the late 1980s.

Contemporary Journalism has given some other names to this inflation—
hopping inflation, jumping inflation
and
running or runaway inflation
.
14

III. Hyperinflation

This form of inflation is ‘
large and accelerating
’
15
which might have the annual rates in million or even trillion
16
. In such inflation not only range of increase is very large but the increase takes place in a very short span of time, prices shoot up overnight.

The best example of hyperinflation that economists cite is of Germany after the First World War—in early 1920s. At the end of 1923, prices were 36 billion times higher than two years earlier.
17
This inflation was so severe that paper German currencies (the Deutsche Mark) were more valuable as stove fuel than as actual money.
18
Some recent examples of hyperinflation had been the Bolivian inflation of mid-1985 (24000 per cent per annum) and the Yugoslavian inflation of 1993 (20 per cent per day).
19

Such an inflation quickly leads to a complete loss of confidence in the domestic currency and people start opting for other forms of money, as for example physical assets, gold and foreign currency (also known as “inflation proof” assets) and people might switch to barter exchange.
20

Other VariAnts of Inflation

Other than the three broad categories we analysed above, some other variants of inflation are also considered by governments in their policy making:

I. Bottleneck Inflation