Indian Economy, 5th edition (26 page)

The index has increased by 20 points in all the three years – 2008, 2009, 2010. However, the inflation rate (calculated on ‘year-on-year’ basis) tends to decline over the three years from 20 per cent in 2008 to 14.29 per cent in 2010. This is because the absolute increase of 20 points in the price index in each year increases the
base year price index
by an equivalent amount, while the absolute increase in price index remains the same. The ‘year-on-year’ inflation is calculated by the formula –

Current Inflation Rate = [(Current Price Index – Last year’s Price Index)]
÷
Last year’s Price Index] x 100

Effects of Inflation

There are multi-dimensional effects of inflation on an economy both at the micro and macro levels. It redistributes income; distorts relative prices; destabilises employment, tax, saving and investment policies and finally it may bring in recession and depression in an economy. We may have a brief and objective look on the effects of inflation as given below:

I. On Creditors and Debtors

Inflation redistributes wealth from creditors to debtors i.e. lenders suffer and borrowers benefit out of inflation. The opposite effect takes place when inflation falls (i.e. deflation).

II. On lending

With the rise in inflation, lending institutions feel the pressure of higher lending. Institutions don’t revise the nominal rate of interest as the ‘real cost of borrowing’ (i.e. nominal rate of interest minus inflation) falls by the same percentage with which inflation rises.

III. On Aggregate Demand

Rising inflation indicates rising aggregate demand and indicates comparatively lower supply and higher purchasing capacity among the consumers. Usually, higher inflation suggests the producers to increase their production level as it is generally considered as an indication of higher demand in the economy.

IV. On Investment

Investment in the economy is boosted by the inflation (in the short-run) because of two reasons:

a.
Higher inflation indicates higher demand and suggests enterpreneurs to expand their production level, and

b.
Higher the inflation, lower the cost of loan (as shown above in no.II)

V. On Saving

Holding money does not remain an intelligent economic decision (because money loses value with every increase in inflation) that is why people visit banks more frequently and try to hold least money with themselves and put maximum with the banks in their saving accounts. This is also known as the
shoe leather cost
35
of inflation (as it consumes the precious time of the people visiting the bank frequently tagging their shoe!). It means that saving rate increases. But this happens as a short-term effect of inflation. In the long-run, higher inflation depletes the saving rate in an economy. Just the opposite situation arises when inflation falls or shows falling traits with decreasing saving, in the short-run and increasing saving in the long-run, respectively.

VI. On Tax

On tax structure of the economy, inflation creates two distortions:

(a)
Tax-payers suffer while paying their direct and indirect taxes. As indirect taxes are imposed ad valorem (
on value
), increased prices of goods make tax-payers to pay increased indirect taxes (like cenvat, vat, etc. in India).

Similarly, due to inflation, direct tax (income tax, interest tax, etc.) burden of the tax-payers also increases as tax-payer’s gross income moves to the upward
slabs
of official tax brackets (but the real value of money does not increase due to inflation; in fact, it falls). This problem is also known as
bracket creep
— i.e.
inflation-induced tax increases
36
. Some economies (as in the US and many European countries) have
indexed
their tax provisions to neutralise this distortion on the direct tax payers.

(b)
The extent to which tax collections of the government are concerned, inflation increases the nominal value of the gross tax revenue while real value of the tax collection does not compare with the current pace of inflation as there is a lag (
delay
) in the tax collection in all economies.

But governments get an advantage on their interest burden on their borrowings as inflation benefits borrowers. This benefit, however, depends upon the contemporary levels of fiscal deficit and the total national debt.

In the case of a government incurring high fiscal deficit (increased borrowing, printing currency) inflation functions as a tax i.e.
inflation tax
via which the government fulfills its expenditure by cutting down the expenditure and consumption of the people.

VII. On Exchange Rate

With every inflation the currency of the economy
depreciates
(loses its exchange value in front of a foreign currency) provided it follows the flexible currency regime. Though it is a comparative matter, there might be inflationary pressure on the foreign currency against which the exchange rate is compared.

VIII. On Export

With inflation, exportable items of an economy gain competitive prices in the world market. Due to this, the volume of export increases (keep in mind that the value of export decreases here) and thus export income increases in the economy. It means export segment of the economy benefits due to inflation. Importing partners of the economy exert pressure for a stable exchange rate as their imports start increasing and exports start decreasing (see the next point).

IX. On Import

Inflation gives an economy the advantage of lower imports and import-substitution as foreign goods become costlier. But in the case of compulsory imports (i.e. oil, technology, drugs, etc.) the economy does not get this benefit and loses more foreign currency instead of saving it.

X. On Trade Balance

In the case of a developed economy, inflation makes trade balance favourable while for the developing economies inflation is unfavourable for their trade balance. This is because of composition of their foreign trade. The benefit to export which inflation brings in to a developing economy is usually lower than the loss they incur due to their compulsory imports which become costlier due to inflation.

XI. On Employment

Inflation increases employment in the short-run but becomes neutral or even negative in the long run (see the Phillips Curve and the NAIRU in the earlier sections).

XII. On Wages

Inflation increases the nominal (face) value of the wages while their real value falls. That is why there is a negative impact of inflation on the purchasing power and living standard of the wage employees. To neutralise this negative impact the Indian government provides
dearness allowance
to its employees twice a year.

XIII. On Self-employed

Inflation has a neutralising impact on the self-employed people in the short-run. But in the long run they also get affected as the economy as a whole gets affected.

XIV. On Economy

All the segments discussed above belong to an economy but we must know the overall short-term and long-term impact of inflation on an economy.

Experiences of the world economies in the late 1980s that a particular level of inflation is healthy for an economy. This specific level of inflation was called as the ‘range’ of inflation and every economy needs to calculate its own range. Inflation beyond both the limits of the range is never healthy for any economy. In the case of India it is considered 4 to 5 per cent which is also known as the ‘comfort zone’ of inflation in India. Similarly for Australia, New Zealand, the USA, Canada and the European Union the healthy range today is 1 to 3 per cent. This is why every economy today utilises
inflation targeting
as part of its monetary policy.

Inflation beyond the limits of the decided/prescribed range brings in recession to depressions. (We will see them in the Section B of this Chapter ‘Business Cycle.)

INFLATION IN INDIA

Every economy calculates its inflation for efficient financial administration as the multi-dimensional effects of inflation make it necessary. India calculates its inflation on two price indices i.e. the wholesale price index (WPI) and the consumer price index (CPI). While the WPI-inflation is used at the macrolevel policy making, the CPI-inflation is used for micro level analyses. The inflation at the WPI is the inflation of economy. Both the indices follow the ‘point-to-point’ method and may be shown in
points
(i.e digit) as well as in
percentage
relative to a particular
base year
.

Wholesale Price Index

The first index number of wholesale prices commenced in India for the week January 10, 1942. It was having the base week ending August 19, 1939 = 100 which was published by the office of the Economic Adviser to the Government of India (Ministry of Industry)
37
. Independent India followed the same series with more number of commodities included in the index. Several changes regarding inclusion of commodities, assigning them the logical weights took place in the coming times including revisions in the
base years
for the WPI. The WPI base year has been revised five times till date. The base years are as given below:

(i)
1952–53 Base Year (112 Commodities) issued from June 1952.

(ii)
1961–62 Base Year (139 Commodities) issued from July 1969.

(iii)
1970–71 Base Year (360 Commodities) issued from January 1977.

(iv)
1981–82 Base Year (447 Commodities) issued from January 1989.

(v)
1993–94 Base Year (435 Commodities) issued from July, 1999.

(vi)
2004-05 Base Year (676 Commodities) released in September 2011.

New Series of WPI

With the purpose of making inflation data in India more transparent, updated and similar to the practices among most of the economies, a
Working Group for Revision of WPI Number
was set up under the Chairmanship of the Planning Commission member, Prof. Abhijit Sen. In light of the recommendations the Government recently announced the
New Series of Wholesale Price Index.

Headline inflation in India is measured in terms of Wholesale Price Index (WPI) and the Office of the Economic Adviser, Department of Industrial Policy & Promotion is entrusted with the task of releasing this index. WPI is an important statistical indicator, as various policy decisions of the Government, like inflation management, monitoring of prices of essential commodities etc., are based on it.

It is one of the key variables for monetary policy changes by the Reserve Bank of India. In addition to its role as a policy variable, WPI is also used by various departments for arriving at the escalation costs of various contracts.

Considering the importance of WPI as a tool for various policy decisions, it is necessary to disseminate the most comprehensive, credible and accurate information, reflecting the realities of the present economic situation of the country. In order to capture the structural changes happening in the economy, the base year of WPI needs to be updated.

The Office of the Economic Adviser undertook the work relating to revision of the existing series of WPI (base 1993–94=100), which not only addressed the issue of change in base year, but also revised the entire commodity basket and the weighting diagram so as to better reflect the price trends in economy. The revised series of WPI was officially launched on
14 September, 2010
by the Ministry of Commerce & Industry.

Features of the Revised Series of WPI

A representative commodity basket comprising
676 items
has been selected in the new series (base 2004–05=100) as against 435 in the old series (base 1993–94=100) and weighting diagram has been derived for the new series consistent with the structure of the economy. There has been a substantial increase in the number of quotations selected for collecting price data for the above items. The number of price quotations for the new series is
5482
whereas in the old series, it was 1918.

The selection of the base year and the commodity basket was made on the basis of the recommendations of the Working Group set up specifically for this purpose. The Working Group was headed by Professor Abhijit Sen, Member, Planning Commission and included as its Members all stake-holders covering the users of the price data and the providers of the prices. The working group in its Technical Reports gave detailed recommendations with regard to the choice of the base year, the method of selection of items, preparation of weighting diagram and the collection of prices. The new index along with the base year and the commodity basket was also examined by Technical Advisory Committee (TAC) on Prices and Cost of Living based in Central Statistical Organisation. Before the launch of the new index, inter-departmental consultations were held and opinions obtained from Economic Advisory Council of the Prime Minister.

A comparative statement of weights, number of items and number of quotations between the
old series
and
new series
at Group level is as below: