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What is Inflation?

Introduction

Inflation is defined as an increase in the prices of goods and services such as food, clothes, housing, recreation, transportation, consumer staples, and so on. Inflation is defined as the average price change over time of a basket of goods and services. The opposite and rare fall in the price index of this basket of items is called ‘deflation’. Inflation is defined as a decrease in the purchasing power of a country's currency unit. This is measured in percentage.

Types of Inflation


The four major forms of inflation are as follows:


Creeping Inflation


It is a circumstance in which an economy's inflation steadily rises. It is one of the mildest kinds of inflation and is essential to keep the economy steady.

Walking inflation


It is also known as trotting inflation, and it occurs when prices climb by up to 10%. Walking inflation serves as a warning indication that galloping inflation is imminent.

Galloping inflation


It refers to the state of the economy when the prices of goods and services increase at a rapid rate of 10% and more. The currency loses value in this situation, and people are unable to keep up with rising costs for goods and services. It produces a significant economic imbalance in the nation and necessitates rigorous control measures.


Hyperinflation


When prices rise by more than 50% in a month, an economy is said to be experiencing hyperinflation. The major cause of such circumstances is an increase in money supply in an economy that is not supported by GDP growth. Hyperinflation is a rare phenomenon.



What are the causes of Inflation?



Inflationary pressures in an economy may be caused by a variety of sources. Some of the key reasons of inflation are as follows:


Demand-pull inflation


Demand pull inflation happens when an economy's total demand for services and goods grows faster than the economy's production capacity. This results in a demand-supply imbalance, with increased demand and lower supply, resulting in higher prices. For example, if oil-producing nations decide to reduce their production of petroleum and other hydrocarbons, supply falls. This reduced supply for current needs raises prices and adds to inflation.

Cost-push inflation

According to this hypothesis, when companies encounter increasing input costs such as labour and raw materials or commodities, they maintain their profitability by passing on the increased cost of production to the consumer in the form of higher prices, which adds to inflation. For example, if the price of milk rises, so will the price of each cup of coffee at your neighbourhood coffee shop.


Built-in inflation


As the cost of products and services rises over time, workers/employees anticipate higher wages/salaries to maintain their standard of life. Their increased wages/salary results in higher cost of goods and services, and this wage-price spiral tends to continue, as one factor induces the other and vice-versa.


Exchange rates


One of the most important elements in influencing the rate of inflation is the exchange rate. When the exchange rate falls and the rupee becomes less valued compared to foreign currency, foreign products and consumers become more costly to Indian consumers while Indian goods, commodities, services, and exports become less expensive to consumers abroad.


Money supply


The quantity of cash in circulation determines the value of money. When the expansion of the money supply outpaces the growth of economic production, i.e. when more money is chasing the same quantity of products, the increasing demand allows companies to raise prices, resulting in inflation.

National debt


Over time, national debt may cause inflation to rise. To pay off its national debt, a country has two options: increase taxes or create additional money. If the government raises taxes, firms will raise their pricing to compensate for the higher corporate tax rate. If the government selects the latter option, it will immediately increase the money supply, causing the currency to devalue and contribute to inflation.


How is Inflation Measured?

In India, inflation is largely monitored by two indices: the WPI (Wholesale Price Index) and the CPI (Consumer Price Index), which represent wholesale and retail price fluctuations, respectively.

  • Wholesale Price Index: It measures the changes in the prices of goods sold and traded in bulk by wholesale businesses to other businesses. Published by the Office of Economic Adviser, Ministry of Commerce and Industry. In India, it is the most extensively used inflation indicator. The index faces significant criticism due to the fact that the general public does not purchase things at wholesale prices. In 2017, the All-India WPI base year was changed from 2004-05 to 2011-12.


  • Consumer Price Index (CPI): It assesses price fluctuations from the standpoint of a retail customer. The National Statistical Office publishes it (NSO). The CPI measures the difference in the prices of items and services purchased by Indian consumers for usages, such as food, medical care, education, and gadgets. Food and drinks, fuel and light, housing and clothes, bedding and footwear are all sub-groups of the CPI. CPI's base year is 2012.


CPI for Industrial Workers (IW)

CPI for Agricultural Labourer (AL)

CPI for Rural Labourer (RL)

CPI (Rural/Urban/Combined)


The first three are produced by the Labour Bureau, which is part of the Ministry of Labour and Employment. The NSO at the Ministry of Statistics and Programme Implementation compiles the fourth.


The Monetary Policy Committee (MPC) uses CPI data to control inflation. In April 2014, the Reserve Bank of India (RBI) had adopted the CPI as its key measure of inflation.


Headline Inflation


Because headline inflation covers all sectors of an economy that experience inflation, it is not adjusted to eliminate extremely volatile data, such as those that may vary independently of economic circumstances.


Core Inflation


Core inflation excludes CPI components that might vary greatly from month to month, causing an undesired distortion in the headline number. The most commonly removed factors are those relating to the cost of food and fuel. Food costs may be influenced by variables other than those associated with the economy, such as environmental conditions that disrupt crop growth.


What are the ways to control inflation?


In general, there are two strategies to reduce inflation in an economy:


  • Monetary policies and

  • Financial measures


Monetary Policies


The Central Bank's monetary policy is the most essential and widely utilised strategy of controlling inflation. High-interest rates are the conventional method used by most central banks to combat or avoid inflation:


Tight money policy, Contractionary money policy and Hawkish money policy.


  • Bank rate policy is used as the main instrument of monetary control during the period of inflation. When the central bank raises the bank rate, it is said to have adopted a dear money policy. The cost of borrowing rises when the bank rate rises, reducing commercial banks' borrowing from the central bank. As a result, the flow of money from commercial banks to the general population is limited. Therefore, inflation is controlled to the extent it is caused by bank credit.


  • Cash Reserve Ratio (CRR): To control inflation, the central bank boosts the CRR, reducing commercial banks' lending capacity. As a result, the flow of money from commercial banks to the general people reduces. In the process, it halts the increase in prices induced by bank credits to the general public.


  • Open Market Operations: The central bank's selling and purchase of government securities and bonds are referred to as open market operations. To control inflation, the central bank sells the government securities to the public through the banks. It soaks liquidity from the market.


Fiscal Measures Taxation, government spending, and public borrowings are examples of fiscal policies used to control inflation. The government may also enact certain protectionist policies (such as banning the export of essential items such as pulses, cereals and oils to support domestic consumption, encouraging imports by lowering duties on import items etc.).



Is Inflation bad for everyone?


Inflation is good for the economy but within limits. RBI is responsible for keeping Inflation under check between 4 plus-minus 2. Inflation is perceived differently by everyone depending upon the kind of assets they possess.


For someone with investments in real estate or stocked commodities, inflation means that the prices of their assets are set for a hike. Those who possess cash may be adversely affected by inflation as the value of their cash erodes.



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