INFLATION

BY

SHYAM S KAGGOD

INTRODUCTION

“Inflation is the persistent increase in the price levels of

basket of commodities”

“Inflation is nothing more than a sharp upward rise in price

level.”

Too much money chasing too fewer goods.

Inflation is a state in which the value of money is falling i.e.

prices are rising.

TYPES OF INFLATION-BASED ON RATE

Moderate (Creeping and trotting-single digit)

Galloping (two digits or three digits)

Hyperinflation (astronomical rise)

TYPES OF INFLATION-BASED ON CAUSE

Demand Pull Inflation

Cost Push Inflation

Structural Inflation

Cartelization

Hoarding

DEMAND PULL INFLATION

Increasing government expenditure

Increasing money supply (liberal monetary/fiscal policy)

Parallel economy/black money

Increasing forex reserves

COST PUSH INFLATION

Increase in wages

Increase in taxes

Increase in prices of raw materials

Supply shocks

STRUCTURAL INFLATION

Food shortage

Scarcity of resources

Scarcity of foreign exchange reserves

TWO MEASURES OF INFLATION

WPI

CPI

HOW INFLATION IS CALCULATED

Commodity Weightage Price

(BY)

Price

(PY)

Price

Ratio

Weighted

ratio

x 60% 20 24 1.2 72

y 30% 10 11 1.1 33

z 10% 500 600 1.2 12

Total 100 117

WPI

Base year revised from 2004-05 to 2011-12 The number of items has been increased from 676 to 697

In all 199 new items have been added and 146 old items have been

dropped

Recommendations from Saumitra Chaudhuri working committee

Given by Economic Advisor (commerce ministry)

Published once a month

WPI REBASING

WPI REBASING

CPI

Previously three different types-IW,UNME and AL

Changed to CPI (C) = CPI (U)+CPI (R)

Base year was initially fixed at 2010 but again changed to

2012

Calculated by CSO

CPI Before After

Rural 437 448

Urban 450 460

CPI

Industrial

Workers (IW)

Urban Non-

Manual

Employees

(UNME)

Agricultural

Labourers (AL)

Base year 2001 1984-85 1986-87

Number of

articles

370 180 60

Services included Yes Yes No

Published by Ministry of

Labour

MoSPI Ministry of

Labour

CPI- RURAL, URBAN & COMBINED

Rural Urban Combined

Food and beverages 54.18 36.29 45.86

Pan, tobacco and

intoxicants

3.26 1.36 2.38

Clothing and footwear 7.36 5.57 6.53

Housing Not compiled 21.67 10.07

Fuel and light 7.94 5.58 6.84

Miscellaneous 27.26 29.53 28.32

COMPONENTS

Inflation Main category Sub-category

WPI Manufacturing (64%) Chemicals, textiles, wood and paper, metals

and alloys, Beverages, tobacco etc

Primary Articles (22%) Food articles, non-food articles, minerals

(crude petroleum)

Fuel (13%) Electricity, coal, mineral oils, LPG

CPI Food & Beverages (45.86%) Cereals, meat, fish, egg, milk etc

Miscellaneous (28.32%) Health, transport and communication,

education, recreation etc

Housing ((10.07%) Only in urban

Fuel & Light (6.84%) Fuel and light

Clothing & Footwear (6.53%) Clothing and footwear

Pan Tobacco and Intoxicants

(2.38%)

Pan Tobacco and Intoxicants

EFFECTS OF INFLATION

Reduces purchasing power

Reduces real rate of returns

Has an effect on exports

Effects investment scenario

HOW TO CONTROL INFLATION

Credit Control

Reduction in Unnecessary Expenditure

Increase in Taxes

Increase in Savings

Public Debt

To Increase Production

Rational Wage Policy

Demonetization of Currency

OTHER CONCEPTS

Deflation: Negative growth in the inflation rate

Dis-inflation: the rate change of inflation is slower or not

proportional

Core inflation: what is the inflation rate when volatile

commodities (such as food and energy items) are ignored

Headline Inflation: measure of total inflation in the economy

INFLATION TARGETING

Government has given the function of controlling inflation to RBI

MPFA was signed between GoI and RBI

As per this the RBI has to maintain Inflation at 4% (+/- 2%)

WPI AND CPI

PHILIPS CURVE

Represents the inverse relationship between the inflation and

unemployment rate

QUESTIONS

Which reference to inflation in India, which of the

following statements is correct? (2015)

a. Controlling the inflation in India is the responsibility of the

Government of India only

b. The Reserve Bank of India has no role in controlling the

inflation

c. Decreased money circulation helps in controlling the

inflation

d. Increased money circulation helps in controlling the

inflation

QUESTIONS

Which of the following brings out the ‘Consumer

Price Index Number for the Industrial Workers’?

(2015)

a) The Reserve Bank of India

b) The Department of Economic Affairs

c) The Labour Bureau

d) The department of Personnel and Training

QUESTIONS

Consider the following statements : (2013)

1. Inflation benefits the debtors.

2. Inflation benefits the bond-holders.

Which of the statements given above is/are correct?

(a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2

Inflation

Inflation is a persistent increase in the price levels of a basket of commodities

Price and price levels are two different things- price refers to the monetary value

that is paid/received for a good sold/bought respectively it is an individual

concept; whereas price level is an aggregate concept which is the monetary value

of basket/group of goods/services

It is important because inflation is a measure of change in the price levels as the

household buys a mix of goods and services and inflation tries to measure the

impact on the household

It is a macro-economic aggregate as it takes into consideration a basket of

commodities

Classification of inflation

o Based on the rate

Moderate-single digit inflation

Galloping-double/triple digit

Hyper-astronomical

o Based on the cause

Demand pull inflation

Increasing government expenditure

Increasing money supply (liberal monetary/fiscal policy)

Parallel economy/black money

Increasing forex reserves

Because of the above reasons the demand will go up and in this

situation there could be two outcomes- increase in the production

or increase in the prices. Since in a short run production cannot be

expanded, there will be increase in the prices.

Cost push inflation

Increase in wages

Increase in taxes

Increase in prices of raw materials

Supply side shocks

Structural inflation (is more a feature of a developing country as the

resources availability is limited for them)

Food shortage

Scarcity of resources

Scarcity of foreign exchange reserves

Reasons for inflation

o Demand pull factors-higher expenditure by government, expansionary

monetary/fiscal policy

o Cost push factors- increase in wages, increase in taxes etc

o Structural factors-lower investment, lower growth in agriculture,

unscientific storage of food grains etc

o Cartelization-suppliers come together and increase the price irrationally

o Hoarding-the middlemen store part of the goods and create an artificial

scarcity in the market

Two measures of inflation

o WPI

o CPI

WPI (Wholesale Price Index)- it measures the level of price changes at a

wholesale market level

It was reformed after the recommendations of Pronab Sen committee

o Base year changed from 1993-94 to 2004-05

o Coverage increased from 435 commodities to 676 commodities

o Published once a month

o Published by Economic Advisor

o Weightages also changed

o All the commodities which were of no daily use were taken off and new

commodities added to make it more representative

In 2017, the government has rebased the WPI and IIP

o The change of BY is from 2004-05 to 2011-12. The working committee that was set up by the government in this regard was headed by Dr Saumitra Chaudhuri

o The revision is done to reflect the changes in the industrial sector, to align it with the base year of other macroeconomic indicators like the Gross Domestic Product (GDP), Consumer Price Index (CPI-BY 2012)

o Under the new system

An institutional mechanism (Technical Review Committee) has been established

For facilitating dynamic revision of the item list of products and the panel of factories

It will be chaired by Secretary (Ministry of Statistics & PI)

This Committee will meet at least once a year for identifying new items that need to be included in the item basket and removing those that have lost its relevance in the industrial sector or are no longer being produced

The revised series will continue to represent the Mining, Manufacturing and Electricity sectors

The revised series uses the National Industrial Classification (NIC) 2008 for the purpose of classification of industrial production

The weightage given to the groups will be (for WPI will be)

Primary articles – 22.62%

Manufacturing – 64.233%

Fuel and Power – 13.15% Increase in number of items from 676 to 697. In all 199 new items

have been added and 146 old items have been dropped The new series is more representative with increase in number of

quotations from 5482 to 8331, an increase by 2849 quotations A new WPI Food Index will also be published (recommendation of

Ministry of Finance). It will be compiled by taking aggregates of WPI for food “products” under “manufactured goods” and “primary articles”

The practice of using Wholesale Price Index (WPI) to deflate items for which data is reported in value terms will continue

In the new series of WPI, prices used for compilation do not include indirect taxes in order to remove impact of fiscal policy. This is in consonance with international practices and will make the new WPI conceptually closer to ‘Producer Price Index’

o WPI and IIP is calculated by CSO o The unit coverage of IIP will, as before, cover entities in the organized

sector units registered under the Factories Act, 1948 o The weightage given to the groups will be (for IIP will be)

Mining – 14.373% (previously it was 14.157%) Manufacturing – 77.633% (previously it was 75.527%) Electricity – 7.994% (previously it was 10.316%)

CPI (Consumer Price Index)- it measures the changes in the price levels at retail

level. This inflation has the impact on the common man

o CPI previously was calculated for various groups based on their

consumption patterns

o Recently the CPI has been reformed-the base year has been shifted to

2012. Rather than having various CPIs, there are three CPIs now which are-

CPI (Urban), CPI (Rural) and CPI (Combined).

Rural Urban Combined

Food and beverages

54.18 36.29 45.86

Pan, tobacco and intoxicants

3.26 1.36 2.38

Clothing and footwear

7.36 5.57 6.53

Housing Not compiled 21.67 10.07

Fuel and light 7.94 5.58 6.84

Miscellaneous 27.26 29.53 28.32

Industrial

Workers

Urban Non-

manual

Employees

Agricultural

Laborers

Base year 2001 1984-85 1986-87

Number of

articles

370 180 60

Services

included

Yes Yes No

Published by Ministry of

Labour

MoSPI Ministry of Labour

Impact of inflation

o Reduces purchasing power

o Reduces real rate of returns

o Has an impact on exports

o Impact on investment scenario

How to control inflation

o Credit Control-through contractionary monetary/fiscal policy

o Demonetization of Currency-to control the black money

o Reduction in Unnecessary Expenditure

o Increase in Taxes

o Increase in Savings-the government has to incentivize the savings so that

expendable income reduces

o Public Debt-government should not allow the public debt to go beyond the

controllable limit

o To Increase Production-thereby reducing/moderating the prices

o Rational Wage Policy

Inflation impacts the poor, fixed income class and people in unorganized sector

as their purchasing power keeps on reducing and these groups do not have the

savings to tap into. It has very less impact on the rich class hence it could be

concluded that inflation leads to income redistribution in the favor of rich

Inflation (manageable terms always works in favor of producers, as this extra

price will act as an incentive for them to produce more

Inflation Targeting-

o As per the recommendations of Urjit Patel Committee

CPI must be used as an anchor for monetary policy (adopted by RBI)

Inflation must be maintained at 4% (+/-2%) (implemented through

MPFA)

The monetary policy decisions are to be taken my Monetary Policy

Committee (in process)

o RBI in 2015 has signed Monetary Policy Framework Agreement (MPFA)

with the Government and as per this,

it will bring down the inflation to lower than 6% by January 2016

(achieved)

And from 2017-18 the target will be 4%(+/-2%)

will publish a report every 6 months giving-reasons for inflation and

forecasts of inflation

it would have failed if inflation remains either higher than 6% or

lower than 2% for three consecutive quarters

in that case it will give a report to the government charting out the

course and specify duration within which the inflation will be

brought down

Philips Curve- represents the relationship between the inflation and

unemployment

o Rate of unemployment and rate of wage inflation are inversely related

(when there is low unemployment, the labour class is in a better position

to bargain for higher wages)

o Rate of inflation and wage inflation are directly related (higher the

increase in wage, higher demand for goods leading to inflation)

o Hence rate of unemployment and inflation are inversely related and the

representation would be a downward sloping curve

Some terms

Open Inflation- the prices of goods are allowed to fluctuate freely (or there is

least interference of the government in deciding the prices of goods)

Suppressed inflation- goods are sold at lower prices compared to the market

prices (ex-food grains sold under NFSA)

Stagflation- the period when there is inflation accompanied by increasing

unemployment and lower productivity

National Income Aggregate

Tries to measure what has been the growth in the production for comparison

with other countries and with itself over the time (i.e. to comparison over space

and time)

For measuring the production various aggregates are used

o GDP (Gross Domestic Product)

o GNP (Gross National Product)

o NDP (Net Domestic Product)

o NNP (Net National Product)

o National Income

GDP

o It is a geographic concept. It is the total monetary value of all the goods

and services which have been manufactured in a country in a financial

year

o In calculation of GDP

Intermediary goods will not be considered

savings is not considered

goods resold will not be considered (commission generated will be

considered)

social security transfers (eg-pensions) will not be considered

o Three methods to calculate GDP

Output/Product Value method=Total output × market price

Income method=sum of all the factor incomes

Expenditure method=C+I+G+(X-M)

C= consumption expenditure by households

I= Investment expenditure by firms

G= Government expenditure

X= Exports

M= Imports

GNP

o It is a nationality concept

o Under this the production done by citizens of a country is considered

o In a country there are inflows and outflows of foreign currency. The

inflows are because some nationals are working outside but are sending

back the remittances and outflows as foreign nationals are working within

but are sending back the earnings.

o Because there are such inflows and outflows, they need to be accounted

o GNP=GDP+NFIFA (NFIFA=Net Factor Income From Abroad)

o NFIFA=income earned by Indians living abroad-income earned by

foreigners living in India

NDP

o Depreciation- whenever there is usage of machinery in manufacturing,

they undergo wear and tear; and thereby lose value. This loss of value is

considered as depreciation and has to be deducted from the total value of

goods and services produced to give a better picture.

o NDP=GDP-Depreciation

NNP

o Under NNP, the production of citizens of a country is adjusted for

depreciation

o NNP=GNP-Depreciation

o NNP=GDP+NFIFA-Depreciation

National Income

o Is considered as the purest form of the income

o It is the NI=NNPFC=NNPMC - Indirect Taxes + Subsidies

o Factor cost=how much money is spent by manufacturer on all the factors

of production

Why GDP only?

o The inflows and outflows of foreign currency can happen because of

various reasons

o Depreciation rates will vary across countries

o Taxation and subsidization will vary across countries

Current prices and constant prices

o The current prices will represent the prevailing prices. If GDP is calculated

at these prices, then the inflation will not be discounted

o Hence to discount for the inflation rate the GDP is calculated at constant

prices

o And to account for inflation, GDP deflator is used

Limitation of NIA

o Non-availability of data and data collection is a costly affair

o Time lag-it takes time to collect data and arriving at numbers

o Existence of non-monetized consumption (or barter system)

o Parallel economy-the presence of black money in the economy may keep

adding to the demand side

o Lack of occupational specialization-many in India do multiple jobs rather

than sticking to a single job

Per Capita Income (PCI)-is the average income of every citizen of the country in a

particular year

PCI = National Income

Population

Some facts

o 1st estimate - Dadabhai Naoroji (1867-68)

o 1st scientific estimate - Prof V K R V Rao (1931-32)

o 1st official Estimate - Ministry of Commerce (1948-49)

o Calculation done by CSO (MoSPI)

New GDP series

The rebasing of the new GDP series is for the year 2011-12 rather than for 2009-

10 as the data regarding employment is not fully available, there was drought, it

wasn’t a normal year as there was a recession during the year 2009-10

Why the need to rebase

o The structural changes- such as technological changes leading to

production changes, relative changes in the prices of the relative goods

leading to changes in consumption side changes

o This helps in judging the size of the economy

o Which sectors are relatively important can be decided

Whenever rebasing is done

o accounting procedures change

o price indices are changed

o new estimations are used

o new databases are used

Till recently whenever the rebasing was done usually cosmetic or peripheral

changes were done but in the new NAS (National Accounts Statistics) the changes

have been comprehensive hence this has attracted a lot of attention and has led

to discussion

The Present rebasing has been done by CSO taking into consideration the

recommendations given the SNA (System of National Accounts) published by UN

in 2008. The changes introduced in the rebasing involve

o GVA as a concept comes under SNA (System of National Accounts). SNA

was prepared by UN in 1992-93, and has been ratified by WB, IMF, ADB

etc

o Replaced the old base year 2004-05 (decided in 2010) with 2011-12 (in

2015)

o Along with this there have been changes even in the coverage. The old

series covered 8 industries whereas the new covers 11 industries

o GDP at Factor Cost will be replaced with GVA at Basic Prices (The factor

cost do not consider the indirect taxes and subsidies whereas both are

considered under GVA at Basic Prices).

o GDP at Market Costs henceforth will be referred to as GDP

o Gross value added (GVA) is broadly defined as the value of output less the value of intermediate consumption. It measures the contribution to an economy of an individual producer, industry, sector or region

o Production taxes and production subsidies are either paid/received and are

independent of volume of any goods produced.

Production taxes - land revenues, stamps and registration fees and

professional tax etc

Production Subsidies - subsidized to Railways transportation, input subsidies

to farmers, subsidies given to small industries, subsidies given to companies

etc

Product taxes or subsidies are paid/received on per unit of product.

Product taxes - excise tax, sales tax, service tax and import and export duties

etc

Product Subsidies - petroleum and fertilizer subsidies, interest subsidies given

to farmers etc

o The coverage has been increased (Previously RBI used to cover the data

through ASI but has been shifted to MCA21)

o The ASI used the concept of ‘establishment’ (each unit’s GVA was taken into

consideration) whereas the new methodology uses ‘enterprises’ (under this

the parent company’s GVA is taken into consideration which adds to services

such as advertising, accounting, marketing etc) approach. Hence the size of

GVA under the second method will be larger than the first

o The calculation of labour in the previous methodology was based on Labour

Input method (LI Method) wherein the marginal productivities of labour were

not considered whereas in the new methodology Effective Labour Input (ELI)

is used.

Arguments - In 2015-16, India clocked a GDP growth rate of over 7.5% but the

exports had fallen, investments were at the lowest ebb and IIP growth rate gave

a completely different picture. One of the reasons for this diversion is considered

to be the GDP deflator. In case of India, we use the WPI (along with CPI) as the

deflator to deflate the nominal numbers but the WPI does not consider the

services and it is mainly oriented towards commodity prices

Producer Price Index

o PPI measures price changes from the perspective of the seller

o Sellers’ and Purchasers’ prices vary as there are taxes and subsidies

o The WPI does not cover services, whereas the PPI covers services

o Many countries have adopted PPI

o The government in 2014 has set up 12-member committee headed by B

N Goldhar to recommend regarding forming a PPI for India (determining

its methodology, data needed for its construction, and selecting a base

year among other things). It’s not the first time as even before two

committees under the Planning commission have been set up to study

regarding forming a PPI for India-one was headed by Abhijit Sen and the

other by Saumitra Chaudhuri

NATIONAL INCOME

AGGREGATES

BY

SHYAM S KAGGOD

POINTS TO BE COVERED

Why

Types

New GDP Methodology

Questions

AGGREGATES USED

GDP (Gross Domestic Product)

GNP (Gross National Product)

NDP (Net Domestic Product)

NNP (Net National Product)

NI (National Income)

GDP

Total monetary value of all the goods and services produced

within a geographical area within a time period

Three Methods

Output/Product Value method=Total output*market price

Income method=sum of all the factor incomes

Expenditure method=C+I+G+(X-M)

Cost on the company FoP Revenue to the providers

Rent Land Rent

Salary/wage/income Labour Salary/wage/income

Interest Capital Interest

Profit Entrepreneurship Profit

Total cost of productionTotal income received

Calculation of National Income

goods

expenditure

NEW METHOD OF MEASUREMENT

The base year was changed from 2004-2005 to 2011-12

SNA-The SNA was prepared by UN, launched in 1992 and

upgraded in 2008. ratified by WB, IMF, OECD etc

Methodological changes

Shifted from cost price to market price

Coverage has shifted to MCA21 data (ASI to MCA21)

New concept of GVA introduced

New concept of Basic Prices introduced

GROSS VALUE ADDED

Miner Steel

Manufacturer

Utensil

Manufacturer

Intermediate

Goods

00 10 30

Market Prices 10 30 50

Value Added 10 20 20

Value Added=Total Consumption-consumption of Intermediate goods

GDP NEW SERIES

GVABP = GVAFC + Production taxes – Production Subsidies

GDPMP = GVABP + Product Taxes – Product Subsidies

CONCERNS

Discrepancies

The GDP numbers do not reflect the other realities (such as

bank loans growth rate, corporate sector profitability,

industrial growth etc)

GDP-DISCREPANCY

GDP DISCREPANCY

GDP DEFLATOR

Used to adjust for inflation

In case of India WPI is used (in developed countries PPI is

used)

GoI has set up a committee under B N Goldhar

GNP

Total monetary value of all the goods and services by the normal

residents of a country within a financial year

GNP=GDP+NFIFA

NFIFA=FIRILA-FIPFLI

NFIFA=net factor income from abroad

FIRILA=factor income paid to Indians living abroad

FIPFLI=factor income paid to foreigners living in India

NDP

Depreciation is the expenditure in the form of lower value of

machinery, repairs etc

Hence depreciation has to be accounted as it reduces the profit

margins

NDP = GDP - Depreciation

NNP

Accounting for depreciation out of the total production done by

Indians

NNP = GNP - Depreciation

National Income or NNPFC

NNPFC=NNPMC - Indirect Taxes + Subsidies

It is the purest form of an income of a country as it takes

into account depreciation, the indirect taxes as well as the

subsidies

LIMITATIONS OF NIA

Non-availability of data

Time lag

Existence of non-monetized consumption

Parallel economy

Doesn’t consider development, environmental impact etc

PER CAPITA INCOME

Is the average income of the citizen of a country in a year

It is a representative number

PCI

SOME FACTS

1st estimate-Dadabhai Naoroji (1867-68)

1st scientific estimate- Prof V K R V Rao (1931-32)

1st official estimate-Ministry of Commerce (1948-49)

Calculation done by CSO (MoSPI)

Base year used= 2011-12

QUESTIONS

The national income of a country for a given period is

equal to the (2013)

(a) total value of goods and services produced by the nationals

(b) sum of total consumption and investment expenditure

(c) sum of personal income of all individuals

(d) money value of final goods and services produced

CAPITAL, SAVINGS AND INVESTMENT

BY

SHYAM S KAGGOD

GROSS CAPITAL FORMATION

Gross Savings

Private

Households

(Financial and Physical)

companies

Public

GROSS CAPITAL FORMATION

Of the total production, part is consumed and whatever is left out is

referred to it as savings. This could be either in Public or Private

sector. Whatever is invested back from this is referred to as capital

formation

This ratio is one of the indicators of health of the economy

YEAR GCF

2012-13 38.6

2013-14 34.7

2014-15 34.2

GROSS CAPITAL FORMATION (GCF)

GCF

GFCF

Infrastructure such as building,

machinery, means of transport, roads,

canal etc

Stock

Change in raw materials,

inventories, finished/semi-

finished goods etc

GROSS FIXED CAPITAL FORMATION

SAVINGS AND INVESTMENT

SAVINGS AND INVESTMENT

2003 (% of GDP) 2007 (% of GDP) 2017 (% of GDP)

GFCF 26.5% 35.6% 26.4%

Domestic Savings 29.2% 38.3% 29% (for 2016)

SAVINGS & INVESTMENT

CHANGES IN SAVINGS/INVESTMENTS

CONNECTION BETWEEN INTEREST RATES AND INVESTMENTS

Fisher Equation

r=n-i

r=real interest rate

n=nominal rate of interest

i=inflation rate

CONNECTION BETWEEN INTEREST RATES AND INVESTMENTS

Projects Investment Project

Returns

Real Interest

rates

Total investment

A 10 Cr 7% 5% 810 Cr (A+B+C+D)

B 20 Cr 9% 8% 800 Cr (B+C+D)

C 300 Cr 8% 9.5% 480 Cr (D)

D 480 Cr 10% 11% ₹ 0 Cr

The inflation rate between FY14 to FY16 has declined by 900 bps (WPI) or by 500 bps

(CPI) whereas, the repo rate has been reduced by 125 bps

This increase the cost of the borrowing for industries hence lesser borrowing

r n i

3% 8% 5%

4% 7% 3%

QUESTIONS

Economic growth in country X will necessarily have to occur

if (2013)

(a) there is technical progress in the world economy

(b) there is population growth in X

(c) there is capital formation in X

(d) the volume of trade grows in the world economy