19

Inflation

INTRODUCTION

Inflation is a major economic problem, which plagues most of the countries in the world today. The present chapter and the next chapter analyse inflation and its related aspects.

The chapter starts with a simple definition of inflation, deflation and other related terms. It goes on to discuss the different measures of inflation, including the consumer price index and the wholesale price index. Inflation has widespread effects including economic and social effects, which have been discussed at length. The chapter also focuses on some features of inflation in India.

MEANING OF INFLATION

Inflation is a persistent and an appreciable increase in the general level of prices. This leads to a decrease in the purchasing power of money. A sustained inflation takes place when the general price level continues to rise over a fairly long time period. Disinflation is a situation where there occurs a decrease in the rate at which prices are rising.

 

Deflation is the opposite of inflation. It is a situation where there exists a persistent decrease in the general level of prices. It leads to a decrease in the purchasing power of money.

• Deflation is the opposite of inflation and leads to a decrease in the purchasing power of money.

MEASUREMENT OF INFLATION

Two measures of inflation are as follows:

1. Change in the Price Index: The rate of inflation can be measured through change in the price index.
   

   where,	t = time period, which has been selected for measuring inflation
   	t – 1 = the preceding year

   As far as the price index is concerned, following two indexes are often used:

   1. Consumer Price Index (CPI): Consumer price index (CPI) is a time-series index. It is a weighted average of prices of a specified basket of goods and services, which are purchased by the consumers. The CPI is a fixed quantity price index and often taken as a cost of living index. The CPI keeps a track of the changes in the price of a specified basket of consumer goods and services. By observing the changes in this index, inflation can be measured.

       

      Consumer Price Index (CPI) is a weighted average of prices of a specified basket of goods and services, which are purchased by the consumers.

   2. Wholesale Price Index (WPI): The wholesale price index (WPI) or what is called the producer price index is used to measure the change in the average price of goods, which are traded in the wholesale market. In India, the WPI has been taken as an indicator of the inflation rate in the economy.

       

      The Wholesale Price Index (WPI) or the Producer Price Index is used to measure the change in the average price of goods, which are traded in wholesale market.

2. Gross National Product Deflator (GNP Deflator): The GNP deflator is not obtained directly like the CPI and WPI. It can be obtained as follows:
   

   where,	Nominal GNP = GNP at current prices
   	Real GNP = GNP at constant prices

The CPI is a weighted average of prices of a specified basket of goods and services, which are purchased by consumers whereas the WPI is used to measure the change in the average price of goods, which are traded in the wholesale market. In contrast, the GNP deflator is based on the prices of all the goods.

• The CPI is a weighted average of prices of goods and services purchased by consumers and the WPI is average price of goods which are traded in wholesale market; the GNP deflator is based on the prices of all the goods.

THE ECONOMIC AND SOCIAL EFFECTS OF INFLATION

In an economy where all prices change proportionately, no one is hurt and no one gains due to the changes in the price level. However, in the real economy all prices do not change proportionately. While some members of the society gain from inflation, others may loose. We can analyse the effects of inflation under two categories, economic effects and social effects.

Economic Effects of Inflation

We hereby examine the economic effects of inflation. They are as follows:

1. On the Distribution of Income: The impact of an increase in the general price level is felt unevenly by the different groups of people, some of whom can be called the gainers whereas the others can be called the losers from inflation.

   Gainers from inflation include the following:

   1. The producers as a group including the manufacturers, traders and the farmers whose income is derived from profits and thus they gain due to inflation.

      As far as the manufacturers are concerned, they are able to sell their goods at high prices. No doubt there is an increase in the wages, interest rates, rent and the cost of the raw materials. However, it has been observed that the increase in the general level of prices is much more than the increase in the cost of production. Thus, the profit margin of the producer grows. Also there exists a time lag between the increase in prices and the wage increase, which again is in the interest of the producers.

      The big farmers and traders again gain during times of inflation. It has been observed that the increase in the prices of the agricultural goods is much more than the increase in the prices of the industrial goods. Also, the demand for agricultural goods is less inelastic and the hoarding of these goods by the traders leads to further increase in their prices. In contrast to the big farmers the small farmers, who have just enough for subsistence, do not gain due to inflation.

   2. Those investing in equities benefit due to inflation. Due to the increase in the price, firms make large profits. The shareholders benefit in two ways: through the increased dividends that they earn and also due to the increase in the price of their shares, which enables them to make capital gains.
   3. The debtors gain during times of inflation. This is because the decrease in the value of money reduces the burden of the interest owed by them.

   Losers from inflation include the following:

   1. The wage and salary earners (who are unorganized and without any wage contracts) lose due to inflation. The organized workers employed in large scale manufacturing units are able to pressurize and achieve wage increases through their unions whenever there is an increase in the price level. It is, however, the unorganized workers employed in small scale manufacturing units who are unable to achieve the wage increases. As a result, their real wages decrease during the times of inflation. Even the agricultural labourers, who are not only unorganized but also uneducated and ignorant, are badly affected due to inflation.
   2. Those investing in bonds lose due to inflation. Due to the increase in the general price level, investors holding fixed interest yielding bonds suffer. These bondholders lose in two ways: through the decrease in the real income from the bonds and also on account of capital losses if they decide to sell the bonds.
   3. The creditors lose during times of inflation. This is because the decrease in the value of money reduces the real worth of the interest that they get from their debtors.
   4. Recipients of incomes from rent are often hurt during inflation. However, this occurs only in cases when there are no escalator clauses, which enable the landlords to protect their interests. In general, inflation leads to a redistribution of income from the creditors to the debtors and from the landlords to the tenants (provided there are no escalator clauses). It can thus be argued that inflation leads to a redistribution of income with the rich becoming richer and the poor becoming poorer.
2. On the Distribution of Wealth: A household’s wealth depends on the difference between the value of its assets and its debts.

   The assets can be divided into two categories:

   1. Variable price assets include all types of physical assets like property, gold and silver jewellery, and financial assets like shares. To what extent does the household gain from these assets depends on the increase in the price of these assets vis-à-vis the inflation rate.
   2. Fixed claim assets include bonds, money, debentures and bank deposits. The money value of these assets is fixed in terms of money. Hence, their real worth declines during inflation. As far as debt is concerned, a household’s debt includes housing loans and others, which are generally fixed in monetary terms.

      To what extent an individual’s wealth is influenced by inflation will depend on two factors: firstly on how the assets are divided between fixed claim assets and variable price assets, and secondly on the extent of its debts in comparison to its fixed claim assets.

3. On Output and Employment: As far as the short run is concerned, economists are of the opinion that for an economy which is operating below full employment, inflation of the creeping or crawling type may prove to be favourable as long as it is unanticipated. The prices increase at a faster rate than the money wages resulting in higher profits and also providing an incentive to the firms to expand the output by hiring more workers. Thus at least in the short run inflation, if unanticipated, will lead to an increase in employment and thus in the output.

   Inflation leads to an increase in the output not only through an increase in employment but also through a reallocation of the resources, including labour. Some economists, however, are of the opinion that inflation leads to a misallocation of the resources, in that the output of only those industries will rise whose prices rise the maximum. The other industries may, in fact, face a contraction in their output. But this is not necessarily true as most prices are flexible upwards and inflexible downwards. In such a situation, a better reallocation of resources is possible only through a price increase.

   It can thus be argued that inflation leads to an improvement in the allocation of resources and thus to an increase in the employment and output.

   However, this is subject to the following two qualifications:

   1. The benefits of inflation may be temporary. In the long run, once the money wages catch up with the rising prices or, in other words, labour finally anticipates the inflation and succeeds in increasing the real wages, the unemployment situation may be back again.
   2. The distortions in the resource allocation caused by inflation may in fact result in a slow down or may even lead to a minor recession.
4. On the Rate of Long Run Economic Growth: It has been observed in various countries that there exists a positive relationship between inflation and economic growth.

   During inflation, wages lagged behind prices. This resulted in

   1. Huge profit margins, which provided not only the incentive but also the resources to the firms to invest in the capital goods. The high profits were also responsible for the huge savings, given the fact that the high income group saves more than the low income group.
   2. A shift of resources away from the wage goods (whose demand were not increasing as rapidly) to the capital goods.

      The result was an increase in the production of capital goods leading to an increase in the productive capacity and hence economic growth.

      In the modern times, the situation seems to be different. Not only are the workers more organized which prevents the wages from lagging behind the prices, in addition savings may not rise because people may find their real net worth shrinking and thus may not increase the fraction of income that they save. Also in the modern world, besides inflation other factors like advances in knowledge are more important for growth.

      Most economists agree that a moderate inflation is conducive to economic growth. Hyperinflation or inflation that occurs at a break neck speed may discourage saving and thus hinder economic growth.

      In the opinion of James Tobin, a little amount of inflation is good for an economy. George L. Perry, George A. Akerlof and William T. Dickens have also argued that a little inflation of about say, 2 or 3 per cent per annum is good from the view point of an economy. It will, to some extent, help in achieving a lower rate of unemployment and thus economic efficiency. Thus, some economists believe that a little inflation ‘greases the wheels’ of the labour market and thus lubricates the economy.

Social Effects of Inflation

Besides the economic effects, inflation has some social effects also which result in problems for the society. To understand these problems, it is important to differentiate between the two types of inflation.

1. Perfectly Anticipated Inflation: Perfectly anticipated inflation exists when the rate of inflation is steady, perfectly predictable and expected (for example, every month there is an increase in the price level, say by 2 per cent). Thus it is inflation, which people expect. Such inflation imposes certain costs on the society. These costs are:

    

   Perfectly anticipated inflation exists when the rate of inflation is steady and perfectly predictable.

   1. Menu Cost: With a high rate of inflation, firms are expected to adjust their announced prices. This involves making changes in the catalogues and cash registers. The costs involved in these changes are called menu costs. The higher the inflation rate the more often the firms have to print the new menus. It has often been noticed that firms facing menu costs are not willing to change prices frequently. This may, in fact, lead to inefficiencies in the allocation of resources.
   2. Shoe leather Cost: The cost of holding money by an individual is the interest, which he foregoes by not holding an asset which could have earned him an interest. When there is a rise in the rate of inflation, there is an increase in the nominal interest rate and thus the interest lost by holding money rises. Hence, there is an increase in the cost of holding money. The demand for money balances falls. Individuals are now required to make more frequent trips to the bank to withdraw smaller amounts of money and leave the rest in interest earning assets. The frequent trips to the bank will involve more of walking to the bank which will make one’s shoes to wear out more quickly. This is the shoe leather cost of inflation.
   3. Distortions in Taxation: Often the tax provisions do not take into consideration the effects of inflation. In India, indexation benefits are available while computing capital gains in respect of assets held over a longer term. However, income slabs and tax rates are generally not inflation linked and are only subject to periodic reviews as part of the government’s annual budgetary exercise. As the tax codes measure the nominal income and not the real incomes, inflation can influence the individuals’ real tax liability. Thus, inflation distorts taxes.
   4. Inconvenience in Using Money as a Yardstick: Money is the yardstick, which measures the economic transactions. However, this yardstick itself is affected by inflation. For example, when the value of the rupee itself keeps changing, then it is less useful in the measurement of economic transactions.
2. Imperfectly Anticipated Inflation: Imperfectly anticipated inflation is that inflation, which people do not expect. Such inflation imposes certain costs on the society. These costs are:

    

   Imperfectly anticipated inflation is that inflation, which people do not expect.

   1. An Arbitrary Redistribution of Wealth (Though already discussed under the economic effects, it is being discussed again with more emphasis on the social aspect). This redistribution occurs because an unexpected inflation:
      1. leads to a decrease in the real value of all assets fixed in nominal term like bonds, money, saving accounts and insurance contracts.
      2. hurts individuals who have a fixed pension and can thus erode the purchasing power of an individual’s lifetime savings.
      3. often the agreements on loans are in terms of the nominal rate of interest, which is further based on the inflation rate existing at that time. If inflation is more than expected, then the debtors stand to gain whereas the creditors lose as the debtors certainly do pay back the loan but with less purchasing power. Thus, inflation leads to a redistribution of wealth between creditors and debtors.
      4. with unexpected inflation, realized real interest rates are lower than nominal interest rates.
   2. An Unfavourable Effect on Decision Making. Due to inflation, while some gain others loose. Unanticipated inflation brings in an additional element of risk. Such an additional risk may affect adversely some of the attractive exchanges, which take place among the consumers and the businesses. This is an additional cost, which occurs due to an unexpected inflation.

• The impact of an increase in the general price level is felt unevenly by the different groups of people, some of whom can be called the gainers whereas the others can be called the losers from inflation.
• It can be argued that inflation leads to an improvement in the allocation of resources and thus to an increase in the employment and output.
• Some economists believe that a little inflation ‘greases the wheels’ of the labour market and thus lubricates the economy.

INFLATION IN INDIA

Inflation continues to be a serious problem that plagues most economies of the world today. It is one of the most closely observed economic variables in India as it has a considerable influence on the life of an average consumer. A controversy that surrounds inflation in India is connected with the methodology used to calculate inflation.

Most of the developed countries use the CPI to calculate inflation, in India the WPI is used. According to the International Monetary Fund (IMF) statistics while 24 countries use the WPI, 157 countries use the CPI as the official measure to track down the inflation rate. India is the only major country that uses a wholesale price index to measure inflation. The CPI, in fact, is a measure of the increase in price that the consumer actually has to pay. In most countries, it is the official barometer of inflation. On the other hand, the WPI does not measure the increase in the price which the consumers actually experiences as it is based on the wholesale prices. Also, it is felt by some economists that a few of the commodities in the WPI are now less important from the consumer’s point of view.

In India, the WPI method is still used because there are many problems associated with the CPI. Not only are there four different types of CPI indices in India (CPI Urban Non-manual Employees, CPI Industrial Workers, CPI Agricultural labourers and CPI Rural labour) but there also exists a lag in the reporting of the CPI numbers. Also, while the WPI is published on a weekly basis the CPI is published on a monthly basis. In India, the rate of inflation is calculated on a weekly basis. The WPI has an economy-wide coverage. Also, the weights used in the commodity basket in the case of the WPI are on the basis of the value of quantities which are traded in the domestic market. In the case of the CPIs, the commodity basket is based on consumer expenditure surveys.

 

Table 19.1 Annual WPI Inflation rate (%) (Base: 1993–94 = 100)

Table 19.1 from the Economic Survey 2008–09 depicts the inflation trends by broad commodity groups from 2000–01 to 2008–09. The years 2000–01, 2004–05 and 2008–09 show the highest average rate of inflation with 2008–09 recording the highest average in the decade. As on 28 March 2009, the WPI overall inflation rate was just 0.8 per cent.

• In India, the WPI method is still used to arrive at the inflation rate because there are many problems associated with the CPI.
• In India, the rate of inflation is calculated on a weekly basis.

INTRODUCTION

Inflation is a major economic problem, which plagues most of the countries in the world today. The present chapter and the next chapter analyse inflation and its related aspects.

MEANING OF INFLATION

1. Inflation is a persistent and an appreciable increase in the general level of prices. This leads to a decrease in the purchasing power of money.
2. A sustained inflation takes place when the general price level continues to rise over a fairly long time period. Disinflation is a situation where there occurs a decrease in the rate at which prices are rising.

MEASUREMENT OF INFLATION

1. The two ways in which inflation can be measured are through a change in the price index and the gross national product deflator.
2. As far as the price index is concerned, two indexes are often used: Consumer Price Index (CPI) is a weighted average of prices of a specified basket of goods and services, which are purchased by the consumers; and Wholesale Price Index (WPI) is used to measure the change in the average price of goods, which are traded in the wholesale market.
3. The GNP deflator is not obtained directly like the CPI and WPI. It is based on the prices of all the goods.

ECONOMIC EFFECTS OF INFLATION

1. As far as the distribution of income is concerned, some gain while others loose due to inflation.
2. The gainers from inflation are: producers including the manufacturers, traders and the farmers whose income is derived from profits; those investing in equities and the debtors who experience a decrease in the burden of the interest owed by them.
3. The losers from inflation are: unorganized workers and agricultural labourers; those investing in bonds; creditors and the recipients of incomes from rent.
4. It can thus be argued that inflation leads to a redistribution of income with the rich becoming richer and the poor becoming poorer.
5. As far as the distribution of wealth is concerned, a household’s wealth depends on the difference between the value of its assets and its debts.
6. The assets can be divided into two categories: variable price assets and fixed claim assets. As far as debt is concerned, a household’s debt includes housing loans and others which are generally fixed in monetary terms.
7. As far as output and employment are concerned in the short run, inflation if unanticipated will lead to an increase in employment and thus in the output.
8. It can be argued that inflation leads to an improvement in the allocation of resources and thus to an increase in the employment and output.
9. As far as the rate of long run economic growth is concerned, it has been observed in various countries that there exists a positive relationship between inflation and economic growth.
10. During inflation, wages lagged behind prices. This resulted in huge profit margins and a shift of resources away from the wage goods to the capital goods leading to an increase in the productive capacity and hence economic growth.
11. Most economists agree that a moderate inflation is conducive to economic growth. Hyperinflation or inflation which occurs at a break neck speed may discourage saving and thus hinder economic growth.

SOCIAL EFFECTS OF INFLATION

1. Perfectly anticipated inflation exists when the rate of inflation is steady, perfectly predictable and expected. Such inflation imposes certain costs on the society, which include menu cost, shoe leather cost, distortions in taxation and inconvenience in using money as a yardstick.
2. Imperfectly anticipated inflation is that inflation, which people do not expect. Such inflation imposes certain costs on the society. These costs are an arbitrary redistribution of wealth and an unfavourable effect on decision making.

INFLATION IN INDIA

1. Inflation is one of the most closely observed economic variables in India as it has a considerable influence on the life of an average consumer.
2. Most of the developed countries use the CPI to calculate inflation, in India the WPI is used.
3. In India, the WPI method is still used because there are many problems associated with the CPI.
4. Economic Survey 2008–09 depicts that the years 2000–01, 2004–05 and 2008–09 show the highest average rates of inflation with 2008–09 recording the highest average in the decade.

TRUE OR FALSE QUESTIONS

1. Inflation is a persistent and an appreciable increase in the general level of prices.
2. Disinflation is a situation where there occurs an increase in the rate at which prices are rising.
3. Wholesale Price Index (WPI) is a weighted average of prices of a specified basket of goods and services, which are purchased by the consumers.
4. Perfectly anticipated inflation exists when the rate of inflation is steady, perfectly predictable and expected.
5. India is the only major country that uses a consumer price index to measure inflation.

VERY SHORT-ANSWER QUESTIONS

1. Write short notes on the following :
   1. Inflation
   2. Sustained Inflation
   3. Disinflation
   4. Deflation
2. Differentiate between the Consumer Price Index (CPI) and Wholesale Price Index (WPI).
3. What is Gross National Product Deflator (GNP Deflator)?
4. 1. What is perfectly anticipated inflation?
   2. What is imperfectly anticipated inflation?
5. What is the shoe leather cost of inflation? Explain.

SHORT-ANSWER QUESTIONS

1. Discuss the following as measures of inflation:
   1. Change in the Price Index
   2. Gross National Product Deflator
2. ‘Most of the developed countries use the CPI to calculate inflation, but in India the WPI is used.’ Comment.
3. What is the impact of inflation on the distribution of income? Who are the gainers and the losers from inflation?
4. ‘Inflation leads to an improvement in the allocation of resources and thus to an increase in the employment and output’. Comment.
5. What is the effect of inflation on economic growth? Does there exist a positive relationship between the two?

LONG-ANSWER QUESTIONS

1. Which are the two ways in which inflation can be measured? Discuss.
2. Analyse the economic effects of inflation
   1. On the Distribution of Income
   2. On the Distribution of Wealth.
3. How does inflation influence the
   1. economy’s output and employment?
   2. rate of Long Run Economic Growth?
4. Examine the social effects of inflation.
5. Write a short note on inflation in India.

TRUE OR FALSE QUESTIONS

1. True. Inflation is a persistent and an appreciable increase in the general level of prices whereas deflation is a persistent decrease in the general level of prices.
2. False. Disinflation is a situation where there occurs a decrease in the rate at which prices are rising.
3. False. Consumer Price Index (CPI) is a weighted average of prices of a specified basket of goods and services which are purchased by the consumers.
4. True. Perfectly anticipated inflation exists when the rate of inflation is steady, perfectly predictable and expected. Thus, it is the inflation which people expect.
5. False. Most of the developed countries use the CPI to calculate inflation, in India the WPI is used. India is the only major country that uses WPI to measure inflation.