Inflation-session 4 and 5

7/31/2019 Inflation-session 4 and 5

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An Analysis


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Contents Impact of inflation Concepts of Core inflation and headline inflation Causes of inflation-Cost push and demand pull

measurement of inflation(a) WPI (Wholesale price Inflation)(b) CPI(c) GDP Deflator

Inflation in India-Measures to combat inflation


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Impact of inflation

Economic redistribution of income, benefits peoplewho invest in equities

wage earners lose, inf lation tax redistribution of assets-towards gold

distortions in resource allocation


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Demand pull inflation Increases in the money supply :Increased money

(increases in the purchasing power) in the hands ofthe people. This view is held by monetarists. They areof the view that inflation everywhere is a monetaryphenomenon.

Increases in government purchases :The increaseddemand for goods by the government.. (Fiscal deficit

impact on inflation).

Increases in the price level in the rest of the worldwould lead to increase in demand for domestic goods.


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Causes of InflationDemand Pull inflation

Inflation could be caused either from the demand side (demand pull) or thesupply side( cost push) The inflation resulting from an increase in aggregate

demand is called demand-pull inflation.Aggregate demand covers (a) consumption demand (b) Investment demand (c)government demand (d) Net exports

Aggregate Demand = C+I+G+NX

For example there could be an increase in private consumption demandInvestment demand is investment in plant and machinery

Government demand

Net exports


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Causes of inflation in recent times in

IndiaSome recent articles suggest that a change in dietary habits towardsprotein-rich foods has been a key driver of high food price inflation inIndia

(a) rising nominal rural wages helped by the expansion of the MahatmaGandhi National Rural Employment Guarantee (MGNREGA) scheme;

(b) inadequate producer supply responses relative to demand; and

(c) shocks from global food inflation, as India integrates

with the world. A more nuanced view is possible on each factor.


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Cost-push inflationInflation can result from a decrease in aggregate supply of a

commodity.( aggregate supply is the total value of the goods and

services produced in a country. The two main sources of decrease in

aggregate supply are

An increase in wage rates

An increase in the prices of raw materials (due to taxes etc)

These sources of a decrease in aggregate supply operate by

increasing costs, and the resulting inflation is called cost-push inflation

Other things remaining the same, the higher the cost of production, thesmaller is the amount produced. At a given price level, rising wage

rates or rising prices of raw materials such as oil lead firms to decrease

the quantity of labor employed and to cut production.


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Core inflation and Headline

inflationCore Inflation is Headline Inflation Minus food and energy components

There is a general view that Core inflation rather than total or headlineinflation is a guide to the underlying inflation rate because the food and

energy components of the WPI tends to be volatile month to month thanother components. Since these movements are not lasting including themyields a noisier signal about the underlying inflation rate to which policymakers are attuned.

The concept of core inflation has become popular for inflation targeting.In more common parlance when we speak of inflation we are referring toHeadline inflation.

For instance, If we take the Indian case, headline inflation has moresense because food items carry maximum weight in our demand basket


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Hyperinflation

What is hyperinflation?

It refers to extraordinarily high rates of inflation. Hyperinflation is definedas inflation exceeding 50%.,

What causes hyperinflation?

Inflation is caused by printing more notes. Germany went through its worst

inflation in 1923. In 1922, the highest denomination was 50,000 Mark. By 1923,the highest denomination was 100,000,000,000,000 Mark. In December of1923 the exchange rate was 4,200,000,000,000 Marks to 1 US dollar.In 1923, therate of inflation hit 3.25 106 percent per month (prices double every two

days).According to author Adam Smith, the price of two cups of coffeerose 40% while customers were still drinking them

What can be done to remedy inflation?

The traditional remedy for inflation in general, and hyperinflation inparticular, is gold. In periods of inflation or even when people are worriedabout inflation people buy tangible assets, such as real estate, commodities

or precious metals. Barter is another remedy.


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Stagflation Stagflation:A condition of slow economic growth and relatively high unemployment

- a time of stagnation - accompanied by a rise in prices, or inflation. An example isthat of the US economy in the 1970s.

US in the 1970s(a) Inflation rates were high 9.2%- people continued to expect increasing prices. This

pushed increasing dd lead to increasing prices. This also led to increased dd forwages. Which pushed prices higher (increased costs of prodn) for the producers. Theinflation factor was also factored into wage contracts. This led to wage-price spiral.

(b)Oil prices rose in 1973-74 and the 1979 price rise(c) Unemployment was at 6%. Government ever increasing need for funds increased the

budget deficit and led to increased govt borrowing. This pushed interest rates up.This led to increased costs of productionleading to fall in output and resultingunemployment.

Which policies to use to attack this situation

If interest rate were increased to combat inflation, then the economy would go deeperinto recession. If interest rates were cut to boost the economy it would lead tofurther inflation. The only solution at that point of time was that as Mr Paul Volckerdid. He tightenend the money supply and thereby increased interest rates. Of coursethis lead to greater umemployment (this led to recession) but this was better thanhaving a persistent situation of stagflation.


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CPI


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GDP deflator This is also referred to as the national income deflator, is a

comprehensive measure which is statistically derived fromnational accounts data released by the Central Statistical

Organisation (CSO) . This is the ratio of GDP at currentprices (Nominal GDP) to GDP at constant prices (RealGDP). Since it encompasses the entire spectrum ofeconomic activities including services, the scope andcoverage of national income deflator is wider than anyother measure.

However at present, the GDP deflator is available onlyannually with a long lag of over one year and hence hasvery limited use for the conduct of economic policy


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Divergence between CPI and WPI The Consumer Price Index (CPI new series) inflation

remained in double-digits in Q1 of 2012-13, driven by bothfood and non-food prices.

The divergence between WPI and CPI inflation was onaccount of two factors. First, there are differences in thecomposition and weights of commodities, especially offood items in the two indices. Second, even in respect ofsimilar items, inflation was higher in CPI than in WPI,suggesting that besides the incidence of higher service

taxes, moderation in non-food manufactured productsprices has not yet been transmitted to the retail level. Therate of increase in the prices of services, which is includedin CPI but not in WPI, was also high


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WPI (Weights for the commodities)


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CPI


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WPI and New-CPI


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Copyright 2007 Wipro Technologies

Case Study :Inflation In India:.


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Growth and inflation in India


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WPI inflation in India


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Causes of inflation. Inflation in 1956-57 was due to high industrialisation

demand in the second five year plan (Investment in heavyindustries with long gestation lags).

Inflation in early 1960s were due to the two wars: 1962 and1965. Crop failures of 1965-66 Agriculture production fellby more than 16%. Inflation was lowest in 1968-69 due tothe large scale agricultural production.

Inflation in the early 1970s due to(a) setback in agricultural production(b) increase in international oil prices

This was specially in 1973-74 and 1974-75. The internationalcrude prices increased by 250%.


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Inflation-fiscalmonetary nexus

(episodic evidence of the 1980s)

High Fiscal deficits

Leads to borrowing from RBI(monetisation of deficit)

Increased money supply

Ceteris paribus , increased inflation

Leads to high governmentexpenditure (more investmentundertaken to increase real outputto satisfy demand).

Leads to high fiscal deficits. Thisleads to the spiral.


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Post Reform period (1992-93 to

1996-97) Characteristics of 1991(a) High BOP problems- Imports increasing at a faster rate due to increase in petroleum

imports. Imports of aircraft and defence equipment rose.(b) Balance on the invisibles also deteriorated due to increased burden of subsidies.(c) Current account deficits were financed by borrowing on commercial terms and

remittances from non resident workers and not by concessional finance. This meantgreater dependence on high cost short maturity financing and heightened sensitivityto creditor confidence.

(d) Lower forex reserves prevented imports to meet this supply gaps. Large fuel pricesalso lead to large price increases.

(e) Indias BOP also suffered due to capital account problems due to loss of investorconfidence.

(f) Commercial bank financing became hard to get.(g) Outflows took place on short term external debt and creditors became reluctant to

roll over maturity loans(h) Increase in the world oil prices(i) Slow growth of our exports to the trading partners.

These events prompted all round reforms-external,industrial and financial sectors.


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Post reform period (1997-78 to

2003-04) During this period inflation was low. This was despite the

large capital inflows and high fiscal deficits. Factors which aided in reducing inflation were(a) Reforms in the government securities market reduced the

monetisation of deficits .(b) Increased yields on the government papers led to the bankers

willingly buying govt securities(c) The RBI could also keep the money supply in line with

inflationary expectations. i.e keeping the money supply closeto the threshold level-acceptable level of inflation.

(d) Fiscal measures

reduction in excise and customs duties.-prevent pass through of increased oil prices

(e) Sterilise capital inflows by open market operations (OMO)and the LAF (liquidity adjustment facility).


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Inflation remained at elevated levels of around

9 per cent on account of three main factors,

viz. (a)high food price inflation, that abated significantly for

cereals and pulses with better availability but which

generally remained at elevated levels and is prone to

shocks, especially for fruits and vegetables and

protein-rich items such as milk, eggs, fish and meat,

as rising demand outpaced supply;

(b) shifting focus

of inflation to non-food manufacturing inflation, asinflationary pressure in food prices spilled over to

manufactures; and (c) rising global commodity prices

of food, industrial materials and fuels that were

transmitted to domestic prices in a cost-push manner

Inflation at present


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Food inflation, prone to supply shocks, is also assuming a structural charactergiven the change in the dietary habits and high demand, in absence ofadequate supply response. Sharp increase in non-food manufactured productinflation suggests that producers are able to pass on the cost increases, givenhigher demand. While the persistence in non-food manufactured products

inflation is high, the persistence of food inflation has increased making theoverall inflation rate sticky. The current inflation process, therefore, is anamalgam of both supply constraints and demand pressures.

Prolonged high inflation even if originating from supply side would give rise toincreased inflation expectations and cause general prices to rise. Poorlyanchored inflation expectations make long-term financial planning more

complex with potential adverse effects on investment and growth. Moreover,high inflation is the most regressive form of taxation, particularly on the poor.It is, therefore, important to contain inflation and keep inflation expectationsanchored so that consumers do not mark up their long-run inflationexpectations by reacting to a short period of higher-than-expected inflation


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Areas of concern for IndiaAgriculture

Fiscal deficit

Subsidies Crude oil market


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Indian context


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Future perspectives on agriculture OECD-FAO estimates4 suggest that with world population

touching 9 billion by 2050, agricultural production will need toincrease by 60 per cent over the next 40 years to meet the risingdemand for food. Additional one billion tonnes of cereals and

200 million tonnes of meat a year has to be produced by the year2050 as compared with 2005-07 levels. The demand for bio-fuelproduction is also expected to double. Increased demand formeat and meat products also require additional agriculturalfeedstocks. Given the limited scope for expanding farmland areaaround the world and problems of soil degradation and water

scarcity, apart from over exploitation of fish stocks, augmentingagricultural production has become a major challenge. Globalwarming, climate change and extreme weather conditions haveadded further uncertainties.

Source: OECD FAO Food and Agricultural Outlook: 2012-2021


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State of Indian agriculture India, for example, is the worlds largest producer of fruit and

vegetables but it has been estimated that inadequate post-harvest storage and transportation cause losses of around 30-40per cent, only 7 per cent value addition takes place, and only

about 2 per cent of production is processed commercially. Roadconnectivity, development of horticulture, dairying & otheranimal husbandry activities and expansion of cash crops, whichprovide the necessary wherewithal for greater access of the farmsector to market oriented agriculture are still lacking in thecountry. This is particularly important for the segment of high

value agriculture, where demand pressures are going to be mostintense in the coming years, and major investments will beneeded in the development of efficient value chains to save onhigh wastages and intermediation costs. The inadequatefacilities for storage of products also results in considerableseasonal f luctuations in the prices of products.


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Agricultural production

Improving agricultural production is not only vital for sustaining growth , butalso to maintain inflation

Problems in the agricultural sector include

(i) technology gaps,

(ii) Lack of timely availability of factor inputs,

(iii) lack of efficient markets for both inputs and outputs

(iv) availability of credit.

Despite some improvement in agricultural performance in recent years,production and productivity of major crops continue to be influenced by

rainfall during the sowing seasons.Therefore, apart from institutional support, the immediate requirement is to

improve irrigation facilities through higher public investment and augment thecropped area as well as yields through various other methods. This will needpublic investment and better management

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Inflation-session 4 and 5