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Institute of Management Technology, Ghaziabad January 3, 2012

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BATTLING AGAINST INFLATION

INFLATION IN INDIA

PROJECT REPORT

INSTITUTE OF MANAGEMENT TECHNOLOGY

GHAZIABAD

Submitted to: Submitted by:

Dr.V.P.Ojha Section F Group 5: PGDM 2011-13

Sundaresh Vishwanathan Iyer (11DM-052)

Sravan Kumar Gundapu (11DM-159)

Saurabh Sharma (11FN-092)

Ravi Dhingra (11DM-122)

Aparna Vyas (11FN-019)

Anupam Sinha (11IT-035)

JANUARY 2012


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Contents

1) What is Inflation

2) Causes of Inflation

2.1)Demand Pull Inflation2.2) Cost Push Inflation

3) Tools for measuring Inflation

3.1)Wholesale Price Index

3.2) Consumer Price Index

3.3) GDP Deflator

4) Difference between Headline and Core Inflation

5) Effects of Inflation

5.1) Positive Effects

5.2) Negative Effects

6) The Indian Scenario

7) Steps taken by Government to reduce Inflation

8) Suggestions and Road Ahead

9) References


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INFLATION DEFINITION:

In economics, inflation is a rise in the general level of prices of goods and services in

an economy over a period of time. When the general price level rises, each unit of currency buys

fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of

money a loss of real value in the internal medium of exchange and unit of account in the economy.

(Source: Wikipedia).

CAUSES OF INFLATION:

y Demand Pull Inflation

y Cost Push Inflation

A) Demand Pull Inflation:

Demand Pull Inflation occurs when Aggregate Demand rises more than the aggregate supply. This is

also described as too much money chasing too few goods.

B) Cost Push Inflation:

Cost-push inflation is a type of inflation caused by substantial increases in the cost of

important goods or services where no suitable alternative is available.Inflation originating from

increase in cost is known as cost-push inflation or supply side inflation


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TOOLS TO MEASURE INFLATION:

A Consumer Price Index (CPI) measures changes in the price level of consumer goods and services

purchased by households.

The Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods. Somecountries (like India and The Philippines) use WPI changes as a central measure of Inflation.

GDP Deflator is the ratio of Nominal GDP in a given year to Real GDP in that year. The deflator

measures the change in prices that has occurred between the base period and current year.

DIFFERENCE BETWEEN HEADLINE INFLATION AND CORE INFLATION:

Headline inflation measures the total Inflation within and economy. It is usually affected by areas of

market which may experience sudden inflationary spikes such as food or energy. As a result, headline

inflation may not present an accurate picture of the current state of the economy. This differs

from core inflation, also called underlying inflation, which excludes factors such as food andenergy costs.

EFFECTS OF INFLATION

Positive Effects of Inflation:

y Inflation is generally an outcome of economic growth. As we see from the demand and supply

diagram, an increase in the aggregate demand causes an increase in National Output as well

as inflation.

y It can benefit a set of economic agents, whose income increases more than the increase in

prices, hence leading to an increase in real income. For example: Debtors (who have taken

debt at fixed rate of interest) are generally a beneficiary of inflation, as the real cost of debtdecreases due to a reduction in the value of money. Effects of inflation are generally felt with

a lag and hence it can benefit a part of the society. Example, increase in the incomes of

farmers when the food prices rise.

y Benefits to Cartels: By inducing supply side inflation, cartels like OPEC can benefit at the

expense of the larger pool of people.

y According to Tobin Effect (nominal interest rates would rise less than one-for-one

with inflation because in response to inflation the public would hold less in money balances

and more in other assets, which would drive interest rates down). A steady rise of inflation

can induce investments in a country since it reduces the returns on monetary assets and

hence people would like to invest in real capital projects, thus leading to faster growth andhigher level of income. Inflation can have real effects.

Negative Effects of Inflation:

y Supply side inflation can lead to reduce the National Output and hence reduce the level of

growth in an economy. It leads to uncertainty about future and may discourage investment

and saving. Hyperinflation: if inflation gets totally out of control (in the upward direction), it can

grossly interfere with the normal workings of the economy, hurting its ability to supply.


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y Relative Price Distortions: Firms do not generally synchronize adjustment in prices. If there is

higher inflation, firms that do not adjust their prices will have much lower prices relative to

firms that do adjust them. This will distort economic decisions, since relative prices will not be

reflecting relative scarcity of different goods.

y Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer

prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wageswill be set as a factor of price expectations, which will be higher when inflation has an upward

trend. This can cause a wage spiral. In a sense, inflation begets further inflationary

expectations.

y Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold

less cash during times of inflation. This imposes real costs, for example in more frequent trips

to the bank

y Menu costs: Firms will have to change the prices of their output more frequently to keep up

with the inflation. For example restaurants having to reprint menus.


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THE INDIAN SCENARIO

Average Inflation in India in 2011 is 9.06%.

As we can see from the above graph, Inflation was hovering between 4 to 6% in the period between

1999-2007. An increase of almost 2% can be seen from 2007 to 2008 and is ranging between 8% and

12% since then.

.


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FACTORS CAUSING INFLATION IN THE INDIAN CONTEXT

Demand Side

An increase in the inflation level can be attributed to the high rate of real GDP growth in 2007-08,

approximately 9%. An increase in the growth rate, means more prosperity and hence more money tospend, which increases aggregate demand and hence inflation. Gross fixed investments as a

proportion of GDP was the highest in 2008 (39%).

Central government plans like National Minimum wages guarantee programme and other constructive

work in the rural India, led to more money in the hands of the poor and hence inflation.

Loan waiver to the tune of 60K crore was initiated which freed up money in the hands of the debtors

and hence raised the price level.

Inflation was predominantly a demand side phenomenon, though supply side was also playing a part

till mid-2008.

Supply Side

Crude Oil price increase due to International Factors: Crude Oil prices had increased on count of

2006 conflict between Israel and Lebanon, worries over Iranian nuclear plants in 2006, Hurricane

Katrina, and various other factors. This led to an increase in the price level in the economy since

crude oil is a major component of imports in India. There was an increase of 5.33 per cent during

2008-09 in quantity terms of crude oil imports and it increased by 25.37 per cent in value terms.

Erratic monsoons leading to more cash crop cultivation by farmers: In 2008, area sown under

rice fell to 11.46 million ha, from 14.52 million ha in 2008, which is a fall of 21%. Reason for the same

wasthat farmers started substituting food grain cultivation with cash crops, since due to erratic and

insufficient monsoons, as cash crops require less water. This was leading to an increase in foodprices. For the first time after 1980, food inflation was recorded at its highest (around 12%).

Bottlenecks in the storage and distribution in India also contributed to spoilage of million tonnes of

food.

Lehman brothers filed its bankruptcy in September 2008 which made its way into global recession.

Indias real GDP growth slid to a lowest of 5.8% in the 2nd

quarter of 2009. However the Indian

economy exhibited broad based recovery in the second half of 2009-10 from the slowdown that had

started in the second half of 2008-09. India achieved 7.4 per cent growth in GDP in 2009-10, one of

the highest in the world. The focus of macroeconomic policies was on management of the recovery. A

strong recovery in industrial sector was combined with a resilient services sector. The contribution of

the industrial sector to the overall growth increased sharply from 9.5 per cent in 2008-09 to 28 per

cent in 2009-10. Inflation in 2009 averaged around 9.5%. Inflation was once again becoming demand

pull.

However one of the major factors contributing to inflation by the late 2009 was food inflation.

Reasons for food inflation:

Bad Monsoon: 60% of the total cropped area in India is not irrigated, along with erratic and insufficient

monsoon; food inflation was a major factor in the overall Inflation.


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Poor harvesting infrastructure: Thisled to losses to the tune of 58,000INR worth of food items in 2008,

such as cold chains, transportation etc.

Growing Population: Population growth in India was to the tune of 1.41%, reduction in food production

along with rising population leads to price rise as number of people to feed rises.

2010

Demand side inflation was a major determinant of inflation till the start of 2010 as the world was

recovering from the recession which was hit in 2008. However Inflation in India started becoming

more of supply side phenomena. Real GDP has been declining since the 2nd

quarter of 2010, but

inflation still remains high. Middle East unrest led to a surge in the crude oil prices, leading to

imported inflation during early 2011. Oil prices in early 2010 were around 75USD a barrel; howeverthey rose to 110USD in 2011. In 2011, India imported around 70% of its crude oil demand.

y Imported Inflation Increase in the prices of imports due to global recession.

India is a major importer of crude oil, precious stones, machinery, fertilizer, iron and steel, chemicals,

an increase in the prices worldwide has raised the prices of imports.

y Increase in Government expenditure: Fiscal deficit has been rising from 2.55% in 2008-09 to

5.09% in 2010-11 Rising fiscal deficit is contributing to high inflation. Rising fiscal deficit i.e.

increasing government expenditure raises aggregate demand and hence is inflationary in nature.

If however this expenditure is incurred on capital projects they lead to growth in the economy. In

India, revenue deficit, which is the excess of revenue expenditure like salaries over revenue

income, rose to Rs 2.84 lakh crore, in 2010 an increase of 100 per cent over one year period.


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Hence, it has contributed to inflation in the country without contributing to growth much. Deficit

financing also plays a key role here as it increases the money supply and is hence inflationary.

y Underground Economy: Indias underground economy is growing. These earnings though lead

to inflation but are not recorded. When income tax payers deliberately misrepresent their income

statements to the tax authorities it leads to creation of black money. Hence people can create

extra demand with this money. Black Market in India is reported to be around 50% of Indias GDP

y Speculative trading in commodities thus raising the prices of commodities. Speculative

commodities trading have been soaring and have contributed to sustained inflation in import

dependent emerging markets like India.

y Depreciation of Rupee The rupee started an alarming fall from August, reflecting both the

global economic uncertainty and also the weakening economic prospects of India.Rupee is

currently in the market at around 52INR/USD. Rupee depreciation makes Indian exports cheaper

and hence adds to the aggregate demand and inflation.


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STEPS TAKEN BY GOVERNMENT TO CONTROL INFLATION

The government has taken the following measures from time to time to curb inflation; however the

effects of these measures have so far not been remarkable:

y Monetary Policy: RBI has taken suitable steps with 13 consecutive increases in policy rates

and related measures to moderate demand to levels consistent with the capacity of the

economy to maintain its growth without provoking price rise. Repo rate in India is currently

8.5% which is at its highest in the last 3 year period.

As a result of an increase in interest rates by RBI, Bank credit growth rate has been declining.

y Reduction in import duties: Import duties for rice, wheat, pulses, onions etc. have been

reduced to almost zero, as inflation hurts the rural poor the most. Government has also

reduced import duty on skimmed milk powder, petrol and diesel and customs duty on crude

oil.


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y Ban on export of edible oils and pulses, suspension of futures trading in rice, urad and tur

dal and extension of stock l imit orders in case of pulses and rice have also been undertaken.

y FDI in Retail: The Government of Indias proposal to allow FDI in multi brand retail would

have led to reduction in the inefficiencies in the supply chain management of food in India,

which will reduce the inflation. However this proposal has been stalled at the moment due to

political factors.

y Food Security: Food security bill has been tabled in the LokSabha in December 2011 which

will entitle cheaper food grains to 63.5% of the population of the country.

y UID Linked Direct Subsidy transfer: subsidies form a major portion of expenditure by the

Indian government. UID linked direct subsidy transfer will reduce the inefficiencies in the

subsidy transfer and hence will reduce the burden on government.

y RBIs intervention to reduce rupee depreciation: RBI in December 2011 announced non-

direct intervention measures in the wake of steady weakening of the rupee against the dollar.

These intervention measures were aimed at curbing speculative positions in the foreign

exchange market. Some highlights are:

i. Re-booking cancelled forward contracts, whatever the type and tenor of the underlying

exposure, by resident and foreign institutional investors has been disallowed. Forward

contracts booked to hedge current account transactions regardless of the tenor were

allowed to be cancelled and rebooked.

ii. The apex bank through the new measures made it clear that forward contracts once

cancelled cannot be rebooked.

iii. The central bank also modified the currency risk hedging norms for importers and

exporters.


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SUGGESTIONS AND ROAD AHEAD

In 2011, among the major economies, India's inflation rate and interest rates were the highest.

From the analysis, we see that the Inflation is becoming more of supply side phenomena than

demand side. RBIs policy of 13 consecutive rate hikes has had minimal impact on the inflation in

India. The current situation demands supply side solution to the problem. We see that food inflation

has a significant impact on the Indian consumer in general and Indian middle class in particular. The

chart given below shows how an average Indian spends his/her income:

As the expenditure on food is to the tune of around 42% in the total expenditure, priority should be to

reduce food inflation.

We suggest the following ways to curb inflation in India:


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y FDI in Retail: The Government of India should give a go ahead for allowing 100% FDI in retail

as it will act as a catalyst to spur competition in the retail industry, which currently is marked by

low competition and poor productivity. This will lead to a reduction in the price level, and will

also lead to efficiency in the supply chain, thus leading to lower infrastructure bottlenecks and

spoilage. However the policy has been criticised heavily as it will lead to closures of small

retailers in the country who will have to shut down their shops because of competition, but the

policy will improve the efficiency in the food sector in the economy will is a major determinant ofinflation.

y Foster Agribusiness :Agribusiness is business involved in food production,

including farming and contract farming, seed supply, agrichemicals, farm

machinery, wholesale and distribution, processing, marketing, and retail sales. From a food and

agribusiness perspective business model innovation which require changes in processes

,technologies, policies, products, structures, services, markets and partnerships for both a

corporate and government perspective to better utilise the factors of production (land, labor and

capital) will lead to specific commercial objectives such as a decrease in cost, improvement of

productivity or an increase in revenues and/or social objectives such as environmental

sustainability, local community engagement and regulatory compliance. This will help in

reducing price rise of food.

y Direct Procurement programmes: Companies must be encouraged to initiate programs like

E-Choupal by ITC, where the raw materials are procured directly by the company from the

farmers, thus reducing the inefficiencies by the intermediaries who charge exorbitant amount

without creating any value.

y Investments in Infrastructure: India needs to invest heavily in infrastructure to combat

inefficiencies and reduce spoilage. India is plagued by malnutrition and soaring inflation, but its

not for lack of food. It is the worlds second largest grower of fresh produce, but loses an

estimated 40 percent of its fruit and vegetables to rot because of a lack of refrigerated trucking,

poor roads, inclement weather and corruption. Investments in infrastructure had been budgeted

at 2,14,000crore for the year 2011, and cold storages have been made a part of the

infrastructure sector in the country, however, the country requires investments in the field of

cold storage, better transportation, roads, godowns, public distribution systems, scientific

irrigation etc.

y Biotechnology: Genetic Modified crops which are resilient to erratic monsoon, pesticides etc,

should be manufactured. Government of India should give incentives to companies which are

operating in the area of producing such crops. However, care must be taken so that we are not

prone to another Monsanto case (Bt. Cotton).

y Use of renewable resources, Reduction in the dependence on Oil: Since India has a huge

dependence on crude oil from abroad, use of renewable sources of energy like solar, wind etc

must be encouraged which will reduce imported inflation. Though these sources of energy

come with initial high fixed costs, however in the long run, they are a sure advantage oftraditional sources of energy.

y Underground Economy to be kept in check: Stringent rules and regulations are required to

minimize the underground economy. Tax evasion should be checked.

y RBIs intervention to curb currency depreciation: RBI must intervene aggressively in the

foreign exchange market to curb Rupee depreciation as it is reaching new heights every day

and leading to huge losses for the country.


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y Reduction in wasteful government expenditure like, subsidies, government salaries:

Subsidies create inefficiencies in an economy since it encourages reliance on the subsidized

products without looking for ways to curb them. Some of the wasteful subsidies like fertilizer

subsidies should be minimized and user charges for electricity etc. should be revised. As much

as 39 % of subsidized kerosene is stolen in India. Inefficiencies in the provision of the same

must also be checked. Government of Indias project of UID can help curb the inefficiencies to a

major extent. Salaries of the government employees must be carefully assessed and incentivebased compensation must be in place.


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References:

http://www.firstpost.com/economy/graft-bad-infrastructure-rot-indias-food-73573.html

http://www.kpmg.com/IN/en/IssuesAndInsights/ThoughtLeadership/Taming-Food-Inflation-

through-Innovations-in-Agribusiness.pdf

http://www.jagranjosh.com/current-affairs/rbi-announced-nondirect-intervention-measures-in-the-wake-of-rupee-depreciation-1324033657-1

http://www.thehindu.com/news/national/article2739277.ece

http://business.rediff.com/report/2010/mar/02/budget-2010-indias-fiscal-deficit-rises.htm

http://www.anirudhsethireport.com/citi-50-per-cent-of-indias-economy-comprises-black-money-

or-640-bn-annual-illegal-outlfows-104-bn/

http://www.livemint.com/2009/07/28000515/Foodgrain-acreage-shrinks.html

http://www.indiainbusiness.nic.in/industry-infrastructure/industrial-sectors/oil-gas.htm

http://currentaffairsappsc.blogspot.com/2011/12/reserve-bank-of-india-kept-its-policy.html

http://www.indexmundi.com/g/g.aspx?c=in&v=71

www.tradingeconomics.com

http://www.livemint.com/2011/09/20224339/Ministry-approves-proposal-for.html?d=1

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