TLI Explains: India's Inflation At 5.77%, A Four Year High
Latest data released by the Ministry for Commerce and Industry indicate India’s Wholesale Price Index (WPI) stood at 5.77 per cent in June 2018, a four and a half year high. This has been attributed to an increase in food and fuel prices.
Within food articles, inflation on vegetables grew by 8.12 per cent, potato by a humongous 99.02 per cent and onions by 18.25 per cent, when compared to the WPI of June last year.
Inflation in ‘fuel and power’ basket too rose sharply to 16.18 per cent in June from 11.22 per cent in May as prices of domestic fuel increased during the month in line with the rising global crude oil rates.
Let us look at what these terms represent and what inflation really indicates
Inflation is a general increase in the price of products and services with the fall in the purchasing value of money. It is an important factor to assess the economy of any nation. It is necessary for an economy to have positive inflation for overall growth. However, a high level of inflation for a long period of time would be perjurious to the said economy.
When the price level rises due to inflation the value of money falls. When there is a persistent rise in the price level, the people need more and more money to buy the same goods and services.
To enable the people to meet their daily needs of consumption of goods and services when their prices are rising, their incomes must rise if they have to maintain their standard of living. For government employees, their dearness allowance is increased. Wages and salaries of those employed in the organised private sector are also raised.
But people with fixed incomes and those who are self-employed are unable to raise their prices and tend to suffer due to inflation. The poor suffer the most from a persistent rise in prices, especially of food-grains and other essential items.
Inflation in India is majorly looked at through the lenses of two indices- the Whole Price Index (WPI) and the Consumer Price Index (CPI). The WPI and the CPI actually represent two different methodologies to estimate the inflation rate. In the WPI we have a basket consisting of 3 broad categories of goods – Primary Articles, Food and Power, Manufactured articles. The WPI basket consists of a total of 676 items. The CPI, on the other hand, contains 299 items and is considered a more accurate description of the hardships faced by the common man. This is because the CPI basket contains goods and services consumed by households and not industries like in WPI.
In 2014, the Reserve Bank of India(RBI) had adopted the new Consumer Price Index (CPI) (combined) as the key measure of inflation. Earlier, RBI had given more weightage to Wholesale Price Index (WPI) than CPI as the key measure of inflation for all policy purposes.
A few essential definitions
Aggregate supply is the total quantity of output firms will produce and sell—in other words, the real GDP.
Aggregate demand refers to the amount of total spending on domestic goods and services in an economy. Strictly speaking, it is what economists call total planned expenditure.
Monetary Policy Committee (MPC) is the body of the RBI, headed by the Governor, responsible for taking the important monetary policy decision about setting the repo rate. Repo rate is ‘the policy instrument’ in monetary policy that helps to realize the set inflation target by the RBI (at present 4%).
Depending upon the specific causes, three types of inflation have been distinguished:
- Demand-pull inflation,
- Cost-push inflation, and
- Structuralist inflation.
Demand Pull Inflation
This represents a situation where the basic factor at work is the increase in aggregate demand from a combination or individual increases in consumption from households or entrepreneurs or the government. The result is that the pressure of demand is such that it cannot be met by the currently available supply of output. This results in more money chasing fewer goods and thus leading to an increase in prices i.e. inflation.
As stated above, demand-pull inflation occurs when there is an increase in any component of aggregate demand, namely, consumption demand by households, investment by business firms, increase in government expenditure outstrips the increase in taxes (that is, government spending more than it earns by borrowing funds from the RBI or external banks).
The MPC of the RBI controls such inflation by increasing the interest rates to guide people to save more in banks thus decreasing the amount of free money chasing the goods and services produced hence controlling inflation.
Demand-pull inflation, in general, is a good sign of a healthy demand existing in an economy but only when not too high (India determines less than 4% to be optimal).
There might arise situations where even though there is no increase in aggregate demand, prices may still rise. This may happen if there is an accidental increase in costs due to internal or external circumstances.
The four main autonomous increases in costs which generate cost-push inflation have been suggested to be:
- Oil Price Shock (Global oil prices can turn volatile in no time because of curtailing of supplies by the Organization of the Petroleum Exporting Countries)
- Farm Price Shock (Less than average monsoons affect crop yield, while heavy monsoons result in loss of harvest; cost of farm inputs like seeds and fertilizers can rise)
- Import Price Shock (War; the current example of US sanctions which restrict trade between India and Iran; Also affected by the strength of the Indian Rupee)
- Wage-Push Inflation (In developed countries, extremely strong labour unions result in higher wages thus leading to increased cost of living)
It is said Cost-push inflation not only causes rise in price level (or inflation) but also brings about a fall in GDP level.
It has been argued by the exponents of structuralism theory of inflation that economies of the developing countries of Latin America and India are structurally underdeveloped as well as highly fragmented due to the existence of market imperfections and structural rigidities of various types.
As a result of these structural imbalances and rigidities, we find that in some sectors of these developing countries there are shortages of supply relative to demand, while in other sectors there is underutilization of resources and excess capacity because of lack of demand. According to structuralists, these structural features of the developing countries make the aggregate demand-supply model of inflation inapplicable to them.
In this regard, it must be noted that Prof. V.N. Pandit of Delhi School of Economics has also felt the need for distinguishing price behaviour in the Indian agricultural sector from that in the manufacturing sector.
India is a developing country with a large amount of the workforce dependent on agriculture. Thus grains and vegetables are produced in an enormous quantity. But lack of proper storage facilities, erratic monsoons, and damage in transit lead to their scarcity. Production cost is also volatile as the cost of fertilizers can rise in response to the cost of Oil imports. All this results in low supply leading to demand-pull inflation.
Domestic factors in developing economies like lesser developed financial markets, lack of proper monitoring of investments, high electricity tariffs also cause inflation. This could be termed to be structuralist inflation.
Impact of Inflation
The common man suffers the most due to inflation as the general price of all the essential commodities gets hiked. His monthly income becomes less than expenditure leading to a burden and pressure to earn more. Also, a fall in household savings has been observed at the time of inflation.
It has been observed that there is an increase in home loan rates by 1-2% (because of an increase in Repo rate by RBI ). This has a direct impact on EMI.
The hike in petrol and diesel prices affects almost all household consumption goods. All this leads to a decline in the standard of living.
How to rein in the inflation dragon in India?
The major reason for inflation in India is the ever-increasing difference between Aggregate Demand and Aggregate Supply. In India, supply is almost constant whereas demand is increasing. So if India wants to control inflation then this gap has to be reduced. India must focus on increasing its production through increasing efficiency in existing industries or establishing new ones.
A fair share of structural reforms which are yet to be undertaken could help us in controlling inflation better. Better linkages between supply and distribution centres (read villages and cities), guiding investment into efficient centres of production, a more updated CPI basket list are all potential reforms in this regard.
We as a nation should also focus on reducing our import bill (especially oil) and try to achieve an economy with net positive exports i.e. more exports than imports.
Inflation is as complex an issue as they come because while falling food prices are good news for India’s rising middle-class, they haven’t gone down well with farmers, many of whom have taken to the streets to protest.