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It is measured as an annual percentage increase As inflation rises, the value of currency goes down. Thus the purchasing power of the currency, i.e. the goods and services that can be bought in a unit of currency, too goes down. Inflation is divided into two types: Price Inflation is when there is a rise in the general level of prices of goods and services over a period of time Monetary Inflation is when there is a rise in the quantity of money in an economy. Both types are in many times interrelated, and both have negative effects on the economy and individuals. 2 Effects of Inflation : Effects of Inflation Hoarding (people will try to get rid of cash before it is devalued, by hoarding food and other commodities creating shortages of the hoarded objects). Distortion of relative prices (usually the prices of goods go higher, especially the prices of commodities). Fixed income recipients will feel the heat (because while inflation increases, their income doesn’t increase, and therefore their income will have less value over time). Lowers national saving (when there is a high inflation, saving money would mean watching your cash decrease in value day after day, so people tend to spend the cash on something else). Currency debasement (which lowers the value of a currency) 3 The Flip Side : The Flip Side However, Many economists argue that a low steady rate of inflation as opposed to zero (or negative) inflation is good for the economy. ‘Inflation is the grease on the wheels of the economy’- they advocate. This leads to the concept of ‘Inflation Targeting’, now adopted by many countries. 4 Economic Factors : Economic Factors Inflation is caused due to several economic factors: Demands pull inflation, wherein the economy demands more goods and services than what is produced. Cost push inflation or supply shock inflation, wherein non availability of a commodity would lead to increase in prices. Increase in production and labor costs, have a direct impact on the price of the final product, resulting in inflation. When the government of a country print money in excess, prices increase to keep up with the increase in currency, leading to inflation. When countries borrow money, they have to cope with the interest burden. This interest burden results in inflation. 5 The consequences : The consequences Inflation can create major problems in the economy. Price increase can worsen the poverty affecting low income household. Inflation creates economic uncertainty and is a dampener to the investment climate slowing growth and finally it reduce savings and thereby consumption. When the balance between supply and demand goes out of control, consumers could change their buying habits, forcing manufacturers to cut down production. The producers would not be able to control the cost of raw material and labor and hence the price of the final product. This could result in less profit or in some extreme case no profit, forcing them out of business. Manufacturers would not have an incentive to invest in new equipment and new technology. Uncertainty would force people to withdraw money from the bank and convert it into product with long lasting value like gold, artifacts. 6 Measure of Inflation : Measure of Inflation India uses the Wholesale Price Index (WPI) to calculate the inflation rate. Most developed countries use the Consumer Price Index (CPI) to calculate inflation as this actually measures the increase in price that a consumer will ultimately have to pay for. Presently 145 Countries practice CPI compared to 27 practicing WPI. Wholesale Price Index (WPI) WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI. WPI is now available on a monthly basis. Consumer Price Index (CPI) CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. 7 Slide 8: WPI was first published in 1902, and was one of the more economic indicators available to policy makers until it was replaced by most developed countries by the Consumer Price Index in the 1970s. Some economists assert that India's method of calculating inflation is wrong as there are serious flaws in the methodologies used by the government. They point out that WPI does not properly measure the exact price rise an end-consumer will experience because, as the same suggests, it is at the wholesale level. WPI is supposed to measure impact of prices on business. But we use it to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index. It does not factor in services which have assumed so much importance in the economy. Latest statistics show that the prevailing annual rate of CPI inflation is 7.2 per cent, while WPI inflation is about 5 per cent. This implies that CPI inflation can be positive even when WPI is negative. 8 INFLATION and the Common People : INFLATION and the Common People The common man is least interested in knowing either the WPI/CPI or the calculations thereof. What he wants is reasonable price and not made to pay a higher price for the same item every next time he goes to market. 9 INFLATION: the Indian Scenario : INFLATION: the Indian Scenario India after independence has had a more stable record with respect to inflation than most other developing countries. Since 1950, the inflation in Indian economy has been in single digits for most of the years Between 1950-1960 The inflation on an average was at 2.00% Between 1960-1970 The inflation on an average was at 7.2% Between 1970-1980 The inflation on an average was at 8.5%. Inflation At Present Inflation is at a 30 year low. The inflation ended at a low of 0.61% in the week ended May 9, 2009 this after reaching a 16 year high of 12.91 % in August 2008. 10 The Frustrating Fallacy : The Frustrating Fallacy 11 Slide 12: 12 Dipping Inflation Rising Prices Slide 13: It is normally understood that when inflation is low or in the negative terrain, the prices are expected to decrease. Inflation stood at -1.17 per cent for the week ending July 17. However, the prices of commodities and food items were on the high. This is because The Wholesale Price Index (WPI) of food items is still above six per cent. Though inflation is in the negative, we continue to pay higher prices for food grains as the country is majorly dependent on the seasonal production of commodities. The monsoon plays a crucial role in this. If rains are delayed or scarce, then prices are bound to go up. As mentioned earlier, CPI inflation can be positive even when WPI is negative. Thus, flaw of the method is also accountable. 13 Slide 14: The Story of Oil Spoil 14 Slide 15: 15 From 1973 to now, an Indian pays 48 times for one litre of fuel. The international price has just gone up 7.5 times. * Negligible Government Subsidy * Government Subsidy of approx Rs. 1,50,000 crores. Slide 16: 16 Why is this difference? Slide 17: 17 This anomaly can be attributed to exchange rate which in turn is largely influenced by the Monitory Policy of the Govt. Abnormal movement in the exchange rate i.e. Rupee vs. Dollar disturbs growth. Weak Rupee benefits exporters, and strong Rupee helps importers. India imports more than it exports, so a strong rupee would help the country India’s major import bill is oil. Major importer is the Government. Weak Rupee causes higher oil prices. Either the people pay for it directly through higher petrol and diesel prices, or indirectly through oil subsidies (1,50,000 Crores in 2008). An Illustration : An Illustration If Oil price is US$ 100/barrel and Rupee exchange rate is Rs.40/US$, then a barrel of oil in India costs Rs. 4000/- If Oil Price remains the same, but Rupee exchange rate becomes Rs. 45/ US$, then a barrel of oil in India now costs Rs. 4,500/- This leads to inflation in India, even when there is no inflation in the world. If Oil Price increases to US$ 110/barrel, but Rupee exchange rate becomes Rs. 36/ US$, then a barrel of oil in India would cost Rs.3,960/- 18 Slide 19: 19 A Foray into Forex Slide 20: 20 Exchange Rate It is the rate at which one currency is sold to buy another. Fixed FX rate is the rate fixed by the central bank against major world currencies like USD dollar. Floating FX rate is the rate determined by market forces based on demand and supply of a currency. India had semi fixed rate model till the 90s RBI and Government Role RBI Buys US Dollars Sells Indian Rupees When Indian Rupee is created by the RBI to buy US Dollars, the value of the rupee reduces RBI invests US Dollars in low yielding assets globally Indian Rupee injected in the system is sucked out by selling Government Bonds under Market Stabilisation Scheme (MSS) As interest rates in India go up, the cost of sucking out liquidity rises Extra liquidity causes asset bubbles Real Estate Equity) Extra Liquidity causes inflation Revelations: : Revelations: From Jun 07 – Jun 08, RBI bought US$ 107 billion RBI Hiked CRR and Sold MSS Bonds to suck out Rupee Liquidity totaling US$ 42 billion Total MSS bonds outstanding = Rs. 1,71,000 crores. Total Cost of MSS borrowing @ 9% = 15,390 crores. Extra Liquidity injected after all this Rs. 2,50,000 crores, approximately 6.5% of GDP Total oil Subsidy Bill = Rs. 1,50,000 crores. All these activities added on to facilitate higher inflation. 21 Slide 22: 22 Misleading Myths Slide 23: 23 Myth1: It's all about food prices. Fact: Inflation stripped of food and energy, or other volatile components, is still rising. The WPI includes 435 commodities data apart from food. Myth2: A stronger rupee does nothing to control inflation Fact: A stronger rupee helps reduce inflation because it lowers the import prices of oil, other raw materials and capital goods and this, in turn, lowers the cost of production. It also reduces the prices of import-competing goods, like steel. A related myth is that a strong rupee will kill the economy by hurting exporters. A stronger rupee does reduce the rupee value of export earnings - but it also reduces the cost of imported inputs, and to the extent that it dampens inflation, it limits the need for interest-rate hikes. The Bottom Line : The Bottom Line Only the Government can rectify the situation by adopting A truly reflecting measure like CPI Suitable Monetary Policy Inflation Targeting 24 Slide 25: 25 You do not have the permission to view this presentation. In order to view it, please contact the author of the presentation.