A

Report on contemporary issue

ON

“Inflation”

St. Wilfred’s Institute of Management & Technology, Jaipur

Submitted To: - Submitted By: -

Ms. KAVITA GIDWANI CHOTE LAL PATALIYA
MBA 2nd SEM

2009-2011

1
 Preface
Inflation is a situation of sustained and inordinate increase in the prices of
goods and services. Read on to understand the various types of inflation.

One of the economic effects of inflation is the change in the marginal cost of
producing money. This involves the appropriate 'price' of money which, in this
case, is the nominal rate of interest. This 'price' indicates the return which has to
be pre-determined to hold back the printing presses, in place of some other
assets which offer the market interest rate.

In addition, if a country has a higher rate of inflation than other countries, its
balance of trade is likely to move in an unfavorable direction. This is because
there is a decline in its price competitiveness in the global market.

According to the 2008 Economic Survey Report, India’s inflation rate was
targeted by the Reserve Bank of India (RBI) to be 4.1%, down from a rate of
5.77% in 2007. Inflation rates for many investment goods have decreased
dramatically in recent years.

2
 Acknowledgemen t

I express my sincere thanks to my all M.B.A faculty, for guiding me right form the
inception till the successful completion of the project. I sincerely acknowledge

them for extending their valuable guidance, support for literature Ms. Kavita

Gidwani, critical reviews of project and the report and above all the moral
support she had provided to me with all stages of this project. This project has
helped us to learn the intricacies of restructuring and we are grateful to them for
making this learning possible.

Last but not the least we would like to thank each and every one who has
Helped us in our learning process.

3
 Contents

1. Introduction of Inflation……………………………………5

2. Causes of Inflation…………………………………………..7

3. How is inflation calculated………………………………….13

4. Problems of inflation………………………………………...14

5. Economic Effects of inflation………………………………..16

6. Measure to Control Inflation……………………………….17

7. Type of inflation……………………………………………...18

8. Inflation in India……………………………………………..26

9. RBI’S Credit Policy Review : Growth VS

Inflation……….37

10 Conclusion…………………………………………………...40

11. Bibliography……………………………………………………41

4
 INTRODUCTION OF INFLATION

Inflation is when prices continue to creep upward, usually as a result of

overheated economic growth or too much capital in the market chasing too few
opportunities. Usually wages creep upwards, also, so that companies can retain
good workers. Unfortunately, the wages creep upwards more slowly than do the
prices, so that your standard of living can actually decrease..

How Does Inflation Impact our Life?

Inflation hurts your standard of living because you have to pay more and more for
the same goods and services. If your income doesn't increase at the same rate
as inflation, you will find your standard of living declining even though you are
making more. Also, inflation doesn't impact everything equally, so that some
things (such as gas prices) can double while other things (your home) may lose
value. For this reason, it makes financial planning more difficult. Inflation is really
bad for your retirement planning because your target will have to keep getting
higher and higher to pay for the same quality of life. In other words, your savings
will buy less and less, so you will need to save more and more.

Inflation and the economy of a country are closely related. The effect on the
economy of any country is not immediate or it does not affect the economy
overnight. There is a cumulative effect. Several such changes build up to bring
about a big change. The economy of a country is affected by inflation in a
number of ways.

5
Inflation and the economy both influence all the major macroeconomic indicators
of a country. The various macroeconomic indicators include the following:

• Gross domestic product or GDP

• Producer price index (industrial)

• Consumer price indices

• Industrial production

• Capital Investment

• Agricultural production

• Export

• Import

• Demography

• Debt

Inflation not only affects the macroeconomic indicators, it affects the living
standards of the people. As the percentage of inflation increases, the cost of all
commodities also increases. This in turn influences trade. When exchange rates
are affected, the interest rates cannot be far behind.

Inflation and its effect on economy may be of two types:

• Expected inflation

• Unexpected inflation

6
 CAUSES OF INFLATION

A sustained rise in the prices of commodities that leads to a fall in the purchasing
power of a nation is called inflation. Although inflation is part of the normal
economic phenomena of any country, any increase in inflation above a
predetermined level is a cause of concern.
The basic causes of inflation were covered at AS level. This note considers the
demand and supply-side courses in more detail including the impact of changes
in the exchange rate and the prices of goods and services in the international
economy.

Cost Push Inflation:-

Cost-push inflation occurs when businesses respond to rising production costs,

by raising prices in order to maintain their profit margins. There are many
reasons why costs might rise:

Rising imported raw materials costs perhaps caused by inflation in countries

that are heavily dependent on exports of these commodities or alternatively by a
fall in the value of the pound in the foreign exchange markets which increases
the UK price of imported inputs. A good example of cost push inflation was the
decision by British Gas and other energy suppliers to raise substantially the
prices for gas and electricity that it charges to domestic and industrial consumers
at various points during 2005 and 2006.

Rising labour costs - caused by wage increases which exceed any improvement
in productivity. This cause is important in those industries which are ‘labour-
intensive’. Firms may decide not to pass these higher costs onto their customers

7
(they may be able to achieve some cost savings in other areas of the business)
but in the long run, wage inflation tends to move closely with price inflation
because there are limits to the extent to which any business can absorb higher
wage expenses.

Higher indirect taxes imposed by the government – for example a rise in the
rate of excise duty on alcohol and cigarettes, an increase in fuel duties or
perhaps a rise in the standard rate of Value Added Tax or an extension to the
range of products to which VAT is applied. These taxes are levied on producers
(suppliers) who, depending on the price elasticity of demand and supply for their
products, can opt to pass on the burden of the tax onto consumers. For example,
if the government was to choose to levy a new tax on aviation fuel, then this
would contribute to a rise in cost-push inflation.

Cost-push inflation can be illustrated by an inward shift of the short run aggregate
supply curve. This is shown in the diagram below. Ceteris paribus, a fall in SRAS
causes a contraction of real national output together with a rise in the general

8
level of prices.

Demand Pull Inflation:-

9
Demand-pull inflation is likely when there is full employment of resources and
when SRAS is inelastic. In these circumstances an increase in AD will lead to an
increase in prices. AD might rise for a number of reasons – some of which occur
together at the same moment of the economic cycle

• A depreciation of the exchange rate, which has the effect of increasing

the price of imports and reduces the foreign price of UK exports. If
consumers buy fewer imports, while foreigners buy more exports, AD will
rise. If the economy is already at full employment, prices are pulled
upwards.
• A reduction in direct or indirect taxation. If direct taxes are reduced
consumers have more real disposable income causing demand to rise. A
reduction in indirect taxes will mean that a given amount of income will
now buy a greater real volume of goods and services. Both factors can
take aggregate demand and real GDP higher and beyond potential GDP.
• The rapid growth of the money supply – perhaps as a consequence of
increased bank and building society borrowing if interest rates are low.
Monetarist economists believe that the root causes of inflation are
monetary – in particular when the monetary authorities permit an
excessive growth of the supply of money in circulation beyond that needed
to finance the volume of transactions produced in the economy.
• Rising consumer confidence and an increase in the rate of growth of
house prices – both of which would lead to an increase in total household
demand for goods and services

10
11
The effects of an increase in AD on the price level can be shown in the next two
diagrams. Higher prices following an increase in demand lead to higher output
and profits for those businesses where demand is growing. The impact on prices
is greatest when SRAS is inelastic.

The wage price spiral – “expectations-induced

inflation”

Rising expectations of inflation can often be self-fulfilling. If people expect prices

to continue rising, they are unlikely to accept pay rises less than their expected
inflation rate because they want to protect the real purchasing power of their

12
incomes. For example a booming economy might see a rise in inflation from 3%
to 5% due to an excess of AD. Workers will seek to negotiate higher wages and
there is then a danger that this will trigger a ‘wage-price spiral’ that then requires
the introduction of deflationary policies such as higher interest rates or an
increase in direct taxation.

Inflation influences in the British economy

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o Average earnings comprise basic pay + income from overtime payments,
productivity bonuses, profit-related pay and other supplements to earned
income
o Productivity measures output per person employed, or output per person
hour. A rise in productivity helps to keep unit costs down. However, if
earnings to people in work are rising faster than productivity, then unit
labour costs will increase
o The growth of unit labour costs is a key determinant of inflation in the
medium term. Additional pressure on prices comes from higher import
prices, commodity prices (e.g. oil, copper and aluminum.
o Prices also increase when businesses decide to increase their profit
margins. They are more likely to do this during the upswing phase of the
economic cycle.

HOW IS INFLATION CALCULATED?

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The Retail Price Index surveys changes in the prices of goods

and services.

GOOD 2000 PRICE 2001 PRICE CHANGE

CDs 9.00 9.50 0.50
Sweets 0.20 0.25 0.05
Bread 0.80 1.00 0.20
Total 10.00 10.75 0.75
INFLATION 0.75 or 7.5%

In the above example prices have gone up by £0.75 or 7.5%

PROBLEMS OF INFLATION

• Prices increase therefore people may buy fewer goods, the economy may
suffer

• People need to keep asking for pay increases to match price rises. This can
cause problems at work

• If people are on fixed incomes e.g. pensioners or students. They will be worse
off because they will be able to buy fewer goods

• The costs to businesses may increase. They may cutback on production.

• If the prices of UK goods increase too much then people and businesses may
start to import more goods from abroad because they are cheaper. This will
cause major problems for the economy.

inflation and the housing market

Inflation in the housing market due to demand pull inflation

15
Notting Hill is a very popular district of London. In 1999 the average house sold
for a price of £200,000. This was satisfactory to both buyers and sellers of
houses.

However in the year 2000 houses suddenly became far more popular in Notting
Hill. This was due to a number of reasons

• popularity of the area due to Hugh Grants film

• feelgood factor and consumer confidence
• income tax cuts meant that people had more money to spend
• lower interest rates meant that mortgage repayments were lower

INFLATION, ECONOMIC INFLATION

Inflation means a persistent rise in the price levels of commodities and services,
leading to a fall in the currency’s purchasing power. The problem of inflation used
to be confined to national boundaries, and was caused by domestic money
supply and price rises. In this era of globalization, the effect of economic inflation
crosses borders and percolates to both developing and developed nations.

Central bankers believe that mild inflation, in the 1 to 2 per cent range, is the
most benign for a country’s economy. High inflation, stagflation or deflation are
all considered to be serious economic threats.

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 CAUSES OF ECONOMIC INFLATION

The following factors can lead to inflation:

• Increases in production costs.

• Tax rises.
• Declines in exchange rates.
• Decreases in the availability of limited resources such as food or oil.
• War or other events causing instability.

Economists generally believe that money supply is the key cause of inflation; in
2008, however, skyrocketing prices of oil, food and steel caused runaway levels
of inflation in the world economy that collapsed only because of the global
Financial Crisis.

ECONOMIC EFFECTS OF INFLATION

One of the economic effects of inflation is the change in the marginal cost of
producing money. This involves the appropriate 'price' of money which, in this
case, is the nominal rate of interest. This 'price' indicates the return which has to
be pre-determined to hold back the printing presses, in place of some other
assets which offer the market interest rate.

In addition, if a country has a higher rate of inflation than other countries, its
balance of trade is likely to move in an unfavorable direction. This is because
there is a decline in its price competitiveness in the global market.

A high rate of inflation can cause the following economic impediments:

• The value of investments are destroyed over time.

• It is economically disastrous for lenders.

17
 • Arbitrary governmental control of the economy to control inflation can
restrain economic development of the country.

MEASURES TO CONTROL INFLATION

The central banks, monetary authorities or finance ministries of most nations

have the authority to take economic measures to control rising inflation by
regulating the following factors:

• Reducing the central bank interest rates and increasing bank interest
rates.
• Regulating fixed exchange rates of the domestic currency.
• Controlling prices and wages.
• Providing cost of living allowance to citizens in order to create demand in
the market.

Different schools of thought emphasize different factors as the root cause of

inflation. However, there is a consensus on the view that economic inflation is
caused either by an increase in the money supply or a decrease in the quantity of
goods being supplied, and that the effects of either high inflation or deflation are
extremely damaging to the economy.

18
 TYPES OF INFLATION

Inflation is a situation of sustained and inordinate increase in the prices of goods

and services. Read on to understand the various types of inflation.
When there is a rise in general price level for all goods and services it is known
as inflation. An inflationary movement could be because of the rise in any single
price or a group of prices of related goods and services.

There are four main types of inflation. The various types of inflation are briefed
below.

1. Wage Inflation: Wage inflation is also called as demand-pull or excess

demand inflation. This type of inflation occurs when total demand for goods and
services in an economy exceeds the supply of the same. When the supply is
less, the prices of these goods and services would rise, leading to a situation
called as demand-pull inflation. This type of inflation affects the market economy
adversely during the wartime.

2. Cost-push Inflation: As the name suggests, if there is increase in the cost

of production of goods and services, there is likely to be a forceful increase in the
prices of finished goods and services. For instance, a rise in the wages of
laborers would raise the unit costs of production and this would lead to rise in
prices for the related end product. This type of inflation may or may not occur in
conjunction with demand-pull inflation.

3. Pricing Power Inflation: Pricing power inflation is more often called as

administered price inflation. This type of inflation occurs when the business
houses and industries decide to increase the price of their respective goods and

19
services to increase their profit margins. A point noteworthy is pricing power
inflation does not occur at the time of financial crises and economic depression,
or when there is a downturn in the economy. This type of inflation is also called
as oligopolistic inflation because oligopolies have the power of pricing their goods
and services.

4. Sectoral Inflation: This is the fourth major type of inflation. The sectoral
inflation takes place when there is an increase in the price of the goods and
services produced by a certain sector of industries. For instance, an increase in
the cost of crude oil would directly affect all the other sectors, which are directly
related to the oil industry. Thus, the ever-increasing price of fuel has become an
important issue related to the economy all over the world. Take the example of
aviation industry. When the price of oil increases, the ticket fares would also go
up. This would lead to a widespread inflation throughout the economy, even
though it had originated in one basic sector. If this situation occurs when there is
a recession in the economy, there would be layoffs and it would adversely affect
the work force and the economy in turn.

Other Types of Inflation

Fiscal Inflation:

Fiscal Inflation occurs when there is excess government spending. This occurs
when there is a deficit budget. For instance, Fiscal inflation originated in the US
in 1960s at the time President Lydon Baines Johnson. America is also facing
fiscal type of inflation under the presidentship of George W. Bush due to excess
spending in the defense sector.

Hyperinflation:
Hyperinflation is also known as runaway inflation or galloping inflation. This type
of inflation occurs during or soon after a war. This can usually lead to the
complete breakdown of a country’s monetary system. However, this type of

20
inflation is short-lived. In 1923, in Germany, inflation rate touched approximately
322 percent per month with October being the month of highest inflation.
How to reduce the level of inflation in an economy

1. REDUCE DEMAND PRESSURES

If inflation is caused by high demand then

* Raise interest rates to reduce consumers disposable incomes

* Raise interest rates to discourage borrowing and demand
* Raise taxes to reduce disposable income and spending

2 REDUCE COST PUSH PRESSURES

• Limit wage increases if possible e.g. public sector workers

• Force electricity and gas companies to hold their prices
• Increase the value of £ in order to reduce the cost of importing

3. REDUCE MONEY SUPPLY PRESSURES

If inflation is caused by too much money in the economy

• Print less money

• Withdraw some money from circulation.

Zimbabwe Inflation 'to Hit 1.5m%'

Zimbabwe's inflation will rocket to 1.5m% before the end of the year, the US
ambassador to Harare predicted today, forecasting massive disruption and
instability that will drive
President Robert Mugabe from office.

In a telephone interview with the Guardian, Christopher Dell said prices were
going up twice a day, sapping popular confidence in a government that is now
"committing regime

21
change on itself".

"I believe inflation will hit 1.5m% by the end of 2007, if not before," Mr Dell said. "I
know that sounds stratospheric but, looking at the way things are going, I believe
it is a
modest forecast."

Zimbabwe's official inflation is 4,500% but independent economists and retailers

say it is actually above 11,000% and picking up speed. The black market rate for
the pound soared from Z$160,000 last week to Z$400,000 this week. The US
dollar rate has topped Z$250,000, while the official rate is fixed at just Z$250. Mr
Mugabe stubbornly insists
that the Zimbabwe currency must not be devalued.
"Prices are going up twice a day, in some cases doubling several times a week,"
said Mr Dell, who is approaching the end of his posting to Zimbabwe. "It
destabilizes everything. People have completely lost faith in the currency and
that means they have lost faith in
the government that issues it.

"By carrying out disastrous economic policies, the Mugabe government is

committing regime change upon itself," he said. "Things have reached a critical
point. I believe the excitement will come in a matter of months, if not weeks. The
Mugabe government is
reaching end game, it is running out of options."

For Zimbabweans living in the turmoil of economic meltdown, hyperinflation is

spreading poverty, as even basic goods become unaffordable. Supermarkets'
trollies lie idle as few can afford to buy more than a handful of goods.
Government regulations will only permit withdrawals from banks of Z$1.5m per
day, which is not enough to buy a
week's worth of groceries.

22
At golf courses, golfers pay for their drinks before they set off on their round,
because the price will have gone up by the time they have finished the 18th hole.
One individual was recently told by a pension company that it would no longer
send him statements as his
fund was worth less than the price of a stamp.

"I can barely cope with inflation in the thousands, but millions? We will die," said
Iddah Mandaza, a Harare factory worker. Mr Mandaza said some workers are
now saving on transport costs by "going to their jobs on Monday and sleeping at
the workplace until Friday. They all share their meals. That's what they do to get
by."

Many Zimbabweans are resorting to barter. "I traded some soap for two buckets
of maize

meal [Zimbabwe's staple food]. It was far much better than trying to buy it in the
shops," said worker Richard Mukondo. "People in the rural areas are even worse
off. You can see they are hungry and their clothes are in tatters. They trade in
whatever they can produce:
tomatoes, onions, chickens and eggs."

Tony Hawkins, professor of economics at the University of Zimbabwe, said that

no one holds cash in the country any more. "People spend it as soon as they get
it. Goods hold their value, not money. The government has run out of solutions.
At this rate perhaps inflation could hit 1m%, but one gets a sense that things will
crack before then."

At the other end of the technological scale, enterprising Zimbabweans abroad

have set up internet trading schemes, such as Mukuru.com, in which
Zimbabweans overseas pay for goods with foreign currency and then vouchers

23
for fuel, food and medicines are sent to recipients in Zimbabwe via email or on
their cell phones.

This business has thrived because more than three million Zimbabweans - a
quarter of the country's 12 million people - now live abroad. Half of Zimbabwe's
families depend on remittances from overseas to pay basic monthly bills,
according to a recent survey by the
University of Zimbabwe.

Mr Dell, 51, who has had a tumultuous three years as ambassador to Zimbabwe,
said that Mr Mugabe faces further trouble from his army, which used to be
considered solidly loyal to the president. Last week six men, including an army
private and a retired senior officer, were charged in court for plotting against the
president. He said the allegations of the coup plot show divisions within Mr
Mugabe's ruling party, the Zimbabwe African
National Union-Patriotic Front (Zanu-PF).

"I don't believe it was a real coup plot. I think it shows one side of Zanu-PF
plotting against the other. The bitter factional infighting is now dragging in the
military. That cannot be good news for Mugabe," said Mr Dell. South African
president Thabo Mbeki's efforts to mediate between Zanu-PF and the opposition
Movement for Democratic

24
Inflation and its impact on the Pakistan

economy

Inflation is the rise in the prices of goods and services in an economy over a
period of time. When the general price level rises, each unit of the functional
currency buys fewer goods and services; consequently, inflation is a decline in
the real value of money — a loss of purchasing power in the internal medium of
exchange, which is also the monetary unit of account in an economy. Inflation is
a key indicator of a country and provides important insight on the state of the
economy and the sound macroeconomic policies that govern it. A stable inflation
not only gives a nurturing environment for economic growth, but also uplifts the
poor and fixed income citizens who are the most vulnerable in society.

25
ALL THREE INDICES CPI, SPI AND WPI AT A GLANCE

Average July–April over same period of previous year

(Change of indices in %)

Index 2006-07 2007-08 2008-09

CPI 7.89 10.27 22.35

SPI 11.13 14.09 26.33

WPI 6.92 13.70 21.44

26
 INFLATION IN INDIA

The 1990s is widely described in general as a price stability era all over the
globe. During the early part of the decade developed and developing countries
alike experienced "a distinct ebbing of inflation", so observes India's central
banking authorities, Reserve Bank of India (RBI). Inflation in India, barring some
external factors like bouts of increase in international oil price and natural
disasters like drought or flood, is showing an ebbing trend. The first half of India's
fiscal 2002-03 (beginning April 1, 2002) witnessed uptrend in inflation largely due
to increase in oil prices twice during the period and adverse impact of drought on
agri- products leading to increase in prices – particularly of oilseeds and edible
oils. The efficient handling of supply management helped inflation eased in the
second half of the fiscal. As a whole at the end of the fiscal 2002-03 inflation was
up 3.3 percentage points. In the light of overall variation in wholesale price
inflation, the inflation in fiscal 2002-03 was dominated by non-food items unlike
preceding years, according to a RBI report.

One of the major import contents of India's inflation in fiscal 2002-03 were
edible oils and oil cakes that recorded highest price increase. Acute shortfall in
production of the commodity led to about half the domestic demand met by
imports. The RBI report also states that the underlying inflation (measured by
average WPI) during this fiscal was dominated by manufactured product
groups. Within manufactures again, edible oils, oil cakes and manmade fibres
were largely responsible uppish trend in inflation. Inflation measured by average
consumer price index for industrial workers (CPI-IW) however eased in fiscal
2002-03.

27
 Monthly Inflation Rate Table
Monthly Inflation
Month
Rate
January 2008 0.50%
February 2008 0.29%
March 2008 0.87%
April 2008 0.61%
May 2008 0.84%
1.01%
June 2008

July 2008 0.53%

August 2008 -0.40%
September 2008 -0.14%
October 2008 -1.01%
November 2008 -1.92%
December 2008 -1.03%
January 2009 0.44%
February 2009 0.50%
March 2009 0.24%
April 2009 0.25%
May 2009 0.29%
June 2009 0.86%
July 2009 -0.16%
August 2009 0.22%
September 2009 0.06%
October 2009 0.10%
November 2009 0.07%
December 2009 -0.18%
January 2010 0.34%
February 2010 0.025%
March 2010 0.41%
April 2010 0.17%

Red indicates Deflation (falling prices)

-1.92% monthly = 23.04% Annual Deflation

-0.50% monthly = 6% Annual Deflation
.10% monthly= 1.2% annual inflation

28
.20% monthly= 2.4% annual inflation
.25% monthly= 3% annual inflation
.50% monthly= 6% annual inflation
.85% monthly= 10.2% annual inflation
1.00% monthly= 12% annual inflation

The long term average inflation rate from 1913 through 2009 is 3.41%

Current Inflation Rate

Ye
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Ave
ar
- - -
200 0.03 0.24
0.38 0.74 1.28 NA NA NA NA NA NA NA NA
9 % %
% % %
200 4.28 4.03 3.98 3.94 4.18 5.02 5.60 5.37 4.94 3.66 1.07 0.09 3.85

8 % % % % % % % % % % % % %
200 2.08 2.42 2.78 2.57 2.69 2.69 2.36 1.97 2.76 3.54 4.31 4.08 2.85

7 % % % % % % % % % % % % %
200 3.99 3.60 3.36 3.55 4.17 4.32 4.15 3.82 2.06 1.31 1.97 2.54 3.24

6 % % % % % % % % % % % % %
200 2.97 3.01 3.15 3.51 2.80 2.53 3.17 3.64 4.69 4.35 3.46 3.42 3.39

5 % % % % % % % % % % % % %
200 1.93 1.69 1.74 2.29 3.05 3.27 2.99 2.65 2.54 3.19 3.52 3.26 2.68

4 % % % % % % % % % % % % %
200 2.60 2.98 3.02 2.22 2.06 2.11 2.11 2.16 2.32 2.04 1.77 1.88 2.27

3 % % % % % % % % % % % % %
200 1.14 1.14 1.48 1.64 1.18 1.07 1.46 1.80 1.51 2.03 2.20 2.38 1.59

2 % % % % % % % % % % % % %
200 3.73 3.53 2.92 3.27 3.62 3.25 2.72 2.72 2.65 2.13 1.90 1.55 2.83

1 % % % % % % % % % % % % %
200 2.74 3.22 3.76 3.07 3.19 3.73 3.66 3.41 3.45 3.45 3.45 3.39 3.38

0 % % % % % % % % % % % % %

29
India’s 2008 Economic Survey Report targeted a drop in India’s Inflation
Rate – but with food, oil and commodity price rises worldwide, the opposite
is happening.

According to the 2008 Economic Survey Report, India’s inflation rate was
targeted by the Reserve Bank of India (RBI) to be 4.1%, down from a rate of
5.77% in 2007. Inflation rates for many investment goods have decreased
dramatically in recent years. The price of basic goods such as lentils, vegetables,
fruits and poultry were expected to slow their rise. The price of various
manufactured goods also fell in 2007, and this contributed to a reduced inflation
rate

However, the beginning of 2008 has seen a dramatic rise in the price of rice
and other basic food stuffs. There has also been a no-less alarming rise in the
price of oil and gas. When coupled with rises in the price of the majority of
commodities, higher inflation was the only likely outcome.

Indeed, by July 2008, the key Indian Inflation Rate, the Wholesale Price
Index, has risen above 11%, its highest rate in 13 years. This is more than
6% higher than a year earlier and almost three times the RBI’s target of
4.1%.

Inflation has climbed steadily during the year, reaching 8.75% at the end of
May. There was an alarming increase in June, when the figure jumped to 11%.
This was driven in part by a reduction in government fuel subsidies, which have
lifted gasoline prices by an average 10%.

The Indian method for calculating inflation, the Wholesale Price Index, is
different to the rest of world. Each week, the wholesale price of a set of 435

30
goods is calculated by the Indian Government. Since these are wholesale
prices, the actual prices paid by consumers are far higher.

How India calculates inflation

• India uses the Wholesale Price Index (WPI) to calculate and then decide
the rate of inflation in the economy. Most developed countries use the
Consumer Price Index (CPI) to calculate inflation.
• WPI was first published in 1902, and was one of the major economic
indicators available to policy makers until it was replaced by the Consumer
Price Index in most developed countries by in the 1970s.
• WPI is the index that is used to measure the change in the average price
level of goods traded in wholesale market. In India, price data for 435
commodities is tracked through WPI which is an indicator of movement in
prices of commodities in all trades and transactions. It is also the price
index which is available on a weekly basis with the shortest possible time
lag -- two weeks. The Indian government has taken WPI as an indicator of
the rate of inflation in the economy.
• 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.
• CPI is a fixed quantity price index and considered by some a cost of living
index. Under CPI, an index is scaled so that it is equal to 100 at a chosen
point in time, so that all other values of the index are a percentage relative
to this one.
• Some economists argue that it is high time that India abandoned WPI and
adopted CPI to calculate inflation.

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• India is the only major country that uses a wholesale index to measure
inflation. Most countries use the CPI as a measure of inflation, as this
actually measures the increase in price that a consumer will ultimately
have to pay for.
• CPI is the official barometer of inflation in many countries such as the
United States, the United Kingdom, Japan, France, Canada, Singapore
and China. The governments there review the commodity basket of CPI
every 4-5 years to factor in changes in consumption pattern.
• 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.
• The main problem with WPI calculation is that more than 100 out of the
435 commodities included in the Index have ceased to be important from
the consumption point of view. Take, for example, a commodity like
coarse grains that go into making of livestock feed. This commodity is
insignificant, but continues to be considered while measuring inflation.
• India constituted the last WPI series of commodities in 1993-94; but has
not updated it till now that economists argue the Index has lost relevance
and can not be the barometer to calculate inflation.
• The WPI is published on a weekly basis and the CPI, on a monthly basis.
And in India, inflation is calculated on a weekly basis and announced on
every Friday.

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Inflation Rate, Rate of Inflation

The inflation rate is the percentage by which prices of goods and services rise
beyond their average levels. It is the rate by which the purchasing power of the
people in a particular geography has declined in a specified period. The rate of
inflation may be calculated weekly, monthly or annually. However, it is always
expressed as an annualized figure.

Inflation Rate: Indices

The inflation rate can be calculated for different price indices. For the national
inflation rate, the consumer price index (CPI) is considered. This index measures
the actual prices of goods and services needed by the common man. The
inflation rate can also be measured by the following indices:

 Cost-of-living index (COLI): This is used to adjust income scales so that the
real value of earnings remains the same.
 Producer price index (earlier Wholesale Price Index): This measures the
average change in prices that domestic producers receive for their products. This
index measures the growing pressure on producers due to changes in the costs
of their raw materials. This pressure might get passed on to consumers,
absorbed by profits or offset by a rise in productivity.
 Commodity price index: This measures the prices of a selected group of
commodities.
 Core price index: This removes the volatile components (primarily food and
oil) from broader indices, like the CPI. Short term changes in demand and supply
conditions do not significantly affect such indices. Central banks use it to assess
the need for adjusting the monetary policy.

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Methods of Calculating the Inflation Rate

The two main methods used to calculate the inflation rate are:

 Base period: This method is the more common of the two and assigns a
relative weight to each element while making calculations.
 Chained measurements: In this method, the contents of the ‘commodity
bundle’ are adjusted, along with the prices. Besides, individual time periods in
which the price levels fluctuate are also taken into account.

Any undesired change in the rate of inflation can affect the economy and national
development at large. The appropriate estimation of inflation rates is necessary
to get an overview of the national economy.

Inflation Rate: The Formula

The equation to calculate the inflation rate is:

Inflation Rate = (Po- P-1)* 100 / P-1,

where

Po = the present average price

P-1 = the price that existed last year.

The inflation rate is always stated as a percentage. Another way of calculating

the inflation rate is to apply the log rule. The inflation rate is important, since it is
subtracted from various economic rates in order to eliminate the impact of
inflation. The real increase in wages is also counted by taking into account the
prevailing inflation rate.

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Cur r ent Inflation, Cur rent Inflation Rate

The current inflation rates across the world, as of April 2009, were low due to
the global recession that peaked in September 2008. The recessionary
pressures felt across the globe resulted in a massive decline in the supply of
money. This, in turn, affected commodity prices, resulted in low inflation rates.
Current inflation is measured by the International Monetary Fund.

Current Inflation Trends in the World

According to an IMF report, headline inflation in the developed nations is

expected to decline from 3.5% in 2008 to a record low of 0.25% in 2009. It is
expected to recover to 0.75% in 2010. In the emerging economies, inflation is
expected to fall to 5.75% in 2009 and 5% in 2010, from 9.5% in 2008. For the
quarter ended March 31, 2009, the current inflation rates of major nations are
listed in the table given below:

Countries Current Inflation

(%)
New Zealand 3
UK 2.9
Australia 2.5
EU 0.6
Japan -0.3
US -0.4

Calculation of Current Inflation Rates

Current inflation rates are calculated for different timeframes – from as short a
period as a week to as long as a year. Short-term inflation rates facilitate the
analysis of the sudden effects of economic, political and social changes on

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current inflation. Long-term rates are a better measure, as they reflect the
economic situation in a more comprehensive way by rounding off the effects of
sudden price movements.

The current inflation rates released by the IMF and various national
governmental bodies are calculated on an annual basis. The weekly and monthly
figures announced by these organizations are annualized figures.

Current Inflation and Unemployment

According to an ILO report, the world unemployment rate is projected to reach

7.1% in 2009 if the sluggish economic performance continues. This is estimated
to increase worldwide unemployment by 50 million. According to the Bureau of
Labor Statistics, 651,000 jobs were lost in February 2009 in the US alone.

The IMF has projected world economic growth at 0.5% for 2009, a record low
since World War II. However, given the constant efforts to ease credit strains by
implementing expansionary fiscal and monetary policies, the world economy is
expected to recover by 2010.

Core Inflation, Core Inflation Rate

Core inflation is a measure of inflation that excludes items such as food

products and energy, which are prone to volatile price movements. The concept
of core inflation rate was introduced by Robert J. Gordon in 1975.

Significance of Core Inflation

Core inflation is an indicator of long-term inflation at a fundamental level. It is

considered while framing monetary policies, as it supports the primary goal of
central banks – price stability along with sustainable economic output and
employment. Core inflation does not consider products that are easily influenced
by supply shocks. This is because such items can move away from the overall
inflation trend and represent a false picture.

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Measuring Core Inflation

Core inflation is calculated in various ways:

1. Outliers method: This excludes products that have the largest price
changes.

2. Statistical methods: These include trimmed mean and weighted mean.

These methods are derived from a highest-to-lowest ranking of
individual price changes for each given month.

3. Consumer Price Index (CPI): This measures inflation and excludes the
prices of volatile products such as food and energy.

Monitoring the Core Inflation Rate

In an economy facing inflationary pressure, the central bank typically aims at

controlling the core inflation rate, as this is easier to control

RBI’S CREDIT POLICY REVIEW: GROWTH VS

INFLATION

Inflation control at the cost of growth seems to be message being sent by the RBI
in the first quarter review of Monetary Policy for 2008-09. Reserve Bank of India
has hiked key rates in order to curb credit growth and has simultaneously

37
lowered its expectation of GDP growth rate. Banks have been sounded off on the
merits of good quality credit.

The Reserve Bank of India announced its first quarter review of the Monetary
Policy for 2008-09, and there is no good news. Inflation figures are looking higher
than ever and the central bank announced an extremely hawkish policy to control
the spiraling prices, and ready to forsake growth in the process.

Highlights : RBI hikes repo rate by 50 bps; CRR by 25 bps | Interest rates
may rise as RBI tightens monetary policy | 'RBI measures to contain
inflation'

The central bank has kept the Bank Rate and reverse repo rate unchanged, but
has hiked the repo rate by 50 basis points, from 8.5 per cent to 9 per cent. The
Cash Reserve Ratio (CRR) has been increased by 25 basis points to 9 per cent
with effect from August 30, 2008. CRR has touched 9 per cent for the first time
since 2000.

While expressing alarm at the double-digit inflation, RBI has given the impression
that it will not come down anytime soon. It has projected a “realistic” inflation rate
of 7 per cent by March 2009. However, the GDP growth rate has been revised
downwards as well. The expectation now stands at 8 per cent for FY09 as
against 8-8.5 per cent as announced in the Annual Policy in April, earlier this
year.

Auto shares slump after RBI policy | RBI trims GDP growth rate to 8% | Housing,
consumer loans to become costlier. Severe targets have been set for growth in

money supply. While the target for M3 is 17 per cent, credit growth has been set
a target of 20 per cent and deposit growth of 17.5 per cent.

Strictures for banks

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Simultaneously, commercial banks have been given strict instructions about the
quality and quantity of credit. Banks have been asked to review their long-term
business strategies, which should not only be viable, but focus on credit quality
as well. RBI would like to review these strategies from time to time, it said. “The
central bank has given a word of caution,” said T S Narayanasami, CMD, Bank of
India.

It appears that banks have been sounded off on the perils of credit expansion.
The central bank has kept in mind the worsening trade deficit and growing
concerns over fiscal deficit, before setting these targets. With a more than
expected slowdown in industrial and service sector growth, RBI wants to make
demand control its goal, therefore credit growth must be moderate. This is
evident from the first quarter policy review.

“There is pressure on banks to increase lending rates,” according to M D Mallya,

Chairman and Managing Director, Bank of Baroda.

How does all this impact the growth story?

The hike in repo rate and CRR seems to be an ongoing process. HDFC has
predicted another 50-70 basis points hike in the repo rate during the coming
months.

A curb on credit expansion, could impact the investment demand of the corporate
sector. Even though banking is a small part of the growth story, a 100-125 basis

points increase in the lending rates could raise the cost of funds in the system
considerably.

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So far, the consistent but moderate increases in lending rates have applied to the
retail side of banking. Now they could affect the investment side. Once access to
capital is restricted and recourse to external finance is limited, the expansion
programme of several corporates could be put on hold or curtailed.

Could this sluggishness in growth persist?

If investment becomes moderate, we may find the average rate of growth of GDP
to be in the range of 7-8 per cent over the next 2-3 years, according to
economists. While FY08 promises to be a difficult years, the impact of curtailed
demand and sluggish investment will be felt with a lag in FY10.

Here’s what a few banks have to say. While Deutsche Bank has predicted a GDP
growth rate of 7.3-7.8 per cent, HSBC is expecting the GDP to grow at 7.5-7.8
per cent during FY09.

India was looking at catching up with China in the growth story. However,
stumbling blocks like inflationary pressures, caused by external and internal
shocks, has postponed its plans for now. Inflation control at the cost of growth
has become a reality.

CONCLUSION:-

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After reading this tutorial, you should have some insight into inflation and its
effects. For starters, you now know that inflation isn't intrinsically good or bad.
Like so many things in life, the impact of inflation depends on your personal
situation.

Some points to remember:

• Inflation is a sustained increase in the general level of prices for goods

and services.
• When inflation goes up, there is a decline in the purchasing power of
money.
• Variations on inflation include deflation, hyperinflation and stagflation.
• Two theories as to the cause of inflation are demand-pull inflation and
cost-push inflation.
• When there is unanticipated inflation, creditors lose, people on a fixed-
income lose, "menu costs" go up, uncertainty reduces spending and
exporters aren't as competitive.
• Lack of inflation (or deflation) is not necessarily a good thing.
• Inflation is measured with a price index.
• The two main groups of price indexes that measure inflation are
the Consumer Price Index and the Producer Price Indexes.
• Interest rates are decided in the U.S. by the Federal Reserve. Inflation
plays a large role in the Fed's decisions regarding interest rates.
• In the long term, stocks are good protection against inflation.
• Inflation is a serious problem for fixed income investors. It's important to
understand the difference between nominal interest rates and real interest
rates.
• Inflation-indexed securities offer protection against inflation but offer low
returns.

Bibliography

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www.inflation.Com

www.indiabudget.com

www.google.com

www.yahoo.com

www.businessballs.com

Magazine & Newspapers

Outlook Express

Economics times

Financial times

DNA

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