Inflation in the Indian context

The discussion on the causes and consequences of rise in the rate of inflation in the
Indian context has been obfuscated by a lot of jargon flying over the people’s heads,
leaving them none the wiser. Comments of experts are reminiscent of those of the ‘Six
Blind Men of Hindostan’ who, to learning much inclined (as the poet says), wanted to
have an idea about what the elephant looked like.

What precisely is the nature of the inflation which has the nation in its grip? Is it headline
inflation, core inflation, demand-pull inflation, cost-push inflation or imported inflation?
There are commentators plumping for each of these schools of thought. The average
householder, however, is not interested in academic and official juggling with words. He
only wants to know, in simple words, why prices of commodities in which he is interested
are rising markedly and when the trend will be arrested. For both these direct questions,
he has not so far received direct answers.

The problem with the English-educated elite manning the governments, academia and
think-tanks in India is that they are interested more in parading their imported erudition
than in solving the problem on hand. They feel that their job is done with dabbling in
some esoteric, exogenous explanations which may not be pertinent to the prevailing
circumstances. In other words, looking at Indian problems through Indian eyes based on
the Indian situation does not come easy to them.

Let us get back to inflation. First of all, the faulty method of calculating the inflation rate,
basing it on the wholesale price index (WPI), instead of on the consumer price index
(CPI), as in all other countries, gives no indication of its real impact on the people.

The official line is that what India is faced with is imported inflation, meaning that the rise
in the global prices of crude oil and agricultural commodities, including foodgrains, and
industrial products, and setbacks to global economy resulting from sub-prime mortgage
disaster and US recession have contributed to India’s inflation. Of course, in an
interdependent world, everything affects everything else, but for that reason, to palm off
all that is happening elsewhere as the reason for the rise in the prices of foodgrains,
edible oil, vegetables and items of daily use in India is to take the people too much for
granted.

Loss of manoeuvrability

Traditionally, it is the prices of foodgrains that had kept other prices under check in the
Indian context. This is because the food budget of an average Indian household
constitutes close to 70 per cent of the total expenditure.

Indeed, the very fact that there is enough stock of foodgrains and essential commodities
under the Government’s control in the warehouses of the Food Corporation of India (FCI),
and that the Government was determined to procure them directly from the farmers
without the interposition of middlemen is enough to make the markets behave.

Unfortunately, in recent years, by allowing the exports of foodgrains and by drawing

down the stocks of foodgrains with the FCI to unsafe levels, the Government lost the
degree of manoeuvrability which is imperative to keep prices stable.

If only the Government had begun taking action a year earlier on to stop exports of
foodgrains, intensify procurement, maintain buffer stock at the desired level of at least
35 million tonnes under Central account, instead of letting it fall to around 10 million
tonnes (as on January 31 this year) and ensure flow of adequate quantities of essential
commodities through the public distribution channels at regulated prices, the inflation
rate could well have remained within the comfort zone of five per cent. Even now it is not
too late.

India calculated its official inflation based on Wholesale Price Index (WPI) rather than
CPI based inflation. In Pakistan, 40.3 per cent weightage of the CPI is given to food,
whereas, this number drops to 26.9 per cent for India’s WPI.

India calculated its inflation based on WPI and its base year is also 15 years’ old
(1993-94), which therefore does not reflect the current consumption pattern of the
Indian society.

The usage of WPI for calculating India’s inflation resulted in showing a lower figure.

In FY 2004, the CPI-based food inflation in Pakistan was 6pc while India’s WPI
inflation was 5.5pc. In FY 2005, CPI-based food inflation in Pakistan stood at 12.5pc
whereas it was 6.5pc in India’s WPI based inflation.

The CPI-based food inflation was 6.9pc in Pakistan, whereas, it was hovering around
a mere 4.4pc in India’s WPI.

The CPI based food inflation stood at 10.3pc in FY 2007 in Pakistan while it was 5pc
in India.

During July-Jan period of the current fiscal, the CPI based food inflation was 12.5pc
whereas it stood at only 4.9pc in India.

Contrary to the normal practice for calculating CPI based inflation as being done in
USA, Canada, UK, Japan, Singapore, China and Pakistan, Indian authorities are using
WPI based inflation on the pretext of various reasons.

In Pakistan, inflation is measured using the conventional Consumer Price Index

(CPI), though other indices such as Wholesale Price Index (WPI) and Sensitive Price
Index (SPI) are also released on a regular basis. CPI measures the cost of the given
basket of goods and services which the consumers have to pay. Globally also, CPI
remains the official barometer of inflation in many countries such as USA, UK, Japan,
France, Canada, Singapore and China.

Of course, the constituents of the commodity basket for CPI measurement vary from
country to country, as is their consumption pattern.

In most of the countries mentioned above, their economic authorities review the
commodity basket of CPI at least every 5 to 6 years or whenever it deserves a
review.

Interestingly, India uses the WPI as its main measure of inflation.

The WPI, as its name indicates, is designed to measure the changes in price at the
wholesale level of all the commodities.

It is not the price that consumers face in the market. Furthermore, the base year for
the WPI in India is 15 years old and does not reflect the current consumption pattern
of the Indian society.

The author of the research paper further states that India does have a measure in
terms of CPI, but it is not used as the official index at the national level. Their CPI
has been divided into four major categories: Consumer Price Index (CPI) for
industrial worker (CPI-IW), for agriculture labour (CPI-AL), for rural labour (CPI-RL),
and for urban non-manual employees (CPI-NUME) and their base years are as old as
1982, 1986-7, and 1984-05 respectively.

India’s use of the WPI as their official inflation index, with the base year of 1993-4 is
very suspicious. Firstly, the price changes in the service sector of India are not duly
captured in the WPI, despite this sector forming an essential part of the consumption
of everyone in the country. For example, services like health, transportation,
telecommunication, education etc are not included in the WPI. Hence, the changes in
the costs of acquiring these services are not reflected in the WPI movement, thus, an
accurate picture of the state is again not given.

The Indian authorities’ reasons for using the WPI as their primary measure are that
it is more frequently released, thus minimising the time lag issues for policy making,
and that the use of four different CPI measures is a complicated and timely measure,
which cannot be used on a national level.

However, this does not justify them using the WPI, a measure from the production
aspect, as their official use to measure price changes that affect the consumers and
their spending behaviour.

The IMF is consulting India under its Article-IV consultation but the Breton Wood
Institutions (BWI) never bothered to remind India of its responsibility to provide
correct estimates of Inflation.
India calculates inflation base
d on WPI
India

Components of the money supply of India 1970-2007

The Reserve Bank of India defines the monetary aggregates as[31]:

• Reserve Money (M0): Currency in circulation + Bankers’ deposits with the RBI
+ ‘Other’ deposits with the RBI = Net RBI credit to the Government + RBI credit
to the commercial sector + RBI’s claims on banks + RBI’s net foreign assets +
Government’s currency liabilities to the public – RBI’s net non-monetary
liabilities.
• M1: Currency with the public + Deposit money of the public (Demand deposits
with the banking system + ‘Other’ deposits with the RBI).
• M2: M1 + Savings deposits with Post office savings banks.
• M3: M2+ Time deposits with the banking system = Net bank credit to the
Government + Bank credit to the commercial sector + Net foreign exchange
assets of the banking sector + Government’s currency liabilities to the public –
Net non-monetary liabilities of the banking sector (Other than Time Deposits).

M4: M3 + All deposits with post office savings banks (excluding

National Savings Certificates). [edit] Link with inflation

[edit] Monetary exchange equation

Money supply is important because it is linked to inflation by the equation of

exchange[citation needed]:

MV = PQ
 • M is the total dollars in the nation’s money supply
• V is the number of times per year each dollar is spent
• P is the average price of all the goods and services sold during the year
• Q is the quantity of assets, goods and services sold during the year

U.S. M3 money supply as a proportion of gross domestic product.

where:

• velocity = the number of times per year that money turns over in transactions for
goods and services (if it is a number it is always simply nominal GDP / money
supply)
• nominal GDP = real Gross Domestic Product × GDP deflator
• GDP deflator = measure of inflation.

The quantity of assets goods and service sold during the year could be grossly estimated
by GDP back in the 1960s. This is not the case anymore because of the rise of financial
transactions relative to real transaction. Money supply may be less than or greater than
the demand of money in the economy. If the money supply grows faster than its use,
inflation in a class of goods or assets is likely to follow (according to Milton Friedman,
"inflation is always and everywhere a monetary phenomenon"). This statement must be
qualified slightly, due to changes in velocity. While the monetarists presume that velocity
is relatively stable, in fact velocity exhibits variability at business-cycle frequencies, so
that the velocity equation is not particularly useful as a short run tool. Moreover, in the
US, velocity has grown at an average of slightly more than 1% a year between 1959 and
2005.

Economists have noted that M3 growth may not affect all assets or goods equally. For
example, an almost constant rise in M3 in the 1970s, '80s and '90s produced a rise in
consumer goods prices "inflation" in the seventies and a rise in the stock market in the
'80s and '90s and a rise in home prices after 2001. When home prices went down, the
Federal Reserve kept its loose monetary policy and lowered interest rates; the attempt to
slow price declines in one asset class, e.g. real estate, may well have caused prices in
other asset classes to rise, e.g. commodities[citation needed].

[edit] Percentage

In terms of percentage changes (to a small approximation, the percentage change in a

product, say XY is equal to the sum of the percentage changes %ΔX + %ΔY). So:

%ΔP + %ΔQ = %ΔM + %ΔV

That equation rearranged gives the "basic inflation identity":

 %ΔP = %ΔM + %ΔV - %ΔQ

Change in Inflation (%ΔP) is equal to the rate of money growth (%ΔM), plus the change
in velocity (%ΔV), minus the rate of output growth (%ΔQ).[33]

U.S. M3 money supply as a proportion of gross domestic product.

where:

• velocity = the number of times per year that money turns over in transactions for
goods and services (if it is a number it is always simply nominal GDP / money
supply)
• nominal GDP = real Gross Domestic Product × GDP deflator
• GDP deflator = measure of inflation.

The quantity of assets goods and service sold during the year could be grossly estimated
by GDP back in the 1960s. This is not the case anymore because of the rise of financial
transactions relative to real transaction. Money supply may be less than or greater than
the demand of money in the economy. If the money supply grows faster than its use,
inflation in a class of goods or assets is likely to follow (according to Milton Friedman,
"inflation is always and everywhere a monetary phenomenon"). This statement must be

Bank reserves at central bank

The examples and perspective in this section may not represent a worldwide view of
the subject. Please improve this article and discuss the issue on the talk page.

When a central bank is "easing", it triggers an increase in money supply by purchasing

government securities on the open market thus increasing available funds for private
banks to loan through fractional-reserve banking (the issue of new money through loans)
and thus grows the money supply. When the central bank is "tightening", it slows the
process of private bank issue by selling securities on the open market and pulling money
(that could be loaned) out of the private banking sector. It reduces or increases the supply
of short term government debt, and inversely increases or reduces the supply of lending
funds and thereby the ability of private banks to issue new money through debt. Note that
while the terms "easing" and "tightening" are commonly used to describe the central
bank's stated interest rate policy, a central bank has the ability to influence the money
supply in a much more direct fashion, as explained earlier in this paragraph.
The operative notion of easy money is that the central bank creates new bank reserves (in
the US known as "federal funds"), which let the banks lend out more money. These loans
get spent, and the proceeds get deposited at other banks. Whatever is not required to be
held as reserves is then lent out again, and through the "multiplying" effect of the
fractional-reserve system, loans and bank deposits go up by many times the initial
injection of reserves.

However, in the 1970s the reserve requirements on deposits started to fall with the
emergence of money funds, which require no reserves. Then in the early 1990s, reserve
requirements were dropped to zero on savings deposits, CDs, and Eurodollar deposit. At
present, reserve requirements apply only to "transactions deposits" – essentially checking
accounts. The vast majority of funding sources used by private banks to create loans are
not limited by bank reserves. Most commercial and industrial loans are financed by
issuing large denomination CDs. Money market deposits are largely used to lend to
corporations who issue commercial paper. Consumer loans are also made using savings
deposits, which are not subject to reserve requirements. These loans can be bunched into
securities and sold to somebody else, taking them off of the bank's books.

Some academics argue that the money multiplier does not exit, because this would
assume that the money supply is exogenous, i.e. determined by the monetary authorities
via open market operations. If we know that the Central Banks usually target the interest
rates (policy instrument) then this leads of endogenous money supply (policy outcome).
[34]

This article may need to be updated. Please update this article to reflect recent events
or newly available information, and remove this template when finished. Please see the
talk page for more information. (March 2009)

Neither commercial nor consumer loans are any longer limited by bank reserves. Since
1995 the amount of consumer loans has steadily increased:

In recent years, the irrelevance of open market operations has also been argued by
academic economists renowned for their work on the implications of rational
expectations, including Robert Lucas, Jr., Thomas Sargent, Neil Wallace, Finn E.
Kydland, Edward C. Prescott and Scott Freeman.

[edit] Arguments

The main functions of the central bank are to maintain low inflation, and a low level of
unemployment. The U.S. Central bank may attempt to do this by artificially stimulating
demand by affecting the nation's money supply via lower (or higher) interest rates.
Furthermore, deficit spending on the authorization of the U.S. Government is designed to
artificially stimulate aggregate demand for products and services within an economy.
Another means of stimulating demand would be changes in both consumption taxes, and
personal income taxes. The argument for either, as per the efficiency to which the
additional dollars are being utilized, would determine their overall effect on the GDP of a
nation, and whether or not a sustainable stimulus is in effect. For example, a dollar given
to a tax-payer (tax credit) for purchases of products or services (stimulating monetary
velocity), versus a dollar given to an additional construction laborer - infrastructure
redevelopment (for example, also stimulating monetary velocity).

The main debate amongst economists in the second half of the twentieth century
concerned the central banks ability to predict how much money should be in circulation,
given current employment rates, and inflation rates. Some economists like Milton
Friedman believed that the central bank would always get it wrong, leading to wider
swings in the economy than if it were just left alone.[35] This is why they advocated a non-
interventionist approach.

Chairman of the U.S. Federal Reserve, Ben Bernanke, has suggested that over the last 10
to 15 years, many modern central banks have become relatively adept at manipulation of
the money supply, leading to a smoother business cycle, with recessions tending to be
smaller and less frequent than in earlier decades, a phenomenon he terms "The Great
Moderation" [36] However these assumptions may very well prove ill-conceived by the
global financial crisis of 2008–2009. History will judge whether or not the now classical
thinking of interest, and money supply moderation, have proven effective in preventing
recessions, severe or mild. Furthermore, it may be that the functions of the central bank
may need to encompass more than the 'jigging' up or down of interest rates in order to
influence money supply, in the sense that these tools, although valuable, do not in fact
control the very volatility, nor directly the velocity, of money supply in a nation's
economy.

Core inflation
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Core inflation is a measure of inflation which excludes certain items that face volatile
price movements, notably food and energy.

The preferred measure by the Federal Reserve of core inflation in the United States is the
core Personal consumption expenditures price index (PCE). This is based on chained
dollars.

Since February 2000, the Federal Reserve Board’s semiannual monetary policy reports to
Congress have described the Board’s outlook for inflation in terms of the PCE. Prior to that, the
inflation outlook was presented in terms of the CPI. In explaining its preference for the PCE, the
Board stated: The chain-type price index for PCE draws extensively on data from the consumer
price index but, while not entirely free of measurement problems, has several advantages relative
to the CPI. The PCE chain-type index is constructed from a formula that reflects the changing
composition of spending and thereby avoids some of the upward bias associated with the fixed-
weight nature of the CPI. In addition, the weights are based on a more comprehensive measure of
expenditures. Finally, historical data used in the PCE price index can be revised to account for
newly available information and for improvements in measurement techniques, including those
that affect source data from the CPI; the result is a more consistent series over time. —Monetary
Policy Report to the Congress, Federal Reserve Board of Governors, Feb. 17, 2000

Previously the Federal Reserve had used the US Consumer Price Index as its preferred
measure of inflation. The CPI is still used for many purposes, for example, for indexing
social security. The equivalent of the CPI is also commonly used by central banks of
other countries when measuring inflation. The CPI is presented monthly in the US by the
Bureau of Labor Statistics. This index tends to change more on a month to month basis
than does "core inflation". This is because core inflation eliminates products that can
have temporary price shocks (i.e. energy, food products). Core inflation is thus intended
to be an indicator and predictor of underlying long-term inflation.

Contents
[hide]

• 1 History
• 2 See also
• 3 External links

• 4 References

[edit] History

The concept of core inflation as aggregate price growth excluding food and energy was
introduced in a 1975 paper by Robert J. Gordon.[1] This is the definition of "core
inflation" most used for political purposes. Core inflation was also developed and
advocated by Otto Eckstein, in (Eckstein 1981).

Analysis by the Federal Reserve Bank of New York indicates that this measure is no
better than a moving average of the Consumer Price Index as a predictor of inflation.[2]

There are also other types of measuring inflation rates. In the United States the Dallas
Federal Reserve computes a trimmed mean PCE price index, which separates "noise" and
"signal". This is trimmed at 19.4% at the lower tail end and 25.4% at the upper tail. The
Cleveland Federal Reserve computes a Median CPI and a 16% trimmed mean CPI.
Trimmed means that the highest rises and declines in prices are trimmed by a certain
percentage, attributing to a more accurate measurement on core inflation. In relation to
this, the Median CPI is usually higher than the trimmed figures for both PCE and CPI.
There also is a median PCE, but is not widely used.

Inflation rate
From Wikipedia, the free encyclopedia

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It has been suggested that this article or section be merged into Inflation. (Discuss)
This article or section has multiple issues. Please help improve the article or discuss
these issues on the talk page.

• It needs additional references or sources for verification. Tagged since February

2009.
• It is in need of attention from an expert on the subject. Tagged since February 2009.
• It needs to be expanded. Tagged since February 2009.

• It may require general cleanup to meet Wikipedia's quality standards. Tagged

since February 2009.
The examples and perspective in this article may not include all significant
viewpoints. Please improve the article or discuss the issue on the talk page. (February
2009)

Inflation rates around the world in 2008.

Annual inflation rates in the U.S., 1666-2004.

In economics, the inflation rate is a measure of inflation, the rate of increase of a price
index (for example, a consumer price index).It is the percentage rate of change in price
level over time. [1] The rate of decrease in the purchasing power of money is
approximately equal.

It's used to calculate the real interest rate, as well as real increases in wages, and official
measurements of this rate act as input variables to COLA adjustments and Inflation
derivatives prices.
Contents
[hide]

• 1 Description of the rate

• 2 Definitions
• 3 See also
• 4 External links

• 5 References

[edit] Description of the rate

The rate is usually expressed in annualized terms, though the measurement periods are
usually different from one year. Inflation rates are often given in seasonally adjusted
terms, removing systematic quarter-to-quarter variation.

sagar.

[edit] Definitions
See also: price index

If P0 is the current average price level and P − 1 is the price level a year ago, the rate of
inflation during the year might be measured as follows:

After the year the purchasing power of a unit of money is multiplied by a factor 1 / ( 1 +
inflation rate ).

There are other ways of defining the inflation rate, such as logP0 − logP − 1 (using the
natural log), again stated as a percentage. In this case after the year the purchasing power
of a unit of money is multiplied by a factor e − inflation rate.

There are two general methods for calculating inflation rates - one is to use a base period,
the other is to use "chained" measurements. Chained measurements adjust not only the
prices, but the contents of the market basket involved, with each price period. More
common, however, is the base period reference. This can be seen from inflation reports
from the "relative weight" assigned to each component, and by looking at the technical
notes to see what each item in an inflation basket represents and how

Curbing inflation

1.) Decrease Aggregate Demand

 - Decrease money supply
- Increase short term interest rates

2.) Increase Productivity

-Increase output without increasing input.

-Increase output using less input.
-Both of the above are typically the accomplished through the development of
economies of scale, new technology and/or new more efficient methods of
production.

The situation in most Indian households and corporate offices today shows one major
action taken - cost-cutting. This action is attributed to the inflation rates in India as well
as the looming global recession. Inflation is defined as a sustained increase in the general
level of prices for goods and services.

According to the 2008 Economic Survey report, the Reserve Bank of India had targeted
trimming down India’s inflation rate from 5.77 per cent in 2007 to 4.1 per cent. However,
by July 2008, the key Indian Inflation Rate, the Wholesale Price Index, had risen above
11 per cent; it’s highest in 13 years. This is more than 6 per cent higher than a year earlier
and almost three times RBI’s target of 4.1 per cent.

Such desperate situations call for desperate measures. Inflation is a hydra-headed

monster. It cannot be controlled by taking a single measure. However, if finances are
wisely coordinated, it can greatly help in controlling the continuous process of rising
prices. To handle your finances during inflation, you should:

1. Curb your expenditure: Do not overuse daily essentials like cooking gas, electricity
etc. Cut down on inessentials when buying groceries. Look for cheaper alternatives to
products that you normally buy.

2. Follow a budget: Create a budget for monthly spending and savings. Save money at
the beginning of the month and stick to your spending limits. Do not eat into your savings
or debt amounts.

3. Invest in government-backed investment and deposit schemes: Government-

backed investment schemes such as Post Office Savings Schemes, Public Provident
Funds (PPF) and National Savings Certificates (NSC) are best to invest in when inflation
is slowly inching up and you are only looking at safety, not returns.

Even bank fixed deposits are a good bet. These instruments also offer attractive rates of
return. For instance, while post office schemes offer 8 to 9% guaranteed returns, the same
can go up to 10-11% in the case of bank fixed deposits, which can’t be considered bad in
the current scenario.

However, inflation eats into the returns offered by assured return schemes like fixed
deposits and small savings schemes, thereby leaving investors with dismal real returns.

4. Diversify your investments: Risk and return always go hand in hand while investing.
When you choose to save in government-backed savings plans, you can’t expect a higher-
than-market rate of return for the money, because your primary objective is security of
the funds and not returns.

So, even if some of your money is safe, you are still not meeting many of your financial
goals. To accomplish your financial goals within the desired time, your investments
should have some exposure to equity, real estate and other high-return instruments.

5. Invest in gold: Commodities like gold are a hedge against inflation. This is mainly
because the factors that affect the prices of gold are different from those that impact the
prices of other assets like equities for instance.

When uncertainty affects global markets, investors prefer to take refuge in gold because
in times of inflation, gold prevents erosion in the value of the purchasing power.

6. Invest as per your risk appetite: Investing long-term or short-term should all depend
on your risk appetite. However, shorter the term, lesser the risk you should take with your
funds. This will ensure that the uncertainty of returns is lesser as you gradually approach
your financial goal!

7. Safeguard your investments: Invest in short term deposits and funds, commodities
and property. This will help you to slowly reach your financial goals while safeguarding
your hard-earned money.