Institute of Management Technology, Ghaziabad

January 3, 2012

BATTLING AGAINST INFLATION

INFLATION IN INDIA
PROJECT REPORT

INSTITUTE OF MANAGEMENT TECHNOLOGY GHAZIABAD

Submitted to:
Dr.V.P.Ojha

Submitted by:
Section F Group 5: PGDM 2011-13
Sundaresh Vishwanathan Iyer (11DM-052) Sravan Kumar Gundapu (11DM-159) Saurabh Sharma (11FN-092) Ravi Dhingra (11DM-122) Aparna Vyas (11FN-019) Anupam Sinha (11IT-035)

JANUARY 2012

Institute of Management Technology, Ghaziabad

January 3, 2012

Contents
1) What is Inflation 2) Causes of Inflation 2.1)Demand Pull Inflation 2.2) Cost Push Inflation 3) Tools for measuring Inflation 3.1)Wholesale Price Index 3.2) Consumer Price Index 3.3) GDP Deflator 4) Difference between Headline and Core Inflation 5) Effects of Inflation 5.1) Positive Effects 5.2) Negative Effects 6) The Indian Scenario 7) Steps taken by Government to reduce Inflation

8) Suggestions and Road Ahead

9) References

Institute of Management Technology, Ghaziabad

INFLATION DEFINITION:

January 3, 2012

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy. (Source: Wikipedia). CAUSES OF INFLATION: y y Demand Pull Inflation Cost Push Inflation

A) Demand Pull Inflation: Demand Pull Inflation occurs when Aggregate Demand rises more than the aggregate supply. This is also described as too much money chasing too few goods.

B) Cost Push Inflation: Cost-push inflation is a type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available.Inflation originating from increase in cost is known as cost-push inflation or supply side inflation

Institute of Management Technology, Ghaziabad

TOOLS TO MEASURE INFLATION:

January 3, 2012

A Consumer Price Index (CPI) measures changes in the price level of consumer goods and services purchased by households. The Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods. Some countries (like India and The Philippines) use WPI changes as a central measure of Inflation.

GDP Deflator is the ratio of Nominal GDP in a given year to Real GDP in that year. The deflator measures the change in prices that has occurred between the base period and current year. DIFFERENCE BETWEEN HEADLINE INFLATION AND CORE INFLATION: Headline inflation measures the total Inflation within and economy. It is usually affected by areas of market which may experience sudden inflationary spikes such as food or energy. As a result, headline inflation may not present an accurate picture of the current state of the economy. This differs from core inflation, also called underlying inflation, which excludes factors such as food and energy costs. EFFECTS OF INFLATION Positive Effects of Inflation: y Inflation is generally an outcome of economic growth. As we see from the demand and supply diagram, an increase in the aggregate demand causes an increase in National Output as well as inflation. It can benefit a set of economic agents, whose income increases more than the increase in prices, hence leading to an increase in real income. For example: Debtors (who have taken debt at fixed rate of interest) are generally a beneficiary of inflation, as the real cost of debt decreases due to a reduction in the value of money. Effects of inflation are generally felt with a lag and hence it can benefit a part of the society. Example, increase in the incomes of farmers when the food prices rise. Benefits to Cartels: By inducing supply side inflation, cartels like OPEC can benefit at the expense of the larger pool of people. According to Tobin Effect (nominal interest rates would rise less than one-for-one with inflation because in response to inflation the public would hold less in money balances and more in other assets, which would drive interest rates down). A steady rise of inflation can induce investments in a country since it reduces the returns on monetary assets and hence people would like to invest in real capital projects, thus leading to faster growth and higher level of income. Inflation can have real effects.

Negative Effects of Inflation: y Supply side inflation can lead to reduce the National Output and hence reduce the level of growth in an economy. It leads to uncertainty about future and may discourage investment and saving. Hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.

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January 3, 2012

Relative Price Distortions: Firms do not generally synchronize adjustment in prices. If there is higher inflation, firms that do not adjust their prices will have much lower prices relative to firms that do adjust them. This will distort economic decisions, since relative prices will not be reflecting relative scarcity of different goods. Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral. In a sense, inflation begets further inflationary expectations. Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank Menu costs: Firms will have to change the prices of their output more frequently to keep up with the inflation. For example restaurants having to reprint menus.

Institute of Management Technology, Ghaziabad

THE INDIAN SCENARIO

January 3, 2012

Average Inflation in India in 2011 is 9.06%. As we can see from the above graph, Inflation was hovering between 4 to 6% in the period between 1999-2007. An increase of almost 2% can be seen from 2007 to 2008 and is ranging between 8% and 12% since then. .

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FACTORS CAUSING INFLATION IN THE INDIAN CONTEXT

January 3, 2012

Demand Side An increase in the inflation level can be attributed to the high rate of real GDP growth in 2007-08, approximately 9%. An increase in the growth rate, means more prosperity and hence more money to spend, which increases aggregate demand and hence inflation. Gross fixed investments as a proportion of GDP was the highest in 2008 (39%). Central government plans like National Minimum wages guarantee programme and other constructive work in the rural India, led to more money in the hands of the poor and hence inflation. Loan waiver to the tune of 60K crore was initiated which freed up money in the hands of the debtors and hence raised the price level. Inflation was predominantly a demand side phenomenon, though supply side was also playing a part till mid-2008.

Supply Side Crude Oil price increase due to International Factors: Crude Oil prices had increased on count of 2006 conflict between Israel and Lebanon, worries over Iranian nuclear plants in 2006, Hurricane Katrina, and various other factors. This led to an increase in the price level in the economy since crude oil is a major component of imports in India. There was an increase of 5.33 per cent during 2008-09 in quantity terms of crude oil imports and it increased by 25.37 per cent in value terms. Erratic monsoons leading to more cash crop cultivation by farmers: In 2008, area sown under rice fell to 11.46 million ha, from 14.52 million ha in 2008, which is a fall of 21%. Reason for the same wasthat farmers started substituting food grain cultivation with cash crops, since due to erratic and insufficient monsoons, as cash crops require less water. This was leading to an increase in food prices. For the first time after 1980, food inflation was recorded at its highest (around 12%). Bottlenecks in the storage and distribution in India also contributed to spoilage of million tonnes of food. Lehman brothers filed its bankruptcy in September 2008 which made its way into global recession. nd Indias real GDP growth slid to a lowest of 5.8% in the 2 quarter of 2009. However the Indian economy exhibited broad based recovery in the second half of 2009-10 from the slowdown that had started in the second half of 2008-09. India achieved 7.4 per cent growth in GDP in 2009-10, one of the highest in the world. The focus of macroeconomic policies was on management of the recovery. A strong recovery in industrial sector was combined with a resilient services sector. The contribution of the industrial sector to the overall growth increased sharply from 9.5 per cent in 2008-09 to 28 per cent in 2009-10. Inflation in 2009 averaged around 9.5%. Inflation was once again becoming demand pull. However one of the major factors contributing to inflation by the late 2009 was food inflation. Reasons for food inflation: Bad Monsoon: 60% of the total cropped area in India is not irrigated, along with erratic and insufficient monsoon; food inflation was a major factor in the overall Inflation.

Institute of Management Technology, Ghaziabad

January 3, 2012

Poor harvesting infrastructure: Thisled to losses to the tune of 58,000INR worth of food items in 2008, such as cold chains, transportation etc. Growing Population: Population growth in India was to the tune of 1.41%, reduction in food production along with rising population leads to price rise as number of people to feed rises.

2010 Demand side inflation was a major determinant of inflation till the start of 2010 as the world was recovering from the recession which was hit in 2008. However Inflation in India started becoming more of supply side phenomena. Real GDP has been declining since the 2nd quarter of 2010, but inflation still remains high. Middle East unrest led to a surge in the crude oil prices, leading to imported inflation during early 2011. Oil prices in early 2010 were around 75USD a barrel; however they rose to 110USD in 2011. In 2011, India imported around 70% of its crude oil demand. y Imported Inflation Increase in the prices of imports due to global recession.

India is a major importer of crude oil, precious stones, machinery, fertilizer, iron and steel, chemicals, an increase in the prices worldwide has raised the prices of imports. y Increase in Government expenditure: Fiscal deficit has been rising from 2.55% in 2008-09 to 5.09% in 2010-11 Rising fiscal deficit is contributing to high inflation. Rising fiscal deficit i.e. increasing government expenditure raises aggregate demand and hence is inflationary in nature. If however this expenditure is incurred on capital projects they lead to growth in the economy. In India, revenue deficit, which is the excess of revenue expenditure like salaries over revenue income, rose to Rs 2.84 lakh crore, in 2010 an increase of 100 per cent over one year period.

Institute of Management Technology, Ghaziabad

January 3, 2012

Hence, it has contributed to inflation in the country without contributing to growth much. Deficit financing also plays a key role here as it increases the money supply and is hence inflationary. y Underground Economy: Indias underground economy is growing. These earnings though lead to inflation but are not recorded. When income tax payers deliberately misrepresent their income statements to the tax authorities it leads to creation of black money. Hence people can create extra demand with this money. Black Market in India is reported to be around 50% of Indias GDP Speculative trading in commodities thus raising the prices of commodities. Speculative commodities trading have been soaring and have contributed to sustained inflation in import dependent emerging markets like India. Depreciation of Rupee The rupee started an alarming fall from August, reflecting both the global economic uncertainty and also the weakening economic prospects of India.Rupee is currently in the market at around 52INR/USD. Rupee depreciation makes Indian exports cheaper and hence adds to the aggregate demand and inflation.

Institute of Management Technology, Ghaziabad

STEPS TAKEN BY GOVERNMENT TO CONTROL INFLATION

January 3, 2012

The government has taken the following measures from time to time to curb inflation; however the effects of these measures have so far not been remarkable: y Monetary Policy: RBI has taken suitable steps with 13 consecutive increases in policy rates and related measures to moderate demand to levels consistent with the capacity of the economy to maintain its growth without provoking price rise. Repo rate in India is currently 8.5% which is at its highest in the last 3 year period.

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

Reduction in import duties: Import duties for rice, wheat, pulses, onions etc. have been reduced to almost zero, as inflation hurts the rural poor the most. Government has also reduced import duty on skimmed milk powder, petrol and diesel and customs duty on crude oil.

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Ban on export of edible oils and pulses, suspension of futures trading in rice, urad and tur dal and extension of stock limit orders in case of pulses and rice have also been undertaken. FDI in Retail: The Government of Indias proposal to allow FDI in multi brand retail would have led to reduction in the inefficiencies in the supply chain management of food in India, which will reduce the inflation. However this proposal has been stalled at the moment due to political factors. Food Security: Food security bill has been tabled in the LokSabha in December 2011 which will entitle cheaper food grains to 63.5% of the population of the country. UID Linked Direct Subsidy transfer: subsidies form a major portion of expenditure by the Indian government. UID linked direct subsidy transfer will reduce the inefficiencies in the subsidy transfer and hence will reduce the burden on government. RBIs intervention to reduce rupee depreciation: RBI in December 2011 announced nondirect intervention measures in the wake of steady weakening of the rupee against the dollar. These intervention measures were aimed at curbing speculative positions in the foreign exchange market. Some highlights are: i. Re-booking cancelled forward contracts, whatever the type and tenor of the underlying exposure, by resident and foreign institutional investors has been disallowed. Forward contracts booked to hedge current account transactions regardless of the tenor were allowed to be cancelled and rebooked. The apex bank through the new measures made it clear that forward contracts once cancelled cannot be rebooked. The central bank also modified the currency risk hedging norms for importers and exporters.

ii.

iii.

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Institute of Management Technology, Ghaziabad

SUGGESTIONS AND ROAD AHEAD

January 3, 2012

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

From the analysis, we see that the Inflation is becoming more of supply side phenomena than demand side. RBIs policy of 13 consecutive rate hikes has had minimal impact on the inflation in India. The current situation demands supply side solution to the problem. We see that food inflation has a significant impact on the Indian consumer in general and Indian middle class in particular. The chart given below shows how an average Indian spends his/her income:

As the expenditure on food is to the tune of around 42% in the total expenditure, priority should be to reduce food inflation. We suggest the following ways to curb inflation in India:

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Institute of Management Technology, Ghaziabad

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January 3, 2012

FDI in Retail: The Government of India should give a go ahead for allowing 100% FDI in retail as it will act as a catalyst to spur competition in the retail industry, which currently is marked by low competition and poor productivity. This will lead to a reduction in the price level, and will also lead to efficiency in the supply chain, thus leading to lower infrastructure bottlenecks and spoilage. However the policy has been criticised heavily as it will lead to closures of small retailers in the country who will have to shut down their shops because of competition, but the policy will improve the efficiency in the food sector in the economy will is a major determinant of inflation. Foster Agribusiness :Agribusiness is business involved in food production, including farming and contract farming, seed supply, agrichemicals, farm machinery, wholesale and distribution, processing, marketing, and retail sales. From a food and agribusiness perspective business model innovation which require changes in processes ,technologies, policies, products, structures, services, markets and partnerships for both a corporate and government perspective to better utilise the factors of production (land, labor and capital) will lead to specific commercial objectives such as a decrease in cost, improvement of productivity or an increase in revenues and/or social objectives such as environmental sustainability, local community engagement and regulatory compliance. This will help in reducing price rise of food. Direct Procurement programmes: Companies must be encouraged to initiate programs like E-Choupal by ITC, where the raw materials are procured directly by the company from the farmers, thus reducing the inefficiencies by the intermediaries who charge exorbitant amount without creating any value. Investments in Infrastructure: India needs to invest heavily in infrastructure to combat inefficiencies and reduce spoilage. India is plagued by malnutrition and soaring inflation, but its not for lack of food. It is the worlds second largest grower of fresh produce, but loses an estimated 40 percent of its fruit and vegetables to rot because of a lack of refrigerated trucking, poor roads, inclement weather and corruption. Investments in infrastructure had been budgeted at 2,14,000crore for the year 2011, and cold storages have been made a part of the infrastructure sector in the country, however, the country requires investments in the field of cold storage, better transportation, roads, godowns, public distribution systems, scientific irrigation etc. Biotechnology: Genetic Modified crops which are resilient to erratic monsoon, pesticides etc, should be manufactured. Government of India should give incentives to companies which are operating in the area of producing such crops. However, care must be taken so that we are not prone to another Monsanto case (Bt. Cotton). Use of renewable resources, Reduction in the dependence on Oil: Since India has a huge dependence on crude oil from abroad, use of renewable sources of energy like solar, wind etc must be encouraged which will reduce imported inflation. Though these sources of energy come with initial high fixed costs, however in the long run, they are a sure advantage of traditional sources of energy. Underground Economy to be kept in check: Stringent rules and regulations are required to minimize the underground economy. Tax evasion should be checked. RBIs intervention to curb currency depreciation: RBI must intervene aggressively in the foreign exchange market to curb Rupee depreciation as it is reaching new heights every day and leading to huge losses for the country.

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Reduction in wasteful government expenditure like, subsidies, government salaries: Subsidies create inefficiencies in an economy since it encourages reliance on the subsidized products without looking for ways to curb them. Some of the wasteful subsidies like fertilizer subsidies should be minimized and user charges for electricity etc. should be revised. As much as 39 % of subsidized kerosene is stolen in India. Inefficiencies in the provision of the same must also be checked. Government of Indias project of UID can help curb the inefficiencies to a major extent. Salaries of the government employees must be carefully assessed and incentive based compensation must be in place.

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References:
 

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http://www.firstpost.com/economy/graft-bad-infrastructure-rot-indias-food-73573.html http://www.kpmg.com/IN/en/IssuesAndInsights/ThoughtLeadership/Taming-Food-Inflationthrough-Innovations-in-Agribusiness.pdf

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

  

http://www.thehindu.com/news/national/article2739277.ece http://business.rediff.com/report/2010/mar/02/budget-2010-indias-fiscal-deficit-rises.htm http://www.anirudhsethireport.com/citi-50-per-cent-of-indias-economy-comprises-black-moneyor-640-bn-annual-illegal-outlfows-104-bn/

     

http://www.livemint.com/2009/07/28000515/Foodgrain-acreage-shrinks.html http://www.indiainbusiness.nic.in/industry-infrastructure/industrial-sectors/oil-gas.htm http://currentaffairsappsc.blogspot.com/2011/12/reserve-bank-of-india-kept-its-policy.html http://www.indexmundi.com/g/g.aspx?c=in&v=71 www.tradingeconomics.com http://www.livemint.com/2011/09/20224339/Ministry-approves-proposal-for.html?d=1

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