INFLATION

INTRODUCTION
DEFINITION OF INFLATION
Inflation is defined as a sustained increase in the general level of prices for
goods and services.
When the general price level rises, each unit of currency buys fewer goods
and services. Thus, inflation results in loss of value of money.
It is measured as an annual percentage increase.
STAGES OF INFLATION
Depending on the characteristics and the intensity of inflation, there are
several stages, namely.
Creeping inflation
Trotting inflation (Walking And Running Inflation)
Galloping inflation
Hyper inflation
Creeping Inflation
When there is a general rise in prices at very low rates, which is usually
between 2-4 percent annually, this is known as creeping inflation.
Trotting Inflation
Trotting inflation occurs when the percentage has risen from 5 to almost 10
percent. At this level it is a warning signal for most governments to take
measures to avoid exceeding double- digit figures.
Galloping Inflation

Another type of inflation is the galloping inflation, where the rate of inflation
is increasing at a noticeable speed and at a remarkable rate, usually from 1020 percent.
Hyper Inflation
However, when the inflation rate rises to over 20% it is generally considered
as hyper inflation and at this stage it is almost uncontrollable because it
increases more rapidly in such a little time frame.
CAUSES OF INFLATION
Demand-pull inflation occurs when the consumers, businesses or the
governments demand for goods and services exceed the supply;
therefore the cost of the item rises, unless supply is perfectly elastic.
Cost-push inflation is caused by an increase in production costs. It is
generally caused by an increase in wages or an increase in the profit
margins of the entrepreneurs.
TYPES OF INFLATION
Wage inflation
This is the typical situation in which demand is more and supply is less
(commonly referred to as the demand-pull occurrence, or excess demand
inflation). When wage inflation occurs, the prices for the product or service
increase, thus leading into the situation known as demand-pull. An example
of this would be the dramatic changes in the economy during war.
Pricing Power Inflation
Commonly known as the Administered Price Inflation, this occurs when
business and individuals raise their prices retrospectively to increase their
profits. On a side note, pricing power inflation does not occur during
economic depression or financial drops.
Cost-Push Inflation

When an increase of price occurs in regard to the product or maintenance of

a service or product, the expected increase in price is the resultant effect. For
an example, if a car manufacturer paid more for a vital part of an engine, the
labour cost would decrease to counter the new price.
Sectoral Inflation
This occurs when the price of one product directly affects the price of another
product or service.
EFFECTS OF INFLATION
Almost everyone thinks inflation is evil, but it isnt necessarily so. Inflation
affects different people in different ways. It also depends on whether inflation
is anticipated or unanticipated. If the inflation rate corresponds to what the
majority of people are expecting (anticipated inflation), then we can
compensate and the cost isnt high. For example, banks can vary their interest
rates and workers can negotiate contracts that include automatic wage hikes
as the price level goes up.
Problems arise when there is unanticipated inflation:
Creditors lose and debtors gain if the lender does not anticipate inflation
correctly. For those who borrow, this is similar to getting an interest-free
loan.
Uncertainty about what will happen next makes corporations and consumers
less likely to spend. This hurts economic output in the long run.
People living off a fixed-income, such as retirees, see a decline in their
purchasing power and, consequently, their standard of living.
The entire economy must absorb repricing costs (menu costs) as price lists,
labels, menus and more have to be updated.
If the inflation rate is greater than that of other countries, domestic products
become less competitive.
The value of investments are destroyed over time.
Non-uniform inflation can lead to heavy competition in the global market and
threaten the existence of small economies.

MEASUREMENT OF INFLATION
Increase or decrease in general price level is measured against price level of
some reference year called base year. Inflation is expressed as percentage
increase in the general price level with reference to base year of the given
basket of commodities.
Inflation= current prices - base year prices/base year prices x 100
Currently, there are five different primary measures of inflation - the
Wholesale Price Index (WPI) and four measures of the Consumer Price Index
(CPI). In addition, Gross Domestic Product (GDP) deflator and Private Final
Consumption Expenditure (PFCE) deflator from the National Accounts
Statistics (NAS) provide implicit economy-wide inflation estimate.
Inflation rates in India are usually quoted as changes in the Wholesale Price
Index, for all commodities. Many developing countries use changes in the
Consumer Price Index (CPI) as their central measure of inflation. India used
WPI as the measure for inflation but new CPI(combined) is declared as the
new standard for measuring inflation (April 2014).
Wholesale Price Index (WPI)
The Wholesale Price Index or WPI is "the price of a representative basket of
wholesale goods". The Wholesale Price Index focuses on the price of goods
traded between corporations, rather than goods bought by consumers, which
is measured by the Consumer Price Index. The wholesale price index (WPI) is
based on the wholesale price of a few relevant commodities of over 240
commodities available.
Consumer Price Index (CPI)

A consumer price index (CPI) measures changes in the price level of a market
basket
{The term market basket or commodity bundle refers to a fixed list of items
used specifically to track the progress of inflation in an economy or specific
market} of consumer goods and services purchased by households. At the
retail level, CPI is meant to reflect the cost of living conditions and is

computed on the basis of the changes in the level of retail prices of selected
goods and services on which consumers spend the major part of their income.
The annual percentage change in a CPI is used as a measure of inflation.
Producer Price Index
India revised the WPI, but still dont have a Producer Price Index (PPI). The PPI
covers price changes faced by the producers on primary, intermediate and
finished goods and services ready for the market. The primary difference
between the WPI and the PPI is, in addition to the coverage, that the WPI
reflects changes in the average cost of production including mark-ups and
taxes, while the PPI measures price changes of transacted goods at the gate
excluding taxes. The purpose of the PPI is to provide a measure of prices
received by producers of commodities. The PPI usually covers the industrial
(manufacturing) sector as well as public utilities (electricity, gas and
communications).
MEASURES TO CONTAIN INFLATION
Monetary measures: Monetary measures relate to the control in the supply
and circulation of money in the country.
Bank rate policy: In case of inflation, the bank rate is increased; the supply of
money is controlled.
Open market operation: During inflation, the central bank sells govt.
securities and price bonds in the open market in order to contract the supply
of money.
Variable reserve ratio: In order to control inflation, the central bank increases
the reservation.
Credit Rationing: When there is inflationary pressure, the state bank adopts
the policy of credit rationing.
Fiscal Measures: Measures in connection with public borrowing, public
expenditures and public revenues are called fiscal measures.
Public Borrowing: During inflation, increase the public borrowing, during
deflation, decrease in public borrowing.
Public Revenues: In order to control inflation, the increase in public revenues
by the Govt.

Public expenditures: Inflation is also controlled by decreasing the public

expenditures by the Govt.
Realistic Measures: Increase the supply of goods and services: When the
supply of goods and services is increased, the prices will come down.
Population planning: Control on population by adopting different measures
of family planning will reduce the demand and finally prices will be controlled.
Price control policy: The govt. should adopt strict price control policy against
the profiteers and hoarders.
Economic Planning: Effective economic planning is necessary to control the
inflation in the country.
INFLATION RELATED TERMS
DEFLATION
A general decline in prices, often caused by a reduction in the supply of
money or credit is deflation. Deflation can be caused also by a decrease in
government, personal or investment spending. The opposite of inflation,
deflation has the side effect of increased unemployment since there is a lower
level of demand in the economy, which can lead to an economic depression.
Central banks attempt to stop severe deflation, along with severe inflation, in
an attempt to keep the excessive drop in prices to a minimum.
HYPER-INFLATION
Extremely rapid or out of control inflation is Hyper-Inflation. There is no
precise numerical definition to hyperinflation. Hyperinflation is a situation
where the price increases are so out of control that the concept of inflation is
meaningless.
STAGFLATION
A condition of slow economic growth and relatively high unemployment - a
time of stagnation - accompanied by a rise in prices, or inflation.

DISINFLATION
A slowing in the rate of price inflation is disinflation. Disinflation is used to
describe instances when the inflation rate has reduced marginally over the
short term. It is used to describe periods of slowing inflation.
REFLATION
Reflation is the act of stimulating the economy by increasing the money
supply or by reducing taxes. It is the opposite of disinflation.
PHILLIPS CURVE
Phillips curve is a historical inverse relationship between the rate of
unemployment and the rate of inflation in an economy. Stated simply, the
lower the unemployment in an economy, the higher the rate of inflation.
While it has been observed that there is a stable short run tradeoff between
unemployment and inflation, this has not been observed in the long run.
RBI ANNOUNCED SCHEME FOR INFLATION INDEXED BONDS 2013-14
1. Pursuant to the announcement made in the Union Budget for 2013-14 to
introduce instruments that will protect savings of poor and middle classes
from inflation and incentivise household sector to save in financial
instruments rather than buy gold, RBI, in consultation with Government of
India, has decided to launch Inflation Indexed Bonds (IIBs).
2. For appropriate price discovery and market development, it is however,
necessary to issue comparable instruments through auctions to the
institutional investors such as Pension Funds, Insurance, and Mutual Funds
etc.; This will create demand for IIBs and help in making them tradable in the
secondary market.; It is therefore proposed to issue initial series for all
categories of investors including institutional investors and, later, another
series, exclusively for retail investors. First series of IIBs would be issued in
first half of the current financial year.; To target greater retail participation for
this series also, it has been decided to enhance the non-competitive segment
for retail and mid-segment investors to 20 per cent from the present level of 5
per cent applicable to auction of usual GOI (Government of India) securities.
3. The details for first series of IIBs are as under:

 IIBs will be having a fixed real coupon rate and a nominal principal value
that is adjusted against inflation.; Periodic coupon payments are paid on
adjusted principal.; Thus these bonds provide inflation protection to both
principal and coupon payment.; At maturity, the adjusted principal or the
face value, whichever is higher, will be paid.
Index ratio (IR) will be computed by dividing reference index for the
settlement date by reference index for issue date (i.e., IR set date = Ref.
Inflation Index Set Date / Ref Inflation Index Issue Date).
Final Wholesale Price Inflation (WPI) will be used for providing inflation
protection in this product.; In case of revision in the base year for WPI
series, base splicing method would be used to construct a consistent series
for indexation.
Indexation Lag:; Final WPI with four months lag will be used, i.e. Sept 2012
and Oct 2012 final WPI will be used as reference WPI for 1st Feb 2013 and
1st March 2013, respectively.; The reference WPI for dates between 1st Feb
and 1st March 2013 will be computed through interpolation.
Issuance method:; These bonds will be issued by auction method.
Retail Participation:; Non-competitive portion will be increased from
extant 5 per cent to up to 20 per cent of the notified amount in order to
encourage participation of retail and other eligible investors.
Maturity:; Issuance would target various points of the maturity curve in
order to have benchmarks. To begin with, these bonds will be issued for
tenure of 10 years.
Issuance Size:; Each tranche of IIBs will be for 1,000 - 2000 crore and total
issuance would be for about 12,000-15,000 crore in 2013-14.
Issuance Date:; First such tranche will be issued on June 4th 2013 and the
same would be issued regularly through auctions on the last Tuesday of
each subsequent month during 2013-14.
4.
Second series of IIBs exclusively for retail investors will be issued in second
half of the financial year.; First series of the IIBs will help in determining the
coupon rate for the bonds through auction. This will help in benchmarking IIBs.;
Based on the experience in the initial issuances, second series of IIBs for the retail
investors is proposed to be issued around October.; Terms of issuance of IIBs for
retail investors would be announced in due course.