Dr.

Ram Manohar Lohia National Law University

Lucknow,U.P.

SUBJECT : ECONOMICS

TITLE OF PROJECT:

INFLATION AND ITS EFFECTS

ON

VARIOUS SECTIONS OF INDIAN ECONOMY

(Final Draft)

Submitted to: Submitted By:

Ms. Mitali Tiwari Himanshu Verma

Assis.Prof.(Economics) Roll no. 61(2nd semester)

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 ACKNOWLEDGEMENT

Any accomplishment requires effort of many people and this work is no different. I take this
opportunity to thank Ms. Mitali Tiwari (Assistant Professor, Economics) for giving me such a
wonderful topic for research and providing me valuable training and guidance at the various
stages of my project.

I will also remain highly indebted to the librarian for providing the requisite research material.

Lastly I am thankful to all my colleagues who have given time to help me during the completion
of the project.

HIMANSHU VERMA

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 TABLE OF CONTENTS

1. Introduction- ……….4
 Objective
 Sources
 Research Methodology

2. Inflation : A Problem or a Necessity ……….5

3. Types of Inflation- ……….6

 Based on Speed
 Based on Government Reaction
 Stagflation

4. Theories of Inflation- ……….8

 Demand- Pull Theory
 Cost Push Theory

5. Causes of Inflation- ……….10

6. Effects of Inflation on various sections of Economy- ……….11

7. Measurement of Inflation in India- ....…….13

 GDP Deflator
 Wholesale Price Index (WPI)
 Consumer Price Index (CPI)

8. Trends of Inflation in India- …….....15

9. Conclusion ……….18

References ……….19

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 INTRODUCTION

Inflation means a considerable and persistent rise in the general price of goods and services over
a period of time. It indicates the percentage rise in the general prices today compared to a year
ago. The rise in inflation means that purchasing power of money declines whereas the fall in
inflation means that the purchasing power of money increases.

The effects of inflation are not distributed evenly in the economy, as they affect different
sections of economy differently, and as a consequence there are hidden costs to some and
benefits to others from this decrease in the purchasing power of money.

OBJECTIVE

The objective of my project will be discussing about inflation and its various types. The various
causes behind the problem of inflation will also be discussed alongwith the theories of inflation.
The effect of inflation on various sections of the economy will be an important point of the
research alongwith the analysis of the various trends of inflation in India in the year 2011-2012
and 2012-2013.

RESEARCH METHODOLOGY

The method which will be followed for the study would be purely doctrinal in nature. I have
gone through various books, articles and web resources.

SOURCES

The sources used for the project are various books, articles and newspapers. Web sources have
also been an inspiration in making the project.

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 INFLATION : A PROBLEM OR A NECECESSITY

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. Thus inflation can influence the economy of a country
in both ways, i.e. it can help in development of an economy or it can prove to be destructive to
the economy.

Inflation as a Problem:

The problem of inflation has received a more serious attention since the early 1970s. A
continuous rise in the general price level over a long period of time has been the most common
feature of both developed and developing economies. India, a fast developing nation is facing a
high rate of inflation which has created economic, social, and political problems of the country.
It is the stage of too much money chasing too few goods. It is perhaps the second most serious
macroeconomic problem confronting the world economy today. This problem has claimed more
attention of the economists, policy makers and politicians. The prices of commodities will, over
time, rise and fall, responding to the pulls and pushes of demand and supply. These price
movements are nature’s way of signaling to consumers that they should consume less of the
commodity facing shortage and more of the commodity in glut and to producers to produce more
of what is in short supply and less of what is available in plenty.

Inflation as a Necessity:

But, in contrary to that inflation is also necessary for the sustainable growth of economy, for
which a country must have a desirable rate of inflation. A price rise of 2-3% per annum in the
developed and 4-5% per annum in the developing economies is generally considered as the
desirable rate of inflation. An inflation rate of 4% in India is considered to be socially desirable
and conducive to economic growth.

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 TYPES OF INFLATION

Inflation is of various types. Broadly it can be divided into two categories, one based on the
factors and the other based on the speed of inflation.

Types of Inflation based on Speed of Inflation:

 Creeping Inflation – When the increase in price is very slow like that of a snail or
creeper, it is called creeping inflation. In terms of speed, a sustained rise in prices of
annual increase of less than 3 percent per annum is characterized as creeping inflation.
The creeping inflation is considered to be safe as well as essential for economic growth.

 Walking Inflation – Walking inflation is the inflation which occurs when prices rise
moderately and the annual inflation rate is in the intermediate range of 3 to 6 percent per
annum or less than 10 percent. Walking inflation is a warning signal for the government
to control it before it turns into running inflation.

 Running Inflation – Running inflation is the situation when the price rice is rapid or at a
speed of 10 to 20 percent per annum. It affects the poor and middle classes adversely. Its
control requires strong monetary and fiscal measures, otherwise it may lead to hyper
inflation.

 Hyperinflation – Hyperinflation as characterized by certain economists, is a situation

when the rise in the price is of double or triple digit rates from 20 to 100 percent. It is
also known as runaway or galloping inflation. It results into sharp increase in prices and
depreciation of the domestic currency.

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Types of inflation on basis of Government's reaction or its degree of control:-

 Open Inflation - When government does not attempt to restrict inflation, it is known as
Open Inflation. In a free market economy, where prices are allowed to take its own
course, open inflation occurs. Thus open inflation is the result of uninterrupted operation
if the market mechanism. Unchecked open inflation ultimately leads to hyper inflation.

 Suppressed Inflation - When government prevents price rise through price controls,
rationing, etc., it is known as Suppressed Inflation. It is also referred as Repressed
Inflation. However, when government controls are removed, Suppressed inflation
becomes Open Inflation. It reduces the incentive to work because people do not get the
commodities which they want to have. Lastly, it leads to corruption, black marketing,
artificial scarcity, etc.

One special type of inflation is based upon the inflation and the rate of growth of economy at the
same time. It is discussed below:

Stagflation – Stagflation is a paradoxical phenomenon where the economy experiences

stagnation as well as inflation. It is a situation when recession is accompanied by a high rate
of inflation. It is, therefore, also known as inflationary recession. The principal cause of this
phenomenon has been excessive demand in commodity markets thereby causing prices to
rise, and at the same time the demand for labor is deficient thereby creating unemployment in
the economy. Stagflation is a new term which has been added to economic literature in the
1970s.

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 THEORIES OF INFLATION

Inflation has been very complex as well as important economic factor on which the development
of whole economy of a country depends. Thus it is important to understand the inflation for
which various theories have been given. Two of the most important theories of inflation are:

1. Demand Pull Inflation

2. Cost Push Inflation

DEMAND PULL INFLATION:

Demand-Pull Inflation is the inflationary rise in the prices due to excess of aggregate demand
over the aggregate supply. It is also known as Excess Demand Inflation. It is often described as
a situation of “too much money chasing too few goods.”

It can be explained by two theories:

 Quantity theory version: This theory states that prices rise in the proportion to the
increase in the money supply. It says that doubling the money supply will double the
price level given that there is full employment level of output. Thus inflation or increase
in price level is directly proportional to the expansion in the money supply. In the
analysis of this theory, it is assumed that the aggregate supply is fixed and there is always
full employment level in the economy.
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  Keynesian theory version: This theory states that so long as there are unemployed
resources in the economy, an increase in economy will lead to increase in employment
income and output. Once full employment is reached, further increase in expenditure will
lead to excess demand because here output seizes to rise as there is (full employment)
thereby leading to rise in prices. As a result of this, production costs of other sectors also
rise and thereby push up the prices of their products.

COST PUSH INFLATION:

Cost push inflation is the sustained increase in the price of goods and services, caused by the
passing off increased production costs to the consumers by the producers. It is caused by wage
increases enforced by unions and profit increases by employers.

The cost-push theory of inflation assumes that prices of goods are basically determined by their
costs, whereas supplies of money are responsive to demand. In these circumstances, increasing
costs may create an inflationary pressure that becomes continuous through the operation of the
"price-wage spiral”.

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 CAUSES OF INFLATION

Inflation is caused when the aggregate demand exceed the aggregate supply of goods and
services. Thus the causes of inflation are based on factors affecting demand and factors effecting
supply.

Various causes of inflation are as follows:

o High Demand: If the demand for a commodity is much above than the supply, the price
of the commodity would increase. It is so happened in 2010 that a decrease in sugarcane
production led to decreased production of refined sugar causing its prices to rise in the
open market. This kind of inflation is called demand pull inflation.
o Supply led Inflation: The recent rise in rubber, iron, and steel prices have led to an
increase in the production cost of automobiles with the consequence that their prices have
been hiked by the manufactures. The inflation caused by such a price is called cost push
inflation.
o Black Marketing: When a particular type of commodity has stocked by a wholesaler and
sell in the time of scarcity of the commodity then it increase the price not only of that
commodity but also those which manufactured by the stocked commodity. For example if
sugar is stocked by the wholesalers this create the scarcity of the sugar in the market and
when demand of sugar reach on peak then it releases on the high prices, the prices of
sweets will also go high.
o Increase in Purchasing Capacity of Consumer: If some where a retailer increased the
price of commodity for its own profit and more than 50% consumers of the city do not
object of this means the 50% consumers have the capacity to purchase that commodity
and this will led the inflation.
o Interest Rate on Loan given to the Manufacturer by the Banks: When the rate of
interest is increased on the corporate loan the input cost of the manufactured commodity
will increased so the cost of finished goods in the market will increased.
o Interest Rate on Saving: When the interest rate on savings decreases the common man
do not want to put their money into the banks and so the money will automatically flow
towards the market and this will contribute to the inflation.

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 o International fuel Prices: The country like India is highly dependent on the import of
crude oil. It imports more than 70% crude oil from the countries like Iran, and other Arab
countries. This crude oil is refined and then converted into petroleum products like petrol,
diesel, cooking gas, CNG, kerosene oil, and many more. These fuels are running our
houses as well as our transportation system. So, if the price of crude oil fluctuates in
international market then in that consequence the prices of all commodities will get
affected.
o Foreign Exchange Rate: Recently the value of Rupee has depreciated against US
Dollar. This fluctuation in the price of rupee against dollar contributes highly to inflation.
We are not independent of the crude oil generation and we purchase the crude oil from
other countries. To make this deal we have to pay the dollar for an international deal and
to purchase dollar we have pay more amount in Rupees if the price of a dollar is high.
Interest rate on loan taken from other countries and IMF will become more costly. It
simply means the import becomes costly and interest paid on the debt taken contributes to
inflation.

EFFECT OF INFLATION ON VARIOUS SECTIONS OF ECONOMY

Inflation has certain definite and predictable effect on the income of certain sections of society,
which are as follows:

A) Wage Earners: The labour market in the less developed countries, mostly in the country like
India, which facing a large scale open and disguised unemployment, are generally divided
between organized and unorganized labour markets. The employment share of unorganized
sector is much larger than that of the organized sector. The wage rate in the unorganized labour
market has not increased in proportion to the rate of inflation. So, the labour in this sector is a net
loser during the period of inflation. The organized labour uses its union power to get
compensatory increase in their wages. The labour in this sector is adequately compensated for
the loss of purchasing power due to inflation. So the wage earners in this sector have gained
during the period of inflation.
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B) Producers: Producers gain or loss due to inflation depends on the rates of increase in prices
they receive and the prices they pay. These prices rise first due to demand pull factors such as
rise in money supply, rise in income, increase in investment, increase in export etc. The input
prices remaining the same, profit margin increases. This creates additional demand for inputs
pushing the input prices up, though at different rates and with different time lags. Other input
prices increase at a lower rate. So producers are the net gainers due to wage-lags during the
period of inflation. However, firms have to bear some additional cost during the period of
inflation, especially when inflation rate keeps increasing; firms are required to receive their
prices, print new price lists and publicize their new prices. The cost incurred for this purpose is
called menu cost and in spite of these costs, the firms stand to gain from inflation.

C) Fixed Income Class: The income of the fixed income class people remains constant during
the period of inflation but the prices of goods and services they consume increases. As a result,
the purchasing power of their income gets eroded in proportion to the rate of inflation and they
become net losers during inflation. The fixed-income groups are the worst sufferers during
inflation.

D) Borrowers and Lenders: Under inflation borrowers gain and lenders lose because when
borrower repays to the lender under inflationary situation, then he will be returning less
purchasing power to the lender than what he borrowed earlier. Hence, debtors will gain as the
real value of money has gone down since the time they took loan and creditors lose as the
principle sum received is less in terms of real income.

E) Business Community: The business community, i.e., the producers, traders, entrepreneurs,
speculators, etc., stand to gain during inflation. They earn wind-fall profits because prices rise at
a faster rate than the cost of production. They also gain because they act as borrowers of money
for business purposes.

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F) Investors: The effect of inflation on investors depends on in which asset the money is
invested. If the investors invest their money in equities, they are gainers because of the rise in
profit. If the investors invest their money in debentures and fixed income bearing securities
bonds, etc, they are the loser because income remains fixed.

G) Farmers: Farmers generally gain during inflation because the prices of the farm products
increase faster than the cost of production, thus leading to higher profits during inflation.

Thus inflation redistributes income and wealth in such a way as to harm the interests of the
consumers, creditors, small investors, labourers, middle class and fixed income groups and to
favour the businessmen, traders, debtors, farmers etc.

MEASUREMENT OF INFLATION IN INDIA

Inflation refers to percentage change in the price of a set of goods and services over a period of
time. It represents change in overall price level in the economy. The issue of measurement of
Inflation has got a lot of attention in India. Presently, there are different primary measures of
Inflation:

 GDP Deflator: Growth Domestic Product Deflator refers to the index of the average
price of the goods and services produced in the economy. It is a measure of the level of
prices of all new, domestically produced, final goods and services in an economy. Thus,
whether they are produced by foreigners or locals operating in the country, and bought by
local consumers, firms, the government, or even foreigners, all are included. It ignores
the prices of imported goods, which enter our consumption basket and list of inputs in
production. It is calculated quarterly with a lag of two months since 1996. If the value of
price deflator is 500, it means that the current year price is five times the base year.

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  Wholesale Price Index: The Wholesale Price Index refers to the index of the average
price of all commodities produced and transacted in the economy at the wholesale level.
WPI is the weighted price index of a basket of goods consisting of 435 commodities.
It is available for all commodities as well as for major groups, sub groups and individual
commodities, and is regularly published on a weekly basis by the office of the Economic
Adviser, Ministry of Industries, and Government of India. These features make WPI as
an ideal measure of the Inflation rate, particularly from the managerial point of view. As
the data is available for different commodity groups, policy makers can easily pin down
the source of inflation and then suggest the policy measures to deal with it. It excludes
the prices of all services, such as health, education, banking, transport and
communication and it also does not actually measure the exact price that a consumer has
to bear, since it tracks wholesale prices. The revision of the base year is also not being
done as frequently. In spite of this, the Indian Government has taken WPI as an indicator
of the rate of inflation in the economy.

 Consumer Price Index: Consumer Price Index is measured on the basis of the change in
retail prices of a specified set of goods and services on which a particular group of
consumers spend their money. It excludes the prices of capital goods, raw materials and
intermediate goods. It includes the prices of services as well as of imported goods. The
consumption basket depends on the level of income, rural-urban living, and type of
profession the family is engaged in, habits and customs and so on. It reflects the cost of
living index condition for a homogenous group based on retail price. It actually measures
the increase in price that a consumer will ultimately have to pay for.

Since the different indices cover different set of items, and prices at different sales’ levels, these
indices yield different rate of inflation. Each of them is useful. Due to its high frequency
(weekly), short time lag (2 weeks), and commodity wise availability, the WPI is used to measure
the official rate of inflation in India. The Indian Government continues to use WPI for measuring
inflation because there is only two week time lag in reporting WPI numbers whereas measuring
of CPI indices involves a huge time lag of about two months. Neither any of the three CPIs is a
perfect measure of the cost of living, nor is the WPI a true measure of the inflation rate. Since the
GDP deflator alone covers the level of prices of an entire range of economic activities including
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domestically produced, final goods and services, and its weighing pattern reflects the implicit
sector-wise shares of the nominal and real value added, it is the most ideal measure of the overall
price situation in the economy.

TRENDS IN INFLATION IN INDIA

Inflation Trend in Indian in the year 2011-2012:

 Headline WPI inflation remained persistently high and relatively sticky at around 9 per
cent during 2011. Though inflation remained high throughout the year 2011-2012, it
started showing signs of moderation lately. One such indicator of the trend is the
seasonally adjusted three-month moving average data in all the major groups of the WPI
(Figure 1.2). The financial year 2011-12 started with a headline inflation of 9.7 per cent,
which briefly touched double digits in September 2011 before declining to 6.6 per cent in
January 2012. Consumer price index (CPI) inflation for the major indices declined to
below 7 per cent in December 2011.

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  The major contributory factors to headline inflation during the current financial year
include (a) higher primary articles prices driven by vegetables, eggs, meat, and fish due
to changing dietary pattern of consumers; (b) increasing global commodity prices
especially metal and chemical prices which ultimately led to higher domestic
manufactured prices; and (c) persistently high international (Brent) crude petroleum
prices in the last two years averaging around $ 111 per barrel (/bbl) in 2011 (January-
December) as compared to $ 80/bbl in 2010 (January-December).
 Compared to a relatively stable inflationary period in the earlier part of the last decade,
average headline WPI inflation started to rise in 2008-9 and persisted. The pressure was
mainly from primary and fuel products with average inflation in these commodities
remaining continuously in double digits for a major period since 2008-9. In comparison,
inflation in manufactured products remained relatively stable, dropping sharply in 2009-
10 because of the global economic crisis and its impact in India, before it started to pick
up and exceed its long-run average of around 5 per cent in early 2011-12.
 In the current financial year (2011-12), the gap between WPI and CPI inflation has
significantly narrowed due to a fall in food inflation. The year-on-year inflation released
recently by the CSO for CPI (urban), CPI (rural), and CPI (combined) was 8.25 per cent,
7.38 per cent, and 7.65 per cent respectively in January 2012.

Inflation Trend in India in the year 2012-2013:

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The inflation in the year 2012-2013 in India was as follows:

 Headline WPI inflation remained relatively sticky around 7 to 8 per cent in the current
financial year and moderated to a three-year low of 7.18 percent in December 2012. The
decline is mainly due to moderation in nonfood manufacturing inflation (core as defined
by the RBI). Core inflation remains muted and declined to 4.24 per cent in December
2012 from its peak of 8.35 per cent in November 2011. Apart from monetary measures
taken by the RBI, softening of international and domestic prices of metals, chemicals, and
textiles products also contributed to the moderation of core inflation.
 Elevated food inflation, however, remains an area of concern with inflation gradually
inching upwards to double digits in December 2012. Unlike the previous year, when food
inflation was mainly driven by higher protein food prices, this year the pressure has been
coming mainly from cereals, mainly on account of an increase in prices of wheat, rice,
and maize. Besides an increase in the minimum support price (MSP) for wheat and rice,
inadequate open market availability relative to demand, particularly for wheat, has also
resulted in a build-up of price pressure and hardening of inflation for cereals. The recent
increase in onion prices in December 2012- January 2013 may also put some pressure on
primary food articles inflation. However, milk and other protein items witnessed
moderation in inflation in the second and third quarters of 2012-13.
 Rising food inflation has also widened the gap between inflation measured in terms of
CPIs and WPI to 3.91 percentage points in December 2012 from 1.55 percentage points
in May 2012.

Measures to reduce inflation for the upcoming years:

From the government's perspective, a major contribution to the fight against inflation will be to
reduce the fiscal impetus to demand. Also a focus on incentivizing food production through
measures other than price supports, while facilitating storage and distribution, can help contain
food inflation, which is hard for the RBI to control. Policy on price and procurement supports
should be calibrated so as to not encourage more production of crops that are already abundantly
supplied. Other measures to increase investment more broadly, and therefore supply, can also
help over the medium term.
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 CONCLUSION

Inflation is an intractable problem. Its effects are felt to some degree by every citizen and in
every corner of the country. Most economists generally agree that a moderate rate of inflation is
conducive to economic growth and that, in the short run, there is positive relationship between
moderate rate of inflation and economic growth. A high rate of inflation, especially when it is
unanticipated, throws investment and production plans out of gear. When price rise is
unpredictable, people find it very difficult to determine the course of their response to the price
changes. This upsets the price system which causes inefficient allocation of resources and,
thereby, a lower output. This adds inefficiencies in the market and makes it difficult for
companies to plan long term. Inflation can act as a drag on productivity as companies are forced
to shift resources away from products and services in order to focus on profit and losses from
currency inflation. The WPI provides an idea about the average price level of goods traded in
wholesale market whereas the CPI measures the final cost paid by consumers. CPI inflation is
more important from the point of view of controlling inflation, especially in a country like India,
where the existence of the unorganized sector and incidence of poverty is reasonably high.

The effect of inflation is seen in various sections of the economy. It provides gain to
businessmen, farmers, shareholders, debtors etc whereas creditors, wage earners, pensioners,
bondholders etc suffer losses due to inflation.

The trend of inflation in India in the past two years has been fluctuating up and down constantly
but with small differences. Thus the government needs to adopt appropriate measures by which
the country can reach the desirable rate of inflation.

Inflation is a long term phenomenon, a result of rapid economic growth, rising incomes of a
youthful population, stagnating agricultural production and supply capacity falling short of
demand. Hence, it is imperatives to moderate inflationary pressures and absorb the price shocks
before they hit the real economy. Monetary management and fiscal policies such as price
controls and quantitative restrictions can only prove to be effective as short term solutions.

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 BIBLIOGRAPHY

 Books:
1. Gupta, G. S. (2008). Macroeconomics Theory and Applications. (3 ed.). New Delhi:
Tata McGraw-Hill Publishing Company Limited.
2. Jhingan, M. L. (2004). Monetary Economics. (6 ed.). Delhi: Vrinda Publications.
3. Nordhaus, S. (2005). Economics. (18 ed.). New Delhi: Tata McGraw-Hill Publishing
Company Limited.

 Websites:
1. Goyal, R. (n.d.). What is Inflation, Deflation, Stagflation, Hyperflation. Retrieved
March 11, 2014, from http://www.allbankingsolutions.com/Banking-
Tutor/Inflation.htm
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city.blogspot.com/2011/07/types-of-inflation-in-economics-with.html
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http://economics.about.com/cs/money/a/inflation_terms.htm
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12/echap-01.pdf
6. (n.d.). Retrieved from
http://shreeprakashan.com/Documents/20128271919583.9.Ms. Poonam.pdf
7. What is cost-push theory. (n.d.). Retrieved from
http://www.chacha.com/question/what-is-the-cost-push-theory
8. The effect of inflation on different groups of society. (n.d.). Retrieved from
http://www.preservearticles.com/2011092213869/the-effects-of-inflation-on-
different-groups-of-society-are-as-follows.html

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