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All you need to know about Inflation in India Research Team | Posted On Wednesday, September 25,2019, 06:23 PM

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All you need to know about Inflation in India



All you need to know about Inflation in India

Do you still get nightmares which keep you awake at night? Do you see yourself being trampled by a herd of buffaloes? Yes, inflation represents that herd of buffaloes. Inflation has this knack of creeping up suddenly on you when you least expect it.

Inflation causes massive damage to ones investments. Before one realizes all ones wealth is eroded. One has surely heard the proverb "There’s No Time Like The Present". If one wants to beat inflation one has to prepare for it.

One has to start by reading up the financial instruments which help you to beat inflation. If one were to study the current state of the economy one notices a policy paralysis in the government. There is no decisive push being given to the economy. Most of the industrial sectors are in stagnation. Retail inflation is peaking. Our Current Account Deficits are reaching very high levels. All this means that your returns need to grow at a faster rate than inflation.

Care to know which instruments help you to beat inflation? I would like to remind you that the team of Financial Planners at are always there for you to plan your financial needs in a most effective and efficient manner. You can explore this unique Free Advisory Service just by giving a missed call on 022 6181 6111.

Is Gold A Hedge Against Inflation?

Gold for centuries has been used as a hedge against inflation. Even in ancient times in almost all parts of the world gold could purchase food, clothing, shelter and a fair measure of luxury. Even today gold continues to maintain its luster. It certainly commands a premium. So Why Is Gold A Safe Haven In Times Of Inflation? 

When inflation goes up the price of gold goes up. Gold Beats Inflation. The precious metals of silver and platinum are commodities with industrial applications. Gold is a stored commodity. Its values likes locked up in safes and households in Asian countries particularly India where greed for this precious metal continues unabashed. Gold does not get tarnished. Gold mined thousands of years ago is no different in quality than gold mined today.

Gold is known to follow the price movement of oil. When the price of oil shoots up so does gold. Gold is heavily traded in US Dollars. Any decline in the value of the dollar leads to a rise in the price of gold. As the dollar gains in value against the rupee gold price in India increases. A depreciating rupee leads to a rise in gold prices as we import huge quantities of gold.

Gold not only served as a hedge against inflation but also generated stupendous rates of return. The US Dollar is the Worlds reserve currency and is stored in Central Banks across the World particularly in Asian countries of Japan, China, South Korea, and Philippines. The reserves of Japan and China are over a trillion dollars each.

Any decrease in the value of the dollar causes the price of gold to shoot up and as the US Dollar is no longer backed by gold it tends to be a fancy paper. Gold mining across the world is in a decline. Demand in countries like China and India is far more than the mined supply of gold. This demand of gold helps to maintain the value and the price of gold.

The price of gold is immune to scandals and stock market crashes and even if it loses its value in the short term one can expect gold to regain its value as it has done for centuries. Another important point to be noted is the price movement of gold in the opposite direction to stocks and equity. The movement of gold is negatively correlated to stocks. This means that gold functions as an important diversifier of one’s portfolio.

One needs to see that at least 20% of one’s portfolio is allocated to gold. One can use the SIP route to invest in Gold ETF’s in India thereby purchasing gold for the long term. The depreciation in the value of the rupee vis-à-vis the dollar as well as the legendary Indian appetite for gold should more or less guarantee a good return in the long term and a bull run for gold.

Are Equities A Boon Or a Bane Against Inflation?

Currently one notices that apart from select IT Stocks and the Pharma segment most of the stocks especially banking stocks have been heavily beaten down. So When Is The Best Time To Enter The Stock Market? Should You Try To Time The Market? 

One of the safest methods to enter the stock market is the SIP route. One gets more number of shares when the market is in a downward trend and when the markets are peaking lesser number of shares are obtained. However in this case one needs to note one’s capabilities when choosing whether to invest directly in the equity market by directly purchasing shares or invest through equity mutual funds.

Both these methods have their own advantages and since equity mutual funds are managed by a fund manager they are safer for the people who are new to investing in stocks and provide a measure of protection. One needs to invest in equity diversified mutual funds as they invest in different categories and different sectors of stocks and provide a measure of safety.

However one needs to stay invested for long periods of time. Try to maintain a 10 year investment horizon. Over a long term, equities yield returns as high as 20%. Clearly this is an inflation beater. However, it would be wise to shift a portion of your equity into debt after you get phenomenally high returns in equity.

Why Are Equity Instruments Feared In India?

Investors in equity in India are a careful lot. A large number of investors in India especially in direct equity have shifted to debt instruments in the past few years. So Why Does This Happen? A number of investors have burnt their fingers in the stock market in the past few years and do not want to have anything to do with the stock markets.

Investors invest for a short period of time pocket 10-15% rate of return and then exit quickly. They do not like to stay invested in the market. They shift their returns into debt instruments as a safety measure. In India profit booking is the sole reason people invest in the markets in order to cash out their existing losses. By the time they make a decision to invest the market has risen to very high levels.

Most of the Indian Investors are play safe or risk averse investors who want to cash in on a quick profit. Indians first focus on real estate and gold purchases. Equity comes later. Most of us Indians invest heavily in savings with a percentage as high as 26%. Most of this is parked in savings bank accounts.

However savings bank accounts give returns of around 4% while equity can give returns as high as 20% in some cases. However it would be wise to remember not to invest your livelihood in stocks. Invest only the excess amounts or surplus cash in stocks in order to tap in the benefits these instruments yield.

I would like to end this article with the famous saying "Insanity Is Doing the Same Thing Over And Over Again but Expecting a Different Set of Results". Always study Inflation so that you know which financial instruments help you to beat inflation. This would help you to maximize your returns in the long run.

How Inflation Can Play Havoc with Your Savings?

One must have surely heard the famous quote "Inflation is a Painless Disease with a Cure that Hurts.” One has surely gone to the theatre in the last few weeks. The tickets are priced in the range of INR 200-INR 300.

What was the price of a movie ticket about 5 years ago? Let us consider the price of vegetables and fruits especially apples in the local market of your city. The vendors quote a ridiculously high price of INR 200 Rupees per Kilo. One must have surely heard from one’s parents and grandparents the cost of fruits, vegetables, fish and other products in their youthful days.

It must have been a few rupees in your parent’s time and a few paisa’s in your grandfather’s time. So What Led To The Ridiculously High Current Prices Of All These Items? Your Dad’s salary must have been a few Hundred Rupees about 35 Years ago and now is close to a Lakh of Rupees. Yet Money Never Seems To Be Enough.

I spent a few hundred Rupees as fees during my schooling days. Nowadays schooling in a city like Bangalore costs INR 50000 for a student who is in the first standard. Mind Numbing Isn’t It? Do Your Salaries Match Such High Standards Set By Inflation? Is it time to ask your Boss for that long pending raise? I would like to remind you that the team of Financial Planners at are always there for you to plan your financial needs in a most effective and efficient manner. You can explore this unique Free Advisory Service just by giving a missed call on 022 6181 6111.

See Also: Inflation Rate in India

What Is The Effect Of Inflation On My Savings?

One notices a general rise in prices of all commodities with the passing of time. This is known as Inflation. Let us consider that one invests INR 10000 in a fixed deposit for a period of one year. The rate offered is 8.5%. After tax rate of return is still lesser that this amount. India’s Wholesale Price Index has galloped to 4.86% for the month of June 2013. Retail inflation is 9.87%.for the month of June 2013. This means that your effective or real rate of return is negative.

This means that even if you park your funds in the bank in a Fixed Deposit you do not gain any value due to the effect of inflation on your investment. I would not even care to compare the returns on the Savings Bank amounts that lie in your account. This means that you are actually losing money on the amounts you invest in your savings bank accounts and the fixed deposits. The central bank of India known as the RBI used to measure the Wholesale Price Index and not the Consumer Price Index which is a truer measure of inflation. One can note the difference in value between the Consumer Price Index which is closer to 10% while the Wholesale Price Index is around 5%. It is the general belief that CPI should be used as it is a true indicator of inflation.

So How Is Inflation Calculated?, What Is The Consumer Price Index?

Let us take note of the Consumer Price Index which is 9.87% for the month of June 2013. This is a measure updated every month. The components include Food, Clothing, Fuel, Housing, Education, Medical, Recreation, Transport, Personal Care, Household Items among others. If one has a look at these components one can easily conclude that these are the items one uses or depends upon in his day to day life.

If one looks at this index and compares this to real life situations what do you notice? As affluence increases in society people shift their eating patterns from cereals to protein-rich foods. There is a general shift mainly noticed in the Southern Regions of India where people shift from eating plain rice to allocating a greater share to pulses such as Soybean, lentils, beans, fish, eggs, and meat in their diet which are rich in proteins.

Protein rich foods are also heavily consumed in the Northern parts of India. This has led to the doubling in prices of Onions in June this year as compared to the previous year. Prices of Wheat and Rice have increased at the rate of 19% and 13% from the previous months. The protein rich foods are soaring with the prices of chicken and fish hitting ridiculously high levels.

The rise in fuel, food and housing has resulted in a general price rise in transport, recreation, education and so on which contributes to the rise in the CPI. The post office workers are sent to collect the primary data mainly in the rural areas. They collect data by using questionnaires from a test sample. They then use Statistical techniques such as simple random sampling, cluster sampling, systematic sampling and homogenous sampling to arrive at the requisite result. Similarly National Sample Survey Organisation collects data from the urban areas. The old CPI had a base year of 1984-1985 for Urban Non Manual Employees and 1986-1987 for agricultural laborers.

So How Is The Consumer Price Index Calculated?

One knows that the Consumer Price Index has a base Year of 2010-2011. This consists of a number of components as explained above. One notices a price increase in all the components of the index over a period of time. Let us consider a base value of 100 in the year 2010-2011.In the year of 2012-2013 owing to a general increase in all prices and components of the index the value changes to 125. However the knowledge of this movement in values alone does not help us. One has to convert it to a percentage. However, if there is too wide a gap between the base year and the current year it would not be a proper representation of the true value. Hence for the year 2013 one would have to replace the base year 2010-2011 by 2011-2012.

See Also: What Is Cost Inflation Index?

[(B)-(A)]/A * 100 Here one has the value of 100 for the base year and A=100 (2010-2011).B=125 (2012-2013).
(125-100) / 100 * 100 =25%.This represents a 25% change in the value of the components of the CPI index over a couple of years.

What Is The Wholesale Price Index?

One notices in the WPI the components include food products and fuel just as in the consumer price index. In addition one notices leather goods, transport equipment, Industrial Machinery, Sugar, Edible Oils, Rubber, Paper Products, Plastics, Chemicals, Iron and Steel, Cement, Wood and so on.WPI is most widely used in India and includes a measure of components used in Industries. Even though this index is widely used CPI gives a true measure of the rise in retail prices in Society. The WPI is updated every week. It uses 435 commodities while calculating inflation. The latest WPI is a measure of prices of components about two weeks back. Housing is not reflected in this index and this cannot be a true measure of inflation in society.

How Is WPI Calculated?

One has the formula (WPI at the end of the year-WPI at the beginning of the year)/ (WPI at the beginning of the year) * 100. Let us assume the WPI value on January 1st 2010 is 130. The value on January 1st 2011 was 142. One has 142-130/130 * 100 = 9.2%.Thus one can say the inflation for the Year 2011 was 9.2%.

Inflation-Indexed Bonds A Solution To This Problem?

RBI has just released the WPI data for the month of June 2013. This value is 4.86%. But does this value represent the true prices of the month of May 2013. No definitely not?. This may be a reflection of the prices of September 2012 . This data is then interpolated to arrive at an accurate figure for the month of June 2013. A lag is allowed as adjustments due to revision might be necessary as you must have seen on a regular basis in recent years.

Let us see how inflation-indexed bonds work. We have MrRakesh who purchases a 5 year bond of face value INR 100. The coupon rate is 7% per annum. According to this MrRakesh should earn INR 107 inclusive of interest every year. Do you think is it fair if the inflation rate has changed or increased to 8% when the coupon rate is just 7%. One now has Inflation Indexed Bonds in order to resolve this shortfall in returns. However if inflation rate falls then you suffer losses on your investment. Now you will be able to understand more clearly about how inflation-indexed bonds work with the help of the following calculations.

One notices different values of inflation over a 5 year period. As shown in the table the principle as well as interest amount changes according to the inflation rates.

Year 1: Let us consider that inflation rate is 7% as shown in the table. Initially WPI index was 200 which changed to 214.
Principal = issue time principal * (current WPI / WPI index at issue time).
New Principal= 100*(214/200) = 107.
Interest based on the coupon rate =7% of the new principal =7% of 107=INR 7.49.

Year 2: Let us consider that inflation rate is 6% for the following year. So the WPI is 214*106%= 226.84 (6% shown in the table).
New Principal= 100*(226.84/200) = 113.42.
Interest=7% of the new principal =7% of 113.42=INR 7.9394.

In this way one can see the principal and interest goes on increasing and changing as per the inflation rates. If inflation rises as you must have noticed then you will get a higher principal and a higher interest and vice versa.

I would like to end this article with the famous quote " When You Reach The End Of Your Rope Tie A Rope And Hang On ".Never allow inflation to affect your finances and utilize all possible financial instruments to beat inflation.

Interest Rates Effect on Inflation

You might have thought many times that what does these big economists do and how does their decisions affect us…..? So this time we are trying to take you through some of the main concepts of economic policies and the affects of those on each of us the so called “AamAadmi”. So basically there are two kinds of economic policies taken by a Govt. or regulatory bodies, such as Monetary and Fiscal policies.

Monetary policies are those which a central bank or government of a country takes to keep a control on demand and supply of money with an objective of attaining growth and stability of the economy.

Recently RBI the central Bank of India announced its monetary policies. Before going into the reasons and impacts of that, let us understand what policy rates are and what is the impact they can directly have on other rates like home loanspersonal loans and lending rates…?

What Does Policy Rates Mean?

In simple words Policy rates are the monetary tools of RBI (Reserve Bank of India) which it uses to control the money supply in the country, determining and maintaining day to day liquidity in the system and to determine other bank rates. Some of the key Policy rates are given below;

  • Cash Reserve Ratio (CRR)
  • Repo Rates
  • Reverse Repo Rates

Cash Reserve Ratio (CRR)

All the banks have to maintain a certain percentage of cash deposits with RBI that amount of funds are called Cash Reserve Ratio (CRR). Increase in the rate of CRR means Banks have to park more money with RBI and the funds available with banks will come down. RBI increases the rate to pull out excessive money from the banks and to maintain a balance.

Repo Rates

This is the rate at which Banks borrows money from RBI. It’s the lending rate of the central bank. So if the Central bank increases the Repo rate it is not good news for banks as they have to borrow money at a high cost. This compels banks to increase their lending rates as they get money at high rates.

Reverse Repo Rates

Reverse Repo rate is the opposite of repo rate. It means the rate at which RBI borrows funds from the banks. If RBI increases this rate its good for the banks as they get higher returns by lending money to RBI. So these are the basic policy rates which are very crucial not only for the economy but also for a common man because who is going to be effected ultimately.

Recent Increase in the Policy Rates

Recently RBI has hiked CRR by 25 basis points, Repo rate by 25 basis points and Reversed Repo Rate also by 25 basis points. Due to this move by RBI 12500 crore of excess funds will be pulled out of the Economy. But this move has raised our eyebrows as on the one hand country is facing inflationatory pressure and on the other hand economic recovery is under way. So how effective is this move, we all have to wait and watch.

Trends of Repo and Reverse Repo rates


Reverse Repo Rate

Repo Rate

November 2008



December 2008



January 2009



March 2009



April 2009



March 2010



April 2010



What is the Reason for Increase in Rates?

The first reason to increase rates is to tame inflation. You can see the rising trend in the Inflation in India, so to control this RBI has taken this step.

The second reason is to pull out money from the system- As the recent data on Industrial Production and Growth shows that Economy is on the recovery path and system has enough liquidity with good credit growth backup so according to RBI it is the right time for normalization of monetary policy.

What are the Impacts of Rate Hikes?

As on the macroeconomic front, we have discussed a lot but now its time to see how a common man will get affected from this move of RBI.

  • Impact on Home loans
  • Impact on your loan installments
  • Impact on Car loans
  • Impact on inflation

Impact on Home loans

As we saw after the hike in rates in March, many banks have hiked the interest rates for home loans. The trend will remain the same and shortly we can see a hike in interest rates on the bank Home Loans.

See Also: Impact Of Increasing Repo Rates

Impact on your loan installments

RBI has decided to follow tight monetary measures and increased the rates; rate hikes will have an adverse impact on the long term payments of the loans as it may affect your monthly installments (EMI).

For example; If you have a loan of 50lacs for 20 years your repayment may go up by nearly 10 lakhs if the rate goes up by 1 percentage. So you can think of the impact of mere rate hikes in long term.

Impact on Car loans

If you are planning to buy a new car it is not the right time to do so. There are two reasons first is the impose of excise duty by Government in budget and other reason being the recent hikes in interests on car loans by the lenders. They have increased the rate by 75 to 100 basis points.

But on the contrarily it can be the best time for buying a Car as the interests are going to be high in the near future.

Impact on Inflation

In the figure, we can see how inflation has raised from negative to near double digits. As the rate hikes are lower compared to the high level of inflation so the question arises will this hike be able to make any impact on the inflation?

The hike is basically to strike a balance between growth and inflation. Although this move will curb inflation but the current inflation is dependent on various other factors as such monsoon, food inflation, crude oil price and state of the global economy.

Will This Have Any Effect on the Investments?

As system still has enough liquidity, rate hike will not have any adverse effect on the investment part. In addition to liquidity the credit availability is good for the retail investors. So this rate hikes will take money out but still the investments will not be affected in short run.

We have already discussed the reasons, trends, and impact of Policy rates of RBI on economy and the common man. But what should one do in near future considering the state of economy and policies of the RBI. It is very much clear that this move is the normalization of monitory policy, not tightening of it. So you have to keep in mind that interest rates are going to be on the rising trends and consider this as an opportunity to get home loans and car loans as the rates will go up in the future.

In my previous article on inflation, I discussed the causes and effects of inflation and how the central bank uses its tools to influence inflation. In this article, I will discuss the rising inflation situation in India in 2008 and how RBI and central government responded to control it.

You may remember that the main culprits of inflation last year were:
1. Higher crude prices – Due to the rapid growth of global economy in 2007 and early 2008 there was a huge demand for crude. Also, when the stock market started showing weaknesses across the globe, investors started parking their money in commodities such as Crude.
2. Supply constraint – Unprecedented drought in Australia and some part of the Americas caused shortage of food grains in the global market. India too had a very bad production year and we had to import grains from the global market. This led to an increase in general increase in food grains prices.
3. Excess liquidity – High growth in emerging economies like India attracted huge amount of foreign capital. A situation like too much money chasing too few goods lead to inflation. This exactly what happened in India.

Why does rise in crude price lead to inflation?
Let us begin with a brief discussion on crude prices. It is an extremely important commodity which affects our day to day life in some form or other. Crude prices gave sleepless nights to almost everyone on this planet. Governments across the world were busy thinking how to tame inflation which resulted from crude prices.

This indicates that the crude price directly affects the inflation. I have done a comparative analysis of increase in crude price and inflation to figure this out.

You can see the graphs for crude oil prices and inflation rate almost mirrors itself. Would it be safe to assume that crude influences inflation to a great extent? Well to a great extent YES. The crude price is an extremely important part of inflation calculation whether it is based on CPI or WPI. If we see the table below, fuel has over 10% weight in the WPI index, which is used to calculate inflation in India. Moreover, the change of fuel prices affects almost every goods and services in India because it increases transportation costs, cost of production for manufacturing and utilities prices. Thus, any change in fuel price affects inflation.

Major Group/Group

Base Year 1993-94


Weights in WPI (%)


All Commodities








Primary Articles




Food Articles




Non-food Articles












Fuel, Power, Light & Lubricants








Manufactured Products




Food Products




Beverages, Tobacco & Tobacco Products








Wood & Wood Products




Paper & Paper Products




Leather & Leather Products




Rubber & Plastic Products




Chemicals & Chemical Products




Non-Metallic Mineral Products




Basic Metals. Alloys & Metals Products



Machinery & Machine Tools




Transport Equipments &Parts




Other Misc. Manufacturing Industries*



Chronology of Inflation in FY 2008


Inflation Rate


RBI Measures



Rising prices of fruits and vegetables, pulses, cereals, condiment and spices and some manufactured items such as sugar and ground nut oil.

RBI increased CRR by 0.5% to 8%. The hike will come into effect in two tranches on April 26 and May 10.

RBI increased rates to tighten money supply in the economy to control rising inflation.



Higher prices of food items, including jaggery and fish.



Higher prices of food articles like rice, milk, tea, vegetables and some manufactured products. Also, prices of Light Diesel Oil and furnace oil went up.



Prices of tea, fruits, vegetables, spices and fishes increased. Also cement and aluminum prices rose.



Prices of essential food items such as coffee and maize and some manufactured products increased.



Rising prices of fruits and vegetables, pulses, spices and some industrial fuels.

RBI raised Cash Reserve Ratio by 0.25 per cent to 8.25 per cent on May 24. The CRR was raised to remove additional money from the market to check inflation.



Cereals, eggs, meat, fish, imported edible oil, paper and paper products, chemical, machinery and automobile parts turned expensive.




Rising prices of food articles and vegetables as well as increase in domestic fuel prices.




Sharp increase in fuel and cooking gas prices as well as food prices.




Higher prices of food articles including milk, cereals, tea, edible oils and some manufactured items like soaps and detergents.

RBI increased CRR by a steep 50 basis points. This hike took effect in two stages. First, a 25 basis point hike on July 5, and another 25 basis point hike on July 19. By July 19, CRR stood at 8.75%.

RBI also hiked the repo rate by 50 basis points, which was effective immediately.



Increase in prices of fruits, vegetables, imported edible oils, tea, sea fish, cement and iron and steel and spices.



Higher prices of essential food items such as mustard oil and some manufactured products such as cement and edible oils.



Prices of pulses, fruits and spices, and some manufactured products items.

RBI raised short-term lending rate, Repo, by 0.50 per cent from 8.5% to 9% and mandatory deposit requirements for banks, CRR, by 0.25% to 9% with effect from the fortnight beginning August 30, 2008.



Prices of pulses, spices, eggs, fish, and meat among other things continued to rise.



Price of major food items such as pulses, spices, fish and meat went up.



Rise in prices of food items like fruits, vegetables, and milk. Prices of cement and tea rise as well.



Prices of food items falls.



Lower prices of food items like fruits, vegetables, and milk.




Lower prices of food items like fruits, vegetables, and milk.








Prices of essential items like cereals, pulses, sugar, and edible oils declined




Some food items turned cheaper

RBI reduced CRR by 50 bp (i.e. 0.5%) to 8.5% on October 6




RBI reduced CRR again by 100 bp (i.e. 1%) to 7.5%



Decline in oil prices and manufactured goods.




Lower prices of food, non-food items, and metals such as lead and zinc.

RBI announced a reduction in the repo rate by 100 basis points from 9.0 to 8.0% on Oct 20



Lower interest rates, Decline in prices of manufactured goods and crude.

RBI reduced the repo rate by 50 basis points to 7.5 percent. CRR is reduced by 100 basis points from 6.5% to 5.5%. It was affected in two stages: by 50 basis points retrospectively with effect from the fortnight beginning October 25, and by a further 50 basis points prospectively with effect from the fortnight beginning November 8, 2008. RBI has also lowered the statutory liquidity ratio (SLR) by 100 basis points to 24 per cent






Fall in prices of crude oil, metals and other manufactured items.




Decline in the prices of metals, fruits and some manufactured items such as imported edible oil and rubber.




Sharpe decline in commodity prices such as fuel and steel and food items.




Decline in the prices of fruits and vegetables.

RBI further announced rates cut. The short-term lending rate (repo) will fall from 7.5% to 6.5% and borrowing (reverse repo) rate to 5%. CRR remained same.



Reduction in fuel prices, cement prices, food items, and manufactured goods.




Reduction in fuel prices, food items and excise duty announced by the government on December 7.

CRR cut by 50bp from 5.5% to 5%. Repo rate was reduced by 100bp to 5.5% while reverse repo rate was down to 4%.



Cheaper food and manufactured items.




Decline in prices of food articles, crude oil, and manufactured goods.




Higher prices of edible items like fruits and vegetables, caused mainly due to the truckers' strike.




Rising prices of food items, jet fuel and alcohol (Truckers strike)




Prices of fruit and vegetables and manufactured goods falls


Table: Inflation table for the year 2008

Inflation - its causes and effects on the economy

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Inflation can also be described as a decline in the real value of money—a loss of purchasing power in the medium of exchange which is also the monetary unit of account and the monetary store of wealth. When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time.

When I was a kid my grandparents used to tell me – “Son, in our time we use to take money (paisa) in pockets and carry goods to home in bags. But at your age, you will carry money (rupees) in bags and carry goods to home in your pocket”. He was so right! This is inflation –which reduces the purchasing power of common man.

Measuring Inflation

In major economies, inflation is measured by CPI, which is Consumer Price Index. CPI is a measure of the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation. Two basic types of data are needed to construct the CPI: price data and weighting data.

The price data are collected for a sample of goods and services from a sample of sales outlets in a sample of locations for a sample of times. The weighting data are estimates of the shares of the different types of expenditure as fractions of the total expenditure covered by the index. These weights are usually based upon expenditure data obtained for sampled periods from a sample of households.

In other words, Inflation is calculated as percentage change in CPI in two periods. Hence,
Inflation (%) = (CPI2- CPI1)*100/CPI1

Where, CPI1 = CPI in the previous period and CPI2 = CPI in the current period

India uses a different price index called the Wholesale Price Index (WPI) to calculate the rate of inflation in our economy. It is quite similar to Consumer Price Index, but uses whole sale prices instead of retail consumer prices. WPI is the index used to measure changes in the average price levels in the wholesale market. Data on 435 commodities are tracked through WPI, in India, which is an indicator of movement in prices. I share the common view of other economists who believe WPI, as a measure of inflation, is flawed. India should switch to CPI, which has been adopted by most developed countries.

There are several other ways of measuring inflation as well. They are GDP price deflator, Producer Price Indices, and Commodity Price Indices. However, they are not commonly used.

Flaws of WPI

Former RBI governor once explained why India does not use CPI as a measure of inflation. The CPI data is not released as frequently as WPI data. WPI data is released almost weekly and sometimes at most biweekly, where as CPI data is released once in a month. There is also a lot of lag in collating all the CPI data.

There is another problem with the CPI data in India. We don’t have a single CPI data, but four different CPI figures relating to agriculture goods, urban manual labor and non-urban labor etc. There is no discipline in when these different figures are released and with what frequency. So the government of India has a genuine reason in not going for CPI based inflation.

WPI based calculation is full of flaws. WPI is supposed to measure impact of prices on business. But we use it to measure the impact on consumers. The WPI that was constituted in 1993-94 has virtually remained unchanged since then, and it has lost quite a bit of its relevance while calculating inflation. Some of the WPI commodities include coarse grains that go into making of livestock feed but they continue to be considered while measuring inflation. The sole reason why many unimportant commodities continue to remain included is possibly because data on their prices was available!

Causes of Inflation

Let’s get back to our discussion on the fundamentals of inflation. Economists believe that inflation is a monetary phenomenon. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices, and interest rates.

1. Over-expansion of money supply i.e. excess liquidity in the economy leads to inflation because “too many money would be chasing too few goods”.

2. Expansion of Bank Credit Rapid expansion of bank credit is also responsible for the inflationary trend in a country.

3. Deficit Financing: The high doses of deficit financing which may cause reckless spending, may also contribute to the growth of the inflationary spiral in a country.

4. A high population growth leads to increase in demand and money income and cause a high price rise.

5. Excessive increase in the price of fuel or food products due to political, economic or natural reasons will lead to inflation for short- as well as long-term.

For example – We all remember that price of crude went up from $50 to $140 within two years. Almost every industry including agriculture, transportation, and manufacturing depends on crude for its operation. Any excessive increase in the price of crude leads to increase in cost of good and services i.e. inflation.

Another example – China and India consist of almost 34% of the world’s population. As the economy in these two countries are growing at a rate of over 9%, people are consuming more and more goods due to increased income and better life. Demand for those goods and services has led to a high inflationary environment in these countries.

States of Inflation

There are different states of inflation which is characterized based on its value as well as variation from the previous value.

1. Hyperinflation – It is a very high rate of inflation, usually a rate in excess of 50%. History has some excellent examples of hyperinflation. In Germany, inflation exceeded 1 million % in 1923. It was said that a horse cart full of money would not buy even a newspaper. Right now, Zimbabwe is having an inflation of 1 million %. They have to issue currency of $500 Million dollar (I am not kidding!!) which could only buy a lunch at McDonalds.

2. Deflation – It is the decrease in the general price level of goods and services only when annual inflation is below 0% resulting in the real value of money. Hence, it is sometimes called “negative inflation”. Japan suffered from deflation for almost a decade in 1990s. To control recession and Central Bank of Japan was forced to have a negative interest rate on deposit for over a decade.

3. Disinflation – It refers to a time when the rate of change of prices is falling while the inflation rate is positive. For example – if the inflation rate comes down from 3% to 2%, we would say it is disinflation. In India, we have a disinflation because inflation has come down from a high of 13% to 6% and it is still dropping.

4. Stagflation – It is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time. Stagflation can result when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.

Effects of Inflation on economy

As we know Inflation is the increase in the price of general goods and service. Thus, food, commodities, and other services become expensive for consumption. Inflation can cause both short-term and long-term damages to the economy; most importantly it causes slow down in the economy.

1. People start consuming or buying less of these goods and services as their income is limited. This leads to slowdown not only in consumption but also production. This is because manufactures will produce fewer goods due to high costs and anticipated lower demand.

2. Banks will increase interest rates as inflation increases otherwise real interest rate will be negative. (Real interest ~ Nominal interest rate – inflation). This makes borrowing costs for both consumers and corporate. Thus people will buy fewer automobiles, houses and other goods. Industries will not borrow money from banks to invest in capacity expansion because borrowing rates are high.

3. Higher interest rates lead to a slowdown in the economy. This leads to an increase in unemployment because companies start focusing on cost cutting and reduce hiring. Remember Jet Airways lay off over 1000 employees to save cost.

4. Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation.

5. Inflation affects the productivity of companies. They add inefficiencies in the market and make it difficult for companies to budget or 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.

Inflation Targeting

There are various ways of controlling inflation in an economy. We’ll discuss two main ways of doing so:

Monetary Policy

The most important and commonly used method is monetary policy. Most central banks use high-interest rates and slow growth of the money supply as the traditional ways to fight or prevent inflation. RBI raised CRR, Repo rate and Reverse repo rate to reduce money supply in the economy to fight inflation which was hovering in double-digit. High-interest rates make borrowing expensive and hence, people as well as corporate borrow less money from banks. This reduced the demand for goods and services such as real estate, automobiles, and others.

Fixed Interest Rate

We know high inflation reduces the value of money. A number of smaller countries who do not have a sophisticated banking system rely on tying their currency with that of a developed country. Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-à-vis the currency it is pegged to.

Government Measures
Apart from these two broad methods, the government takes some protectionist measures as well to fight inflation. The government may ban the export of essential items such as pulses, cereals, and oils to support the domestic consumption and hence reduced their prices. Also, the government may lower duties on the import of similar items which are having less supply in the economy.

Positive side of inflation
You may be wondering how come inflation is good for the economy. A little bit of inflation is not a bad thing. It implies the possibility of higher prices and profits in the future. To the worker, a little bit of inflation may imply rising wages in the future. What we are trying to say is that they are based more on “psychology” than “economics”.

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