The Hindu Editorial Analysis- 23rd May 2024 | Current Affairs & Hindu Analysis: Daily, Weekly & Monthly - UPSC PDF Download

A Vegetable Triumvirate, Inflation and the Takeaway 

Why in News?

Inflation is a critical indicator of an economy’s health, reflecting the changes in the general price level and the cost of living. In India, the Consumer Price Index (CPI) is used to measure price inflation which is largely based on the Laspeyre’s price index and measures the economy’s cost of living. The CPI basket comprises 299 items of which vegetables account for a weight of 6.04% in the total basket.

Inflation

• Inflation signifies a reduction in the purchasing power of a country's currency and is typically measured in percentages.
• It is classified into three main types: Demand-pull, Cost-pull, and Built-in.
• The primary inflation indexes used are the Consumer Price Index (CPI) and Wholesale Price Index (WPI).
• Inflation gauges the average price fluctuation in a collection of goods and services over time. Conversely, a rare decline in the price index of this collection is known as "Deflation."

Further Insight into Inflation

• Inflation, as a concept, points to the erosion of a currency's purchasing power within a nation, denoted in percentage terms.
• Its classification into Demand-pull, Cost-pull, and Built-in types helps in understanding the diverse causes behind rising prices.
• The widely used Consumer Price Index (CPI) and Wholesale Price Index (WPI) serve as essential tools for monitoring inflationary trends.
• By tracking changes in the price levels of goods and services over time, inflation provides a snapshot of economic health. Conversely, deflation, representing a decrease in this price index, poses distinct challenges.

What is Inflation?

Inflation refers to the general increase in the price levels of goods and services within an economy over time. Essentially, when inflation occurs, each unit of currency can purchase fewer goods and services. This results in a decrease in the purchasing power of money. In simpler terms, inflation signifies a reduction in the value of money as prices rise. According to Crowther, inflation represents a scenario where the value of money diminishes while prices escalate.

Advantages

• Slow inflation contributes positively to economic growth. It is considered favorable compared to deflation since it helps in avoiding recessions.
• Inflation allows for a smoother adjustment of prices within the economy.
• It facilitates the adjustment of real wages, ensuring that wages keep pace with the rising price levels.

Disadvantages

• May lead to uncertainty and lower investments
• Higher rate of inflation can lead to lower growth and instability
• Reduces international competitiveness
• Distorts the planning process
• May also give rise to speculative investment
• May result in a decline in the value of savings
• May lead to inequality in the income distribution

Types of Inflation

The three types of inflation are demand-pull, cost-pull, and hyperinflation. Let's explore each of them:

Demand-pull

• Takes place when total demand grows at an unsustainable rate, creating pressure on scarce resources and a positive output gap.
• Excess demand prompts producers to raise prices for higher profits, leading to a situation of "too much purchasing power chasing too few goods."

Here is an example to illustrate demand-pull inflation:

• Imagine a scenario where consumers suddenly have more disposable income due to a tax cut. As a result, they start buying more goods and services, driving up the demand. However, if the economy cannot keep up with this increased demand, prices will rise.

Causes

• Declined exchange rate of the country’s currency: This leads to higher prices of imports and lower prices of a country’s exports, affecting the trade balance.
• Higher government spending: Increased government expenditure boosts the money supply, fostering additional demand in the economy.
• Lower tax rate: When direct taxes are decreased, consumers have more disposable income, driving up demand for goods and services.
• Loose monetary policy: A central bank's lenient monetary approach, resulting in lower interest rates, may spur excessive demand, potentially leading to inflationary pressures.
• Increase in standard of living: Enhanced living standards often correlate with a heightened demand for products associated with a better quality of life.

Causes of Cost-Push Inflation

Decline in the Exchange Rate

• When the country's currency depreciates, prices of imported goods rise.
• This leads to increased costs for materials, components, and finished products.

Higher Tax Rate

• An increase in direct taxes results in higher prices for final goods.
• Every product is charged a certain tax rate, contributing to inflation.

Increase in Labor Cost

• Low unemployment rates can push up wages as skilled workers become scarce.
• This situation prompts higher pay levels, adding to production costs.

Component Costs

• Rising prices of raw materials and components drive cost-push inflation.
• Commodity price hikes, like oil and agricultural products, impact manufacturing costs.

Tight Monetary Policy

• Under a tight monetary policy, borrowing costs increase for businesses.
• This results in higher expenses for firms, contributing to cost-push inflation.

Hyperinflation

Hyperinflation refers to a situation where prices increase rapidly as a currency loses its value. This extreme form of inflation can have devastating effects on an economy, leading to a loss of confidence in the currency and severe economic instability.

Causes of Hyperinflation

Excessive Money Supply and Hyperinflation

• Excessive money supply can lead to hyperinflation if not supported by economic growth, typically measured by the GDP (gross domestic product).
• Hyperinflation often arises when there is a significant loss of trust in a country's financial system and doubts about the central bank's capacity to uphold the value of its currency.

Explanation:

• When a country's money supply grows rapidly without a proportional increase in economic output, prices tend to rise uncontrollably, causing hyperinflation.
• This scenario can occur when people start losing faith in the stability of the financial institutions and their ability to ensure the purchasing power of the currency.

Examples:

• In Zimbabwe during the late 2000s, the government excessively printed money leading to hyperinflation. Prices were doubling every day, and the currency lost its value rapidly.
• Venezuela is another example where hyperinflation occurred due to a combination of factors such as economic mismanagement and political instability, resulting in citizens needing stacks of cash just to buy basic goods.

How is Inflation Measured?

Inflation measurement is crucial for understanding economic trends. Here's how it is calculated:

• Consumer Price Index (CPI)
• Wholesale Price Index (WPI)

Both CPI and WPI play significant roles in measuring inflation. Here's how they are utilized:

• CPI is used to measure inflation. The rate of inflation is the difference between the WPI calculated at the start and end of a year.
• WPI is computed by the Ministry of Commerce & Industry using the formula: (WPI of end of year - WPI of beginning of year) / WPI of beginning of year x 100.

Understanding these measures is essential for economists, policymakers, and businesses to gauge economic health accurately.

How to Control Inflation?

Now, let's examine various methods to manage and control inflation effectively:

• Monetary Policy

• The Central Bank has the authority to adjust interest rates, making borrowing more costly and saving more appealing. This strategy aims to restrict the growth of consumer spending while encouraging investments.

• Controlling Money Supply

• Many nations implement an inflation target as part of their monetary policy. When the public perceives this target as reliable, it helps to diminish inflation expectations, fostering controlled inflation.

• Fiscal Policy

• Governments can raise taxes and reduce spending to enhance their budgetary position and dampen demand within the economy. These actions collectively work towards curbing inflation by moderating total demand growth.

• Wage Control

• If inflation stems from wage increases, constraining wage growth can be instrumental in managing inflation. Limiting wage escalation assists in combating cost-push inflation and mitigating demand-pull inflation pressures.

• Supply-side policies

Inflation can often be triggered by a lack of competitiveness and increasing costs of raw materials. Employing supply-side policies can enhance a country's competitiveness and aid in managing inflationary pressures.

Other methods to control inflation are:

Other methods to control inflation are:

• Increasing population
• Implementing a rational-wage policy
• Enforcing price controls
• Implementing rationing
• Importing high-demand commodities
• Regulating hoarding and speculation
• Reducing exports

Effects of Inflation

• Creditors & Debtors

  Creditors are negatively impacted while debtors benefit during inflation. This is because debts are typically fixed in terms of the currency. When debtors repay their debts, the real value of the repayment decreases due to the increase in the price level. As a result, creditors experience a loss in monetary terms.

• Bond & Debenture Holders

  Individuals holding bonds and debentures receive fixed interest payments. As inflation rises, these individuals experience a decrease in their real income because the purchasing power of their fixed interest income diminishes with the increase in prices.

• Investors

  During inflation, individuals who invest in shares are likely to benefit. This is because the potential for earning profits from businesses increases as prices rise.

• Salaried Individuals & Wage-Earners

  People with fixed incomes, such as salaried individuals and wage-earners, are adversely affected by inflation. This leads to a decline in the real purchasing power of their fixed incomes as prices increase.

• Profit-Earners, Speculators, Black Marketers

  Profits generally increase during inflation as businesses raise prices, resulting in higher profitability. This is particularly advantageous for profit-earners, speculators, and black marketers who exploit the price hikes to enhance their gains.

Recent Trends in Inflation in India

• India's Economic Downturn:

  India faced a significant economic downturn in the first quarter of 2020-21, with a staggering -23.9% contraction, marking one of the most severe contractions globally.

• Projections for Real GDP Growth:

  Forecasts for India's real GDP growth in 2020-21 vary, ranging from -5.8% according to the RBI's Survey of Professional Forecasters to -14.8% as projected by Goldman Sachs.

• OECD's Contraction Prediction:

  The Organisation for Economic Cooperation and Development (OECD) has forecasted a 10.2% contraction in the Indian economy for the financial year 2021.

• Contraction in Nominal GDP Growth:

  Annual projections indicate a high probability of a contraction even in nominal GDP growth for the year 2020-21.

UPSC Civil Services Examination, Previous Year Question (PYQ)

Prelims

Q 1. The lowering of Bank Rate by the Reserve Bank of India leads to (2011)

(A) More liquidity in the market
(B) Less liquidity in the market
(C) No change in the liquidity in the market
(D) Mobilization of more deposits by commercial banks

Ans: A

Q.2 Consider the following statements: (2020)

1. The weightage of food in Consumer Price Index (CPI) is higher than that in Wholesale Price Index (WPI).
2. The WPI does not capture changes in the prices of services, which CPI does.
3. Reserve Bank of India has now adopted WPI as its key measure of inflation and to decide on changing the key policy rates.

Which of the statements given above is/are correct?

(a) 1 and 2 only
(b) 2 only
(c) 3 only
(d) 1, 2 and 3

Ans: (a)

Q 3. If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do? (2020)

1. Cut and optimize the Statutory Liquidity Ratio
2. Increase the Marginal Standing Facility Rate
3. Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below:

(A) 1 and 2 only
(B) 2 only
(C) 1 and 3 only
(D) 1, 2 and 3

Ans: B