ICAI Notes 6.5 - Inflation | Business Economics for CA Foundation PDF Download

Learning Objectives

•  understand the meaning of inflation.
• know various types of inflation.
• understand how prices have moved in India.
• know the general causes behind inflation in India.
• know the measures taken by the government to control inflation in India.

5.0 MEANING AND TYPES OF INFLATION

Inflation refers to a persistent upward movement in the general price level. It results in a decline of the purchasing power. According to most economists inflation does not occur until price increase averages less than 5% per year for a sustained period. Inflation can broadly be of the following types:

(i) Demand-pull inflation : In a market there is interaction between the flow of money and flow of goods and services. When more money chases relatively less quantity of goods and services the excess of demand relative to supply pushes up the prices of goods and services. Such inflation, as a result of increased money expenditure, is called demand-pull inflation. In other words, when demand for goods and services is more than their supply, their prices rise. Such price rise is called demand pull inflation.

(ii) Cost-push inflation : Cost push inflation refers to a situation where prices persistently rise because of growing factor costs. Cost push inflation results when factors of production especially wage earners try to increase their share of the total product by raising their prices. A rise in factor prices leads to a rise in the total cost of production and consequently a rise in the price level. This may result in an inflationary spiral. Inflation once set in motion due to phenomenon of cost push in one industry or sector spreads throughout the economy. For example, due to rise in wages in the steel industry, prices of steel may rise and this will raise the prices of vehicles, machines, etc., using steel as input. The rise in prices of vehicles may in turn raise the cost of transport and manufactured goods. The cost of agriculture may also rise due to high prices of tractors. Ultimately, food and raw material prices will also go up leading to higher cost of living. Higher cost of living will further push wage rates. Cost push inflation is much more difficult to control than demand pull inflation. This is because cost push inflation is not susceptible to direct control. Often the demand pull inflation precedes the cost push inflation. When the former sets in, there is an increasing demand for factors of production; the prices of these also rise, leading to rise in general prices.

(iii) Stagflation : The combined phenomenon of demand-pull and cost-push inflation is found in many countries, both the developed and the developing. One of these situations is in the form of stagflation under which economic stagnation, in the form of a low rate of growth, combines with the rise in general price level. In the developing countries, this happens when aggregate demand increases at a fast rate due to high public expenditure and expansion of credit money organised labour exerts its influence in raising up wages thus combining cost-push effect with the demand pull inflation. Such inflationary situations when unchecked by appropriate monetary and fiscal measures, may lead to galloping or hyper-inflation leading to price increase of even 40% to 100% every year.

Stagflation in India has been interpreted to mean that the economy is growing slowly or stagnating (i.e. GNP is either increasing slowly or remaining constant or even declining) and at the same time experiencing a high rate of inflation. In India during 1991, partly as a result of large budget deficits resulting in rapid expansion in money supply and partly due to supply shocks delivered by Gulf war in 1990-91 and sharp increase in the procurement prices of foodgrains the high rate of inflation emerged in the economy. Along with high inflation rate, rate of industrial and economic growth, was very low. Thus, during the period 1991-94 high inflation occurred in India while the economy was stagnating. Therefore, it is correct to say that India was experiencing stagflation during the period.

Deflation: Deflation is a state in which the prices are falling and thus the purchasing power of money is increasing. Deflation is just the opposite of inflation.

5.1 PRICE TRENDS IN INDIA

During the fifties, the average decadal rate of inflation was very low at 1.7 per cent. During the sixties, the average decadal inflation edged up to 6.4 per cent. The inflationary pressures started mounting from 1962-63, on account of the Chinese war in 1962 and unsatisfactory supply position. The Pakistan war in 1965 and the famine conditions during 1965-67 aggravated the situation further. The maximum inflation at 13.9 per cent was recorded for the year 1966-67. The average inflation rate during the seventies was still higher at 9 per cent. The decade was the most tumultuous as far as the price situation was concerned as undue hike in oil prices in this decade, once in 1972-73 and again in 1979-80 led to overall rise in prices. During the eighties, the decadal average inflation moved down somewhat to 8.0 per cent.

During the first half of nineties average inflation rate was around 10 per cent The years 1990 and 1991 witnessed a very high inflation rate of more than 12 per cent. The accelerated rise in price reaching double digit during 1990-91 was mainly due to fiscal imbalances leading to higher liquidity growth, Gulf crisis leading to the shortage of petroleum products and consequently pushing general price index, tight position of balance of payments and supply demand imbalances of some essential items. The next three years saw lowering of inflation rate (to around 10 per cent) .

The growth in prices both at the wholesale level and retail level has been particularly low between the period 1996-97 to 2003-04. It has been around 5 per cent per annum during 1996- 2001 and around 4 per cent per annum during 2001-04. Contributions to low inflation rates during the second half of the last decade were mainly due to stable prices of manufactured goods and also because of good monsoons resulting in only moderate price rise of primary products. The trend was reversed in 2004-05 with pressure on prices across the group. Erratic and delayed monsoon in 2004-05, hardening of international prices of crude oil, minerals and related products led to high inflation rate in 2004-05. It averaged around 6.5 per cent during this year. Crude oil prices continued rising during 2005-06 but due to monetary and fiscal measures taken by the government the inflation was contained at 4.7 per cent during 2005-06.

The inflation rate in 2006-07 has been on a general upward trend with intermittent decreases. In terms of wholesale Price Index (WPI) , annual point to point inflation was 6.11 per cent on January 20, 2007 compared to 4.24 per cent in the corresponding week of the previous year. However, average inflation for the whole year remained at 5.4 per cent. Shortfall in domestic production vis-a-vis domestic demand, hardening of international prices of primary products like wheat, pulses, edible oils, fruits, vegetables and spices have led to higher inflation during 2006-07. The long term inflation for 2001-06 comes out to be 4.7 per cent per annum.

In 2007-08, the fiscal, monetary and administrative measures undertaken during the year together with improved availability of wheat, pulses and edible oil started working in through in terms of decline in inflation. The average inflation for the whole year (in terms of WPI) comes out to be 4.7 per cent.

The fiscal year 2008-09 had been a very unusual year, marked by extremes in price movements. The year 2008-09 recorded the highest average inflation of the decade with WPI recording a growth of 8.4 per cent. In contrast, annual inflation as on end-March 2009 recorded the lowest rate of 0.8 per cent.

There has been a significant variation in inflation rate in terms of WPI and the Consumer Price Indices (CPIs). Inflation rate as per CPI for rural labour (CPI-RL) was 9.7 per cent and CPI for industrial worker (CPI-IW) was 8 per cent as of end-March 2009. The average inflation on CPI-RL and CPI-IW for the year was 10.2 and 9.1 per cent respectively. It has been observed that in the first half of the fiscal year 2008-09, the inflationary pressure was on account of the momentum in the international commodity prices and the domestic prices of food items like cereals and pulses. However, the monetary, fiscal and administrative measures helped in containing inflation. Later, the global meltdown in commodity prices particularly in energy, metals and agricultural intermediates across the world led to a corresponding decline in the domestic prices.

5.2 CAUSES OF INFLATION IN INDIA

A general price rise can take place either as a result of rise in aggregate demand or a failure of aggregate supply or both. Increase in public expenditure, deficit financing, and rapid growth of population can be mentioned as demand factors and erratic agricultural growth, agriculture price policy, inadequate rise in industrial production and upward revision of administered prices etc. can be mentioned as supply factors which have led to inflationary price rise in India.

(i) Increase in public expenditure : Public expenditure has risen from 18.6 per cent of NNP in 1961 to 33.3 per cent in 1980-81 and further to around 35 per cent in 2007-08 (current prices). With a rise in national income and also rapid growth of population an increase in public expenditure is unavoidable. But the spectacular rise in the public expenditure is not justifiable. Approximately 45 per cent of the government expenditure in India is on nondevelopmental activities. No doubt, defence and maintenance of law and order are essential for the stability of the society. At the same time, it must not be forgotten that due to their unproductive nature, expenditure on these activities results in inflationary price rise. The government expenditure on non-developmental activities, by putting purchasing power into the hand of its employees, creates demand for goods and services, but it does nothing whereby their supply could increase. Under these circumstances the general price level shows an inevitable tendency to rise.

(ii) Deficit financing : Deficit financing means financing of budget deficits (shortages) by borrowing from the banks or printing of more currency. The Government of India has frequently resorted to deficit financing in order to meet its developmental expenditure. A small dose of deficit financing is helpful in tiding over the gap between public revenue and public expenditure and making available funds for the growth of the economy but a large dose and that too in a period of relatively slow growth turns out to be inflationary. This happens because by financing the deficit the government puts purchasing power in the hands of people but it does nothing for creating real resources for the economy at least in near future. In India from plan to plan, the recourse to deficit financing has been increasing and the budgetary deficit during the Eighth Plan was Rs. 20000 crore but actual deficit was very high at Rs. 29,000 crore. In the Ninth, Tenth and Eleventh Plans, the government decided not to raise the money through deficit financing.

(iii) Erratic agricultural growth : The Indian agriculture largely depends on monsoons and thus crop failures due to drought have been regular feature of agriculture in this country. In the years of scarcity of foodgrains not only price of food articles increases but the general price level also rises.

(iv) Agricultural price policy of the Government : The government has been pursuing a policy of price support to the agriculturists. For this, it announces the price at which it would be buying agricultural products. This ensures certain minimum price to the farmers. This policy benefited farmers in India but this has been a major contributory factor to the inflationary price rise in the country.

(v) Inadequate rise in industrial production : Performance of the industrial sector, particularly in the period 1965 to 1985, has been rather disappointing. Over the 20 years period, industrial production increased at a modest rate of 4.7% per annum. The performance of essential consumer goods sector which includes industries like oil, food manufacturing, textiles, weaving, apparel and footwear was particularly disappointing. Moreover, in the ten years period from 1991-92 (except for 1995-96), the industrial sector registered slow growth of around 6 per cent per annum. In the wake of a large expansion of the money supply creating big demand for these goods, inadequate increase in their production pushed up their prices.

(vi) Upward revision of administered prices : There are a number of important commodities for which price level is administered by the government. Many of these commodities are produced in the public sector. The government keeps on raising prices from time to time in order to cover the losses in the public sector which often arise due to inefficiency and unimaginative planning. This policy results in cost push inflation.

(vii) Other factors : Besides the above factors, the following have also contributed to inflationary trends in price in India: Failure of the government to fully bring within the ambit of taxation the increasing income of the people, large scale tax evasion and avoidance, increasing reliance on indirect taxes, black marketing and hoarding of essential commodities, unused capacity in industries, high capital-output ratio, shortage of essential raw materials, low surplus from public sector undertakings, infrastructural bottleneck and rising prices of imports.

5.3 MEASURES TO CHECK INFLATION

Since inflation is a phenomenon where money income or purchasing power is rising faster than the real goods and services, the measures to check inflation should either be of a check on the increase in money incomes or making available more of real goods and services. The various measures can be studied under three main heads – monetary and fiscal measures, control over investment and other measures.

(i) Monetary measures : Monetary measures are applied to check the supply of currency and credit. These measures consist of quantitative measures (open market operations, statutory reserve requirements and Bank Rate) and qualitative measures (margin requirements, moral suasion etc.). When the Reserve Bank of India wants to control inflation it uses any one or more of the above measures. Thus, it may sell government securities in the open market. By issuing (i.e. by selling) government securities, the government takes away liquidity (i.e. cash etc.) from the people. This lowers the balances with the banks; which in turn will reduce their capacity to create credit or lend money for investment purposes. This will reduce liquidity in the economy and bring the prices under control. Similarly, by raising Bank Rate or statutory reserve rates the RBI controls liquidity and credit and ultimately prices. The extent to which these will be effective will depend on the intensity of the investment demand. The raising of the statutory reserve ratio is very widely used measure in India but the effect of this measure also depends on the banking habits of the people. However in those countries where banking is not fully spread and all money is not quickly banked, the effect will be much smaller.

There are several selective measures of credit, such as variable interest rates, variable margin requirement, ceiling on certain types of loans, minimum and maximum rates of interest etc. There is need for selective control of credit when the rise in prices is confined to some commodities only e.g. necessities of life.

(ii) Fiscal measures : These are the measures taken by the government with regard to taxation, expenditure and public borrowings. Taxes determine the size of the disposable income in the hands of the public. In the case of inflation, a proper tax policy will be to avoid tax cuts, or to introduce some increase in the existing rates so as to reduce the purchasing power in the hands of the people and thus reduce the pressure of demand on prices. The fiscal tools have been extensively used as tools to control inflation in India. The progressive income tax system, control over public expenditure, introduction of new types of taxes, improving profits of public sector units, etc. are all meant to control inflation in the country.

(iii) Control over investment : Controlling investments is also considered necessary because, due to the multiplier effect, the initial investment leads to large increase in income and expenditure and the demand for both the consumer and capital goods goes up speedily. Therefore, it is necessary that the resources of the community should be employed for investment which does not have the effect of increasing inflation.

(iv) Other measures : These measures can be divided broadly into short term and long term measures. Short term measures can be in regard to public distribution of scarce essential commodities through fair price shops. There may also be control over movement of commodities from one state to another. In India whenever shortage of basic goods has been felt, the government has resorted to imports so that inflation may not get triggered. It has also resorted to rationing of essential goods in times of shortages. The long term measures will require accelerating economic growth especially of the wage goods which have a direct bearing on the general price and the cost of living. Some restrictions on present consumption may help in improving saving and investment which may be necessary for accelerating the rate of economic growth in the long run.

SUMMARY 

Inflation or persistent upward movement of prices results in a decline in the purchasing power of money. A small dose of inflation at the rate of less than 5 per cent is good for the economy because it strengthens the developmental push of the economy. But inflation at a higher rate has bad economic and social consequences for the economy. Inflation could be caused either because of excess of demand over supply or because of increase in the cost of production or both. Inflation can be checked with the use of monetary measures, fiscal measures and investment control. In India, general causes of inflation have been population explosion, poor performance of agricultural and industrial sectors, high government expenditure, and tendency of the people to emulate people in prosperous countries and so on. Various measures mentioned above have been used to control inflation in India.