Inflation Demystified

What is inflation?

In simple terms, inflation is the increase in the price of goods and services, and the inflation rate is the rate at which such increase takes place.

Let’s say, the price of apple increases from Rs. 100 per kg to Rs. 110 per kg. It is inflation. The inflation rate of apples is (110-100)/100= 10%.

Inflation decreases the worth or value of money. 100 rupees could buy 1 kg of apples previously, but now 100 rupees can buy less than 1 kg of apples, as 1 kg of apples cost 110. Hence, the purchasing power/ worth of money declines if there is inflation.

But, in an economy, there are many goods and services. So, how is inflation in the economy calculated?

Inflation is defined as the increase in prices of goods and services over time. It is usually calculated by the rate of increase in the Consumer Price Index (CPI).

Consumer Price Index is the weighted average of the prices of selected goods and services consumed by people. It is also called the retail price index. The basket includes those goods and services in the retail market which are representative of expenditure by a typical consumer. In India, CPI is published on a monthly basis and yearly basis. CPI data is published by the National Statistical Office (NSO), Ministry of Statistics and Programme Implementation (MoSPI). The base year of CPI is 2012

Another way to calculate inflation is to use the Wholesale Price Index (WPI). This index measures the price level of goods traded in the wholesale market. Presently, in India, it includes prices of 676 commodities. It is published weekly and monthly. WPI data is published by the Office of Economic Adviser, Ministry of Commerce and Industry. The base year for WPI is 2011-12.

So, CPI measures inflation at the retail level and WPI measures inflation at the wholesale level.

What are the causes of inflation?

There are two main reasons for inflation or price rise.

The first is when the demand for goods increases. It is because people have more money to spend i.e. the money supply in the economy increases and so they start buying more goods and services.  This leads to price rise. This is also called demand-pull inflation.

Money Supply ↑ ⇒ demand ↑ ⇒ price ↑ ⇒ inflation ↑

RBI tries to reduce the rate of inflation by reducing demand. It increases interest rates. This leads to a reduction in borrowings because the cost of borrowing (interest rates) increases. It leads to a decrease in the money supply. People have less money in their hands, so they demand fewer goods and services. Hence, prices decrease.

Interest rate ↑ ⇒ borrowing ↓ ⇒ money supply ↓ ⇒ demand ↓ ⇒ price ↓ ⇒ inflation ↓

[You may also read: repo, reverse repo, CRR, SLR, etc explained]

The second is when the cost of production of goods increases leading to an increase in price. The reasons for this could be excise duty/ other tax increase, wages increase, or raw materials price increase. This is also called cost-push inflation.

Excise duty ↑ ⇒ cost of manufacturing ↑ ⇒ price ↑ ⇒ inflation ↑

Cost-push inflation can also happen due to disruptions in the supply chain which decreases the supply of goods and services and push up the prices. For instance- if the onion farms get destroyed due to unseasonal rains, it will lead to an increase in price.

That said, apart from other factors, the reason why the inflation rate has come down in India is that prices of crude oil in the world market has decreased. Oil is used as a raw material in certain industries and also oil affects the transportation cost of goods as the price of petrol etc declines.

Oil price ↓  ⇒ transportation cost ↓ ⇒ cost of manufacturing ↓⇒ price ↓ ⇒ inflation ↓

[You may also read: Oil price wars amidst COVID 19]

What is headline inflation and core inflation?

The measure of inflation that includes the prices of all types of goods is called headline inflation. In core inflation, we exclude the prices of food and fuel. The reason is the prices of food and fuel are volatile and makes the measure of inflation unstable.

Is inflation always bad?

No. Moderate inflation is a sign of a healthy economy. It signifies robust growth, investment, and demand. Most countries target an inflation rate of 2 to 3% because if there is deflation in the economy, it indicates there is very little consumer demand. Also, consumer demand falls further as people stop buying goods expecting a fall in price. This sets off a vicious cycle.  People do not invest in a deflating economy.

There are signs that India has entered a deflationary stage. The headline inflation rate based on the Wholesale Price Index (WPI) lowered to -4.95% (negative) in August 2015. CPI inflation eased to 3.66%. Read more about it in this Hindu article.

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