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Inflation and the Indian Economy

by FinEdge Research Desk

Inflation is a sustained increase in the general prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. .

Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. Inflation in India is measured under the following methods:

Consumer Price Index:

Various categories and sub-categories have been made for classifying consumption items and on the basis of consumer categories like urban or rural. Based on these indices and sub indices obtained, the final overall index of price is calculated mostly by national statistical agencies. It is one of the most important statistics for an economy and is generally based on the weighted average of the prices of commodities. The percentage change in this index over a period of time gives the amount of inflation over that specific period, i.e. the increase in prices of a representative basket of goods consumed. Inflation at the consumer level stood at 4.41% for the month of Sep 2015 up from 3.66% MoM from Aug 2015.

Wholesale Price Index:

Wholesale Price Index (WPI) represents the price of goods at a wholesale stage i.e. goods that are sold in bulk and traded between organisations instead of consumers. WPI is used as a measure of inflation in some economies. WPI is used as an important measure of inflation in India. Fiscal and monetary policy changes are greatly influenced by changes in WPI. In the United States, Producer Price Index (PPI) is used to measure inflation. The Wholesale Price Index, WPI) decelerated to -4.95% for the month of August 2015. This negative growth in prices at the Wholesale level was one of the lowest ever recorded for the Indian economy.

Inflation can have both negative as well as positive effects on an economy. Negative effects of inflation includes erosion of value of the currency, hardening of interest rates – which may discourage investment, and if inflation were rapid enough, shortage of goods as consumers begin hoarding out of concern that prices will increase in the future.

Positive effects include ensuring that central banks can adjust real interest rates and encouraging investment in non-monetary capital projects.

Factors that affect inflation:

Demand Factors:

It occurs in a situation when the aggregate demand in the economy has exceeded the aggregate supply. It could further be described as a situation where too much money chases just few goods. A country has a capacity of producing just 550 units of a commodity but the actual demand in the country is 700 units. Hence, as a result of which due to scarcity in demand the prices of the commodity rises.

Supply Factors:

The supply side inflation is a key ingredient for the rising inflation in India. The agricultural scarcity or the damage in transit creates a scarcity causing high inflationary pressures. Similarly, the high cost of labor eventually increases the production cost and leads to a high price for the commodity.

External Factors:

India is a net importer of commodities. Hence, the foreign exchange rate plays a very important role in the management of inflation. For e.g. When the Rupee touched 68 to a dollar, inflation rose to unprecedented levels. Similarly, a war in the Middle East could push up oil prices globally and would further stoke inflation.

 

Central Banks take various steps to control inflation, which include tight control over money supply and policy rates. In India the RBI through its monetary policy announces its stance on inflation on a bi-monthly basis. Policy rates that include the Repo and the Reverse Repo are key from the Central Banks perspective to control inflation. The Government also takes fiscal measures in order to control inflation. Fiscal measures include control over Government spending and deficit financing. Inflation is a sound indicator on the health of the economy and any increase or decrease makes for prudent policy decisions by the Central Bank and the Government. Thanks to the reforms process of the government, intervention of RBI and softening of commodity prices, India has been witnessing a downward inflation trend. This is a very good starting point for kick starting the economy. With softening of interest rates, the government is hoping to kick start, the investment cycle, which would augur well for the overall health of the economy.

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