Inflation and its impact on Indian Economy

Context:

The official inflation rate in the Indian economy dipped to 1.5% last month, the lowest in almost two decades.

Introduction:

• India’s long-term record in managing inflation has been very impressive when compared with most developing countries.
• Countries like Israel and Latin American economies have never experienced hyperinflation.
• The relatively high double-digit inflation experienced between 2010 to 2013 was an aberration, which had a political consequence.
• The recent drop in the inflation rate has been caused by a steep fall in the prices of vegetables (-17%) and pulses (-22%).
• Keeping them low and stable involves policies such public procurement and a minimum support price regime.
• Growth in India is forecast to pick up further in 2017 and 2018, in line with the April forecast, “the International Monetary Fund (IMF) said in its latest World Economic Outlook (WEO) report.

Reasons for recent drop in Inflation

The recent drop in inflation rate is due to various reasons some of them are discussed below:

• It must be because the money supply has been kept “dear”, or tight.
• India’s real interest rates, i.e.
• net of inflation, are quite high even compared to other developing countries. Most of the developed countries have ultra-low rates, with some countries like Sweden, Switzerland and Japan even having negative interest rates.
• The impact of GST is bound to be inflationary because bulk of India’s GDP is in services whose tax rate has moved from 15% to 18%.
• Many state governments have introduced additional levies to counter their apprehension of a loss of revenue under the GST.
• The impact of the award of the Seventh Pay Commission to government employees. This effect will cascade to public sector organizations and state-level employees as well, and put pressure on prices.
• Another factor could be the loan waivers announced in some states which can cause fiscal stress.
• High deficit spending is not compatible with lower interest rates.
• Low inflation is also because of a steep fall in prices of fruits, vegetables and pulses, none of which was caused by high interest rates.
• India has also benefited from low and stable crude oil prices, which are a crucial determinant of transport and energy costs.

Food prices as indicator:

• Inflation is also an indicator of whether there is an excess demand or supply of goods.
• For example, with a bumper crop of fruits and vegetables, price plunge, even though money supply might be unchanged.
• Food prices are a big component in the determinant of the overall inflation rate based on the consumer price index basket.

What is Inflation?

• Inflation is the percentage change in the values of the Wholesale Price Index (WPI) on a year-on year basis.
• It effectively measures the change in the prices of a basket of goods and services in a year.
• Inflation occurs due to an imbalance between demand and supply of money, changes in production and distribution cost or increase in taxes on products.
• When economy experiences inflation, the value of currency reduces.
• India used WPI as the measure for inflation but new CPI (Combined) is declared as the new standard for measuring inflation (April 2014).

Adverse impacts of inflation:

• Inflation causes decrease in the real value of money and other monetary items over time.
• Inflation causes uncertainty over future and this may discourage investment and savings.
• High inflation may lead to shortages of goods if consumers begin hording out of concern that prices will increase in the future.

Favorable impacts of Inflation:

• Inflation ensures that the central banks adjust the interest rates.
• Inflation encourages non-monetary investment

Types of Inflation:

There are three major types of inflation, which is also known as Triangle Model.

1. Demand Pull Inflation

• Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc.
• Demand-pull inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
• Demand-pull theory states that the rate of inflation accelerates whenever aggregate demand is increased beyond the ability of the economy to produce (its potential output). Hence, any factor that increases aggregate demand can cause inflation.
• However, in the long run, aggregate demand can be held above productive capacity only by increasing the quantity of money in circulation faster than the real growth rate of the economy

2. Cost Push Inflation

• Cost- Push inflation, also known as “supply shock inflation”, is caused by a drop in aggregate supply. This may be due to some natural disasters, or increased prices of inputs.
• For example increase in sudden decrease in the supply of oil, leading to increased oil prices.
•  Built in Inflation · Built-in inflation is induced by adaptive expectations, and is often linked to the “price/wage spiral”. · It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a ‘vicious circle’. · Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Reasons of Inflation:

Several reasons of inflation are as follows:

1. Increase in Money Supply: The most important reason of inflation is excessive growth of the money supply. A long sustained period of inflation is caused by money supply growing faster than the rate of economic growth. This is the main reason the RBI takes tight policy measures to reduce money in the system.
2. Increased Effective Demand: Another reason for inflation is effective demand for goods and services. When there is an increased demand, the people tend to offer higher price for same goods or commodity.
3. Decreased Effective supply or aggregate output: Negative changes in available supplies such as during scarcities cause inflation.

Measures to control Inflation: The current inflation target is 4% plus or minus 2%. De’Anthony Thomas – Oregon Ducks

• Controlling money supply is part of the strategy for controlling inflation.
• Inflation control requires a combination of monetary management along with measures to increase supply of goods as also anti-hoarding measures or the release of stocks from government warehouses.
• Price stability is important in order to control inflation.
• Reform of monetary management is also an important tool in controlling inflation. Last year, in a landmark reform of monetary management, the government officially gave an inflation target to the RBI.
• The Reserve Bank of India performs multiple objectives such as enhancing growth and reducing unemployment, although price stability was undoubtedly paramount.

Solutions to control Inflation:

• Inflation is a monetary phenomenon –more money chasing over fewer goods. So, controlling money supply is part of the strategy for controlling inflation.
• Setting the benchmark interest rate.
• Inflation control thus involves a combination of monetary management along with measures to increase supply of goods as also anti-hoarding measures or the release of stocks from government warehouses.

Conclusion:

Inflation is a challenge that affects everyone, whether one have a job or not. The most of the western countries are fighting disinflation if not outright deflation. But in India we are still struggling with inflationary conditions and expectations. A low and stable inflation rate is a perquisite for sustained high economic growth. Over the past decade India has increasingly opened itself to the global economy and has become one of the world’s fastest-growing economies. As it seeks to sustain rapid growth and improve the welfare of its large and fast-growing population, India also needs to aim for greater price stability. The growth impact of the GST, the improving ease of doing business and increasing supply of goods and strong domestic currency, will all help keep inflation low.