Inflation: Why it happens and measures to control it

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Understanding Inflation and how to control it

Inflation: Why it happens and measures to control it

 

Understanding Inflation : One problem that has troubled the brains of the laymen and economic experts alike is inflation. Moreover, this is something which most of us do not understand correctly and thus it is difficult to deal with.

 

What inflation is not?

Relative change in prices of goods and services due to changing demand and supply.

What inflation actually is?

Phenomenon in which average price of goods rises over time in a sustained manner for a certain time period.

People have developed policies and techniques to tackle inflation without actually having an insight to what it is and what causes it.

Inflation, being an emotive matter, has given rise to popular resentment in many cases over the years. Even though the knowledge shared here is not intended to influence the policy decisions on controlling inflation directly, but understanding inflation in and out can have disproportionately high returns in the long term.

Inflation in India

  • India is suffering from an inflationary phase since 2010. The main cause of concern is that inflation has again picked up since Dec 2011 and unfortunately the downward trajectory of the same has been too slow.
  • For a year before 2010, the inflation was negligible but from March-December 2008 the WPI (Wholesale Price Index) was close to 10%.
  • India’s highest inflation phase was in September 1974 at 33.3%.

Lessons from the world

  • German hyperinflation in 1923 was extensively diagnosed and analyzed. It caused a lot of political tensions in nation, lubricating the rise of Nazism, played havoc with the economic conditions of the nation and also led to psychological disturbances throughout.
  • Huge hyperinflations occurred in more recent times in Latin America. One country that revived itself from mega-inflations and has now stabilized is Brazil, and is now among the well-run economies in the world market.
  • Brazil’s hyper-inflation study shows that correlation between growth rate and rate of inflation is relatively less when inflation is below 10%, but at very high rates of inflation it leads to very low economic growth.
  • US Fed kept controlling its prices by selling and buying government bonds, in effect absorbing money from the market and releasing money into it respectively. But the presence of ‘near monies’ in the economy has compelled the Fed to change strategies in order to maintain stable prices.

Also Read:

Understanding deflation and the countries facing it

 

Inflation Indices

  • CPI (Consumer Price Index)- Change in price level of household purchased consumer goods and services. Its annual change in percentage is used for measuring inflation.
  • WPI (Wholesale Price Index)- Price of a representative basket of wholesale goods. It is focused on prices of goods that are traded among corporations instead of consumers. It is used as a Central measure of inflation.
  • Inflation measured using these indices tend to converge more or less over time.
  • It has been difficult to warrant one index over the other considering their respective pros and cons.
  • Perishable food items lead to price stabilization due to their ability of being stored for limited time, causing less volatility thus less inflation in the food market.
  • Few years back, Indian economy was agriculture driven. But now the share of agriculture in the economy has reduced, thus making the economy less vulnerable to inflation due to lack of supply in the agricultural sector at times.

Major problems in controlling inflation

  • Less than 20% of the poorest households in India get food from Public Distribution System. This causes inflation due to the bloating up of the fiscal expenditure.
  • Diesel and petrol price control is a major issue as subsidizing these and holding the price constant will lead to lack of economization by consumers, which would lead to inflation when the global supply of fuel runs short.
  • A lot of problem is caused due to micro-inefficiencies like the injudicious expenditure of fuel by government users who don’t need to pay for fuel by their own pockets.

Controlling and predicting inflation

  • The Central Bank and the Treasury of India are entrusted with the task of adopting policies to control inflation as well as forecasting it.
  • It has been observed that the forecast of inflation affects the actual resulting inflation, due to people withdrawing money from markets on hearing such news, leading to further inflation. This poses a dilemma to the Central bank and Treasury about which task they should perform properly out of the two- tackling inflation or tackling its forecast! This is a global problem which all nations face.
  • Inflation is the overall price increase; the relative price increases should be left alone mostly as this is how the supply and demand is equilibrated in the market.
  • Government can redistribute the existing demand to the future so that the aggregate demand does not exceed the supply to cause inflation. This is done by taking 5% temporary income tax which the government holds with itself without using it and it is paid back to the tax payers gradually over 5 years or so, when the inflation starts to ease out.
  • The RBI influences interest rates by adjusting repo and reverse repo rates; this is done to influence the market liquidity and hence the inflation.
  • Liquidity is affected through not only the RBI/government intervention but also through the activities of banks, farmers and individuals.
  • In general, the demand for credit decreases with increasing interest rates and the credit supply increases. Thus liquidity can be curbed by decreasing credit demand or increasing interest rates. Thus, by curbing liquidity, inflation can be controlled.

Understanding inflation to the core is certainly the only way to manage or control it.

 

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