22 July 2011

The Explainer: Inflation

Friends, this Friday's Explainer focuses on 'Inflation'. 
I have kept jargon out of this article; in fact, I have used a conversational mode of writing to explain this important issue. 

What is inflation?
Inflation relates to the sustained rise, over a period of time, in the general price level when there is a rise in demand (for goods) without an equal rise in supply.
In today’s interconnected world, a lack of stability in the prices of goods and services characterises all types of economies, be it in an emerging economy like India or in an advanced economy like the United States or underdeveloped economy like that of Senegal. But as we all know, any kind of uncertainty is not good for business; so is the case with price instability.

What causes inflation?
Generally, there is never a single cause behind the sustained rise in prices of a basket of goods and services, like wheat, rice, and cooking oil. However, some general reasons include:
(a) increase in money supply;
(b) rise in government spending;
(c) rise in purchasing power (a direct result of rising incomes);
(d) low supply across a range of goods, and
(e) infrastructure issues.
In India, inflation is seen as a result of a combination of all these factors. Let us elaborate on a few of them.

Explanation of causes

Since independence, the Government of India’s (GoI) expenditure has been shooting up steadily. Currently, the GoI’s spends lakhs of crores of rupees every year on welfare functions (like subsidies and insurance for the poor), development works (like building roads) and administrative expenses (like salary payments).
For your information, the current expenditure of the Government of India is more than Rs12,00,000 crore – yes, a staggering Rs12 lakh crore! To put this in perspective, the expenditure in 1980 was just a little over Rs23,000 crore.
When the government spends, it puts money into the hands of the common man, which increases her purchasing power. In short, higher spending would mean higher income, leading to higher purchasing capacity of the individual.
Higher purchasing power often raises the demand for goods and services; however, in the short run, the supply of such goods and services may not rise in equal proportion to meet the demand. This would lead to a rise in prices, a situation dubbed ‘inflation’.
Also, black-marketing, hoarding, speculation, and exploding population have all contributed to a rise in demand for goods and services.
It is also true that inflation might arise because of cost-push factors, like changes in production (as in the case of foodgrains), rise in prices of controlled-supply goods (like LPG and kerosene), and external factors like oil prices and global inflation. Yes, you could add increase in indirect tax too.

Cascading effect
By itself a rise in price of diesel won’t raise the overall inflation rate. It is just one commodity among a wide range of commodities consumed by us. However, when you look at the cascading impact of the rise in price of diesel, you will know that it straight way impacts you too!
It is like this: a rise in price of diesel will force the transporters to increase freight cost. Now vegetable / grain vendors use trucks to transport large quantities of their stocks to the market; this would mean that rising freight cost would add to the price they charge from the retailer / consumer. This means that we will have to pay more to buy the same old stuff!
Take another example, this time on indirect tax (a favourite tool of the government to increase its tax revenues). You must have heard of Service Tax (ST) and Value Added Tax (VAT), which the government imposes on a range of services, including on restaurants.
Let us say, you go down to your favourite restaurant to gorge on the delicious buffet spread. Now the bill arrives, and you notice that the final bill includes items like ST and VAT! (No, no, you didn’t order for these items but the government did!) All these taxes will add up to a substantial part of your food bill and that’s how indirect tax lead to inflationary situation.

How does inflation affect the common man?
Rapidly rising inflation leads to a fall in the purchasing power of money. In other words, the purchasing value of money comes down during an inflationary situation.
For example, let’s say you have Rs100 and a kilogram of mangoes cost Rs100. One month later, you visit the market, again, with Rs100. This time the mangoes are priced at 150 per kg. How much will you be able to buy with Rs100? About 2/3 kg or 670 grams. In short, the purchasing value of your money has fallen by 1/3.

What are WPI & CPI?
Dear Reader, to be honest, any note on these indexes will have to include jargon, which is, for most people, difficult to understand. So, I will reserve that stuff for some other day. Anyway, I will stick to some basic aspects of these indexes.

WPI stands for Wholesale Price Index while CPI stands for Consumer Price Index. The WPI is prepared by the Central Statistical Organisation (CSO). It includes all the important and price-sensitive goods, which are traded in wholesale markets across the country. The articles in the WPI consist of major foodstuffs, raw materials, semi-manufactured goods and manufactures. Hey, that’s too much technical stuff already!

What does it mean if today’s newspaper says that the current inflation rate is 10%?
If a newspaper story title screams that the inflation rate is 10%, then it means that the prices, on an average of a basket of commodities (like those in the WPI – oil, rice, wheat), have gone up by 10% over the prices that prevailed exactly on that date last year. (It’s actually calculated on a fortnight basis; however for simplicity’s sake, we took this approach.)

Confused? Let’s simplify. Let us say, on July 22 last year, you spent Rs100 to buy a basket of commodities. If the inflation rate today is 10%, it means that the price of that basket of commodities would have gone by 10%, to Rs110, today, i.e. on July 22 this year. It also means that the purchasing value of your Rs100 has gone down by 10%. 

Forget the Indian middle class; rising inflation has pushed more than one crore households, which would mean a minimum of 6 crore people, into poverty. It has the debilitating impact of depriving people of nourishment. Such deprivation affects the poor and the marginalised the most. It is no secret that more than 65% of all Indian children and 52% of all Indian women are malnourished; rising prices have only added to their woes. 

Kindly forgive me for any spelling / grammatical error; I write in one go! Thank you!

(Please select your reaction to this post in the footer; see below.)


shravan said...

Thank you very much sir for your effort...It is written in a very simple manner, making it easy for us.

Anonymous said...

Sir as u mentioned inflation is because the purchasing power is increasing, also the govt is spending more & more each year, but the paradox is rise in poverty how is that possible, is it like only certain section of society is getting that purchasing power and not the people at bottom of pyramid????

Anonymous said...

thank you sir for the article but i have a doubt that if the purchasing power increases inflation why does govt spend more money on expenditures?

Anonymous said...

"Let us say, on July 22 last year, you spent Rs100 to buy a basket of commodities. If the inflation rate today is 10%, it means that the price of that basket of commodities would have gone by 10%, to Rs110, today, i.e. on July 22 this year. It also means that the purchasing value of your Rs100 has gone down by 10% "....

Sir , I think the purchasing power wud decrease by 9.09 % and not 10 %.
[ Initially he bought..1 unit ,
After inflation.....100/110 unit,

Decrease in purchasing power....(Original -final)/original

i.e... (1- (100/110))/1 *100

= 9.09 %

Correct me if m mistaken !


Your Student

Bharat C. Jain said...

@ Anonymous Mathematician, my Math is not great, it never was! Lol :)

Thanks, anyway!

emperork said...

Very interesting,thank you sir!

Anonymous said...

I have a small doubt in the article sir. Is the inflation calculated with reference to a base year or with reference to the previous year?

Anonymous said...

Great article Sir! Thank you!

Anonymous said...

Sir Great Article.
Sir can you please write one article on how to control inflation or who controls it by what sorts of methods,which one is practicably better,Thanks.

Unknown said...

thanking very much sir..The article cleared many of my doubts.It's a good start of my day.

Unknown said...

Hello Sir,
Is moderate Inflation Good? Please Explain.

shrey deepum said...

Well another explainer to explain the most unexplainable market stuff..
Kudos to ur effort sir..

Would b waiting fr more of these..

Anonymous said...

Awesome article sir.
Was searching articles on inflation and found this. Incredible work :)