Inflation

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.[1] When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy.[2][3] A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.[4] Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation which may discourage investment and savings, and if inflation is rapid enough, shortages 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 nominal interest rates (intended to mitigate recessions),[5] and encouraging investment in non-monetary capital projects. Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply.[6] Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.[7][8] Today, most economists favor a low, steady rate of inflation.[9] Low (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary policy from stabilizing the economy.[10] The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control monetary policy through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.[11] INFLATION: IT'S MEASURES, CAUSES AND REMEDIES One of the most intricate challenges of our present times is the problem of rising Inflation. Its effect can be felt by each and every person to at least some degree, whether he is an engineer, doctor, lawyer, govt. servant or anybody. Inflation makes no partiality in choosing its innocent victims. So what exactly is inflation and how is it caused? Whether it originates in our home country or it is imported from abroad? What are our Economists doing to control Inflation? These are the questions that naturally arise in anyone's mind. What is Inflation: Inflation is defined as a general rise in prices of all commodities. It is not the rise in the price of my favorite commodity e.g. McDonalds Pizza, but the overall rise in the prices of all the goods and services manufactured and consumed within the territory of a nation. When we say that the monthly rate of Inflation is 12%, what it means is that on an
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average, the prices of all goods and services have increased by 12% in the period of last one month. Measures of Inflation: In India, Inflation is measured using WPI (Wholesale Price Index). It is very tedious to track each and every commodity and calculate its price rise. Instead of that an Index of several goods and services is prepared. India's WPI is a weighted-index of 435 commodities. It means price-rise of all commodities will not be treated equally. The pricerise of rice will have more weight-age than price-rise of a Maruti-car. That is because rice is consumed by a very large number of people compared to a Maruti car. The weight-age of a Mercedez car will be still lower in the WPI. So when this WPI increases from say 100 to 112, we say that the rate of inflation is 12%. Many other countries like UK, USA, China, etc. use CPI (Consumer Price Index) to measure inflation. This is a more realistic measure because it computes the index based on the increase in actual price paid by the consumer. On the other hand, WPI considers the rise in the price by the Wholesalers of the goods and services. Causes of Inflation: Inflation is basically a combination of two types of phenomenon. Its causes could be nailed down to Cost-Push inflation and Demand-Pull inflation. Cost-Push Inflation is caused by rise in the cost of factors of production. In classical economic theory, there used to be only three factors of production - land, labor and capital. However, in today's complex world, infinite factors are required to produce a single product or commodity e.g. house-rent, electricity, admin-expenses, raw-materials, fuel (petroleum), steel, etc. The price rise in any one or more of these factors will increase the cost of production of the final product. The producer of the commodity (the businessman) will naturally shift this cost to his consumers by raising the cost of his final product. This phenomenon is called Cost-Push Inflation. Let us take a simple example. Suppose a bakery owner produces bread by using several factors like wheat, flour, machines, labor, etc. The cost of production of one piece of bread comes to Rs.20. He adds Rs.5 as his profit-margin and sells it to consumers at Rs.25. This continues for several days. Now suppose the price of wheat increases. Now the owner recalculates his cost of production. It comes to Rs.20. He now adds his margin of Rs.5 and increases the cost of bread to Rs.25. This directly results in 25% rise in the cost of bread, or in the bread component of the WPI. Demand-Pull Inflation is another type of inflation. In this case, the cost of factors of production remains same. However, due to increase in the demand of the commodity by consumers in the market relative to its supply, the owner will naturally increase the prices. In this case, demand has increased, but supply has remained constant. Returning to the example of the bread producer, suppose the cost of production of one piece of bread remains constant at Rs.15. He adds his margin of Rs.5 and charges Rs.20 to each consumer. Now suppose the preference of his bread increases among the consumers, as it becomes more popular. This results in an increased demand for bread (This is a simplified example, in real world demand and supply is more complex). So sensing more demand for his product, the owner increases the price to Rs.25. In our example, let's assume his margin increases Rs.5to Rs.10. Again, in the real world this might not be the case. As for e.g. if we assume competition among many bread-producers, the factors i.e. laborers will also demand a chuck of that margin in the form of increased wages. So, the owner will have to sacrifice some or all of his

margin and distribute it to his laborers, otherwise they will stop working for him and work for another bakery-owner who is in competition.

Liquidity: The term Liquidity is usually used to identify hard cash. In fact Liquidity just
means money in any form. Liquidity is also referred to the ability and ease with which an asset could be converted to money. For e.g. cash is the most liquid asset as it comes under the standard definition of money. Savings-account deposit could also be called liquid asset. That's because it is possible to convert savings-account deposit to cash by withdrawing from an ATM. It could also be used to pay by means of a cheque or on-line transfer. Land and Buildings is a less liquid asset. That's because it's difficult (or at least it takes some time) to convert it to money instantly. How is Liquidity related to Inflation you may ask? The answer is simple. It's because of Demand-Pull Inflation. The demand for the commodity is directly influenced by the amount of money that people have. The Government or Central Bank can directly influence demand-pull inflation by controlling liquidity. Remedial Measures to control Inflation: In India, the Ministry of Finance and the RBI (Reserve Bank of India) always strive to control inflation. They control inflation by directly affecting the demand pull inflation by changing the amount of liquidity circulating in the economy. The RBI (the Central Bank of India) can change the liquidity by its various tools viz. CRR, Bank-Rate (REPO and Reverse-REPO), SLR, etc. CRR (Cash Reserve Ratio) is the proportion of amount which each commercial bank has to maintain in the form of hard cash. All commercial banks accept deposits from individuals and lend it to borrowers at a higher interest rate. The difference between the interest rate which they collect from borrowers and which they pay to their depositors is their profit. Naturally, each bank will try to lend all the money they collect from depositors. However, banks can't lend all the money they have. Under law, each bank has to maintain a certain proportion of cash as reserve. This is known as CRR. For e.g. if the CRR is 5% and the bank collects Rs.100 from its depositors. Then it has to maintain Rs.5 as Reserve. It can lend other Rs.95 to its borrowers. RBI can decrease vast amounts of liquidity circulating in the economy by raising the CRR. When RBI increases the CRR, the bank's lending power decreases. Less lending means less borrowing, this in turn means less money in the economy. Last month, the RBI increased the CRR from 8.75% to 9% to control inflation. SLR (Statutory Liquidity Ratio) is also similar to CRR. But in case of SLR, Government-Securities need to be maintained by the commercial banks instead of cash. Bank-Rate is basically the interest rate at which the Central Bank borrows from the other scheduled commercial banks. This rate is directly linked to the interest rates charged in turn by all the commercial banks to its customers. All these other interest rates on Home-loans, Personalloans, etc. also increase with the increase in bank-rate. Thus, by raising the Bank-Rate and in turn all other Interest Rates, the RBI makes borrowing money from banks a very costly affair. People are thus discouraged to borrow more money and total amount of liquidity decreases in the economy. Last month, the RBI increased the Bank Rate from 8.5% to 9.5%. This was an increase of 50 basis-points (0.5%) to control inflation. The above mentioned measures viz. CRR, SLR, Bank-Rate are called monetary policy tools. Apart from these, there are certain fiscal policy tools which the Government can use. One recent example of fiscal tool is the recent ban placed on the export of Basmati rice by the Finance Minister. By banning the export of rice, the supply of rice will increase in the home country relative to its demand. This will naturally bring down the price of rice which is a major component of WPI. The price-rise in Basmati rice is an example of Demand-pull inflation
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because demand has increased relative to supply. Although, it could be said that demand for rice is not related to liquidity but is inelastic (where demand is autonomous and not related to increase in price or income). Although the rise in interest rates initially makes life difficult for people who have taken loans on floating interest rates, it is a required step to bring down inflation which is a larger evil. It might also be noted that RBI, by making the policy changes can control only one type of inflation i.e. demand-pull inflation. It cannot affect the other type of inflation i.e. cost-push inflation which is caused by rise in prices of raw-materials and other factors of production. That is why the rate of inflation is increasing continuously since last six months although the RBI is trying to control it. In fact, only the cost-push component of inflation is rising which consists of increase in prices of steel, cement, petroleum, etc. Some of these factors are produced in our country and others are imported. But the prices of none of them can be controlled by the government. Inflation and Growth: Inflation is not harmful at all times. In fact only when there is a sustained increase above 7% to 8%, there is cause for worry. In fact a low level of inflation between 2% and 5% is a sign of prosperity. It is required for growth. That's because it gives the producer of goods and services a certain impetus to stay in the market. This in turn gives rise to growth, development and employment which is very much required. Inflation is also closely linked to employment but that is the topic of discussion for another day.

NFLATION- CAUSES AND REMEDIES

By MARIA 12 'E' Published on 30 th Aug, 2012 Inflation, in the everyday sense refes to increase in prices, which is calculated on the basis of WPI, which means whole sale price index. The annual inflation rate for a particular week tells you how much the average level of prices of the commodities tracked by WPI has risen compared to the corresponding week a year (or 52 weeks to be precise) earlier. Thus wheat or rice which is consumed every day will have a relatively high weight, compared to the glass which would have a lower weightage. Today's inflation rate in India is 11.05% highest since 1995. The main cause of today's inflation is because of global oil price rise. Since import of crude oil is a must, the prices of petrol, diesel and domestic gas has gone up. All sectors of business depend on transportation for their transport of goods, which has automatically transformed the increase in prices. OTHER FACTORS CAUSING RISE IN INFLATION

Prices of individual goods can keep rising or falling due to several factors affecting their demand and supply. But price level as a whole is determined primarily by the quantum of goods and services available in the country and the total amount of money chasing them. Increase in the prices of some goods is bound to lead to fall in the prices of some other goods, unless the quantity of money is increased. Price level as a whole goes up only when more money is injected into the system or its velocity of circulation goes up due to changes in habits and practices. Currency and total money supply both have to remain under strict control to ensure a reasonably stable price level. In India, in the course of last 34 years, the price level has gone up 16 times with the result that value of money is reduced by 94 %. VICTIMS OF INFLATION By printing money and promoting inflation Government also causes immense damage to the poorest of the poor and the labour classes, because wages are sticky and do not keep pace with fall in the value of money, particularly in the short run. Large scale printing of money provides the most subtle way of taxing the poor and the lower middle class people. They are forced to part with a major part of their hard earned income. Fast rising prices and fall in the value of money adversely affect the household budget of everybody. Fixed income earners are the worst hit. Employees of public and private sectors all have to keep fighting continuously for increase in salary and wages rather than concentrate on productive work. In the interest of justice, fairness and welfare of the common man, stability of the price level is very essential. The most ideal course would be to increase money supply only to the extent of increase in GDP so that the price level does not go up at all. But in order to facilitate rapid growth of the economy, some excess of money supply may be unavoidable. Moreover, it is not possible to match the two exactly. This excess should, however, be so small that the price level does not go up by more than around one percent per year, as has happened in countries like Singapore or in India during the period of British rule