Inflation and its impact on indian economy free essay sample

In economics, inflation is a persistent increase in the general price level of goods and services in an economy over a period of time. When the general 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. 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. Inflations effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include an increase in the opportunity cost of holding money, 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. We will write a custom essay sample on Inflation and its impact on indian economy or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page Positive effects include ensuring that central banks can adjust real interest rates (to mitigate recessions), and encouraging investment in non-monetary capital projects. Economists generally believe that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. However, money supply growth does not necessarily cause inflation. Some economists maintain that under the conditions of a liquidity trap, large monetary injections are like pushing on a string. 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 changes in the velocity of money supply measures; in particular the MZM (Money Zero Maturity) supply velocity. 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. Today, most economists favor a low and steady rate of inflation. 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. 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. Definition of Inflation The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum. As inflation rises, every dollar will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1. 02 in a year. In simple terms, the word Inflation refers to a growth or increase in money supply. As one of the important economic concepts, the effects of inflation exert impact both in the economic and social spheres of a nation and on its inhabitants. Most countries central banks will try to sustain an inflation rate of 2-3%. Effects of Inflation: General Inflation affects both the economy of a country and its social conditions, as well as the political and moral lives of its inhabitants. However, the economic effects of Inflation are stated and described below: †¢Price inflation has immense effect on the Time Value of Money (TVM). This acts as a principal component of the rates of interest, which forms the basis of all TVM calculations. The real or estimated changes occurring in the rates of inflation lead to changes in the rates of interest as well. †¢Inflation exerts impact on the treasury of a nation as well. In United States of America, Treasury Inflation-protected Securities (TIPS) ensures safety to the American government, assuring the public that they will get back their money. However, the rates of interest charged by TIPS are less compared to the standard Treasury notes. †¢The most immediate effect of inflation is the decrease in the purchasing power of dollar and its depreciation. Inflation influences the investments of a country. The Inflation-protected Securities (IPSs) may act as a guard against the loss in the purchasing power of the fixed-income investments (like fixed allowances and bonds), which may occur during inflation. †¢Inflation changes the allocation of income. This exerts maximum effect on the lenders than the borrowers at the time of persisting inflation, because the loans sanctioned previously are paid back later in the form of inflated dollars. †¢Inflation leads to a handful of the consumers in making extensive speculation, to derive advantage of the high price levels. Since some of the purchases are high-risk investments, they result in diversion of the expenditures from regular channels, giving birth to a few structural unemployment’s. Inflation in India The inflation rate in India was recorded at 6. 16 percent in December of 2013. Inflation Rate in India is reported by the Ministry of Commerce and Industry, India. Inflation Rate in India averaged 7. 71 Percent from 1969 until 2013, reaching an all time high of 34. 68 Percent in September of 1974 and a record low of -11. 31 Percent in May of 1976. In India, the wholesale price index (WPI) is the main measure of inflation. The WPI measures the price of a representative basket of wholesale goods. In India, wholesale price index is divided into three groups: Primary Articles (20. 1 percent of total weight), Fuel and Power (14. 9 percent) and Manufactured Products (65 percent). Food Articles from the Primary Articles Group account for 14. 3 percent of the total weight. The most important components of the Manufactured Products Group are Chemicals and Chemical products (12 percent of the total weight); Basic Metals, Alloys and Metal Products (10. 8 percent); Machinery and Machine Tools (8. 9 percent); Textiles (7. 3 percent) and Transport, Equipment and Parts (5. 2 percent). Many developing countries use changes in the Consumer Price Index (CPI) as their central measure of inflation. However, this method is unsuitable for use in India, for structural and demographic reasons. CPI numbers are typically measured monthly, and with a significant lag, making them unsuitable for policy use. Instead, India uses changes in the Wholesale Price Index (WPI) to measure its rate of inflation. Provisional annual inflation rate based on all India general CPI (Combined) for November 2013 on point to point basis (November 2013 over November 2012) is 11. 24% as compared to 10. 17% (final) for the previous month of October 2013. The corresponding provisional inflation rates for rural and urban areas for November 2013 are 11. 74% and 10. 53% respectively. Inflation rates (final) for rural and urban areas for October 2013 are 10. 19% and 10. 20% respectively. The WPI measures the price of a representative basket of wholesale goods. In India, this basket is composed of three groups: Primary Articles (20. 1% of total weight), Fuel and Power (14. 9%) and Manufactured Products (65%). Food Articles from the Primary Articles Group account for 14. 3% of the total weight. The most important components of the Manufactured Products Group are Chemicals and Chemical products (12%); Basic Metals, Alloys and Metal Products (10. 8%); Machinery and Machine Tools (8. 9%); Textiles (7. 3%) and Transport, Equipment and Parts (5. 2%). WPI numbers are typically measured weekly by the Ministry of Commerce and Industry. This makes it more timely than the lagging and infrequent CPI statistic. Issues The challenges in developing economy are many, especially when in context of the Monetary Policy with the Central Bank, the inflation and price stability phenomenon. There has been a universal argument these days when monetary policy is determined to be a key element in depicting and controlling inflation. The Central Bank works on the objective to control and have a stable price for commodities. A good environment of price stability happens to create saving mobilization and a sustained economic growth. The former Governor of RBI C. Rangarajan points out that there is a long-term trade-off between output and inflation. He adds on that short-term trade-off happens to only introduce uncertainty about the price level in future. There is an agreement that the central banks have aimed to introduce the target of price stability while an argument supports it for what that means in practice. The Optimal Inflation Rate It arises as the basis theme in deciding an adequate monetary policy. There are two debatable proportions for an effective inflation, whether it should be in the range of 1-3 per-cent as the inflation rate that persists in the industrialized economy or should it be in the range of 6-7 per-cents. While deciding on the elaborate inflation rate certain problems occur regarding its measurement. The measurement bias has often calculated an inflation rate that is comparatively more than in nature. Secondly, there often arises a problem when the quality improvements in the product are in need to be captured out, hence it affects the price index. The consumer preference for a cheaper goods affects the consumption basket at costs, for the increased expenditure on the cheaper goods takes time for the increased weight and measuring inflation. The Boskin Commission has measured 1. 1 per cent of the increased inflation in USA every-annum. The commission points out for the developed countries comprehensive study on inflation to be fairly low. Money Supply and Inflation The Quantitative Easing by the central banks with the effect of an increased money supply in an economy often helps to increase or moderate inflationary targets. There is a puzzle formation between low-rate of inflation and a high growth of money supply. When the current rate of inflation is low, a high worth of money supply warrants the tightening of liquidity and an increased interest rate for a moderate aggregate demand and the avoidance of any potential problems. Further, in case of a low output a tightened monetary policy would affect the production in a much more severe manner. The supply shocks have known to play a dominant role in the regard of monetary policy. The bumper harvest in 1998-99 with a buffer yield in wheat, sugarcane, and pulses had led to an early supply condition further driving their prices from what were they in the last year. The increased import competition since 1991 with the trade liberalization in place have widely contributed to the reduced manufacturing competition with a cheaper agricultural raw materials and the fabric industry. These cost-saving driven technologies have often helped to drive a low-inflation rate. The normal growth cycles accompanied with the international price pressures has several times being characterized by domestic uncertainties. Global Trade Inflation in India generally occurs as a consequence of global traded commodities and the several efforts made by The Reserve Bank of India to weaken rupee against dollar. This was done after the Pokhran Blasts in 1998. This has been regarded as the root cause of inflation crisis rather than the domestic inflation. According to some experts the policy of RBI to absorb all dollars coming into the Indian Economy contributes to the appreciation of the rupee. When the US dollar has shrieked by a margin of 30%, RBI had made a massive injection of dollar in the economy make it highly liquid and this further triggered off inflation in non-traded goods. The RBI picture clearly portrays for subsidizing exports with a weak dollar-exchange rate. All these account for a dangerous inflationary policies being followed by the central bank of the country. Further, on account of cheap products being imported in the country which are made on a high technological and capital intensive techniques happen to either increase the price of domestic raw materials in the global market or they are forced to sell at a cheaper price, hence fetching heavy losses. Factors There are several factors which help to determine the inflationary impact in the country and further help in making a comparative analysis of the policies for the same. The major determinant of the inflation in regard to the employment generation and growth is depicted by the Phillips curve. Demand Factors It basically 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. This has generally been seen in India in context with the agrarian society where due to droughts and floods or inadequate methods for the storage of grains leads to lesser or deteriorated output hence increasing the prices for the commodities as the demand remains the same. 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. The energies issues regarding the cost of production often increases the value of the final output produced. These supply driven factors have basically have a fiscal tool for regulation and moderation. Further, the global level impacts of price rise often impacts inflation from the supply side of the economy. Domestic Factors The underdeveloped economies like India have generally a lesser developed financial market which creates a weak bonding between the interest rates and the aggregate demand. This accounts for the real money gap that could be determined as the potential determinant for the price rise and inflation in India. There is a gap in India for both the output and the real money gap. The supply of money grows rapidly while the supply of goods takes due time which causes increased inflation. Similarly Hoarding has been a problem of major concern in India where onions prices have shot high in the sky. There are several other stances for the gold and silver commodities and their price hike. External Factors The exchange rate determination is an important component for the inflationary pressures that arises in the India. The liberal economic perspective in India affects the domestic markets. As the prices in United States Of America rises it impacts India where the commodities are now imported at a higher price impacting the price rise. Hence, the nominal exchange rate and the import inflation are a measures that depict the competitiveness and challenges for the economy. EFFECTS OF HIGH INFLATION ON ECONOMY In an economy in which the prices of everything, including the prices of assets and debt instruments, changed proportionally with the price level, nobody would be hurt by our benefit from changes in the price level, unless those changes affected the economy’s output and the rate at which that output grew. However, in the real economy, all prices do not change at the same rate. Consequently, inflation does provide gains to some and losses to others, apart from any effect on the output level and its growth rate. 1. Effects on the distribution of income and wealth There are two ways to measure the effects of inflation on the redistribution of income and wealth in a society: (i) on the basis of the change in the real value of such factor incomes as wages, salaries, rents, interests, dividends and profits. Here, income is narrowly defined, (ii) on the basis of the size distribution of income over time as a result of inflation. The change in a household’s net worth from one date to another is the difference between the changes in the amounts of its assets and liabilities. Conceptually this is a broader definition of income. In terms of the narrow definition, inflation affects the distribution of income only to the degree that it alters the way that the flow of total income is distributed by income class. If this remains unchanged despite inflation, then by definition inflation does not affect distribution of income. However, by the broad definition, inflation may leave the flow covered by the narrow definition unchanged, but still significantly alter the distribution of income by causing changes in the distribution of net worth of household by income class. The effects of inflation on redistribution of income can be understood by knowing the effect of inflation on different group of societies which are as follows: (i) Debtor and Creditors: During inflation, debtors return the same amount of money, but they pay less in terms of goods and services. Thus, the burden of the debt is reduced and debtors gain. On the other hand, creditors lose because they receive less in real. Thus, inflation brings about a redistribution of real wealth in favor debtors. (ii) Salaried Class: During rising prices, salaried persons lose because their salaries are slow to adjust when prices are rising. (iii) Fixed Income Class: The recipients of transfer payments such as pensions, unemployment insurance, social security, etc. and recipients of interest and rent live on fixed incomes. All such persons lose because they receive fixed payments, while the value of money continues to fall with rising prices. There are two types of investors: first, who invest in shares or stocks of companies and second who invest in fixed interest bearing bonds. Investors of first group gain because when prices are rising, business activities expand which increase profit of companies. As profits increase, dividends on equities also increase at a faster rate than prices. But investor of second type loses during inflation because they receive a fixes sum while the purchasing power is declining. (v) Farmer: Landlord loses during rising prices because they get fixed rents. But peasant proprietors who own and cultivate their farm gain. The landless agricultural workers are hit hard by rising prices. (ii) The Effects of inflation on Output, Employment and the Growth Rate For an economy producing below potential, many economists maintain that inflation of the creeping or crawling variety will have a tonic effect on output and employment. In the event of unanticipated inflation, prices rise faster than money wage rates, and the resulting reduction in the real wage rate gives business the profit incentive to hire more workers and expand output. Consequently, a rise in the inflation rate, if unanticipated, may lead to a reduction in the unemployment rate. Given an inflation in which wages lag behind prices, the wage share of total income shrinks and the fraction of total income saved expands. This follows from the fact that a larger portion of the total income goes to profits and other non wage income, the recipients of which are typically upper income groups with a relatively high propensity to save. That a greater saving will occur under the conditions here specified is well established. When one compares the rate of inflation and the rate of growth of real gross national product in major industrialized countries over the period since World War II, one finds no clear pattern. West Germany (with the lowest rate of inflation) has shown one of the highest rates of growth and Japan (with a high rate of inflation) has shown by for the higher rate of growth. The U. K. (with the lower rates of growth) is among the highest in terms of the rate of inflation. These are problems of interpretation here due to the impact of World War II. (iii) Other Effects of Inflation Inflation leads to a number of other effects which are discussed as under (i) Government: The government gains under inflation for rising wages and profits spread as illusion of prosperity with in the country. (ii) Balance of Payments: During inflation, domestic become costlier compared to foreign products. This leads to increase imports and reduce exports, thereby making the balance of payments unfavorable for the country. But there is no adverse impact on the balance of payments if the country is on the flexible exchange rate system. Inflation should be tackled from various angles as it is a complex phenomenon. In modern economy, the broad categories of instruments of commonly used to manage inflation are (1) Monetary policy, (2) Fiscal policy, (3) Direct control, and (4) Miscellaneous measures. Monetary policy The basic underlying assumption behind the use of monetary policy to control inflation is that a rise in prices is due to excess of monetary demand for goods and services by the people since bank credit is easily available to them. Monetary policy is, thus, concerned with banking and credit availability to firms and households, interest rates, public debt and its management and the monetary standard. Therefore, the most logical way out to check inflation is to prevent the flow of money supply by framing apt monetary policies and cautiously implementing monetary measures. A dear money policy is followed to curb inflationary pressures. The total volume of credit is depleted by using quantitative methods. In this regard, (1) benchmark rate may be hiked, (2) open market operations may be undertaken, and (3) in extreme cases, reserve requirement ratio may be enhanced. Keeping in mind the above, RBI reduced the Cash Reserve Ratio from 4. 5% in September 2012 to 4. 25% in October’ 2012. RBI also made no changes in the benchmark repo rate. It stood at 7% in October 2012 RBI also conducts regularly MSS auctions to suck out excess liquidity from the system . However, looking at high inflation, further action on the monetary front is very much necessary. Fiscal policy Fiscal policy is the policy concerning the revenue expenditure and debt of the Government for achieving certain objectives like control of inflation, public expenditure etc. It is quite clear that public expenditure is on the increase continuously and the increased expenditure is either met by deficit financing or by borrowings. Borrowings results into inflation in the economy and on the other hand deficit financing leads to high prices. Hence, a need arises for a policy which can bring stability on one hand and can control public expenditure on the other hand. Fiscal measures can effect changes in the total expenditure. It may involve increase in taxation and decrease in government spending. The government is supposed to counteract an increase in private spending during inflation. During the last one year, the government has taken the following steps to control the prices of essential items, food and oil items, in particular. 1. Reduction in central sales tax 2. Reduction in ad valorem excise duty on both petrol and diesel 3. Duty cut on all refined oil items 4. Slashing of import duty on all crude vegetable oils 5. Import duty cut on butter and ghee 6. Ban on export of pulses and basmati rice 7. Implementing excise duty on steel However, these measures may result in lower tax revenue which, in turn, may increase the fiscal deficit of the government. Direct Controls Direct Controls refer to the regulatory measures undertaken to convert an open inflation into repressed one. Such regulatory measures include rationing of scarce goods and direct control on prices. They can be introduced or changed quickly and easily. Hence, the effect of these changes can be rapid. The government of India directly controls the prices of petroleum goods and also uses certain indirect measures to control the prices of cement, steel and essential goods. These are more useful when they are applied to specific scarcity areas. These are to be used only in extraordinary circumstances and not during peacetime. Miscellaneous Measures Some other measures which may help in curbing the inflation are 1. Increase the supply of essential goods by producing more. 2. Stop wage price spiral by exercising the control on salaries 3. Produce certain essential items at the expense of luxury goods 4. Relaxation of restrictions on imports 5. Reduction in exports 6. Check the growth of population through an effective family planning program 7. Indexing Conclusion Incidence of inflation has been viewed as a monstrous occurrence. It squanders money and destroys economies. Literary works apprehend dire consequences of high and hyper inflation. As the saying goes,† a stitch in time saves nine†, the monetary policy should be preemptive and proactive in order to avoid it. As the causes of inflation differ from country to country, it becomes essential for the central banks to respond to these occurrences fast and intelligently by using the appropriate monetary policy tools. It should be flexible enough to act according to the changing scenarios. Inflation-targeting framework can be an effective option. Economic history is full of inflationary instances. What lacks is the material linking of the concepts with that of the practical experiences. Several variables in the economy that are affected by the money supply have been looked at in this paper. Each of these real variables is influenced by inflation to a certain extent. Though all the effects that inflation causes cannot be explained by inflation, there is no doubt that inflation does play a role in the economy’s growth. Inflation, as a subject, has been a major area of economic research and public debate, all over the world, and particularly so in India, where strong democratic traditions and intellectuals’ activism are well-rooted. There is a need for working out a national consensus on the acceptable level of inflation. What may be called inflation-consensus should be followed by an explicit inflation-mandate. Our track record on inflation has been satisfactory, and there are good chances that could be improved upon if analytical tools are kept sharp and the timeliness and coordination especially between fiscal and monetary operations as well as effectiveness of policy responses are ensured.