Inflation

Circular Flow of Income

Concept:

Nominal income is the actual dollar amount that the person receives as income and has not been adjusted for the inflation rate. Inflation is the increase in the general price level which means that if your income is the same and the price level goes up then you will be able to buy lesser in that income because now the products will be expensive. For example if a person is given a salary of $ 2500 then it generally refers to the nominal income as it does not account for inflation. Real income is adjusted for this increase in prices and represents a realistic picture and shows how much a person is left with when the increase in prices is deducted from nominal income. It shows the purchasing power of the person by relating the income to the goods or services that can bought with it instead of just the dollar amount. 
Real Income = Nominal Income – Inflation

Nominal Income=Real income*Price

Relation between N.I and R.I. should be stable mean price level should be stable.

But price instability is fundamental economic disturbance like if price increases – Inflation and if price decreases –Deflation

Inflation	Deflation
It creates Spiral down effect of economy which may ultimately lead to depression
Consumption level decline   Increased production-consumption gap      reduced production effort      Reduced production level(Lowering of GDP growth)	It reduces rate of economic reward to producer class       production effort weakens           production quantity reduces                             Reduces income level of working class      consumption capacity reduces
It may be problematic in future	It is immediately harmful
It increases production and employment may rise	It hurts producers class and unemployment may rise

Note: In both, inflation and deflation, consumption hurt mechanism is different but both are harmful.

Inflation:

Now first we should discuss about how we can measure it. Then there are two indices at large (i) WPI and (ii) CPI

What is an Index Number?

 An Index number is a single figure that shows how the whole set of related variables has changed over time or from one place to another.  In particular, a price index reflects the overall change in a set of prices paid by a consumer or  a producer, and is conventionally  known as a Cost-of-Living index or Producer's Price Index as the case may be.

 WPI:

This index is the most widely used inflation indicator in India.  This is published by the Office of Economic Adviser, Ministry of Commerce and Industry.  WPI captures price movements in a most comprehensive way.   It is widely used by Government, banks, industry and business circles.   Important monetary and fiscal policy changes are linked to WPI movements. The current series of Wholesale Price Index has 2004-05 as the base year.   Latest revision of WPI has been done by shifting base year from 1993-94 to 2004-05 on the recommendations of the Working Group set up with Prof Abhijit Sen,, Member, Planning Commission as Chairman for revision of WPI series

Consumer Price Index (CPI)

The CPI measures price change from the perspective of the retail buyer. It is the real index for the common people. It reflects the actual inflation that is borne by the individual.  CPI is designed to measure changes over time in the level of retail prices of selected goods and services on which consumers of a defined group spend their incomes.   Till January 2012, in India there were only following four CPIs compiled and released on national level.    (In some countries like UK, Malaysia, Poland it is also known as Retail Price Index). 

(1) Industrial Workers (IW) (base 2001),

(2) Agricultural Labourer (AL) (base 1986-87) and

(3) Rural Labourer (RL) (base 1986-87)

(4) Urban Non-Manual Employees (UNME) (base 1984-85),

 The first three are compiled by the Labour Bureau in the Ministry of Labour and Employment, and the fourth is compiled by Central Statistical Organisation (CSO) in the Ministry of Statistics and Programme Implementation.   These four CPIs reflect the effect of price fluctuations of various goods and services consumed by specific segments of population in the country.   These indices did not encompass all the segments of the population and thus, did not reflect the true picture of the price behaviour in the country as a whole.  

	WPI	CPI - New Series wef Feb 2012
Base Year	2004-05	2010
Elementary Items	676	200 (Weighted items)
Weightage of Food products (%)	243	49.71
Weightage of Energy products (%)	14..91	9.49
Weightage of Miscellaneous Items (%)	Services not included	26.31

CPI vs WPI

Inflation in all major indices largely followed each other .The gap between the WPI and CPI may be widened due to higher food inflation as food items have much higher weight in CPI vis-a-vis the WPI .The CSO, ministry of statistics has introduced a new CPI series (base 2010=100) for all-India and states /union territories separately for Rural, Urban and combined with effect from Jan 2010-2011.

Types of inflation:-

COST PULL INFLATION: This type of inflation occurs when general price levels rise owing to rising input costs. In general, there are three factors that could contribute to Cost-Push inflation: rising wages increases in corporate taxes, and imported inflation. [Imported raw or partly-finished goods may become expensive due to rise in international costs or as a result of depreciation of local currency]

DEMAND - PUSH INFLATION:  In this type of inflation prices increase results from an excess of demand over supply for the economy as a whole. Demand inflation occurs when supply cannot expand any more to meet demand; that is, when critical production factors are being fully utilized, also called Demand inflation.

HYPERINFLATION: 

Hyperinflation is a situation where the price increases are too sharp.  Hyperinflation often occurs when there is a large increase in the money supply, which is not supported by growth in Gross Domestic Product (GDP).  Such a situation results in an imbalance in the supply and demand for the money.  In this inflation remains unchecked; it results into sharp increase in prices and depreciation of the domestic currency.

 GALLOPING INFLATION:

It occurs when a persistent inflation gets out of control and there is decline in value of money. In this situation each increase in prices becomes the signal for an increase in wages as costs which again pushes prices up still further.

PPP CATCH-UP INFLATION: a $ 100 note is exchangeable today at around 4500 Indian rupees. But with 4500 rupees you can buy more goods and services in India than with $100 in the US .India’s PPP correction factor is 2.9, meaning the stuff available here for $100 will cost in US $290. That corresponds to an exchange rate of roughly rupees 15.5 to one dollar. So what here in India is Catch-up Inflation?

 Advantage of inflation;

1.       The Nobel Prize winning economist James Tobin at one point argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least a higher study level of income .This is because inflation lowers the real return on monetary assets relative to real assets, such as physical capital. To avoid this effect of inflation, investors would switch from holding their assets as money (or,a similar, susceptible –to-inflation, form) to investing in real capital projects.
2.       A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above Zero so that if need arises the bank can cut the nominal Interest rate.
 Negatives of inflation:1.       It adds inefficiency in the Market and make it difficult for companies to budget or plan long term.
2.       Uncertainty about future purchasing power of money discourages investment and saving.
3.       Inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates unless the tax brackets are indexed to inflation.
4.       With the inflation, Purchasing power is redistributed from those on fixed nominal incomes, such as some pensioners whose pensions are not indexed to price level ,towards those with variable incomes whose earnings may be better keep pace with inflation.
5.       This also affects international trading, where fixed exchange rates are imposed, higher inflation in one economy than another will cause the first economy‘s exports to become more expensive and affect the balance of trade.
6.       After inflation greater than 10 %, income earning has to be more and so a trap of economy.
7.      If inflation then saving  down  capital formation down     investment down   so the   production capacity down