Notes on Inflation

 

Inflation is a continuous increase in the general price level. It measures the changes in the price level in the economy. If the firms desire a stability in price, the price levels must remain stable. Therefore, an eye on inflation figures is no doubt important for any manager or an entrepreneur. For the inflation to be measured, there must be a construction of general price level. Generally, there are two measures that are constructed for general price level. Going back to the circular flow model, there are two actors, the firms and the households in the economy. Firms produce goods and services which the households consume. The firms sell goods at certain prices and the households consume the goods at certain other prices. There is a difference between the prices at which the firms sell and the prices at which the households consume. Therefore it becomes important to know which prices have to be taken for constructing a general price level. In all cases, price levels are constructed at both ends. The Wholesale Price Index (WPI) or Producer Price Index (PPI) is constructed at the firm’s end. Similarly the Consumer Price Index (CPI) is constructed for prices prevailing at the household level. There are different methods of constructing these indices and different countries adopt these different methods. The methods imply changes in the base years and the frequency at which these base years get changed. Without digressing into the methodology- which needs a separate treatment- the current focus on basics of understanding inflation.

 

WPI and CPI both are constructed in the Indian context. For many years until around 2012-13, the primary measure for inflation was WPI. In other countries however, CPI remained the primary measure for inflation all these years. The current monetary policy which adopts inflation targeting as its objective switched to CPI during the times of Raghuram Rajan as Governor from WPI in the earlier years. This in itself set off a controversy which again requires a separate analysis, something away from the objectives of the current post. In India, the objective of WPI as primary indicator of inflation was its lesser lag time. Given the complexities in data collection for CPI and consequently the time lag for reporting, CPI was not used as a primary measure for calculating the inflation. Yet, CPI has always been the primary measure for calculation cost of living allowances. Further, each household is unique and thus there took a considerable time to build a representative basket for all the households. CPI gets constructed differently for different households. There is a construction for household of a typical industrial worker, a typical household basket for an agricultural labourers, a typical basket for a household of an urban non manual employee so on and so forth. With passage of time, a rural household basket was constructed and so did a representative basket for an urban household. The average of the two were built into a combined CPI which has been calculated since 2012-13 and currently remains the primary measure for inflation in the country.

Yet in understanding the implication of inflation, the aggregate figure might be of little help. Decomposition of inflation would be in order. Therefore, it must be analysed on what is actually driving the inflation. Furthermore, it must be analysed on how sustainable are those drivers. It would be prudent to decode the permanency or otherwise of the drivers of inflation. The total measure of inflation including all the commodities is what is known as headline inflation. CPI combined figures as well as WPI for all commodities can be termed as headline CPI and headline WPI respectively. Yet as noted above, the headline gives only the broad direction. It needs to be decomposed further. Usually the food and the fuel prices are volatile. Food prices are contingent on the idiosyncrasies of the agricultural seasons. Fuel prices are an outcome of the production in oil producing countries. Any crisis in the Gulf for instance can set off price upticks in the fuel sector. Therefore both fuel and food prices depend on vagaries of weather or geopolitics or other factors and thus tend to be volatile. Therefore any inflation measure must factor in these volatilities. Inflation minus the food and fuel prices is what is called as core inflation. Core inflation signifies the inflationary tendencies in the economy aside of volatile factors. It eliminates the volatility element in the economy. The seasonal inflationary element that is characteristic of food and fuel prices is called the non-core inflation.

 

Inflation originates to two different causes. Not that the causes are independent, often they feed on each other. There is a possibility for instance because of increased salaries, the consumption will begin to increase rapidly. In other words, aggregate demand (AD) will increase with the pace outstripping the pace of growth of aggregate supply (AS). In this context, the increased AD relative to AS will cause the rise in prices. Since the price rise originates from imbalances arising out of increased AD relative to AS, it is called as demand pull inflation. There is also a possibility that certain crisis or external factors might derail aggregate supply. In this context while the aggregate demand might not have changed, aggregate supply finds itself reduced. In other words,, AS slows down relative to the growth in AD. The imbalances resulted from this slowdown will cause a rise in production costs. This in turn leads to rise in prices. The rise in prices caused by the imbalances arising out of AS not keeping pace with AD is called cost push inflation. This is because the AS is hindered by rising costs and thus named so. However, in general, to isolate an inflationary tendency to demand pull or cost push would be difficult. They often feed on each other. The rise in AD might cause the AS to increase but this gets accompanied by higher costs of production thus higher prices. So the demand pull results into a cost push too. Therefore, while there might be different causes, both act upon each other thus magnifying the inflationary tendencies.

 

Monetary theory calls for containing inflation or in technical terms inflation targeting. This is sought to be achieved through monetary instruments since the theory posits a direct linkage between the money supply and price level. This of course needs to be discussed at length but will become a subject matter of another post.