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Awareness Article # 9 INFLATIONWhat is inflation?

Inflation rate of a country is the rate at which prices of goods and services

increase in its economy. It is an indication of the rise in the general level of

prices over time. Since its practically impossible to find out the average change

in prices of all the goods and services traded in an economy (which would givecomprehensive inflation rate) due to the sheer number of goods and services

present, a sample set or a basket of goods and services is used to get an

indicative figure of the change in prices, which we call the inflation rate.India uses the Wholesale Price Index (WPI) to calculate and thendecide the inflation rate in the economy.Most developed countries (UK, US, JAPAN and CHINA) use theConsumerPrice Index (CPI) to calculate inflation.What is WPI?WPI is the index that is used to measure the change in the average pricelevel of goods traded in wholesale market. In India, a total of 435

commodities data on price level is tracked through WPI which is an indicator

ofmovement in prices of commodities in all trade and transactions. It is also theprice

index which is available on a weekly basis with the shortest possible timelag only two

weeks. The Indian government has taken WPI as an indicator ofthe rate of inflation in

the economy.What is CPI?

CPI is a statistical time-series measure of a weighted average of prices of a

specified set of goods and services purchased by consumers. It is a price

index that tracks the prices of a specified basket of consumer goods and

services, providing a measure of inflation.How WPI is calculated?

In this method, a set of 435 commodities and their price changes are used for

the calculation. The selected commodities are supposed to represent various

strata of the economy and are supposed to give a comprehensive WPI value for

the economy.WPI is calculated on a base year and WPI for the base year is assumed tobe 100. To show the calculation, lets assume the base year to be 1970. Thedata of wholesale prices of all the 435 commodities in the base year and thetime for which WPI is to be calculated is gathered.

Let's calculate WPI for the year 1980 for a particular commodity, say wheat.Assume that

the price of a kilogram of wheat in 1970 = Rs 5.75 and in 1980 = Rs 6.10The WPI of wheat for the year 1980 is,

(Price of Wheat in 1980 Price of Wheat in 1970)/ Price of Wheat in 1970 x 100

i.e. (6.10 5.75)/5.75 x 100 = 6.09

Since WPI for the base year is assumed as 100, WPI for 1980 will become 100

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+ 6.09 = 106.09.

In this way individual WPI values for the remaining 434 commodities are

calculated and then the weighted average of individual WPI figures are found

out to arrive at the overall Wholesale Price Index. Commodities are given

weight-age depending upon its influence in the economy.

How is Inflation rate calculated?If we have the WPI values of two time zones, say, beginning and end of year,the inflation rate for the year will be,(WPI of end of year WPI of beginning of year)/WPI of beginning of year x 100For example, WPI on Jan 1st 1980 is 106.09 and WPI of Jan 1st 1981 is109.72 then inflation rate for the year 1981 is,(109.72 106.09)/106.09 x 100 = 3.42% and we say the inflation rate for theyear 1981 is 3.42%.

Since WPI figures are available every week, inflation for a particular week is

calculated based on the above method using WPI on the later week and WPI on

the previous week. This is how we get weekly inflation rates in India.

Characteristics of WPIFollowing are the few characteristics of Wholesale Price Index1.WPI uses a sample set of 435 commodities for inflation calculation2.The price from wholesale market is taken for the calculation3.WPI is available for every week4.It has a time lag of two weeks, which means WPI of the week two weeksback will be available now.Disadvantages of WPIFollowing are the disadvantages of Wholesale Price Index1.India is the only major country that uses a wholesale index to measure

inflation. Most countries use the CPI as a measure of inflation, as thisactually measures

the increase in price that a consumer will ultimatelyhave to pay for.2.It pointed out that WPI does not properly measure the exact price rise anend-consumer will

experience because, as the same suggests, it is at thewholesale level.3.The main problem with WPI calculation is that more than 100 out of the435 commodities included in the Index have ceased to be important fromthe consumption point of view.

4.India constituted the last WPI series of commodities in 1993-94; but hasnot updated it till

now that economists argue the Index has lost relevanceand can not be the barometer to

calculate inflation.5.WPI is supposed to measure impact of prices on business. But India usesit to measure the impact on consumers. Many commodities not consumedby consumers get calculated in the index. And it does not factor inservices which have assumed so much importance in the economy.Why India is not shifting to CPI ?

In India, there are four different types of CPI indices, and that makes

switching over to the Index from WPI fairly 'risky and unwieldy.' The four

CPI series are: CPI Industrial Workers; CPI Urban Non-Manual

Employees; CPI Agricultural labourers; and CPI Rural labour.

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The CPI cannot be used in India because there is too much of a lag inreporting CPI numbers.The WPI is published on a weekly basis and the CPI, on a monthly basis.And in India, inflation is calculated on a weekly basis

WHOLESALE PRICE INDEXWPI was first published in 1902, and was one of the more economic indicatorsavailable to policy makers until it was replaced by most developed countries bythe Consumer Price Index in the 1970s. WPI is the index that is used to measurethe change in the average price level of goods traded in wholesale market. InIndia, a total of 435 commodities dataon price level is trackedthrough WPI whichis an indicator of movement in prices of commodities in all trade and transactions.It is also the price index which is available on a weekly basis with the shortest

possible time lag only two weeks. The Indian government has taken WPI as anindicator of the rate of inflation in the economy.

Consumer Price Index (CPI)CPI is a statistical time-series measure of a weighted average of prices of a specified setof goods and services purchased by consumers. It is a price index that tracks the pricesof a specified basket of consumer goods and services, providing a measure of inflation.India is the only major country that uses a wholesale index to measure inflation. Mostcountries use the CPI as a measure of inflation, as this actually measures the increasein price that a consumer will ultimately have to pay for.

CAUSES FOR INFLATION IN INDIAThe government of India has always been under theThe government of India has always been under theimpression that:impression that:(b)(b)Some inflationary rise in prices is inherent in rapidSome inflationary rise in prices is inherent in rapideconomic development- and GDP growth has beeneconomic development- and GDP growth has beenaround 7-8 per cent.

around 7-8 per cent.(d)(d)RBI has always given the impression that by usingRBI has always given the impression that by usingmonetary policy of rate of interest and CRR, itmonetary policy of rate of interest and CRR, itcould control the volume of money supply andcould control the volume of money supply andvolume of demand so as to maintain the annual

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volume of demand so as to maintain the annualrate of inflation around 5.5%- such a rate ofrate of inflation around 5.5%- such a rate ofinflation is permissible and manageable in theinflation is permissible and manageable in thecontext of economic growth.

context of economic growth.

CAUSES FOR INFLATION INCAUSES FOR INFLATION ININDIAINDIAThe current rise in inflation has its roots in supply-side factors.The current rise in inflation has its roots in supply-side factors.There was shortfall in domestic production vis-a-vis domesticThere was shortfall in domestic production vis-a-vis domesticdemand anddemand and

Hardening of international prices, prices of primaryHardening of international prices, prices of primarycommodities, mainly food items. Wheat, pulses, edible oils, fruitscommodities, mainly food items. Wheat, pulses, edible oils, fruitsand vegetables, and condiments and spices have been the majorand vegetables, and condiments and spices have been the majorcontributors to the higher inflation rate of primary articles.contributors to the higher inflation rate of primary articles.The inflation was also accompanied by buoyant growth of moneyThe inflation was also accompanied by buoyant growth of moneyand credit.and credit.

While the GDP growth zoomed to 9.0 per cent per annum, theWhile the GDP growth zoomed to 9.0 per cent per annum, thebroad money (M3) grew by more than 20 per cent.broad money (M3) grew by more than 20 per cent.Demand for nearly everything from housing to fast movingDemand for nearly everything from housing to fast movingconsumer goods is outpacing supply in part because white-collarconsumer goods is outpacing supply in part because white-collarsalaries are rising faster in India than anywhere else in Asiasalaries are rising faster in India than anywhere else in Asia

CAUSES FOR INFLATION IN

CAUSES FOR INFLATION ININDIAINDIAIt would be too simplistic to hold any one factorIt would be too simplistic to hold any one factorresponsible for inflationary rise in prices in India inresponsible for inflationary rise in prices in India inrecent years.recent years.

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Actually, all of them collectively have contributed to theActually, all of them collectively have contributed to theprice situation in India in recent years.price situation in India in recent years.All the factors responsible for the rise in general pricesAll the factors responsible for the rise in general prices

can be categorized ascan be categorized as(F)(F)Demand-Pull FactorsDemand-Pull Factors(G)(G)Cost-Push FactorsCost-Push Factors(H)(H)Other FactorsOther Factors

Monetary tightening will kill the expansionKeeping inflation under control, in fact, is key to sustaining the expansion.Waiting until inflation rises to higher levels will only make the job of stabilizingprices harder. The international experience on this score is clear: When inflationexpectations get entrenched at high levels, central banks have to tighten evenmore sharply to get inflation down.

A stronger rupee does nothing to control inflation

A stronger rupee helps reduce inflation because it lowers the import prices of oil,other raw materials and capital goods and this, in turn, lowers the cost ofproduction. It also reduces the prices of import-competing goods, like steel.

A related myth is that a strong rupee will kill the economy by hurting exporters. Astronger rupee does reduce the rupee value of export earnings - but it alsoreduces the cost of imported inputs, and to the extent that it dampens inflation, itlimits the need for interest-rate hikes. Moreover, exporters are in a robust positionnow: Among 80 companies surveyed according to a study, net profits rose 67percent in the October-December quarter.

Policy tightening will deny credit to small businesses and thecommon man, as well as hurt the poor.It is true that small businesses and the common man have only limited access to credit.This is a serious problem, but not one that can be solved through easy monetary policy.

The poor, meanwhile, not only have limited access to credit, but live on fixed incomesand have few or no assets to hedge against inflation - so that high inflation hurts themmore than higher interest rates. Consistent with this idea, research by William Easterlyand Stanley Fischer has shown that in a range of countries, higher inflation is associated

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