IntroductionThe General Index of Wholesale prices prepared and published by the Ministry of Commerce & Industry to the Govt. of India stood at 177.6 on March 2014. This represents a rise of around 77.6% since March 2004. It should however be noted that increasing since 2005 at increasing rate but after April 2010, it increased at a decreasing rate. Apart from this significant increase in the prices, there are other factors also which are indicating towards the highly inflationary conditions rising in the country during the past 1 years or more. If these high prices are not of much concern today or not attracting the public attention to the required extent, the rightly explanations is the fact that the economy has nearly adjusted itself to the higher price plateau and public have become accustomed to the experience of buying less goods with more money. But this danger of inflation going out of hand is as real as ever before and the need for maintaining the right and stable prices for the welfare of this developing country is increasing day by day.In the last two years, inflation has become a major barrier to the nations ability to enjoy the fruits of brisk economic growth. Left unaddressed, inflation could become a permanent feature of Indias growth story.A main driver of inflation during the last few years has been high food prices. Food inflation reached a dizzying 16.6 % in September 2013. Moreover, it has exceeded overall inflation since June 2012. Consistently high food inflation is eating into the ability of low-income households to build up enough disposable income to buy high-end consumer products.Food inflation is being driven by forces that show little sign of easing up. Employment under the auspices of the Mahatma Gandhi National Rural Employment Guarantee Act (MNREGA) is enabling millions of rural workers to earn wages higher than the prevailing minimum wages in many states. This employment scheme has provided a stable non-agriculture income for a large number of low-income rural households. It has also helped raise the benchmark wage rate in rural areas. As a result, wages have grown steeply in recent years. According to the RBI, the average nominal rural wage increase during 2008-2009 to 2012-2013 was on the order of 17 %. The government plans to raise MNREGA wages before the general elections and wants to align these wages with the rural consumer price index. Thus many observers expect wage inflation in the farm sector to escalate further in the coming year. Poor agricultural yields failed to neutralize the impact of inflationary pressure on food markets. During 2008-2009 through 2012-2013, the yield in food grains, pulses and vegetables registered average increases of 4.7 %, 6.2 % and 6.5 %, respectively. The chances that yield growth will match increases in food inflation in the near future seem bleak, owing to a lack of sustained capital investments in agriculture technologies and agriculture extension services. Unsafe storage of food grains and inadequate storage facilities is further driving food inflation. Fruits, grains and vegetables worth US$7 billion are wasted every year because of inadequate storage infrastructure. According to government estimates made in November 2011, the total gap of storage capacity in the country stood at 14 million tons, and an investment of about US$642 million is needed to bridge the gap.12Finally, fuel-cost inflation is worsening food inflation. Inflation of fuel commodities stood at more than 8 % year-over-year in the first two quarters of FY2013-2014. Prices of dieselthe dominant fuel used in Indiahave jumped by more than 12 % each year during December 2009 to December 2013. The government will likely continue raising retail prices of petrol and diesel to help oil marketing companies to bridge revenue gaps. This mechanism, coupled with rising import prices of petroleum crude as a result of a volatile rupee, will only exacerbate fuel-price inflation, further raising food prices.In this assignment an attempt is made to examine the extent to which economic growth is related to inflation and vice versa. But before that it is necessary to have a general Idea of the economics of inflation.

InflationBy Inflation most people understand a substantial and rapid rise of the general level of prices.The term Inflation refers to sustained increases in the general level of prices. What it basically convey is deplorably vague in several respects. There would be no accepted accession as to how briskly general prices would have to climb, or how sustained the climb would have to be, in order to legitimize use of the term Inflation. But however vague may be the borderline between pricy stability and inflation, the concept has weighty meaning beyond that borderline, and it is important not to confuse that meaning.1) Increase in the quantity of money are not inflation, though in some cases they may lead to it.2) Budget deficits are not inflation, though they will cause it under some circumstances.3) Increase in individual prices, or even of large groups of prices such as those of non-agriculture output, are not inflation.4) Brief periods of considered price increases are not generally regarded as inflation, though this clearly introduces the vagueness of the term which makes dangerous its use in many specific instances.One of the leading monetary economists of early generation, Pigou, defined Inflation in his Economics of Welfare (1920) as that part of the rise in prices that is consequent upon governmental interference with money and banking.On the other hand Irving Fisher in his book Inflation has stated that supply of goods has not influenced prices as much as supply of money.A logical step from a definition of inflation on these lines is to establish a cause and effect relationship between volume of money on the one hand and prices on the other hand. When once it is admitted that money supply more than the supply of commodities determines price level, it follows that an expansion of money followed by no commensurate expansion of the supply of goods should result in an inevitable rise in prices. In this sense, Inflation occurs when the volume of money actively bidding for goods and services increases faster than the available supply of goods, when the growth of national income in money units is greater than its growth in physical units.

Literature ReviewMeasurement of InflationBoth Inflation and Price Stability refer to some general level of prices, these definitions are both incomplete until the appropriate basket of goods for their measurement is specified.Measuring Inflation is a difficult problem for Govt. statisticians. To do this a number of goods that are representative of the economy are put together into what is referred to as a Market Basket. The cost of this basket is compared over time.

Various Indexes have been devised to measure different aspects of Inflation. Some of them are given below:1. Consumer Price Index (CPI)The Consumer Price Index(CPI) is the Bureau of Labour Statistics attempts to measure the prices of Market basket of goods bought by city wage earners and clerical workers.The estimation of CPI is calculated quite rigorously. Consumption goods are classified in various categories and sub categories on the basis of consumer categories like urban or rural. Then the overall index of price is calculated on the basis of indices and sub-indices obtained by National Statistical Agencies. It basically gives an overall idea of the cost of living. CPI thus obtained is used to measure inflation. The %age change in this CPI over a specific period of time is the amount of inflation over that period, i.e. the increase in prices of a representative basket of goods consumed.There are, however, limitations to the use of this index as a measure of inflation. Like the other consumer price indices, this index is also based on controlled prices of many commodities and ignores the higher black-market prices prevailing in the market for some commodities and therefore, underrates the extent of price changes. In fact, any index for that matter has certain limitations. However, this index may be considered to be a reasonably satisfactory indicator of the degree of inflation in our country.2. Employment Cost Index (ECI)The relative changes in wages, benefits and bonuses for a particular group of occupations is measured by the Employment Cost Index. The reason the ECI is thought to be an indicator of inflation is that as wages increases the added cost is often passed to consumes shortly thereafter in the form of higher prices, which lead to inflation. In combination with the productivity report, the ECI can reveal whether the increased cost of labour is justified or not. Therefore ECI provides an early indicator of Inflation.3. Producer Price Indexes (PPI) The average change in selling prices received by domestic producers of goods and services over time is measured by another family of indexes i.e. known as PPI or Producer Price Indexes. It measures price change from perspective of the seller.The PPI looks at 3 areas of production:i. Industrial based companiesii. Commodity based companiesiii. Stage of processing based companiesIt is also known as WPI (Wholesale Price Index)PPI serves two main functions. The first is to provide an indication of price change by producers of goods and services, and therefore as an indicator of inflationary pressure on CPIs. Increasing, given the increased tendency of global production processes, they can also serve as indicators of inflationary pressures in importing countries. The second reflects their role in deflating current price estimates of economic activity to arrive at measures of activity in constant prices.In India, Whole sale Price Index (WPI) takes the data of 435 commodities with different weights which indicate the movement of prices of commodities used in all trade and transactions.There are limitations in using the wholesale price index numbers to measure inflation. In India, the index numbers are based on prices quoted to Government inspectors and in the case of some items include only controlled prices. They do not take into account the higher black market prices prevailing for many commodities. 4. Gross Domestic Product Deflator (GDP-Deflator)GDP deflator is a measure of the level of prices of all new domestic goods and services in an economy. All the types of goods and services used to measure the implicit price deflator are updated regularly in GDP-deflator depending on which goods are being bought.Eg. If the price of Mobile calls increases relative to landline calls, people will spend less on mobiles so the price becomes less significant.GDP-Deflator is similar to CPI except that GDP-Deflator tends to use a more fixed basket of goods. The basket of goods in GDP is updated regularly as compared to CPI. Even if people stop buying the mobile phones, the price increases will contribute to the CPI.

Types of InflationAt this stage it may be useful to turn to a brief account of the types of inflation.1. Open InflationAs it is commonly understood and what is in fact the situation, inflation is characterised by a substantial general rise in prices of commodities and cost of services that is not temporary in character. When prices rise substantially and continuously, the phenomenon is called Open Inflation. The community is building up its liquid resources-cash, bank deposits and short-term investments. However, sooner or later there must be spending out of them, for consumption and investment; that is to say, latent inflation will become open.

2. Latent InflationSometimes, such as during a war or even during a normal period, as a result of either voluntary restraint on the part of the people as a measure of public cooperation or as a result of price controls, for a relatively short period there may be no increase in prices but there will be a substantial build-up of what is known as latent Inflation.3. Demand Pull InflationDemand Pull inflation will arise when prices are rising as a result of growing demand for goods and services in relation to their supplies. Generally speaking, demand-pull inflation is caused by rising current and capital expenditure on the part of the government and the public, financed to a large extent by recourse to the banking system, the commercial banks as well as the central bank of the country.Demand pull inflation can be shown in a diagram such as the one below. LRAS = Long Run aggregate SupplySRAS = Short Run aggregate SupplyAD = Aggregate Demand

4. Cost-Push InflationThe cost-push type of inflation arises when there is a substantial increase in cost, on account of wage and salary increase much in excess of productivity increases and increase in the prices of important goods and services, all leading to a snowballing effect. Even if the productivity declines, without wage rising, there will be cost-push inflation, but this is rare. What is more common is a rise in emoluments and fall in productivity.Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of GDP together with a rise in the level of prices. One of the risks of cost-push inflation is that it can lead to Stagflation.Where inflation begins as a demand-pull type, sooner or later there will be demands for adjustments in wages and salaries, these not infrequently going beyond what is required to neutralise the rise in prices and cost of living. Likewise, the cost-push type of inflation cannot be sustained for long without causing unemployment, if there were not forces at play in the economy leading to a growth in demand through creation of bank credit in a big way. In recent years cost-push inflation is becoming common superimposed on an inflation that was thriving on excessive demand.So far as India and the developing countries generally are concerned, the inflation is predominantly of the demand-pull type. Large Government expenditure, for developmental and non-developmental purposes, financed to a marked extent by resort to central bank credit, has been the principal contributory factory of Inflation.Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of GDP together with a rise in the level of prices. One of the risks of cost-push inflation is that it can lead to Stagflation. StagflationStagflation occurs when the economy isn't growing but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fuelling sharp inflation in developed countries. For these countries, including the U.S., stagnation increased the inflationary effects.

LRAS = Long Run aggregate SupplySRAS = Short Run aggregate SupplyAD = Aggregate Demand

Causes of InflationDifferent schools of thought provide different views on what actually causes inflation. However, there is a general agreement amongst economists that it is the result of economic forces at work, rather than the conspiracy of merchants and manufacturers, or the faulty functioning of the market mechanism; these can only occur for a short period. Basically inflation represents an imbalance between the flow of incomes to people and the spending power available with them on the one hand and the availability of goods and services on the other. So, if inflation has to be avoided (or for that matter deflation) action has to be taken on both the fronts, namely, on the income stream and on the production stream. Thus, inflation can occur with unchanged availability of goods and a marked increase in incomes in the hands of the people and desire to spend from past savings. It can also occur as a result of incomes remaining unchanged but production diminishing, which is especially true in the case of agricultural production.Generally speaking, the most important reason for rapid increase in incomes is the enormous volume of Government expenditure, for defence, administration and development. Even if all the expenditure is financed in a non-inflationary manner, there is an inherent tendency for prices to rise on account of the many imperfections in the markets for commodities and labour: there is not sufficient mobility of factors of production. This is especially in a country like India, with all kinds of barriers of caste, language etc. But such an inflation can only be of modest dimensions.Causes may be different for different types of inflation like for there are different causes for Demand Pull Inflation and also they are different for Cost Push Inflation. Some of those causes are given below other than mentioned above.Causes for Demand Pull Inflationi. A depreciation of the exchange rate which makes exports more competitive in overseas markets leading to an injection of fresh demand into the circular flow and a rise in national and demand for factor resources there may also be a positive multiplier effect on the level of demand and output arising from the initial boost to export sales. ii. Higher demand from a government (fiscal) stimulus e.g. via a reduction in direct or indirect taxation or higher government spending and borrowing. If direct taxes are reduced, consumers will have more disposable income causing demand to rise. Higher government spending and increased borrowing feeds through directly into extra demand in the circular flow. iii. Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand for example in raising demand for loans or in causing rise in house price inflation. iv. Faster economic growth in other countries providing a boost to UK exports overseas. v. Improved business confidence which prompts firms to raise prices and achieve better profit marginsCauses for Cost-Push InflationCost-push inflation occurs when businesses respond to rising costs, by increasing their prices to protect profit margins. There are many reasons why costs might rise: i.Component costs: e.g. an increase in the prices of raw materials and components. This might be because of a rise in global commodity prices such as oil, gas copper and agricultural products used in food processing a good recent example is the surge in the world price of wheat. ii.Rising labour costs - caused by wage increases that exceed improvements in productivity. Wage and salary costs often rise when unemployment is low (creating labour shortages) and when people expect inflation so they bid for higher pay in order to protect their real incomes. iii.Higher indirect taxes imposed by the government for example a rise in the duty on alcohol, cigarettes and petrol/diesel or a rise in the standard rate of Value Added Tax. Depending on the price elasticity of demand and supply, suppliers may pass on the burden of the tax onto consumers.iv.A fall in the exchange rate this can cause cost push inflation because it normally leads to an increase in the prices of imported products. For example during 2007-08 the pound fell heavily against the Euro leading to a jump in the prices of imported materials from Euro Zone countries.Deficit financing, contrary to general view, is not confined to the Government sector. Private sector also engages in deficit financing by borrowing from the banking system. As a result of deficit financing by Government, the supply of primary money in the form of currency or deposits with the central bank increases. This makes possible a secondary expansion of money supply through the loan and investment operations of commercial and cooperative banks. In the most countries today, there is hardly any limits to the ability of the central bank to create money whether for the government or the private sector, through invariably it is the Government which is the big borrower from the central bank.

Analysis of Inflation in IndiaWholesale Price Index (WPI 2004-05=100): The WPI inflation for the month of December 2012 is reported at 7.18 %, as against 7.24 % in the previous month and 7.74 % in the corresponding month last year. The inflation has declined mainly on account of manufactured products (sugar, edible oils, metals, chemicals, fertilizers and non-metallic mineral products) and fuel (non-administered mineral oils).Inflation for Primary Food Articles (Wt. 14.34 %) increased to 11.16 % in December 2012 from 8.50 % in the last month mainly on account of cereals, fruits & vegetables, fish-inland, chicken and tea. However, inflation has declined for pulses. Inflation for fuel & power (Wt. 14.91%) declined to 9.38 % in December 2012 from 10.02 % in November 2012. The average WPI inflation rate for last 12 months (Jan to Dec, 2012) was 7.54 % as compared to 9.47 % during corresponding period in 2011-12. The build-up of inflation since March stood at 4.72 % as against 5.22 % in the corresponding period last year. WPI inflation rates for major subgroups are indicated in Table given below.

Inflation based on Consumer Price Indices (CPIs): The all India CPI inflation (combined) has increased to 10.56% in December 2012 from 9.90% in the November 2012. The inflation remains elevated for vegetables, cereals, pulses, oils & fats, meat & fish and sugar in the current month. Inflation based on CPI-IW declined marginally to 9.55% in November 2012 from 9.60% in October 2012.CPI-IW food inflation in November 2012 increased to 10.85% from 9.91% in October 2012. Food inflation for CPI-AL and CPI-RL was 9.80% and 9.95% respectively in November 2012 as against 8.97% and 9.28% in the previous month.

MethodologyCointegration and error correction modelThe theory of Cointegration and Error Correction Models (ECM) is applied to examine the extent to which economic growth is related to inflation and vice versa. The short-run and long-run relationships between two variables is examined with the help of this model.The Engle-Granger (1987) two-step cointegration procedure is used to test the presence of cointegration between the two variables. If both time series are integrated of the same order then it is possible to proceed with the estimation of the following cointegration regression: = + + = + +

Where = economic growth rate, = inflation rate at time t, and and are random error terms (residuals). Residuals and measure the extent to which and are out of equilibrium. If and are integrated of order zero, I (0), then it can be said that both and are cointegrated and not expected to remain apart in the long run. If cointegration exists, then information on one variable can be used to predict the other.

Data AnalysisEquations are estimated over the period 1972-73 to 2012-13 using annual data collected from CSO and RBI. Inflation (P) is measured from the average wholesale price index (WPI) and growth (Y) rates of gross domestic product are calculated at 1993-94 prices.Results of unit root tests are reported in tables 1 and 2. They show that both growth rate (Y) and inflation (P) are integrated of order zero for India.Table 1. Average inflation and growth ratesInflationGrowth

Mean7.895.59

Standard Deviation4.123.67

Table 2. Unit root test with DF and ADF

Table 3. Phillips Perron test for unit root

c = intercept and c & t = intercept and the time trend.

Next, we examine the cointegrating relationship between economic growth and inflation. First, cointegrating equations (a) and (b) are estimated.Results of cointegration tests and estimates of the cointegrating parameters are reported in tables 4 and 5. They show that growth rates and inflation rates are cointegrated. The empirical evidence also implies that there is a long-run relationship between growth rates and inflation rates and the interesting finding, is that the relationship between inflation and growth rates is negative.Table 4. Unit root test for the residuals and the coefficient of the dependent variables from equation (a)

Table 5. Unit root test for the residuals and the coefficient of the dependent variables from equation (b)

These findings have important policy implications inflation is harmful rather than helpful to growth. Caution is needed since higher inflation may trigger inflationary spirals beyond a safe level as implied by larger inflation elasticitys. As Bruno (1995: 38) puts it, chronic inflation tends to resemble smoking; once you get the habit; it is very difficult to escape a worsening addiction.

Table 6. Error correction model for GDP on WPI

Table 7. Error correction model for WPI on GDP

Tables 6. and 7. present estimated coefficients of the error correction term (long-run effects) and the lagged values of the two series (short-run effects). The estimated coefficients of the error correction term 1, and 2 are significant at the 5 % level from growth rates to inflation and vice versa with appropriate (negative) signs. This means that if the two series are out of equilibrium, as specified in the cointegrating regression (a) and (b), growth rates will adjust to reduce the equilibrium error and vice versa.

ConclusionThis study has been motivated by the recent developments in the literature on the relationship between inflation and growth and the apparent contradictory evidence provided for the developed and developing economies. In this paper, the cointegration and error correction models have used to empirically examine long-run and short-run dynamics of the inflation-economic growth relationship in India using annual data. The main objective was to examine whether a relationship exists between economic growth and inflation and, if so, its nature. The interesting results found in this exercise is that the, inflation and economic growth are negatively related. Second, the sensitivity of inflation to changes in growth rates is larger than that of growth to changes in inflation rates. These findings have important policy implications. In this study, the inflation-growth nexus in India has been systematically analysed. The important conclusion is that any increase in inflation from the previous period negatively affects growth. Therefore, unlike in the case of the EMU area, the most desired policy for India is the one in which there is always a downward pressure on inflation, without having to worry about what is the threshold level. Further, the policymakers should note that any increase in inflation from the previous period at any level has negative effect on economic growth. However, the fact that the common people and the decision makers do not like inflation has enormous effects on the consumption pattern, which in turn affects the output demanded. Macroeconomic stability and the necessary infrastructure are among the preconditions for sustained growth. Among the ways inflation can affect growth, an important avenue is the effect of inflation on investment. Low or moderate inflation is an indicator of macroeconomic stability and creates an environment conducive for investment. A review of the existing cross-country international evidence, as well as evidence from Asia, indicates a negative relationship between inflation and long-term growth. Countries with low or moderate rates of inflation have higher growth rates over the long-term compared with countries with high inflation rates. However, low inflation does not constitute a sufficient condition for growth. The Indian experience appears to support the above view. In India inflation has generally been kept under control. There have been two episodes of high inflation since 1980 but price rise has been controlled by various fiscal, monetary and administrative measures. Also, evidence from investment behaviour in private manufacturing suggests that an increase in the rate of inflation has a negative impact on private investment in manufacturing. The regression for private investment in agriculture points towards complementarities between public and private investment. Taking economy-wide linkages into account, the analysis suggests that higher growth can be achieved by controlling inflation and raising public investment. To promote growth and keep inflation low, the government needs to control budget deficits. While simulations indicate that this can be achieved by switching public expenditure from consumption to investment, this may be a difficult policy to pursue, especially in a developing country with a multiparty democracy. It may be more realistic to choose tolerable levels of inflation rate and achieve the maximum possible growth given that rate, by deficit-financed public investment. The model allows the policy maker to see the various trade-offs involved. The overall message is clearthe government should curtail unproductive expenditure, which is bad for both growth and inflation, in favour of investment. Providing stability and the necessary infrastructure can set the stage for the use of other more direct policy measures aimed at promoting growth.