What Does Inflation Mean?
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.
Annual Inflation
Annual inflation, measured in the WPI (Wholesale Price Index), jumped to a 13-year high of 11.05 per cent in the week ending 7 June 2008 from 8.75 per cent in the preceding week. Inflation has been rising rapidly since January 2008 and the weekly rise in inflation in the week ending on 7 June 2008 was the highest in the current calendar year.
This steep rise in inflation came mainly on account of the sharp jump in prices in the fuel group. Inflation in the fuel more than doubled to 16.25 per cent from 7.86 per cent in the week ending 31 March 2008. This was the highest rate of inflation in the fuel prices ever since 17 March 2001. The government had partially passed on the burden of the rising international crude oil prices to the Indian consumer by hiking the prices of petrol, diesel and LPG (liquid petroleum gas) by Rs.5 per litre, Rs.3 per litre and Rs.50 per 14.2 kg cylinder, respectively, with effect from 5 June 2008.
Causes of Inflation
The basic causes of inflation were covered at AS level. This note considers the demand and supply-side courses in more detail including the impact of changes in the exchange rate and the prices of goods and services in the international economy.
Cost Push Inflation
Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. There are many reasons why costs might rise:
Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on exports of these commodities or alternatively by a fall in the value of the pound in the foreign exchange markets which increases the UK price of imported inputs. A good example of cost push inflation was the decision by British Gas and other energy suppliers to raise substantially the prices for gas and electricity that it charges to domestic and industrial consumers at various points during 2005 and 2006.
Rising labour costs - caused by wage increases which exceed any improvement in productivity. This cause is important in those industries which are ‘labour-intensive’. Firms may decide not to pass these higher costs onto their customers (they may be able to achieve some cost savings in other areas of the business) but in the long run, wage inflation tends to move closely with price inflation because there are limits to the extent to which any business can absorb higher wage expenses.
Higher indirect taxes imposed by the government – for example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation.
Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. This is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a contraction of real national output together with a rise in the general level of prices.
Demand Pull Inflation
Demand-pull inflation is likely when there is full employment of resources and when SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of reasons – some of which occur together at the same moment of the economic cycle
- A depreciation of the exchange rate, which has the effect of increasing the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while foreigners buy more exports, AD will rise. If the economy is already at full employment, prices are pulled upwards.
- A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond potential GDP.
- The rapid growth of the money supply – perhaps as a consequence of increased bank and building society borrowing if interest rates are low. Monetarist economists believe that the root causes of inflation are monetary – in particular when the monetary authorities permit an excessive growth of the supply of money in circulation beyond that needed to finance the volume of transactions produced in the economy.
- Rising consumer confidence and an increase in the rate of growth of house prices – both of which would lead to an increase in total household demand for goods and services
- Faster economic growth in other countries – providing a boost to UK exports overseas.
In the first diagram the SRAS curve is drawn as non-linear. In the second, the macroeconomic equilibrium following an outward shift of AD takes the economy beyond the equilibrium at potential GDP. This causes an inflationary gap to appear which then triggers higher wage and other factor costs. The effect of this is to cause an inward shift of SRAS taking real national output back towards a macroeconomic equilibrium at Yfc but with the general price level higher than it was before.
The rising inflation is due to the rising oil prices in the global markets which have increased to 135 dollars per barrel. The global demand for the oil is also on an increase with growing countries like China and India consuming more and more oil and the already developed economies not reducing their fuel demand. Every time the country goes through a price hike in crude oil, there is an economic and political crisis. This time around as well, the government is under great pressure from the public at large and opposition parties. The Prime Minister Dr. Manmohan Singh and finance minister Mr P. Chidambaram are in a tight spot as the inflation seems to be uncontrollable, along with the fear of interim elections.
The inflation has not only hit hard the consumers but has also had an adverse effect on the stock market. Already week with wounds of U.S subprime crisis, the stock market is on a bearish trend after the impact of inflation. The worst hit stocks are real estate stocks, with the likes of D.L.F going below their issue price as well. The market is sluggish and is showing no signs of recovery. Even an investment in bank deposits is running in to losses with respect to real interest rate. (Real interest rate is nominal interest rate adjusted for inflation). At nominal interest rate of 9% and inflation of 11.05%, the investor incurs a loss of 2.05% in terms of real interest. So an investment in fixed deposit is actually eating up your money.
The R.B.I has increased repo rate i.e. the rate at which it lends money to commercial banks and also raised the cash reserve ratio as part of its defence mechanism. But this is not enough as the base of monetary policy in India is still very weak. Efforts should be made to appreciate rupee so as to reduce the cost of imports of crude oil and reduce inflation. Hiking the interest rate is another option which will reduce the purchasing power of people and thus inflation. But the R.B.I cannot hike the interest rate beyond a certain level as it will hinder the growth of infrastructure which is essential to support the growth of the economy.
According to Robert Prior-Wandesforde, chief Indian economist at HSBC in Singapore inflation figures are likely to remain in double digits for the next nine months and peak at 15 percent by the end of 2008. But according to Chief Economic Advisor to the Finance Ministry Arvind Virmani inflation will have a clear downward trend in October-December this year. Whether any of these predictions will come true or not is still to be seen.
Manveen a good try but no referencing and title not as per guidelines????? Also topic changed?
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