Inflation
Saugata Bhattacharya
Senior Manager @ Oracle Corp | Operations l Strategy l IIFT Delhi(International Business) I IIM Ahmedabad
The macroeconomic causes of inflation are complex, but its effects on individuals are straightforward and severe. While the wealthy may be insulated, the middle class and those in the lowest financial strata bear the brunt of inflation. For some households, coping with rising prices is nearly impossible, leading to starvation, malnutrition, and a profound sense of helplessness.
So, what is inflation, and why does it matter? Inflation refers to the rising prices of goods and services over time, measured against a previous baseline, in relation to income levels. While inflation affects nearly every category of goods and services, its impact varies. For instance, inflation in food prices is more harmful than in clothing because food is essential for daily survival, unlike clothing, which is not needed as frequently. Similarly, inflation in luxury items has a smaller impact compared to essential goods like clothing. People can forgo luxury purchases, but they cannot avoid buying necessities.
How is inflation calculated? Well, the govt of India like any other country calculates inflation including consumer price index and wholesale price index. The govt also uses a basket of items on which the calculations are done. The basket includes items like food, housing, clothing, transportation, medical care, and education. Inflation is primarily measured and managed by 5 govt institutions like the Reserve Bank of India, Ministry of Statistics and Programme Implementation (MoSPI), Ministry of Commerce and Industry, Ministry of Finance and Ministry of Consumer Affairs, Food and Public Distribution. The economic policies and strategies of the Indian government and handled by the office of the chief economic advisor. The CEA advises the government on a wide range of economic policies, including fiscal policy, inflation management, and international trade.
Cost/Supply-Push and Demand-Pull Inflation
Cost/Supply-Push Inflation: Occurs when the costs of production for goods and services increase, leading businesses to raise prices to maintain profit margins. This could be due to rising labor costs, raw material prices, or supply chain disruptions.
Demand-Pull Inflation: Occurs when demand for goods and services exceeds supply, causing prices to rise. This can be triggered by an increase in consumer spending, government spending, or investment.
Simplistic Calculation of Inflation
I am referring to a simplistically represented calculation for inflation , published by Professor Satish Deodhar, Indian Institute of Management Ahmedabad.
Let's assume the consumer basket has 2 commodities- food and clothing. The price of food on 01-Jan, 2009 was Rs 80 and that of clothing as on the same date was Rs 90. Say the price increases to 100 and 99 as on 01-Jan, 2010. Hence the % price increase of food between 2009 to 2010 was ((100-80)/80)*100=25% and clothing was ((99-90)/90)*100=10%. The arithmetic average increase= (25+10)/2=17.5 %. This can be further represented as 1/2*(25) + 1/2(10)=17.5 . This means that an equal weightage of 1/2 has been assigned to both price rises.
But in real life, a person does not spend equal income on food and clothing. People does need new clothes everyday, but need a constant supply of food materials to survive, so naturally the expenditure on food is more than clothing. Lets assume a person consumes 5 units of food and 2 units of clothing. Expenditure in 2009 is 80*5=400 on food and 2*90=180 on clothing. The fractional expenditure on food=400/(400+180)=.69 and for clothing=180/(400+180)=.31 .Hence the general price % rise obtained earlier can now be weighed as .69*25%=17.25 for food and .31*10%=3.1 . Total price rise=17.25+3.1 = 20.35. So clearly, after introducing the unequal quantities of consumption, the general price rise % is now 20.35 , while when equal weightage was given, it was 17.5 , an increase by 2.85 . This is how inflation rate is calculated by the govt. After calculating the inflation, the govt comes up with the general price level in the economy. To calculate that, the price level in the base year is always assumed to be 100. Assuming the price level in 2009 was 100, the general price level index in 2010=Base value+inflation=100+20.35=120.35 .
I am also mentioning an alternate formula for calculating the price level index.. The Laspeyres Index, coined by German economist Etienne Laspeyres. As per the formula:
Price index in year T=(Sum(Price of goods in year T)*Quantity of consumption in base year)) / (Sum(Price of goods in base year)*Quantity of consumption in base year))
Calculation of Inflation using CPI
Lets take the same example from previous section. The basket contains 5 units of food and 2 units of clothing. Its overall price in 2009 =(80*5 + 90*2)=580 . Overall price on 2010=(100*5+99*2)=698.
CPI=(Cost?of?Market?Basket?in?Current?Year/Cost?of?Market?Basket?in?Base?Year)×100=698*100/580=120.34
So, the CPI for 2010 is 120. This means that the overall price level has increased by 20% since the base year 2020.
Now having calculated the CPI, lets try find the inflation.
Inflation?Rate=(CPI?in?Current?Year?CPI?in?Previous?Year/CPI?in?Previous?Year)×100
Putting in the values in the above equation will help find the inflation in percentage.
Alternate Calculation of Inflation - Quantity Theory
This theory links the money supply with nominal GDP and price levels (which relate to inflation).
MV=PY
Rearranging this, we get the inflation rate (P) in terms of money supply, velocity, and GDP:
P=MV/Y
This shows that if the money supply (M) grows faster than real GDP (Y), inflation (P) will tend to increase.
Macroeconomic Analysis of Indian Inflation between 2020 and 2024
Before delving into this analysis, let us study the 2 key indexes that are used for measuring inflation. I have made a mention of both in the introduction section of this article. I have also mentioned that the dataset on which the CPI is calculated is termed as a basket of goods and services and contains price levels of food, housing, clothing, transportation, medical care, and education. And lastly, we have seen in the previous section that inflation is calculated with respect to a baseline, termed as the base year.
The consumer price index measures the change in the price level of a basket of consumer goods and services purchased by households. It reflects the cost of living and directly impacts consumers. On the other hand, the wholesale price index (WPI) measures the change in the price of goods at the wholesale level, i.e., before they reach the retail level. It reflects the prices of goods sold in bulk and is an indicator of price movement in the economy at an earlier stage. The basket used to calculate WPI includes items like manufactured products, primary articles (such as agricultural goods), and fuel.
CPI= ((Current?Year?Price?of?Basket) / (Base?Year?Price?of?Basket))×100
WPI= ((Current?Year?Price?of?goods) / (Base?Year?Price?of?Goods))×100
Inflation in an economy has a complex but cognizable relationship with the Gross Domestic Product(GDP). High economic growth substantiating high GDP can lead to inflation. This is because when the economy grows, it puts in more money in the hands of people. This increases demand in the economy as people have more disposable income. Increasing demand pushes the price level of commodities upwards, leading to inflation. Governments around the world and in India as well are accused of neglecting inflation in the pursuit of chasing higher GDP. High GDP is often used by the governments as a measure of their performance and are used to win votes. Such actions often undermines the inflation associated. Because, when inflation rises quickly, it can erode purchasing power, reduce consumer and business confidence, and lead to uncertainty in the economy. This can result in reduced investment and consumption, ultimately slowing GDP growth.
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Lets analyze the economic activity in India during the pandemic, year 2020-21.
Hence , Deflator during 2020-21= (198.01/135.58)*100= 146.04
Deflator during 2019-20 = (200.75/145.16)*100=138.3
Change?in?Deflator=Inflation=(GDPDeflatorYear2-GDPDeflatorYear1/GDPDeflatorYear1)×100
Hence the inflation during 2020-21 with respect to 2021-22=((146.04-138.3)/138.3)*100 = 5.6.
This shows, price inflation rose by 5.6% during 2020-21 with respect to 2019-20 .
In conclusion, the analysis of Indian inflation during the COVID-19 pandemic underscores the unprecedented challenges faced by the economy. The pandemic-induced disruptions led to a complex interplay of supply-push inflation, driven by supply chain breakdowns and rising input costs, alongside demand-pull pressures as the economy began to recover. The sharp rise in food and fuel prices further exacerbated inflation, straining household budgets and complicating policy responses. Navigating through this period required careful balancing by policymakers to support economic recovery while containing inflationary pressures, highlighting the need for resilient supply chains and adaptive economic strategies in the face of global crises.
Inflation Control
The govt in unison with the reserve bank of India can control inflation in many ways. I will list down the various means as bullet points.
IT Industry Influence on Inflation
The impact of the IT industry on inflation is often discussed as an indirect effect. Higher average wages in the IT sector compared to other industries lead to increased consumer spending and higher market demand. When demand outstrips supply, prices tend to rise, contributing to inflation.
However, it’s important to differentiate between nominal wages and real wages. While nominal wages may appear to increase, inflation reduces their real value. As inflation rises, the purchasing power of wages decreases, narrowing the gap between wage increases and the cost of goods and services.
For instance, consider India’s Consumer Price Index (CPI) data, which provides insights into inflation trends. Here are some key CPI figures for recent years to illustrate the relationship between inflation and wages.
Key Figures:
Let's consider year 2022, when the CPI was at 6.7% .
Considering 2021 as the base year, lets consider that the yearly income of an IT professional was 1,000,000 per annum. The employee gets a hike that is average of 8 to 10% = 9%. Nominal?Wage?Increase=((New?Wage?Old?Wage)/Old Wage)*100 = (90,000/1000000)*100=9% = .09 , same as what I mentioned above.
Inflation=6.7% = .067
Real?Wage?Increase= (1+Nominal?Wage?Increase)/(1+Inflation?Rate)-1 = (1+.09/1+.06)-1 = .02 = 2% .
Similarly, considering 2022 as the base year and 2023 as the actual year and a CPI inflation of 5.4(.054) , real wage increase= (1+.09)/(1+.05)-1 = .038 = 3.8% .
Therefore, although the employee received a 9% year-over-year salary increase, the effective increase was only 2% in 2022 and 3.8% in 2023 after accounting for inflation. Thus, rather than being the cause of inflation, the employee is more accurately a recipient of its effects.
Inflation at Play - Top 20
Conclusion
Inflation, both in India and globally, presents a multifaceted challenge with far-reaching implications. In India, the interplay of domestic policies, external pressures, and sector-specific factors and employment levels have shaped the inflationary landscape. The Reserve Bank of India and the government employ various measures to manage inflation, including monetary policy adjustments and fiscal interventions. However, the effectiveness of these measures often hinges on a delicate balance between stimulating economic growth and curbing price increases.
Globally, inflationary phenomena have ranged from the absurdly high denominations of Zimbabwean banknotes to the humorous anecdotes of hyperinflation in Weimar Germany and Argentina. Each case highlights the diverse ways inflation can impact economies and everyday life, from using wheelbarrows full of cash for basic purchases to referring to currency as "play money" in Iceland. These examples underscore how inflation can transform from a serious economic issue into a source of remarkable and sometimes amusing historical anecdotes.
The broader implications of inflation reveal its capacity to affect everything from consumer behavior to international economic stability. While inflation can erode purchasing power and create financial instability, it also provides a lens through which to understand the resilience and adaptability of economies and individuals alike. As nations navigate the complexities of inflation, both past and present, the lessons learned offer valuable insights into managing economic stability and fostering sustainable growth in an ever-evolving global landscape.
Senior Manager @ Oracle Corp | Operations l Strategy l IIFT Delhi(International Business) I IIM Ahmedabad
6 个月This post aims to open a platform for macroeconomic discussions from which we can all gain insights. Regarding my article, I am putting a question in the public domain: In the Union Budget of 2024, the Government of India projected a real growth rate of 6 to 7%. The government used a deflator of 1.7 overall. I invite your thoughts on the effectiveness of this deflator. Given that the manufacturing sector's growth, according to CAGR data, is still below 4%, do you believe the cumulative deflator is justified?