Inflation and Price Indices: WPI, CPI and Exam Notes

Inflation is a sustained rise in the general price level of an economy, which is the same thing as a fall in the purchasing power of money. A rise in the price of one commodity is not inflation; the general level of prices must rise over a period. The opposite, a sustained fall in the general price level, is deflation. Because wages, interest rates, dearness allowance and the whole of monetary policy are tied to these numbers, the way inflation is measured is as important in an examination as the definition itself.

How inflation is measured in India

Inflation is measured through index numbers. A basket of goods and services is fixed in a base year, the base year value is set at 100, and the cost of the same basket is compared in later periods. Indian price indices use the Laspeyres formula, which keeps the base year quantities as the weights. The rate of inflation is the percentage change in the index over the same month of the previous year, which is why it is called the year on year rate.

The Wholesale Price Index has three groups, primary articles, fuel and power, and manufactured products, and manufactured products carry the largest weight. It counts only goods, so a service like a haircut or a school fee never enters it. The Consumer Price Index measures prices at the retail level, includes services and gives the largest weight to food and beverages, which is why a rise in vegetable or cereal prices moves it sharply. The GDP deflator is a third measure, the ratio of nominal GDP to real GDP multiplied by a hundred; it covers every good and service produced in the economy but is available only with the national income data, and so it is the broadest and the slowest measure.

Types of inflation

By cause there are two basic kinds. Demand-pull inflation happens when total demand runs ahead of the supply of goods, as when money supply, government spending or credit grows quickly; too much money chases too few goods. Cost-push inflation happens when the cost of producing goods rises, as with costlier crude oil, higher wages or a fall in the rupee that makes imports dearer; producers pass the cost on. Structural inflation arises from bottlenecks in supply such as poor storage or transport. By speed, economists distinguish creeping inflation of a few per cent a year, walking or trotting inflation, running inflation, and galloping or hyperinflation, in which prices rise so fast that money stops being used; Germany in 1923 and Zimbabwe in the 2000s are the standard examples.

Terms that examiners confuse

• Deflation: a sustained fall in the general price level, usually with falling demand and output.
• Disinflation: a fall in the rate of inflation, so prices still rise but more slowly.
• Reflation: a deliberate policy of raising demand and prices after a period of deflation.
• Stagflation: high inflation together with stagnation, that is low growth and high unemployment.
• Skewflation: a sharp rise in the prices of a few items, such as food, while others stay steady.
• Headline and core inflation: headline inflation is the full index, while core inflation leaves out food and fuel because their prices swing with weather and global markets.

Who gains and who loses

Inflation redistributes income silently. Borrowers gain because they repay loans in money worth less than what they borrowed, while lenders and creditors lose. People on fixed incomes, such as pensioners and salaried workers whose pay is not indexed, lose; holders of real assets like land, gold and shares tend to gain. Producers and traders holding stocks gain from rising prices. Because the poor spend most of their income on food, inflation acts like a hidden tax that falls hardest on them, and it is often called the cruellest tax. A real interest rate is the nominal rate minus the rate of inflation, so when inflation is higher than the interest on a deposit, the saver is losing value even while the balance grows.

Inflation targeting in India

The Reserve Bank of India was given a legal inflation target after the Reserve Bank of India Act was amended in 2016 on the recommendation of the Urjit Patel Committee, which had proposed the consumer price index as the nominal anchor. Under the framework the Central Government fixes the target once in five years in consultation with the Reserve Bank; the target notified in 2016 and again in 2021 was four per cent, with a tolerance band of two percentage points on either side. The rate is judged on the Consumer Price Index (Combined), not on the wholesale index. A six member Monetary Policy Committee decides the policy repo rate, with three members from the Reserve Bank and three appointed by the Central Government; the Governor chairs it and has a casting vote in case of a tie, and the committee meets at least four times a year. If average inflation stays outside the band for three consecutive quarters, the Reserve Bank must report to the Government explaining the failure, the remedial action it proposes and the time it will take. The main tools are the repo rate, the reverse repo and standing deposit facility, the cash reserve ratio and open market operations.