Indian Economy, 5th edition (25 page)

This inflation takes place when the supply falls drastically and the demand remains at the same level. Such situations arise due to supply-side accidents, hazards or mismanagement which is also known as ‘structural inflation’. This could be put in the ‘demand-pull inflation’ category.

II. Core Inflation

This nomenclature is based on the inclusion or exclusion of the goods and services while calculating inflation. Popular in western economies, core inflation shows price rise in all goods and services excluding
energy
and
food articles
. In India, it was first time used in the financial year 2000–01 when the Government expressed that it was under control—it means the prices of manufactured goods were under control.
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This was criticised by experts on account of excluding food articles and energy out of the inflation and feeling satisfied on the inflation front. Basically, in the western economies, food and energy are not the problems for the masses, while in India these two segments play the most vital role for them.

Other Important Terms

Inflationary Gap

The excess of total government spending above the national income (i.e. fiscal deficit) is known as the inflationary gap. This is intended to increase the production level which ultimately pushes the prices up due to extra-creation of money during the process.

Deflationary Gap

The shortfall in total spending of the government (i.e. fiscal surplus) over the national income creates deflationary gap in the economy. This is a situation of producing more than the demand and the economy usually heads for a general slowdown in the level of demand. This is also known as the
output gap
.

Inflation Tax

Inflation erodes the value of money and the people who hold currency suffer in this process. As the governments have authority of printing currency and circulating it into the economy (as they do in the case of deficit financing), this act functions as an income to the governments. This is a situation of sustaining government expenditure at the cost of people’s income. This looks as if inflation is working as a tax
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. That is how the term inflation tax is also known as
seignorage
. It means, inflation is always the level to which the government may go for deficit financing—level of deficit financing is directly reflected by the rate of inflation.

It could also be used by the governments in the form of prices and incomes policy under which the companies pay inflation tax on the salary increases above the set level prescribed by the government.
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Inflation Spiral

An inflationary situation in an economy which results out of a process of wage and price interaction ‘
when wages press prices up and prices pull wages up
’
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is known as the inflationary spiral. It is also known as the
wage-price spiral
. This wage-price interaction was seen as a plausible cause of inflation in the year 1935 in the US economy, for the first time.
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Inflation Accounting

A term popular in the area of corporate profit accounting. Basically, due to inflation the profit of firms/companies gets overstated. When a firm calculates its profits after adjusting the effects of current level of inflation, this process is known as inflation accounting. Such profits are the real profit of the firm which could be compared to a historic rate of inflation (inflation of the base year), too.

Inflation Premium

The bonus brought by inflation to the borrowers is known as the inflation premium. The interest banks charge on their lending is known as the
nominal
interest rate which might not be the real cost of borrowing paid by the borrower to the banks. To calculate the real cost a borrower is paying on its loan, the nominal rate of interest is adjusted with the effect of inflation and thus the interest rate we get is known as the real interest rate. Real interest is always lower than the nominal interest if the inflation is taking place—the difference is the inflation premium.

Rising inflation premium shows depleting profits of the lending institutions. At times, to neutralise the effects of inflation premium, the lender takes the recourse to increase the nominal rate of interest.
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In recent times, it was done by the Indian banks in July 2003 to ward off their depleting profits when inflation had crossed the 7 per cent level—the level of inflation was threatening to deplete even the capital base of the banks. Since then the RBI has been following a tighter credit policy as inflation was going beyond the upper limit of its healthy range (i.e. 4–5 per cent in Indian case).

Phillips Curve

It is a graphic curve which advocates a relationship between inflation and unemployment in an economy. As per the curve there is a ‘trade off’ between inflation and unemployment i.e. an inverse relationship between them. The curve suggests that lower the inflation, higher the unemployment and higher the inflation, lower the unemployment.
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During 1960s, this idea was among the most important theories of the modern economists. This concept is known after the economists who developed it—Alban William Housego Phillips (1914–75). Bill Phillips (popular name) was an electrical engineer from New Zealand and was an economist at the London School of Economics when propounded the idea. In
‘The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957’
(published in
Economica
in 1958), he provided empirical evidence to support his ideas.
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By the early 1960s, an economic wisdom emerged around the world that by following a certain kind of monetary policy, unemployment could be checked forever and at the cost of a slightly higher inflation, unemployment could be reduced permanently. The Central Banks of the developed world started framing the required kind of monetary policies mixing the trade-off between inflation and unemployment. The idea became popular among the developing economies too by the late 1960s, though they were a bit confused, as most of them were fighting the menace of higher inflations (double digit) along with high level of unemployment.
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By the early 1970s, two American economists, Milton Friedman (Nobel Laureate, 1976) and Edmund Phelps challenged the idea of the Phillips Curve. According to them the trade-off between inflation and unemployment was only short-term, because once people came to expect higher inflation they started demanding higher wages and thus unemployment will rise back to its ‘
natural rate
’ (the unemployment rate that occurs at full employment when the economy is producing at potential output, it is usually called the natural rate of unemployment
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). They advocated that there was no long-term trade-off between inflation and unemployment. In the long run, monetary policy can influence inflation. They suggested that if monetary policy tried to hold unemployment below its natural rate, inflation will be rising to higher level—which is known as the
non-accelerating inflation rate of unemployment (NAIRU)
also.
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The NAIRU is that rate of unemployment which is consistent with a constant rate of inflation. It means at NAIRU, the upward and downward forces on price (inflation) and wage (unemployment) neutralise each other and there is no tendency of change in the rate of inflation. We may say that the NAIRU is the lowest unemployment rate that an economy can sustain without any upward pressure on inflation rate.

Reflation

Reflation is a situation often deliberately brought by the government to reduce unemployment and increase demand by going for higher levels of economic growth
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. Governments go for higher public expenditures, tax cuts, interest rate cuts, etc. Fiscal deficit rises, extra money is generally printed at higher level of growth, wages increase and there is almost no improvement in unemployment.

Reflation can also be understood from a different angle—when the economy is crossing a cycle of recession (low inflation, high unemployment, low demand, etc.) and government takes some economic policy decisions to revive the economy from recession, certain goods see sudden and temporary increase in their prices, such price rise is also known as reflation.

Stagflation

A situation in an economy when inflation and unemployment both are at higher levels, contrary to conventional belief. Such a situation first arose in 1970s in the US economy (average unemployment rate above 6 per cent and the average rate of inflation above 7 per cent)
32a
and in many Euro-American economies. This took place as a result of oil price increases of 1973 and 1979 and anticipation of higher inflation. The stagflationary situation continued till the early 1980s. Conventional thinking that a trade-off existed between inflation and unemployment (i.e. Phillips curve) was falsified and several economies switched over to alternative ways of economic policies such as monetaristic and supply-side economics.

When the economy is passing through the cycle of stagnation (i.e. long period of low aggregate demand in relation to its productive capacity) and the government shuffles with the economic policy, a sudden and temporary price rise is seen in some of the goods—such inflation is also known as stagflation. Stagflation is basically a combination of high inflation and low growth.
32b

Inflation Targeting

The announcement of an official target range for inflation is known as inflation targeting. It is done by the Central Bank in an economy as a part of their monetary policy to realise the objective of a
stable
rate of inflation
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(the Government of India asked the RBI to perform this function in the early 1970s).

New Zealand was the first economy to go for inflation targeting in 1989
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which has been followed by almost all economies since then. In the Indian case, the target ranges between 4 to 5 per cent which is also popular as the
comfort zone
of inflation in India.

By early 2013, there had been a debate on the issue of revising this ‘comfort zone’ for India (after such a suggestion coming from the ex-RBI Governor Y V Reddy at a Panel Discussion). But C Rangarajan, the present Chairman of the PM’s Economic Advisory Council, suggested it to be kept at the present range of 4 to 5 per cent itself which has been set by the RBI. It should be noted that in 1998, Mr Rangarajan (while he was Governor, RBI) had called inflation rate at 6 to 7 per cent as ‘acceptable level’. His idea of
threshold
was – at what level of inflation do adverse consequences set in? ‘At that time, inflation level was as high as 10 -11 per cent, so cutting down inflation to 6 per cent was also very difficult that is why he suggested a higher ‘comfort zone’ (as was explained by Rangarajan to a recent media query)!

Skewflation

Economists usually distinguish between inflation and a relative price increase. ‘Inflation’ refers to a sustained, across-the-board price increase, whereas ‘a relative price increase’ is a reference to an episodic price rise pertaining to one or a small group of commodities. This leaves a
third phenomenon
, namely one in which there is a price rise of one or a small group of commodities over a sustained period of time, without a traditional designation. ‘
Skewflation
’ is a relatively new term to describe this third category of price rise.

In India, food prices rose steadily during the last months of 2009 and the early months of 2010, even though the prices of non-food items continued to be relatively stable. As this somewhat unusual phenomenon stubbornly persisted, policymakers conferred on how to bring it to an end. The term ‘skewflation’ made an appearance in internal documents of the Government of India, and then appeared in print in the
Economic Survey 2009-10
, GoI, MoF.

The
skewedness
of inflation in India in the early months of 2010 was obvious from the fact that food price inflation crossed the 20 per cent mark in multiple months, whereas wholesale price index (WPI) inflation never once crossed 11 per cent. It may be pointed out that the skewflation has gradually given way to a lower-grade generalised inflation. (with the economy in the middle of 2011 inflating at around 9 per cent with food and non-food price increases roughly at the same level).

Given that other nations have faced similar problems, the use of this term picked up quickly, with the
Economist
magazine
(Jan. 24, 2011),
in an article entitled
‘Price Rises in China: Inflated Fears’,
wondering if China was beginning to suffer from an Indian-style skewflation.

GDP Deflator

This is the ratio between GDP at
Current Prices
and GDP at
Constant Prices.
If GDP at Current Prices is equal to the GDP at Constant Prices, GDP deflator will be 1, implying no change in price level. If GDP deflator is found to be 2, it implies rise in price level by a factor of 2, and if GDP deflator is found to be 4 , it implies a rise in price level by a factor of 4. GDP deflator is acclaimed as a
better measure
of price behaviour because it covers all goods and services produced in the country (because the weight of services has not been equitably accounted in the Indian ‘headline inflation’ i.e. inflation at the WPI).

BASE EFFECT

It refers to the impact of the rise in price level (i.e. last year’s inflation) in the previous year over the corresponding rise in price levels in the current year (i.e., current inflation). If the price index had risen at a high rate in the corresponding period of the previous year, leading to a high inflation rate, some of the potential rise is already factored in, therefore, a similar absolute increase in the Price index in the current year will lead to a relatively lower inflation rates. On the other hand, if the inflation rate was too low in the corresponding period of the previous year, even a relatively smaller rise in the Price Index will arithmetically give a high rate of current inflation. For example: