What is Inflation? Its Causes, Consequences and Remedies

One of the most important challenges of the present times is the problem of rising inflation. Its effect can be felt by each and every person to at least some degree, whether he is an engineer, doctor, lawyer, govt. servant or anybody. Inflation is impartial in choosing its innocent victims. So what exactly is inflation and how is it caused? Whether it originates in our home country or it is imported from abroad? What are our economists doing to control inflation? These are the questions that naturally rise in anyone’s mind.

What is Inflation: Inflation is defined as a general rise in prices of all commodities. It is not the rise in the price of my favorite commodity e.g. McDonalds burger, but the overall rise in the prices of all the goods and services manufactured and consumed within the territory of a nation. When we say that the monthly rate of Inflation is 12%, what it means is that on an average, the prices of all goods and services have increased by 12% in the period of last one month.

Measures of Inflation: In India, inflation is measured using WPI (Wholesale Price Index). It is very tedious to track each and every commodity and calculate its price rise. Instead of that an index of several goods and services is prepared. India’s WPI is a weighted-index of 435 commodities. It means price-rise of all commodities will not be treated equally. The price-rise of rice will have more weight-age than price-rise of a Maruti-car. That is because rice is consumed by a very large number of people compared to a Maruti car. The weightage of a Mercedez car will be even lower in the WPI. So when this WPI increases from say 100 to 112, we say that the rate of inflation is 12%.
Many other countries like UK, USA, China, etc. use CPI (Consumer Price Index) to measure inflation. This is a more realistic measure because it computes the index based on the increase in actual price paid by the consumer. On the other hand, WPI considers the rise in the price by the Wholesalers of the goods and services.

Causes of Inflation: Inflation is basically a combination of two types of phenomenon. Its causes could be nailed down to Cost-Push inflation and Demand-Pull inflation.Cost-Push Inflation is caused by rise in the cost of factors of production. In classical economic theory, there used to be only three factors of production – land, labor and capital. However, in today’s complex world, infinite factors are required to produce a single product or commodity e.g. house-rent, electricity, admin-expenses, raw-materials, fuel (petroleum), steel, etc. The price rise in any one or more of these factors will increase the cost of production of the final product. The producer of the commodity (the businessman) will naturally shift this cost to his consumers by raising the cost of his final product. This phenomenon is called Cost-Push Inflation.
Let us take a simple example. Suppose a bakery owner produces bread by using several factors like wheat, flour, machines, labor, etc. The cost of production of one piece of bread comes to Rs.8. He adds Rs.2 as his profit-margin and sells it to consumers at Rs.10. This continues for several days. Now suppose the price of wheat increases. Now the owner recalculates his cost of production. It comes to Rs.10. He now adds his margin of Rs.2 and increases the cost of bread to Rs.12. This directly results in 2% rise in the cost of bread, or in the bread component of the WPI.
Demand-Pull Inflation is another type of inflation. In this case, the cost of factors of production remains same. However, due to increase in the demand of the commodity by consumers in the market relative to its supply, the owner will naturally increase the prices. In this case, demand has increased, but supply has remained constant.
Returning to the example of the bread producer, suppose the cost of production of one piece of bread remains constant at Rs.8. He adds his margin of Rs.2 and charges Rs.10 to each consumer. Now suppose the preference of his bread increases among the consumers, as it becomes more popular. This results in an increased demand for bread (This is a simplified example, in real world demand and supply is more complex). So sensing more demand for his product, the owner increases the price to Rs.12. In our example, let’s assume his margin increases from Rs.2 to Rs.4. Again, in the real world this might not be the case. As for e.g. if we assume competition among many bread-producers, the factors i.e. laborers will also demand a chuck of that margin in the form of increased wages. So, the owner will have to sacrifice some or all of his margin and distribute it to his laborers, otherwise they will stop working for him and work for another bakery-owner who is in competition.

Liquidity: The term Liquidity is usually used to identify hard cash. In fact Liquidity just means money in any form. Liquidity is also referred to the ability and ease with which an asset could be converted to money. For e.g. cash is the most liquid asset as it comes under the standard definition of money. Savings-account deposit could also be called liquid asset. That’s because it is possible to convert savings-account deposit to cash by withdrawing from an ATM. It could also be used to pay by means of a cheque or on-line transfer. Land and Buildings is a less liquid asset. That’s because it’s difficult (or at least it takes some time) to convert it to money instantly. How is Liquidity related to Inflation you may ask? The answer is simple. It’s because of Demand-Pull Inflation. The demand for the commodity is directly influenced by the amount of money that people have. The Government or Central Bank can directly influence demand-pull inflation by controlling liquidity.

Remedial Measures to control Inflation: The Ministry of Finance and the RBI (Reserve Bank of India) always strive to control inflation. They control inflation by directly affecting the demand pull inflation by changing the amount of liquidity circulating in the economy. The RBI can change the liquidity by its various tools viz. CRR, Bank-Rate (REPO and Reverse-REPO), SLR, etc.
CRR (Cash Reserve Ratio) is the proportion of amount which each commercial bank (like SBI, ICICI, etc.) has to maintain in the form of hard cash. All commercial banks accept deposits from individuals and lend it to borrowers at a higher interest rate. The difference between the interest rate which they collect from borrowers and which they pay to their depositors is their profit. Naturally, each bank will try to lend all the money they collect from depositors. However, banks can’t lend all the money they have. Under law, each bank has to maintain a certain proportion of cash as reserve. This is known as CRR. For e.g. if the CRR is 5% and the bank collects Rs.100 from its depositors. Then it has to maintain Rs. 5 as Reserve. It can lend other Rs. 95 to its borrowers. RBI can decrease vast amounts of liquidity circulating in the economy by raising the CRR. When RBI increases the CRR, the bank’s lending power decreases. Less lending means less borrowing, this in turn means less money in the economy. Last month, the RBI increased the CRR from 8.75% to 9% to control inflation. SLR (Statutory Liquidity Ratio) is also similar to CRR. But in case of SLR, Government-Securities need to be maintained by the commercial banks instead of cash.
Bank-Rate is basically the interest rate at which the Central Bank borrows from the other scheduled commercial banks. This rate is directly linked to the interest rates charged in turn by all the commercial banks to its customers. All these other interest rates on Home-loans, Personal-loans, etc. also increase with the increase in bank-rate. Thus, by raising the Bank-Rate and in turn all other Interest Rates, the RBI makes borrowing money from banks a very costly affair. People are thus discouraged to borrow more money and total amount of liquidity decreases in the economy. Last month, the RBI increased the Bank Rate from 8.5% to 9.5%. This was an increase of 50 basis-points (0.5%) to control inflation.
The above mentioned measures viz. CRR, SLR, Bank-Rate are called Monetary Policy tools. Apart from these, there are certain Fiscal Policy tools which the Government can use. One recent example of fiscal tool is the recent ban placed on the export of Basmati rice by the Finance Minister. By banning the export of rice, the supply of rice will increase in the home country relative to its demand. This will naturally bring down the price of rice which is a major component of WPI. The price-rise in Basmati rice is an example of Demand-pull inflation because demand has increased relative to supply. Although, it could be said that demand for rice is not related to liquidity but is inelastic (where demand is autonomous and not related to increase in price or income).

Although the rise in interest rates initially makes life difficult for people who have taken loans on floating interest rates, it is a required step to bring down inflation which is a larger evil. It might also be noted that RBI, by making the policy changes can control only one type of inflation i.e. demand-pull inflation. It cannot affect the other type of inflation i.e. cost-push inflation which is caused by rise in prices of raw-materials and other factors of production. That is why the rate of inflation is increasing continuously since last six months although the RBI is trying to control it. In fact, only the cost-push component of inflation is rising which consists of increase in prices of steel, cement, petroleum, etc. Some of these factors are produced in our country and others are imported. But the prices of none of them can be controlled by the government.

Inflation and Growth: Inflation is not harmful at all times. In fact only when there is a sustained increase above 7% to 8%, there is cause for worry. In fact a low level of inflation between 2% and 5% is a sign of prosperity. It is required for growth. That’s because it gives the producer of goods and services a certain impetus to stay in the market. This in turn gives rise to growth, development and employment which is very much required. Inflation is also closely linked to employment but that is the topic of discussion for another day.

3 comments:

mvrr said...

it was a great explanation by you guys ,it was like tailor made for those who doesnt have any idea on this...but i have a small doubt that at last it is said that cost pull inflation cant be controlled by the government becoz increase in price of steell etc..but if the liquidity is decreased then consumer faces diffficulty to buy .. so defntly price of steel etc shuld be decreased ri88

mvrr said...

nice you can also give the remedies for cost pull inflatiion plzz

Prahlad Yeri said...

@mvrr -
>>..but if the liquidity is decreased then consumer faces diffficulty to buy .. so defntly price of steel etc shuld be decreased
To some extent what you are saying is right. But in most modern Free Economies, the Governments don't have that kind of control over liquidity to drastically control the prices. Of course, the Central Banks use tools like CLR/SLR sometimes to affect money supply, but thats only as a last resort. Prices are usually affected only by the free market mechanism.