Inflation: Concept, Types and Measurement | UPSC

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Introduction:

  • Context: The Reserve Bank of India has cautioned that extreme weather events associated with climate change could pose a risk to inflation and other policies of the RBI.

Analysis

What is inflation?

  • Inflation is the rate at which the general price level of goods and services rises persistently over a period of time. This, in turn, causes a drop in purchasing power. 
  • This is not to be confused with the change in the prices of individual goods and services, which rise and fall all the time. 
  • Inflation happens when prices rise across the economy to a certain degree.

How is Inflation Measured in India?

  • The two most-often used inflation rates in India are the Wholesale Price Index (WPI) based inflation rate and Consumer Price Index (CPI) based inflation rate.
    • WPI and CPI consist of two different baskets of goods and services. 
  • The CPI-based inflation data is compiled by the Ministry of Statistics and Programme Implementation (MoSPI).
  • The WPI-based inflation data is put together by the Department for Promotion of Industry and Internal Trade (DPIIT).

What is concept of ‘Inflation Target’

  • Under the Reserve Bank of India Act, 1934, RBI is entrusted with the responsibility of conducting monetary policy in India with the primary objective of maintaining price stability while keeping in mind the objective of growth.
  • Under the RBI Act, the Central Government, in consultation with the RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in five years.
  • Accordingly, the Central Government has notified 4 per cent Consumer Price Index (CPI) inflation as the target for the period from April 1, 2021 to March 31, 2026 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent. 

What happens when RBI fails to maintain ‘Inflation Target’

  • The Central Government has notified the following as the factors that constitute failure to achieve the inflation target: 
    • (a) the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or 
    • (b) the average inflation is less than the lower tolerance level for any three consecutive quarters.
  • Where the Bank fails to meet the inflation target, it shall set out in a report to the Central Government:
    • (a) the reasons for failure to achieve the inflation target;
    • (b) remedial actions proposed to be taken by the Bank; and
    • (c) an estimate of the time-period within which the inflation target shall be achieved.

Types of Inflation

a) Retail Inflation

  • In India, the index which shows the inflation rate at retail level is known as Consumer Price Index (CPI). 
  • CPI is based on retail prices and this index is used to calculate the Dearness Allowance (DA) for government employees. 

b) Headline Inflation

  • Headline inflation is the raw inflation figure reported through the Consumer Price Index (CPI).
  • The Monetary Policy Committee of the RBI uses ‘headline inflation’ to take its decision.

c) Retail Inflation Vs Headline Inflation

  • While retail inflation specifically focuses on the prices of goods and services consumed by households, headline inflation encompasses the broader spectrum of price changes in an economy, including those beyond retail consumption. 

d) Core Inflation

  • Core inflation removes the CPI components that can exhibit large amounts of volatility from month to month, which can cause unwanted distortion to the headline figure. 
  • The most commonly removed factors are those relating to the cost of food and energy. 

e) Galloping Inflation 

  • Steady and fairly high rate of increases in the general price level is known as galloping inflation. 
  • The rate of inflation runs into two digits (20 percent, 40 per cent, etc.) and sometimes even as high as three digits (i.e., 200 percent). 

f) Hyper-Inflation 

  • Hyper-inflation is a situation where the rate of inflation is very high. Thus, the value of money gets eroded rapidly. 
  • In order to cope with such a situation, households minimize their holdings of local currency. 
  • Generally, it happens in an economy which faces wars and their aftermath, socio-political upheavals or other crises. 
    • In these situations, it is very difficult to impose tax on the residents by the government, which leads to a fiscal deficit and the government has to finance it primarily through money creation rather than imposing taxes or borrowings. 
  • In a situation of hyper-inflation, certain functions of money such as ‘a store of value’ and ‘a medium of exchange’ are no longer valid. 
  • A recent example of hyperinflation in Zimbabwe during 2008-09.

g) Stagflation

  • The term stagflation (stagnation plus inflation) refers to the situation where an economy grows very slowly or at zero rate (stagnant) and prices keep rising. 
  • The side effects of stagflation are increase in unemployment– accompanied by a rise in prices, or inflation. 
    • It raises economic dilemmas as the actions designed to lower inflation may worsen unemployment and vice versa. 
  • This happened during the 1970s, when crude oil prices rose dramatically, fuelling sharp inflation in developed economies. 
    • Stagflation is characterized by slow economic growth and relatively high unemployment in an economy.
    • It is a period of inflation combined with a decline in the gross domestic product (GDP). 
    • It is a period of rise in prices with little change in output.

h) Shrinkflation

  • It is a new form of inflation that isn’t easily visible to the Consumers.
  • It is the practice of reducing the size or quantity of a product while the price of the product remains the same or slightly increases. 
  • In some cases, the term may indicate lowering the quality of a product or its ingredients while the price remains the same.
  • This phenomenon has become quite common in the food and beverage industry.
  • To tackle high raw material costs, several fast-moving consumer goods (FMCG) companies in India are downsizing product packets, while keeping the price unchanged. Shrinkflation’ thus effectively means consumers are paying the same for less of the product.

i) Reflation

  • Inflation deliberately undertaken to relieve a depression is called Reflation. An economic depression is a steep and sustained drop in economic activity featuring high unemployment and negative GDP growth.
  • A country is said to have entered a technical ‘recession’ if its GDP growth rate stays in the negative territory for two consecutive quarters.

j) Imported Inflation

  • When the general price level rises in a country because of the rise in prices of imported commodities, inflation is termed as imported. 
  • India imports about three quarters of its total crude oil consumption. Therefore, if the oil prices go up in the international market, inflation in India will also go up due to higher prices of the petroleum products. 
  • However, it is not always necessary that only a rise in the price of a traded commodity in the international market fuels imported inflation. 
  • Inflation may also rise because of depreciation of the domestic currency. For example, if the rupee depreciates by 20% against the US dollar in a particular period, the landed rupee cost of oil will also go up by the same proportion and will affect the price levels and inflation readings. 

k) Continuous Vs Benign Inflation

  • Price rise at full employment is called Continuous inflation.
  • The term ‘benign inflation’ implies a mild rate of inflation. 

Cost-Push Inflation Vs Demand-Pull Inflation

  • There are four main drivers behind inflation:
    • cost-push inflation
    • demand-pull inflation
    • increase in the money supply of an economy and 
    • decrease in the demand for money.
  • Cost-push inflation is the decrease in the aggregate supply of goods and services stemming from an increase in the cost of production whereas demand-pull inflation is the increase in aggregate demand.
  • Demand-pull inflation can be caused by an expanding economy, increased government spending, or overseas growth.  
  • Another factor can be the depreciation of local exchange rates. As a result, the purchasing of imports decreases while the buying of exports by foreigners increases. This raises the overall level of aggregate demand. 
  • Finally, if a government reduces taxes, households are left with more disposable income in their pockets and hence increase the overall demand. 
  • Note: In Keynesian economics, an increase in aggregate demand is caused by a rise in employment, as companies need to hire more people to increase their output. 

a) Ways to counter both cost-push inflation and demand-pull inflation 

  • To counter cost-push inflation, supply-side policies need to be enacted with the goal of increasing aggregate supply.
    • To increase aggregate supply, taxes can be decreased and central banks can implement contractionary monetary policies, achieved by increasing interest rates. 
    • Contractionary monetary policy is driven by increases in the various base interest rates. The goal is to reduce inflation by limiting the amount of active money circulating in the economy.
  • Countering demand-pull inflation would be achieved by the government and central bank implementing contractionary monetary and fiscal policies. 
    • This would include increasing the interest rate; the same as countering cost-push inflation because it results in a decrease in demand, decreasing government spending, and increasing taxes, all measures that would reduce demand.

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Miscellaneous

a) Disinflation Vs Deflation

  • When the inflation rate declines over time, but it remains positive (that is, say prices grow at 1% instead of 5%), it is called “disinflation.”  
    • When the inflation rate actually contracts (that is, say prices reduce by 1% instead of growing at 5%), it is called “deflation.”
  • Deflation is the drop in general price levels in an economy, while disinflation occurs when price inflation slows down temporarily.
  • Deflation, which is harmful to an economy, can be caused by a drop in the money supply, government spending, consumer spending, and corporate investment.
  • Central banks will fight disinflation by expanding its monetary policy and lowering interest rates.
  • Disinflation can be caused by a recession or when a central bank tightens its monetary policy. 
  • Deflation, which is the opposite of inflation, is mainly caused by shifts in supply and demand. Disinflation, on the other hand, shows the rate of change of inflation over time. 

b) Phillips Curve 

  • Phillips curve describes the inverse relationship between inflation and unemployment. It shows the possibility that unemployment can be reduced at the cost of higher inflation.

References:

Practice Questions for UPSC Prelims:

  1. With reference to term ‘Shrinkflation’, consider the following statements:
  2. It is when a product downsizes its quantity while keeping the price the same.
  3. It deceives consumers into believing that the brands they buy are not affected by inflation.
  4. It occurs when a product removes some ingredients while maintaining its price.
  5. It makes it more difficult to accurately measure price changes or inflation.

How many of the above statements are correct?

(a) Only one

(b) Only two

(c) Only three

(d) All four

Answer: (d) 

Explanation:

Shrinkflation: Meaning, Causes and Implications 

  • Shrink inflation is when a product downsizes its quantity while keeping the price the same. (Hence, Statement 1 is correct)
  • For example, reducing the scoops of ice cream in a container or reducing the number of chips in a packet would count as shrinkflation. 
  • It occurs when manufacturers downsize products to offset higher production costs but keep retail prices same.
  • Shrinkflation deceives consumers into believing that the brands they buy are not affected by inflation, since container and vessel sizes are reduced by very small amounts. (Hence, Statement 2 is correct)
  • Shrinkflation occurs when materials or ingredients used to make products become more expensive and when there is intense competition in the market. (Hence, Statement 3 is correct)
  • As a result, instead of raising prices, they might just give you less of the product so as to maintain their profit margins. 
  • Shrinkflation can occur in different ways. A product can reformulate or remove ingredients while maintaining its price. 
  • For example, Cadbury Dairy Milk stopped using foil which it used to prevent chocolate from losing its quality and flavor in order to save expense. 

Various implications

  • Though downsizing products reduces costs for manufacturers, it is an unfair practice toward consumers. 
  • It can lead to a loss of trust if companies fail to properly communicate with them. 
  • Shrinkflation can lead to customer frustration and deterioration of consumer sentiment towards a producer’s brand.  
  • In the event of shrinkflation, it is more difficult to accurately measure price changes or inflation. (Hence, Statement 4 is correct)

Hence, all the statements given above are correct.

Therefore, option (d) is the correct answer.

Subject: Current Affairs | Economy

Level of Difficulty: Moderate | Factual

Answer Writing Practice for UPSC Mains GS Paper 3:

  • Q. Discuss the role of central banks in managing climate change outcomes, considering their mandates and the potential impact on monetary stability, financial entities, and global cooperation efforts. (Answer in 250 words)

Introduction

  • Climate change presents significant challenges to long-term growth and financial stability, necessitating a multi-faceted approach involving various stakeholders. Central banks play a crucial role in managing the outcomes from climate change due to their mandates concerning monetary policy, financial stability, and regulation.

Analyzing Climate Risks

  • Central banks must address two primary channels through which climate change impacts the economy: physical risks and transition risks. 
  • Physical risks include direct consequences of climatic events, such as disruptions to production and supply chains, leading to inflationary pressures and financial losses for banks and financial institutions. 
  • Transition risks arise from adjustments to reduce emission intensity, potentially causing asset price fluctuations and market disruptions.

Central Banks’ Response

  • Central banks worldwide are increasingly recognizing and evaluating climate-related risks to monetary policy, financial stability, and regulated entities. 
  • Collaborative efforts at the global level, such as those undertaken by the G-20 and standard-setting bodies like the Financial Stability Board (FSB), aim to address vulnerabilities arising from climate change.

Data Transparency and Risk Assessment

  • Measuring and quantifying climate-related risks is challenging but crucial for effective risk management. 
  • Encouraging firms to disclose their carbon intensity and conducting scenario analysis and stress testing are essential steps in identifying vulnerabilities. 
  • Central banks can leverage their supervisory frameworks to incentivize climate-friendly investments and develop standards for green finance, promoting transparency and integrity in the market.

Policy Measures and Initiatives

  • By the virtue of their mandate for regulating and supervising the financial sector, central banks are uniquely placed to influence the behaviour of institutions within the financial system, incentivize climate-friendly investments, and support the mobilization of capital for sustainable development.
  • Over the years, the Reserve Bank has been taking various policy measures to promote and support green finance initiatives. For example, finance to renewable energy projects have been included as a part of Priority Sector Lending (PSL) portfolio of banks. 
  • Earlier in 2023, the Reserve Bank supported the Government of India in successfully issuing sovereign green bonds (SGrBs). The proceeds of the SGrBs are intended to be deployed in public sector projects which will help in reducing the carbon intensity of the economy. The issuance of SrGBs would also help in price discovery for other financial instruments and give a fillip to development of a market for green financing ecosystem in the country.

Global Cooperation and Equity

  • Global cooperation is essential in managing climate risks, considering past emissions and the disproportionate impact on lower-income countries. 
  • However, implementation of climate finance commitments by advanced economies remains inadequate, highlighting the need for collective action to bridge the gap between pledges and actual contributions.

Conclusion

  • Dealing with climate change requires sustained efforts and global cooperation. While challenges persist, central banks’ proactive measures and collaborative initiatives demonstrate a commitment to mitigating climate-related risks and fostering sustainable development. 
  • Urgent action and equitable distribution of responsibilities are crucial in achieving long-term resilience against the impacts of climate change.

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