Banking Notes: INFLATION

"INFLATION"

Introduction:

Inflation is defined as a sustained increase in the general level of price for goods and services. Inflation is the percentage change in the value of the Wholesale Price Index (WPI) on a year-on year basis. It effectively measures the change in the prices of a basket of goods and services in a year. When the general price level rises, each unit of currency buys fewer goods and services. Thus Inflation results in loss of value of money.

Formula of Calculating Inflation:

(WPI in the month of current year-WPI in the same month of previous year)×100

                             WPI in the same month of previous year

Causes of Inflation:

• Cost-push inflation is caused by an increase in production costs. It is generally caused by an increase in wages or an increase in the profit margins of the entrepreneurs.
• Demand-pull inflation occurs when the consumers, businesses or the governments demand for goods and services exceed the supply; therefore the cost of the item rises, unless supply is perfectly elastic.
• Build-in inflation is induced by adaptive expectations and is often linked to the wage spiral. It involves workers trying to keep their wages up with prices.

Type of Inflation:

• Wage Inflation:This is typical situation in which demand is more and supply is less. It’s commonly known as “Demand-Pull” or “Excess Demand Inflation”.

• Pricing Power Inflation:It’s commonly known as the “Administered Price Inflation”. This occurs when business and individuals raise their prices respectively to increase their profits.

• Cost-push Inflation:When an increase of price occurs in regard to the product or maintenance of a service or product, the expected increase in price is the resultant effect.

Stage of Inflation:

Depending on the characteristics and the intensity of inflation, there are several stages, namely

1. Hyper Inflation
2. Creeping Inflation
3. Galloping Inflation
4. Trotting Inflation

Measurement of Inflation:

Measuring Inflation is a difficult problem for government statisticians. Inflation is expressed as percentage increase in the general price level with reference to base year of the given basket of commodities. Increase or decrease in general price level is measured against price level of some reference year called Base Year. Four different primary measures of Inflation:

1. Wholesale Price Index (WPI) - The Wholesale Price Index is the “price of a representative basket of wholesale goods”. It is based on the wholesale price of a few relevant commodities of over 240 commodities available.
2. Consumer Price Index (CPI) – The wholesale price index focuses on the price of goods traded between corporations, rather than goods bought by consumers, which measured by the Consumer Price Index. It measures changes in the price level of market basket.
3. Gross Domestic Product (GDP) Deflator- It is measure of the price of all the goods and services included in Gross Domestic Product.
4. Producer Price Index (PPI) - The Producer Price Index covers price changes faced by the producers on primary, intermediate and finished goods and services ready for the market. The PPI usually covers the industrial (manufacturing) sector as well as public utilities (gas, electricity and communications).

Effects:

However, once inflationary process gathers some strength, its ill effects come to dominate the scene.

• Inflation distorts the financial system of the country.
• Inflation leads to a shift in the asset performance of wealth holders.
• If the inflation rate is greater than that of other countries, domestic products become less competitive.
• The value investments are destroyed over time.
• Inflation leads to balance of payment problem.