Inflation is a situation of rising prices in the economy. Inflation means an increase in the cost of living as the price of goods and services rise. The rate of inflation measures the annual percentage change in the general price level. Inflation is also called a “necessary evil” -- no one likes it but it is needed for economic growth. However, too much inflation can create major problems for policy makers.
The recent action of the Reserve Bank of India (RBI) to raise the repo rate by 40 basis points and cash reserve ratio (CRR) by 50 basis points is a clear recognition that Inflation is getting out of control and bold steps need to be taken to tackle inflation. Inflation is a big economic worry not just in India. It has assumed menacing proportion in most of the countries. The situation is the worst in the United States where the consumer price inflation stood at 8.56%, a level not reached for several decades! As a consequence, Indian Government has banned Wheat Exports and is taking many steps to control the situation.
In this context, it becomes imperative to understand Inflation – its causes, measures, pros and cons. This topic is expected to appear in GD PI WAT for IIM and other MBA Admission personal assessment round. Continue reading this MBAUniverse.com GD Topic 2022 for complete insights on this topic.
Table of contents
- Key Terms to understand Inflation
- Current status of Inflation in India
- Reasons for Increasing Inflation in India
- Impact of Higher Inflation in India
- Challenges in Tackling High Inflation In India
- Steps to tame high inflation
- Advantages and Dis-advantages of Inflation
1. Key Terms
To understand Inflation well, one has to know some key terms like below.
1.1. Repo Rate is the interest charged by the RBI when commercial banks borrow from them by selling their securities to the central bank. Essentially it is the interest charged by the RBI when banks borrow from them - much like commercial banks charge you interest for a car loan or home loan.
1.2. Under Cash Reserve Ratio (CRR), the commercial banks have to hold a certain minimum amount of deposit as reserves with the central bank. The percentage of cash required to be kept in reserves as against the bank's total deposits is called the Cash Reserve Ratio.
1.3. Wholesale Price Index (WPI) – It is estimated by the Ministry of Commerce & Industry and measured on a monthly basis.
1.4. Consumer Price Index (CPI) – It is calculated by taking price changes for each item in the predetermined lot of goods and averaging them.
1.5. Producer Price Index – It is a measure of the average change in the selling prices over time received by domestic producers for their output.
1.6. Commodity Price Indices – It is a fixed-weight index or (weighted) average of selected commodity prices, which may be based on spot or futures price
1.7. Core Price Index – It measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices. It is a way to measure the underlying inflation trends.
2. Current status of Inflation in India
Official data tells us that wholesale price index (WPI)-linked inflation went double-digit at 10.5% year-on-year in April 2021 (from 7.4 per cent in March), for the first time since 2010. The CPI inflation, moderated to 4.3 per cent (from 5.5 per cent in March) – led by a high base of the previous year (it had spiked to 7.2 per cent in April 2020). But last year’s base may not reflect accurate trends, as data collection was disrupted in April and May 2020. A month-on-month analysis may put the picture in better perspective.
3. Reasons for Increasing Inflation in India
The sharp rise in commodity prices across the world is a major reason behind the inflation spike in India. Experts have sighted many reasons for rise of Inflation in India.
3.1. Rise in prices of petroleum and natural gas: The high rate of inflation in March 2022 is mainly due to rise in prices of crude petroleum and natural gas, mineral oils, basic metals, etc. owing to disruption in the global supply chain caused by the Russia-Ukraine conflict. Brent crude prices crossed $65 per barrel in May 2021, more than double of what it was a year ago.
3.2. Rising prices of essential Food items: The retail inflation rose mainly on account of rising prices of essential food items like 'oils and fats', vegetables and protein-rich items such as 'meat and fish'. Ukraine is a major exporter of sunflower oil.
3.4. Sharp rise in commodity prices: The sharp rise in commodity prices across the world is a major reason behind the inflation spike in India. This is increasing the import cost for some of the crucial consumables, pushing inflation higher.
4. Impact of Higher Inflation in India
4.1 Repo Rate Hike:
- It is expected to push up interest rates in the banking system. Equated Monthly Installments (EMIs) on home, vehicle and other personal and corporate loans are likely to go up.
- Deposit rates, mainly fixed term rates, are also set to rise.
- Consumption and demand can be impacted by the Repo rate hike.
4.2 CRR Hike:
- The hike in CRR will suck out Rs 87,000 crore from the banking system. The lendable resources of banks will come down accordingly.
- It also means the cost of funds will go up and banks’ net interest margins could get adversely impacted.
5. Challenges in Tackling High Inflation In India
In the current situation, it is argued that inflation will come down, if some part of the increase in crude prices is absorbed by the government. There may be a case for reducing the duties on petroleum products for the simple reason that one segment of the population should not bear excessive burden. The same consideration applies to food prices. But to think that it is a magic wand through which inflation can be avoided is wrong. If the additional burden borne by the government (through loss of revenue) is not offset by expenditures, the overall deficit will widen. The borrowing programme will increase, and additional liquidity support may be required.
Central banks cannot order interest rates. For a rise in the interest rate to stick, appropriate actions must be taken to contract liquidity. That is what the rise in CRR will do. In the absence of a rise in CRR, liquidity will have to be sucked by open market operations.
6. Steps to tame high inflation
Experts suggest many steps should be taken to tame the high inflation in India. Some of these steps are outlined below:
6.1. Fuel duty cut: Government recently cut fuel prices on petrol and diesel. Further duty cuts by at least Rs 5 per litre will help ease inflation. It can lower the inflation by 15-20 bps.
6.2. Food Prices Control: Government has already taken steps to ban export of wheat and restrict the export of some food products like Sugar. There should be a crackdown on supply side if hoarding happens. Government can take some steps to ease import limits on pulses, oil seed etc.
6.3. More duty cuts: More duty cuts for edible oil imports is required. However, it was reduced from 19 .25%to 13.75%.
6.4. Use Buffer stock: Experts say that India must be prepared to use buffer stock if inflation spills over to cereals.
6.5. Higher economic growth: According to experts, a 10% higher industrial output can ease retail inflation by 40 bps
6.6. Boost income generating capacity: Especially by offering urban and rural income schemes.
7. Pros or Advantages & Cons or Disadvantages of Inflation
Finally, lets understand why Inflation is termed as a necessary evil – because it has both advantages and disadvantages.
7.1 The Advantages of inflation
- When prices are falling, people are reluctant to spend money because they feel that goods will be cheaper in the future; therefore they keep delaying purchases.
- Moderate inflation enables adjustment of wages.
- Inflation enables adjustment of relative prices.
- Inflation can boost growth.
7.2 The Dis-advantages of inflation
1. Inflationary growth tends to be unsustainable leading to a damaging period of boom and bust economic cycles.
2. Inflation tends to discourage investment and long-term economic growth.
3. Inflation can make an economy uncompetitive.