BackHow fluctuations in prices impact overall economy
Retail inflation at 4.3% in April is well within the central bank’s comfort zone of 4% (+/-2%). Amid the growing risk that localized curbs might disrupt supply chains, consumer price index (CPI)-based inflation dipping to three-month low gives policymakers some breathing space
PremiumRetail inflation at 4.3% in April is well within the central bank’s comfort zone of 4% (+/-2%). Amid the growing risk that localized curbs might disrupt supply chains, consumer price index (CPI)-based inflation dipping to three-month low gives policymakers some breathing space.
How is inflation measured?
Inflation is measured by the CPI and the wholesale price index (WPI). The CPI measures changes in prices of essential commodities at the consumer level, while the WPI notes changes at the producer level. The commodities considered for measuring the WPI are manufactured products (63.75% weightage), primary articles such as food (20.02%), and fuel and power (14.23%). For the CPI, the commodities are food and products (45.86%), housing (10.07%), clothing (6.53%), and fuel among others. Inflation is indicative of the decreasing purchasing power of the country’s currency and vice versa.
How do price changes impact an economy?
Inflation increases the cost of production, which is passed on to consumers. With the WPI rising to 10.49% in April as against 7.39% in March, cost push pressures have been witnessed. Cost push pressures hit purchasing power that results in a fall in the standard of living. Inflation also results in increasing project costs. Employers then have to compensate this through variable pay such as dearness allowance if the trend in the WPI gets extended to the CPI too. On the other hand, demand pull inflation incentivises produ-cers to make more. Rising inflation is an advantage for borrowers and disadvantage for lenders.
What is the political impact of inflation?
Increasing price levels, especially for essential items, around election time could destabilize the incumbent government. The ruling party is thus always sensitive to inflation. On the other hand, a slower increase in price levels especially fruits and vegetables means worsening terms of trade for farmers, again impacting the government.
What is the relevance for monetary policy?
As a monetary policy objective, the RBI started inflation targeting of 4% (+/- 2%) since 2016. In increasing inflationary conditions, the RBI adopts a contractionary monetary policy. In case of a slow-down, it adopts an expansionary monetary policy, which leads to increased money supply, lower interest rates, lower borrowing costs, and increasing aggregate demand thereby giving a boost to the economy. But, due to covid, the past one year has been an exception for inflation targeting as economic revival got precedence.
Is a fall in inflation rate always good?
If a fall is because of decreasing demand, it is not a good sign. Other than declining food prices, fall in price levels in April can also be attributed to subdued economic activity because of the lockdowns. People lost their means of income, resulting in a fall in demand and pushing down price levels. Besides, data collection in April and May was disrupted, leading to the base not being reflective of accurate trends. A healthy rise in the price level of 4% is good.
Jagadish Shettigar and Pooja Misra are faculty members at BIMTECH.
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