Inflation rate: monetary measures and controls

The loss of a currency’s relative buying power over time is referred to as inflation. The increase in the average price level of a basket of chosen goods and services over time in an economy can provide a quantitative approximation of the rate at which the reduction in buying power happens. A unit of currency essentially buys less due to the increase in pricing, which is sometimes stated as a percentage.

Deflation, on the other hand, is characterised by a rise in the buying power of money and a decrease in prices. For e.g A shirt is initially priced at Rs 1000, taking the inflation rate of 6% p.a., after one year the same shirt would cost around Rs1060 without any change in size and material.

Causes of Inflation

Inflation is caused by a rise in the quantity of money, albeit this can happen through a variety of economic causes. The monetary authorities can boost a nation’s money supply by:

1. Printing additional currency and distributing it to people
2. Legally depreciating (decreasing) the value of the money that is legal tender
3. Acquiring government bonds from banks on the secondary market in order to create fresh money as reserve account credits through the banking system (the most common method)

In each of these scenarios, the money ultimately loses its ability to buy things. Three different sorts of inflationary processes may be identified as a result of this: demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-pull Inflation

It happens when an economy’s total demand for goods and services grows faster than its ability to produce them. This occurs when the quantity of money and credit increases. This raises demand, which causes price hikes.

A positive consumer mood increases spending when people have more money, which raises prices since there is more demand for goods and services. Higher demand and a less adaptable supply lead to a demand-supply mismatch, which raises prices.

Price Push Effect

Cost-push inflation is a result of price increases spreading through the inputs used in manufacturing. Costs for all types of intermediate products increase when more money and credit are directed toward the commodity or other asset markets, particularly when this is accompanied by a negative economic shock to the supply of important commodities.

These changes drive up the price of the final good or service, which in turn drives up consumer pricing. For instance, the cost of energy for all kinds of purposes may increase and contribute to rising consumer prices, which is represented in many measures of inflation, when the expansion of the money supply causes a speculative boom in oil prices.

Built-in Inflation

Adaptive expectations, or the notion that individuals anticipate the current inflation rates to persist in the future, are connected to built-in inflation. The cost of products and services is rising, and as a result, employees and other people begin to demand higher expenses or wages in order to maintain their quality of life. The cost of products and services rises as a result of their increased earnings, and this wage-price spiral keeps going as one element drives the other and vice versa.

Measuring inflation

Various sorts of baskets of commodities are created and tracked as price indices to measure inflation in the economy depending on the chosen set of goods and services used. The Consumer Price Index (CPI) and the Wholesale Price Index are the two most often used price indices (WPI).

The Consumer Price Index (CPI)

The CPI is a metric that looks at the weighted average of costs for a selection of products and services that are essential to meeting consumers’ basic requirements. They consist of lodging, supper, and medical attention. By averaging the price changes for each item in the preset basket of products according to their proportional weight in the entire basket, the consumer price index (CPI) is derived. The costs taken into account are the retail costs per item as they are offered for sale to private persons.

The Wholesale Price Index (WPI)

The WPI is another well-known inflation indicator that follows and assesses changes in product prices in the stages before to retail. While WPI commodities vary from nation to country, they often contain wholesale or producer-level goods. For instance, it contains cotton apparel pricing as well as raw cotton, cotton yarn, and cotton grey items prices.

The price index variations indicated above can be used to determine the amount of inflation between two specific months (or years). Although there are many pre-made inflation calculators currently available on several financial portals and websites,

It is always preferable to be aware of the underlying approach in order to assure accuracy with a clear grasp of the calculations. Mathematically,

Percent Inflation Rate = (Final CPI Index Value / Initial CPI Value) x 100

Food and beverages make up the majority of the consumer price index in India (45.86 % of the total weight), with prepared foods like meals, snacks, and sweets coming in at 5.55%, vegetables at 6.04 %, milk and products at 6.61 %, meat and fish at 3.61 percent, and oils and fats at 9.67%. Transportation and communication (8.59%), health (5.89%), and education (28.13%) make up the remaining categories 4.46%. 10.07 % of the economy is devoted to housing, 6.84% to energy, 6.53%t to clothing and footwear, and 2.38 % to alcohol, tobacco, and other drugs.

Due to its significant budget deficit, reliance on energy imports, uncertainty around the impact of monsoon rains on its extensive agriculture sector, and inadequate roads and infrastructure, India’s consumer price fluctuations may be extremely erratic. As the primary indicator of inflation, the consumer price index (CPI) took the place of the wholesale price index (WPI) in 2013. See the chart below showing the trend of inflation rate in India since 1960.

Measures adopted to control inflation in India

Let’s quickly go through the key elements involved in inflation management.

#1. Repo Rate

This is the proportion of money that the Reserve Bank of India, (RBI), the country’s central bank gives to commercial banks.

When it comes to the amount of money that the government is spending, this proportion is highly significant. Any time commercial banks run out of money, they can turn to the RBI for assistance. The government frequently use the repo rate as a tool to manage inflation.

Using this technique, the government may reduce the amount of money entering the economy. They only need to raise the repo rate to stop the flow of cash. That’s why Recently Reserve Bank of India has increased Repo Rate by 50 basis points to tackle increasing inflation in the economy. See the past trend in Repo rate in India with the help of the graph.

#2. CRR (Cash Reserve Ratio)

The Cash Reserve Ratio is yet another crucial instrument. The RBI often uses this tool. It has the power to regulate the flow of money throughout the economy. The CRR really represents a specific sum of cash that commercial banks are permitted to hold with the Reserve Bank of India.

The central government may significantly affect the inflation rate by raising the CRR rate. One of the best government measures to reduce inflation is this.

#3. Reverse Repo Rate

Making use of the reverse repo rate is an additional method of reducing inflation. The rate at which commercial banks lend money to the RBI is known as Reverse Repo Rate.

An economy may have inflation or money shortages at any particular time. The Reverse Repo rate, which is a component of a liquidity adjustment facility used by central banks, is then put to use.

Consider the fact that the reverse repo rate is often a percentile lower than the present repo rate as an example. The RBI can take money out of the economy by using the reverse repo rate to try and reduce inflation.

Now let us talk about it in further detail.

Monetary Measures

These procedures can be used to restrict income as part of monetary policies to control inflation.

Credit Control: The central bank (RBI) uses a few strategies to manage both the amount and quality of credit. In order to accomplish its objectives, it doesn’t just increase bank rates and reserve requirements—it also sells securities on the open market. Additionally, it controls consumer credit, which has been shown to be advantageous when a demand-pull element is present.

Demonetization: Governments use this drastic measure to eradicate black money from the market. The government has the authority to invalidate denominations of currency if it believes that a significant amount of black money is having an impact on the economy.

On November 8, 2016, the Prime minister of India announced ‘demonetisation’ to weed out black money from the country. The move, which saw the currency notes of Rs 500 and Rs 1,000 denominations getting banned, wiped out 86% of India’s currency overnight.

Fiscal Measures

The next topic we’d cover is how to reduce inflation through fiscal policy. These actions are effective at reducing rising public spending as well as private and public investment.

Cutting excessive costs: In an effort to combat inflation, the government should take action to cut costs that are not essential. For the same reason, personal costs should be kept under control. Taxation must be included in the measure.

Increase in Tax: Taxes might be raised or new taxes can be enacted by the government to reduce individual consumption costs. The increase in tax rates must not deter individuals from investing and saving, nevertheless.

Government must also impose penalties on those who avoid paying taxes. They should pay significant penalties. These actions were successful in reducing inflation.

Savings Increase: More money should be saved by people. As a result, fewer people should have disposable income. The government must take a proactive approach to public loans with high-interest rates, benefit programmes, mandatory provident funds, provident fund-cum-pension plans, etc.

Budget Surpluses: The government may decide to adopt an anti-inflationary budgetary strategy. Giving up deficit financing might help with this.

Public Debt: The repayment of public debt should be under its authority. Until inflationary pressures are under control, it should be delayed.

A controlled level of inflation is beneficial for the nation’s development. But if it spirals out of hand, it will trigger hyperinflation and send the economy into a downward spiral. Therefore, the central bank and the government together devise the necessary steps to keep it under control.

 

About the Author

Ketan Sonalkar (SEBI Rgn No INA000011255)

Ketan Sonalkar is a certified SEBI registered investment advisor and head of research at Univest. He is one of the finest financial trainers, with a track record of having trained more than 2000 people in offline and online models. He serves as a consultant advisor to leading fintech and financial data firms. He has over 15 years of working experience in the finance field. He runs Advisory Services for Direct Equities and Personal Finance Transformation.

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