12

Inflation in India

S. Narayanan

12.1 Introduction

The Indian economy had achieved substantial economic progress in many fronts since the implementation of the economic reforms in 1991. But a major problem faced during the post-reform period has been the higher levels of inflation. During the first half of the 1990s, the economy experienced a spurt in inflation. The annual average inflation rate during the period was 10.6 per cent. However the inflation rate fell to 5.10 per cent during the second half of the 1990s. There was a marginal fall in the inflation growth during the first half of the first decade of the 21st century. But the inflation rate again increased during the end of the first decade. In this context, the chapter examines the recent trends and patterns of inflation in India. In this chapter, we present the theoretical issues in Section 12.2, the history of whole sale price index in India in Section 12.3 and the trends in inflation in Section 12.4.

12.2 Conceptual and Theoretical Issues

‘Inflation is a process of continuously rising prices or equivalently continuously falling value of money.’ Its importance stems from the pervasive role played by money in an economy. It is one of the economic phenomena which affects every one in the economy. Whenever inflation goes up to two digits, public concern about it increases and there are demands that the monetary authorities should take measures to contain inflation. On the other hand, when prices go down and reach the bottom the public concern is nil. The ordinary citizen is baffled by the phenomenon of inflation falling and prices going up. The fact is that when inflation is falling, it is only the rate of increase in price that is falling and not the level of prices.

In their article ‘A Survey of Inflation’, Martin Bronefenbrenner and Franklin D. Holzman stated, ‘Since 1945, the geographical extent and temporal stuburness of inflation has shaken many economists’ faith in the orthrodoxies of preceding generations’. The earlier economists, steeped in the quantity theory tradition, viewed inflation fundamentally as a monetary phenomenon. Some would go further and agree with Milton Friedman that ‘Inflation is always and everywhere a monetary phenomenon and can be produced by a more rapid increase in the quantity of money than in output’. While few would deny that inflation is a monetary phenomenon, many would agree that its origins are not monetary alone. That is why J. R. Hides wrote, ‘our present troubles are not cured by monetary means’, and that ‘while it was true in the old days that inflation was a monetary matter, prices rose because the supply of money was greater than the demand for it money is now a mere counter which is supplied by the banking systems (or by the government through the banking system) just as it is required’. Since numerous discussions on inflation centre around the direction and causation between money and the prices, it is only proper that we look at inflation from the demand and cost perspectives. Even though the distinction is central to much of the literature on inflation, in the first place, such a distinction is imprecise, as D. H. Robertson wrote, ‘the economic stalactite of inflated demand has met the sociological stalagmite of upthrusting claims, and when the stalactite and the stalagmite meet and fuse in an icy kiss nobody on earth can be quite sure where the one ends and the other begins’.

In the second place, the distinction implied that inflation can be analysed by examining separately the supply and demand sides of both the product and factor markets, and this does not accord with the structure of much modern inflation. A better distinction would be between the perfectly anticipated inflation and the imperfectly anticipated inflation. The monetary explanations of inflation concentrate on the former. However, if inflation is to be perfectly anticipated, all economic agents have the same expectations and since it is not the case, imperfectly expected inflation is more realistic. Notwithstanding these facts, the conventional wisdom of distinguishing between the demand pull and the cost push has relevance because inflation emanates from the demand side or supply side or a mix of both. Framing policies to control inflation necessitates a proper understanding of the demand side and supply side causes of inflation.

12.2.1 Demand Inflation

Conventionally there are two traditions of explaining inflation in terms of demand—the quantity theory tradition which attributes price level changes to changes in the quantity of money (a stock) and the Keynisian tradition which attributes inflation to the level of expenditure (a flow), i.e., increased expenditures open an inflationary gap after full employment. Most of the pre-Keynesian economists preferred quantity theory explanation to establish a long proportionality between the prices and the quantity of money. This theory was discarded in the 1930s mainly due to the sharp changes in the velocity of circulation of money which orthrodox quantity theory considered nearly constant. The postwar monetary position on inflation was provided by Milton Friedman who brought to the centre stage the quantity theory of money which had been in oblivion ever since the publication of General Theory. The monetarist position on inflation was provided by Friedman who maintained that the money stock rather than the income flow determined both the price level and the level of economic activity. Before the Great Depression, the accepted view was that the stock of money determined the level of prices and economic activity. According to Friedman, the Great Depression was a testimony to the fact that the monetary factors were behind recessions and inflations. The intellectual revolution pioneered by Keynes pushed money to the background and the view became widespread that ‘money does not matter’ and the stock of money was purely passive concomitant of the economic change. The monetarist counter revolution led by Friedman brought money back to the centre stage and he argued, ‘many countries in the post-war period . . . pursued cheap money policies. Every such country experienced either open inflation or a net work of controls designed to suppress the inflationary pressure. No country succeeded in stemming inflation without adopting measures at restraining the growth of stock of money’.

The traditional Keynesian approach to demand inflation in the goods markets investigates the behaviour of aggregate demand curve (C + 1 + G) at full employment, and at successively higher price levels. If the economy produces at the potential level of output, any increase in the aggregate expenditure can only lead to a rise in the prices. Thus the Kenyesian approach to inflation has been largely confined to an excess demand in the market for goods.

12.2.2 Supply Inflation or Cost Inflation

Ever since the monetary system has come to exist, cost inflation has been laymen’s instinctive explanation of inflation. Inflation has been blamed by many on wage increases, profit hikes and negative supply shocks. In his Treatise on Money Kenyes made a distinction between ‘spontaneous’ and ‘induced’ rise in price, the former being wage inflation. In the 1950s there has been a revival of interest in cost inflation which came to be known as ‘new inflation’. Though it was a counter to the demand pull orthrodoxy the advocates of cost inflation did not deny the role of increase in the money stock, money income and expenditure on inflation. The cost explanation of inflation encompasses the opinion that the strength of pressure groups including trade unions, profiteers and speculators increases the likelihood of anticipated inflation. The more inelastic the demand and supply of labour, the more the likelihood of wages rising. This does not imply that wage rise is not possible in competitive industries, if the trade union bargaining power is high.

The theoretical work on the negative correction between wage inflation and unemployment is provided by the Phillips Curve. The central idea of Phillips Curve is derived from two behavioural relations: (1) a positive relation between excess demand for labour and wage change (2) an inverse relation between wage rises and unemployment as well as the rate of change in unemployment. A rise in wage leads to inflation and hence the trade-off between inflation and the unemployment. The Friendman—Phelps hypothesis emphasizes that the expected rate of inflation plays a crucial role in determining the actual rate of inflation.

The mark up pricing in monopolistic and oligopolistic markets facilitates inflationary potential of the cost push type. Under conditions of stable and gently rising demand, the mark up pricing tends to increase the Consumer Price Index (CPI) and this will prompt the unions to demand higher wages leading to wage inflation. An enterprise that seeks to maximize short-run profits would cut back on employment and output in the event of a wage increase or increase in the other costs. Under conditions of stable demand, the prices would rise.

Supply Shocks: A large part of inflation can be attributed to the negative supply shocks. A rise in the prices of oil contributes to cost push inflation. In our country bad monsoons often lead to crop failure causing inflationary pressures. Such rises in the prices are transient and often do not contribute to the long-run underlying inflation.

12.2.3 Inflation Measures in India

1. The National Income Deflator: This is defined as the ratio of GDP at current prices to the GDP at constant prices. It is a comprehensive measure because it encompasses all goods and services produced in the economy and is statistically derived from the data revealed by the Central Statistical Organization (CSO). Since it encompasses the entire structure of economic activities, including services, its scope and coverage are wider than other measures. At present it is released quarterly with a lag of two months. Hence its applicability is limited.
2. Wholesale Price Index (WPI): This is the main measure of the rate of inflation in India and is used for policy purposes. The WPI is available for all commodities and for major groups and industrial commodities. The advantage of this index is its availability at a greater frequency than the GNP deflator, at present with a gap of one month. This enables a constant monitoring of price situation for policy purposes. The limitation of this index is that it does not cover non-goods producing sectors like services. At present the base is 1993–94 = 100. A working group under the chairmanship of Prof Abhijith Sen has recommended a shifting of the base from 1993–94 to 2000–01 for the revised WPI services.
3. New Series ofWPI: The Ministry of Commerce and Industry introduced a new series of WPI with 2004–05 as the base year in September 2010. Instead of435 commodities, the new series had 676 commodities. The number of primary articles increased from 98 to 102 and manufactured products from 318 to 555. Due to an increase in the number of commodities, the weights of the commodities also registered a change. The items of commodities in the old and the new series and the weights of WPI are given in Boxes 12.1 and 12.2.

   Box 12.1: Old Series of WPI

   Major groups	Old WPI (1993–94)
   	Weight (%)	No. of items
   All commodities	100.00	435
   1. Primary articles	22.02	98
   2. Fuel and power	14.22	19
   3. Manufactured products	63.74	318

   Box 12.2: New Series of WPI

   Major groups	New WPI (2004–05)
   	Weight (%)	No. of items
   All commodities	100.00	676
   1. Primary articles	20.11	102
   2. Fuel and power	14.91	19
   3. Manufactured products	64.97	555

4. Consumer Price Indices (CPI): Within the consumer price indices there are four sub-indices that are based to capture price levels across different types of consumers.
   • Consumer Price Index for Industrial Works (CPI-IW): The CPI-IW is an important measure at the point of consumption. This refers to the cost of living conditions and is estimated on the basis of the changes in the level of retail prices of the selected commodities, on which a homogenous group of consumers spends a large share of their income. Since it is a more appropriate measure of the cost of living, it is used to determine the dearance allowance of the employees, both in the public and the private sectors, and is considered an appropriate index of general inflation.
   • Consumer Price Index for Urban Non-Manual Employees (CPI-UNME): It has limited use and is basically used to determine the dearance allowance of employees working in the public and private sector.
   • Consumers Price Index for Agricultural Labour (CPI-AL): It is basically used for raising the minimum wages of agricultural labourers in the different states.
   • Consumer Price Index for Rural labour (CPI-RL): It is mainly used for fixing the minimum wages of the rural workers. The CPI-AL, CPI-UNNE and CPI-RL are not considered robust national inflation measures because they are designed for specific groups of population. Its major purpose is to measure the impact of price rise on the rural and urban poverty.

Each of these indices has its own strengths and weaknesses. Any measure of inflation should reflect the interplay of the supply and demand forces in the economy. The index should have a frequency and its cover of commodities should be high. By these criteria, WPI is a better measure of headline inflation in India because it has a high coverage of 435 commodities and is less volatile. In the recent period there has been a large difference between WPI-based inflation and CPI-based inflation. The differences in CPI and WPI are largely due to differences in the coverage of commodities and the weighting pattern. While food items get the maximum weight in CPI, ranging from 46 per cent in CPI-IW and 69 per cent in CPI-AL, this group gets only 25.43 per cent weight in WPI, whereas manufactured products have a weight of 63.75 per cent.

12.3 History of the WPI in India

The Office of the Economic Adviser to the Government of India (Ministry of Industry) undertook to publish for the first time, an index number of the wholesale prices, with base week ending 19 August 1939 = 100, from the week commencing on 10 January 1942. The WPI was calculated as the geometric mean of the price relatives of 23 commodities. Each item was assigned equal weight, and for each item there was a single price quotation. From 1947, the series included as many as 78 commodities, covering 215 individual quotations, classified into five groups—the food articles, the industrial raw materials, the semi-manufactures, the manufactures and the miscellaneous. In accordance with the recommendations of the Standing Committee of the Departmental Statisticians, the Economic Adviser’s Office issued a revised series of WPI, with 1952–53 as the price base and 1948–49 as the weight base, consisting of112 commodities, and 555 individual quotations. The commodities were classified into five groups: the food articles; liquor and tobacco; fuel, power, light and lubricants; the industrial raw materials; and the manufactures. The weighted arithmetic average was adopted in preference to the weighted geometric mean used for the earlier series. A new series of WPI with base 1961–62 = 100 and with an improved coverage of the non-agricultural commodities was issued from July 1969. It covered 139 commodities and 774 quotations. For commodity classification, the ‘Standard International Trade Classification’ (SITC), with slight alterations made to fit in with the Indian conditions was followed. While introducing the series with base 1961–62, it was decided to constitute a working group to go into the methodological aspects of the index relating to the revised series, with a more recent year as base.

Based on the recommendations, a new series, with the base year as 1970–71 was introduced in January 1977. The items covered in the new series increased to 360 items and 1295 price quotations. In the case of non-agricultural items, the commodities with a total value of production of more than Rs one crore each were included. The selection of the agriculture commodities was done in consultation with the Directorate of Economics and Statistics, Ministry of Agriculture. To set a more representative sample, weights were assigned on the basis of the entire wholesale transactions in the economy. Attempts were also made to bring about a greater uniformity by National Industrial Classification (NIC). The commodities were classified into three major groups, viz., (1) primary articles; (2) fuel, power, light and lubricants; and (3) manufactured products.

The WP Index with 1981–82 as the base year continued the conceptual definition used earlier. The 1981–82 series included 447 distinct commodities and 2371 price quotations. The method of compilation and the assigning of weights continued without change. The classification of goods into three major groups continued. The subsequent new series with the base year 1993–94 followed the same methodology of estimation. The total number of commodities in the group increased to 435, comprising of 98 ‘primary articles’, 19 items of ‘fuel, power, light and lubricants’, and 318 ‘manufactured products.’

12.4 Trends in Inflation

12.4.1 Wholesale Price Index

We may examine the trends in inflation during the post-reform period based on the WPI. The WPI, the widely used measure, is the calculated weighted arithmetic mean of price relatives of 435 commodities which includes 98 primary commodity articles, 19 items of fuel, power, light and lubricants and 318 manufactured products, each item being assigned equal weight and for each item there is only a single price quotation. In the revised series of WPI, with base year 1993–94, there are 435 commodities of which the primary commodities are accorded a weight of 22.03 per cent; fuel, power, light and lubricants 14.23 per cent; and manufactured products 63.75 per cent.

The trends in inflation during the post-reform period showed that the rate of inflation was very high during the first half of the 1990s (Table 12.1). The annual average inflation was estimated as 10.6 per cent. In the second half, the rate of inflation fell to 5.1 per cent. During the first half of the present decade, there was a marginal decline in the rate of inflation. In the case of primary articles and manufactured products, we can notice the same trend in the rate of inflation during the above period. But in the case of fuel, power, light and lubricants, the rate of inflation remained at higher levels in the second half of 1990s and the first half of the present decade.

TABLE 12.1 Annual Average Inflation Rate Based on WPI (per cent)

Table 12.2 gives the annual average inflation rate based on WPI for different groups of commodities during the first decade of 21st century. A noticeable development was the increase in the rate of inflation to 8.4 per cent in 2008–09. Another change was the steady increase in the rate of inflation in the case of primary articles and manufactured products during the second half of the decade. The rate of inflation of the primary products increased to 10.1 per cent in 2008–09. The inflation rate of fuel, power, light and lubricants was also at higher level during the second half of the present decade except one year.

Table 12.2 Annual Average Inflation Rate Based on WPI (per cent)

Table 12.3 presents the annual average inflation rate of the major groups of commodities between 2005–06 and 2009–2010. From the table we may draw the following conclusions.

For all the three groups of primary articles, viz., food, non-food and minerals, the rate of inflation was fairly high during the period. Mineral oil is another item which shows a high rate of inflation. In the case of manufactured food products, we can notice a continuous increase in its price. Wood and wood products, rubber and plastic products, chemical products, non-metallic mineral products, basic metal alloys and machinery are the other products which registered an increase in their prices.

TABLE 12.3 Annual Average Inflation by Major Heads in WPI (per cent)

12.4.2 Consumer Price Indices

We may examine the trends in inflation based on the consumer price indices. The consumer price indices give an indication in the variation of consumption expenditure of different sections of people. Table 12.4 gives the annual inflation rate based on various consumer price indices between 2000–01 and 2009.

An examination of inflation measured in terms of the CPI of industrial workers shows that there has been a continuous increase in the index during the second half of the present decade. It increased from 4.4 per cent in 2005–06 to 9.1 per cent in 2008–09. During the year 2009, we can see a spurt in the growth of the index (Table 12.4). The index increased from 8.7 per cent in April 2009 to 11.9 per cent in July and 15.0 per cent in December. The inflation measured in terms of the CPI of the urban non-manual employs also indicates the same trend in its growth rate during the first decade of the 21st century (Table 12.4). The index registered a steep increase during the second half of the present decade.

The CPI of agriculture labourers gives an idea about the cost of living of the labour engaged in agriculture. The index which remained at a low level till 2005–06 registered a substantial increase since then (Table 12.4). The index increased from 7.8 per cent in 2006–07 to 10.2 per cent in 2008–09. During the year 2009, the index reached a very high rate of 17.2 per cent. The trend in CPI of the rural workers was also similar to that of agriculture workers.

TABLE 12.4 Annual Inflation Rate Based in Consumer Price Indices (per cent)

From the above review of the four indices, we can conclude that all the indices registered a continuous increase during the second half of the present decade. There was also a spurt in the indices in the year 2009, mainly due to an increase in the price of food items comprising of primary articles and manufactured food items. A number of monetary and fiscal measures were taken by the RBI and the central government to contain inflation during 2009–10. The monetary measures and fiscal measures are given in Boxes 12.3 and 12.4.

12.5 Conclusion

The trends in inflation during the post-reform period showed that the rate of inflation was very high in the first half of the 1990s. During the second half of 1990s, there had been a substantial decline in the inflation rate. The rate of inflation showed a marginal fall during the first half of the first decade of 21st century. However, the rate of inflation registered a steep increase in the second half of the present decade. During the year 2009, there had been a spurt in inflation due to an increase in the prices of food items, comprising of the primary articles and the manufactured food products. A review of the consumer price indices during the present decade suggests that the year, 2009, witnessed the highest rate of inflation in the recent years.

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