The Hindu Business Line : What is inflation and what causes it?

The inflation rate (WPI) for the week ended February 3 was 6.73 percent, the highest in two years. This gave rise to a lot of talk about why the rate was going up. The RBI increased the Cash Reserve Ratio (CRR) by 50 basis points and had previously increased the repo rate (the rate at which the RBI lends money to banks). Everyone has `inflation' on their lips but it is worth looking at what exactly inflation is, and how it arises.

Inflation pared down to the essentials means a rise in an index consisting of many goods that have weights attached to them. The index always has a base year. If a particular item has a higher weight and its price rises, it will have a greater effect on the inflation rate. At the end of the day it depends on how much weight a particular item is assigned. Most countries use a consumer price index (CPI) while India has a wholesale price index (WPI).

As their names suggest, the CPI pertains to a set of items that a consumer consumes while the WPI is a basket particular to the wholesale market. Therefore, if the inflation for a particular week is, say, 10 per cent, it means the index is 10 per cent higher than it was the same week the previous year. Then there is core-inflation, which means the inflation rate without taking into account food and fuel. Some say both need to be taken out because of their volatility, while some argue that both items cannot be taken out because a consumer does pay for the rise in their prices. The people arguing for the latter do have a point.

Milton Friedman once said: "Inflation is always and everywhere a monetary phenomenon." What exactly does that mean? It essentially means that inflation is always caused because of too much money in the system. In other words, inflation in a country is always caused because the supply of money is much greater than the demand for it. However, Prof Friedman later changed that to: "Substantial inflation is always and everywhere a monetary phenomenon," meaning that hyperinflation (a monthly inflation rate of 50 per cent or more) is caused because of too much money in the system and is usually the result of the central bank printing too much money to finance government operations.

Therefore, one needs to ask what causes the milder type of inflation, such as what India is experiencing. Two different types of inflation are generally associated with this. They are:

Demand-pull inflation: This is basically when the aggregate demand in an economy exceeds the aggregate supply. It is also defined as `too much money chasing too few goods'. Bare-boned, it means that a country is capable of producing only 100 items but the demand is for 105 items.

It's a very simple demand-supply issue. The more demand there is, the costlier it becomes. Much the same as the way real estate in the country is rising.

Cost-push inflation: This is caused when there is a supply shock. The best example to describe cost-push inflation is the oil shock in the 1970s. When OPEC was formed, it squeezed the supply of oil and this caused oil prices to rise, contributing to higher inflation. This is similar to what has happened recently when the oil price hike increased inflation in many a country.

However, whether you believe that inflation can be caused by `cost-push factors,' it depends on whether you're a Keynesian or a Monetarist (Prof Friedman, et al). If you are the former, you would believe in the above two reasons; but, if you're a monetarist, you would believe that only money supply matters.

The Monetarists believe that if the central bank keeps the money supply constant, then increases in the price of a Good A will reduce the money available for other goods.

Therefore, the price of the other goods will fall and offset the price increase of Good A.

However, leaving that said aside, what is causing inflation in India? The WPI consists of 435 items and has three broad categories. They are Primary Articles (weight of 22.0253), Fuel, Power, Light, and Lubricants (weight of 14.2262) and Manufactured Products (weight of 63.7485). The base year of the WPI is 1993-94. The base year usually chosen is one where there has been fairly less volatility. So now let's look at what caused the inflation.

If one looks at the three broad categories, primary articles rose by 12.26 per cent, fuel increased 2.33 per cent and manufactured products 6.37 per cent. However, if one takes the different weights into account, a clearer picture emerges. Because of the weights, of the 6.73 per cent of inflation, manufactured goods contributed 4.29 per cent while primary goods contributed 1.48 per cent, and Fuel, Power, etc., contributed to 0.95 per cent.

It has been reported that the manufacturing capacity in India is running around 95 per cent, which usually means it is running at full capacity. Therefore, when the price of manufactured products is increasing, it means that demand is usually higher than supply and that is a clear case of demand-pull inflation.

On the primary goods front, which consists of fruits, vegetables, food-grains. Etc., it is not that straight-forward. It has certainly been all over the news that the prices of fruits and vegetables are increasing and a trip to the supermarket or local grocery shop will testify to that.

Why the price rise in primary goods is not straight-forward is that while on the one hand, it is a clear case of demand-pull inflation, on the other, it is also a bit of a supply shock when one considers the fact that there is an abnormally high percentage of fruits and vegetables that goes to waste because of the lack of cold-storage facilities. Some estimates say 50 per cent of produce goes to waste and that is a conservative number. The increase in fuel is easy to understand.

(Send in your queries on economics to Whackonomics@gmail.com)

Sunil Rongala