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Causes and Effects of Inflation in India

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Published: Thu, 01 Feb 2018

Introduction

Inflation is defined as the constant rise in the price of a particular goods and services over a period of time. When the level of prices increases, each unit of currency can purchase lesser goods and services making the purchasing power will decrease. There are two types of inflation in this world including the positive inflation and negative inflation. A negative inflation will increase the chances of investors to hold their money as the future is still in uncertainty. They do not want to take risks of their money to invest in uncertainty and hence will lead to surplus of goods in market. A positive inflation will help the bank to adjust their real interest rate in a short run and encourage investment in the non-monetary capital project.

Summary

In recent years, high food inflation in India is one of the factors which bring to non-food inflation and aggregate inflation. There are 4 factors that affect food inflation occur, which are international prices and trade policy, rising demand supply mismatch, stagnant productivity and minimum support prices. During 2008 and 2010, international economist forecasted that will be inflation on that year caused that the international price of good increase. It affects the cost of input which import from foreign country has been increased as well. Besides, rising per capita income and diversification of diet in India causes that the demand of high-value product like eggs, meat fruits and other rise while the response of supply of these products is being weak. To overcome the problem of stagnant productivity, Mahatma Gandhi National Rural Employment Guarantee Act (MNREGA) is promoted and it affect that the rural wages in India rise. Under this program, the indexation of wage rate to Consumer Price Index has been pushed up the minimum wage. (Sonna, October 2014)

Food inflation will cause that wage rate increase because labor can request for a higher wage since food is constituted as an important good in their consumption basket. Increase of wage will increase the cost of production and make the prices of non-food increase as well. On the same time, the real income of producer in food sector is increased during the rise in food price. It cause that the demand of non-food items will rise due to the increases of food prices which relative to aggregate price through substitution effects and through income effect of the food producer. (Sonna, October 2014)

When the price of food inflates, it will drive the fluctuation in currency which has created a huge impact on all the sectors. For instance, the domestic oil price is linked with the international oil price. This lead to the oil price has a direct relationship with the Indian currency as US dollar which has already become one of the acceptable global currencies in the international market. However, the impact brought by the increase in oil price is not heavy and will cause a big burden to the market because this increase in price will go through the other sectors in the market. This contributes to share the burden of the increase in oil price among the other sectors. This causes inflation of other goods to happen due to the chain reaction happen when the prices of the domestic oil increase. (Dr.A.Hidhaya & Mahammad Rafee.B, 2014)

As the oil price and inflation build a cause and effect relationship, the fluctuations of oil prices have significant impact on the inflation. The impacts of oil prices fluctuations are different in oil exporting and in oil importing countries. For the oil exporting countries, the increment of oil prices constituted good news while the increment of oil prices constituted bad news for oil importing countries. For instance, China and India were known as the most consumption on the oil among the oil importing countries in the world. Anshul Sharma stated that inflation will move in the same direction with the movement of oil prices. The inflation rate increases as the crude oil increases and vice versa. Since the early of the 21st century, the prices of oil has rising heavily. This contributed to the higher inflation as the cost of production increased. The increment of cost of production led to the increment of fuel costs and then caused the decrement of supply. Jose De Gregorio et al. stated that the fluctuation of oil prices had adverse impact on the economy. (M. Anandan, S. Ramaswamy and S. Sridhar, 2013)

Besides, depreciation in the currency will subsequently lead to the people to buy lesser goods with the same amount of money they hold. This case can be defines as a decrease in the purchasing power of currency. This journal has mentioned that India is considered as one of the largest market in the world that does not have any monetary policy framework to help to control the market. This is why the India always faces inflation after a financial crisis. There is no initiative taken by India to handle the inflation brought by the financial crisis which will lower down the currency of the country. People will now start to demand fewer rupees and consider investing in other country’s currency. (Zainab Mulla, 2014)

There is a strong pressure on the Rupee currency which is caused by the strong demand of US dollar. This will lead to a major impact of inflation. The Rupee depreciation will make India to produce competitive goods in global market which will bring benefit for India’s exports. The exporters gain advantages as the abroad exported goods return more Rupees which are translated from dollar to Rupees. As a result, there is a relationship between Rupees depreciation and the inflation. (Deepa Divakaran.N and Dr.G.S.Gireeshkumar, 2014)

According to Kamiar Mohaddes & Mehdi Raissi (2014), the inflation could lower the growth by reducing the productivity and investment. Barro stated that there is a strong evidence for the negative impact of inflation on growth. Besides, the journal stated the inflation-growth relationship is highly non-linear. Besides, Khan and Senhadji stated that the inflation rate above the ‘threshold’ is negative and significant on growth whereas the inflation rate below the ‘threshold’ is positive and insignificant.

Gillman and Kejak stated that the inflation and growth has surveyed by various models and resulting in generating a negative relationship between inflation and growth. De Gregorio and Gomme proved that the relationship between inflation and growth is non-linear which means the growth rate will be lower as the inflation rate increases. Based on AK and AH models, inflation play a role as tax on either physical capital or human capital. This will lead to the decrement of the growth rate. Akerlof et al. also stated the low inflation rate may have a positive relationship with output growth. This is because of low inflation causes the increment of productivity and resulting in higher growth. (Kamiar Mohaddes & Mehdi Raissi, 2014)

Discussion

Crude oil is an input in the value added chain of most agricultural products such as machinery fuel, transport and fertilizers. The rising of crude oil price causes that the cost of production rises and the price of final product increase as well. Moreover, nowadays food products are common used in producing of biofuel energy based on environmental preoccupation. Therefore, the substitution of crude oil by food product to produce fossil fuel causes that the food product demand increases in the market. As a prove, we found the data from US Energy Information Administration and FAO which shows that the price of oil and food is positive relationship at year 2000 to 2010.

When food inflation occurs, the wage rate will increases due to the productivity need to increase but supply of labour is limited in the market. By this, not only wage of labour will increase, but the income of producer in food sector also increase because of the windfall profits will raise higher than cost of production. It means that the citizen become richer and their demand of goods and services will increase as well through income effect. The increase of demand causes that it excess than supply in the market and then causes inflation occur. In order to prove that food inflation will affect nonfood inflation and aggregate inflation, there was a Forecast Error Variance Decomposition (FEVD) analysis is done and shows that variation of food inflation contributes 54% of variation of nonfood inflation and 46% variation in aggregate inflation after 1 month of the shock. After 10 month, the variation of nonfood inflation decreases to 46% while the variation of aggregate inflation increases to 72%. (Sonna, October 2014)

Over the years, the currency rate of Rupee to US Dollar is increasing each year. In year 2000, 1 USD can exchange for 45 Rs. However, in year 2013, the exchange rate has increased that 1 USD can exchange for 58.53 Rs. This causes the Rupee to depreciate its value due to the strong demand of US Dollar by the citizens. In order to prove the statement of Deepa Divakaran N and Dr G.S.Gireeshkumar, the major impact of inflation in India is caused by the peer pressure faced by Rupee currency as there are many people who demands US Dollar rather than holding Rupee.

When the currency is facing depreciation, people will tend to hold other’s countries’ currency as Rupee has no more holding value. The demand for Rupee will drop and thus drives up the inflation. Cost-push inflation will occur when people now feel reluctant to spend their Rupee on normal goods and causes supply to be surplus and push the price to increase. Therefore, a drop in the currency of Rupee will affect inflation to happen.

Throughout the research, we have figured out that the purchasing power for India is increasing linearly year by year since from year 1999 until now. Starting from year 1999, the GDP (Purchasing Power Parity) is 1,805 Billion Dollar and for year 2014, it has increase to 7,277.3 Billion Dollar. This means that the purchasing power for India is getting bigger and bigger every year. As GDP grows, there will be more transaction happen daily and this will lead to an increase in the demand of Rupee. Thus, it will help to raise the exchange rate of Rupee to other country’s currencies. This will result in the increase of purchasing power of Indians’. When the nation’s GDP (Purchasing Power Parity) increases, the exchange rate of Rupee to other country’s currency will decrease and this caused the import fee to decrease as well. This causes more and more transaction will occur because the export fee is lower compared to the older time and this can help to drive up the country’s GDP.

In order to prove the statement of Zainab Mulla, when the GDP (Purchasing Power Parity) in year 1999 is still at a lower stage, the citizens can barely afford to buy breads with 60Rs. However for year 2014, the GDP (Purchasing Power Parity) increase drastically, making the purchasing power of Rupee to increase. As a result, now they can afford to buy few types of bread with 60Rs. This shows that Rupee in year 2014 has more value than year 1999 because we can buy more stuff with 60Rs over 15 years. When the purchasing power of citizens increases, they will tend to spend more money rather than keeping it because they can get more goods with the current value. This action also can help to increase the country’s GDP.

On the other hand, the decrease in the price of the crude oil also becomes one of the catalysts in the economic growth in India. Crude oil as the largest internationally traded items will have an abrupt changes in economic if there are any changes in the price for the oil exporting and importing countries. This can be seen when the economic growth of India had shown a decrease sign from year 2010 to year 2013, which is decrease from 10.3% to 5.0%. This is because of the recent crude oil price has increased from 3,463Rs in year 2010 to 6,415Rs in year 2013. The increment in the price of crude oil will affect inflation to happen if the government chooses to absorb the burden by increasing the price of other petroleum products.

In order to prove the statement of Gillman and Kejak, when the price of crude oil increase, the growth of the country will decrease as the petroleum-based products will have them increase in the price which causes the consumers will try to consumer less of these products. When these products have a low demand, the supply will be overloaded and then leading to the output production level of the factory drop. Hence, the whole economic growth will be stalled.

Conclusion

In the nutshell, there are many causes and effect that are brought by inflation. It is undeniable that inflation is not favor in the country as it brings a lot of negative effect and will drag the growth of country. However, we could not avoid inflation from happening in a country. What we can do is just try to minimize the impact bring by the inflation.

One of the solutions to curb the inflation problem is by selling bonds to the non-residential investors of the country. As we know that the poverty of Indians is very serious, the residents have less money to afford the bond sold by the government. Hence, the government should make the bond available to the investors from other country which can afford it so that there is more money inflow to the country so that the government has more money to circulate the daily money flow of money.

Other than that, the government should implement some policy that makes them to be less dependent to the import industry. They should encourage more export activities because they can earn more money when the exchange rate of Rupee drops. Incentives should be given in order to encourage this action.

In addition to the above, the government can also control the price of oil and give subsidies for the crude oil. By controlling the price of oil, all the petroleum-based products will also have their price controlled because they do not have to share the burden of increased price of oil. This will subsequently keep the inflation rate to remain under the threshold and will not cause any major problem to the economic growth of India.

Last but not least, if the entire precaution steps have been taken to handle inflation problem, we can surely minimize the impact that bring by inflation.


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