Inflation within the Indian Economy

3990 words (16 pages) Essay in Economics

5/12/16 Economics Reference this

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By inflation one generally means rise in prices. To be more correct inflation is persistent rise in the general price level rather than a once-for-all rise in it, while deflation is persistent falling price. A situation is described as inflationary when either the prices or the supply of money are rising, but in practice both will rise together. These days economies of all countries whether underdeveloped, developing as well developed suffers from inflation. Inflation or persistent rising prices are major problem today in world. Because of many reasons, first, the rate of inflation these years are much high than experienced earlier periods. Second, Inflation in these years coexists with high rate of unemployment, which is a new phenomenon and made it difficult to control inflation.

An inflationary situation is where there is ‘too much money chasing too few goods’. As products/services are scarce in relation to the money available in the hands of buyers, prices of the products/services rise to adjust for the larger quantum of money chasing them.

Inflation is no stranger to the Indian economy. The Indian economy has been registering stupendous growth after the liberalization of Indian economy. In fact, till the early nineties Indians were used to ignore inflation. But, since the mid-nineties controlling inflation has become a priority. The natural fallout of this has been that we, as a nation, have become virtually intolerant to inflation. The opening up of the Indian economy in the early 1990s had increased India’s industrial output and consequently has raised the India Inflation Rate. While inflation was primarily caused by domestic factors (supply usually was unable to meet demand, resulting in the classical definition of inflation of too much money chasing too few goods), today the situation has changed significantly.

Inflation today is caused more by global rather than by domestic factors. Naturally, as the Indian economy undergoes structural changes, the causes of domestic inflation too have undergone tectonic changes. The main cause of rise in the rate of inflation rate in India is the pricing disparity of agricultural products between the producer and consumers in the Indian market. Moreover, the sky-rocketing of prices of food products, manufacturing products, and essential commodities have also catapulted the inflation rate in India. Furthermore, the unstable international crude oil prices have worsened the situation.


The different causes of inflation which are experienced in Indian economy in a large proportion would be:-

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. This represents the condition where, even though there is no increase in Aggregate Demand, prices may still rise. I.e. non availability of a commodity would lead to increase in prices. This may happen if the costs of especially wage cost rise.

Imported Inflation: This is inflation due to increases in the prices of imports. Increases in the prices of imported final products directly affect any expenditure-based measure of inflation. They play an important role in driving the rise in domestic prices. The rise in the global prices of crude oil and agricultural commodities, including food grains, and industrial products, and setbacks to global economy resulting from sub-prime mortgage disaster and US recession have contributed to India’s inflation.


When the government of a country print money in excess, prices increase to keep up with the increase in currency, leading to inflation.

Increase in production and labour costs, have a direct impact on the price of the final product, resulting in inflation.

When countries borrow money, they have to cope with the interest burden. This interest burden results in inflation.

High taxes on consumer products, can also lead to inflation. An increase in indirect taxes can also lead to increased production costs.

Inflation can artificially be created through a circular increase in wage earners demands and then the subsequent increase in producer costs which will drive up the prices of their goods and services. This will then translate back into higher prices for the wage earners or consumers. As demands go higher from each side, inflation will continue to rise.


Inflation in India is mainly estimated on the basis of fluctuations in the wholesale price index (WPI). The wholesale price index comprises of the following indices:

Domestic Wholesale Price Index (DWPI)

Export Price Index (EPI)

Import Price Index (IPI)

Overall Wholesale Price Index(OWPI)

The new inflation index has already commenced. The index has changed the composition of the Wholesale Price Index (WPI) series. The new data series lowers weight age of the more volatile food items and correspondingly hikes that of core manufacture, products.

The new series has incorporated consumer items such as ice cream, mineral water, refrigerator, computer, and TV. The price volatility in these items is relatively limited as compared to fuels or food products. The data released by the Ministry of Commerce and Industry is the first that uses the new base year of 2004-05 and covers a wider basket of goods. The old series used 1993-94 as the base year. The release of the current series of WPI with 1993-94 as its base will be discontinued. The new basket of the WPI has a broader representation of commodities, change in base year and lower weights accorded to primary articles.

Problems Due to INFLATION

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. Although 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 fuel price hike is a straight example of cost push inflation. When OPEC (The Organization of the Petroleum Exporting Countries) was formed, it squeezed the supply of oil and this caused oil prices to rise, contributing to higher inflation. Since oil is used in every industry, a sharp rise in the price of oil leads to an increase in the prices of all commodities.

The in depth problems due to inflation would be:

When the balance between supply and demand goes out of control, consumers could change their buying habits, forcing manufacturers to cut down production.

Inflation can create major problems in the economy. Price increase can worsen the poverty affecting low income household.

Inflation creates economic uncertainty and is a dampener to the investment climate slowing growth and finally it reduce savings and thereby consumption.

The producers would not be able to control the cost of raw material and labour and hence the price of the final product. This could result in less profit or in some extreme case no profit, forcing them out of business.

Manufacturers would not have an incentive to invest in new equipment and new technology.

Uncertainty would force people to withdraw money from the bank and convert it into product with long lasting value like gold, artefacts.

The imbalances inflation has created in the Indian economy:-

It has created a new rich class in social and political lives who are corrupt themselves and also corrupt the overall society.

The increased prices reduced the capacity to save and people preferred present consumption to future consumption.

It has provided protection and subsides to industries which bred inefficiency.

It has lead to misallocation of resources due to distortion of relative prices and finally a redistribution of wealth from the poor to the rich. It disturbs balance of payments.

Controlling method

Firstly save!!! As much of our money as possible should be saved. This will reduce the demand on the economy and hopefully reduce inflation. Do not overuse daily essentials like cooking gas, electricity etc. Cut down on inessentials when buying groceries. Look for cheaper alternatives to products that we normally buy.

Keep roads, highways, sidewalks, etc., beautified to help attract tourism and bring additional monetary into a growing economy. Stop illegal immigration. Illegal activities reap the benefits of the country but don’t pay taxes. Government-backed investment schemes such as Post Office Savings Schemes, Public Provident Funds (PPF) and National Savings Certificates (NSC) are best to invest in when inflation is slowly inching up and we are only looking at safety, not returns. Invest in short term deposits and funds, commodities and property. This will help we to slowly reach our financial goals while safeguarding our hard-earned money


To know the impact of inflation on the consumer.

To know that consumer decision for purchasing at the time of inflation

To know that how consumer manage the daily needs purchase at the time of inflation.

To know that how inflation effect the economy

To know that how consumers reduce their consumption at the time of inflation.



Wright D.Brain and Williams C. Jeffery(3 August 1988)in this article observed that partial equilibrium analysis is appropriate, there is little difference between exact measures of consumer gains from market stabilization and approximations such as expected change in marshallian or hicksian consumer surplus. Careful specification of the nature of stabilization is more crucial than the choice of welfare measure. It is important to represent correctly the demand curvature and supply response and to determine whether general equilibrium responses can be ignored. In any event, an improved analytical approximation and a simple numerical method for calculating the exact measures make it unnecessary to rely on suspect measures.


DImoand A.Peter(FEB.1992) in this article observed that equilibrium in a market with free entry where consumers search and firms set prices on individual units of the commodity. The prices attached to newly produced goods are continuously adjusted. Prices attached to previously produced goods can only be changed at a cost. Thus inflation reduces the real price of goods in inventory awaiting sale. The presence of previously priced goods lowers the reservation price of customers. Thus, inflation cuts into the market power created by the need to search for the good. Consumer welfare is inverse $u$-shaped in inflation with a strictly positive optimal inflation rate.

3. Inflation in India during the 80s: An Analytical Review:-

Samanta GP (Feb. 19, 1994) in this article observed that Structural constraints play a major role in the movement of the general price level in developing countries like India. Thus the inflationary dynamics in these countries cannot be explained purely as a monetary phenomenon. Even aggregative analysis, taking demand and supply factors along with monetary variables, has been found to be empirically unsatisfactory as quantifying the impact of any one variable on sectoral prices is not easy. This study attempts a disaggregative analysis by considering the structural variables first and then analysing the influence of monetary aggregates on sectoral prices taking into account the time series properties of price indices and specifying the sectoral price equations.

4. How best to model inflation in India:-

Balakrishnan pulapre (1 April 2002) in this article observed that Econometric specifications relating to two well-known explanations of inflation are generated and, using data from the Indian economy, the principle of encompassing is brought to bear upon the choice between these. The results are conclusive for two tests, which is itself of interest because we have non-nested models here and the tests could in principle have resulted in each model rejecting the other. It appears then from the past experience of the Indian economy that the policymaker is advised to consider sectoral price behaviour explicitly when attempting to model the inflationary process.


Browne Frank and Cronin David (11 April 2007) in this article observed that The influence of commodity prices on consumer prices is usually seen as originating in commodity markets. We argue, however, that long run and short run relationships should exist between commodity prices, consumer prices and money and that the influence of commodity prices on consumer prices occurs through a money-driven overshooting of commodity prices being corrected over time. Using a co integrating VAR framework and US data, our empirical findings are supportive of these relationships, with both commodity and consumer prices proportional to the money supply in the long run, commodity prices initially overshooting their new equilibrium values in response to a money supply shock, and the deviation of commodity prices from their equilibrium values having explanatory power for subsequent consumer price inflation.


Gillman Max (2 July 2007) in this article observed that Reserve banks worldwide have been moving towards zero inflation policies. Confusion clouds the welfare cost of maintaining such inflation policies despite the best attempts at clarification. Monetary theory research has shifted from partial to general equilibrium economies. This shift has left the partial equilibrium estimates of the welfare cost of inflation below most of the general equilibrium estimates. Put on a comparable basis, partial equilibrium estimates compare more closely with the general equilibrium estimates. Furthermore, evidence suggests that integration under the money demand function appears applicable in general equilibrium economies. Finally, the estimates depend on the elasticities of money demand and the underlying structural parameters.

7. Inflation targeting in India: issues and prospects

Jha Raghbendra (mar. 2008) in this article observed that evaluation the case for inflation targeting (IT) in India. It states the objectives of monetary policy in India and argues that, with widespread poverty still present, inflation control cannot be an exclusive concern of monetary policy. The rationale for IT is spelt out and found to be incomplete. The paper provides some evidence on the effects of IT in developed and transition economies and argues that although IT may have been responsible for maintaining a low inflation regime, it has not brought down the inflation rate itself substantially and or changed the volatility of the exchange rate. Output movements in transition countries adopting IT have been higher than in developed market economies. I discuss India’s experience with using nominal targets for monetary policy and why India is not ready for IT. Further, even if India’s central bank wanted to, it could not pursue IT because the short-term interest rate does not have a significant effect on inflation. The paper concludes by listing monetary policy options for India.

8. Competition and Price Variation When Consumers Are Loss Averse :-

Heidhues, Paul, and Botond Koszegi. (Sept 2008) in this article observed that of price competition with differentiated products by assuming that consumers are loss averse relative to a reference point given by their recent expectations about the purchase. Consumers’ sensitivity to losses in money increases the price responsiveness of demand and hence the intensity of competition at higher relative to lower market prices, reducing or eliminating price variation both within and between products. When firms face common stochastic costs, in any symmetric equilibrium the mark-up is strictly decreasing in cost. Even when firms face different cost distributions, we identify conditions under which a focal-price equilibrium (where firms always charge the same “focal” price) exists, and conditions under which any equilibrium is focal.

9. The Misperception of Inflation by Irish Consumers:-

David Duffy in this article The Misperception of Inflation by Irish Consumers observed that Perceptions and forecasts of inflation have the potential to impact on a range of economic outcomes. We reveal large, systematic overestimation of inflation by Irish consumers, which varies by social group. In contrast to previous work in this area, our models suggest the upward bias and the variation by social group should be considered substantially separate phenomena. We also offer evidence that inflation misperceptions are linked to attitudes and intentions with respect to consumption and saving and, hence, are likely to affect household decision-making. The findings therefore raise issues regarding the relationship between financial literacy and consumer behaviour.

10. Extracting information on inflation from consumer and wholesale prices and the NKE aggregate supply curve.

Goyal Ashima and Tripathi Shruti in this article observed that Since consumer prices are a weighted average of the prices of domestic and of imported consumption goods, and producer prices feed into final consumer prices, wholesale price inflation should cause consumer price inflation. Moreover, there exist a long-term equilibrium relationship between consumer and wholesale price inflation and the exchange rate. But we derive a second relation between the price series from an Indian aggregate supply function, giving reverse causality. The CPI inflation should Granger cause WPI inflation, through the effect of food prices on wages and producer prices. These restrictions on causal relationships are tested using a battery of time series techniques on the indices and their components. We find evidence of reverse causality, when controls are used for other variables affecting the indices. Second, both the identity and the AS hold as long-run co integrating relationships. There is an important role for supply shocks. Food price inflation is co integrated with manufacturing inflation. The exchange rate affects consumer prices. The insignificance of the demand variable in short-run adjustment indicates an elastic AS. There is no evidence of a structural break in the time series on inflation. Convergence is slow, and this together with differential shocks on the two series may explain their recent persistent divergence.


After study on this topic I can understand that the inflation effect the consumer decisions like their consumption decision, saving decision and it effects the future expectation of buying.

Inflation always hurts our standard of living. Rising prices means we have to pay more for the same goods and services. If our income increases at a slower rate as inflation, our standard of living declines even if we are making more. Inflation’s main consequence is a subtle reduction in our standard of living.

Inflation doesn’t affect everything equally. Gas prices can double while our home loses value. This makes financial planning more difficult.

Inflation is really bad for our retirement planning because our target has to keep getting higher and higher to pay for the same quality of life. In other words, our savings will buy less. As a result, we will need to save more today to pay for higher priced goods and services in the future. Since everything we buy today costs more, so we have less left-over income available to save.

Inflation has another bad side-effect…once people start to expect inflation, they will spend now rather than later. That’s because they know things will only cost more later. This consumer spending heats up the economy even more, leading to further inflation. This situation is known as spiraling inflation because it spirals out of control.

Inflation is important if we are holding bonds or Treasury notes. These fixed price assets only give a fixed return each year. As inflation spirals faster than the return on these assets, they become less valuable. As they become less valuable, people rush to sell them, further depreciating their value. As their value becomes lower, the U.S. government is forced to offer higher interest rates to sell them at all. This increases mortgage interest rates.

We should be wary, in this post, about cost-push inflation. With wages increasing and input prices (thanks to oil/petrol/gasoline) increasing, prices consumers pay have to increase with the costs-of-production. In turn we demand higher wages, and with a squeezed supply of labour we can get them, sending prices higher still.

In the graph nicked from the textbook use, example economy has expanded beyond potential real GDP (i.e. Full Employment). In the labour market this means more jobs than people (keeping it simple), driving up wages. In the consumer market it means more demand than supply, driving up prices, which drive up wages – do you see the spiral? In fact our economy will not sustain unemployment below the Non-Accelerating Inflation Rate of Unemployment. Thus we end up back at Full Employment in the graph, inexorably, but along the way we’ve picked up positive inflation.


The methodology used was secondary research. Data and findings from the research papers and articles of other people was selected and reviewed. Brief review of all the articles and papers studied has been given in the Review of Literature. These all articles were studied deeply to gather maximum knowledge of the Report on the topic Inflationary incidence on consumer equilibrium. Though no research has been done on the comparative Analysis of inflationary incidence on consumer equilibrium but this paper collected data from the news articles available from different sources.


After study this topic I found that Inflation directly affected to consumer equilibrium. At the time of inflation increases the prices of commodities increases which reduce the purchasing power of the consumers, and consumers have to reduce the consumption. Inflation has another bad side-effect…once people start to expect inflation, they will spend now rather than later. That’s because they know things will only cost more later. This consumer spending heats up the economy even more, leading to further inflation. This situation is known as spiraling inflation because it spirals out of control.

After study this topic I found there are some advantage and disadvantage of inflation.

Advantages –

People feel richer (money illusion).

Unexpected inflation benefits borrowers

Could be from extra growth in the economy or extra money which would lead to lower unemployment rates.

If prices rise, then a currency devalues which would lead to growth in the export sector.

Disadvantages –

Lower retain-able income due to higher expenditure.

Expensive loans burdening those who have taken loans on floating rate and also shelving or postponing plans of many to most people.

Increase in raw materials might further increase prices such that a lower inflation number overall does not really mean lower price of final goods.

There is problem of complacency – with increase of fuel price auto prices have gone up. Even if the prices come down later does anyone think that the prices will be revised downwards.

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