Inflation & Control Mechanism
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services.It is the percentage change in the value of the Wholesale Price Index (WPI) on a year-on year basis. It effectively measures the change in the prices of a basket of goods and services in a year. In India, inflation is calculated by taking the WPI as base.
Formula for calculating Inflation=
(WPI in month of current year-WPI in same month of previous year)
————————————————————————————– X 100
WPI in same month of previous year
Inflation occurs due to an imbalance between demand and supply of money, changes in production and distribution cost or increase in taxes on products. When economy experiences inflation, i.e. when the price level of goods and services rises, the value of currency reduces. This means now each unit of currency buys fewer goods and services.
It has its worst impact on consumers. High prices of day-to-day goods make it difficult for consumers to afford even the basic commodities in life. This leaves them with no choice but to ask for higher incomes. Hence the government tries to keep inflation under control.
Contrary to its negative effects, a moderate level of inflation characterizes a good economy. An inflation rate of 2 or 3% is beneficial for an economy as it encourages people to buy more and borrow more, because during times of lower inflation, the level of interest rate also remains low. Hence the government as well as the central bank always strive to achieve a limited level of inflation.
Various measures of Inflation are:-
- GDP Deflator
- Cost of Living Index
- Producer Price Index(PPI)
- Wholesale Price Index(WPI)
- Consumer Price Index(CPI)
There are following types on Inflation based on their causes:-
- Demand pull inflation
- cost push inflation
- structural inflation
Various control measures to curb rising inflation are:-
- Fiscal measures like reduction in indirect taxes
- Dual pricing
- Monetary measures
- Supply side measures like importing the shortage goods to meet the demand
- Administrative measures to curb hoarding, Cratelization.
Monetary Measures to curb rising inflation
The most important and commonly used method to control inflation is monetary policy of the Central Bank. Most central banks use high interest rates as the traditional way to fight or prevent inflation.
Monetary measures used to control inflation include:
(i) Bank rate policy :-When the central bank raises the bank rate, it is said to have adopted a dear money policy. The increase in bank rate increases the cost of borrowing which reduces commercial banks borrowing from the central bank. Consequently, the flow of money from the commercial banks to the public gets reduced. Therefore, inflation is controlled to the extent it is caused by the bank credit.
(ii) Cash reserve ratio :-the central bank raises the CRR which reduces the lending capacity of the commercial banks. Consequently, flow of money from commercial banks to public decreases.
(iii) Open market operations:-Open market operations refer to sale and purchase of government securities and bonds by the central bank. To control inflation, central bank sells the government securities to the public through the banks. This result in transfer of a part of bank deposits to central bank account and reduces credit creation capacity of the commercial banks.
Fiscal Measures to curb rising inflation
The government may raise both direct and indirect taxes to wipe out excess aggregate spending. Once a tax on income and/or wealth is imposed, disposable income gets reduced. This will greatly reduce private aggregate spending.
Direct control on prices and rationing of scarce goods are the two such regulatory measures.
1. Direct Controls on Prices:
The purpose of price control is to fix an upper limit beyond which the price of particular commodity is not allowed and to that extent inflation is suppressed.
When the government fixes the quota of certain goods so that each person gets only a limited quantity of the goods, it is called rationing. Rationing becomes necessary when the essential consumer goods are relatively scarce.
The purpose of rationing is to divert consumption from those goods whose supply needs to be restricted for some special reason, e.g., to make such commodities available to a large number of people.
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