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— Meera Malhan and Aruna Rao
(The Indian Express has launched a new series of articles for UPSC aspirants written by seasoned writers and scholars on issues and concepts spanning History, Polity, International Relations, Art, Culture and Heritage, Environment, Geography, Science and Technology, and so on. Read and reflect with subject experts and boost your chance of cracking the much-coveted UPSC CSE. In the following article, Meera Malhan and Aruna Rao, Professors in economics, elucidate the term inflation.)
Driven by a 10.87 per cent spike in food prices, India’s retail inflation surged to a 14-month high of 6.21 per cent in October this year. While unseasonal rains and extended monsoons in certain parts of the country contributed to the surge in vegetable prices, rising global food and fuel prices due to geopolitical tensions also contributed to domestic inflation.
But what is inflation? How does it affect real income and real interest rates? How is it measured? What is its effect on households, especially on the ones with lower and fixed incomes?
Inflation refers to the rate at which the general price level for goods and services increases over a period of time, causing a decrease in purchasing power of money or real income. In other words, as inflation rises, each unit of currency can buy fewer goods and services than before.
Rising inflation affects the financial well-being of households, especially those with lower incomes or fixed incomes. As the cost of goods and services increases, it reduces the quantity of goods and services that can be purchased with the same nominal income, thereby affecting households’ cost of living.
But what is nominal and real income? Nominal income is the total amount of money that an individual, household or entity earns over a specific period. For instance, if someone earns Rs. 50,000 per month, this amount is their nominal income. However, if the cost of goods and services increases (inflation), the real value of Rs. 50,000 decreases.
Real income, on the other hand, stands for the actual value of income in terms of what it can buy after adjusting for inflation.
Real Income = Nominal Income ÷ Price of Goods
In addition to real income, rising inflation affects real interest rates. Real interest rate is essentially derived after subtracting the inflation rate from the nominal interest rate (what the bank pays you). If the nominal interest rate is 10 per cent and inflation is 8 per cent then the real interest will be 2 per cent.
Real Interest = Nominal Interest Rate — Inflation Rate
Therefore, with rising inflation, the real interest rate goes down, which might discourage people from saving because the value of their money doesn’t grow as much.
There are different methods for measuring inflation such as Consumer Price Index (CPI), Wholesale Price Index (WPI), GDP deflator, Producer Price Index (PPI), and wage inflation, with each focusing on a specific aspect of price changes.
Consumer Price Index (CPI)
Typically, inflation relates to consumer prices of all goods purchased by the consumer which may be either domestically produced or imported. The government publishes CPI each month. CPI measures changes over time in the general level of prices of goods and services that households purchase for consumption.
The formula for calculating inflation is ((CPI x+1 – CPI x )/CPI x ))*100.
CPI x = the value of the CPI in the initial/base year x.
The government releases the annual inflation rate figures every year. The annual inflation rate is calculated by measuring a year-on-year change in CPI, that is, the current month CPI over the CPI of the same month in the previous year. The percentage increase in this index over 12 months indicates the rate at which prices have risen.
The Ministry of Statistics and Programme Implementation (MoSPI) calculates and publishes the CPI for the entire country as well as for the individual states.
Wholesale Price Index (WPI)
While the CPI measures the price changes in the retail market (maximum retail prices{MRP}, inclusive of taxes), the WPI measures the price changes in the wholesale market. Say, for example, the price of a commodity (such as onions) would vary depending on the fact that it is bought from the wholesale market or retail market.
The WPI measures the inflation of goods across 697 commodities that consumers buy in bulk from factories, mandis, etc. (reflecting wholesale prices). A key difference between CPI and WPI is that while CPI takes into account the change in prices of services — say a haircut or a banking transaction, WPI doesn’t.
The official increase in WPI for October 2024 in India is 2.36 per cent, while the increase in CPI for the same period is 6.21 per cent. This increase is mainly due to an increase in inflation of vegetables, fruits, oils, and fats. The difference in percentage rates reflects the use of WPI and CPI in calculating inflation. In India, the inflation figures over the past 12 months have averaged 5 per cent.
GDP deflator
Another measure of inflation relates to the rate at which the prices of all domestically produced goods and services change. The price index used in this case is the GDP deflator.
The GDP deflator (also called implicit price deflator) is the ratio of the value of goods and services an economy produces in a particular year at current prices to that at prices prevailing during any other reference (base) year.
Since the GDP deflator covers the entire range of goods and services produced in the economy — as against the limited commodity baskets for the wholesale or consumer price indices — it is seen as a more comprehensive measure of inflation.
GDP Deflator = ((Nominal GDP/real GDP))*100.
The GDP deflator captures price changes for all domestically produced goods and services but excludes imports, while CPI focuses on a basket of goods and services and includes imports. Therefore, the GDP deflator and the CPI give different values.
Producer Price Index (PPI)
The Producer Price Index (PPI) is another indicator that measures the average changes in prices that producers receive for their goods and services produced. Here, we look at prices from the producer’s point of view.
The PPI excludes the taxes, transport, trade margins and other charges that are imposed when those products reach consumers or as inputs to other producers. In other words, it is the suppliers’ price.
Wage Inflation
Moreover, it is possible to give the rate of inflation of wage rates (wage inflation). Wage inflation refers to the rate at which wages (the compensation paid to workers) increase over time. Thus, compared to general inflation which measures the increase in prices of goods and services, wage inflation measures the rise in wages.
The labour unions, while negotiating the increase in wages rate, base their calculations on the expected rate of inflation. If the expected rate of inflation is 2 per cent, they will negotiate for a wage increase of more than 2 per cent, so that the increase in the wage rate will be positive in real terms. Wage inflation helps understand labour market dynamics.
What is inflation, and how does it affect the purchasing power of money?
What is nominal income, and how is it different from real income?
What is the Wholesale Price Index (WPI), and how is it different from the CPI in measuring inflation?
What is wage inflation, and how is it different from general inflation?
(Meera Malhan and Aruna Rao are Professors in economics at Delhi University. In the second part of the article, the authors will analyse the causes of inflation.)
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