Explaining Inflation..

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WPI based for the month of April was released last week with inflation showing an increase for the first time after 17 months. The reversal may cause anxiety if this turns out to be the beginning of another upward movement in the inflation cycle.

Inflation is a word that every policymaker, and of course, the household, fears.. Dr C. Rangrajan, former Chief Economic Advisor and Governor of RBI and a widely respected  economist commented in 2006 that we broke the back of inflation about a decade ago and it came back to haunt the economy soon after, probably taking a cue from him..! (Sure, he must have forgotten to say ‘touch-wood’ after that..!)

A complexity with inflation is that there are a large number of factors which influence it very decisively and it is not easy to attribute it specifically to money supply at national level (although at a global level, money supply would be a significantly stronger determinant of inflation). For instance, imposition of export duty on sugar brings down its prices whereas lifting of export duty on iron ore increases its domestic prices. Similarly, increase in imports of metals brings down its prices or a global glut in textiles industry or even a stringent regulation in a major importing nation reduces its exports and brings down the domestic prices. These are the factors quite independent of money supply which affect inflation of the product group significantly.

Concept of core inflation has been devised which is calculated after removing Food and Fuel group since their linkage with money supply is weak. These two groups account for nearly 40% of weight in WPI. However, it still doesn’t take care of price fluctuation due to changes in export/import or due to changes in duty/ tax rate.

Despite all the deficiency, inflation measurement and monetary policy based on that remains the best bet for the policy makers to give an inclusive direction to the economy. So, monetary easing which gives a fillip to the economy and thereby generates employment may still not be a solution if the inflation rate is high which affects everyone specially the poor section. And, if there are other ways, such as through higher imports or release of excess stock in the open market to reduce demand-supply gap, to beat inflationary expectations and the aggregate inflation, the process of monetary easing may probably become easier.

Attached, a brief explanation on 12 month inflation trends. Please open the PDF..

Inflation Explained


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