Inflation Terms and Inflation Management

In the first part on Inflation, we have understood the definition of inflation, its measurement and effects. In this post, we will understand some important terms associated with inflation that are asked in Prelims and Mains. Also we will understand how inflation is managed or controlled in Indian economy.

Inflation Terms

Often some terms associated with inflation are asked in Prelims or Mains (2 and 5 markers). Let’s see which are these terms and what do they mean.

Point-to-Point Inflation: It means that the reference dates for the annual inflation is January 1 to January 1 of two consecutive years and not for January 1 to December 31 of the concerned year. Similarly, weekly inflation measurement refers to inflation measured on same week of two consecutive years. In India, this is measured on two consecutive last days of the week. (i.e. 5 PM of two Fridays in India).

Inflationary Gap: The excess of total government spending above the national income (i.e. fiscal deficit) is known as the inflationary gap.

Inflation Tax: Inflation tax is not an actual legal tax paid to a government; instead “inflation tax” refers to the penalty for holding cash at a time of high inflation. When the government prints more money or reduces interest rates, it floods the market with cash, which raises inflation in the long run. If an investor is holding securities, real estate or other assets, the effect of inflation may be negligible. If a person is holding cash, though, this cash is worth less after inflation has risen. The degree of decrease in the value of cash is termed the inflation tax for the way it punishes people who hold assets in cash, which tend to be lower- and middle-class wage earners. (Source)

Inflation Spiral: A situation when wages push prices up and prices pull wages up is known as the inflationary spiral. It is also known as wage-price spiral.

Inflation Accounting: Profits of companies get overstated due to increase in inflation. When a firm calculates its profits after adjusting the effects of current level of inflation, this process is known as inflation accounting.

Reflation: It is an act of stimulating the economy (economic growth) by higher government expenditure, tax and interest rate cuts, reducing tax rates etc. Major world economies like USA, UK went for reflationary measures to emerge from the economic recession that had set in since 2008 following the sub-prime crisis.

Stagflation: It is a combination of high inflation and low or stagnant growth (stagnant growth + inflation = stagflation). In such a situation, inflation and unemployment both are at higher levels.

Phillips Curve: It is a graphic curve depicting an inverse relationship between inflation and unemployment in an economy. The curve suggests that lower the inflation higher the unemployment and vice-versa.

Inflation Targeting: Every government aims for a stable level or comfort zone of inflation aims to target inflation rate within this range. The Reserve Bank of India (RBI) has set a inflation target of 4-5% for the Indian economy. Of course, this target is not fixed for all times but is revised as per needs of the economy.

Skewflation: Skewflation refers to skewed or lopsided inflation where there is sustained price rise in a small group of commodities even though prices of other commodities remains relatively stable. For instance, in India, food prices rose steadily during 2009 and 2010 even though prices of non-food items continued to be stable.

Inflation Management

As mentioned above, the aim in India is to maintain inflation within the comfort zone of 4-5%. For this inflation is to be managed or controlled properly. For managing inflation, three set of policy measures are available viz. fiscal policy, administrative policy and monetary policy. The government administers the fiscal and administrative policies while the Reserve Bank of India (RBI) administers the monetary policy. Let us see some of the measures taken in each category to control inflation in India recently.

Fiscal Policy Measures

  1. Reduced import duties to zero for rice, wheat, onion, pulses, edible oils to bring down cost of essential food items
  2. Permitted import of 50,000 tonnes of skimmed milk powder and whole milk powder

Administrative Measures

  1. Removed levy obligation in respect of all imported raw sugar and white/refined sugar
  2. Banned export of edible oils and pulses to increase availability of these essential items in the country and thus manage demand
  3. Imposed ban on export of non-basmati rice and wheat for a short period of time
  4. Suspension of futures trading in rice, urad and tur
  5. Ban on export of onion for short period

Monetary Measures

Monetary policy is adopted by RBI to control supply of money in the economy by targeting, mostly, the interest rate of credit in the country. The chief tools of monetary policy are Cash Reserve Ratio (CRR), Bank Rate, Repo and Reverse Repo Rate and open market operations.

CRR is the  portion of bank deposits kept with RBI. If RBI wants to suck money out of the system it increases CRR usually by 0.25% or 0.5% points so banks have less money to lend since they keep a larger portion of their deposits with RBI.

Bank Rate is the rate at which the RBI lends credit to commercial banks. Again, if RBI wants to reduce the money supply, it increases the Bank Rate so loans become costlier due to increased interest rates.

Open market operations include buying and selling of government securities to mop up or increase money supply in the economy. When the RBI feels there is excess liquidity in the market, it resorts to sale of securities thereby sucking out the rupee liquidity. Similarly, when the liquidity conditions are tight, the RBI will buy securities from the market, thereby releasing liquidity into the market.

Repo means re-purchase options. Repo rate is the rate at which the RBI lends shot-term money to the banks against securities. When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI. The banks use this tool when they feel that they are stuck with excess funds and are not able to invest anywhere for reasonable returns. An increase in the reverse repo rate means that the RBI is ready to borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep more and more surplus funds with RBI.

Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks.

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19 Comments

    1. Because merely printing money does not increase economic output rather just increases money supply. This results in increased demand without matching supply and so prices increase.

  1. hello…. sir
    its really helpfull to read your article , its give more precise data to elaborate our view to any subject… thanks
    keep it up… all the best sir…..

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