HOW INFLATION AFFECTS COST OF LIVING

THE CONTEXT: In October 2024, India’s annual inflation rate soared to 6.21%, up from 5.49% in September, marking the highest level over a year. This surge exceeded market expectations of 5.81% and pushed inflation beyond the Reserve Bank of India’s (RBI) target range of 2-6%. Food inflation, which accounts for nearly half of the price basket, jumped to 10.87% in October 2024, driven by sharp increases in vegetable prices (42.18%) and oils and fats (9.51%).

DEFINITION OF INFLATION: Inflation refers to a general increase in the prices of goods and services in an economy over time, decreasing the purchasing power of money. It is typically measured using a consumer price index (CPI), which tracks the average price changes of a basket of goods and services commonly purchased by households.

CAUSES OF CURRENT INFLATION:

• • Food price volatility: Unseasonal rains and extended monsoons in certain parts of India have contributed to fluctuations in food prices, particularly vegetables.
  • Global commodity prices: Rising global food and fuel prices, partly due to geopolitical tensions like the Russia-Ukraine conflict, have impacted domestic inflation.
  • Pent-up demand: As the economy recovers from the pandemic, increased consumer spending has put upward pressure on prices.
  • Monetary policy: The RBI’s accommodative stance during the pandemic, which included lowering interest rates and increasing money supply, may have contributed to inflationary pressures.
  • Currency depreciation: A weaker rupee has made imports more expensive, contributing to cost-push inflation.
  • Structural issues: Inefficiencies in the agricultural supply chain and inadequate storage facilities continue to impact food inflation.

CONCEPT OF GENERAL PRICE LEVEL INCREASE:

• • Inflation refers to a sustained increase in the general price level of goods and services in an economy over time. This increase is typically measured using price indices, with the Consumer Price Index (CPI) being the most widely recognized. The general price level is a hypothetical measure representing the overall prices for goods and services, often called the consumer basket.
  • In October 2024, India’s annual inflation rate rose to 6.21%, up from 5.49% in September, marking the highest level in over a year. This means that, on average, goods and services in India cost 6.21% more than they did a year ago. The classical dichotomy theory distinguishes between overall price increases (nominal variables) and underlying economic variables (real variables).

IMPACT ON PURCHASING POWER:

• • One of inflation’s primary effects is the erosion of purchasing power. As prices rise, each unit of currency buys fewer goods and services. This impact is particularly significant for consumers, especially those with lower or fixed incomes.
  • The impact of inflation on purchasing power can be illustrated through real wages. Using the wage rate formula:
  • Real Wage = (Nominal Wage / CPI) × 100
  • Consider a worker earning 50,000/- in 2023 with a CPI of 100. If their salary increases to 52,000/- in 2024, but the CPI rises to 105, their real wage would be:
  • Real Wage 2024 = (52,000 / 105) × 100 = 49,523.81/-

RELATIONSHIP BETWEEN INFLATION AND REAL INCOME:

• • Real income is the amount of money an individual or entity makes after accounting for inflation. The relationship between inflation and real income is inverse – as inflation rises, real income tends to fall, assuming nominal income remains constant.
  • Real Income = Nominal Income / (1 + Inflation Rate)
  • For instance, if an individual’s nominal income is 60,000/- and inflation is 2.4%, their real income would be:
  • Real Income = 60,000/- / (1 + 0.024) = 58,594/-
  • This calculation shows that despite earning 60,000/-, the individual’s purchasing power is equivalent to $58,594/-due to inflation.

NOMINAL INCOME VS. REAL INCOME:

• • Nominal income is the total amount of money an individual or entity earns in a given period without adjusting for inflation. On the other hand, real income represents the purchasing power of nominal income after accounting for inflation.
  • Real Income = (Nominal Income / Price Index) × 100
  • For example, if an individual’s nominal income is 60,000/- and the price index is 105, their real income would be:
  • Real Income = (60,000 / 105) × 100 = 57,142.86/-

IMPACT OF INFLATION ON REAL INCOME:

• • Inflation erodes the purchasing power of nominal income, leading to a decrease in real income if nominal income doesn’t increase at the same rate as inflation. This relationship can be expressed as:
  • Real Income = Nominal Income / (1 + Inflation Rate)
  • For instance, if nominal income is 50,000/- and inflation is 2%, real income would be:
  • Real Income = 50,000 / (1 + 0.02) = 49,019.61/-

CONSUMER PRICE INDEX (CPI):

• • The Consumer Price Index (CPI) measures the average change in household goods and services prices over time. It reflects consumers’ living costs and is calculated using a representative basket of goods and services.
  • CPI = (Cost of basket in current year / Cost of basket in base year) × 100
  • CPI is widely used as the primary measure of retail inflation. It directly impacts consumers’ purchasing power and living standards. Central banks and policymakers use CPI to make decisions on monetary policy, adjust social security payments, and determine cost-of-living adjustments for wages.
  • In India, the CPI is released by the Ministry of Statistics and Programme Implementation (MoSPI). As of October 2024, India’s annual inflation rate based on CPI was 6.21%, exceeding the Reserve Bank of India’s target range of 2-6%.

WHOLESALE PRICE INDEX (WPI):

• • The Wholesale Price Index (WPI) measures the average change in prices of goods at the wholesale level before they reach consumers. It focuses on the prices of goods traded between corporations rather than those consumers buy.
  • WPI covers goods, including primary articles, fuel and power, and manufactured products. In India, the current WPI series uses 697 items with a base year of 2011-12.

GDP DEFLATOR:

• The GDP Deflator is a comprehensive inflation measure covering all domestically produced goods and services. It is calculated as the ratio of nominal GDP to real GDP:
• GDP Deflator = (Nominal GDP / Real GDP) × 100
• The GDP Deflator is considered more comprehensive than CPI or WPI because it includes all goods and services produced in an economy. It automatically accounts for changes in consumption patterns and new products, making it a broader measure of inflation.

PRODUCER PRICE INDEX (PPI):

The Producer Price Index (PPI) measures the average change in selling prices domestic producers receive for their output over time. It focuses on the price change from a producer’s perspective, incorporating the cost of raw materials and supplies that affect production.

EFFECTS ON LOWER-INCOME HOUSEHOLDS:

• • Disproportionate burden: Low-income consumers spend more of their incomes on necessities such as food and energy, often subject to higher inflation rates. For example, food costs account for 40% of consumer spending in India, compared to just 17% in advanced economies.
  • Limited flexibility: While middle-income households can often switch to cheaper alternatives or generic brands when prices rise, low-income households typically lack this flexibility as they are already consuming the cheapest products available.
  • Wage growth inadequacy: Despite experiencing higher wage growth in tight labor markets, lower-wage earners still report significant stress from inflation, indicating that wage increases have not been sufficient to offset rising prices.

IMPLICATIONS FOR SAVINGS AND INVESTMENTS:

• • Decreased Household Savings Rate: Between fiscal years 2021 and 2023, household savings in India decreased from 22.7% to 18.4% of GDP, highlighting the financial strain inflation places on families. This decline indicates that households are saving less as they struggle to keep up with rising costs.
  • Negative Real Returns on Fixed Income Securities: Fixed-income investments like bonds may offer nominal returns that fail to keep pace with inflation, resulting in negative actual returns. For example, if a bond offers a 5% nominal return but inflation is 6%, the real return is -1%.
  • Generational differences: Surprisingly, a higher percentage of younger workers (under 45) feel they need to save more and work longer because of recent market events despite having more time to adjust their strategies.

THE WAY FORWARD:

• • Flexible Inflation Targeting (FIT): The RBI aims to maintain a CPI inflation target of 4%, with a tolerance band of 2% to 6%. This framework provides flexibility to accommodate supply shocks and forecast errors while prioritizing price stability.
  • Interest Rate Adjustments: The RBI uses tools like the repo rate to influence money supply and control inflation. For instance, between May 2022 and February 2023, the RBI increased the repo rate by 250 basis points to absorb excess liquidity and curb inflationary pressures.
  • Fiscal Policy: The government can influence aggregate demand by adjusting taxation and public spending. For example, higher taxes can reduce disposable income, curbing spending and inflation.
  • Food Price Management: Initiatives like the Minimum Support Price (MSP) and Public Distribution System (PDS) help stabilize food prices, significantly contributing to inflation in India.

THE CONCLUSION:

While monetary policy focuses on controlling demand-pull inflation through interest rates and liquidity management, fiscal policy addresses supply-side constraints through public spending and regulatory measures.

UPSC PAST YEAR QUESTION:

Q. What are the causes of persistent high food inflation in India? Comment on the effectiveness of the monetary policy of the RBI to control this type of inflation. 2024

MAINS PRACTICE QUESTION:

Q. Discuss the various measures of inflation used in India and their respective roles in economic policy formulation. How do inflationary trends impact different income groups?

SOURCE:

https://indianexpress.com/article/upsc-current-affairs/upsc-essentials/how-does-inflation-affect-cost-of-living-9695351/