For several decades after World War II (1939-1945) the main inflation theories were demand-pull and cost-push. The cost-push theory basically emphasized the role of excessive increases in wages relative to productivity increases as a cause of inflation, whereas the demand-pull theory tended to attribute inflation more to excess demand in the goods market caused by expansion of the money supply. A central concept in inflationary theory since the mid-1950s has been the Phillips curve, which relates the level of unemployment to the rate of inflation.

The Phillips Curve Suggests That Society Can Make A Choice Between Various Combinations Of Inflation Rate And Unemployment Level. Many economists, however, dispute whether such a choice really exists, saying that in order to keep unemployment under control it will be necessary to accept continuously increasing inflation. At the same time many economists dispute whether a stable relationship between unemployment and the level of real wage demands exists.

Inflation is Good for the economy in some ways, because Inflation helps producers realise better margins. This incites them to do better and produce more and harmful because it reduces the buying power of the consumer in real terms.

Causes of inflation

There are many causes for inflation, depending on a number of factors. For example, inflation can happen when money supply increases. This may be due to governments printing money, spending more, increase in wages and salary or even due to cheap money policy. This is called the demand-pull, in which prices are forced upwards because of a high demand.

Another common cause of inflation is a rise in production costs, which leads to an increase in the price of the final product. For example, if raw materials increase in price, this leads to the increasing cost of production, which in turn leads to the company increasing prices to maintain steady profits. Rising labor costs can also lead to inflation. As workers demand wage increases, companies usually chose to pass on those costs to their customers.  Cost may also rise because of increase in taxes, technological inefficiency, frequent shut downs etc.

Inflation IndICES

Measuring Inflation

In India most commonly used inflation rate is calculated on the basis of whole sale price index. The annual rate of inflation is calculated on point-to-point basis, i.e comparison of whole sale price index in the particular week in the current year with the corresponding week of the previous year.

• Wholesale Price Index
• Consumer Price Index 
• GDP Deflator (basically GDP at current prices divided by GDP at constant prices multiplied by 100). 

The WPI and CPI have been discussed as under:

Wholesale Price Index

• Introduced in 1942 for 23 commodities
• It measures the changes in the wholesale prices of goods used by general population on a monthly basis.
• It does not take into account the services.

The Government periodically reviews and revises the base year of the macroeconomic indicators as a regular exercise to capture structural changes in the economy and improve the quality, coverage and representativeness of the indices.    In  this direction, the base year  of All-India WPI has been revised  from  2004-05 to  2011-12 by the  Office of  Economic  Advisor (OEA), Department of Industrial Policy and Promotion, Ministry of Commerce and Industry to align it with the base year of other macroeconomic indicators  like  the Gross  Domestic Product (GDP)  and Index of Industrial Production (IIP).

The Wholesale Price Index (WPI) series in India has undergone six revisions in 1952-53, 1961-62, 1970-71, 1981-82, 1993-94 and 2004-05 so far. The current series is the seventh revision. The revision entails shifting the base year to 2011-12 from 2004-05, changing the basket of commodities and assigning new weights to the commodities. It has generally been the practice to undertake the revisions on the advice of a Working Group constituted each time.  For the new series with base 2011-12=100, a Working Group was  constituted  on  19th  March  2012    chaired by  Late  Dr.  Saumitra Chaudhuri, Member, erstwhile Planning Commission and comprised most stakeholders.

In the revised series, WPI will continue to constitute three Major Groups namely  Primary  Articles, Fuel  &  Power  and  Manufactured Products. Highlights  of  the  changes introduced in the  new series are summarized below:

• Updated  item  basket and  weighting structure conforming to  the structure of economy in 2011-12.
• Increase in number of items from 676 to 697.  In all 199 new items have been added and 146 old items have been dropped.
• The new series is  more representative with increase in number of quotations from 5482 to 8331, an increase by 2849 quotations (52%).

New Features

• In the new series of WPI, prices used for compilation do not include indirect taxes in  order  to  remove  impact  of  fiscal policy.  This  is  in consonance  with  international practices and  will   make  the  new  WPI conceptually closer to ‘Producer Price Index’.
• A new “WPI Food Index” will be compiled to capture the rate of inflation in food items.
• Seasonality of fruits and vegetables has been updated to account for more months as these are now available for longer duration.
• Item level aggregates for new WPI are compiled  using Geometric Mean (GM) following international best practice and as is currently used for compilation of All India CPI.
• A high level Technical Review Committee has been set up for the first time to carry out dynamic review process in order to keep pace with the changing structure of the economy.

New Weighting Structure

The index basket of the new series has a total of 697 items including 117 items for Primary Articles, 16 items for Fuel & Power and 564 items for Manufactured Products.

Consumer Price Index (CPI)  is released by Central statistical office (CSO) with base year of 2011-12. It calculates inflation at consumer level. In India consumers show huge differences in their consumption choice, purchasing power etc. a single CPI could not provide the whole picture. Thus, by considering different socio-economic conditions of consumer, India has four different CPI:

1. CPI IW: Consumer price Index for Industrial workers. I take into account around 260 items including both goods and services. This index is used fo Dearness allowance calculation for Central government employees. Even pay commission also uses this index for their recommendation.
2. CPI UNME: Consumer price Index for Urban Non-Manual Employees. This index depicts the changes in the level of average retail prices of goods and services consumed by the urban segment of the population. The target group of this index was urban families who derived major portion of their income from non-manual occupations in the non-agricultural sector. This index had a limited use as it was used for determining dearness allowances of employees of some foreign companies working in India in service sectors such as airlines, communications, banking, insurance and other financial services.
3. CPI AL: This Index is meant for agricultural laborer’s Labour Bureau has been compiling CPI Numbers for Agricultural Labourers since September, 1964.The base of CPI(AL) was 1960-61=100. This series of CPI Numbers was then replaced by CPI for (i) Agricultural and (ii) Rural Labourers with base 1986-87=100 from November, 1995 onwards . CPI for Agricultural and Rural labourers on base 1986-87=100 is a weighted average of 20 constituent state indices and it measures the extent of change in the retail prices of goods and services consumed by the agricultural and rural labourers as compared with the base period viz 86-87. This index is released on the 20th of the succeeding month. CPI-AL is basically used for revising minimum wages for agricultural labour in different States.
4. CPI RL:  There is yet another Consumer Price Index for the Rural Labourers (CPI-RL) with 1983 as the base year, data is collected at 600 villages on monthly frequency with three weeks time lag, its basket contains 260 commodities.The agricultural and rural labourers in India create an overlap, i.e., the same labourers work as the rural labourers once the farm sector has either low or no employment scope. Probably, due to this reason this index was dropped by the government in 2001–02. But after the government change at the Centre the index was revived again.

Revision of CPI

It was in 2011 that the government announced a new Consumer Price Index (CPI) – (Rural); CPI (Urban) and by combining them into a ‘national’ CPI-C (where ‘C’ stands for ‘Combined’). Meanwhile, the data for the existing four CPIs were also being published by the CSO. The base year was also revised from the existing 2004–05 to 2010–11.

In 2015 CPI was revised again. Apart from changing the base year several other changes are also introduced:

• Now the Basket of items and their weight in the index will be prepared on the basis Modified Mixed Reference period data of Consumer Expenditure Round of National Sample Survey (NSS).This has been done to make it consistent with the international practice of shorter reference period for most of the food items and longer reference period for the items of infrequent consumption.
• With this change in the weighing diagrams, the gap between Weight Reference Year and Price Reference Year (Base Year), which was six years in the old series, has now been reduced to six months only. Due to change in the consumption pattern from 2004–05 to 2011–12, the weighing diagrams (share of expenditure to total expenditure) have changed.

Comparison of weighing diagrams of the existing and revised series of CPI

• The number of Groups, which was five in the old series, has now been increased to six. ‘Pan, tobacco and intoxicants’, which was a Sub-group under the group ‘Food, beverages and tobacco’, has now been made as a separate group. Accordingly, the group ‘Food, beverages and tobacco’ has been changed to ‘Food and beverages’.
• Egg, which was part of the sub-group ‘Egg, fish and meat’ in the old series, has now been made as a separate sub-group. Accordingly, the earlier sub-group has been modified as ‘Meat and fish’.
• The elementary/item indices are now being computed using Geometric Mean (GM) of the Price Relatives of Current Prices with respect to Base Prices of different markets in consonance with the international practice.
• Prices of PDS items under Antyodaya Anna Yojana (AAY) have also been included for compilation of indices of PDS items, in addition to Above Poverty Line (APL) and Below Poverty Line (BPL) prices being taken in the old series.
• Sample size for collection of house rent data for compilation of House Rent Index, which was 6,684 rented dwellings in the old series, has now been doubled to 13,368 rented dwellings in the revised series.
• Apart from All-India CPIs (Rural, Urban, Combined) for sub-group, group and general index (all-groups), which were released for the old series, all India Item CPIs (Combined) will also be available.

Recent trends - Producer Price Index (PPI)

• A Working Group on Revision of Wholesale Price Index (WPI) (1993-94=100), under the chairmanship of Prof. Abhijit Sen, Member, Planning Commission, is inter-alia, looking into the feasibility of switching over from WPI to a Producer Price Index (PPI) in India. PPI measures price change from producers’ perspective as against the Consumer Price Index (CPI), which measures price change from consumers’ perspective. The Group is also examining alternative weighting diagrams based on concepts like gross value of output, value added, and net output concepts.
• Most of the countries have switched over to PPI from WPI.
• The government had in 2014 constituted a committee under Professor BN Goldar to devise a PPI after the Reserve Bank of India began considering consumer price inflation as a better gauge of inflation than WPI. In 2019, government has set up a working group under Niti Aayog member Ramesh Chand to revise the current series of Wholesale Price Index (WPI) with base 2011-12 and devise a new Producer Price Index (PPI).

Consumer Price Index

United Consumer Index

• The Reserve Bank of India (RBI) has suggested construction of a Harmonized Index of consumer prices, based on existing Four Consumer Price Index Series, which would provide a common measure of consumer price inflation for the country as a whole and also could facilitate international comparisons of consumer price inflation.
• Few other important terms related to inflation are
• Core Inflation: This inflation is computed for framing long term policy by Government or Central Bank. It excludes more volatile categories such as food and energy prices.
• Headline Inflation: This inflation is computed through WPI. 
• Structural Inflation: Inflation not caused merely by the excess of demand over supply but built into an economy due to the government's monetary policy or supply chain inefficiencies or due to adjustments in changes in basic structure of economy.
• Reflation: It refers to measures undertaken by Government to induce inflation into economy to revive it.

Inflation Targeting

There is an increasing focus on inflation targeting as a framework for implementing monetary policy. Inflation targeting may be defined as a framework for policy decisions in which the central bank makes an explicit commitment to conduct policy to meet a publicly announced numerical inflation target within a particular time frame.

Pioneered by the Reserve Bank of New Zealand in 1990, Inflation targeting has been adopted by a number of central banks around the world, including those in Australia, Canada, Finland, Israel, Spain, Sweden, and the U.K.

Inflation targets may help provide a clear path for the medium- term inflation outlook, reducing the size of inflationary shocks and their associated costs. Since long-term interest rates fluctuate with movements in inflation expectations, targeting a low rate of inflation would lead to more stable and lower long-term rates of interest.

Important considerations

Inflation targeting attempts to relate monetary policy implications on inflation. However, concentrating only on numerical inflation objectives may reduce the flexibility of monetary policy, especially with respect to other policy goals. Since monetary policy actions affect inflation with a lag, inflation targeting would mean that the central bank would need to rely on forecasts of future inflation. Given the uncertainties, an inflexible and undue reliance on inflation forecasts can create policy problems. Therefore inflation targets should leave room for a good deal of flexibility and should be adjusted for volatile (supply-side) components. However too flexible a target reduces the credibility of the central bank.

Countries adopting inflation targeting need to fulfill some pre-requisites before adopting targeting. It is imperative that the central bank should not be constrained to finance the Government Budget and must have an effective monetary policy instrument like the short-term interest rate that is fully market determined. Moreover, transparency and accountability of the Central Bank is essential to anchor inflationary expectations. The Central Bank must possess the ability to forecast inflation and to assess the impact of monetary policy on inflationary expectations.

The country adopting inflation targeting has to select the relevant price index that is to be targeted. Most countries have adopted the Consumer Price Index for this purpose. Countries, which are susceptible to external shocks and supply side shocks, may target their core or underlying inflation rate rather than the headline inflation. The inflation-targeting framework should be forward looking as any monetary policy action has a lagged effect.

Developing countries generally have relatively higher rates of inflation. Predicting future inflation is often uncertain. Hence, missing inflation targets is more likely in developing economies. Moreover, in many developing countries, central bank autonomy is more a statutory than a de facto situation, because its decisions are still governed primarily by the need to finance the fiscal deficit. Therefore, central banks might hesitate to raise interest rates for fiscal reasons, although they would be required to do so to contain inflation.