If we measure the GDP of a country in two consecutive years and see that the figure for GDP of the latter year is twice that of the previous year, we may conclude that the volume of production of the country has doubled. But it is possible that only prices of all goods and services have doubled between the two years whereas the production has remained constant.
Therefore, in order to compare the GDP figures (and other macroeconomic variables) of different countries or to compare the GDP figures of the same country at different points of time, we cannot rely on GDPs evaluated at current market prices. For comparison we take the help of real GDP.
Real GDP is calculated in a way such that the goods and services are evaluated at some constant set of prices (or constant prices). Since these prices remain fixed, if the Real GDP changes we can be sure that it is the volume of production which is undergoing changes.
Real GDP = GDP at Constant Prices
On the other hand, the GDP at current prevailing Prices is called Nominal GDP.
Nominal GDP = GDP at Current Prices
Suppose a country only produces bread. In the year 2019 it had produced 100 units of bread, price was Rs 10 per bread. Then –
GDP at current price was Rs 1,000.
In 2020 the same country produced 110 units of bread at price Rs 15 per bread.
Therefore nominal, GDP in 2017 was Rs 1,650 (=110 × Rs 15).
Real GDP in 2017 calculated at the price of the year 2016 (2016 will be called the base year) will be =110 × Rs 10 = Rs 1,100.
Base Year: The year whose prices are being used to calculate the Real GDP
From the above example we got an idea of how the prices have moved from the base year (the year whose prices are being used to calculate the real GDP) to the current year. In the calculation of real and nominal GDP of the current year, the volume of production is fixed. Therefore, if these measures differ it is only due to change in the price level between the base year and the current year.
GDP Deflator: The ratio nominal to real GDP is called GDP Deflator, a well-known index of prices. It is also called General Price Level
GDP Deflator = Nominal GDP/Real GDP OR GDP at current Prices/ GDP at Constant Prices
From Previous example
In 2017 Nominal GDP = Rs 1650 / – and Real GDP = Rs 1100 / –
Then the GDP Deflator =Nominal GDP/Real GDP = 1650/1100 = 1.50
This implies that the price of bread produced in 2017 was 1.5 times the price in 2016.
Note: Sometimes the deflator is also denoted in the percentage terms as follows:
GDP Deflator = Nominal GDP/Real GDP*100
Consumer Price Index (CPI)
This is the index of prices of a given basket of commodities which are bought by the representative consumer. CPI is generally expressed in percentage terms. We have two years under consideration – one is the base year, the other is the current year. We calculate the cost of purchase of a given basket of commodities in the base year. We also calculate the cost of purchase of the same basket in the current year. Then we express the latter as a percentage of the former. This gives us the Consumer Price Index of the current year vis-à-vis the base year.
CPI =Cost in Current Year/Cost in Base Year*100
Example: let us take an economy which produces two goods, rice and cloth. A representative consumer buys 90 kg of rice and 5 pieces of cloth in a year.
Suppose in the year 2015 the price of a kg of rice was Rs 10 and a piece of cloth was Rs 100.
So, the consumer had to spend a total sum of Rs 10 × 90 = Rs 900 on rice in 2015.
Similarly, he spent Rs 100 × 5 = Rs 500 per year on cloth.
Summation of the two items is, Rs 900 + Rs 500 = Rs 1,400.
Now suppose the prices of a kg of rice and a piece of cloth has gone up to Rs 15 and Rs 120 in the year 2016. To buy the same quantity of rice and clothes the representative will have to spend Rs 1,350 and Rs 600 respectively (calculated in a similar way as before).
Their sum will be, Rs 1,350 + Rs 600 = Rs 1,950.
The CPI therefore will be = 1950/1400*100=139.30(approx)
Wholesale Price Index
Many commodities have two sets of prices. One is the retail price which the consumer actually pays. The other is the wholesale price, the price at which goods are traded in bulk. These two may differ in value because of the margin kept by traders. Goods which are traded in bulk (such as raw materials or semi-finished goods) are not purchased by ordinary consumers. Like CPI, the index for wholesale prices is called Wholesale Price Index (WPI). In countries like USA it is referred to as Producer Price Index (PPI).
Why CPI differ from GDP Deflator?
- The goods purchased by consumers do not represent all the goods which are produced in a country. GDP deflator takes into account all such goods and services.
- CPI includes prices of goods consumed by the representative consumer; hence it includes prices of imported goods. GDP deflator does not include prices of imported goods.
- The weights are constant in CPI – but they differ according to production level of each good in GDP deflator.
Inflation refers to the rise in general price level in the country over a period of time. During periods of inflation, there is an increase of the money supply.
When you have inflation more money being circulated, which causes the currency to lose its purchasing power which leads to an increase in the price of goods and services.
Causes of Inflation:
Inflation causes due to mismatch between demand and supply, i.e. when demand exceeds supply. Thus, inflation can occur due to changes in the demand side or the supply side or both. Now let’s study them separately.
Demand side inflation: Increase in demand can occur due to many reasons, such as-
- Increase in public expenditure, especially by the government operating large fiscal deficits.
- Loose monetary policy of the Central Bank, which leads to low interest rates and thus, higher consumption.
- Rapid GDP growth, which leads to more employment, higher wages and thus, higher inflation
- Increase in population
- Depreciation of exchange rate, which reduces imports, increases exports and thus, pulls up demand
- Reduction in direct taxes, which puts more money in the hands of households
- Speculations in commodities market
Supply Side Inflation: Factors influencing inflation from the supply side can also be many, such as-
- Backward agricultural sector, which not able to produce enough food
- Inefficient storage, transportation and marketing infrastructure, which leads wastage and reduction in supplies.
- Hoarding by traders of essential items artificially reduces supply and causes inflation
- Rise in the prices of crude oil, fertilizers etc.
- Rise in labour costs
- Higher costs of imported materials
- Higher costs of capital due to squeezing of credit by the Central Bank
- Monopoly of a single suppliers in the market, enabling his to set arbitrary prices
- Pushing up of profits by the management of a company by increasing the prices also leads to inflation
Note: it is not always easy to differentiate between demand and supply side inflation and an example from demand side can also be explained from the supply side and vice-versa
Effects of inflation:
Inflation affects different people differently. When price rises or the value of money falls, some groups of the society gain, some lose and some stand in between. Let’s discuss-
- Effect on Business Community:
- Inflation has a positive impact on business community because they gain profit by rising prices
- The value of their inventories and stocks of goods is raised in money terms. They also find that prices are rising faster than the costs of production, so that their profit is greatly enhanced.
- Effects on Fixed Income Groups:
- Inflation hits wage-earners and salaried people very hard. Since, wages do not rise at the same rate as the general price level, the cost of living Index raises and the real income of the wage earner decreases.
- Effects on the Farmers:
- Farmers usually gain during inflation, because they can get better prices for their harvest during inflation
- Effects on Investors:
- Those, who invest in debentures and fixed-interest bearing securities, bonds etc., lose during inflation. However, investors in equities, benefit because more dividend is yielded on account of high profit made by joint-stock companies during inflation
Note: Inflation will lead to deterioration of Gross Domestic Savings and less Capital formation in the economy and less long-term economic growth rate of the economy.
Measures of Inflation
Inflation refers to the changes in general price level in the country over a period of time. There are three stand measures of inflation-
- Wholesale Price Index (WPI)
- Consumer Price Index (CPI)
- GDP Deflator
Note: In India to measure inflation both the WPI and CPI are used.
Measures used to Check Inflation in India
The handling of India’s inflation challenge consists of a careful combination of effort on the part of the RBI and government, including the Ministry of Finance and several other ministries along with advisory support by the Inter-Ministerial Group (IMG) on inflation. There are three different ways to contain inflation such as: fiscal measures, administrative measures and monetary measures. Let’s discuss them-
Fiscal Measures: (Legislative Measures)
- Fiscal policy can be effectively employed to check inflation. Manipulation of Public expenditure, taxation and Public debt can be used for this purpose.
- Government can spend more money in the developmental sphere to increase supply by improving productivity. Tax incentives can also be used to improve the supply situation.
Administrative Measures: (Executive Measures)
- Remove levy obligations in respect of imported materials
- Ban export of constraint materials
- Maintain the central issue price, particularly for rice and wheat
- Suspend future trading
- Allot rice and wheat under Open Market Sale Scheme and many more
Monetary measures: (Central Banking Measures)
- Through the monetary policy review, RBI tries to control price rise and maintain economic growth and financial stability.
Role of RBI to Curb Inflation
- RBI is armed with Monetary Policy with three objectives: controlling inflation, encouraging growth and financial stability. In India monetary policy instruments typically consists of Repo-rate, Cash Reserve Ratio, SLR and some other occasional interventions, like Open Savings Bank Interest Rate Policy which may or may not be constructed as monetary policy.
- When RBI raises any of these rates (that is CRR, SLR etc.) money supply in the economy is reduced. Reduced Money supply reduces demand and thus, brings down inflation. Reducing the policy rates on the other hand leads to increased demand and higher inflation
- RBI manages the exchanges rates fluctuations to cope with the exchange rate sensitive inflation. In this case, when RBI wants to devalue rupee, they may intervene in the foreign exchange market by using rupee to buy up foreign currency or conversely, if they want to revalue the rupee, they may intervene by selling off foreign reserves.
Note: On the recommendation of the Narasimhan Committee, RBI reduces CRR and SLR in a phased manner and does not vary them often for the purpose of monetary policy. Repo and Reverse-repo now the primary tools of the bank to control money supply.
Few more terms related to Inflation
- Deflation: when the general level of price is falling it is termed as deflation. This is opposite of inflation
- Hyperinflation is usually rapid inflation. In extreme cases, this can be lead to the breakdown of the nation’s monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2500% in one month
- Stagflation is the combination of high unemployment and economic stagnation with inflation.