Inflation and its Drivers
Indian Economy
- PYQs9
- Articles1
Foundation
Static background & why it matters
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time, leading to a fall in the purchasing power of currency. In India, the measurement of inflation is primarily undertaken by the National Statistical Office (NSO) for Consumer Price Index (CPI) and the Office of Economic Adviser (OEA) for Wholesale Price Index (WPI). The Reserve Bank of India (RBI) is mandated by the government to maintain price stability, primarily by targeting CPI inflation within a specified band.
Inflation is a critical macroeconomic indicator affecting purchasing power, economic stability, and monetary policy decisions. Fuel prices are a significant component of both WPI and CPI, directly impacting inflation.
- Inflation
- A sustained increase in the general price level of goods and services, leading to a fall in purchasing power.
- CPI (Consumer Price Index)
- Measures changes in the retail prices of a basket of consumer goods and services purchased by households.
- WPI (Wholesale Price Index)
- Measures changes in the average price of goods at the wholesale level, before they reach retailers.
- Headline Inflation
- The raw inflation figure reported through CPI or WPI, including all components.
- Core Inflation
- Inflation that excludes volatile components like food and fuel prices, providing a clearer picture of underlying price trends.
Static core
Acts, bodies, facts & tables
Types of Inflation: Inflation can be categorized based on its rate (creeping, walking, galloping, hyperinflation) or its causes. Demand-pull inflation occurs when aggregate demand in an economy outpaces aggregate supply, leading to upward pressure on prices. Cost-push inflation arises from increases in the cost of production, such as higher wages, raw material prices, or fuel costs, which producers pass on to consumers. Built-in inflation, or wage-price spiral, occurs when workers demand higher wages to compensate for rising prices, leading firms to raise prices further.
Drivers of Inflation: Key drivers include monetary factors like excessive money supply growth, fiscal factors such as large government deficits financed by borrowing from the central bank, and supply-side factors like agricultural supply shocks (e.g., monsoon failures), infrastructure bottlenecks, or global commodity price increases (e.g., crude oil). Structural rigidities in the economy, such as inefficient supply chains or cartelization, can also contribute.
- RBI's Primary Mandate
- To maintain price stability while keeping in mind the objective of growth.
- Inflation Target (India)
- 4% for CPI, with a tolerance band of +/- 2% (i.e., 2% to 6%).
- Key Components in CPI
- Food and fuel components have significant weight, making headline inflation susceptible to their volatility.
- Inflation Expectations
- Play a crucial role in determining future inflation trends and wage negotiations.
- Phillips Curve
- Illustrates the short-run inverse relationship between inflation and unemployment.
- Disinflation vs. Deflation
- Disinflation is a slowdown in the rate of inflation; deflation is a sustained decrease in the general price level.
| Feature | CPI (Consumer Price Index) | WPI (Wholesale Price Index) |
|---|---|---|
| What it measures | Retail prices paid by consumers | Wholesale prices of goods |
| Basket of goods | Includes goods and services (food, fuel, housing, education, healthcare) | Only goods (manufactured products, primary articles, fuel & power) |
| Users | Used by RBI for monetary policy, wage indexation | Used for macroeconomic analysis, producer price trends |
| Base Year | 2012 | 2011-12 |
| Published by | National Statistical Office (NSO), MoSPI | Office of Economic Adviser (OEA), MoC&I |
| Type | Description | Cause |
|---|---|---|
| Demand-Pull Inflation | Aggregate demand exceeds aggregate supply | Excess money supply, increased government spending, rising consumer confidence |
| Cost-Push Inflation | Increase in the cost of production | Higher wages, increased raw material prices (e.g., crude oil), supply shocks |
| Built-in Inflation (Wage-Price Spiral) | Expectations of future inflation lead to higher wage demands and subsequent price increases | Adaptive expectations, bargaining power of labor |
| Creeping Inflation | Slow and predictable rise in prices (2-3% annually) | Considered healthy for economic growth |
| Galloping Inflation | Rapid and accelerating price increases (double or triple-digit rates) | Causes significant economic instability |
| Hyperinflation | Extremely rapid and out-of-control price increases (often >50% per month) | Collapse of currency, severe economic crisis |
| Category | Specific Drivers | Impact |
|---|---|---|
| Monetary Factors | Excessive money supply, easy credit policies | Increases aggregate demand, leading to demand-pull inflation |
| Fiscal Factors | Large government deficits, increased public spending | Injects more money into the economy, boosting demand |
| Supply-Side Shocks | Crop failures, natural disasters, global commodity price hikes (e.g., crude oil) | Reduces availability of goods, increases production costs, leading to cost-push inflation |
| Structural Rigidities | Inefficient supply chains, infrastructure bottlenecks, cartelization | Creates artificial scarcity, prevents efficient price discovery |
| Exchange Rate Depreciation | Weakening of domestic currency | Makes imports more expensive, contributing to imported inflation |
| Type | Reference |
|---|---|
| Conceptual area | Indian Economy |
| Conceptual area | Macroeconomic Trends & Inflation |
| Body | Role |
|---|---|
| Reserve Bank of India (RBI) | Conducts monetary policy to control inflation |
| Ministry of Finance | Formulates fiscal policy impacting inflation |
Exam lens
Prelims framing, traps & PYQs
Prelims: UPSC Prelims often tests foundational knowledge of inflation, including definitions of various types (demand-pull, cost-push, core, headline), differences between CPI and WPI, their base years, and the bodies responsible for their publication. Questions may also cover the RBI's inflation targeting framework, the components of different price indices, and the general effects of inflation on different economic agents. Understanding the basic causes and policy tools (monetary vs. fiscal) is also crucial.
Mains: For Mains, the focus shifts to analytical understanding. Questions might delve into the causes of current inflationary trends in India (e.g., global commodity prices, supply chain disruptions, fiscal stimulus), the effectiveness of monetary and fiscal policies in controlling inflation, and the trade-offs between inflation control and economic growth. Candidates are expected to discuss the impact of inflation on various sectors (agriculture, industry, services), income distribution, and India's external competitiveness. The role of fuel prices as a significant driver of both WPI and CPI, and its implications for policy, is a recurring theme.
- Inflation is the rate of increase in the general price level.
- Fuel price hikes contribute significantly to cost-push inflation.
- Impacts transport costs, manufacturing, and food prices, leading to cascading effects.
- Measured by Consumer Price Index (CPI) and Wholesale Price Index (WPI) in India.
- RBI uses monetary policy tools (e.g., repo rate) to manage inflation within a target range.
| Year | Framing tags |
|---|---|
| 2023 | Multi-statement analysis, Conceptual understanding |
| 2022 | Statement-based questions, Conceptual understanding |
| 2022 | Multi-statement analysis, Conceptual understanding |
| 2021 | Multi-statement analysis, Conceptual understanding |
| 2021 | Conceptual understanding, Cause and effect relationships |
| 2020 | Multi-statement analysis, Conceptual understanding |
| 2015 | Statement-based questions, Conceptual understanding |
| 2015 | Factual recall, Institutional roles and functions |
| 2013 | Conceptual understanding, Multi-statement analysis |
Latest
Current affairs & evolution
Recent increases in fuel prices, as highlighted by the linked headline, directly contribute to both wholesale and retail inflation, acting as a significant cost-push factor across the economy.
Global crude oil price volatility remains a major external driver of inflation in India, given the country's high dependence on oil imports. Increases in international prices, coupled with domestic taxes (excise duty, VAT), directly push up petrol and diesel prices.
Timeline
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Indian Economy
Conceptual area
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Macroeconomic Trends & Inflation
Conceptual area
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Prelims 2013
Conceptual understanding, Multi-statement analysis
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Prelims 2015
Statement-based questions, Conceptual understanding
-
Prelims 2015
Factual recall, Institutional roles and functions
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Prelims 2020
Multi-statement analysis, Conceptual understanding
-
Prelims 2021
Multi-statement analysis, Conceptual understanding
-
Prelims 2021
Conceptual understanding, Cause and effect relationships
-
Prelims 2022
Statement-based questions, Conceptual understanding
-
Prelims 2022
Multi-statement analysis, Conceptual understanding
-
Prelims 2023
Multi-statement analysis, Conceptual understanding
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Petrol, diesel prices by 87-91 paise per litre; third hike this month
The sustained increase in the general price level of goods and services in an economy, often driven by factors like rising fuel costs (cost-push inflation), demand-pull factors, or supply shocks.
See also
Dashed boxes: related topics without a notes page yet. Tap a solid box to open notes.
Past papers
2013–2023 · 8 questions
In the news
Petrol, diesel prices by 87-91 paise per litre; third hike this month
The sustained increase in the general price level of goods and services in an economy, often driven by factors like rising fuel costs (cost-push inflation), demand-pull factors, or supply shocks.
Try these PYQs
Correct the following statements:
Statement-I: In the post-pandemic recent past, many Central Banks worldwide had carried out interest rate hikes.
Statement-II: Central Banks generally assume that they have the ability to counteract the rising consumer prices via monetary policy means.
Which one of the following is correct in respect of the above statements?
* Statement I- correct: In the aftermath of the COVID-19 pandemic, many central banks around the world observed rising inflation. To combat this inflation, they resorted to raising interest rates. This is a well-established monetary policy tool to curb inflation by making borrowing more expensive and encouraging saving, thereby reducing the money supply in circulation. * Statement II- correct: Central banks are entrusted with maintaining price stability and managing inflation. Raising interest rates is one of the primary instruments they use to achieve this objective. While other factors can influence inflation, central banks do have the ability to significantly impact it through monetary policy measures. Therefore, both statements accurately reflect the role of central banks and their use of interest rates to manage inflation and statement 2 is the correct explanation for statement 1.
Consider the following statements:
1. The weightage of food in Consumer Price Index (CPI) is higher than that in Wholesale Price Index (WPI).
2. The WPI does not capture changes in the prices of services, which CPI does.
3. Reserve Bank of India has now adopted WPI as its key measure of inflation and to decide on changing the key policy rates.
Which of the statements given above is/are correct?
Statement 1 is correct. As per the data given in the Economic Survey 2019-2020, the weightage of food in the Consumer Price Index (CPI) Combined is 45.9% as compared to 24.4% in Wholesale Price Index (WPI). Statement 2 is correct. The CPI measures the average change in prices over time that consumers pay for a basket of goods and services, commonly known as inflation, whereas WPI does not measure the average change in prices. Statement 3 is incorrect. In April 2014, the RBI adopted the Consumer Price Index (CPI) as its key measure of inflation. Hence, option A is the correct answer.
A rise in the general level of prices may be caused by:
1. an increase in the money supply
2. a decrease in the aggregate level of output
3. an increase in the effective demand
Select the correct answer using the codes given below.
Statement 1 is correct: According to the quantity theory of money, if the money supply increases faster than output, it leads to more money chasing the same amount of goods, causing inflation. Statement 2 is correct: When output decreases but demand remains the same, there is excess demand relative to supply, which can push prices up (cost-push inflation). Statement 3 is correct: Effective demand refers to the total demand for goods and services at a given price level. If it increases beyond the economy's productive capacity, it causes demand-pull inflation.
With reference to the Indian economy, consider the following statements:
1. An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee.
2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.
3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER.
Which of the above statements are correct?
* Statement 1 is correct. The nominal Effective Exchange Rate (NEER) is a measure of the value of a country's currency against a basket of other currencies weighted by their importance in trade. If NEER increases, it means that the value of the currency has increased relative to the currencies in the basket, indicating appreciation. * Statement 2 is incorrect. The Real Effective Exchange Rate (REER) takes into account both nominal exchange rates and relative price levels (inflation) between countries. An increase in REER means that the country's currency is overvalued relative to its trading partners, which can reduce trade competitiveness. * Statement 3 is correct. If domestic inflation is higher than inflation in other countries, the real value of the domestic currency decreases faster than the nominal value, causing a divergence between NEER and REER. Therefore, the correct statements are 1 and 3.
Which of the following brings out the ‘Consumer Price Index Number for Industrial Workers’?
The Labour Bureau, attached to the Ministry of Labour and Employment, is responsible for compiling and publishing the Consumer Price Index Number for Industrial Workers (CPI-IW) in India. This index tracks changes in the retail prices of a basket of goods and services consumed by industrial workers. It serves as a crucial indicator of inflation faced by this specific segment of the population. The Labour Bureau is responsible for maintaining:
- CPI (Industrial Workers) - CPI (Rural Labourers) - CPI (Agricultural Labourers)
Show 4 more PYQs
Which one of the following is likely to be the most inflationary in its effects?
Out of the given options, the most inflationary effect is likely caused by (D) Creation of new money to finance a budget deficit. Option A is incorrect: Repayment of public debt actually removes money from circulation, potentially leading to deflationary pressure. Option B and C are incorrect: Borrowing from the public (B) or banks (C) - While these options involve increasing government debt, they don't directly increase the money supply. The government essentially takes money that already exists in the economy. Option D is correct: Creation of new money is the most inflationary option. This can lead to an increase in the money supply, which can put upward pressure on prices (inflation) if not accompanied by a corresponding increase in goods and services. In essence, printing new money directly expands the money supply, potentially outpacing economic growth and leading to inflation.
With reference to the Indian economy, consider the following statements:
1. If the inflation is too high, Reserve Bank of India (RBI) is likely to buy government securities.
2. If the rupee is rapidly depreciating, RBI is likely to sell dollars in the market.
3. If interest rates in the USA or European Union were to fall, that is likely to induce RBI to buy dollars.
Which of the statements given below is/are correct?
Statement 1 is incorrect. Typically, the RBI uses open market operations to sell government securities to drain money from the system and control inflation. Buying government securities would inject money into the system, potentially fueling inflation further. Statement 2 is correct. Selling dollars in the market - If the rupee is rapidly depreciating, the RBI might intervene in the foreign exchange market by selling dollars from its reserves. This increased supply of dollars in the market can help stabilize the exchange rate and slow down the depreciation of the rupee. Statement 3 is correct. Lower interest rates in the US/EU make India a more attractive destination for foreign investment, leading to a large inflow of dollars. This causes the rupee to strengthen (appreciate). To prevent the rupee from appreciating too rapidly and hurting exporters, the RBI buys the excess dollars from the market.
India Government Bond Yields are influenced by which of the following?
1. Actions of the United States Federal Reserve.
2. Actions of the Reserve Bank of India.
3. Inflation and short-term interest rates.
Which of the statements given above is/are correct?
Statement 1 is correct: The Federal Reserve's monetary policy decisions, particularly regarding interest rates, can impact global capital flows. If the Fed raises interest rates, it can make US investments more attractive, potentially leading to some outflow of capital from India. This could affect demand for Indian government bonds and influence their yield. Statement 2 is correct: The RBI's monetary policy plays a crucial role in influencing Indian government bond yields. The RBI's actions like setting repo rates, open market operations, and cash reserve ratio (CRR) can affect the overall liquidity in the banking system. Higher liquidity can lead to lower yields, and vice versa. Statement 3 is correct: Inflation expectations and short-term interest rates are important factors for investors when considering the return on government bonds. Higher inflation expectations can lead investors to demand higher yields to compensate for the potential erosion of purchasing power. Similarly, short-term interest rates can act as a benchmark for bond yields. Therefore, all three factors significantly influence the yields of Indian government bonds.
Which reference to inflation in India, which of the following statements is correct?
Option A and B are incorrect: RBI plays a key/primary role in controlling inflation through its monetary policy. Option C is correct: Decreased money circulation can help control inflation, while increased circulation can contribute to it. Option D is incorrect: Increased money supply shall only increase inflation.