Inflation: measures, causes and control

If one topic is guaranteed to follow you through RBI Grade B, it is inflation. It appears in ESI and Finance & Management, it drives half the General Awareness news about the RBI, and an interview panel at a central bank will almost certainly ask you about it. The good news is that the core ideas are few and stable. Master how inflation is measured, what causes it and what each policy can and cannot do, and you can write on almost any inflation question.

What inflation is

Inflation is a sustained rise in the general price level, which reduces the purchasing power of money. Two words matter. Sustained: a one-off jump in one price is not inflation until it spreads or persists. General: it is about the overall level, measured by an index, not a single item.

The inflation rate is the percentage change in a price index, usually year-on-year: this month's index compared with the same month last year.

Worked example: computing inflation and the base effect

1. Suppose the CPI was 190.0 in March last year and is 199.5 this March. Inflation = (199.5 − 190.0) ÷ 190.0 = 9.5 ÷ 190 = 5.0%.
2. Now the base effect. Suppose the index is 111 this June. If last June it was 104, inflation is 111 ÷ 104 − 1 ≈ 6.7%. If last June there had been a spike to 108, inflation would be 111 ÷ 108 − 1 ≈ 2.8%.

Same prices today, very different headline numbers. A high base (last year's spike) makes this year's inflation look low, and a low base makes it look high. That is why monetary policy statements often discuss base effects when explaining sharp moves in the headline rate.

How India measures inflation

A few points examiners like:

• WPI has no services, and manufactured products carry about two-thirds of its weight. CPI includes services such as housing, health, education and transport.
• Food carries a heavy weight in CPI. In the 2012-base CPI (Combined), food and beverages had a weight of about 46%. That is why food shocks move headline inflation so strongly in India.
• The two indices can diverge sharply. In 2015–16, for instance, WPI inflation was negative for months, driven by falling global commodity and fuel prices, while CPI inflation stayed positive.

Headline and core

• Headline inflation is the change in the full index.
• Core inflation strips out volatile items, usually food and fuel, to show underlying, demand-driven pressure.

India targets headline CPI, on the recommendation of the Urjit Patel Committee (2014). The reasoning: households experience headline prices, and in India food prices feed quickly into wage demands and inflation expectations, so they cannot simply be ignored.

What causes inflation

Two classic frameworks help in descriptive answers:

• The quantity theory, MV = PY. If money supply (M) grows 12% a year, velocity (V) is stable and real output (Y) grows 7%, prices (P) rise by roughly 12 − 7 = 5%. Excess money growth over output growth shows up as inflation in the long run.
• The Phillips curve. In the short run, lower unemployment can come with higher inflation. Once expectations adjust, the trade-off largely disappears, which is why anchoring expectations is the central bank's main job.

Why food inflation is so persistent in India

• Weather: uneven monsoons and heatwaves hit output of vegetables, pulses and cereals.
• Perishability: tomatoes, onions and potatoes have limited storage, so supply shocks turn into price spikes within weeks.
• Structural gaps: India imports a large share of its edible oils and has had recurring shortfalls in pulses.
• Supply chains: post-harvest losses, many intermediaries and gaps in cold storage.
• Changing diets: rising demand for protein-rich foods (milk, eggs, meat, pulses) faster than supply.
• Costs: higher input costs and minimum support prices can add cost-push pressure.

The government's tools are largely on the supply side: buffer stocks and the Price Stabilisation Fund for pulses and onions, open market sales of wheat and rice by the FCI, stock limits under the Essential Commodities Act, 1955, cuts in import duties, and export restrictions (wheat exports were restricted in May 2022 and non-basmati white rice in July 2023). Operation Greens targets the tomato, onion and potato supply chains.

Who gains and who loses

Real interest rate ≈ nominal rate − inflation. A fixed deposit paying 7% with inflation at 5% earns a real return of about 2% (more precisely, 1.07 ÷ 1.05 − 1 ≈ 1.9%). If inflation were 8%, the real return would be negative.

Moderate, stable inflation is not the enemy; high and unpredictable inflation is, because it discourages saving and long-term investment. Falling prices can be just as harmful, because people postpone spending and the real burden of debt rises.

How inflation is controlled

Monetary policy cannot grow tomatoes. Faced with a supply shock, a central bank usually looks through the first-round effect on prices, but acts if the shock starts to spread to wages, core inflation and expectations (the second-round effects). That is the logic of India's flexible inflation-targeting framework, explained in the monetary policy framework guide.

Model answer outline (15 marks)

Question: Why is food inflation a persistent challenge in India? Why can monetary policy alone not solve it?

1. Opening: define food inflation; note food's heavy weight in CPI, so it drives headline inflation and hurts poorer households most.
2. Causes: weather shocks, perishability, pulses and edible oil gaps, supply chain losses, diet shifts, cost pressures.
3. Why monetary policy is limited: interest rates act on demand with a lag, while food shocks come from supply; tightening to fight them can hurt growth without increasing supply.
4. Where monetary policy still matters: preventing second-round effects on wages and core inflation; anchoring expectations.
5. Supply-side measures: cold chains and warehousing, market reform, crop diversification and climate-resilient seeds, better buffer stock management, predictable trade policy, pulses and oilseed missions.
6. Conclusion: coordination between the government's supply-side action and the RBI's focus on expectations.

Short model answer (10 marks)

Question: Distinguish between CPI and WPI. Why does the RBI target CPI inflation?

The Consumer Price Index measures changes in the retail prices of a basket of goods and services bought by households. It is compiled monthly by the National Statistics Office for rural, urban and combined India. The Wholesale Price Index measures changes in the prices of goods at the wholesale or first-transaction level, and is compiled by the Office of the Economic Adviser, DPIIT. The key differences: WPI covers only goods and gives manufactured products the largest weight, while CPI includes services and gives food a large weight.

The RBI targets CPI inflation for three reasons. First, it reflects the cost of living that households actually face. Second, inflation expectations and wage demands are shaped by retail prices, especially food. Third, the Urjit Patel Committee recommended headline CPI as the nominal anchor, and the 2016 amendment to the RBI Act set the target in terms of CPI.

WPI remains useful for tracking producer costs and early signs of pressure, but CPI is the better measure of what inflation means for people.

Practice questions

1. Which index includes services: CPI or WPI?
   • CPI. WPI covers goods only.
2. Who compiles the Wholesale Price Index?
   • The Office of the Economic Adviser, DPIIT.
3. A price index rises from 160 to 168. What is the inflation rate?
   • 5% (8 ÷ 160).
4. Inflation falls from 6% to 4%. This is:
   • Disinflation. Prices still rise, only more slowly.
5. CPI-IW is compiled by which body, and what is it mainly used for?
   • The Labour Bureau; to revise dearness allowance.
6. A deposit pays 8% and inflation is 6%. The real return is about:
   • 2% (more precisely, 1.08 ÷ 1.06 − 1 ≈ 1.9%).

What to do next

• Recompute the base-effect example with this year's actual index values.
• Type the 15-mark answer in 27 minutes.
• Read the agriculture guide for the supply side of food prices.